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HW7 Solution Key
UCDavis, 160a,
Problem Set 1: Trade Policy large country
Prof. Farshid Mojaver
Problem 1
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).
Problem Set 2: Trade Policy
1. The graph below shows an equilibrium point, B, corresponding to the intersection of Home
import demand and Foreign export supply. In this exercise we compare two potential export
supply curves: X1* and X2*.
a)
Which export supply curve has a higher elasticity of export supply at point B. Interpret the
meaning of this difference in words.
X2* has a higher elasticity of export supply at point B that is given a price change
export responds is higher in X2* compared to X1*
b) Suppose that the Home country imposes a tariff of t. Show the effect on both export supply
curves of the tariff.
A tariff will shifts export supply curve upward by t, as shown below:
t
b) Draw the Home supply and demand diagram for this good beside (to the left of)
this graph. Illustrate on your graphs the price seen by Home consumers and price
received by Foreign producers.
S
X1*
P2M
X2*
P1M
PW
P2X
P1X
M
D
X2 X1
Note:
- P2M = the price seen by home consumers when foreign export supply curve is X2*
- P1M = the price seen by home consumers when foreign export supply curve is X1*
- PW = the price seen by home consumers and foreign firms when there is no tariff
- P2X = the price received by foreign firms when foreign export supply curve is X2*
- P1X = the price received by foreign firms when foreign export supply curve is X1*
c) What can you say about the relationship between the elasticity of Foreign export
supply and the amount of the tariff absorbed by Foreign producers?
The higher the elasticity of foreign export supply, the smaller the amount of the tariff
absorbed by foreign producers.
2. Assuming perfect competition in the Home industry, rank the following in ascending
order of Home welfare and justify your answers. If two items are equivalent, indicate as
such accordingly.
a) Quota of M in a small country, with quota licenses distributed to non-rent-seeking
Home firms.
b) Quota of M in a small country, with quota licenses auctioned.
c) Quota of M in a small country, with the responsibility of implementing the quota
given to the exporting country.
d) Quota of M in a small country, with quota licenses distributed to rent-seeking
Home firms.
Measured in total national welfare, from lowest to highest:
(c) < (d) < (a) = (b).
Case a) and b) have the same welfare effect, where rent is earned by domestic
residents without (significant) loss. Case d) incurs some waste in the process of rentseeking, which could be as large as the rent. In case c) all rent is earned by foreigners.
3. Extend question 2 by also ranking the three tariff scenarios listed in d), e) and f), under perfect
competition, and the quota in h) with imperfect competition. Compare each of these to the quotas
in a), b), c) and d). If two items cannot be ranked, just indicate that.
a) Quota of M in a small country, with quota licenses distributed to non-rent-seeking Home
firms.
b) Quota of M in a small country, with quota licenses auctioned.
c) Quota of M in a small country, with the responsibility of implementing the quota given to
the exporting country.
d) Quota of M in a small country, with quota licenses distributed to rent-seeking Home
firms.
e) Tariff, t, in a small country corresponding to the quantity of imports M.
f) Tariff, t, in a large country corresponding to the same quantity of imports M.
g) Tariff, t’, in a large country corresponding to the quantity of imports M’>M.
h) Quota of M in a small country, but with Home monopoly.
First of all, case e) has the same welfare effect as case a) and b). Case f) has a higher
national welfare than cases a), b) or c) does, because a large country can benefit from
the improvement of terms of trade when setting a tariff. But we cannot say which one
of case f) and g) is better, since we have no idea about the export elasticity and thus
the optimal tariff. Neither can we compare case g) and e). As for case h), it incurs an
efficiency loss compared to cases a), b) and e), since quota splits the market and now
the domestic firm can act as a monopoly firm and thus lead to a dead weight loss.
Summary (ordered by total national welfare):
f) > a) = b) = e) > d) > c)
g) ? f), g) ? e)
a) = b) = e) > h)
Illustration 1: case e) vs. case f)
S
XS’
XS
PW
a
b
c
d
b+d
e
e
MD
D
Net welfare change in case e): – (b + d)
Net welfare change in case f): e – (b + d)
Illustration 2: case a) vs. case h)
S
PW
a
b
c
MC
d
D
S1 S2
D2
D1
MR
S2 S1
D-M
D2
D
D1
Net welfare change in case a): – (b + d)
Net welfare change in case h): – (b + d + efficiency loss due to monopoly)
3. Ceteris paribus (i.e. all else unchanging), describe the impact of each of the following
outcomes of the Hong Kong WTO meeting on world prices and domestic prices of a large
country:
a) The abolition of agriculture export subsidies
Once export subsidies of a large economy are abolished, the country will export less
agricultural products and thus world prices will rise and domestic prices will fall.
b) The reduction of agricultural tariffs
The reduction of tariffs will stimulate the exports of agricultural products to the
country and result in higher world prices and lower domestic prices.
