Homework 6
UCDavis, 160a, SSII, 2008
Prof. Farshid Mojaver
Problem Set 1: WTO
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?
2. 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.
b. A subsidy to U.S. wheat exports, aimed at recapturing some of the markets lost to
the European Union.
c. A U.S. tariff on Canadian lumber exports, not matched by equivalent reductions
on other tariffs.
d. A Canadian tax on lumber exports, agreed to at the demand of the United States to
placate U.S. lumber produces.
e. A program of subsidized research and development in areas related to hightechnology goods such as electronics and semiconductors.
f. Special government assistance for workers who lose their jobs because of imports
competition.
Problem Set 2: Trade Policy 1: Tariffs and Quota
Questions from ch8
1. Consider a small country applying a tariff, t, to imports of a good like that represented
in Figure 8-5.
a. Suppose that the country decides to reduce its tariff to t’. Redraw the graphs for the
Home and import markets and illustrate this change. What happens to the quantity of
goods produced at Home and their price? What happens to the quantity of imports?
Answer: The reduction of the tariff, and corresponding decrease in domestic price in the
small country, leads to a reduction in domestic production (to S3) and an increase in
domestic quantity demanded (to D3). The result is an increase in imports (to M3). See the
following figure.
b. Are there gains or losses to domestic consumer surplus due to the reduction in tariff?
Are there gains or losses to domestic producer surplus due to the reduction in tariff? How
is government revenue affected by the policy change? Illustrate these on your graphs.
Answer: Consumer surplus increases because consumers now buy a greater quantity of
products at a lower price. Domestic producer surplus, on the other hand, decreases
because producers sell a smaller quantity of products at a lower price. Government
revenue changes from the rectangle S2D2PWPW + t to the rectangle S3D3PWPW + t’. Notice
that the area of the rectangle does not necessarily decrease when the tariff is lowered
because, although the tax per import is less, the amount of imports has increased.
c. What is the overall gain or loss in welfare due to the policy change?
Answer: The overall welfare gain from the reduction in the tariff is illustrated by the
decrease in total deadweight loss. On our graphs this is the reduction in the size of the
striped triangles; after the reduction in the tariff, total deadweight loss is represented by
the smaller solid triangles.
2. Consider a large country applying a tariff, t, to imports of a good like that represented
in Figure 8-7.
a. How does the export supply curve in panel (b) compare with that in the small country
case? Explain why these are different.
Answer: The export supply curve is upward-sloping in the large-country case (it was
horizontal in the small-country case). In the small-country case, a horizontal export
supply curve means that the supply of exports from the rest of the world is infinitely
elastic. This corresponds to the price taking assumption in perfect competition. In
contrast, an upward-sloping export supply curve means that the price of exports from the
rest of the world responds when the large country changes its import demand. For
instance, if the large-country importer applies a tariff that decreases its demand for
imports, the price charged by foreign exporters falls.
b. Explain how the tariff affects the price paid by consumers in the importing country,
and the price received by producers in the exporting country. Use graphs to illustrate how
the prices are affected if (i) the export supply curve is very elastic (flat), or (ii) the export
supply curve is inelastic (steep).
Answer: Refer to Figure 8-5: In the small-country case (flat export supply curve), a tariff
increases the amount that consumers pay by exactly the amount of the tariff and foreign
exporters are paid the original world price, P*; the difference is collected by the domestic
government as tax revenue. Refer to Figure 8-7: With an upward-sloping export supply
curve (in the large-country case) foreign exporters reduce their price due to a tariff; that
is, foreign exporters receive less than they did prior to the tariff. Domestic consumers pay
more than before, but by less than the full amount of the tariff. Again, the difference
between what consumers pay and what Foreign exporters receive is the amount of the
tariff, t, collected by the domestic government. In the large-country case, the incidence of
the tariff is shared by domestic consumers and foreign producers. Moreover, a steeper
foreign export supply curve implies that foreign exporters absorb more of the price
increase due to the tariff.
