The diagram shows an economy Gamma producing and importing cars in the form of intra-industry trade. The economy is contemplating forming a customs...

The diagram shows an economy Gamma producing and importing cars in the form of intra-industry trade. The economy is contemplating forming a customs union with one of the two economies, M or N. The supplies of cars before the customs union from the two economies are denoted by SM and SN respectively. Once the customs union is formed, Gamma will import from the member country without any tariff but will impose a tariff of T when imports from the non-member economy.

(a) Prior to the formation of the customs union, explain which economy Gamma should import the cars from. Determine the levels of domestic production, domestic consumption, and imports.  (10 marks)

(b) If Gamma forms the customs union with economy N, explain whether the custom union is trade creation or trade diversion. Analyse the net welfare effects of such a customs union with reference to the appropriate areas in the diagram.(10 marks)

(c) If Gamma forms the customs union with economy M, explain whether the custom union is trade creation or trade diversion. Analyse the welfare effects of such a customs union with reference to the appropriate areas in the diagram.(10 marks)

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