Car production is a constant cost industry (i.e., supply curves are perfectly elastic)

| November 24, 2016

Car production is a constant cost industry (i.e., supply curves are perfectly elastic). Japan can produce cars for $12,000 each; the United States can produce them for $16,000; and Mexico can produce them at a cost of $20,000 each. In the questions below, you are asked about the effects on the Mexican economy of a free trade agreement with the United States. To answer these questions, assume that Mexican consumers will buy 1 million cars per year if the price is $20,000 and that every $1,000 drop in the price generates an additional purchases of 100,000 cars.

1. Before the free trade agreement, Mexico had a tariff on cars equal to $10,000 per car. What was the price of cars in Mexico before the FTA?

2. Mexico signs the free trade agreement with the United States but retains the tariff of $10,000 on Japanese cars. What will the price of cars be in Mexico now?

3. What is the change in Mexico’s economic welfare in going from the situation in Question 1 to that in Question 2?

4. Repeat the analysis in Question 3, but assume this time that Mexico’s tariff on cars is $6,000 instead of $10,000. What is the effect of the FTA on Mexico’s economic welfare in this case?

5. Mexico’s tariff is again $6,000. But now assume that U.S. production costs will fall to $13,000 per car if the U.S. auto industry can serve the entire North American market. What would be the effect of the FTA on Mexico’s economic welfare in this case?

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