Trade Creation

Trade created due to regional economic integration; occurs when high-cost domestic producers are replaced by low-cost foreign producers in a free trade area.

Trade Diversion

Trade diverted due to regional economic integration; occurs when low-cost foreign suppliers outside a free trade area are replaced by higher-cost foreign suppliers in a free trade area.

Suppose the United States and Mexico imposed tariffs on imports from all countries, and then they set up a free trade area, scrapping all trade barriers between themselves but maintaining tariffs on imports from the rest of the world. If the United States began to import textiles from Mexico, would this change be for the better? If the United States previously produced all its own textiles at a higher cost than Mexico, then the free trade agreement has shifted production to the cheaper source. According to the theory of comparative advantage, trade has been created within the regional grouping, and there would be no decrease in trade with the rest of the world. Clearly, the change would be for the better. If, however, the United States previously imported textiles from Costa Rica, which produced them more cheaply than either Mexico or the United States, then trade has been diverted from a low-cost source—a change for the worse.

ANOTHER PERSPECTIVE China Complains to WTO Against the U.S. Solar Protectionism

The United States Department of Commerce (DOC) recently imposed import tariffs from 31 percent to 250 percent on Chinese solar panel manufacturers, accusing Beijing of dumping the solar cells in the U.S. It all started in October when seven solar firms, including SolarWorld A.G. (ETR:SWV), filed a complaint with the U.S. International Trade Commission and Commerce accusing the Chinese solar cell manufacturers of improper trade practices. The U.S. immediately started investigating into the matter, which eventually led to trade barriers. This compelled China to start its own investigation into the U.S. in November. According to China’s mission to WTO headquarters in Geneva, the U.S. investigation process was inconsistent with “WTO rules and rulings in many aspects.” If the U.S. import subsidies were meant to support the local solar industry, which has witnessed four bankruptcies in the past year, then it has missed its target by miles. The U.S. actions could have initiated a trade war between the two biggest economies of the world. The U.S. and other western economies are going through a period of financial recovery. Their focus is on cutting down expenses and creating more jobs. Under such circumstances, according to WTO chief Pascal Lamy, the wrong thing to do is to erect more trade barriers, which can provide short-term relief at the cost of long-term damage.

Source: Excerpted from “China Complains to WTO Against the U.S. Solar Protectionism,” by Sarfaraz Khan, May 26, 2012, http://solarpvinvestor.com/spvi-news/222-china-complains-to-wto-against-the-us-solar-protectionism. Reprinted with permission.

In theory, WTO rules should ensure that a free trade agreement does not result in trade diversion. These rules allow free trade areas to be formed only if the members set tariffs that are not higher or more restrictive to outsiders than the ones previously in effect. However, as we saw in Chapter 7, GATT and the WTO do not cover some nontariff barriers. As a result, regional trade blocs could emerge whose markets are protected from outside competition by high nontariff barriers. In such cases, the trade diversion effects might outweigh the trade creation effects. The only way to guard against this possibility, according to those concerned about this potential, is to increase the scope of the WTO so it covers nontariff barriers to trade. There is no sign that this is going to occur anytime soon, however, so the risk remains that regional economic integration will result in trade diversion.

• QUICK STUDY

What are the main economic arguments against regional economic integration?

When does the establishment of a regional bloc result in trade creation? When does it result in trade diversion?

Regional Economic Integration in Europe

LEARNING OBJECTIVE 4

Explain the history, current scope, and future prospects of the world’s most important regional economic agreements.

Europe has two trade blocs—the European Union and the European Free Trade Association. Of the two, the EU is by far the more significant, not just in terms of membership (the EU currently has 27 members; the EFTA has 4), but also in terms of economic and political influence in the world economy. Many now see the EU as an emerging economic and political superpower of the same order as the United States. Accordingly, we will concentrate our attention on the EU. 6