Question

What are the factors that determine whether a trade diverting FTA leads to a net increase or decrease in the welfare of a member nation? In particular, what economic conditions make it more likely that joining a FTA will increase the welfare of a member nation?

Draw a figure illustrating the effects of a trade-diverting customs union that reduces the welfare of a nation joining it.

Answer 1

Trade diversion means that a FTA diverts trade away from a efficient supplier outside the FTA,towards a less efficient supplier within the FTA.It may reduce a country's welfare or could result in improve in trade.It can be understood by the diagrams provided below.

As seen in the above diagram,before the US joined the FTA it had a common tariff on all cars imports and bought from low cost canada at price p2 including the tariff. After it joined the the FTA it can benefit from tariff free imports from mexico and other FTA producers at price p1. It gains consumer surplus of a+b+c+d and US manufacturers lose producer surplus of a the loss of tariff revenue from imports from canada is c+e. There will be net loss from trade diversion in joining FTA if b+d(gain in consumer surplus) is less than e(loss of tariff revenue from canada imports). A net gain from trade diversion would rise if b+d is greater than e.

Trade diversion loss and gain

As seen in part a) of diagram below,because the difference between very low cost canada(without the tariff) and the FTA is significant,the net gain of b+d is less than the loss of tariff revenue from canada imports of e. So, trade diversion away from low cost canada creates a net loss to the US from joining the FTA.

As seen in the part b) of above diagram,because the difference between lower cost canada(without the tariff) and the Customs is not so significant,the net gain of b+d is more than the loss of tariff revenue from canada imports of e. So, trade diversion away from lower cost canada actually creates net gain to the US as a result of joining the customs.