In 2020, a Free Trade Agreement (FTA), namely the United States-Mexico-Canada Agreement (USMCA), took into effect between the three ratifier nations. This FTA is also sometimes referred to as "NAFTA 2.0" or as the "New NAFTA", as it replaced the North American Free Trade Agreement (NAFTA) which was implemented since 1994. The NAFTA was in fact preceded by the Canada-United States Free Trade Agreement (CUSFTA) that was signed in 1988 between Canada and the United States. We will refer to this 2-country agreement for this question. Clausing (2001) studied the trade effects in this earlier bilateral CUSFTA, motivated by the unknown effects of tariff liberalisation. (Reference: K.A. Clausing, 2001. Trade creation and trade diversion in the Canada - United States Free Trade Agreement. Canadian Journal of Economics, Vol. 34, No. 3, pp. 677-696.

(a) With the use of an appropriate diagram, illustrate and explain the theory of trade creation and trade diversion (static effects), using the example of the FTA between Canada (home country) and the United States (foreign country). Clearly organise your response to compare before and after the implementation of the CUSFTA, to derive at the trade creation and diversion effects.

(b) In extension to the examples covered in class, Clausing (2001) further proposed two (2) possible cases as follows: Firstly, "if the United States were already the low cost producer before the FTA, trade creation would result in welfare gains... without any trade diversion losses." Secondly, "If U.S. supply were instead uncompetitive before the tariff reduction, however, and just epsilon less than the ROW tariff inclusive supply after the FTA, only trade diversion would take place..." o Where epsilon refers to a small value For each of the two (2) cases, show with diagrams and explain briefly the static effects.