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 the United States.As a result,Canada realizes:

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When Canada forms a free trade area with the United States, it eliminates its tariff on imports of radios from the US. As a result, Canadian consumers switch from domestic radios priced at $50 to US radios priced at $40. This leads to trade creation, as the cheaper radios from the US enter the Canadian market.

However, Canada's tariff on imports from Mexico continues to exist, and the country does not form a free trade area with Mexico. As a result, Mexican radios priced at $30 face a higher tariff, making them less competitive in the Canadian market. This leads to trade diversion, as Canadian consumers switch from Mexican radios to US radios.

Overall, the trade creation from the US more than offsets the trade diversion from Mexico, leading to potential gains in overall welfare. Hence, the correct answer is D.

Suppose That Canada Has Domestic Firms That Could Supply Its