The Simple Analytics of Trade Creation, Diversion and Reversion

Classical analysis of free trade agreements (FTAs) highlights the close connection between trade creation and the benefit of an FTA, and the equally close connection between trade diversion and the potential harm. In this paper, we study a case in which a country that already has one FTA adds another one. We show that the new FTA causes trade to be diverted from its prior FTA partner, an effect that we call ‘trade reversion'. In contrast to conventional trade diversion, trade reversion causes neither harm nor benefit to the importing country. Unlike conventional trade diversion, which causes a loss of revenue without any corresponding private sector gain, trade reversion does not affect government revenue. When we look at world welfare, if trade reversion is equal to trade diversion, their two effects cancel out, leading the effect on world welfare to be a simple function of the amount of trade creation and the size of the tariff.