The demand curve 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 United States, but they can be imported either from Mexico or from the rest of the world. The price of spark plugs in Mexico is $20, and the price from the lowest-cost supplier in the rest of the world is $10. In each case, spark plugs are produced with a horizontal supply curve, so these prices are fixed and will not change with changes in U.S. policy. The U.S. MFN tariff on spark plugs is a specific tariff in the amount of $15 per unit imported.
(a) If there is no PT A, so that every country must pay the same tariff, from where will U.S. consumers import their spark plugs, Mexico or the rest of the world? Compute the equilibrium price of spark plugs in the United States, the quantity imported and consumed, and U.S. consumer surplus, tariff revenue, and social welfare.
(b) Now, suppose that the United States and Mexico sign a free-trade agreement that eliminates the tariff on spark plugs from Mexico, but leaves the tariff on spark plugs 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 U.S. welfare?
(d) Now, how would your answer in (c) change if the MFN tariff had been $50? Explain clearly; a diagram might help, but there is no need for additional calculation.
(e) Now, how would your answer change if the MFN tariff had been $5? Again, no calculation is needed.