Trading blocs: costs, benefits and conflicts with the WTO

Trade creation and trade diversion

• Trade creation: removing tariffs inside the bloc lets a member import from a lower-cost partner instead of producing at higher cost at home. Resources are used more efficiently; consumers pay less.
• Trade diversion: the common external tariff makes imports from a lower-cost non-member dearer than from a higher-cost member, so trade switches to the less efficient member. World efficiency falls.

Diagram in words: on a domestic demand and supply diagram, world supply from the cheapest non-member is a horizontal line at the world price; the partner's supply is a higher horizontal line. With a tariff on everyone, the price is the world price plus tariff. Joining the bloc removes the tariff on the partner only, so the price falls to the partner's price: consumers gain, imports rise (trade creation), but imports now come from the partner instead of the cheaper non-member, and the tariff revenue is lost (trade diversion).

After joining, buyers switch from the $10 producer to the $11 partner: trade diversion

Other costs and benefits

Benefits: bigger market and economies of scale; more competition lowers prices and costs; lower transaction costs (less paperwork, and no currency conversion in a monetary union); factor movement fills skill shortages and lets capital find the best returns; more FDI from firms wanting to be inside the CET; political cooperation.

Costs: trade diversion; loss of sovereignty over trade policy (and over monetary policy in a monetary union); membership fees; regional problems if factors move away; possible retaliation from non-members.

Conflicts between trading blocs and the WTO

WTO rules allow blocs as an exception to the most-favoured-nation principle, provided they cover substantially all trade. But:

• Blocs discriminate against non-members, contrary to the spirit of MFN.
• Trade diversion reduces world efficiency.
• Bloc members may negotiate as a group, making global agreements harder.
• Bloc-to-bloc trade disputes can lead to retaliation.

Supporters argue blocs are stepping stones: they liberalise trade faster than slow WTO rounds and can later be widened.

Worked example

Using the table, find the change in price paid per unit by consumers after joining and the tariff revenue lost per unit.

1. Before: cheapest option is the non-member at 10 + 3 = $13; government gets $3 tariff
2. After: the partner's price is $11, so consumers pay $2 less
3. The government no longer collects $3 per unit, because imports come tariff-free from the partner

Answer: Consumers save $2 per unit; tariff revenue of $3 per unit is lost; world cost of production rises by $1 (from $10 to $11).

Check yourself

1. Trade creation occurs when joining a bloc causes a country to
   • import from a higher-cost member instead of a lower-cost non-member
   • stop all imports
   • import from a lower-cost member instead of producing at higher cost at home
   • raise its tariffs on members
   Show answer

   import from a lower-cost member instead of producing at higher cost at home. Production moves to a more efficient source.

2. Why does trade diversion reduce world efficiency?
   • Production moves from a lower-cost to a higher-cost producer
   • Consumers pay lower prices
   • Tariff revenue rises
   • Transport costs fall
   Show answer

   Production moves from a lower-cost to a higher-cost producer. Resources are used less efficiently when the higher-cost producer supplies.

3. A non-member produces a good at $20 and a partner at $22. The common external tariff is 25%. What price does the non-member's good sell for inside the bloc?
   Show answer

   $25. 20 x 1.25 = $25, more than the partner's $22, so buyers switch to the partner.

4. In the previous question, by how much per unit does the world cost of producing the good rise when buyers switch to the partner?
   Show answer

   $2. 22 - 20 = $2 per unit of extra resource cost.

5. Explain how membership of a trading bloc can lower firms' average costs.
   Show answer

   Firms gain access to a larger market, so they can increase output and benefit from economies of scale, lowering average costs.. Bigger markets allow larger output and lower average costs.

6. Explain one way trading blocs conflict with the aims of the WTO.
   Show answer

   Blocs give tariff-free access only to members and keep tariffs on non-members, which discriminates against non-members and goes against the most-favoured-nation principle.. Preferential treatment of members conflicts with non-discrimination.

7. Which benefit is specific to a monetary union rather than a customs union?
   • No tariffs between members
   • A common external tariff
   • Trade creation
   • No currency conversion costs or exchange rate risk between members
   Show answer

   No currency conversion costs or exchange rate risk between members. A single currency removes conversion costs and exchange rate uncertainty.

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Sources

• Pearson Edexcel International Advanced Level in Economics specification (issue 2)

Last updated 8 November 2026. Spotted a mistake? Tell us.