Preferential Trade Agreements and Trade Liberalization Efforts in the OIC Member States
With Special Emphasis on the TPS-OIC
10
to respond to competitive pressure. All of this may lead to higher levels of economic activity
and therefore welfare gain.
As each of these effects are likely to be driven by trade liberalisation, then it is natural to
suppose that partial trade liberalisation, partly leads to such gains. To some extent this is likely
to be correct. However, the story becomes somewhat more complicated. Whenever a country
liberalises its trade with a subset of countries (e.g. bilateral liberalisation v unilateral
liberalisation, or bilateral liberalisation v multilateral liberalisation) there are two effects likely
to be present, and which were identified as far back as the 1950s by Viner. These two effects
are trade creation and trade diversion:
Trade Creation
In principle there are two aspects to trade creation. First, suppose that prior to the reduction
of tariffs between countries A and B that there is a product, k, which is produced and supplied
internally within each country and is not traded. Once tariffs are reduced bilaterally country A
has a comparative advantage in that product and therefore it is now exported to country B.
Note that we would expect imports from country A to increase in the product, and for
production in country B to decline. This is the process of (intra-regional) specialization and
trade is occurring where it did not occur before and therefore there has been trade creation.
Second, suppose that B was already importing product k from country A, but the level of
imports was restricted by the tariff. As tariffs are liberalised more trade takes place once again
trade is being created. These effects are an illustration of (i) above, and tend to increase real
GDP in the economy.
Trade Diversion
Now suppose that prior to signing the agreement product k was imported from country C, ie
from a non-partner country. Once A and B sign the agreement it may be possible for country A
to undercut country C in the market of country B. Hence instead of importing the good from
country C, country B now imports the good from A. Here, the source of imports has switched
(hence this is sometimes referred to as supply switching) from C to A. However, if prior to the
agreement country B levied the same tariffs on imports from C and imports from A, and
country B chose to import the good from C, then presumably this is because C was relatively
more efficient than A. So the bilateral agreement between A and B has resulted in a switch of
imports from a more efficient supplier (country C) to a less efficient supplier (country A). In
other words trade has been diverted away from C. Because you are now importing from a less
efficient supplier this tends to decrease real GDP in the economy.
All preferential trade agreements are likely to comprise some mix of both trade creation and
trade diversion. The former is welfare increasing the latter is welfare decreasing. Whether the
agreement overall is welfare increasing or not will therefore depend, in the first instance, on
the relative magnitudes of trade creation and trade diversion respectively. The empiric of this
is taken up later on in this report.