Importance of Trade Creation Versus Trade Diversion - Essay Example

Most countries, both developed and developing countries have opened their economies with a view to take advantage of the existing opportunities. However, it is not clear whether the benefits and costs of increased trade integration between these countries depends on the relative importance of trade creation versus trade diversion, plus the dynamic gains from integration. The focus of this paper is to ascertain whether in light of the countries involved, the above connotation is true. Trade creation and trade diversion are two important components in increasing the rate of growth of world trade.

They are also important components that help increase the benefits and costs of increased trade integration. Viner (2009) was the first researcher to introduce the terms “trade creation versus trade diversion” which became useful in analyzing custom unions and other trade related economics issues. Trade creation as envisaged by Viner (2009) refers to a situation in which two countries operating within customs union start trading with each other whereas they formerly produced products in questions for themselves.

In international economics terms, it implies that these countries move from autarky to trading with no tariffs on these goods while they both benefit. In trade creation the cost of goods in consideration decreases upon the economic union formation leading to increased efficiency of economic integration. This means that the essence of trade creation is to eliminate custom tariffs on the unifying state’s inner borders causing further decrease in the prices of goods (El-Agraa, 1981). On the other hand, trade diversion, occur whenever two countries start trading within the union (Institute for the integration of Latin America and the Caribbean, 2004).

But formerly, these two countries imported the product or from outside the union. In this case, importing country had previously had same tariffs on other countries, but had opted to buy from outside the union because that was somewhat lower (Institute for the integration of Latin America and the Caribbean, 2004). The country then switches its purchases from its initial lowest price to the higher price country after the union. This eventually has a negative efficiency effect. Basically what this means is that trade diversion involves diverting trade flows from the actual cost-efficient partner countries to less efficient partner countries, which became an economic union member and made its products cheaper within the union but somewhat higher when compared to the other place in the world.

Worth nothing is the fact that both trade diversion and trade creation effects occur because of formation of economic union. Currently, efficiency of economic integration of unions is assessed as the final outcome between trade diversion and trade creation effects (Irwin, 2006). Trade diversions as discussed involves creating free-trade areas, and is important in creating larger markets, which provide more completion as it creates increased access to raw materials (Institute for the integration of Latin America and the Caribbean, 2004).

The happy ending will be the lower unit costs because firms can now gain economies of scale in this arrangement. From the point of view of consumers, greater choices and lower prices makes them happy too. On the other hand, in trade creation two countries involved reduce tariffs on their goods. It can also imply simplifying export or import procedures thus reducing bureaucracy.