Question

Suppose that Canada has domestic firms that could supply its entire market for radios at a price of $50, while U.S. firms could supply radios at $40 and Mexico at $30. Suppose that Canada initially has a 50 percent tariff on imports of radios and then forms a free trade area with Mexico. As a result, Canada realizes a. trade creation, no trade diversion, and overall welfare losses. b. trade diversion, no trade creation, and potential overall welfare losses. c. trade creation, no trade diversion, and overall welfare gains. d. trade diversion, trade creation, and potential overall welfare gains.

Answer 1

d. trade diversion, trade creation, and potential overall welfare gains

Step-by-step explanation:

Trade creation is where the trade is increased between members of the trading bloc after the removal of the trade barriers. This will result in the price to fall and trade to rise. In the given question, Canada has created free trade between Mexico which increase the trading between both countries. This mean trade creation has been established.

On the other hand, trade diversion is where trade is decreased with the non-trading bloc members and replaced with trading bloc members whose cost of goods is high. In this case the import tariff of 50% has resulted in the decrease in trade from U.S. (non-trading bloc member) and therefore, trade diversion has been created.

Finally, whether overall there is welfare loss or gain depends on the difference between the gain achieved from trade creation and the loss resulted from trade diversion. However, in this case Mexico is providing radios at $30 while U.S. price is at $40. This means that there is overall welfare gain from establishing the trade creation and trade diversion.