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Homework 5
UCDavis, 160a, SSII08
Prof. Farshid Mojaver
Economies of Scale and Imperfect Competition
1. Explain how increasing returns to scale in production can be a basis for trade.
2. Why is trade within a country greater than trade between countries?
3. 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?
4. Starting from the long-run trade equilibrium in the monopolistic competition model, as
illustrated in Figure 6-7, consider what happens when industry demand, D, increases. For instance,
suppose that this is the market for cars and lower gasoline prices generate higher demand D.
a. Redraw Figure 6-7 for the Home market and show the shift in the D/NT curve and the new
short-run equilibrium.
b. From the new short-run equilibrium, is there exit or entry of firms, and why?
c. Describe where the new long-run equilibrium occurs, and explain what has happened to the
number of firms and the prices they charge.
5. Our derivation of the gravity equation from the monopolistic competition model used the
following logic:
(1) Each country produces many products;
(2) Each country demands all of the products that every other country produces;
(3) Thus, large countries demand more imports from other countries.
The gravity equation relationship does not hold in the Heckscher-Ohlin model. Explain how the
logic of the gravity equation breaks down in the Heckscher-Ohlin model: that is, which of the
above statements is no longer true in the Heckscher-Ohlin model?
6. The United States, France, and Italy are among the world’s largest producers. To answer the
following questions, assume that their markets are monopolistically competitive, and use the
gravity equation with B = 93 and n = 1.25.
a. Using the gravity equation, compare the expected level of trade between the United States and
France and between the United States and Italy.
(Note: These numbers are larger than is realistic because we are using the gravity equation
estimated on the United States and Canada state/provincial trade, rather than the equation
estimated on international trade.)
b. The distance between Paris and Rome is 694 miles. Would you expect more French trade with
Italy or with the United States? Explain what variable (i.e., country size or distance) drives your
result.
7. What evidence is there that Canada is better off under the free-trade agreement with the United
States?
8. 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.
9. Suppose the Home firm is considering whether to enter the Foreign market. Assume that the
Home firm has the following costs and demand:
Fixed Costs = $140
Marginal Costs = $10/unit
Local Price = $25
Local Quantity = 20
Export Price = $15
Export Quantity = 10
a. Calculate the firm’s total costs from selling only in the local market.
b. What is the firm’s average cost from selling only in the local market?
c. Calculate the firm’s profit from selling only in the local market.
d. Should the Home firm enter the Foreign market? Briefly explain why.
e. Calculate the firm’s profit from selling to both markets.
f. Is the Home firm dumping? Briefly explain.
10. Suppose consumers at Home have the following demand:
P = 50 – 0.5Q
a. Write the Home monopolist’s marginal revenue equation.
b. Assuming that marginal costs and average costs both equal $10 per unit, what is the firm’s
profit-maximizing level of output and price?
c. Calculate the Home firm’s profit.