Trade Diversion

Trade diversion occurs when tariff preferences cause a country to replace imports from a lower-cost non-member with imports from a higher-cost member. It is a possible consequence of a preferential trade agreement (PTA) because members receive more favourable market access than outsiders.

How trade diversion occurs

Before the agreement, the importing country may buy from the most efficient global producer despite imposing a tariff. After granting a partner a lower or zero preferential tariff, the partner's product can become cheaper in the domestic market even though its production cost is higher.

• The switch is caused by differential tariffs rather than an improvement in the partner's productive efficiency.
• The preference creates discrimination against suppliers still facing the most-favoured-nation tariff.
• For example, imports may shift from an efficient non-member charging 100 units to a member charging 110 units because only the former faces the tariff.

Welfare implications

Trade diversion contrasts with trade creation, in which preferential liberalisation replaces costly domestic production with cheaper imports from a partner.

• Trade diversion weakens efficient global allocation because production shifts to a higher-cost source.
• The importing government loses tariff revenue previously collected on non-member imports.
• Consumers may gain from a lower domestic price, but the resource-cost increase and revenue loss can make the overall welfare effect adverse.
• A PTA's net welfare effect depends on the balance between trade creation and trade diversion, alongside terms-of-trade effects.

When it is likely and why it matters for India

• Diversion is more likely when the agreement maintains a high external tariff and the preferred partner is less competitive than available non-members.
• Developed-country PTAs can divert import demand away from efficient Indian exporters if competing members receive tariff preferences.
• When assessing India's own trade agreements, policymakers must compare partner costs with world prices and consider possible losses of customs revenue, not merely the rise in bilateral trade.

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