This question explores multilateral trade organizations and the more restrictive free trade areas/customs unions. Suppose there are three nations A, B, and C. Nation A is the high cost producer of a commodity X. Its autarky price for X is $10 compared to $8 in nation B and $6 in nation C. Nation A currently has a nondiscriminatory ad velorem tariff of 100% on imports of commodity X.
a. Graph the current equilibrium in the market for X in country A. Identify the amount of imports of X from country B and country C.
b. Provide the definition of a Free Trade Area and a Customs union. Give one example of each. Suppose country A forms a free trade area/customs union with B. Provide a welfare analysis of the impact of this free trade area/customs union using your graph. Identify the new level of imports from B and C. Does welfare rise or fall? Be sure to identify and discuss the trade creation and trade diversion effects.
c. What is the WTO? Outline the basic principles of the WTO. Suppose that A, B, and C join the WTO and, as a consequence, A eliminates tariffs on imports from A and B. Prove that this policy unambiguously improves welfare and must be at least as good as the policy of forming a customs union/free trade area with either B or C.
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