Download hw4s - Economics

HW4 Solution Key
UCDavis, 160a, SSII, 2007
Prof. Farshid Mojaver
Problem set 1: Economies of Scale and Imperfect Competition
Problem 1
There are some shops in Japan that sell Japanese goods imported from the United States at a discount over the prices
charged by other Japanese shops. How is this possible?
The Japanese producers are price discriminating (“dumping”) across United States and
Japanese markets, so that the goods sold in the United States are much cheaper than those
sold in Japan. It may be profitable for other Japanese to purchase these goods in the
United States, incur any tariffs and transportation costs, and resell the goods in
Japan. Clearly, the price differential across markets must be nontrivial for this to be
profitable. (i.e. the foreign and domestic markets are not sufficiently “segmented”)
Problem 2
Consider two industries: In industry A, internal economies of scale allow monopolistic competition to develop. Can this
give rise to trade? What sort of trade is likely here (similar products and countries)? Explain your reasoning. Discuss
the possible welfare effects. Now consider industry B. Each firm is perfectly competitive, but the industry as a whole,
gains from “external economies”. Can this lead to trade? Why does this sort of trade often lead to losses for consumers
in the importing country or countries?
For Industry A, “internal” economies of scale occur at the level of the individual firm.
The larger the output of a product by a particular firm, the lower its average costs. This
gives rise to trade because firms cannot sell a large enough quantity in the autarkic,
domestic market, to take full enough advantage of such increasing returns to scale
with respect to the production of a wide range of goods. Thus, in autarky, the few local
firms focus on producing only a limited number of “local” varieties that are the most
popular. Of course, not every consumer is content with just the few local varieties,
although that is the best that the local firms can do and still taking some advantage of
increasing returns to scale. If the local firms were to produce a little bit of every variety
then they would be even less efficient because they would be taking even less advantage
of available increasing returns to scale to large-scale production.
Therefore, trade is necessary to expand the consumer market enough to allow firms to
produce a “large enough” quantity so that they can take full advantage of increasing
returns to scale. That is, only with free trade can each firm sell and produce large
quantities and lower its average costs, thereby taking fuller advantage of increasing
returns to scale. This type of trade is called intra-industry trade and it will dominate
“comparative advantage-based” or inter-industry trade when there are similar
products being produced by similar firms in similar countries. In fact, because this
type of trade does not rely on a firm being in one country vs. the other (in order to take
advantage of a relative labor abundance in one country vs. the other, for instance) the
location of the firms is not important to realize the gains from trade.
With free entry, as in the Monopolistic Competition model that we studied in class, the
gains from firms being more efficient and lowering their average costs is passed
completely on to the consumers, through lower prices than in autarky.
Also, with it now being feasible for firms to produce both the domestic and foreign
varieties, consumers enjoy a greater variety in consumption and no longer have to “make
do” with just a few local varieties. Finally, there are not as severe, detrimental income
distribution effects or price distortions that reduce welfare in the resource based models
of trade that rely on comparative advantage. That is, because the exporters and the
importers all belong to the same industry and trade across two similarly endowed
countries, the “winners” no longer have to necessarily compensate the “losers” from freer
trade in order to realize widespread benefits or gains from intra-industry trade.
Of course, the potential problem is that when increasing returns are internal to the firm,
this can lead to imperfect competition, as in petrochemicals, aircraft, and autos. Imperfect
competition was assumed away as part of the Monopolistic Competition model that we
studied in class by assuming “free entry”.
Without free entry and with internal increasing returns to scale, location of these
larger firms matters! Location of big, imperfectly competitive firms benefits the host
country and labor in the host country, which can then capture some monopoly rents.
However, it may hurt the rest of the world, which could then face higher prices on its
consumption goods.
Even with many, many firms in Industry B, “external” economies of scale should still
lead to concentration of production in just a few locations or countries. This reduces the
industry's average costs even while the scale of operation of individual firms
remains small. Therefore, external economies need not lead to imperfect competition.
