5. Suppose that the autarky price of commodity X is $10 in country A, $8 in coun

Question

5. Suppose that the autarky price of commodity X is $10 in country A, $8 in country B, and $6 in country C, and country A is too small to affect prices in countries B and C by trading. If country A initially imposes a non-discriminatory ad valorem tariff of 100 per cent on its imports of commodity X from countries B and C, will country A produce commodity X domestically or import it from country B or country C? If country A subsequently forms a customs union with country B, will country A produce commodity X domestically or import from country B or country C? is the customs union that country A forms with country B trade creating, trade diverting, or neither?

Explanation / Answer

Consider the given problem here there are three countries “A”, “B” and “C”. Now, “A” is a small country don’t have any power to influence the country “B” and “C”. So, if the “100%” ad valorem tariff is imposed then price of “X” will be “16” if imported from “B” and “12” if imported from “C”. So, “16” and “12” both are less than “10” the autarkic equilibrium price of “A”, => the “A” will not import from any country rather will choose to produce domestically.

Now, if “A” and “B” form a custom union then “A” can import “X” at the price “8” less than the autarkic equilibrium price of “X”, => “A” will prefer to import it from “B” rather to produce domestically.

So, as the “CU” is formed it creates trade between “A” and “B”, => it’s an example of “trade creation”.

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