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TRADE CREATION AND TRADE DIVERSION

Updated on June 12, 2012

Illustrated that when trade barriers between countries are removed, the coun- tries and their industries will concentrate on the most efficient use of resources and trade for those goods that they are inefficient at producing. The result is that both coun-tries will gain from trade.....a win-win situation. The question is whether similar gains from trade will be realized when free trade is limited to one group of countries. The answer to this question may by yes and no, depending on whether established trade- ing patterns are disrupted by the establishment of a trading bloc. The entry of Spain into the European Union provides an interesting example of trade creation and trade diversion.

In 1986, Spain formally entered the European Union (EU) as a member. Prior to membership, Spain...like all nonmembers such as the United States, Canada, and Japan...trade with the EU and suffered from the common external tariff imposed by the EU. Imports of agricultural products from Spain or the United States had the same tariff applied to their products, for example, 20 percent. During this period, the United States was a lower-cost producer of wheat compared to Spain. U.S. exports to EU members may have cost $3.00 per bushel, plus a 20 percent tariff of $0.60, for a to tall of $3.60 per bushel. If Spain at the same time produced wheat at $3.20 per bushel, Spain's wheat was more expensive and therefore less competitive.

But when Spain joined the EU as a member, its products were no longer subject to the common external tariffs; Spain had become a member of the ''club'' and therefore enjoyed its benefits. Spain was now the low-cost producer of wheat at $3.20 per bushel, compared to the price of $3.60 from the United States. Trade flows changed as a result. The increased export of wheat and other products by Spain to the EU as a result of its membership is termed trade creation. The elimination of the tariff literally created more trade between Spain and the EU. At the same time, because the United States is still outside of the EU, its products suffer the higher price as a result of the tariff applicant- tion. U.S. exports to the EU ell. When the source of trading competitiveness is shifted in this manner from one country to another it is termed trade diversion.

Whereas trade creation is distinctly positive in moving toward freer trade, and therefore lower prices for consumers within the EU, the impact of trade diversion in nega- tive. Trade diversion is inherently negative because the competitive advantage has shifted away from the lower-cost producer to the higher-cost producer. The benefits of Spain's membership are enjoyed by Spanish farmers (greater export sales) and EU consumers (lower prices). The two major costs are reduced tariff revenues collected and costs borne by the United States and its exports as a result of lost sales.

From the perspective of nonmembers like the United States, the formation or ex- pension of a customs union is obviously negative. Most damaged will naturally be coun- tries that may need to have trade to build their economies, such as the countries of the Third World . From the perspective of members of the customs union, the formation or expansion of a customs union is only beneficial if the trade-creation benefits exceed trade-diversion costs.

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