Trade Diversion and Trade Creation - Essay Example

Trade Diversion and Trade Creation Introduction Trade as known refers to the transfer of possession of services and goods from one entity to another in exchange of goods or money for other services. This paper is going to talk about various forms of trade. The document addresses trade creation and trade diversion. The paper will also contain diagrams of the trade diversions and the trade establishments. The differences that usually exist between countries before trade diversions and after the trade creations are also considered. Finally, the paper will also discuss some of the effects that lead countries to trade agreements. Trade Diversion and Trade Creation The concept of trade creation and the trade diversion is based on the cost of production and the value of the outcomes among countries or regions. Trade creation arises because of trade deals that occur between different countries that are involved in a spending shift by the domestic consumers. The agreement aims at moving local consumer expenditure from higher cost source domestic spending to a lower cost source partner spending (El-Agraa and El-Agraa, 2007). To clarify the concept of trade diversion, take an example of two countries within the EU that have signed a trading agreement. Taking in country A and country B. Country A households can switch their spending on insurance and cars supplied by its domestic suppliers at a higher cost to those provided by country B suppliers at a lower cost operating in the same market. The primary essence of trade creation is to encourage an upsurge in trade among countries that enters an agreement by signing the trade accord (Laine, 2011). The trade creation also leads to an efficient allocation of limited resources and raises gain in user and manufacturer welfare. Below is a diagram showing both the domestic supply and the internal demand for trade creation in the European Countries. The diagram demonstrates that, access to cheaper supplies allows a lower price, which benefits the final consumer. The diagram also shows that a reduction in price that leads to an expansion in demand thus an increase in consumer surplus. The incurred surplus further leads to a net improvement in the country’s economic welfare. Figure 1: Domestic supply and the internal demand for trade creation in the European Countries (Laine, 2011) On the other hand, trade diversion is best defined as a change in local customer speeding from a zone of lower cost source to an area of higher partner cost source. It occurs because of the removal of tariffs on the imports acquired from the other partner countries. Trade diversion is commonly based on the existing tariffs on the external imports of the goods and services. The higher the tariffs on goods and services the higher the cost of production thus the higher the consumer price. Mostly in the international trades, trade diversion arises as a result of one business being able to offer importation into a particular country at a lower production cost than the other business competitors The diagram shows that before the UK joined EC, the importation price from New Zealand was P1 and UK consumed Q1 to produce Q2. That is as per the New Zealand's tariffs. However, on joining the EC, it is able to enjoy the EC free price tariff price of P2, which is above the tariff-free price P3 of the New Zealand. Therefore, to state the losses and gains in welfare, there is a rise in consumer extra in area 1+2+3+4. In the producer in area 1, there is a reduction in the surplus of the producer. Finally, there will also be a loss of the government revenue tariff of area 3. In countries involved in both trade creation and trade diversion, there are several differences realized before the trade creation and after the trade creation. To start with, trade creation eliminates trade barriers between the member countries thus encouraging the trade between the member countries, therefore, discouraging the trade between the non-member one. Before trade creation, this phenomenon is not realized. To add on that, after trade creations, member countries are free to exploit and freely trade with members of their choice. The member countries can also import goods at a lower cost thus enabling them to produce goods and services at a lower cost. Nevertheless, before trade creation, no country is allowed to trade freely with its country of choice. This ends up in higher costs of production that result from higher importation cost (Laine, 2011). Moreover, prior to trade creation, every country works as individual imposing different tariffs on various countries to protect their industries. After trade creation, all member countries within the union have standardized tariffs. Another difference is that, after trade creation, once a union is formed, all members agree to eliminate all tariffs between them. As a result of these zero tariffs on imports, consumer demand raises thus leading to another trade creation. Before the union creation, there is import tariffs that make the production cost to be higher hence reducing the consumer demand (Hanushek, Machin and Woessmann, 2011). Additionally, before trade creation, many countries are not able to access all factors of production