Trading blocs, trade creation and trade diversion

Overview

Trading bloc, difference between a free trade area and a customs union and trade creation.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What is a trading bloc?

   Model answer

   A trading bloc is a group of countries that agree to reduce or remove trade barriers among themselves while continuing to treat non-members differently. Blocs vary in depth from simple tariff removal on goods to arrangements that cover services, capital, labour mobility and a common currency, and the degree of integration determines how much national policy autonomy members give up.

2. 2

   What is the difference between a free trade area and a customs union?

   Model answer

   In a free trade area members abolish tariffs on trade between themselves but each keeps its own external tariff on imports from outside the area. In a customs union members abolish internal tariffs and also adopt a common external tariff, so imports face the same duty whichever member they enter through. The difference has a practical consequence: a free trade area needs rules of origin to stop goods entering through the lowest-tariff member and being forwarded onward duty free, whereas a customs union does not, but a customs union requires members to negotiate external trade policy jointly and so surrender more independence.

3. 3

   How do a customs union, a single market and a monetary union differ from one another?

   Model answer

   A customs union removes internal tariffs and sets a common external tariff on goods. A single market goes further by removing non-tariff barriers as well, harmonising or mutually recognising regulations and permitting the free movement of services, capital and often labour, so that firms face one set of rules across the whole area. A monetary union replaces national currencies with a single currency and a single monetary policy, removing exchange rate risk and transaction costs between members but also removing each member's ability to set its own interest rate or let its currency adjust.

4. 4

   What are rules of origin and why does a free trade area need them?

   Model answer

   Rules of origin are the criteria determining which country a good is deemed to come from, typically based on where it was substantially transformed or on the share of local content. A free trade area needs them because members keep different external tariffs, so without such rules an importer could bring goods into the member with the lowest external tariff and then move them tariff free to a member with a high one, a practice known as trade deflection. The rules are administratively burdensome and can themselves become a barrier where the local content thresholds are set high.

5. 5

   What is trade creation?

   Model answer

   Trade creation occurs when the formation of a bloc causes a country to replace higher-cost domestic production with lower-cost imports from a partner. Because the good is now supplied by whoever produces it most cheaply among the members, real resources are saved and the change raises welfare.

6. 6

   What is trade diversion?

   Model answer

   Trade diversion occurs when the formation of a bloc causes a country to switch its imports from a lower-cost outside supplier to a higher-cost partner, purely because the partner's goods now enter tariff free while the outsider's still face duty. Real resources are wasted because the good is now made by a less efficient producer, and the country also loses the tariff revenue it previously collected, so the change can reduce welfare.

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