3. Consider a large country applying a tariff, t, to imports of a good like that represented
in Figure 8-7. How does the size of the terms-of-trade gain compare with the size of the
deadweight loss when (i) the tariff is very small, and (ii) the tariff is very large?
Use graphs to illustrate your answer.
Answer: Refer to panel (b) of Figure 8-7: As the size of the tariff increases, the export
supply curve shifts upward by more, M2 decreases by more (relative to M1), and the size
of the triangle with area b+ d increases relative to rectangle e. That is, consumer
deadweight losses get larger relative to terms-of-trade gains due to the tariff. We can
interpret this as meaning that for small tariffs the welfare gains from terms of-trade
improvements outweigh consumer deadweight losses, but the opposite is true for tariffs
that are sufficiently large.
4. Consider the following scenarios:
a. If the foreign export supply is perfectly elastic, what is the optimal tariff Home should
apply to increase welfare? Explain.
Answer: This is the small-country case. Because the incidence of the tariff is shouldered
completely by consumers and there is no terms-of-trade gain to applying a tariff, the
optimal tariff is zero.
b. If the foreign export supply is less than perfectly elastic, what is the formula for the
optimal tariff Home should apply to increase welfare?
Answer: This is the large-country case. The optimal tariff is determined as: t=1/E*X,
where E*X is the Foreign export supply elasticity.
c. What happens to Home welfare if it applies a tariff higher than the optimal tariff?
Answer: Refer to Figure 8-8: For a tariff higher than the optimal tariff, welfare declines
because deadweight losses increasingly outweigh terms-of-trade gains. For a sufficiently
high tariff, welfare can go as low as the autarky level.
5. Rank the following in ascending order of Home welfare and justify your answers. If
two items are equivalent, indicate this accordingly.
a. Tariff of t in a small country corresponding to the quantity of imports M.
b. Tariff of t in a large country corresponding to the same quantity of imports M.
c. Tariff of t’ in a large country corresponding to the quantity of imports M’> M.
Answer: a < c < b. For the same quantity of imports, M, Home welfare is greater in the
large-country case relative to the small-country case because (assuming an optimal tariff)
the terms-of-trade gain partially offsets the deadweight losses due to the tariff; thus, a< b.
A larger quantity of imports implies that t’< t. Therefore, in the large-country case with
optimal tariff t, the welfare associated with a tariff of t’ is somewhere in between the
small-country case and the large country case; thus, a < c < b.
6. Rank the following in ascending order of Home welfare and justify your answers. If
two items are equivalent, indicate this accordingly.
a. Tariff of t in a small country corresponding to the quantity of imports M.
b. Quota with the same imports M in a small country, with quota licenses distributed to
Home firms and no rent seeking.
c. Quota of M in a small country with quota licenses auctioned to Home firms.
d. Quota of M in a small country with the quota given to the exporting firms.
e. Quota of M in a small country with quota licenses distributed to rent-seeking Home
firms.
Answer: d = e < a = b = c. A tariff t corresponding to imports M, and a quota on M units
of import corresponding to tariff t are equivalent in terms of welfare so long as proceeds
from quota rents remain in the Home country and are not squandered by rent-seeking
activities: a = b = c. When quota rents are either given away to Foreign firms or are
squandered completely by Home firms seeking access to rents, Home welfare diminishes
by an equal amount (the amount of the quota rents):
d = e < a = b = c.
7. Suppose Home is a small country. Use the graphs below to answer the questions.
a. Calculate Home consumer surplus and producer surplus in the absence of trade.
Answer: Total surplus in the absence of trade is 35.
Consumer surplus without tariff:
Producer surplus without tariff:
CS = 0.5 . 5 .(18 - 9)
PS = 0.5 . 5 . (9 - 4)
CS = 22.5
PS = 12.5
b. Now suppose that Home engages in trade and faces the world price, P*= $6.
