Under a system of perfectly free commerce, each country naturally devotes its capital and labour to such employments as are most beneficial to each. This pursuit of individual advantage is admirably connected with the universal good of the whole… It is this principle which determines that wine shall be made in France and Portugal, that corn shall be grown in America and Poland, and that hardware and other goods shall be manufactured in England…
If Portugal had no commercial connexion with other countries, instead of employing a great part of her capital and industry in the production of wines, with which she purchases for her own use the cloth and hardware of other countries, she would be obliged to devote a part of that capital to the manufacture of those commodities, which she would thus obtain probably inferior in quality as well as quantity.
The quantity of wine which she shall give in exchange for the cloth of England, is not determined by the respective quantities of labour devoted to the production of each, as it would be, if both commodities were manufactured in England, or both in Portugal.
England may be so circumstanced, that to produce the cloth may require the labour of 100 men for one year; and if she attempted to make the wine, it might require the labour of 120 men for the same time. England would therefore find it her interest to import wine, and to purchase it by the exportation of cloth.
Prior to the late 1600s, the British drank plenty of wine, mostly French, a little Spanish, but virtually nothing from Portugal. The wars of 1689-1713 gave the Portuguese allies the opportunity of ten lifetimes. Beginning in 1703 a treaty was signed granting Portugal access to British markets for their wines—generally of a much lower quality than those of France, and often needing to be fortified with brandy or spirits in order to keep from going bad. The Methuen Treaty (as it was known) promised that Portuguese tariffs would always be at least a third lower than those of other nations, most especially France.
Of course, most of the Portuguese wine trade was dominated by British ships, merchants, and even vintners working in Iberia. The end of hostilities between Britain and France was seen as a grave threat to all these British interests, and vigorous lobbying by brewers, distillers, and the Anglo-Portuguese merchants stopped attempts to return to the period of open trade with the French.
Trade theorists have learned their lesson: use Greek letters rather than real world examples!
Hat tip: EconTalk.
Trade Diversion 