IBonomicsTrade Diversion – Switching from a Lower Cost External Producer to a Higher Cost Bloc MemberHL
Global EconomicsThis diagram illustrates trade diversion, which occurs when a country joins a trading bloc and must impose a common external tariff on non members. As shown in the diagram, the country originally imports from the USA at the lowest price P_USA. After joining the customs union, it must apply the common external tariff to the USA, raising the relevant import price to P_USA+t. Although China is a higher cost producer than the USA, China becomes the cheaper source once the tariff is imposed. Imports therefore shift away from the lower cost USA to the higher cost China, reducing efficiency. Consumers now purchase from a less efficient producer at a higher price than before, leading to a welfare loss and a misallocation of global resources.
Curves and elements
- p usa
- USA No Tariff Price (P_USA): The lowest world price before joining the trading bloc.
- p usa tariff
- USA + Tariff Price (P_USA+t): The higher import price once the common external tariff is imposed on the USA.
- p china
- China Price (P_China): The price of imports from a higher cost member country, which becomes artificially cheaper once tariffs redirect trade.
- domestic supply
- Domestic Supply (Sd): The supply from domestic firms, which may contract as competition from bloc members increases.
- domestic demand
- Domestic Demand (Dd): Consumer demand, which shifts along the curve when prices rise after trade diversion.
Key explanations
- 1
Before joining the trading bloc, the importing country buys from the USA at price P_USA, which is the lowest cost option. Domestic supply is limited, and most consumption occurs through these low cost imports.
- 2
After joining the customs union, the country must impose a common external tariff on all non members, including the USA. This raises the effective price of US goods to P_USA+t.
- 3
China, as a member of the customs union, can export without tariffs at price P_China. Even though China is a higher cost producer than the USA, it becomes the cheaper option once the tariff is applied to the USA.
- 4
Imports therefore divert from the lower cost US supplier to the higher cost Chinese supplier. This shift represents trade diversion and is considered inefficient because resources move to producers with a higher opportunity cost.
- 5
Consumers lose out because they now face a higher price than before, leading to reduced consumer surplus. Production becomes concentrated in a less efficient member country rather than in the globally most efficient producer.
- 6
A further drawback of joining the trading bloc is that domestic firms may face stronger competition from bloc members. This can lead to short term unemployment as less efficient domestic industries contract under competitive pressure.
Example exam question
Using the trade diversion diagram, explain why joining a customs union can reduce global efficiency when imports shift from a lower cost non member to a higher cost member country.
Show example answer
Trade diversion occurs when a country joins a customs union and switches imports from a globally efficient non member to a less efficient member country due to the common external tariff. In the diagram, the USA is the lowest cost supplier at price P_USA. After the tariff is applied, the effective price becomes P_USA+t, making China, a higher cost producer, appear cheaper within the bloc. Imports shift from the USA to China, reducing efficiency because production moves away from the lowest cost global supplier. Consumers also face higher prices, and domestic firms may experience unemployment as competition intensifies. This makes trade diversion an undesirable effect of economic integration.