Determine the consumer and producer surplus under free trade. Does Home benefit from
trade? Explain.
Answer: Home is better off with trade because total surplus increases by 15 (i.e., total
surplus under trade is 50).
Consumer surplus under free trade: Producer surplus under free trade:
CS = 0.5 . 8 .(18 - 6)
PS = 0.5 . 2 . (6 - 4)
CS = 48
PS = 2
c. Concerned about the welfare of the local producers, the Home government imposes a
tariff in the amount of $2 (i.e., t = $2). Determine the net effect of the tariff on the Home
economy.
Answer: The net effect on Home welfare is -8.
Consumer surplus with tariff:
Producer surplus with tariff:
CS = 0.5 . 6 . (18 - 8)
PS =0.5 . 4 . (8 - 4)
CS = 30
PS = 8
Government with tariff:
Government = (6 - 4) . (8 - 6)
Government = 4
Fall in consumer surplus:
Rise in producer surplus:
Rise in government revenue:
Net effect on Home welfare:
-18
+6
+4
-8
8. Refer to the graphs in problem 8. Suppose that instead of a tariff, Home applies an
import quota limiting the amount foreign can sell to 2 units.
a. Determine the net effect of import quota on the Home economy if the quota licenses
are allocated to local producers.
Answer: An import quota of 2 units has the same net effect on Home welfare as an
equivalent tariff of $2 when the quota licenses are allocated to local producers as long as
the firms do not participate in rent-seeking activities.
Fall in consumer surplus:
Rise in producer surplus:
Rise in government revenue:
Net effect on Home welfare:
-18
+6
+4
-8
b. Calculate the net effect of the import quota on Home’s welfare if the quota rents are
earned by foreign exporters.
Answer:
Fall in consumer surplus:
-18
Rise in producer surplus: +6
Net effect on Home welfare:
-12
c. How do your answers to parts (a) and (b) compare with part (c) of problem 8?
Answer: With an import quota of 2 units the net effect on Home welfare is equivalent to
that of a tariff of $2 (i.e., the net effect on Home welfare is -8) when the quota licenses
are allocated to local producers. If the quota rents are earned by foreign exporters, Home
welfare falls further so that the net effect is -12.
Questions from Ch 9
1. Figure 9-1 shows the Home no-trade equilibrium under perfect competition (with the
price PC), and under monopoly (with the price PM). In this question, we compare the
welfare of Home consumers in these two situations.
a. Under perfect competition, with the price PC, label the triangle of consumer surplus
and the triangle of producer surplus. Outline the area of total Home surplus (the sum of
consumer surplus and producer surplus).
Answer: Refer to Figure 9-1: Consumer surplus is the area under the demand curve D
and above the market price, and producer surplus is the area above the marginal cost
curve MC and below the market price. Under perfect competition, consumer surplus is
PCBPD, where PD is the intersection of the demand curve with the vertical axis. Producer
surplus is PCBPMC, where PMC is the intersection of the marginal cost curve with the
vertical axis. Total surplus is thus represented by the triangle PMCBPD.
b. Under monopoly, with the price PM, label the consumer surplus triangle.
Answer: Refer to Figure 9-1: Consumer surplus is the triangle PMAPD.
c. Producer surplus is the same as the profits earned by the monopolist. To measure this,
label the point in Figure 9-1 where the MR curve intersects MC at point B’. For selling
the units between zero and QM, marginal costs rise along the MC curve, up to B’. The
monopolist earns the difference between the price PM and MC for each unit sold. Label
the difference between the price and the MC curve as producer surplus, or profits.
Answer: Refer to the following figure: Producer surplus is represented by the trapezoid
PMAB’PMC.
d. Outline the area of total Home surplus with a Home monopoly.
Answer: Refer to the figure from part (c): Total surplus is represented by the trapezoid
PDAB’PMC.
e. Compare your answer with parts (a) and (d) and outline the difference between these
two areas. That difference is called the deadweight loss due to monopoly.
