Trade diversion

Definition

Trade diversion refers to the phenomenon where trade patterns shift as a result of preferential trade agreements or trade restrictions, leading to the replacement of more efficient external suppliers with less efficient internal suppliers. This change can affect the overall efficiency of resource allocation in an economy, as it may create a situation where countries import goods from partners within a trade agreement instead of sourcing them from the global market where they might be available at lower prices. Trade diversion is often contrasted with trade creation, where trade agreements lead to a more efficient allocation of resources by fostering trade between countries.

5 Must Know Facts For Your Next Test

1. Trade diversion can result in higher prices for consumers since they may be paying more for goods sourced from less efficient producers within the trade bloc.
2. The concept highlights the potential downsides of preferential trading arrangements, as they can lead to inefficiencies in global resource allocation.
3. Countries may experience varying effects from trade diversion based on their relative economic size, productivity levels, and competitive advantages.
4. Trade diversion can weaken incentives for domestic industries to innovate or become more competitive since they may rely on protected markets within a trading bloc.
5. It is important to assess the net impact of trade diversion against trade creation to understand the overall benefits or costs of a particular trade policy.

Review Questions

• How does trade diversion impact consumer prices within a trading bloc?
  • Trade diversion often leads to higher consumer prices within a trading bloc because it shifts imports away from more efficient external suppliers to less efficient internal suppliers. This occurs when countries favor imports from partners within the trade agreement due to lower tariffs or other incentives, even if those goods are available at lower costs elsewhere. Consequently, consumers may face increased prices for goods that could have been cheaper if sourced from outside the bloc.
• In what ways does trade diversion contrast with trade creation when assessing the effects of trade agreements?
  • Trade diversion contrasts with trade creation in that while trade creation enhances overall economic efficiency by shifting consumption towards lower-cost producers, trade diversion can lead to inefficiencies by prioritizing higher-cost internal suppliers over more efficient external alternatives. Evaluating both phenomena helps policymakers understand the net effects of trade agreements; ideally, agreements should aim for more trade creation than diversion to maximize welfare benefits.
• Evaluate the long-term implications of persistent trade diversion on domestic industries and overall economic growth within a country.
  • Persistent trade diversion can have significant long-term implications for domestic industries and overall economic growth. By relying on less efficient internal suppliers, domestic industries may lack incentives to innovate or improve productivity due to reduced competitive pressures. This can lead to stagnation and limited growth prospects as resources are not allocated optimally. Furthermore, if consumer preferences shift due to higher prices or lower quality goods resulting from trade diversion, it could hinder economic dynamism and adaptability in an increasingly competitive global market.

Related terms

trade creation:

Trade creation occurs when a trade agreement leads to the importation of goods from a more efficient producer, replacing less efficient domestic production and resulting in an overall increase in economic welfare.

customs union: A customs union is a type of trade agreement where member countries eliminate tariffs on trade between themselves and adopt a common external tariff on imports from non-member countries.

regional trade agreement: A regional trade agreement is an arrangement between countries in a specific region to facilitate trade by reducing tariffs and other barriers, which can lead to both trade creation and trade diversion.