Question

In the world market, a pair of shoes from China is sold for $40 and that from Mexico is $50. U.S. made shoes are $70 a pair. Initially U.S. does not belong to any free trade agreement and imposes an ad valorem tariff of 30%. Later, the U.S. joins a free trade agreement with Mexico and remove all trade barriers including tariffs. The import demand function for the U.S. is Q = 280 – 4P. (Hint: Draw the import demand curve of the world market as shown in the examples on the textbook and lecture slides.)

14. What is the size of trade diversion effect to the U.S. economy of this free trade agreement?

	a.	$8
	b.	$152
	c.	$720
	d.	$864

Answer 1

The below graph shows the import demand and the respective supplies.

Before the agreement, the lowest price was that of the Chinese with tariff. At that point, the price was $52 (30% ad valorem on $40 will be $12). At that point the import was that of or . With a tariff of $12 per unit, the government revenue was $.

After the agreement, the concerned supply is that of from Mexico, at $50 price. At that price, quantity imported would be or . Hence, increase in import is of 8 units. Also, the decrease in price is of $2 (from $52 to $50). A part of the loss in government revenue is added in the consumer surplus, which is area of green-er rectangle, above the Mexico supply line, which is $.

But, as the loss to government revenue is $864; hence, the net loss in this case is $.

hence, te correct option is

c. $720

______________

Note: The answer is a bit adjusted as per the options. The area of the shaded blue region is an increase in consumer surplus. The area of that traingle is dollars. In that case, the trade diversion would be $.