These concepts are used to distinguish between the
effects of free trade area or customs union formation that may be beneficial
from those that are detrimental.
This occurs when consumption shifts from a high cost
producer to a low cost producer. If
we assume that France is the most efficient producer of wine.
After joining the EC it is now possible to import wine from France
without paying the tariff. This will lead to an efficiency gain to UK consumers.
The diagram above shows that before joining the EC the
UK had to pay the French price plus the tariff, P1.
At P1 the UK produced Q2, consumed Q1,
and therefore imported Q1 – Q2.
With the removal of the tariff the price falls to P2.
Consumption increases to Q3 and domestic production falls
to Q4. Imports have
therefore increased to Q3 - Q4.
Trade has been created.
The gain in welfare from the removal of the tariff can
also be demonstrated in the diagram above.
There has been an increase in consumer surplus of areas 1 + 2 + 3 + 4.
On the other hand there has been a reduction in the producer surplus
of UK wine producers of area 1 and a loss in government tariff revenues of
area 3. This means there will
always be a net gain of 2 + 4 when trade creation occurs as a result of a
country joining a trading bloc.
This occurs when consumption shifts from a lower cost
producer outside the trading bloc a higher cost one within it.
Assume the most efficient producer of lamb in the world
is New Zealand – a country outside of the EC.
Assume that before membership the UK an identical tariff on lamb from
any country, it would therefore import lamb from New Zealand rather than the
After joining the EC the removal of the tariff made the
EC lamb cheaper as the tariff remains on the New Zealand lamb.
Consumption is therefore switched to the higher cost EC lamb.
This will lead to a reduction in worldwide efficiency.
As far as the UK is concerned there will be gains and losses in
In the diagram overleaf, before joining the EC the UK
was importing lamb from New Zealand at price P1 (the New Zealand
price the tariff). At this price
the UK consumed Q1, produced Q2 domestically and
therefore imported the remainder Q1 – Q2. On joining the EC it is now possible to consume the EC tariff
free price of P2 (this is above the New Zealand tariff free price
of P3). It is
possible to state the gains and losses in welfare:
has been an increase in consumer surplus of areas 1 + 2 + 3 + 4.
has been a reduction in the producer surplus of UK lamb producers of area
will be a loss of government tariff revenue of 3 + 5.
The will be a net loss in UK welfare if 2 + 4 < 5.
It is possible that trade diversion will lead to an increase in UK
welfare if 2 + 4 > 5, this is shown below.
These theories of trade creation and trade diversion
hold for any good, e.g., agricultural goods (CAP).
A trading bloc is more likely to lead to trade diversion
rather than trade creation if:
the bloc’s external tariff is very high.
Under these circumstances the abolition of the tariff within the
union is likely to lead to a large reduction in the price of the goods
imported from any other country within the bloc.
there is a relatively small cost difference between goods purchased with
and outside the bloc. Here
the abolition of even relatively low tariffs will lead to internally goods
becoming cheaper than externally produced ones.
Preferential trade arrangements are often supported
because they represent a movement in the direction of free trade. If free
trade is economically the most efficient policy, it would seem to follow that
any movement towards free trade should be beneficial in terms of economic
efficiency. It turns out that this conclusion is wrong. Even if free trade is
most efficient, it is not true that a step in that direction necessarily
raises economic efficiency. Whether a preferential trade arrangement raises a
country's welfare and raises economic efficiency depends on the extent to
which the arrangement causes trade diversion versus trade creation.
Aggregate Welfare Effects of a Free Trade Area
The analysis above considers the welfare effects upon
participants in one particular market in one country that is entering into a
free trade area. However, when a free trade area is formed, presumably many
markets and multiple countries are affected, not just one. Thus to analyse
the aggregate effects of a FTA (Free Trade Agreement), one would need to sum
up the effects across markets and across countries.
The simple way to do that is to imagine that a country
entering a FTA may have some import markets in which trade creation would
occur and other markets in which trade diversion would occur. The markets
with trade creation would definitely generate national welfare gains while
the markets with trade diversion may generate national welfare
losses. It is common for economists to make the following statement, "If
the positive effects from trade creation are larger than the negative effects
from trade diversion, then the FTA will improve national welfare." A
more succinct statement, though also somewhat less accurate, is that "if
a FTA causes more trade creation than trade diversion then the FTA is welfare
However, the converse statement is also possible, i.e.,
"if a FTA causes more trade diversion than trade creation then the FTA
may be welfare reducing for a country." This case is actually
quite interesting since it suggests that a movement to free trade by a group
of countries may actually reduce the national welfare of the countries
involved. This means that a movement in the direction of a more efficient
free trade policy may not raise economic efficiency. Although this result may
seem counterintuitive, it can easily be reconciled in terms of the theory of
the second-best (not required knowledge for the A2 examination).
Free Trade Areas and the Theory of the Second-Best
One might ask, if free trade is economically the most
efficient policy, how can it be that a movement to free trade by a group of
countries can reduce economic efficiency? The answer is quite simple once we
put the story of FTA formation into the context of the theory of the
second-best. Second-best theory suggests that when there are distortions or
imperfections in a market, then the addition of another distortion (like a
trade policy) could actually raise welfare, or economic efficiency. In the
case of a FTA, the policy change is the removal of trade barriers rather than
the addition of a new trade policy. However, the second-best theory works
much the same in reverse.
Before a country enters a FTA it has policy imposed
distortions already in place in the form of tariff barriers applied on
imports of goods. This means that the initial equilibrium can be
characterized as a second-best equilibrium. When the FTA is formed some of
these distortions are removed, i.e., the tariffs applied to one's FTA
partners. However, other distortions remain, i.e., tariffs applied against
the non-member countries. If the partial tariff removal substantially raises
the negative effects caused by the remaining tariff barriers with the non-FTA
countries, then the efficiency improvements caused by free trade within the
FTA could be outweighed by the negative welfare effects caused by the
remaining barriers outside the FTA and national welfare could fall.
This is in essence what happens in the case of trade
diversion. Trade diversion occurs when a FTA shifts imports from a more
efficient supplier to a less efficient supplier which by itself causes a
reduction in national welfare. Although the economy also benefits through the
elimination of the domestic distortions, if these benefits are smaller than
the supplier efficiency loss, then national welfare falls. In general, the
only way to assure that trade liberalization will lead to efficiency
improvements is if a country removes its trade barriers against all