The benefits of geographical concentration may include a greater variety of specialized
services to support industry operations, larger labor markets, or thicker input markets.
However, even by concentrating the production of each good produced by an industry
with external economies of scale in one country, rather than spreading the production
over several countries, the world economy will use the same amount of labor to produce
more output (it will be more efficient).
Again, with many competing firms, this lower cost will be passed on to the consumers in
the form of lower prices, to the benefit of global consumers. Monopolistic pricing
behavior is less likely with external economies of scale since imperfectly competitive
markets are less likely. Without trade, only the producers and consumers in the country
where concentrated production was located would benefit. Of course, even consumers in
this “host” country would not benefit as much as with free trade because the scale of
production in Industry B would be much smaller than if this industry could export to a
global market. Therefore, the gains from trade arise from the same basic principle of
being able to take greater advantage of increasing returns to scale, “larger markets
available through free trade lead to larger, more-efficient production, meaning
lower costs for firms and lower prices for consumers”.
However, in the external economies case, location is always important! Globally, in
the short-run, consumers will benefit from external increasing returns to scale, even if
Industry B is all located in a single, distant country. Unfortunately, this may have
occurred due to historical accident or random chance discoveries that enabled that one
country to be the first to develop this industry. Such accidents do not usually imply that
such countries are still the most efficient countries for such production. However, free
trade reinforces their “first-mover” advantage because they now produce such a
large quantity that their average costs are lower, in the short run, than in another
country where costs might actually be less in the long run. That is, a country that
might be a more efficient future host cannot ever get the industry established in the shortrun, as long as there is free trade, because their initial costs of entry, costs of initial
learning by doing, etc. are higher than the first country’s current average costs.
Problem 3
Consider the long-run trade equilibrium in the monopolistic competition model as illustrated below.
Consider a situation where the foreign and domestic demand for a particular good increase. For instance,
suppose that this is the market for cars and lower gasoline prices generates higher demand.
a) Redraw the Figure below and show what happens when this change in demand occurs. Specifically,
show which curve(s) shift.
b) If the old equilibrium is at point C, describe where the new long run equilibrium occurs, and what has
happened to the number of firms and the price they charge.
D0/Nc
C
C’
dc
mrc
dc’
AC
MC
mrc’
Short run effect: Demand goes up and so does price and the scale of production. The
existing firms make above normal profits as the number of firms are fixed in the short
run.
Nd >Nc
D0/Nc
D1/Nd
C
D
dc
mrd
dc’
AC
MC
Long Run effect: Higher profit attracts new firms to the market. As new firms enter the
market demand curve facing each firm shifts down. Consequently the price and the scale
of production fall. But now there are more varieties in the market and demand curve is
flatter.
Jeopardy Answers
DIRECTIONS: As in the popular TV game show, you are given an answer to a question and you must
respond with the question. For example, if the answer is, "a tax on imports", then the correct question is,
"What is a tariff?"
1. term used to describe a tariff that will raise national welfare to the greatest extent for
a large importing country.
Optimal tariff
2. term used to describe a country's counter trade actions in response to it's trading
partner's increase in tariffs.
Countervailing Duties
3. term used to describe the choices economic game players are able to make.
Strategies
4. name given to a non-cooperative solution to an economic game.
Cournot -Nash
5. term used to describe an economic game equilibium which maximizes the sum of the
payoffs to all players.
Cooperative solution
6. an arrangement in which a group of countries agree to eliminate tariffs between
themselves, but maintain their own external tariff on imports from the rest of the
world.
Customs Union
7. term used to describe a change in the pattern of trade, in response to trade
liberalization, in which a country begins to import from a less efficient supplier.
Trade Diversion
8. term used to describe a change in the pattern of trade, in response to trade
liberalization, in which a country begins to import from a more efficient supplier.
Trade Creation
9. a tariff used to offset the injurious effects of a foreign government export subsidy.
