What is the difference between trade creation and trade diversion?

Trade creation and trade diversion are two concepts in international trade theory that describe the impact of economic integration on trade patterns.

Trade creation occurs when the formation of a free trade area or a customs union leads to an increase in trade between member countries, resulting in overall economic benefits for the group. In other words, trade creation refers to the creation of new trade that would not have existed in the absence of the economic integration. This can happen when countries specialize in producing goods that they have a comparative advantage in, and trade with each other to obtain goods that they do not produce efficiently.

A real-world example of trade creation can be seen in the creation of the European Union (EU), which removed trade barriers between member countries and created a single market. As a result, trade between member countries increased significantly, leading to overall economic benefits for the group. For instance, a German car manufacturer can now sell its cars to customers in other EU countries without facing tariffs or other trade barriers, increasing the company's sales and profits.

Trade diversion, on the other hand, occurs when the formation of a free trade area or a customs union leads to a shift in trade patterns away from more efficient producers outside the group towards less efficient producers within the group. In other words, trade diversion occurs when a country or group replaces more efficient producers from non-member countries with less efficient producers from member countries, resulting in overall economic inefficiencies.

A real-world example of trade diversion can be seen in the creation of the North American Free Trade Agreement (NAFTA), which led to an increase in trade between the United States, Canada, and Mexico. However, some critics argue that NAFTA led to trade diversion by allowing less efficient Mexican producers to enter the US market and displace more efficient producers from non-member countries. This, in turn, resulted in an overall loss of economic efficiency in the global market.