TPP brings more trade creation or trade diversion

The new talk among 12 TPP members in March ended without effective deals because the two biggest power- US and Japan cannot agree on the reduction of their tariff on some agriculture products. The Trans-Pacific Partnership aims to tackle the high regulatory and tariff barriers hampering trade flows between the 12 countries, just as the common goal of many FTAs. However, whether TPP will really improve the Asia-pacific Integration and international trade? What is the tradeoff between trade diversion and trade creation in TPP? The following paragraph will discuss the economic impact of many complex FTAs such as TPP.


Free Trade Area (FTA) is an arrangement under which member countries agree to eliminate tariffs and nontariff barriers on trade in goods within the FTA, but each country maintains its own trade policies, including tariffs on trade outside the region.1

The free trade utilizing comparative advantage of each member country will benefit national welfare, which economists call trade creation. However, when a member switches import from an efficient country to a less efficient country due to the FTA, the economic welfare will be hurt, resulting in a trade diversion. For example, there are three countries A, B and C. The price of good X is 5 in A, while only 2 in B and 1.5 in C. Although A put 100% tariff on X, it will still import some X from C due to the price of 3 even after adjusted for tariff. If A forms FTA with B, agreeing to eliminate tariff, A will import X from B at 2. As we can see from the diagram, the net welfare impact is (b+d)-e. The part (b+d) is the welfare benefit from trade creation by FTA while part e is the government loss due to the higher original price agreed under FTZ, which is called trade diversion.

picture 1

In most cases, FTA brings both trade creation and trade diversion with net effects determined by the structure of the FTA. Therefore, the goal of FTA should always be maximizing trade creation or minimizing trade diversion.

According to an estimation by Peter A. Petri and Michael G. Plummer2, TPP will yield an annual global income gains of 295 billion, among which 78 billion will be gained by US through more market access and zero tariff on both exports and imports. However, at the same time, many Asian countries excluded from TPP suffer a lot due to the diversion from their exports especially China. China is estimated to lose 57.4 billion in exports in 2025 because of the exclusion from TPP. US will probably import more manufacturing goods from Vietnam under TPP although China has larger comparative advantage in manufacture. Both countries’ welfare may be hurt by the trade diversion under TPP.

Furthermore, more job opportunities will be lost in the scarce factor industry and wage inequality deepened in U.S. however, TPP proceeds with some other reasons such as to fully exploited economies of scale in production between member countries. One of the most important reasons is the political implication. Some politicians think that TPP is one of the steps in US’s strategy to take control of Asia-Pacific. Considering most TPP members already has bilateral or multinational FTA such as NAFTA with US, TPP brings little marginal benefit to these countries but requires member countries to change a lot of trade and economic regulations to meet the high qualification.

  1. Free Trade Agreements: Impact on U.S. trade and Implications for U.S. trade Policy(William H. Cooper, Congressional Research Service, February 26, 2014)
  2. The trans-Pacific Partnership and Asia-Pacific Integration: Policy Implications(Peter A. Petri and Michael G. Plummer, June 2012, Peterson Institute for International Economy)
  3. Trans-Pacific Partnership talks stall on US-Japan stand-off (Jeremy Grant in Singapore)

  1. Pros & Cons of Free Trade Agreements(Deborah White)

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