Effects of Regional Trade Agreements – Trade Creation and Trade Diversion
Liberalisation of trade by eliminating tariffs within a free trade area or customs union has both benefits and costs because it affects resource allocation within countries. The effects of economic integration through regional trade agreement have been divided into two categories – Trade Creation and Trade Diversion.
Trade Creation –
The favourable effect on world trade, when through free trade agreement two countries mutually eliminates tariffs, is called Trade Creation.
This trade creation occurs because producers in one member country to a free trade agreement are able to sell some products in another member country at cheaper prices than their domestic producers as their domestic producers lose tariff protection as a result of free trade agreement.
For example, when NAFTA eliminated tariffs between the member countries, both USA and Mexico as members, some Mexican forms found that they could sell some of their products in the USA at cheaper prices than the domestic American forms, while some American firms also found that they could sell some of their products in Mexico at cheaper prices than the Mexican firms. This led to more trade between Mexico and the USA. This happened due to the elimination of tariffs between the member countries of the free trade area which caused the change in the prices of goods.
Suppose before NAFTA, Mexico was imposing 25℅ tariff on imports of computers. After the elimination of tariffs American computers became cheaper in Mexico than the prices of the domestic producers of computers in Mexico. This will lead to more exports of American computers in Mexico.
Similarly, Mexican firms also found that they could sell some of their products in the USA at cheaper prices than their domestic American competitors.
In this way, NAFTA led to more trade between member countries with beneficial effects on resource allocation. This trade creation leads to the gain in efficiency in the use and allocation of resources as more efficient member countries of free trade area displaced less efficient countries for protection of various goods.
Trade Diversion –
Regional free trade agreements such as FTA, NAFTA and customs union has also bad effects on world trade. When as a result of elimination of tariffs trade between member countries of a free trade area increases, it causes export losses to the non-member countries. These export losses to non-member countries which are known as Trade Diversion.
Trade Diversion causes loss of efficiency in resource use because less efficient member countries of a free trade area displace more efficient non-member countries.
So, from global perspective trade diversion represents an inefficient use of resources.
Whether or not regional trade agreement between some countries increases world trade depends on as to whether trade creation effect is larger than trade diversion.
From the narrow national point of view of members of free trade agreement, it causes some gains as well as some loss. In so far as there is common desire to increase domestic production in the member countries of free trade area, it brings mutual benefits to the member countries. It gives producers of the member countries of FTA an advantage over producers of the rest of the world. This cause increase in production of goods and services in the member countries of FTA or Customs Union and also trade between them. It also leads to reduction of trade of members of a union with non-member countries.