Discuss the welfare effects of Regional Trade Agreements | IGNOU Economics

Discuss the welfare effects of Regional Trade Agreements in case of (a) Trade diversion and (b) Trade creation.

What is Regional Trade Agreement?

Regional trade agreements (RTAs) are agreements between two or more nations and their governments for doing trade between themselves so that they can import less from countries that are outside their region.

The primary purpose of any regional trade agreement is for economic integration and that's how trade blocs are formed. RTAs are categorized into 5 stages:-
1. Preferential trading area
2. Free trade area
3. Customs union
4. Common market
5. Economic and monetary union


Now trade agreements are also the main reason behind trade creation and trade diversion.

Trade diversion is an economic term related to international economics in which trade is diverted from a more efficient exporter towards a less efficient one by the formation of a free trade agreement or a customs union.

Trade diversion reduces a country's national welfare because in this scenario a country shifts its source of imports from a more efficient country to a less efficient country because of the tariff preferences in a customs union.

Trade creation is also an economic term related to international economics in which trade is created with the help of preferential tariff concessions. Which results in supply from a more efficient producer of a product from a free trade area.

Trade creation raises a country's national welfare as imports will replace high domestic production cost.

Welfare effects of Regional Trade Agreements

Welfare effects depend on whether trade increases primarily at the expense of nonmembers. It has also been observed that regional trade agreements lead to regionalism and that can have long-run effects on external trade liberalization and on the multilateral trading system.

1. As we discussed, trade diversion is the shift of production from efficient external suppliers to inefficient members. And trade creation is the shift of production from inefficient domestic providers to efficient RTA members. While trade creation is associated with the standard gains from trade, trade diversion can make a trade agreement harmful for both members and nonmembers.

2. Wherever trade diversion is minimal, governments tend to choose natural partners for trade creation.

3. On the other hand, wherever trade diversion is high. That leads to the formation of worst type of agreements. 

4. The aggregate welfare effects of RTA can be obtained by summing up the effects across markets and across countries. The net welfare effects are measured by taking both trade creations and trade diversion in account.

5. If the positive effects of trade creation outweighs the negative effects from trade diversion then it is said to be welfare improving.