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Center of Economic Research at ETH Z¨urich ZUE F, 8092 Z¨urich

Dr. des. Christa Brunnschweiler

Problem Set II for International Economics - Solutions

Spring Term 2008

MSc MTEC, MAS MTEC et al.

Hint:

Pay attention to a complete marking of all ﬁgures and graphs!

1 Government Policies

1. Assume a standard model with two goods and two identical countries, in which H imposes a consumption tax on Y (or a consumption subsidy on X ). Graphically illustrate the case in which trade reduces welfare in H. (Hint: this is very similar to Figure 10.4).

Just re-draw Figure 10.4 with point E lying on the PPF above and to the left of the point where the q line cuts the PPF.

2. Assume a small open economy, which imports good X and exports good Y. Is it true or false that a consumption subsidy on X cannot aﬀect the production of X ? Explain your answer.

This is true. The consumption subsidy would aﬀect the consumer price of good X, but not the producer price, which is given by the international price of the good in a small open economy. To put it diﬀerently, suppose there is a consumption subsidy on X in H, which would reduce the consumer price of X. We would have:

p = p H > q H .

(1)

The eﬀect would be not to move the production point along the PPF but to expand the quantity demanded of X. Since X is the imported good, there would be more trade as a result of the subsidy.

You can also show this with the following diagram:

Center of Economic Research at ETH Z¨urich ZUE F, 8092 Z¨urich

Dr. des. Christa Brunnschweiler

Here, production is at B (where p is tangent to PPF) and consumption without the subsidy would be at C. With the consumption subsidy on X, consumption of X rises (and of Y falls) to point S. Note there is more trade because of the subsidy but the economy is worse oﬀ than without it.

2 Imperfect competition and increasing returns to scale

1. Suppose good X is produced by a domestic monopolist in a small country in autarky. Demonstrate how free trade creates a gain from trade and a gain from eliminating the monopoly (a ”pro-competitive gain”). Explain both verbally and graphically. (Hint: you can use Figure 11.3 to explain this.)

You can use Figure 11.3 with the international price ratio p for this. The pro-competitive gain from trade (equal to the gain from eliminating the monopoly in autarky) is the move- ment from A to Q. The usual gain from trade from comparative advantage is the movement from Q to C.

2. Suppose a ﬁrm has a total cost function, T C = F + mX, where F is ﬁxed costs and m is (constant) marginal cost. (i) Prove that either this ﬁrm must charge a price in excess of marginal cost, or it will make losses. (ii) Illustrate your point graphically.

1

(i) AC = T C/X = F/X + m. Price must be at least equal to AC in order to break even.

If price equaled AC, it would still be higher than MC (m). So price must exceed MC. (ii)

A simple illustration is given in Figure 12.3 (showing the monopolist price is not required).

3. Suppose that you have two identical countries, each with CRS in the production of Y and IRS in the production of good X, and that free entry has forced the price of X down to average cost. What happens when the two countries open up to trade? Explain graphically and verbally, and distinguish between pro-competitive gains and gains from ﬁrm exit.

You can use Figure 12.7 to illustrate your answer. Trade causes each X -producer to perceive his demand curve as more elastic and therefore increase output (Cournot-Nash

competition). This however leads to negative proﬁts and the exit of some ﬁrms. Equilibrium

< p x ), with fewer ﬁrms in each country but more in total

will be restored at a lower price (p

f

x

a

than in every single country in autarky. Firm exit frees up resources devoted to ﬁxed costs,

while the ﬁxed costs of the remaining ﬁrms stay the same. This shifts up the production frontier of each country to TFT”. The movement from A to C includes a pro-competitive output-expansion eﬀect (A to B) and a ﬁrm-exit eﬀect (B to C).

4. Deﬁne external economies of scale and give an example.

With external economies of scale, the cost of producing a unit and the IRS depend less on single ﬁrm size than on total industry size. External economies of scale arise when the cost per unit falls as the industry grows larger. Individual ﬁrms typically remain small. Examples are agricultural production, economic clustering such as Silicon Valley or Hollywood.

Center of Economic Research at ETH Z¨urich ZUE F, 8092 Z¨urich

Dr. des. Christa Brunnschweiler

compare this with the answer you would give for the Heckscher-Ohlin model of comparative advantage.

This statement is true, since the reason the seller is a monopolist may be that it happened to have been the ﬁrst to produce this product in this country. It may have no connection to any supply or demand related factors; nor to any natural or man-made availability. This

is all exactly the opposite of the Heckscher-Ohlin model’s explanation of the determinants

6. Explain why positive economies of scale in one (of two) sectors may establish a compara- tive advantage for the large (as compared to the small) country in the production of the commodity which exhibits positive scale economies.

In the case of the H-O model, the actual size of the country is irrelevant in the determination

of the direction of trade. When positive scale economies apply to the production of one product, the country that can devote more resources (in absolute terms) to its production

will be able to sell that product more cheaply, and therefore will be more likely to gain

a ”revealed” comparative advantage in that product. This will be the country with more factors (both labor and capital)– the larger country.