Antidumping Duty (tariff)
Problem Set 1: Trade Policy
Problem 1
Go to: http://www.wto.org/english/thewto_e/whatis_e/tif_e/org6_e.htm , and find out
how many countries belong to the WTO. Which countries joined most recently?
Problem 2 (WTO-GATT)
Which of the following actions would be legal under GATT, and which would not?
a. A U.S. tariff of 20 percent against any country that exports more than twice as much to the United States as it
imports in return.
While tariffs are legal, the United States is obliged to offer compensation for any
unilateral tariff increase by reducing other tariffs to compensate the affected
exporting country.
b.
A subsidy to U.S. wheat exports, aimed at recapturing some of the markets lost to the European Union.
Export subsidies on agricultural products are legal under GATT.
c.
A U.S. tariff on Canadian lumber exports, not matched by equivalent reductions on other tariffs.
This is not legal under GATT because the United States is not offering compensating
reductions in other tariffs on Canadian goods. Interestingly, in the late 1980s, U.S.
efforts to protect the shakes and shingles industry were met with an outcry and
Canadian threats of a trade war. These protectionist efforts by the United States were
rescinded.
d.
A Canadian tax on lumber exports , agreed to at the demand of the United States to placate U.S. lumber
produces.
This is legal under GATT since the action is taken by Canada on its own exports.
e.
A program of subsidized research and development in areas related to high-technology goods such as
electronics and semiconductors.
This is legal under GATT since it does not involve any direct export subsidies.
f.
Special government assistance for workers who lose their jobs because of imports competition.
This is legal under GATT and, in fact, may help increase the benefits from trade.
Problem 3
Assume Austria’s supply and demand for beef is:
S = 200 + 20P
D = 950 - 30P
a. Derive and graph Austria’s import demand schedule. If Austria’s agricultural department outlawed purchasing
foreign beef to prevent mad-cow disease, what would be the price of beef be?
Import demand is domestic demand minus domestic supply:
(D = ) 950 – 30P
-(S = )-(200 + 20P)
MD = 750 – 50P
In Autarky, Austria’s domestic
demand must equal domestic supply
200 + 20P = 950 – 30P
PAUTARKY = 15 for Austria
(Quantity = 500)
b. Now consider Britain, with the following demand and supply schedules for beef:
S* = 40 + 40P
D* = 205 - 15P
Derive Britain’s export supply schedule, if Britain’s agricultural department outlaws exporting beef until more tests are
run for mad-cow disease. What would be the price of beef in the absence of “trade”?
Export supply is domestic supply minus domestic demand:
(S = ) 40 – 40P
-(D = ) – (205 – 15P)
XS = –165 + 55P
In Autarky, Britain’s domestic
demand must equal domestic supply
205 – 15P = 40 – 40P
PAUTARKY = 3 for Britain
(Quantity = 160)
c. Once the tests have been run and all sick cows have been quarantined, beef can be openly traded between Austria
and Britain. What is the world price? What is the volume of trade?
To determine the free trade volume and price, set XS = MD:
–165 + 55P = 750 – 50P
PFREE TRADE = 8.71
Trade Volume = 314 tons
Problem 4
What happens if Austria continues to limit beef “imports” from Britain by adding a specific tariff of 1.0 on beef
imports?
a. Calculate the effect of the tariff on (1) the price of beef in each country, (2) the quantity of beef supplied and
demanded in each country, and (3) the volume of “trade.”
Austria’s specific tariff of 1.0 on beef imports will change Austria’s import demand curve
to 750 – 50(P+1), where P now equals Britain’s price. Therefore, Britain’s excess supply
curve will remain unchanged. So, set the new MD equal to the old XS and then plug in
the prices to the domestic supply and demand curves to get supply and demand in each
country, after Austria imposes the tariff. The easiest way to get the new trade volume is
to plug Britain’s new price into the same old XS curve equation (making sure that you do
not round this new price before doing so).
750 – 50P – 50 = –165 + 55P
b. Determine the effect of the tariff on the welfare of each of the following groups: (1) Austrian beef producers; (2)
Austrian Consumers; (3) The Austrian government.
