Essential definitions

Trade creation

Lower-cost partner production replaces higher-cost domestic production after integration.

Trade diversion

A preference switches imports from a lower-cost non-member to a higher-cost member.

Trade creation saves production resources

Trade creation occurs when removing a barrier replaces higher-cost domestic output with cheaper partner imports. Suppose the domestic resource cost is 15 currency units per item and a partner can supply at 10. Removing the tariff that kept the partner out can save 5 in resources for each replaced domestic unit. Lower prices may also expand consumption.

The resource saving is different from eliminating a tax payment. A tariff collected domestically transfers purchasing power to government; the underlying production cost is what matters for efficiency. State costs and prices per unit before comparing them.

Trade diversion can accompany lower prices

Now suppose an outsider supplies at 8 and the partner at 10. Initially both face a tariff of 4, so imports come from the outsider at a consumer price of 12. Remove the tariff only for the partner: consumers choose its price of 10 over the outsider's 12.

Buyers pay less, but production has switched from a supplier costing 8 to one costing 10. Government also loses tariff revenue. This is trade diversion. Consumer gains and quantity changes must be weighed against higher resource costs and revenue losses to find the national effect. Creation and diversion can occur in different markets within the same agreement; one example cannot establish the whole bloc's welfare result.

Apply and evaluate

• Integration can create some trade and divert other trade simultaneously.
• Compare real resource costs, tax revenue and changes in quantities before judging the net effect.