Background
Trade diversion refers to an economic phenomenon associated with customs unions and free trade agreements where the flow of trade shifts from more cost-efficient suppliers outside the union to less cost-efficient suppliers within the union. This shift occurs because the elimination of tariffs among member countries makes goods from within the union cheaper compared to previously lower-cost imports from non-member countries that are now subject to tariffs.
Historical Context
The concept of trade diversion was prominently introduced by economist Jacob Viner in his 1950 book “The Customs Union Issue.” Viner analyzed the effects of customs unions on member and non-member countries, distinguishing between the beneficial effects of trade creation and the potentially adverse effects of trade diversion.
Definitions and Concepts
Trade Diversion
The redirection of trade away from more efficient non-member producers to less efficient member producers because of tariff differentials within a customs union.
Trade Creation
The process where trade increases between member countries of a customs union due to the removal of tariffs and other trade barriers, leading to welfare improvements as trade occurs with the most efficient producers within the union.
Major Analytical Frameworks
Classical Economics
In the classical framework, trade diversion is examined through the lens of comparative advantage and the efficiency of resource allocation. Classical economists would critique trade diversion for moving away from more efficient global trade patterns.
Neoclassical Economics
Neoclassical models analyze trade diversion in terms of consumer and producer surplus. Economists study how tariff elimination within the customs union impacts prices, production, and consumption, ultimately leading either to welfare gains or welfare losses.
Keynesian Economics
Keynesian analysis would focus on the macroeconomic implications of trade diversion, particularly how changes in trade patterns impact aggregate demand, employment, and growth within member and non-member countries.
Marxian Economics
From a Marxian perspective, trade diversion can be seen as an instrument for capitalist states to fortify their economic dominance and manage intra- and inter-state trade relationships aligning with their interests. Marxian economists might analyze the socioeconomic impacts on labor and capital across different regions.
Institutional Economics
Institutional economics would examine the political and social institutions that influence trade policy decisions leading to trade diversion, including the role of government, trade agreements, and international organizations.
Behavioral Economics
Behavioral economics considers how cognitive biases and heuristic-driven decisions by policymakers and firms influence the formation and outcomes of customs unions, potentially exacerbating or mitigating trade diversion effects.
Post-Keynesian Economics
Focused on the dynamics of economic systems, post-Keynesian scholars would analyze how trade diversion impacts effective demand, especially on non-member countries where high tariffs may lead to economic dislocations.
Austrian Economics
The Austrian school would criticize trade diversion for distorting market signals and interfering with the price mechanism, arguing that free trade based on comparative advantage is more beneficial for overall welfare.
Development Economics
Development economists would be particularly concerned with how trade diversion impacts developing countries, often excluded from large trade blocs, thereby affecting their economic growth and development prospects.
Monetarism
Monetarist analysis of trade diversion might emphasize the effects on money supply, inflation management, and the balance of payments for countries both inside and outside the customs union.
Comparative Analysis
Comparing trade creation and trade diversion highlights their contrasting impacts on economic welfare. While trade creation can enhance aggregate welfare through efficiency gains and lower consumer prices, trade diversion may lead to welfare losses by shifting imports toward less efficient producers. Therefore, the net effect of a customs union depends on the balance between these two forces.
Case Studies
- The European Union: An investigation into how EU membership’s expansion has influenced trade patterns and welfare within the union and neighboring countries.
- NAFTA: Analysis of trade between the USA, Canada, and Mexico, with specific focus on the instances of trade diversion versus trade creation.
- ASEAN Free Trade Area: The impact on ASEAN member states and external countries due to intraregional trade preferences.
Suggested Books for Further Studies
- The Customs Union Issue by Jacob Viner
- Economics of Customs Unions by W.R. Cline
- International Economics: Theory and Policy by Paul Krugman and Maurice Obstfeld
- Trade Blocs by Peter Robson
Related Terms with Definitions
- Customs Union: An agreement between countries to remove tariffs and adopt a common external tariff against non-members.
- Free Trade Area: A region where member countries have eliminated tariffs and other barriers to trade among themselves, but maintain individual external tariffs.
- Preferential Trade Agreement: A trading bloc that gives preferential access to certain products from participating countries through reduced tariffs or other agreements.
