Trade diversion

Trade diversion

Last updated: Mar 13, 2021

One of the significant effects of the rise of trading blocs is that global trade patterns are affected - both in terms of trade within a trading bloc and trade between countries in one bloc and those in another bloc.

Trading blocs

There are ten1 major trading blocs in the global economy, ranging from simple preferential trade areas (PTAs) where members reduce or eliminate tariffs between themselves, to more comprehensive customs unions with an agreed common external tariffs - such as the European Union.

As a member of a trading bloc there will be an incentive to trade more with other members given that barriers to trade are likely to have been fully eliminated. Trade is likely to be based on national specialisation and the exploitation of comparative advantage. The gains from membership that come from free trade within the bloc is called trade creation.

Over time, existing firms develop closer trading relationships with their partners, and new firms emerge as a result of new opportunities to trade. The net result is that trade flows between members are likely to increase increase.

As trade increases ‘dynamic effects’ may appear, including costs reduction as a result of economies of scale, increased competition, and greater efficiency. Productivity is also likely to increase, and the GDP of bloc members will rise accordingly. The popularity of Gravity Theory has also lent weight to the ‘consensus’ that trade is created as a result of the existence of regional trading blocs and increases when they are enlarged.

Trade diversion

However, as members trade more with each other, they tend to trade less with non-members who are often based in more distant regions of the world. The potential downside of the rise of trading blocs is that members lose the opportunity to trade with, perhaps, super-efficient non-members.

Europe

Following the UK’s entry into Europe’s Common Market in 1972, trade with members increased by 180% (between 1972 and 1978) while UK trade with its old commonwealth nations (Australia, Canada, New Zealand and South Africa) fell by 44%.

While trade patterns clearly changed as a result of trade creation in industrial goods as a result of the UK joining the Common Market, it is less clear how much of the 44% reduction in trade with commonwealth countries can count as trade diversion in the sense that there were efficiency losses. Many economists have attempted to quantify the possible trade effects of membership of a trading bloc - especially the EU2.

There is a consensus that ‘all outcomes’ are possible, from a strongly ‘trade diversion’ effect to a strongly ‘trade creation’ effect. Studies have also indicated that the net effect varies from industry or sector to industry, and the individual characteristics of countries, such as whether they are landlocked.

US-China

Though not members of a trading bloc, trade relations between China and the US provide another possible case of trade diversion. The recent trade war between the US and China has been studied in terms of how other countries have benefitted from the increased tariffs on Chinese imports.

For example, a study by Unctad in 20193 found that Taiwan, Mexico, the EU, Vietnam and Canada all increased their trade with the US as a result of the trade restriction on China. The major sectors to gain were office equipment, communications technology, electrical machinery and chemicals.


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1. Culturalrelations.org - Viewed March 10 2021, http://culturalrelations.org/the-10-major-regional-trading-blocs-in-the-world-economy/

2. Kwentua, G.M. (2006) Trade creation and trade diversion effects in the EU-South Africa Free Trade Agreement, Louisiana State University, Viewed 10th June 2020, https://core.ac.uk/download/pdf/217391872.pdf

3. Nicita, A (2019), Trade and trade diversion effects of United States tariffs on China, Trade Analysis Branch Division on International Trade and Commodities UNCTAD, viewed May 21st 2020, https://unctad.org/system/files/official-document/ser-rp-2019d9_en.pdf

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