International Trade (Intl Trade) 101: Trade Policy and Agreements - Trade Creation vs. Trade, Diversion Static and Dynamic Effects

What This Is

Trade creation and trade diversion are two distinct concepts in international trade that have significant implications for businesses and economies. Trade creation occurs when a trade agreement or policy change leads to an increase in trade between countries, resulting in a more efficient allocation of resources. On the other hand, trade diversion occurs when a trade agreement or policy change leads to a shift in trade from a more efficient supplier to a less efficient one, resulting in a misallocation of resources. For example, consider a shipment of electronics from China to the US. If a trade agreement reduces tariffs on electronics, trade creation occurs if the US imports more electronics from China, which is a more efficient supplier. However, if the trade agreement leads to a shift in trade from a more efficient supplier in Japan to a less efficient one in China, trade diversion occurs.

Key Terms & Rules

• Trade Creation: An increase in trade between countries due to a trade agreement or policy change, resulting in a more efficient allocation of resources.
• Trade Diversion: A shift in trade from a more efficient supplier to a less efficient one due to a trade agreement or policy change, resulting in a misallocation of resources.
• Static Effects: The immediate effects of a trade agreement or policy change on trade, which can be either trade creation or trade diversion.
• Dynamic Effects: The long-term effects of a trade agreement or policy change on trade, which can lead to changes in productivity, investment, and economic growth.
• Comparative Advantage: The concept that countries should specialize in producing goods and services for which they have a lower opportunity cost, leading to trade creation.
• Preferential Trade Agreements (PTAs): Trade agreements that reduce tariffs and other trade barriers between participating countries, which can lead to trade creation or trade diversion.
• Most-Favored-Nation (MFN) Tariffs: Tariffs applied to non-participating countries, which can lead to trade diversion if a country shifts trade from a more efficient supplier to a less efficient one.
• Harmonized System (HS) Codes: A standardized system of classifying goods for customs purposes, which can affect trade creation or trade diversion.
• Incoterms: A set of rules for international trade that defines the responsibilities of buyers and sellers, which can affect trade creation or trade diversion.
• Uniform Customs and Practice for Documentary Credits (UCP 600): A set of rules governing letter of credit transactions, which can affect trade creation or trade diversion.

Step-by-Step Process

1. Analyze the Trade Agreement or Policy Change: Determine whether the agreement or policy change is likely to lead to trade creation or trade diversion.
2. Assess the Comparative Advantage: Evaluate whether the countries involved in the trade have a comparative advantage in producing the goods or services being traded.
3. Examine the Tariffs and Trade Barriers: Determine whether the tariffs and trade barriers are likely to lead to trade creation or trade diversion.
4. Consider the Dynamic Effects: Evaluate whether the trade agreement or policy change is likely to lead to changes in productivity, investment, and economic growth.
5. Monitor the Trade Flows: Track the trade flows to determine whether trade creation or trade diversion is occurring.

Common Mistakes

• Mistake: Assuming that all trade agreements lead to trade creation.
• Correction: Trade agreements can lead to either trade creation or trade diversion, depending on the specific circumstances.
• Example: A trade agreement between the US and China reduces tariffs on electronics, but leads to a shift in trade from a more efficient supplier in Japan to a less efficient one in China, resulting in trade diversion.
• Mistake: Failing to consider the dynamic effects of a trade agreement or policy change.
• Correction: The dynamic effects of a trade agreement or policy change can lead to changes in productivity, investment, and economic growth, which can affect trade creation or trade diversion.
• Example: A trade agreement between the US and Mexico leads to an increase in trade, but also leads to changes in productivity and investment, resulting in dynamic effects that affect trade creation or trade diversion.

Exam / Certification Tips

• Common Question Patterns: Trade exams often ask questions about the effects of trade agreements or policy changes on trade creation or trade diversion.
• Tricky Distinctions: Be able to distinguish between trade creation and trade diversion, and understand the implications of each.
• Memory Aids: Use the following memory aid to remember the difference between trade creation and trade diversion: "Trade creation is like a river flowing smoothly, while trade diversion is like a river flowing into a swamp."
• Key Concepts: Make sure to understand the key concepts of comparative advantage, tariffs, and trade barriers, and how they affect trade creation or trade diversion.

Quick Practice Scenario

Scenario: A Chinese exporter sells electronics to a US importer under FOB Shanghai. Who pays for the main carriage?

Answer: The US importer pays for the main carriage.

Explanation: Under FOB Shanghai, the seller is responsible for delivering the goods to the buyer at the port of Shanghai, but the buyer is responsible for the main carriage from the port to their destination.

Last-Minute Cram Sheet

• Trade creation occurs when a trade agreement or policy change leads to an increase in trade between countries.
• Trade diversion occurs when a trade agreement or policy change leads to a shift in trade from a more efficient supplier to a less efficient one.
• Comparative advantage is the concept that countries should specialize in producing goods and services for which they have a lower opportunity cost.
• Preferential trade agreements (PTAs) can lead to trade creation or trade diversion.
• Most-favored-nation (MFN) tariffs can lead to trade diversion if a country shifts trade from a more efficient supplier to a less efficient one.
• Harmonized System (HS) codes affect trade creation or trade diversion.
• Incoterms define the responsibilities of buyers and sellers in international trade.
• Uniform Customs and Practice for Documentary Credits (UCP 600) governs letter of credit transactions.
• Trade agreements can have dynamic effects that lead to changes in productivity, investment, and economic growth.
• Trade creation is like a river flowing smoothly, while trade diversion is like a river flowing into a swamp.
• Under FOB, the seller is responsible for delivering the goods to the buyer at the port, but the buyer is responsible for the main carriage from the port to their destination.
• Trade diversion can occur even if the tariffs are reduced.
• Trade creation can occur even if the tariffs are increased.
• Comparative advantage is not the only factor that affects trade creation or trade diversion.