FEB13085 International Trade Policy Problem Set 3 Solutions PDF

FEB13085: International Trade Policy FEB13085: International Trade Policy Problem Set 3 Solutions Lecturer: Dr. Aksel Erbahar Teaching Assistant: Elizabeth Oluwajimi Trade Policy 1. Assume that we are in a perfect competition and small country setting. The market for cars is described by the followi...

FEB13085: International Trade Policy FEB13085: International Trade Policy Problem Set 3 Solutions Lecturer: Dr. Aksel Erbahar Teaching Assistant: Elizabeth Oluwajimi Trade Policy 1. Assume that we are in a perfect competition and small country setting. The market for cars is described by the following demand and supply equations: QD = 100p−1 QS = p where quantities are in millions and prices are in thousands of dollars. (a) What is the autarky price for cars (pA )? Solution: For this we equate supply and demand, p = 100p−1 , to find that autarky price is 10. (b) Assume that the world price of cars is pW = 5; at this price how much would the country produce, consume, and export/import? Solution: With pW = 5, quantity demanded will be 100/5 = 20 and quantity supplied will be 5. The remaining 15 million cars will be imported. (c) Imagine that the government wants to protect its car industry and thus imposes a quota of 10 million cars per year. What is the amount of cars supplied and demanded with this quota (you can use approximations)? Solution: For this we first need the import demand equation: QD − QS = (100 − p2 )/p which has to equal the quota of 10 million. We can solve for p using the quadratic formula √ 2 b −4ac (remember, x = −b± 2a when ax2 + bx + c = 0 ) which is approximately 6.18. At this price, quantity of production will be about 6.18, quantity demanded will be about 16.18 (domestic production plus imports). (d) Find the specific tariff (t) that would yield exactly the same level of imports as in part (c). What is it as percentage of world price? 1 FEB13085 Problem Set 3 Solution: The tariff equivalent of the quota is 6.18 − 5 = 1.18, which is about a 24% tariff. (e) Discuss the welfare effects for all groups under the three regimes: free trade, import quota, and tariffs (assuming that quotas are randomly assigned and not auctioned). Compute (approximately) the welfare losses due to the two types of trade restrictions. Discuss the welfare effect of these policies on the exporting country. Solution: Since we are in a perfect competition setting, imposing a tariff or a quota has equivalent effects. In both cases the importing economy as a whole loses due to deadweight losses. Consumers lose and producers gain in both cases. The government gains tariff revenue with tariffs, but since the quotas are allocated randomly, quota rents accrue to import license holders in the economy. The overall welfare loss (deadweight losses) for the economy with both types of trade restrictions is approximately (∆p∆m)/2, which in this case is (1.18 × (15 − 10))/2 = 2.95. There is no welfare effect of these policies on the exporting country since we have assumed that the importing country is small and cannot affect world prices (this can also be shown graphically). 2. Assume that a small country has a single tobacco firm which was able to lobby its government to shut down all imports of tobacco. This firm is also active in export markets which is perfectly competitive. The firm will choose to sell y in the domestic market and z for the export market (in tonnes). Its cost function is C(Q) = F + Q2 /2 where Q = y + z and F is the fixed cost of starting a tobacco farm. The inverse demand function in the domestic market is p(y) = 80 − y, and the world price of tobacco is 40 dollars. (a) Find the optimal amounts of y and z for the monopolist. Solution: The firm maximizes y(80 − y) + 40z − (y + z)2 /2 − F by choosing y and z. The first order conditions are: 80 − 2y − (y + z) = 0 and 40 − (y + z) = 0. Solving the equations, we find that y ∗ = 20 and z ∗ = 20. (b) Suppose that a powerful consumer lobby that advocates against smoking manages to get the government ban tobacco sales in the country (y = 0), what would be the optimal amount of exports z? Solution: In this case, we use the FOC: 40 − (y + z) = 0 and find that z ∗ = 40. Note that in this case, MC is 40 which is equal to the MR in the world market. (c) Starting from part (a), suppose that the world demand for this country’s tobacco drops to zero as there are rumors about a bacteria affecting tobacco crops in this country only (z = 0). What would be