Question

Suppose the country of Coventry is joining a customs union (CU). It can buy Product S from the country of Plata or the country of Soyuz. Plata is not in the CU, while Soyuz is in the CU. Before joining the CU, Coventry has a tariff on all imports of Product S. After joining the CU, Coventry does not have a tariff on the Product S imported from other countries in the CU, but maintains its tariff on the Product S imported from countries outside the CU. The tariff, when applicable, is $7. (Use the Basic Tariff Model in this analysis and assume no foreign retaliation on this product.)

1. The price of Product S from Plata is $62 and the price of Product S from Soyuz is $73. Suppose Coventry changes from not being in the CU to being in the CU.

(a) Who is Coventry’s supplier of Product S before joining the CU? After joining the CU?

(b) Is there a trade creation effect in this case?

(c) Is there a trade diversion effect in this case? Why?

(d) What happens to the Coventry Total Surplus for Product S because it joined the CU? Why?

Answer 1

(a) Coventry’s supplier of Product S before joining the CU is  Plata and  After joining the CU, Coventry’s supplier of Product S is Soyuz.

Explanation

Before joining the CU, Coventry can buy Product S from the country of Plata or the country of Soyuz. The price of Product S from Plata is $69 and the price of Product S from Soyuz is $72. Its clearly visible that price of product is lower in Plata as compared to Soyuz.Therefore, Coventry’s supplier of Product S before joining the CU is  Plata.

Where as after joining the CU, the cost of importing Product S from Plata is $62 + $7 = $69 (not join CU)and the cost of importing Product S from Soyuz is $65 (member of CU). Therefore, After joining the CU, Coventry’s supplier of Product S is Soyuz.

(b) Yes, there is a trade creation effect in this case. Trade creation effect means, when tariff is removed among the member countries of CU, domestic country will prefer to import that commodity rather than producing it self. In this case, Coventry is joining a customs union (CU) which involves removing of  tariff on all imports of Product S from country Soyuz. Its beneficial for Coventry to import Product S from country Soyuz rather than producing it self, this effect is known as Trade creation effect.

(c) Yes, there is a trade diversion effect in this case.

Explanation

Before joining the CU, Coventry buy Product S from the country of Plata at $69 rather than from Soyuz at $72.

However, After joining the CU, Coventry remove tariff on all imports of Product S from country Soyuz . As we Know, formation of CU involves removal of tariff among the member countries of CU. So, after joining the CU, Coventry import Product S from country Soyuz at $ 65 rather than from Plata at $69 (not in CU). thus, there is diversion of import from Plata to Soyuz. This diversion of trade is known as trade diversion effect.

(d) The Coventry Total Surplus for Product S, depends on the trade creation effect and  trade diversion effect. Before joining the CU, Coventry buy Product S from the country of Plata at $69 rather than from Soyuz at $72. but after joining the CU, Coventry import Product S from country Soyuz at $ 65 rather than from Plata at $69 (not in CU). It means after it joined the CU,  Coventry pay lower price $65 to Soyuz as compared to $69 to Plata. Therefore,  the Coventry Total Surplus for Product S increases.