Home > Economics FAQs Blogs > Do Trading Blocs Create Trade Diversion?
This question pertains to Macroeconomics and International Trade, covering concepts such as Trade Creation, Trade Diversion, and Economic Integration.
Trading Blocs: Agreements between countries to reduce or eliminate trade barriers, such as tariffs and quotas, among member nations. Examples include the EU, NAFTA (now USMCA), and ASEAN.
Trade Diversion: Occurs when a country switches imports from a more efficient, low-cost producer outside the bloc to a higher-cost producer within the bloc due to tariff preferences.
Trading blocs increase trade among member nations, but they can also lead to trade diversion, which may reduce overall global efficiency.
How Trade Diversion Happens:
Before joining a bloc, a country imports from the most efficient global producer (e.g., if the UK imported cars from Japan due to lower costs).
After joining, the bloc imposes external tariffs on non-members, making imports from Japan more expensive.
The UK may now import from a higher-cost producer within the bloc (e.g., Germany) simply because tariffs on intra-bloc trade are lower.
Effects of Trade Diversion:
Higher Prices for Consumers:
Switching to a less efficient producer means consumers pay more for goods and services.
Reduced Global Efficiency:
Resources are not allocated to their most efficient use, leading to potential economic inefficiencies.
Potential Retaliation from Non-Member Countries:
Countries outside the bloc may impose counter-tariffs, reducing overall global trade.
When Trade Diversion is Likely to Occur:
If the external tariff is high, making non-member imports much more expensive.
If the new trade partners inside the bloc are less efficient than the previous global suppliers.
In blocs with strong protectionist policies, such as the EU’s Common Agricultural Policy (CAP), which protects high-cost European farmers over cheaper global alternatives.
Brexit and Trade Diversion (2021-Present): The UK’s exit from the EU led to higher tariffs on European imports, shifting trade patterns towards the US and Asia.
African Continental Free Trade Area (AfCFTA, 2023): Expected to create both trade creation and trade diversion, depending on external tariff structures.
Trading blocs can create trade diversion if less efficient member countries replace lower-cost global suppliers due to tariff preferences. This reduces consumer welfare and global efficiency, although trade blocs may still bring benefits through trade creation, investment flows, and economic integration. The impact depends on the size of external tariffs, competitiveness of member countries, and the structure of the trading bloc.
