Economic Integration and Globalization
Senior 6 · Economics
Economic Integration and Globalization
Lesson 2 of 5
25 min
The Gatuna–Katuna crossing between Rwanda and Uganda is one of Rwanda's busiest border posts, on the road north towards Uganda and Kenya. On 28 February 2019, during a diplomatic dispute between the two governments, it was closed to most traffic. It reopened on 31 January 2022, almost three years later, after talks between the two countries' leaders (KT Press; ICGLR).
Both countries had been members of the EAC Common Market since 2010. Think: what does this episode tell you about the limits of economic integration? Who would have lost most while the border was closed?
Definition
Trade creation: when joining a customs union shifts purchases from a higher-cost domestic producer to a lower-cost producer in a partner country. Resources are used more efficiently, so welfare rises.
Trade diversion: when joining a customs union shifts purchases from a lower-cost producer outside the union to a higher-cost producer inside it, only because the partner no longer pays the tariff. Resources are used less efficiently.
The ideas come from Jacob Viner's book The Customs Union Issue (1950).
A good can be produced in Rwanda at US$400 a tonne, in a partner country at US$340 and outside the union at US$300. The chart shows what a Rwandan buyer pays for each, including any tariff, before and after Rwanda joins the customs union.
Worked example
Worked example 1: case A, trade creation (tariff 40%)
Before the union every import pays 40%:
The home producer is cheapest, so Rwanda produces the good itself at US$400.
After the union the partner pays no duty (340) while the outside supplier still pays the CET (420). Rwanda now imports from the partner at US$340 instead of producing at US$400. A lower-cost source replaces a higher-cost one: trade creation. Consumers save US dollars a tonne, and home resources move to uses where Rwanda is more efficient.
Worked example
Worked example 2: case B, trade diversion (tariff 25%)
Before the union:
Rwanda imports from outside at US$375, and the government collects US dollars of duty a tonne.
After the union the partner's good costs US$340, cheaper than the outside good at US$375, so imports switch to the partner. For each tonne:
For 10,000 tonnes a year Rwanda loses US dollars, and the world now makes the good at US$340 instead of US$300: trade diversion. (This ignores any change in the quantity bought, which would add a small gain for consumers.)
Warning
Don't judge a union by the price consumers pay. In case B consumers pay less after the union, yet the country is worse off, because the tariff revenue that used to come from the outside supplier is lost. Always compare the cost of production of the old and new sources.
| Advantages | Disadvantages |
|---|---|
| Trade creation: cheaper goods from more efficient partners | Trade diversion away from cheaper outside suppliers |
| A larger market, economies of scale and more competition | Weaker firms close when exposed to stronger regional rivals |
| More investment, attracted by the bigger market | Investment and industry may cluster in the most developed member |
| Free movement of workers and capital to where they earn most | Loss of tariff revenue on trade with partners |
| Joint infrastructure and one-stop border posts cut trade costs | Loss of national control over tariffs and some policies |
| Stronger voice in negotiations; closer political ties | Unequal gains can cause tension between members |
Tip
Creation or diversion? Ask one question. After the union, is the new source of supply the cheapest producer in the world, or at least cheaper to produce than the old one? If the new source costs less to produce: creation. If it costs more: diversion.
Important
Discuss. A customs union with a high common external tariff tends to cause more trade diversion. Should the EAC keep its 35% top band, which protects goods the region can make itself? Weigh the gains to regional industry against the losses from trade diversion.
EconplusDal, "Trade Diversion" (about 8 minutes). A worked example like case B, showing how consumers can gain while the country loses. Compare his figures with the lesson's.
Practice
Sources and credits
Written by Ganzaa: the chart, the tables, the worked examples and the practice items. All costs and tariffs in the worked examples are illustrative.
