Question

who can show me by illustration the different between trade creation and trade diversion?

Answer 1

Trade Diversion

Trade diversion is best described as a shift in domestic consumer spending from a lower cost world source to a higher cost partner source (e.g. from another country within the EU-15) as a result of the elimination of tariffs on imports from the partner. The common external tariff on many goods and services coming into the EU makes imports more expensive. This can lead to higher costs for producers and higher prices for consumers if previously they had access to a lower cost / lower price supply from a non-EU country. The diagram next illustrates the potential welfare consequences of imposing an import tariff on goods and services coming into the European Union.

Trade Creation

This involves a shift in domestic consumer spending from a higher cost domestic source to a lower cost partner source within the EU, as a result of the abolition tariffs on intra-union trade. So for example UK households may switch their spending on car and home insurance away from a higher-priced UK supplier towards a French insurance company operating in the UK market.

Similarly, Western European car manufacturers may be able to find and then benefit from a cheaper source of glass or rubber for tyres from other countries within the customs union than if they were reliant on domestic supply sources with trade restrictions in place. Trade creation should stimulate an increase in intra-EU trade within the customs union and should, in theory, lead to an improvement in the efficient allocation of scarce resources and gains in consumer and producer welfare.