Term
The term was coined by Jacob Viner in The Customs Union Issue in 1950. In its literal meaning the term was however incomplete, as it failed to capture all welfare effects of discriminatory tariff liberalization, and it was not useful when it came to non-tariff barriers. Economists have however dealt with this incompleteness in two ways. Either they stretched the original meaning to cover all welfare effects, or they introduced new terms like trade expansion or internal versus external trade creation.
Viner's article became and still is the foundation of the theory of international economic integration. It considered only two states comparing their trade flows with the rest of the world after they abolish customs tariffs on inner border of their union. Following the fact that economic unions most often include more than 2 states, attempts have been made to increase the number of the states (3+world), but not so successfully, as they did not have as clear conclusions as Viner's.
Opposite to economically efficient trade diversion effect, the trade diversion flow is cost-inefficient compared with the rest of the world. Balance between trade creation and trade diversion effects due to the creation of economic union makes the union either economically efficient (positive balance) or inefficient (negative balance). It is based on the fact that unification of states usually applies mergers of more than 1 sector in economy (even European Coal and Steel Union, which had 2 sectors only) leading to the creation of either trade creation or diversion effects.
Positive effects of trade diversion include increase of trade between unified states, increase of employment in manufacturing states inside the union consequently leading to increase of respective taxes and welfare.
Read more about this topic: Trade Diversion
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