due to the limited freedom to trade with other nations resulting in a lower range of production. After the creation of the trade agreement, member states are free to access most factors of productions from the other member states. As a result of that, the countries can produce a wider variety of goods and services into the market (Cottier, Pauwelyn and Bürgi Bonanomi, 2005). On the other hand, trade diversion creates some differences before it occurs and after it has occurred. Prior to trade diversion, imports among countries are spread almost equally due to the restricted tariffs agreement. After the trade diversion has occurred, tariff contract causes imports to change from the low-cost nations to higher cost countries. It thus leads to the concentration of production in countries with an advanced chance cost and a lower competitive benefit. Every country involved in the manufacture of any goods and services is free to trade with other countries even those that are non-members of the union. After the signing of the union agreement, member countries are no longer free to trade with any other state that has no competitive advantages. For example, before UK joining EEC, it used to have free trade arrangements with other nations like the New Zealand and Australia. Nevertheless, after joining EEC, UK had to accept the wide standard tariffs of importing from outside the EU. The function of the EEC was to brand New Zealand a less competitive agricultural country by converting imports from New Zealand to EU (Pang, 2011). Many countries have been seen seeking membership agreement with others. They do this due to some benefits of trade agreement that do drive them. Some of these benefits include the below-listed ones. First, many countries seek for trade agreement to eliminate tariffs and rations between the associate nations. The main essence of this is to encourage the free exchange of goods and services among the states. For instance, the EU circulates its goods and services among its member nations freely, and they might only be subjected to remove VAT and duty (Announcement, 2007). Other countries seek trade agreement to implement a joint external tariff on the imports from the non-member nations. These countries do this to eliminate the fluctuations in the taxes that may hinder young countries that are not economically stable from trading in the circular. For example, the import of a Japanese TV set resolves the same as the one in the UK. In addition to that, some countries seek trade agreement with other states to have a free single and standard market. Countries enter into an agreement and form a union like the European Countries. This union then helps in the creation of a common market for all of its member countries regardless of their economic status. They do so to encourage competition among the member countries, which then leads to the production of higher quality services and goods to the consumers. Some countries lack enough resources of production. As a result, they seek trade agreement with other countries that have adequate resources and experts needed for their production to enable them achieve their goals. For examples, some countries from Africa like Kenya have resources like petroleum but lacks proper experts and equipment required to harvest then. Because of that, they end up in a trade agreement with stable countries like China to provide them with the needed equipment and experts to help them harvest it. Additionally, some countries seek trade agreement with others to find a market for their products. For example, a country like China that makes a broad range of machines including tractors can go into a trade agreement with an agricultural country like the New Zealand to find a market for its machines. New Zealand as an agricultural country will need some of these machines for its production purpose thus by buying from China; China would have got a market for its products (Hanushek, Machin and Woessmann, 2011). Conclusion In conclusion, trade is essential for the development of any country's economy. For the sake of maximizing production and minimizing on the production costs, countries should exercise trade creation and trade diversion. Likewise, every country needs the assistance of one another; thus, they need to join various unions to enter into trade agreements. As stated earlier in this paper, these trade agreements are of much help to both the countries and the consumers. The importance comes because of the higher competition in the market that leads to high-quality products and the reduction in the price of the product due to a reduced cost of production. References Announcement. 2007. Business & Society, 46(2), pp.128-128. Cottier, T., Pauwelyn, J. and Bürgi Bonanomi, E. 2005. Human rights and international trade. Oxford: Oxford University Press. El-Agraa, A. and El-Agraa, A. 2007. The European Union. Cambridge: Cambridge University Press. Hanushek, E., Machin, S. and Woessmann, L. 2011. Handbook of the economics of education. Amsterdam: North Holland. Laine, E. 2011. U.S. free trade agreements and trade policy. Hauppauge, N.Y.: Nova Science Publishers. Pang, E. 2011. The U.S.-Singapore free trade agreement. Singapore: Institute of Southeast Asian Studies. Read More