Trade Creation and Trade Diversion
These are concepts that explain the economic effects of moving into a customs union where trade barriers are removed.
This occurs when consumption shifts from a high cost producer to a low cost producer. In the example below, we assume that France is the most efficient producer of wine. France is willing to supply all of its wine at SFrance. The UK imposes a tariff on all imports of wine from France.
What quantity is supplied by UK suppliers when the tariff is in place?
What quantity is supplied by French suppliers when the tariff is in place?
After joining the EU it is now possible to import wine from France without paying the tariff.
What has happened to the price of wine after the tariff is removed?
What quantity is supplied by UK suppliers after the tariff has been removed?
What quantity is supplied by French suppliers after the tariff has been removed?
What has happened to the quantity sold by the high cost UK supplier after the tariff is removed?
What has happened to the quantity sold by the low cost French supplier after the tariff is removed?
This movement from the high cost supplier to the low cost supplier is trade creation, it can be highlighted on the diagram below.
There has been an increase in consumer surplus of areas 1 + 2 + 3 + 4. On the other hand there has been a reduction in the producer surplus for UK wine producers of area 1 and a loss in government tariff revenues of area 3. This means there will always be a net gain of 2 + 4 when trade creation occurs as a result of a country joining a trading bloc.
This occurs when consumption shifts from a lower cost producer outside the trading bloc a higher cost one within it.
Assume the most efficient producer of lamb in the world is New Zealand. Before joining a customs union the UK will place an identical tariff on lamb imported from any country, this is shown on the diagram below.
At an equilibrium price of PNZ+t UK producers would supply up to Q3 and New Zealand would supply Q3 to Q4.
After joining the EU the tariff on French lamb will be removed. This reduces the price from PNZ+t to PFrance. Trade diversion now takes place as consumption switches from the low cost New Zealand farmers to the higher cost French farmers.
Why is the price of French lamb cheaper than New Zealand’s if the French are a higher cost producer?
UK producers would supply up to Q1 and France would supply Q1 to Q2.
This will lead to a reduction in worldwide efficiency. As far as the UK is concerned there will be gains and losses in welfare.
There will be a gain in consumer surplus, however the will be a fall in producer surplus and government revenue from the tariff.
On the diagram below it is possible to highlight the gains and losses in welfare:
- There has been an increase in consumer surplus of areas 1 + 2 + 3 + 4.
- There has been a reduction in the producer surplus of UK lamb producers of area 1.
- There will be a loss of government tariff revenue of 3 + 5.
The will be a net loss in UK welfare if 2 + 4 < 5. It is possible that trade diversion will lead to an increase in UK welfare if 2 + 4 > 5, this is shown below. Whether there is a net loss or net gain will depend upon how the elasticity of domestic demand and the size of the initial tariff.