A reminder about the definition of trade diversion

It’s likely been more than a decade since a Trade Diversion blog post actually mentioned trade creation and trade diversion. Having missed numerous opportunities in recent years, I won’t pass up commenting on the following paragraph in Noah Smith’s recent post about experts and public policy:

Nor was this the only form of deception that economists employed in defense of free trade. Economists have known for many decades that some countries as a whole can be hurt by free trade. If a multilateral trade agreement — like the WTO, for example — admits new member countries, existing countries who compete directly with the newcomer nations can become poorer. This is called “trade diversion”, and it follows directly from the same simple classical economic theories of comparative advantage that economists typically use to justify free trade.

That paragraph is neither the most important nor most interesting part of his recent post, but it is salient for the owner of the leading trade-diversion-related domain name on the internet. Simon Lester, David DeRemer, and Michael Lane already pointed out on Twitter that Noah’s description of trade diversion has problems. Michael’s thread explained it clearly, but for posterity’s sake, here’s a blog post about the definition of trade diversion.

The concepts of trade creation and trade diversion concern the economic consequences of preferential trade agreements. They were introduced by Jacob Viner in a 1950 book titled The Customs Union Issue (that was, surprisingly, reprinted with a new introduction in 2014). Alan Deardorff’s glossary contains a concise definition of trade diversion: “Trade that occurs between members of a PTA that replaces what would have been imports from a country outside the PTA. Associated with welfare reduction for the importing country since it increases the cost of the imported good.”

Here’s a longer explanation from Richard Lipsey (Economica, 1957):

A is a small country whose inhabitants consume two commodities, wheat and clothing. A specialises in the production of wheat and obtains her clothing by means of international trade. Being small, she cannot influence the price of clothing in terms of wheat. Country C offers clothing at a lower wheat price than does B, so that, in the absence of country-discriminating tariffs, A will trade with C, exporting wheat in return for clothing. It is assumed that A levies a tariff on imports but that the rate is not high enough to protect a domestic clothing industry, so that she purchases her clothing from C. Now let country A form a customs union with country B, as a result of which B replaces C as the supplier of clothing to A. B is a higher cost producer of clothing than is C but her price without the tariff is less than C’s price with the tariff. Hence, the union causes trade diversion, A’s trade being diverted from C to B.

The language of economics was a bit different in 1957, to say the least.

The welfare losses that might result from trade diversion are a consequence of lost government revenue: consumer expenditure switches to the higher-cost supplier because it does not face an import tariff. Viner wrote “This is a shift which the protectionist approves, but it is not one which the free trader who understands the logic of his own doctrine can properly approve.” If one treats consumer surplus and government tariff revenue as equally valuable, trade diversion may cause a net loss. A typical diagram:

Trade-diversion-UK-New-Zealand

Returning to the blog post that sparked this one, Noah’s paragraph is odd for at least two reasons. First, it’s unusual to think of the World Trade Organization as a preferential trade agreement. WTO members are obliged to charge each other most-favored-nation (MFN) duties. For the WTO to be a preferential agreement associated with trade diversion, Noah must have in mind lower-cost non-WTO suppliers. But China wasn’t joining an exclusive club. Back in 2001, Vietnam and Afghanistan were not yet WTO members, but something like 140 nations already were and Vietnam already had MFN access to the US market.

Second, import duties on Chinese goods were not lowered when it became a WTO member. The United States had charged MFN rates on imported Chinese goods since 1980 (these were annually renewed; China’s WTO accession made them permanent). A policy change that does not lower import duties cannot cause trade diversion in classical trade theory. Of course, trade policy uncertainty was reduced, but that story is a bit far from the theory of comparative advantage taught in undergraduate economics classes.

Bottom line: When thinking about whether the United States was hurt by China joining the WTO, you don’t need to contemplate trade diversion.