Trade diversion happens when countries form a trade bloc (like a customs union or free trade area) and start buying goods from other member countries instead of cheaper, more efficient producers outside the bloc.

How it works:

• Trade blocs remove taxes on goods traded between members, making those goods cheaper.
• Even if a country outside the bloc produces a good more cheaply, extra taxes (tariffs) on their goods make them more expensive to buy.
• Resources are shifted from highly efficient producers worldwide to less efficient ones within the region.

Effects on welfare:

• Consumers often have to pay higher prices than they would under open, global trade.
• Overall global economic efficiency decreases.
• A trade bloc can actually cause economic harm if the negative effects of trade diversion are stronger than the positive effects of trade creation.

This concept was developed by economist Jacob Viner. His analysis showed that joining a trade bloc does not always guarantee economic benefits for a country.