Answer: Refer to the figure from part (c): The deadweight loss due to monopoly is
represented by the triangle ABB’.
2. Figure 9-2 shows the free-trade equilibrium under perfect competition and under
monopoly (both with the price PW). In this problem, we compare the welfare of Home
consumers in the no-trade situation and under free trade.
a. Under perfect competition, with the price PW, label the triangle of consumer surplus
and the triangle of producer surplus. Outline the area of total Home surplus (the sum of
consumer surplus and producer surplus).
Answer: Refer to the following figure: The free-trade equilibrium under perfect
competition has a Home consumer surplus of PDB’PW, and a producer surplus of
PWBPMC.
b. Based on your answer to part (a) in this problem and part (a) of the last problem,
outline the area of gains from free trade under perfect competition.
Answer: Refer to the figure from part (a): Gains from trade are represented by the shaded
triangle.
c. Under monopoly, still with the price PW, again label the triangle of consumer surplus
and the triangle of producer surplus.
Answer: Refer to the figure from part (a): The free-trade equilibrium under monopoly
has a Home consumer surplus of PDB’PW, and a producer surplus of PWBPMC . This is
identical to the free-trade surplus under perfect competition.
d. Based on your answer to part (c) in this problem and part (d) the last problem, outline
the area of gains from free trade under Home monopoly.
Answer: Refer to the following figure: Gains from trade are represented by the shaded
area.
e. Compare your answer with parts (b) and (d). That is, which area of gains from trade is
higher and why?
Answer: The area representing gains from trade is larger in part (d) than in part (b). This
is because the opening of trade in the monopoly case eliminates the monopolist’s ability
to charge a price higher than the perfectly competitive price. As such, trade additionally
eliminates the deadweight loss associated with monopoly, making gains from trade
higher.
3. Rank the following in ascending order of Home welfare and justify your answers. If
two items are equivalent, indicate this accordingly.
a. Tariff, t, in a small country with perfect competition.
b. Tariff, t, in a small country with a Home monopoly.
c. Quota with the same imports M in a small country, with a Home monopoly.
d. Tariff, t, in a country facing a Foreign monopoly.
Answer: c < a = b < d. As shown in problem 2, a small country with free trade has
equivalent levels of welfare under either perfect competition or monopoly. Adding a
tariff in either case reduces welfare due to the deadweight loss associated with the tariff,
but does not reintroduce any additional deadweight losses due to monopoly. Thus, a = b.
A quota in a country with a monopoly maintains the market power of the monopolist, and
the deadweight loss due to monopoly is additive to the deadweight loss due to the quota,
such that: c < a = b. Finally, a tariff with a Foreign monopoly can actually increase
welfare because it generates a terms-of-trade gain, and hence: a = b < d.
5. Why is it necessary to use a market failure to justify the use of infant industry
protection?
Answer: If all markets are working perfectly, there is no reason why a potentially
successful fledgling industry cannot survive without government intervention. Let us
consider the two justifications for using an infant industry tariff. The first is that the
industry will learn over time, which will drive down its average costs to the point where
it is competitive; if credit markets were working perfectly, that industry could borrow
against future profitability to keep it in business until that time. The second justification
explicitly assumes a market imperfection: A positive externality in production implies
that the socially optimal level of infant industry output is above that determined by the
market equilibrium.
6. What is a positive externality? Explain the argument of knowledge spillovers as a
potential reason for infant industry protection.
Answer: Positive externality exists when the increase in production by one firm
generates benefits to other firms by lowering industry costs. By imposing the tariff, the
government could nurture the infant industry because the increase in output allows the
firms to reduce their future costs by learning from each other. Without the protection,
each firm on its own would lack the incentive to invest in learning through increasing its
current production.
7. If infant industry protection is justified, is it better for the Home country to use a tariff
or a quota, and why?
