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:

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Canada's domestic firms can supply radios at a higher price than U.S. firms. With a 50 percent tariff, Canadian consumers buy from domestic firms. When Canada forms a free trade area with Mexico, the tariff on Mexican radios is eliminated, and Canadian consumers switch to buying from Mexican firms, which can supply radios at a lower price. This is trade creation. There is no trade diversion because Canadian consumers are not switching from U.S. firms to Mexican firms; they are switching from domestic firms to Mexican firms. Overall, welfare gains because consumers are able to buy radios at a lower price.

Suppose That Canada Has Domestic Firms That Could Supply Its