For this part, the welfare of Austria is best seen using a combination of the
graphical and numerical solutions below.
(1) The Gain in Producer Surplus is
Area a: (384)(9.24 – 8.71) – .5(384 – 374)(9.24 – 8.71) = 203.52 – 2.6 = 200.92
(2) The Loss in Consumer Surplus is Area a + b + c + d:
(672)(9.24 – 8.71) + .5(689 – 672)(9.24 – 8.71) = 356.16 + 9.01 = 365.17
(3) The Gain for the Austrian Government is simply total tariff revenue c + e:
(288)(1) = 288
Note: Efficiency losses b + d are exceeded by net terms of trade gain e. Also, in the
calculations for the a, b, and d areas number of “0.5” is used. This is because we are
measuring the area of a triangle, which is one-half of the area of the rectangle defined by
the product of the horizontal and vertical sides.
Problem 5
Suppose that Britain was not able to resolve its “Mad Cow” problem and that Austria has to import beef from a much
larger country, like the U.S., where
S* = 200 + 200P
D* = 1025 - 75P
(Notice that this implies that the U.S.’s price of beef in the absence of trade would be the same as Britain’s.)
a. Recalculate the free trade equilibrium and the effects of a 1.0 specific tariff by
Austria.
Import demand and excess supply for Austria remains unchanged: MD = 750 –
50P and XS = –165 + 55P.
However, excess supply from the U.S. is now:
(S = ) 200 + 200P
-(D = ) – (1025 – 75P)
XS = – 825 + 275P
Again, setting this excess supply equal to excess demand in the world yields
– 825 + 275P = 750 – 50P
PFREE TRADE = 4.85
Trade Volume = 508 tons
Imposing the tariff will have the following effect:
750 – 50P – 50 = – 825 + 275P
PUS = 4.69
PAUSTRIA = 5.69
Trade Volume (w/Tariff) = 465 tons
b. Relate the difference in results to the discussion of the “small country” case in the text.
Clearly, when Austria is a relatively smaller country, the distortionary losses from the
tariff swamp the terms of trade gains. That is, the U.S. will barely lower its price at all
from the free trade level (16 cents per ton). Conversely, most of the distortionary effect of
higher prices will have to be born by Austria, whose prices increase by 84 cents per ton.
Obviously, this is 84% of the total amount of the tariff.
The general lesson is the smaller the economy, the larger the losses from a tariff since the
terms of trade gains are smaller.
Problem Set 3: Trade Policy
Problem 1
Which of the following are potentially valid arguments for tariffs or export subsidies, and which are not (explain your
answers)?
a. “The more oil the United States imports, the higher the price of oil will go in the next world shortage.”
This is potentially a valid argument for a tariff, since it is based on an assumed ability
of the United States to affect world prices -- that is, it is a version of the optimal tariff
argument. If the United States is concerned about higher world prices in the future, it
could use policies which encourage the accumulation of oil inventories and minimize the
potential for future adverse shocks.
b. “The growing exports of off-season fruit from Chile, which now accounts for 80 percent of the U.S. supply of such
produce as winter grapes, are contributing to sharply falling prices of these former luxury goods.”
Sharply falling prices benefit U.S. consumers, and since these are off-season grapes and
do not compete with the supplies from U.S. producers, the domestic producers are not
hurt. There is no reason to keep a luxury good expensive so this is an invalid argument.
c. “U.S. farm exports don’t just mean higher incomes for farmers – they mean higher income for everyone who sells
goods and services to the U.S. farm sector.”
The higher income of farmers due to export subsidies and the potentially higher income
to those who sell goods and services to the farmers comes at the expense of consumers
and taxpayers. Unless there is some domestic market failure, an export subsidy always
produces more costs than benefits. Indeed, if the goal of policy is to stimulate the demand
for the associated goods and services, policies should be targeted directly at these goals (a
“first-best” instead of a “second-best” policy like restricting trade). Thus, this in an
invalid argument.
d. “Semiconductors are the crude oil to technology; if we don’t produce our own chips, the flow of information that is
crucial to every industry that uses microelectronics will be impaired.”
