Agreements between countries sit on a ladder of increasing integration, and the rungs are defined by what is unified rather than by how friendly the parties are.
What are the levels of economic integration?
| Rung | Internal tariffs | Common external tariff | Free factor movement | Common policy | Common currency |
|---|---|---|---|---|---|
| Free trade area | removed | no | no | no | no |
| Customs union | removed | yes | no | no | no |
| Common market | removed | yes | yes | no | no |
| Economic union | removed | yes | yes | yes | no |
| Monetary union | removed | yes | yes | yes | yes |
A free trade area removes tariffs between members but lets each keep its own external tariff, which creates the rules-of-origin problem: goods enter through the lowest-tariff member and get shipped onward, so the agreement needs paperwork proving where a good was actually made. A customs union solves that with a common external tariff and gives up independent trade policy to do it. Above that, a common market adds labour and capital mobility, an economic union adds harmonised fiscal and regulatory policy, and a monetary union adds a single currency and with it the loss of an independent monetary policy for every member.
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How do you tell trade creation from trade diversion?
Jacob Viner's 1950 insight is that joining one of these is not unambiguously good, and the arithmetic that decides it is small enough to do in your head once you have seen it done.
Consider a country importing a component. Producing it domestically costs 100 a unit. A prospective partner can make it for 88. A non-member can make it for 80. Those three are real resource costs, and a tariff does not touch them. Holding them fixed while the tariff moves is what makes the comparison work.
Start with a 30% tariff on everyone. The partner's good lands at 114.40 and the non-member's at 104.00, so the country supplies itself at 100 and collects no revenue. Sign a free trade area and the partner lands at 88.00, imports begin, and the real resource cost of supply falls from 100 to 88. That is trade creation, worth 12.00 a unit and a genuine efficiency gain.
Now start with a 12% tariff instead. The partner lands at 98.56 and the non-member at 89.60, so the country already imports from the non-member and the treasury collects 9.60 a unit. Sign the same agreement and the partner's 88.00 beats the non-member's tariff-inclusive 89.60, so trade switches. Consumers save 1.60. The treasury loses the whole 9.60. And the country now buys from an 88-cost producer instead of an 80-cost one:
Net national effect = 1.60 − 9.60 = −8.00 per unit = −(88.00 − 80.00)
That is trade diversion: supply moved from the world's cheapest producer to a partner who is cheaper only because of a tariff preference, so nothing real improved and a tariff wall was simply redrawn. Worked Example 8 runs both cases at 5 million units a year, where the same agreement is worth ₹60,000,000 in one and costs ₹40,000,000 in the other.
When does an agreement create or divert trade?
Both cases are computed from the same three costs, and the only thing that changed was the pre-agreement tariff. High external tariffs mean a member was probably supplying itself, so an agreement is likely to create trade. Low external tariffs mean it was probably already importing from the cheapest global source, so an agreement is likely to divert it. That reversal is the practical test, and it is why the welfare case for a regional agreement is strongest exactly where the pre-existing protection was worst.