Regional trading blocs and trade creation:

Trade creation means that a free  trade area  (ITA),  through preferential tariff concessions, creates trade that would not have existed otherwise. As a result, sunnlv  occnrs  finm a more eficient nrodncer of  the nroduct within a free  trade area. In all cases trade creation will  raise a country's national welfare,  as imports  replace high-cost domestic production.

Trade diversion means that a free trade area diverts  trade, away from a more efficient supplier  outside  the FTA, towards a less efficient supplier within the FTA. In some cases, trade &version will reduce a country's  national welfare but in some cases national welfare could improve despite the  trade diversion. Jacob Viner introduced  the key concepts of trade creation and trade diversion in his pioneering study of the theory of customs unions. Through a simple model, Viner  showed that forming a customs union could have welfare- increasing effects whereas it could have welfare-reducing effects in other circumstances.

This  is  illustrated  in  the Table, which,  shows production cost of  a homogeneous product in three countries.

Assuming  that the production cost determines the price of the good and tariffs remain as  the only source of divergence between price and cost it  is  possible  to understand the effects  of preferential  tariff liberalisation  under a  customs  union. Initially if Ximposes a tariff of 100  per cent, demand  in Xwould have a choice among domestic products at a price of 500, imports from Y at a price of 800, and imports from Z at a price of 600. In such a situation, X would not import the good.

If Xmd Y form a customs union and impose the same 100 per cent tariff on imports  from Z,  consumers  in X will  face a choice between indigenous products at a price of 500, imports from Y at a price of 400, and imports  from Z at a price of 600. X would then import the good from Y.  This is an example of trade creation, which  replaces relatively inefficient (high-cost) indigenous production with efficient (low-cost) imports fiom  the partner country, leading to welfare gains.

In case, before the formation  of a customs  union X levies a  tariff of 50 per cent then consumers demand in Xwould have a choice between domestic goods at a price of 500, important  from Y at a price of 600, and imports from Z at a price of 450. Xwould impod  the good from the lowest-cost import source,  i.e. country Z. At this stage  if X and Y form a customs union consumers in Xwill be faced with the choice of paying 500 for the indigenous products and 400 for imports frpm Y,  and 450 for  imports from Z. X will now import X from Y.  Imports will be switched  fiom  the hwest-cost supplier, Z  to the higher-cost supplier, Y.  This is an example of trade diversion. Trade diversion takes place when a country shifts its source of imports from a more efficient country to a less efficient country because of the tariff-preferences in a customs union. This will lead to a lowering of welfare, as it entails a less efficient allocation of resources.

The  issue  becomes futther  complicated when under a  regional trade agreement (RTA) tariffs are not reduced to liberalised full to make it zero. In which case, the  calculations  to find  out the most-efficient supplier may vary  as the members of the RTA do not have necessarily zero tariffs among them.