PPFs

Trade diversion

The establishment of trading blocs means that trade patterns will be affected, both in terms of trade within a trading bloc and trade between members and non-members.

Trading blocs can be simple preferential trade areas (PTAs) where members reduce or eliminate tariffs between themselves, or more comprehensive customs unions with an agreed common external tariffs.

As a member of a trading bloc there will be an incentive to trade more with other members (called trade creation) given that barriers to trade are likely to be fully eliminated. Trade is likely to be based on national specialisation and the exploitation of comparative advantage.

Over time, as firms develop trading relationships with their partners, trade flows will increase.

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

However, as members trade more with each other, they may trade less with non-members who are often based in more distant regions of the world. The potential danger here is that members may suffer because they cannot now trade freely with super-efficient non-members.

Europe

Following the UK’s entry into Europe’s Common Market, trade with members increase 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 certainly changed and trade in industrial goods was clearly created 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 EU.

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.

US-China

Though not members of a trading bloc, trade relations between China and the US provide another case where trade diversion can be witnessed. 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.

A study by Unctad in 2019 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.

PPFs
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