Suppose the constant marginal cost of producing an automobile is $11,000 in Canada, $8,000 in the United States, and $12,000 in Japan. Each country's automobile industry is perfectly competitive.a. Under free trade, would Canada produce its own cars or import them? If it imports, which country will it import from?b. If the Canadian government imposes a 100 percent tariff on all auto imports, would it produce its own automobiles or import them? If it imports, which country will it import from?c. Canada has a tariff of 100 percent on imported autos. Then Canada decides to join a customs union with the United States (with a uniform external tariff of 100 percent). After the customs union is formed, what will the domestic price of automobiles be in Canada?d. If Canada decides to join this

Question

customs union with the United States, will there be trade creation, trade diversion, or both? Explain.

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE:

a. Canada does not produce its own cars. Canada imports automobiles from the United States.

b. With a 100 percent tariff on imported foreign automobiles, Canadian consumers will buy only Canadian-produced autos because U.S. autos will cost $16,000 and Japanese autos will cost $24,000 to the Canadian consumer.

c. The U.S. automobiles would cost $8,000 in Canada and the Japanese automobiles would cost $24,000. Canada will import automobiles from the United States, and the Canadian domestic price will be $8,000.

d. Before Canada joined the customs union, Canadian consumers were buying only Canadian autos because foreign autos were more expensive (inclusive of the tariff). After Canada joined the customs union with the United States, U.S. autos became cheaper, and Canadian consumers shifted to buying U.S. autos. So, there is trade creation. Trade diversion is nonexistent here, because consumers did not shift purchases from Japanese to U.S. autos.