• Its economic benefits for the partner countries and the world depend on its trade creation, the amount by which it raises the total volume of world trade.
• Its economic costs depend on its trade diversion, the volume of trade it diverts from lower-cost outside suppliers to higher-cost partner-country suppliers.

Other possible sources of gains to members of a trade bloc include increased competition that lower prices or costs, enhanced ability to achieve scale economies, and attracting more direct investment by foreign companies. Whether a trade bloc is good or bad overall depends on the difference between its gains from trade creation (and any other positive effects) and its losses from trade diversion.

The most common kind of trade bloc is the free-trade area, inwhich member countries remove all tariffs and quotas on trade among themselves but keep their separate barriers on trade with nonmember countries. In this case, member countries must use rules of origin and maintain customs administration on the borders between themselves to keep outside products from entering the high-barrier countries cheaply by way of their low-barrier partners. Examples of free-trade areas are the European Free Trade Area created in 1960 and the North American Free Trade Agreement (NAFTA) that came into existence in 1994.

The European Union from 1957 to 1992 was a customs union, in which member countries remove tariffs and quotas on trade among themselves and also adopt a common set of external tariffs. In 1992 the Single European Act promoted free movement of workers and capital, so the EU became a common market. (The Act also required removal of many remaining nontariff barriers to trade among the member countries.) As the EU further integrates, including the adoption of the euro as a common currency by 12 of its members, the EU is moving toward economic union, in which all economic policies would be unified. Efforts by developing countries to form trade blocs failed in the 1960s and 1970s, but they have become more successful since 1990. Trade among the MERCOSUR countries in South America expanded since the bloc was formed in 1991, but some of this expanded intrabloc trade is trade diversion.

Another form of trade discrimination is economic sanctions or trade embargoes. Our basic analysis of an export embargo (which has effects symmetrical with those of an import embargo) reveals how the success or failure of such economic warfare depends on trade elasticities. Success is more likely when the embargoing countries have high trade elasticities, meaning that they can easily do without the extra trade. Success is also more likely when the target country has low trade elasticities, meaning that it cannot easily do without trading with the embargoing countries. As the simple theory implies, embargoes are typically imposed by large trading countries on smaller ones, and success is more likely the quicker and more extreme the sanctions.