The trade creation and trade diversion diagrams are some of the toughest in macroeconomics but mastering them can be a route to the top mark bands in essay questions about economic integration.
One benefit of regional economic integration is the effects of trade creation. As an economy moves into a trading bloc, tariff barriers to trade between members will be removed and this will push down prices for consumers. On the diagram, there will be a gain in consumer surplus of the total area 1+2+3+4. While there will be a loss of producer surplus (area 1) and a loss of government tariff revenue (area 3), the overall net effect of economic integration has been beneficial, shown by areas 2 and 4.
However, balanced against this, are the possibility of trade diversion effects, which occur when more efficient imports from outside a trading bloc are replaced by tariff free imports within the economic area. The diagram again shows prices falling as a result of integration, with consumers the same gains and losses as previously. However this time, as imports were previously coming from a more efficient source, there is an additional loss of tariff revenue shown by area 5. This means that the net effect will not necessarily be beneficial, and will depend on the size of area 5 relative to areas 3 and 4. The relative efficiencies of the trading partners within and outside of the trading bloc will be a key determinant of whether there are net gains or losses as a result of integration in this case.
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