Trade diversion:

Fig demonstrates  as  to how  trade diversion could be welfare reducing to  a country that enters into an FTA.  It  shows the  supply and demand  curves for country  A.  PB and  PC represent  the  free trade supply prices of the  good from countries  B  and  C, respectively. We  assume that A has a specific tariff t^B  =  t^C  =  t* set on imports from both countries B and C. The  tariff raises  the domestic supply prices to PTB  and PTC,  respectively. The size  ofthe  tariff  is equal to P_T^B  - P^B  = P_T^C  - P^C.  It  is quite clear that country A  will import the product from country C and will not trade initially with country B. Imports would be to the order of D₁- S¹.

After countries A and B form an FTA, A would impose zero tariff on imports from country B. Consequently, the domestic prices on goods from countries B and  C  would be PB  and PTC, respectively. Since P^B  < P_T^C,  country A would import only from country B after the FTA. At the lower domestic price,  PB, imports would  rise  to  D²  - S²  . Since the initial price in country C is lesser than the price in country B, imports from B are considered as diverted from a more efficient supplier C to a less efficient supplier B.