Suppose Canada has a 20% tariff on the import of carpets, and Canada currently imports this product from India at a with-tariff price of $22. The with-tariff price of identical carpets from the United States is $24. Now suppose a free-trade agreement with the U.S. eliminates the tariff and so the no-tariff price from the U.S. is $20. Canada now purchases carpets from the U.S. Is Canada made better off from this trade diversion?
◦ Yes, because Canadian consumers are paying less for carpets and consumer surplus has increased.
◦ No, because before the agreement Canada was buying from India at a lower (pre-tariff) price and collecting tariff revenue.
◦ No, because it would still be cheaper for individual consumers to buy carpets from India.
◦ Yes, because Canada has diverted trade toward the United States.
◦ Canada is not better or worse off. The gain in consumer surplus in Canada is identical to the loss in tariff revenue to the Canadian government.
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