Trade Creation

We have seen already in our study of tariffs that imposing a tariff results in some efficiency losses to a country's economy. Economic integration has the opposite result - by removing tariffs for member countries, this loss becomes a gain.

In a protected market, the price of a good is P_w(1+t). By removing tariffs, members of an economic bloc reduce the price back to the world price P_w. The area FCH, which was the production distortion loss due to the tariff, and the area GID, which was the consumption distortion loss, are both restored to the economy. These two areas are now gains when the tariff is removed. (1)

Trade Diversion

Economic integration can also lead to trade diversion, which is not in the best interest of all member countries.

Trade diversion occurs when member countries are not the most efficient producers of a good. Member countries will still trade with the countries offering the best price, but the economic bloc can distort these prices.

Suppose the price of a good in the world market is P_w, and member countries impose a tariff t so that the domestic price is P_w(1+t). Suppose there is also a member country M that produces this good at a price P_m. This is higher than P_w because M is not the most efficient producer.

Now, with a tariff on imports from M, the price is P_m(1+t). Because this is higher than P_w(1+t), member countries will import from the world market rather than the member country M.

However, if tariffs are removed on imports from member countries, then M will offer the price P_m, which is now lower than the world price (which includes the tariff). Thus, the economic integration results in trade being diverted from external countries to member countries.

What effect does this have on an importing country's economy?

By reducing the price from P_w(1+t) to P_m, some efficiency losses (2) are regained. However, there are still some efficiency losses that are not recovered. (2)