Trade creation
Encyclopedia
Trade creation is an economic term related to international economics
in which trade
flows are redirected due to the formation of a free trade area
or a customs union
. The issue was firstly brought into discussion by Jacob Viner (1950), together with the trade diversion
effect. In the former case after the formation of economic union the cost of the goods considered is decreased leading to an increase of efficiency of economic integration. Hence, trade creation's essence is in elimination of customs tariffs on inner border of unifiying states (usually already trading with each other), causing further decrease of price of the goods, while there may be a case of new trade flow creation of the goods between the states decided to economically integrate.
The opposite takes place in case of trade diversion, when the trade flow is diverted from actually cost-efficient partner state to less efficient one - but which became a member of economic union and made its goods cheaper within a union, but higher compared to the rest of the world.
In practice, both trade creation and diversion effects take place due to formation of economic union. Efficiency of economic integration of specific union right now is assessed as a final outcome between trade creation and diversion effects: it is cost-effective in case of prevailing of the trade creation effects, and vice versa.
is formed, the member nations establish a free trade area
amongst themselves and a common external tariff
on non-member nations. As a result, the member nations establish greater trading ties between themselves now that protectionist barriers such as tariffs, import quota
s, and non-tariff barriers such as subsidies have been eliminated. The result is an increase in trade among member nations in the good or service of each nation's comparative advantage
. In other words, increase in trade causes greater revenues, (more profitable).
may hurt other industries. Arguments for protectionism, such as the infant industry argument
, national defense
, outsourcing
, and issues with health and safety regulations are brought to mind. However, customs unions are typically formed with friendly nations, eliminating the national defense argument, and in the long run serves to create more jobs and output due to specialization.
International economics
International economics is concerned with the effects upon economic activity of international differences in productive resources and consumer preferences and the institutions that affect them...
in which trade
Trade
Trade is the transfer of ownership of goods and services from one person or entity to another. Trade is sometimes loosely called commerce or financial transaction or barter. A network that allows trade is called a market. The original form of trade was barter, the direct exchange of goods and...
flows are redirected due to the formation of a free trade area
Free trade area
A free trade area is a trade bloc whose member countries have signed a free trade agreement , which eliminates tariffs, import quotas, and preferences on most goods and services traded between them. If people are also free to move between the countries, in addition to FTA, it would also be...
or a customs union
Customs union
A customs union is a type of trade bloc which is composed of a free trade area with a common external tariff. The participant countries set up common external trade policy, but in some cases they use different import quotas...
. The issue was firstly brought into discussion by Jacob Viner (1950), together with the trade diversion
Trade diversion
Trade diversion is an economic term related to international economics in which trade is diverted from a more efficient exporter towards a less efficient one by the formation of a free trade agreement or a customs union.-Occurrence:...
effect. In the former case after the formation of economic union the cost of the goods considered is decreased leading to an increase of efficiency of economic integration. Hence, trade creation's essence is in elimination of customs tariffs on inner border of unifiying states (usually already trading with each other), causing further decrease of price of the goods, while there may be a case of new trade flow creation of the goods between the states decided to economically integrate.
The opposite takes place in case of trade diversion, when the trade flow is diverted from actually cost-efficient partner state to less efficient one - but which became a member of economic union and made its goods cheaper within a union, but higher compared to the rest of the world.
In practice, both trade creation and diversion effects take place due to formation of economic union. Efficiency of economic integration of specific union right now is assessed as a final outcome between trade creation and diversion effects: it is cost-effective in case of prevailing of the trade creation effects, and vice versa.
Occurrence of Trade Creation
When a customs unionCustoms union
A customs union is a type of trade bloc which is composed of a free trade area with a common external tariff. The participant countries set up common external trade policy, but in some cases they use different import quotas...
is formed, the member nations establish a free trade area
Free trade area
A free trade area is a trade bloc whose member countries have signed a free trade agreement , which eliminates tariffs, import quotas, and preferences on most goods and services traded between them. If people are also free to move between the countries, in addition to FTA, it would also be...
amongst themselves and a common external tariff
Common external tariff
When a group of countries form a customs union they must introduce a common external tariff. The same customs duties, import quotas, preferences or other non-tariff barriers to trade apply to all goods entering the area, regardless of which country within the area they are entering...
on non-member nations. As a result, the member nations establish greater trading ties between themselves now that protectionist barriers such as tariffs, import quota
Import quota
An import quota is a type of protectionist trade restriction that sets a physical limit on the quantity of a good that can be imported into a country in a given period of time....
s, and non-tariff barriers such as subsidies have been eliminated. The result is an increase in trade among member nations in the good or service of each nation's comparative advantage
Comparative advantage
In economics, the law of comparative advantage says that two countries will both gain from trade if, in the absence of trade, they have different relative costs for producing the same goods...
. In other words, increase in trade causes greater revenues, (more profitable).
Downside of Trade Creation
The creation of trade is important to the nation entering the customs union in that increased specializationDepartmentalization
Departmentalization refers to the process of grouping activities into departments.Division of labour creates specialists who need coordination. This coordination is facilitated by grouping specialists together in departments....
may hurt other industries. Arguments for protectionism, such as the infant industry argument
Infant industry argument
The Infant industry argument is an economic rationale for trade protectionism. The core of the argument is that nascent industries often do not have the economies of scale that their older competitors from other countries may have, and thus need to be protected until they can attain similar...
, national defense
Defense (military)
Defense has several uses in the sphere of military application.Personal defense implies measures taken by individual soldiers in protecting themselves whether by use of protective materials such as armor, or field construction of trenches or a bunker, or by using weapons that prevent the enemy...
, outsourcing
Outsourcing
Outsourcing is the process of contracting a business function to someone else.-Overview:The term outsourcing is used inconsistently but usually involves the contracting out of a business function - commonly one previously performed in-house - to an external provider...
, and issues with health and safety regulations are brought to mind. However, customs unions are typically formed with friendly nations, eliminating the national defense argument, and in the long run serves to create more jobs and output due to specialization.
External links
- Regional Integration and Cooperation in Sub-Saharan Africa: Are Formal Trade Agreements the Right Strategy? - this Harvard Institute for International DevelopmentHarvard Institute for International DevelopmentThe Harvard Institute for International Development was a think-tank dedicated to helping nations join the global economy, operating between 1974 and 2000...
discussion paper from 1997 argues that "[T]here is little reason to expect significant economic gains from formal trade agreements at this time. Such agreements, in and of themselves, are unlikely to yield appreciable benefits unless they are preceded by decisions within member countries to follow more general open trade strategies." It summarizes the conclusion of empirical research that there has been "little, if any, impact on intra-regional trade" (i.e. trade creation) from developing nation customs union formation. Many possible reasons are listed for the lack of trade creation evidence, given that developed nation customs unions do seem to have "stimulated increased trade and economic growth".
- The dynamics of trade creation and diversion effects under international economic integration. Ravshanbek Dalimov. Current Research Journal of Economic Theory, 2009, vol. 1. - An article proposes to use similarity between dynamics of gas and liquid moving under pressure difference, and the dynamics of trade flows (output) moved under price difference. This allowed to use Navier-Stokes equation applied for the dynamics of gas and liquid towards the dynamics of inter-regional trade flows. An input of the method to analysis of the trade flows lies in direct linking of price and output dynamics, while Jacob Viner's analysis was classically static consideration.