These concepts are used to distinguish between the effects of free trade area or customs union formation that may be beneficial from those that are detrimental.

Trade Creation

This occurs when consumption shifts from a high cost producer to a low cost producer.  If we assume that France is the most efficient producer of wine.  After joining the EC it is now possible to import wine from France without paying the tariff.  This will lead to an efficiency gain to UK consumers. 

The diagram above shows that before joining the EC the UK had to pay the French price plus the tariff, P₁.  At P₁ the UK produced Q₂, consumed Q₁, and therefore imported Q₁ – Q₂.  With the removal of the tariff the price falls to P₂.  Consumption increases to Q₃ and domestic production falls to Q₄.  Imports have therefore increased to Q₃ -  Q₄.  Trade has been created.

The gain in welfare from the removal of the tariff can also be demonstrated in the diagram above.  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 of 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.

Trade Diversion

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 – a country outside of the EC.  Assume that before membership the UK an identical tariff on lamb from any country, it would therefore import lamb from New Zealand rather than the EC.

After joining the EC the removal of the tariff made the EC lamb cheaper as the tariff remains on the New Zealand lamb.  Consumption is therefore switched to the higher cost EC lamb.  This will lead to a reduction in worldwide efficiency.  As far as the UK is concerned there will be gains and losses in welfare.

In the diagram overleaf, before joining the EC the UK was importing lamb from New Zealand at price P₁ (the New Zealand price the tariff).  At this price the UK consumed Q₁, produced Q₂ domestically and therefore imported the remainder Q₁ – Q₂.  On joining the EC it is now possible to consume the EC tariff free price of P₂ (this is above the New Zealand tariff free price of P₃).  It is possible to state 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.

These theories of trade creation and trade diversion hold for any good, e.g., agricultural goods (CAP).

A trading bloc is more likely to lead to trade diversion rather than trade creation if:

• When the bloc’s external tariff is very high.  Under these circumstances the abolition of the tariff within the union is likely to lead to a large reduction in the price of the goods imported from any other country within the bloc.
• When there is a relatively small cost difference between goods purchased with and outside the bloc.  Here the abolition of even relatively low tariffs will lead to internally goods becoming cheaper than externally produced ones.

Preferential trade arrangements are often supported because they represent a movement in the direction of free trade. If free trade is economically the most efficient policy, it would seem to follow that any movement towards free trade should be beneficial in terms of economic efficiency. It turns out that this conclusion is wrong. Even if free trade is most efficient, it is not true that a step in that direction necessarily raises economic efficiency. Whether a preferential trade arrangement raises a country's welfare and raises economic efficiency depends on the extent to which the arrangement causes trade diversion versus trade creation.

Aggregate Welfare Effects of a Free Trade Area

The analysis above considers the welfare effects upon participants in one particular market in one country that is entering into a free trade area. However, when a free trade area is formed, presumably many markets and multiple countries are affected, not just one. Thus to analyse the aggregate effects of a FTA (Free Trade Agreement), one would need to sum up the effects across markets and across countries.

The simple way to do that is to imagine that a country entering a FTA may have some import markets in which trade creation would occur and other markets in which trade diversion would occur. The markets with trade creation would definitely generate national welfare gains while the markets with trade diversion may generate national welfare losses. It is common for economists to make the following statement, "If the positive effects from trade creation are larger than the negative effects from trade diversion, then the FTA will improve national welfare." A more succinct statement, though also somewhat less accurate, is that "if a FTA causes more trade creation than trade diversion then the FTA is welfare improving."

However, the converse statement is also possible, i.e., "if a FTA causes more trade diversion than trade creation then the FTA may be welfare reducing for a country." This case is actually quite interesting since it suggests that a movement to free trade by a group of countries may actually reduce the national welfare of the countries involved. This means that a movement in the direction of a more efficient free trade policy may not raise economic efficiency. Although this result may seem counterintuitive, it can easily be reconciled in terms of the theory of the second-best (not required knowledge for the A2 examination).

Free Trade Areas and the Theory of the Second-Best

One might ask, if free trade is economically the most efficient policy, how can it be that a movement to free trade by a group of countries can reduce economic efficiency? The answer is quite simple once we put the story of FTA formation into the context of the theory of the second-best. Second-best theory suggests that when there are distortions or imperfections in a market, then the addition of another distortion (like a trade policy) could actually raise welfare, or economic efficiency. In the case of a FTA, the policy change is the removal of trade barriers rather than the addition of a new trade policy. However, the second-best theory works much the same in reverse.

Before a country enters a FTA it has policy imposed distortions already in place in the form of tariff barriers applied on imports of goods. This means that the initial equilibrium can be characterized as a second-best equilibrium. When the FTA is formed some of these distortions are removed, i.e., the tariffs applied to one's FTA partners. However, other distortions remain, i.e., tariffs applied against the non-member countries. If the partial tariff removal substantially raises the negative effects caused by the remaining tariff barriers with the non-FTA countries, then the efficiency improvements caused by free trade within the FTA could be outweighed by the negative welfare effects caused by the remaining barriers outside the FTA and national welfare could fall.

This is in essence what happens in the case of trade diversion. Trade diversion occurs when a FTA shifts imports from a more efficient supplier to a less efficient supplier which by itself causes a reduction in national welfare. Although the economy also benefits through the elimination of the domestic distortions, if these benefits are smaller than the supplier efficiency loss, then national welfare falls. In general, the only way to assure that trade liberalization will lead to efficiency improvements is if a country removes its trade barriers against all countries.