Brief description: Trade creation and trade diversion effects can occur with the formation of trading blocs. The trade creation effect is caused by the extra output produced by the member countries. The trade diversion effect exists because countries within trading blocs, protected by trade barriers, will now find they can produce goods more cheaply than countries outside the trade bloc. Production will be diverted away from those countries outside the trade bloc that have a natural comparative advantage to those within the trading bloc.

Detailed description: The diagram shows the trade creation and trade diversion effects. The country has a domestic supply curve for maize Sz. If it forms a trading bloc with another country then the supply curve for maize is Sz/sa. The world output of maize is shown by the horizontal supply curve Sw. The domestic demand curve for maize is Dz. Assuming no trade the domestic price of maize would be Pz and the quantity would be Q1. By forming a trade bloc with the other country the price of maize would fall to Pz+SA and the quantity produced to Q2. The triangle AEB represents the resulting welfare gain or trade creation effect. If the country trades freely on the world market, a quantity Q3 of maize could be purchased at the world price of Pw. This has been prevented from happening by the formation of the trade bloc, and the imposition of some form of trade barrier. There has therefore been a welfare loss of BFC. This is the trade diversion effect.