Answer: To the extent that the Home infant industry has market power, it is better to use
a tariff rather than a quota. The infant industry calculus weighs the benefits of future
producer surplus against current deadweight losses due to protection. Because
deadweight losses are greater under a quota due to maintaining Home market power,
infant industry protection has a better chance of being worthwhile by using a tariff.
8. In this problem, we analyze the effects of an import quota applied by a country facing
a Foreign monopolist. In Figure 9-10, suppose that the Home country applies an import
quota of X2, meaning that the Foreign firm cannot sell any more than that amount.
a. To achieve exports sales of X2, what is the highest price that the Foreign firm can
charge?
Answer: Refer to the following figure: To achieve export sales of exactly X2, the Foreign
monopolist would charge P2.
b. At the price you have identified in part (a), what is the Home consumer surplus?
Answer: Refer to the figure in part (a): Home consumer surplus is represented by the
shaded triangle with area b.
c. Compare the consumer surplus you identified in part (b) with the consumer surplus
under free trade. Therefore, outline in Figure 9-10 the Home losses due to the quota.
Hint: Remember that there is no Home firm, so you do not need to take into account
Home producer surplus or tariff revenue. Assume that quota rents go to Foreign firms.
Answer: Refer to the figure in part (a): Consumer surplus under free trade is a triangle
with area b + c + d. Under a quota, consumer surplus decreases by c + d. The Home
welfare loss due to the quota is thus area c + d.
d. Based on your answer to (c), which has the greater loss to the Home country: a tariff or
a quota, leading to the same level of sales X2 by the Foreign firm?
Answer: Because there is no terms-of-trade gain associated with the quota, welfare is
lower under a quota regime relative to a tariff regime.
9. Consider the case of a Foreign monopoly with no Home production, shown in Figure
9-10. Starting from free trade at point A, consider a $10 tariff applied by the Home
government.
a. Assuming that the demand curve is linear, as in problem 10 of Chapter 6, what is the
shape of the marginal revenue curve?
Answer: The shape of the marginal revenue curve is also linear, but twice as steep.
b. Therefore, how much does the tariff-inclusive Home price increase because of the
tariff, and how much does the net-of-tariff price received by the Foreign firm fall?
Answer: Because the marginal revenue curve is steeper than the demand curve (twice as
steep in this case), the vertical increase along the marginal revenue curve of $10,
reflecting the tariff, is twice as much as the corresponding vertical increase along the
demand curve. Thus, the Home tariff-inclusive price increases by $5 and the net-of-tariff
Foreign price decreases by $5.
c. Discuss the welfare effects of implementing the tariff. Use a graph to illustrate under
what conditions, if any, there are increases in Home welfare.
Answer: Refer to the following figure: The tariff decreases Home consumer surplus by
the area c _ d, increases government revenue by the area c, and improves Home’s terms
of trade by the area e. Thus if e exceeds d, there is an overall welfare gain from the tariff.
Problem Set 3: Trade Policy 2:Export Subsidies and other policy tools
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.”
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.”
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.”
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.”
e. “The real price of timber has fallen 40 percent, and thousands of timber workers have
been forced to look for other jobs.”
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 PoW, 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?
ii.
change in Foreign producer surplus?
iii.
change in the Foreign government’s revenue?
iv.
total change in Foreign’s welfare. Explain why/whether Foreign’s export
tax makes Foreign better off.
c. Label the areas in the left hand panel. Relative to free trade, what is the
i.
change in Home consumer surplus?
ii.
change in Home producer surplus?
iii.
change in Home government’s revenue?
iv.
total change in Home welfare? Explain why/whether Foreign’s export tax
makes Home worse off.
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?
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.
b. Would Foreign producers be better off/worse off/indifferent if Foreign used a
VER instead of an export tax.? Explain.
Problem Set 4: Trade Creation and Diversion, Strategic trade
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.).
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?
3. Does the U.S. military budget help or hurt the strategic position of U.S. hightechnology industries? Make the case for either point of view.
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?