Homework 4
ECON2252 Theory of International Trade
Deadline: Submit by 12noon, Dec. 7th 2020.
Submission Channels: Electronically only via Moodle. Our TA will set up the link soon.
Format: type version is encouraged. Handwriting-and-scan version is acceptable.
Remark 1 This problem set (long questions) helps you review the External Economies of scale and
monopolistic competition. The multiple questions are used as example of those in the final exam to
help you get familiar with it. You may discuss in groups, with each group up to 5 students. But you
need to write down your homework by yourself.
Section A (18 points): Multiple Choice Questions. Only one choice is correct.
1. In a two-country and two-product Ricardian model, a small country is likely to benefit more
than the large country because
(a) the small country is less likely to trade at price equal or close to its autarkic (domestic)
relative prices.
(b) the small country is less likely to fully specialize.
(c) the small country can raise wages.
(d) the small country is more likely to fully specialize.
(e) the large country will wield greater political power, and hence will not yield to market
signals.
2. International trade can have important effects on the distribution of income because
(a) of government corruption.
(b) the more powerful country dictates the terms of trade.
(c) rich countries take advantage of poor countries.
(d) different countries use different currencies.
(e) different industries employ different factors of production.
3. In the presence of external economies of scale, trade
(a) will unambiguously worsens welfare in both countries.
(b) will unambiguously worsen welfare in the exporting country and improve welfare in the
importing country.
(c) will unambiguously improves welfare in both countries.
(d) will unambiguously improve welfare in the exporting country and worsen welfare in the
importing country.
(e) may or may not improve welfare in both countries.
4. Two countries engaged in trade in products with scale economies, produced under conditions
of monopolistic competition, are likely to be engaged in
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(a) intra-industry trade.
(b) inter-industry trade.
(c) price competition.
(d) immiserizing trade.
(e) Heckscher-Ohlinean trade.
5. A lower tariff on imported steel would most likely benefit
(a) foreign producers at the expense of domestic consumers.
(b) domestic manufacturers of steel.
(c) foreign consumers of steel.
(d) domestic consumers of steel.
(e) workers in the steel industry.
6. A voluntary export restraint will
government revenue, and
producer surplus,
consumer surplus,
overall domestic national welfare.
(a) increase; decrease; increase; have an ambiguous effect on
(b) increase; decrease; decrease; decrease
(c) increase; decrease; have no effect on; have an ambiguous effect on
(d) increase; decrease; have no effect on; decrease
(e) increase; increase; decrease; have an ambiguous effect on
Section B (82 points): Long Questions.
1. (External Economy of Scale. 35 points) Take two countries, Home and Foreign, that both
produce shoes. Suppose both countries have the same technology that displays external
economies of scale, so that average cost of production declines in industry output. Home is
larger so Home has a larger demand at each price. Assume firms are price takers.
(a) Use a clearly labelled graph to show the autarky equilibrium prices and quantity for each
country. Mark the autarky equilibrium as EA for Home and EA∗ for Foreign.
(b) Now suppose these two countries engage in free trade. What will be the equilibrium
price, quantity, and trade pattern? Use a clearly labelled graph to show the result, and
mark the new equilibrium after trade as EW .
(c) Does the equilibrium price increase or decrease after free trade in the Home country?
How about in the Foreign country? Explain why.
(d) Does the free trade increase or decrease the welfare in Home and Foreign in this particular
case? Fundamentally what is the source of gains from trade in this case? Please explain.
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2. (External Economies of Scale: Welfare Effect of Trade. 20 points) Does international trade
always increase the overall welfare of each country, when trade is based on external economies?
If your answer is yes, please explain why. If your answer is no, please use a clearly labelled
graph to present the idea and explain clearly.
3. (Monopolistic Competition: Heterogeneous Effect of Trade. 27 points) Suppose in an industry
firms have internal economies of scale, with total cost function C = F + c ∗ Q, where F is
fixed cost, c is marginal cost, and Q is output quantity. Suppose firms differ in technology
with different marginal cost c, but they have the same fixed costs for simplicity.
Firms produce different variety of products but they face the same demand function Q =
S ∗ [1/n − b ∗ (P − P̄ )], where S is the market size at home, n is the number of firms in
the market, b > 0 is the price sensitivity of demand, P is the output price charged by this
individual firm, and P̄ is the average price charged by all competitors.
Suppose the two countries agree to open up trade, so that the total market size increases from
S to S 0 > S.
(a) How does the increase in market size shift the demand function faced by individual firms?
Draw both the original demand function, DS , and the new demand function associated
with S 0 , DS 0 , in one graph to show the changes. Please explain it clearly.
(b) How does the increase in market size changes the operating profits of firms with different
technology (marginal costs)? Please draw the operating profits associated with S and S’
in one graph to show the changes, with horizontal axis as marginal costs. Please explain
the changes clearly.
(c) Show in the above graph: which group of firms gain, which group of firms shrink, and
which group of firms exit?
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