Duty-free quota-free access for 97% of goods originating in the world’s least
developed countries
This leads to higher world prices and lower domestic prices of the goods in concern.
c)
4. Consider a large country with export subsidies in place for agriculture. Suppose the
country changes its policy and decides to cut its subsidies in half.
a) Are there gains or losses to the large country, or is it ambiguous? What is the impact
on domestic and foreign prices for agriculture?
S
P’+s
P’’+s/2
a
b
c
XS
d
XS’’
PW
XS’
P’’
P’
MD
D
D1D2
S2 S1
X2
X1
Welfare analysis:
For consumers, price decreases from P’+s to P’’+s/2, consumers gain by a+b.
For producers, price decreases from P’+s to P’’+s/2, producers lose by a+b+c
For government, subsidy cost falls by b+c+d plus the shaded area.
Total national welfare increases by b+d plus the shaded area, which means the
exporting country benefits from a subsidy cut policy.
b) Suppose a small food-importing country elsewhere reciprocates by lowering its tariffs on
agriculture by the same amount. Are there gains or losses to the small country, or is it
ambiguous? Is there a net overall gain?
The small importing country gains from foreign subsidy (equivalent of area e’ in
figure 9.2 in the text or e+b+d in figure below) but losses from having tariff on
imports (an amount equivalent of area b+b in figure below). The sum is positive. So
the statuesque is beneficial for the small importing country. Reduction of foreign
export subsidy deprives the country from e+b+d. Lower tariff reduces inefficiencies
by b+d but the country is worse off by area e.
In answering this question it is implicitly assumed that the reduction in world prices is
equal to the reduction in the large country agricultural subsidy. This is consistent with
WTO mandate for reducing tariffs and subsidies for all countries. If Pw↓ is less than
the reduction is subsidy then the answer can be ambiguous.
S
XS-s+t
PW
a
b
c
e
d
D
b+b
XS-s
MD
c) Suppose a large food-importing country elsewhere reciprocates by lowering its tariffs on
agricultural goods by the same amount. Are there gains or losses to this large country, or is it
ambiguous? Is there a net overall gain?
For a large food-importing country, a tariff cut policy will shift the export supply
curve in the international market down, thus completely counteract the subsidy cut
policy, so the world price remains constant.
The large importing country gains from foreign subsidy (equivalent of area e’ in figure
9.2) and gains from having tariff on imports (an amount equivalent of area e-(b+b) in
figure 7.7 in the text, this amount is positive because it is am optimal choice). So the
statuesque is a win-win situation of the food importing country. Reduction of foreign
export subsidy plus the reduction of import tariff leads to a huge terms of trade loss for
this country.
Problem Set 3: Trade Policy
Problem 1
As a result of political and economic liberalization in Eastern Europe, it seems increasingly likely
that Eastern European nations such as Poland and Hungary may join the European Union in the
near future. Discuss the potential economic costs of such an expansion of the European Union,
from the point of view of (1) Western Europe; (2) Eastern Europe; and (3) other nations (like the
U.S.).
The potential economic costs associated with the entrance of Poland and Hungary into an
expanded EU depend largely on whether their membership results in trade creation or
trade diversion.
(1) The Western nations should also be concerned on the trade creation versus trade
diversion aspects of the entry of Poland and Hungary. For distributional and political
reasons, they may be concerned about whether the prices of their own products will be
driven down by competition or whether the entrants will simply bring to the Western
markets an expanded variety of products and scope for additional scale economies of
production. Workers in Western markets may be concerned that inflows of foreign labor
drive down wages, although, as we have observed in previous chapters, the nominal wage
shifts should be considered in light of changes in the prices of consumption goods.
(2) In particular, Poland and Hungary will gain if they engage in new trade with
Western Europe although they might lose if trade within the European Union simply
replaces trad,e which had been occurring with Eastern bloc countries. Furthermore, both
of these nations will face at least higher structural unemployment during the transition
period. Some of the negative effects on workers might be lessened if labor mobility is
permitted across borders.
