Trade Creation vs Trade Diversion: What’s the Difference?
Learn the difference between trade creation and trade diversion, with simple cost examples showing how removing tariffs can change where a country buys goods.
Trade creation happens when a trade agreement leads a country to buy a product from a lower-cost producer in another member country instead of producing it domestically. Trade diversion happens when it switches from a lower-cost producer outside the agreement to a higher-cost producer inside it because the member no longer faces an import tariff.
Why does the switch happen?
A tariff is a tax on imports. In a free trade area or customs union, members remove tariffs on trade between themselves. That can make a member’s product cheaper for buyers, even when a non-member can produce it at a lower cost.
For trade creation, suppose a product costs 121212 currency units to make domestically and 999 to import from a member after the tariff is removed. Buying from the member replaces more expensive domestic production with cheaper imports.
For trade diversion, suppose a non-member produces the product for 888 currency units and a member produces it for 999. Before the agreement, a tariff of 222 on imports from either country makes the non-member’s product cost 101010 to buyers, compared with 111111 for the member’s. Afterwards, the member’s tariff is removed, so buyers pay 999 for its product but still pay 101010 for the non-member’s. They switch to the member, although the non-member remains the lower-cost producer.
The key exam mistake is to call any increase in trade with a member trade creation. Check who supplied the product before the agreement: if domestic production is replaced by cheaper imports, it is trade creation; if lower-cost imports from a non-member are replaced by higher-cost imports from a member, it is trade diversion. Trade creation generally improves resource allocation, while trade diversion can make it less efficient.
