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Trade creation is an economic term related to international economics in which trade flows are redirected due to the formation of a free trade area or a customs union. The issue was firstly brought into discussion by Jacob Viner (1950), together with the trade diversion effect.
In the former case after the formation of economic union, the cost of the goods considered is decreased, leading to an increase of efficiency of economic integration. Hence, trade creation's essence is in elimination of customs tariffs on inner border of unifying states (usually already trading with each other), causing further decrease of price of the goods, while there may be a case of new trade flow creation of the goods between the states decided to economically integrate.
The opposite takes place in case of trade diversion, when the trade flow is diverted from actually cost-efficient partner state to less efficient one – but which became a member of economic union and made its goods cheaper within a union, but higher compared to the rest of the world. In practice, both trade creation and diversion effects take place due to formation of economic union. Efficiency of economic integration of specific union right now is assessed as a final outcome between trade creation and diversion effects: it is cost-effective in case of prevailing of the trade creation effects, and vice versa.
Occurrence of Trade Creation
When a customs union is formed, the member nations establish a free trade area amongst themselves and a common external tariff on non-member nations. As a result, the member nations establish greater trading ties between themselves now that protectionist barriers such as tariffs, import quotas, non-tariff barriers and subsidies have been eliminated. The result is an increase in trade among member nations in the good or service of each nation's comparative advantage. In other words, increase in trade causes greater revenues, (more profitable).
Downside of Trade Creation
The creation of trade is important to the nation entering the customs union in that increased specialization may hurt other industries. Arguments for protectionism, such as the infant industry argument, national defense, outsourcing, and issues with health and safety regulations are brought to mind. However, customs unions are typically formed with friendly nations, eliminating the national defense argument.
- Regional Integration and Cooperation in Sub-Saharan Africa: Are Formal Trade Agreements the Right Strategy? - this Harvard Institute for International Development discussion paper from 1997 argues that "[T]here is little reason to expect significant economic gains from formal trade agreements at this time. Such agreements, in and of themselves, are unlikely to yield appreciable benefits unless they are preceded by decisions within member countries to follow more general open trade strategies." It summarizes the conclusion of empirical research that there has been "little, if any, impact on intra-regional trade" (i.e. trade creation) from developing nation customs union formation. Many possible reasons are listed for the lack of trade creation evidence, given that developed nation customs unions do seem to have "stimulated increased trade and economic growth".
- The dynamics of trade creation and diversion effects under international economic integration. Ravshanbek Dalimov. Current Research Journal of Economic Theory, 2009, vol. 1. - An article proposes to use similarity between dynamics of gas and liquid moving under pressure difference, and the dynamics of trade flows (output) moved under price difference. This allowed to use Navier-Stokes equation applied for the dynamics of gas and liquid towards the dynamics of inter-regional trade flows. An input of the method to analysis of the trade flows lies in direct linking of price and output dynamics, while Jacob Viner's analysis was classically static consideration.