(3) Countries outside of the EU, such as the United States and Japan, would express
concern if the supplies of products to the EU by Poland and Hungary substitute for goods
previously supplied by the United States and Japan. The large outsiders, however, could
reap substantial positive gains from having expanded access to the consumers of Poland
and Hungary.
problems 2
The U.S. Commerce Department has urged that the United States provide special support for
high-technology industries. It argues that these industries have the prospects of rapid future
growth, provide inputs to many other industries, and generate technology that benefits the whole
economy. Furthermore, some U.S. high-technology industries such as aircraft and
microelectronics face challenges by government-supported foreign competitors. Which of these
arguments might be valid reasons for the United States to have a policy targeting these industries?
A valid reason for supporting high-technology industries would be that they generate
technologies which benefit the whole economy. The value to the whole economy of this
aspect of the high-technology firms' existence exceeds the benefits to the firms
themselves, and there will be too little expansion of these firms from a social point of
view. Other stated benefits are not valid reasons for industrial policy since the market
provides incentives for the realization of these benefits. The protection from foreign
competition is also a spurious argument since, as has been shown in previous chapters,
the economy as a whole benefits from cheap foreign high-technology goods. The
exception being if the industry provides monopoly rents and the foreign government is
trying to capture these rents for its home economy.
problems 3
Does the U.S. military budget help or hurt the strategic position of U.S. high-technology
industries? Make the case for either point of view.
The potential gains for the high technology industries depend on the extent to which a
great deal of government sponsored research and development is filtered through the
military budget. This is especially relevant when military expenditures on research and
development have spillover effects and produce a marginal social gain of knowledge
which benefits other firms in U.S. industry. However, there are several caveats to this
argument. To the extent that military industry is particularly concentrated and
oligopolistic, there may be a serious market failure. More importantly, there remains the
issue of how relevant and applicable will be any knowledge spillovers from military
research and development to the high technology sectors. Moreover, the military fields
may be siphoning off many highly talented researchers from civilian high-technology
industries. Much of it may not be well-suited. In this case, the goal of developing a broad
application to high technology through military research would not be a well-targeted
program.
problems 4
Suppose that the European Commission asked you to develop a brief on behalf of
subsidizing European software development –bearing in mind that the software industry
is currently dominated by U.S. firms, notably Microsoft. What arguments would you use?
What are the weaknesses in those arguments?
A primary argument must be that there is some sort of market failure that voids the
standard logic of free trade. One might argue that Microsoft’s’ monopoly position allows
it to capture excessive profits, and that its market power dissuades entry. A statesponsored firm might be able to over-come these entry costs. Furthermore, the software
industry may have numerous knowledge spillovers with other industries and high-tech
applications that make it desirable to have some local presence even if the local industry
loses money. On the other hand, Microsoft may be a natural monopoly. It is much easier
for the world to have one computer standard. Furthermore, state direction of an industry
where innovation is so important is unlikely to be successful. Finally, in software,
physical location may be of minor importance as ancillary industries could develop
anywhere and use modern telecommunications technology to interact with U.S. based
software firms.
Political Economy
You are employed as an economic advisor of a presidential candidate in the Unites
States. One of the issues you need to take a stand is the threat of Chinese imports to US
manufacturing products. A number of labor unions demand a substantial increase in the
import tariff rates on such products.
a) What is your advice to the presidential candidate and why?
b) How would your advice change if you were employed by a major party in India
given that income distribution is less equal in India and that India imports capital
intensive goods?
c) How would your advice change if you were employed by the government of
China, where income distribution is more equal but most of the enterprises are
state-owned?
Here you goal to maximize the votes that you can get and not necessarily economic
efficiency/welfare. In getting peoples vote you consider two factors: median voter and
contribution of political lobbyists. The interests of the median voter and the lobbyists are against
each other. The question is which side you want to lean.
a) Using the median voter model of Mayer we know that when income distribution is
relatively equal like that of US, an increase in tariff would be opposed by the median
voter. Empirical studies of Maggi show that the weigh of consumer welfare in the
government objective function in US is between 50 to 100 times higher than that of
political contributions. So to be popular with the voters your trade policies should
represent the interest of consumers 50 to 100 times that of the lobbyists. You do not go
with the idea of increasing tariff rates on Chinese imports, except for very special items
where you can get a handsome campaign contribution without antagonizing the
consumers.
b) In India income distribution is less equal than US. Plus they import capital intensive
products. From the median voter model of Mayer we know that an increase in import
tariffs would be opposed by the medium voter in India. So just like part (a) you do not
support tariff increase on imports except for selected special items.
c) Maggi empirical work shows that the state-owned enterprises have a weight that is 4 to 7
times greater than that given to consumers. In China actually it is not the people that elect
you. You want to be popular with the power houses that help you get the premier job.
Hence if the state-owned enterprises ask for an increase in import tariff you do it most of
the time.