Trade Creation/ Trade Diversion

Trade Creation

A situation where two countries within the customs union begin to trade with each other, whereas formerly they produced the good in question for themselves.

Trade Diversion

A situation where two countries begin to trade within the union, but one of these countries had formerly imported the good from outside the union.

If there is a country which is a member of the union and imported a good from outside the union because the price was the lowest, after the union, the country switches its purchases from the lowest-price to a higher-price country.

In this case the country could lose from joining the union because of a negative efficiency effect.

What is the Desirability of Customs Unions?

Kemp and Wan 1976 Theorem

Suppose that the customs union keeps the world price p* fixed, or equivalently, keep the purchases from the rest of the world x* fixed.

If each country within the customs union receives the transfers -t1'(mi1-mi0) from the rest of the union, then there is a pattern of lump sum transfers within each country such that no individual is worse off, and the government budget in each country is nonnegative.

What is the Desirability of FTAs?

The Difference between Customs Unions and FTAs

Producer prices must be equalized within the area, but by virtue of their differing tariffs on outside countries, consumer prices can differ within the area.

Krishna and Panagariya 2002 Theorem

Suppose every FTA member import and export the same quantity with the rest of the world as it did before the free-trade area.

Then there is a pattern of lump sum transfers within each country such that no individual is worse off, and the government budget in each country is nonnegative.

Note

To ensure welfare gains, we need to rule out transshipment of goods not produced in the FTA.

In practice, restrictions on such transshipment within FTAs are know as rules of origin.

Within NAFTA, for example, each and every good must be certified as "North American Made" before it can be shipped freely between Mexico, the United States, and Canada.

R. Feenstra, 2004, "Advanced International Trade," p.192-196