the optimal amount of y? 2 FEB13085 Problem Set 3 Solution: In this case, we use the FOC: 80 − 2y − (y + z) = 0 and find that y ∗ ≈ 26.67. Note that in this case, MC is also 26.67 which is equal to MR in the domestic market. (d) In part (a), can the firm be accused of “dumping” based on price differences? What would be the dumping margin? Solution: In part (a), the firm is charging p = 80 − 20 = 60 in its domestic market, but charging 40 in the world market, so it can be accused of dumping. In this case, the dumping margin would be (60 − 40)/40 = 0.5, or 50%. (e) Assume that the firm is selling in both markets and fixed costs F are 1,200. Can the firm be accused of “dumping” due to pricing below average cost? What would be the dumping margin based on costs? Solution: The firm is selling a total of 40 units, so its average cost would be (800 + 1200)/40 = 50, this is higher than the world price of 40 dollars per tonne, so the firm can be accused of dumping. The dumping margin would be (50 − 40)/40 = 0.25, or 25%. Political Economy 3. Consider an application of the “median voter” model studied in class to Britain, with two goods and two factors (capital K and labor L). Each individual h has one unit of labor and K h units of capital. Assume that in Britain, there are 1,000 workers and 10,000 units of capital, and the median voter has 2 units of capital. (a) Assume that the rest of the world has 10,000 workers and 10,000 units of capital. Write down the mathematical expression for the prevailing tariff chosen by the median voter in Britain, and comment on its sign. Solution: First, note that Britain is a relatively capital-abundant country since its capital-labor ratio of 10 (10, 000/1, 000) is higher than the rest of the world’s capital-labor ratio of 1 (10, 000/10, 000). We know that the specific tariff that maximizes the median voter’s utility (tm ) is given by (superscript m denotes the median voter): tm = (1 − ρm ) dr K , dp m0 (p) (1) Km , r is the rental rate of capital, m(p) is imports, and p = p∗ + t is the K/L domestic price of the import good (p∗ is the world price of the import good). where ρm = 3 FEB13085 Problem Set 3 Since in this case ρm = 0.2, the prevailing tariff will be: tm = 0.8 dr K > 0, dp m0 (p) (2) since dr/dp < 0 in a capital-abundant country (labor-intensive good is the import good), and K/m0 (p) < 0. The tariffs in this country will be positive as the median voter will be relatively labor-abundant when compared to the country as a whole, and thus will demand higher prices for the industry where he/she is used more intensively. (b) Assume that the newly elected government implements reforms that lower inequality. Derive an expression that shows how the fall in inequality changes the prevailing tariff in a relatively capital-abundant country. Solution: Take the partial derivative of equation (1) with respect to inequality (1 − ρm ): dr K ∂tm = > 0, ∂(1 − ρm ) dp m0 (p) (3) since dr/dp < 0 and K/m0 (p) < 0. This means that a fall in inequality will lower tariffs in a relatively capital-abundant country. (c) Discuss whether the “median voter” model can explain the Brexit vote in 2016 that resulted in Britain’s average tariffs to rise. Make sure to refer to the model’s predictions. Solution: The median voter model has two predictions. The first one states that we should observe import tariffs on labor-intensive goods in capital-abundant countries (developed countries), and import subsidies on capital-intensive goods in labor-abundant countries (developing countries). Assuming that Britain is a capital-abundant country, and since Brexit potentially entails imposing tariffs on labor-intensive goods, this prediction is in line with the Brexit vote. The second prediction of the model states that a rise in inequality should lead to more protectionist trade policy by developed countries (and vice versa for developing countries). This is also in line with the Brexit vote since wage inequality in Britain has been rising since the 1980s, resulting in a more protectionist stance by the median voter. Multiple Choice Questions 1. The main reason why developed countries today use import tariffs is: a. To sustain a distinctive national culture. b. To help a domestic industry. c. To help domestic consumers. 4 FEB13085 Problem Set 3 d. At the request of foreign governments. e. As a major source of government revenue. 