Question

Consider a hypothetical world consisting of only three countries: Liechtenstein, Canada, and France. Each country produces grain. Liechtenstein is a small economy compared to Canada and France and thus cannot influence foreign prices. On the following graph, the supply and demand schedules of Liechtenstein are shown as Such and Dich. Foreign supply schedules of grain are perfectly elastic: Canada is a more efficient supplier of grain than France because its supply price is $0.80 per bushel (Scu), whereas France's supply price is $1.60 per bushel (Sp). PRICE (Dollars) 0 12 18 24 30 38 42 48 GRAIN (Thousands of bushels) 54 60

Answer 1

1. The supply price of Canada is lower than the supply price of France under free trade as well as under tariff. The free trade price of Canada $0.80 per bushel. The supply price of France under free trade is $1.60 per bushels. Under tariff the supply price of Canada rise only to $2.40 per bushel. But with tariff the supply price of France is $3.20 per bushels. In both the case Liechtenstein has a comparative advantage in importing from Canada. Thus under free trade and tariff Liechtenstein will import from Canada only. The quantity of import is domestic demand minus domestic supply. The quantity of import under free trade is 48000 bushels (domestic supply under free trade with Canada is 6000 and domestic demand is 54000, then import is 54000 6000= 48000). Under tariff import is equal to 24000. Under tariff price the domestic supply is 18000 and domestic demand is 42000, then quantity of import is 42000-18000- 24000. Under customs union lariff and other traded restrictions were removed among the union partners. The formation of customs union eliminates the tariff on import from France while the tariff on the non member Canada continues. Now France can supply at a lower price than Canada. Aner customs union Licchtenstein imports from France. The total quantity of import is 36000(domestic consumption is 12000 and domestic demand is 48000, then the quantity of import is 48000-12000- 36000) Imports Scenario (Thousands of bushels) Imports from Free trade 48000 Canada With tariff 24000 Canada With customs union | 36000 France Consumption effect is the increase in consumption due to low price. After customs unions the consumption increases from 42000 to 48000. Thus the area 'B' represents the consumption effect. Favourable production effect is the increase in production in union partner due to the formation of customs union. The area 'B' is the increase in production in France. Trade creation is the expansion of trade after customs union. Before the customs union the domestic production was 18000 and the total quantity of import was 24000(42-18) but after the formation of customs union the domestic production falls to 12000, this fall in production equal to 6000 is met through import. The overall import is more than the earlier, total import after customs union is 36000(48-12). The overall creation of trade is fall in domestic production met by

import plus the increased demand met through import which is equal to the areas A+B Trade diversion is the diversion of trade from non member country to member country. Before the customs union the same quantity equal to 42000-18000- 24000 were traded with Canada. But after customs union the same quantity is diverted from Canada to France. Then the arca 'C' represent the trade diversion. Effect А тв с Consumption effect Tavourable production effect Trade creation effect Trade diversion effect . . . The relative to a global tariff, the effect of creating customs union is Liechtenstein in negative since it forms a customs union with high cost country. Answer: True The formation of customs union enlarges trade among member countries and cause increased investment. The formation of customs union promotes world competition. Then countries benefit from competition. Answer: Increased investment Great competition.