Preferential Trade Agreements

The demand curve for T-shirts in the US is given by Q = 100 – P, where Q indicates the number of T-shirts purchased and P is the price. Suppose that there are no T-shirts produced in the US, but they can be imported either from Mexico or from the rest of the world. The price of T-shirts in Mexico is $20, and the price from the lowest-cost supplier in the rest of the world is $10. In each case, T-shirts 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 T-shirts is a specific tariff in the amount of $15 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 T-shirts, Mexico or the rest of the world? Compute the equilibrium price of T-shirts 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 T-shirts from Mexico, but leaves the tariff on T-shirts 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?