2. According to the Infant Industry Argument: a. Countries that allow children to work have an unfair advantage in international trade. b. Poor countries can foster economic development by using tariffs to protect new firms while they learn to become more productive. c. Costs of young firms are low because their workers lack seniority, and this contributes to comparative advantage. d. If a new firm exports for a price lower than it charges in its domestic market, that constitutes unfair trade. e. When technological change creates a new product, it is the innovating country that is likely to export it. 3. Anti-dumping duty is: a. A tax on imports equal to the difference between the price in the exporter’s home market and its export market. b. A tariff on imports that are in excess supply in foreign markets. c. The international obligation not to dispose of waste products in international waters. d. Levied whenever imports cause injury to domestic firms or workers. e. A requirement imposed by the International Monetary Fund (IMF) on countries requesting assistance, designed to prevent them from undermining the IMF’s objectives. 4. Which of the following cannot explain why we observe “dumping” by some firms? a. Firms facing demand curves with different elasticities in different markets. b. Duopolies engaging in Cournot competition. c. Firms engaging in monopolistic competition with trade costs. d. Firms taking advantage of low-wages in their home countries. e. Firms engaging in price discrimination. 5. What is trade depression? a. The decrease in bilateral imports due a trade barrier imposed on the exporting country. b. The increase in imports from a third country due to a trade barrier imposed on another country. c. The increase in imports of a third country from a country whose exports now face a trade barrier imposed by another country. d. The decrease in exports of a third country to the country that imposed the trade barrier. 5 FEB13085 Problem Set 3 e. The decrease in imports of the country whose exports now face a trade barrier. 6. What could cause the effective rate of protection on a good to be negative? a. A positive tariff on an input to producing the good, together with a zero tariff on the good itself. b. A specific tariff that is larger than its ad-valorem equivalent. c. A tariff imposed by a foreign country in retaliation against the home country’s tariff. d. Failure to collect a tariff because importers bribe customs officers. e. An import quota that is set larger than the quantity of imports that would enter under free trade. 7. Which of the following explains why trade diversion is undesirable for an importing country that lowers its tariff against a partner in a free trade area? a. Workers are laid off as their employers move their production to the partner country. b. Consumers pay a higher price for the good imported from the partner country. c. The country imports from the partner at a higher cost than it previously imported from outside. d. Domestic producers suffer a loss of income as demand is diverted towards producers in the partner country. e. All of the above. 8. When the U.S. eliminated tariffs on imports from Mexico as part of the NAFTA, certain goods that the U.S. had previously imported from Asia subject to tariffs were now purchased from Mexico instead. From the perspective of the welfare of the U.S. as a whole, this was: a. Good for the U.S. because the Mexican goods cost less than the Asian ones. b. Bad for the U.S. because American producers were forced to shut down. c. Good for the U.S. because prices of these imports were less distorted by tariffs. d. Bad for the U.S. because Mexico’s cost of producing these goods was higher than Asia’s. e. Good for the U.S. because this new trade with Mexico was free of any trade barriers. 9. A country’s “bound tariff” on a good is: a. The tariff that it intends to levy after it escapes from poverty. b. The maximum that it may normally charge without violating its WTO commitments. c. The tariff level imposed on it by its partners in a preferential trade agreement. 6 FEB13085 Problem Set 3 d. The highest tariff it can charge without driving imports to zero. e. 100 %. 10. According to the Most Favored Nation principle, a. Tariffs should be zero. b. Tariffs should be lowest on imports from countries that cooperate with a nation’s foreign policy objectives. c. A country’s tariff on imports of a good should be the same regardless of origin. d. A country should sign free trade agreements with all other countries. e. Once foreign goods are inside a country, they should be treated the same as domestically produced goods. 7