Consider a model such as in Krishna (2003). Suppose that utility functions are such that a I-percentage-point reduction in Country 1's tariff on Country 2's good will always increase Country 1's imports of Country 2's good by 5 units and reduce Country 1's imports of Country 3's good by 4 units. (In other words, in the notation of equation 15.l, ∆m21 = 5 and ∆m31 = -4, regardless of the value of the initial tariff level.)
(a) Suppose that initially there are no trade preferences. Country 1's tariffs against both of the other countries 'goods are set at a value of 10%. Would a preferential reduction in
Country l's tariff on Country 2's goods to 9%, holding the tariff on Country 3's goods constant, raise or lower Country l's welfare?
(b) Now, suppose that initially Country l's tariff on Country 2's good is 1 %, while its tariff on Country 3's good is still 10%. If Country 1 eliminated its tariff on Country 2's good, holding its tariff on Country 3's good constant, would Country l's welfare go up or down?
(c) Explain the difference between the result in parts (a) and (b), making reference to trade creation and trade diversion.