Trade Creation and Trade Diversion

A preferential trade agreement (PTA) gives imports from member countries more favourable market access than comparable imports from non-members, usually through lower tariffs. Trade creation occurs when this preference causes higher-cost domestic production to be replaced by lower-cost imports from a member country. Trade diversion occurs when imports shift from a lower-cost non-member supplier to a higher-cost member supplier because the latter receives preferential treatment.

The core distinction

The distinction is based on the source of imports before and after preferential treatment, and on underlying production costs rather than tariff-inclusive prices alone.

• In trade creation, a member country begins importing a product from another member instead of producing it domestically at a higher resource cost.
• Trade creation usually increases imports and specialization within the agreement, producing efficiency gains and wider consumption opportunities.
• In trade diversion, a member replaces imports from an efficient non-member supplier with imports from a less efficient member supplier.
• Trade diversion arises because the tariff preference can make the member's product privately cheaper even when its production cost is higher.
• The same agreement can create trade in some products while diverting trade in others.

How preferential agreements alter trade flows

By creating different tariff treatment for members and non-members, a PTA changes relative landed prices and therefore the geographical source of imports.

• Removal or reduction of internal tariffs can increase exports between member countries and expand intra-bloc trade.
• Higher-cost domestic producers in an importing member may lose market share to more efficient producers in another member.
• Non-member exporters may lose sales when the preferential margin allows member suppliers to undercut them.
• A non-member can be disadvantaged even if the tariff applied to it is unchanged, because the tariff on competing member goods has been reduced.
• In a free trade area, members remove barriers among themselves while retaining separate external tariffs; in a customs union, they also adopt a common external tariff.

Welfare and policy significance

The overall effect of a PTA depends on the balance between trade creation and trade diversion, together with changes in consumer gains, producer income and government tariff revenue.

• Trade creation generally improves resource allocation because costly domestic production is replaced by lower-cost partner production.
• Consumers commonly benefit from lower prices and greater availability of imported goods following preferential liberalisation.
• Trade diversion can reduce economic efficiency because production shifts away from the lowest-cost global supplier.
• When imports shift from a tariff-paying non-member to a duty-free member, the importing government may lose tariff revenue.
• Member-country exporters may gain market access, while displaced domestic producers and non-member exporters may lose.
• An increase in intra-member trade does not by itself prove that the agreement has raised overall welfare; the counterfactual source and cost of supply must be examined.
• Lower external barriers and inclusion of efficient, competitive suppliers generally reduce the likelihood and cost of trade diversion.

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