Question

Suppose country X currently does not produce widgets. Instead, it imports widgets from country Z. Then country X establishes a regional trade agreement with country Y. Following the formation of the regional trade agreement, it imports widgets from country Y. What has occurred?

Answer 1

Answer:

There is trade diversion and a welfare loss for country X.

Explanation:

A trade diversion is created since country X no longer imports widgets from country Z and instead it imports them from country Y. Since country X started to import from country Y following the formation of a regional trade agreement it is losing welfare. This happens because country Z's widgets had a lower price but they were replaced due to the advantages given to country Y's widgets by the trade agreement.