Trade diversion is the decrease in trade following the formation of a trading bloc as trade with low cost non-trading bloc members is replaced by trade with relatively high cost trading bloc members.
Trade creation and diversion are important direct effects of the formation of a customs union. Trade creation will mean that consumption shifts from a high-cost producer to a low-cost producer and trade therefore expands.
In a situation where countries do not trade freely, by imposing tariffs, or by favouring one country over another in terms of tariff levels, trade will be distorted and the pattern of trade will change. Inefficient producers may be protected and encouraged, at the expense of more efficient imports.
The creation of a customs union, with common external tariffs , will further alter the existing pattern of trade flows. The assumption is that before the union, members imposed differential tariffs on different countries to protect their own industries.
At the same time, New Zealand could produce the same quantity for p, and Denmark could produce it for p. Hence, prior to the formation of a customs union, New Zealand has a comparative advantage in butter, and is the most efficient. Denmark is the second most efficient producer, and the UK is the least efficient. Let us assume that, in order to protect its inefficient farmers equally, the UK imposes differential tariffs on New Zealand and Denmark in order to raise the imported price above its own high cost butter.
We will also assume that, with these tariffs in place, a total demand of 30m kg of butter exists in the UK each year, with UK farmers supplying 20m kg the maximum it can produce , and New Zealand and Danish farmers supply 5m kg each.
Once a union is created, members agree to eliminate tariffs between themselves. The effect of this is that, facing lower priced, zero-tariff, imports from members, consumers increase their demand for these goods, and new trade will be created — a process called trade creation. For example, if Denmark and the UK form a customs union, tariffs on Danish butter must now be reduced, and once they are completely removed, the free market price of p will be highly attractive to UK consumers.
UK consumers will now consume more butter in total because average butter prices will have fallen with the removal of tariffs on Danish butter, and total demand for butter rises. For example, total output and consumption might increase to 32m kgs up by 2m , with UK farmers down from 20m to 15m, New Zealand exports collapsing to just 2m, and Denmark increasing its output and sales of butter to the UK to 10m from 5m to 10m.
A regional free trade agreement will benefit the world only if the amount of trade it creates exceeds the amount it diverts. It refers to the situation where lower cost imports are replaced by higher cost imports from a member after the formation of the bloc. Trade creation: Trade creation is the amplified trade that occurs between member countries of trading blocs following the arrangement or development of the trading block.
It is an economic term associated with international economics in which trade is created by the arrangement of a social union. This comes about as the exclusion of trade barriers allows greater specialization according to proportional advantage. This means that prices can drop and trade can thus enlarge.
In a PTA, countries would offer tariff reductions, though perhaps not eliminations, to a set of partner countries in some product categories. Higher tariffs, perhaps nondiscriminatory tariffs, would remain in all other product categories. Discrimination or preferential treatment for some countries is not allowed. The country is free to charge a higher tariff on imports from non-WTO members, however.
In , the United States proposed legislation to eliminate tariffs on imports from the nations in sub-Saharan Africa. This action represents a unilateral preferential trade agreement since tariffs would be reduced in one direction but not the other. A free trade area FTA A situation in which a group of countries agrees to eliminate tariffs among themselves but maintain their own external tariff on imports from the rest of the world.
A customs union occurs when a group of countries agrees to eliminate tariffs among themselves and set a common external tariff on imports from the rest of the world. The European Union EU represents such an arrangement. A customs union avoids the problem of developing complicated rules of origin but introduces the problem of policy coordination. With a customs union, all member countries must be able to agree on tariff rates across many different import industries. A common market establishes free trade in goods and services, sets common external tariffs among members, and also allows for the free mobility of capital and labor across countries.
The EU was established as a common market by the Treaty of Rome in , although it took a long time for the transition to take place. Today, EU citizens have a common passport, can work in any EU member country, and can invest throughout the union without restriction. An economic union typically will maintain free trade in goods and services, set common external tariffs among members, allow the free mobility of capital and labor, and also relegate some fiscal spending responsibilities to a supranational agency.
A monetary union establishes a common currency among a group of countries. This involves the formation of a central monetary authority that will determine monetary policy for the entire group. The Maastricht treaty, signed by EU members in , proposed the implementation of a single European currency the Euro by Perhaps the best example of an economic and monetary union is the United States.
Each U. However, each state cedes control, to some extent, over foreign policy, agricultural policy, welfare policy, and monetary policy to the federal government. Goods, services, labor, and capital can all move freely, without restrictions among the U.
In the post—World War II period, many nations pursued the objective of trade liberalization. Since GATT and WTO agreements commit all member nations to reduce trade barriers simultaneously, the agreements are sometimes referred to as a multilateral approach to trade liberalization. An alternative method used by many countries to achieve trade liberalization includes the formation of preferential trade arrangements, free trade areas, customs unions, and common markets. Since many of these agreements involve geographically contiguous countries, these methods are sometimes referred to as a regional approach to trade liberalization.
The key question of interest concerning the formation of preferential trade arrangements is whether these arrangements are a good thing.
If so, under what conditions? If not, why not? One reason supporters of free trade may support regional trade arrangements is because they are seen to represent movements toward free trade. Indeed, Section 24 of the original GATT allows signatory countries to form free trade agreements and customs unions despite the fact that preferential agreements violate the principle of nondiscrimination. When a free trade area or customs union is formed between two or more WTO member countries, they agree to lower their tariffs to zero between each other but will maintain their tariffs against other WTO countries.
Thus the free trade area is a discriminatory policy. Presumably, the reason these agreements are tolerated within the WTO is because they represent significant commitments to free trade, which is another fundamental goal of the WTO. However, there is also some concern among economists that regional trade agreements may make it more difficult, rather than easier, to achieve the ultimate objective of global free trade.
The fear is that although regional trade agreements will liberalize trade among their member countries, the arrangements may also increase incentives to raise protectionist trade barriers against countries outside the area.
For this reason, some economists have argued that the multilateral approach to trade liberalization, represented by the trade liberalization agreements in successive WTO rounds, is more likely to achieve global free trade than the regional or preferential approach.
Much has been written on this subject recently. Here we have merely scratched the surface.
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