Question

The demand curve for T-shirts in the US is given by Q = 100 – 2*P. Suppose that there are no T-shirts produced in the US, but they can be imported either from Mexico or from the rest of the world. The price of T-shirts in Mexico is $20, and the price from the lowest-cost supplier in the rest of the world is $15. The US charges a tariff of $10 per unit imported.

a) Consider the case where there is no PTA, so that every country must pay the same tariff. Compute the US consumer surplus in this case.

b) Now, suppose that the US and Mexico sign a PTA that eliminates the tariff on T-shirts from Mexico, but leaves the tariff on T-shirts from the rest of the world unchanged. Compute the US consumer surplus in this case.

c) Compute trade creation and trade diversion due to the PTA.

Answer 1

a) When there is no PTA, every country is paying the same tariff, U.S. will import from lowest cost supplier whose price is $15 and a tariff of $10 is imposed on them which raise the price to $25. Quantity demanded at this price is 50 units.

Consumer surplus is this case is area of portion A whose sum is (1/2) * (50 - 25) * (50 - 0) = 625

Producer surplus in this case is B + D + G.

b) If there is PTA between U.S. and Mexico, all consumers will import T-shirts from Mexico because it will cost them $20 and quantity demanded at this price is 60 units.

Consumer surplus in this case is area of portion A + B + C whose sum is (1/2) * (50 - 20) * (60 - 0) = 900

Producer surplus in this case is D + G.

c) PTA with Mexico result in increase in surplus by area of portion C. Thus, we can say that there is trade creation due to trade with Mexico.