Question

The demand curve for TVs in the US is given by Q = 80 – P, where Q indicates the number of TVs purchased and P is the price. Suppose that there are no TVs produced in the US, but they can be imported either from Mexico or from the rest of the world. The price of TVs in Mexico is $10, and the price from the lowest‐cost supplier in the rest of the world is $5. In each case, TVs are produced with a horizontal supply curve, so these prices are fixed and will not change with changes in US policy. The US MFN tariff on TVs is a specific tariff in the amount of $10 per unit imported. a) If there is no PTA, so that every country must pay the same tariff, from where will US consumers import their TVs, Mexico or the rest of the world? Compute the equilibrium price of TVs in the US, the quantity imported and consumed, and US consumer surplus, tariff revenue, and social welfare. b) Now, suppose that the US and Mexico sign a free‐trade agreement that eliminates the tariff on TVs from Mexico, but leaves the tariff on TVs from the rest of the world unchanged. How will the equilibrium change? Answer the same questions as in a) under the new policy regime. c) Identify the welfare change due to trade creation and the welfare change due to trade diversion, and draw them on a carefully‐marked graph with the equilibrium prices and quantities before and after the free‐trade agreement marked. Does this trade agreement raise or lower US welfare?

Answer 1