International Trade - Theory and Policy, 2010a

trade within the FTA could be outweighed by the negative welfare effects caused by the remaining barriers
outside the FTA, and national welfare could fall.
This is, in essence, what happens in the case of trade diversion. Trade diversion occurs when an FTA shifts
imports from a more-efficient supplier to a less-efficient supplier, which by itself causes a reduction in
national welfare. Although the economy also benefits through the elimination of the domestic distortions,
if these benefits are smaller than the supplier efficiency loss, then national welfare falls. In general, the
only way to assure that trade liberalization will lead to efficiency improvements is if a country removes its
trade barriers against all countries.
KEY TAKEAWAYS
Countries can integrate by reducing barriers to trade under multilateral arrangements like the WTO or by
entering into regional arrangements, including preferential trade agreements, free trade agreements,
customs unions, common markets, or monetary unions.
The formation of a free trade area can lead to trade creation or trade diversion.
Trade creation involves new trade that would not exist without the FTA and is always beneficial for the
countries in terms of national welfare.
Trade diversion involves the shifting of trade away from one country toward one’s free trade partner and
is sometimes detrimental to the countries in terms of national welfare.
Losses caused by trade diversion can be understood in terms of the theory of the second best; because
one market distortion remains when another is removed, welfare can fall.
EXERCISE
1. Jeopardy Questions. As in the popular television game show, you are given an answer to a
question and you must respond with the question. For example, if the answer is “a tax on
imports,” then the correct question is “What is a tariff?”
1. An arrangement in which a group of countries agrees to eliminate tariffs among
themselves but maintain their own external tariff on imports from the rest of the world.
2. The term used to describe a change in the pattern of trade in response to trade liberalization in
which a country begins to import from a less-efficient supplier.
3. The term used to describe a change in the pattern of trade in response to trade liberalization in
which a country begins to import from a more-efficient supplier.
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