3. Suppose that Mexico, before the formation of NAFTA, had the option of importi

Question

3. Suppose that Mexico, before the formation of NAFTA, had the option of importing stoves either from the United States at a constant cost of $500, or from Brazil at a constant cost of 0. It had a 30% tariff on all imports of stoves. Under these circumstances. Mexico was importing sto sloping domestic supply curve. ves and also producing stoves in its domestic stove industry. with an upward a) From which country did Mexico import stoves, prior to NAFTA. and why? (2 points) b) When NAFTA was formed, Mexico reduced its tariffs on all imports from the United States to zero. How, if at all, should that have changed the each of following? (You need only indicate the direction of change, but explain your reasoning.) (6 points) i. The domestic price of stoves in Mexico? ii. The quantity of stoves imported? ii. The country from which it imported? iv. Production of stoves in Mexico? V. Consumption of stoves in Mexico? vi. Mexican tariff revenue? c) Identify "trade creation" and "trade diversion" in this case, and explain how this matters for the welfare of Mexico? (4 points)

Explanation / Answer

a)Mexico imported stoves from Brazil, as their expenditure inclusive of tariff was (1.3)400 = 520 dollars ( from Brazil) & (1.3)500 = 650 dollars (from the US).

b)Removal of tariff on imports of stoves from the United States makes them inexpensive, at 500 dollars, than imports of stoves from Brazil which are still costing 520 dollars(inclusive of tariff).The domestic level of price of stoves in Mexico declines from 520 dollars to 500 dollars. This lessens the manufacture of stoves along the domestic supply curve in Mexico & raises the stove consumption levels along the demand curve. Now, increased quantity of stoves are being imported, & all are imported from the US. Now, the government of Mexico collects no tariff receipts from imports of stoves, as none are being imported from Brazil: the tariff receipts thus declines.

c) Trade diversion denotes the imports that occurred   formerly but have been diverted by the Free Trade Agreement away from the outside supplier, in this case Brazil, to an inside supplier, in this case the US. Trade creation denotes the new imports that are brought about by the Free Trade Agreement- stoves which Mexican economy is now importing from the US that it didn’t formerly import at all. And they incorporate both the stoves that were formerly purchased from Mexican producers & are currently purchased from the United States, as well as those which were formerly not purchased at all due to their price, however currently are purchased from America when the price falls. Trade diversion is detrimental to the welfare of Mexican economy, as these stoves formerly cost the nation only 400 dollars(the additional 520 minus 400=120 was an expense to customers, and not to the economy, as it was tariff receipt for the government of Mexico). Trade creation is advantageous to Mexico as a nation, as it provides benefits to customers.

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