Short Essay on Trade Creation and Diversion

Assuming static conditions, Viner contends that the production effect of a customs union depends on the “trade creation” and “trade diversion” effects of discriminatory tariffs.

Trade creation effect refers to the expansion of trade between the member countries owing to the elimination of inter- union tariffs, so that, the size of market for certain commodities may increase, which in turn permits to increase output and gain economies of scale, thereby increasing the efficiency of production.

Further, elimination of tariffs and other barriers will permit member countries to specialise in the production of goods according to the principles of comparative advantage, so that, the resources will be transferred from the inefficient to efficient utilisation, thereby, lowering the costs and prices which would promote mutual trade between union members. Thus, a trade creating effect, by shifting the production from a high-cost source to a lower cost source, constitutes a movement towards freer trade within the union.

However, a part of the increased trade and specialisation among the member countries is likely to be at the cost of trade and specialisation between the union and the outside countries. Because the removal of tariffs within and adoption of a common external tariff by the union members against outside countries decrease the competitive strength of the former so that, the members’ imports from outside will decline while those from member countries would rise.

Similarly, the union members’ exports to outside countries will also decline as their exports are mostly diverted to their fellow constituent countries, on account of the free movement of trade. Moreover, outside countries may also restrict their imports from union members. Such diversification of trade from outside countries to constituent countries in the customs union is referred to as “trade diversion effect.” Under trade diversion effect, the inefficient domestic production of certain commodities is stimulated; hence, the resources are not optimally used. This effect as such as a detrimental effect on productive efficiency. Further, under this effect when production is shifted uneconomically from lower cost (outside sources) to higher cost (union sources), it leads to a movement away from free trade.

The meaning of trade creation and diversion can be made explicit with the help of a numerical example:

Suppose, there are three countries A, B and C. In producing commodity X, let us assume that, their respective costs are Rs. 10, Rs. 8 and Rs. 9 per unit. Further, we may assume that A imposes a tariff of Rs. 4 on imports from B and C. Likewise, B and C also impose a tariff of Rs. 2 on their imports. In this case, there will be least possibility of any trade between these countries, as each one would find imports costlier than home production. Now suppose A and C combine in a customs union and impose a uniform external tariff of Rs. 3.

Then A will import the product from C as there is no tariff within the union. So it will get X at Rs. 9 (which is cheaper than domestic cost — Rs. 10). And, A will not import from B because it will cost Rs. 11 (Rs. 8 + Rs. 3 tariff). This is, thus, a case of trade creation, where the place of production is moved (from A’s Rs. 10 cost – higher cost) to a lower cost source (country C – where cost is Rs. 9 per unit), so that, production efficiency is increased.

On the other hand, if we assume that A imposes originally a tariff of Rs. 1.50 per unit and B and C impose a tariff of Rs. 2 per unit on their imports. Then A would import from B at Rs. 9.50. Now, if A and C combine in a customs union and impose an external tariff of Rs. 1.80. Then A will import from C at Rs. 9 and stop buying from B as it would cost Rs.9.80 now. This situation represents trade diversion since, production is shifted from a low-cost source-country B, to a high-cost source- country C, hence, a decline in production efficiency is visualised.

Briefly, thus, trade creation effect leads to the efficient reallocation of productive resources resulting in an increase in production whereas, trade diversion effect alters the resources in an inefficient way which causes a decrease in the productive efficiency. Apparently, the total production effect of the customs union depends on the difference between the trade creating and trade diverting effects. A ‘positive’ difference means an increase, while a ‘negative’ difference implies a decrease in world production.