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Trade creation and trade diversion

Let's start with definitions of trade creation and trade diversion.

Trade creation

Trade creation is the increased trade that occurs between member countries of trading blocs following the formation or expansion of the trading bloc. This comes about as the removal of trade barriers allows greater specialisation according to comparative advantage. This means that prices can fall and trade can thus expand.

Trade diversion

Trade diversion is the decrease in trade following the formation of a trading bloc as trade with low cost non-trading bloc members is replaced by trade with relatively high cost trading bloc members.

Trade creation and diversion are important direct effects of the formation of a customs union. Trade creation will mean that consumption shifts from a high-cost producer to a low-cost producer and trade therefore expands. Trade diversion on the other hand means that trade shifts from a lower cost producer outside the union to a higher cost producer inside the union. This will not benefit consumers within the union as they are not getting access to cheaper international goods.