There may be external economies associated with the domestic production of
semiconductors. This is a potentially a valid argument. But the gains to producers of
protecting the semiconductor industry must as always be weighed against the higher costs
to consumers and other industries, which pervasively use the chips. A well-targeted
policy instrument would be a production subsidy. This has the advantage of directly
dealing with the externalities associated with domestic chip production.
e. “The real price of timber has fallen 40 percent, and thousands of timber workers have been forced to look for other
jobs.”
Thousands of homebuyers as consumers (as well as workers who build the homes for
which the timber was bought) have benefited from the cheaper imported timber. If the
goal of policy is to soften the blow to timber workers, a more “efficient” policy (first-best)
would be direct payments to timber workers in order to aid their relocation. So, this is an
invalid argument.
Problem 2
On the following page of this problem set there is a three panel graph. In the left hand panel are the demand and supply
curves in the Home country for some good Q. In the right hand panel are the demand and supply curves for the Foreign
country for the same good. Both Home and Foreign are "large" countries.
A. (a) In the middle panel, draw the import demand (MD) and export supply (XS*) curves for Home and Foreign,
respectively. Be sure to label the curves.
(b) Label the equilibrium world price in free trade as Po W, and indicate quantities consumed (QD) and produced (QS) in
each country, as well as the quantity of good Q traded (label this Mo).
B. Suppose that Foreign imposes a specific export tax of $t.
(a) Show the new equilibrium price in Home and in Foreign, plus the new level of good
Q traded (label this M1). Also indicate the new quantities produced and consumed in each country.
(b) Label the areas in the right hand panel. Relative to free trade, what is the
i) change in Foreign consumer surplus?
CS* = b + c
ii) change in Foreign producer surplus?

PS* = -[ b + c + d + e + f ]
iii) change in the Foreign government’s revenue?
 Gov R* = a + e
iv) total change in Foreign’s welfare. Explain why/whether Foreign’s export tax makes Foreign better off.
.W* = a – d - f
The total effect of an export tax imposed by foreign is ambiguous. It depends on the size of the
government revenue and the dead weight losses that results from over consumption and under
production in the foreign country.
(c) Label the areas in the left hand panel. Relative to free trade, what is the
i) change in Home consumer surplus?
 CS = -[ a + b + c + d ]
ii) change in Home producer surplus?
 PS = a
iii) change in Home government’s revenue?
 Gov R = 0
iv) total change in Home welfare? Explain why/whether Foreign’s export tax makes Home worse
off.
 W = -[ b + c + d ]
(d) Define global welfare as the sum of consumer surpluses, producer surpluses, and government revenues for each
country. Using the labeled areas from the graph, what is the effect of the export tax on global welfare?
Does the export tax raise/lower/have an ambiguous effect on global welfare?
 Wg = a - [ b + c + d + d + f ] = - [ b + d + d + f ] for a = c.
Does the export tax raise/lower/have an ambiguous effect on global welfare?
The export tax has a negative effect on global welfare for a = c.
C. Indicate on the graph above the VER that would be equivalent to Foreign’s export tax t.
(a) Would Home be better off/worse off/indifferent if Foreign used a VER instead of an export tax? Explain.
Home is indifferent to foreign using a VER or an export tax to restrict trade. Home faces the same
import price as before. The difference is now that the foreign producers now receive the
government revenue, previously collected by the foreign government from the tax, as rents
derived from their restricted production.
(b) Would Foreign producers be better off/worse off/indifferent if Foreign used a VER instead of an export tax.?
Explain.
Foreign producers will definitely better off with a VER than an export tax. With the tax they have
to pay areas a & e to the government while with the VER they would receive this money in the
form of rents (This is assuming that the foreign producers get the VER rents. The government
may allocate them in a different way).