4. Effects of a regional trading arrangement Aa Aa Consider a hypothetical world
ID: 1102665 • Letter: 4
Question
4. Effects of a regional trading arrangement Aa Aa Consider a hypothetical world consisting of only three countries: Luxembourg, the United States, and Germany. Each country produces grain. Luxembourg is a small economy compared to the United States and Germany and thus cannot influence foreign prices On the following graph, the supply and demand schedules of Luxembourg are shown as SLux and DLux. Foreign supply schedules of grain are perfectly elastic: The United States is a more efficient supplier of grain than Germany because its supply price is $0.80 per bushel (Su.s.), whereas Germany's supply price is $1.60 per bushel (SGer) PRICE (Dollars) 8.00 Lux 6.40 5.60 4.80 4.00 3.20 2.40 SU.S er Su.s 0.80 0.00 0 6 12 18 24 30 36 42 48 54 60 GRAIN (Thousands of bushels Fill in the missing quantities in the following paragraph about Luxembourg's imports. (Hint: Enter the quantities as numerical values. For example, type in 40,000, not 40 thousand.) Initially, the three nations engage in free trade, and Luxembourg imports producers and imposes a tariff t1.60 per bushel of grain on imports from both the United States and Germany. As bushels of grain from Germany . At some point in time, however, Luxembourg decides to protect its domestic grain a result, Luxembourg imports bushels of grain fromExplanation / Answer
Answer - A graph has been given. The graph shows demand of grains in Luxembourg and supply of grain in Luxembourg. Other countries in the world are US and Germany. A three produces same good in the economy. World supply curve are perfectly elastic. On the graph equilibrium price in Luxembourg is $4 per bushel. Equilibrium quantity in domestic market in Luxembourg is 30,000 bushels.
US is efficient supplier of grain, it supplies price is $0.80 per bushel and Germany supply price of grain is $1.60 per bushel.
According to the graph,
Initially three nations are engage in free trade, Luxembourg imports zero bushels because US is ready supply more quantity on lower price. There is free trade thus; Luxembourg will not import anything from Germany.
At some point of time Luxembourg decides to protect its domestic grain producers and impose tariff of $1.60 per bushel on import from both countries US and Germany. As a result, Luxembourg imports 24000 bushels from United States.
Later on, Luxembourg and Germany forms a 'custom union' as part of trade liberalization agreement, while the trade between Luxembourg and US continues on previous terms. As a result, Luxembourg imports (48-12 = 36) 36000 bushels from Germany.
Complete the table -
The trade-creation effect - Trade creation effect is show by the area 'A+B. Member countries removes tariff and other barriers after formation of custom union which is a advance form of economic integration. A+B is effect which occurs due to formation of custom union.
Trade diversion effect - Trade diversion occurs when a country imports from member country on higher cost than lower cost nonmember country. In the above situation Luxembourg imports from Germany, before formation of custom union Luxembourg was importing from US which was more efficient. Formation of custom union generates loss of tariff revenue. Tariff revenue was lost equal to 'C'. Thus trade diversion effect is 'C'
The production effect - Production decreased by due to formation of custom union in Luxembourg domestic market. Production effect is ''B''
The consumption effect - Formation of custom union increases consumption of Luxembourg. Consumers enjoy cheaper goods in the market. Consumption effect ''A''
The effect of custom union on Luxembourg is negative because (A+B) > C.
Production effect on US will be negative.
Production effects on Germany will Positive.
Custom union’s dynamic gains-
On time boost to economic welfare
Successful collusion of domestic producers.
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