The demand for spark plugs in the United States is given by Q= 100-P, where Q indicates the number of spark plugs purchased and P is the price. Suppose that there are no spark plugs produced in the U.S., but they can be imported from either Mexico or the rest of the world (ROW).The price of spark plugs in Mexico is $20, and the price from the lowest cost supplier is $10. In each case, spark plugs are produced with a horizontal supply curve, so that these prices are fixed and will not change with changes in the U.S. policy. The U.S. tariff on spark plugs is a specific tariff in the amount of $15 per unit imported.
1. If there is no free trade agreement between any countries, so that every country must pay the same tariff, from where will U.S. consumers import their spark plugs: Mexico orROW? Compute the equilibrium price of spark plugs in the U.S., the quantity imported and consumed, and the U.S. consumer surplus and tariff revenue.
2. Now, suppose the US signs a free trade agreement with Mexico that eliminates the tariff on spark plugs from Mexico, but leaves the tariff on sparks plugs from ROW unchanged.How will the equilibrium change? Answer the same questions as in the previous question under this new policy regime.
3. Identify the welfare change due to trade creation, and the welfare change due to trade diversion. Does the free trade agreement raise or lower U.S. welfare?
4. Now, how would your answer to question (7) change if the tariff had been $50? Explain without the need for additional calculations.
5. Now, how would your answer change if the tariff had been $5? No calculation is needed.