1. When a nation imposes a tariﬀ, for example on good X, the tariﬀ generates some govern- ment revenue. Explain and discuss the following points relating to tariﬀ revenue, assuming that H is a SMOPEC.

 (a) How is H’s revenue shown in a two-good, production possibilities graph? Draw the graph and explain. (b) How is its revenue shown in an excess demand graph? (c) If a tariﬀ is prohibitive, what is the implication for revenue?

(a) The tariﬀ on X raises the domestic price of X so p > p. This shifts production to Q t and consumption to C t . Exports of Y are given by the distance Q t Z and total imports of X are given by the distance ZC t . But note that, while exports of Q t Z buys imports of ZC t at world prices p , those same exports are only worth ZV units of X at domestic prices p. Thus, the diﬀerence, V C t , gives tariﬀ revenue in terms of good X.

Center of Economic Research at ETH Z¨urich ZUE F, 8092 Z¨urich

Dr. des. Christa Brunnschweiler

(b) The same eﬀect is shown with an excess-demand graph: a tariﬀ on X will shift down

the import demand section of good X ’s demand curve, where the new section E x is deﬁned by the relationship p ( 1 + t) = p (p being the price along the original excess demand curve).

The tariﬀ reduces imports of X to X t , while tariﬀ revenues are given by the shaded area pp TS.

(c) A prohibitive tariﬀ cuts oﬀ imports altogether, meaning that tariﬀ revenues would be

zero. [For example, in the excess demand graph above, a tariﬀ would be prohibitive if the world price p were between p a and p a .]

2. Discuss why an economy that is experiencing substantial economic growth in production (supply rather than demand) in its import-competing industry X will see greater welfare gains if the industry is protected with quotas than with tariﬀs. What would be the better policy in case of abundant-factor growth?

The quota is preferable in welfare terms to the tariﬀ because as scarce-factor growth proceeds and the domestic economy can produce more of the previously under-supplied good, the quota becomes less binding: the price ratio adjusts toward p , while the tariﬀ prevents the price from falling (it remains at p = p (1 + t)). The essential point here is that market shifts with a tariﬀ in place will change imports but not domestic prices. A quota is a limit on quantity, not a restriction on price, so market shifts with a quota in place will change price but not imports.

If we had had abundant-factor growth, the quota would have become increasingly binding

and the domestic price would have steadily risen. With a tariﬀ on the other hand, this kind

of growth would result in rising imports at unchanged domestic prices.

[See Figure 16.4 for an illustration of the eﬀects of a tariﬀ vs a quota.]

3. Explain the diﬀerence between a quota and a Voluntary Export Restraint (VER). What are the domestic welfare eﬀects in the case of a VER? Why would a country choose to reduce imports via a VER? Name a practical example of a VER.

A VER is a particular form of import quota which leads to the allocation of quota rents

to the exporters in the foreign countries rather than the importers in the home country. Welfare implications for the home country with a VER are always worse than under a domestic import quota, because a VER allows the foreign country to collect and beneﬁt

Center of Economic Research at ETH Z¨urich ZUE F, 8092 Z¨urich

Dr. des. Christa Brunnschweiler

from any quota rents. The foreign country beneﬁts from any positive terms-of-trade eﬀect, while the home country suﬀers both a negative terms-of-trade eﬀect and a negative volume- of-trade eﬀect. Nevertheless, VERs are often employed as an alternative to import quotas because they avoid retaliation from trade partners. With other words, VERs can both appease domestic interest groups AND foreign trade partners, with the added beneﬁt of generally not violating multilateral trade agreements since VERs are voluntary. Examples of VERs are the Japanese-U.S. automobile VEr at the beginning of the 1980s, and the multilateral Multi-Fiber Arrangement limiting textile.

4. Name three examples of a Non-Tariﬀ Barrier (NTB) to trade.

Local content requirement, price restrictions in the form of unit taxes instead of value-unit taxes, national procurement legislation, health and safety standards, red tape,

Center of Economic Research at ETH Z¨urich ZUE F, 8092 Z¨urich

Dr. des. Christa Brunnschweiler

4 Multiple Choice

Mark the correct answer with a cross (only one answer is correct). Hint: Each correctly answered question gives one point. For each falsely answered question, one point will be deducted. Unanswered questions give no points. All in all, this exercise will not be rated with a negative score, i.e. at the least zero points will be allocated.

a) Internal economies of scale arise when the cost per unit

 i) rises as the industry grows larger. ❏ ii) falls as the industry grows larger. ❏ iii) rises as the average ﬁrm grows larger. ❏ iv) falls as the average ﬁrm grows larger. ❏ v) None of the above. ❏ Answer:iv) b) External economies of scale i) may be associated with a perfectly competitive industry. ❏ ii) cannot be associated with a perfectly competitive industry. ❏ iˆıi) tends to result in one huge monopoly. ❏ iv) tends to result in large proﬁts for each ﬁrm. ❏ v) None of the above ❏ Answer:i) c) Where there are economies of scale, an increase in the size of the market will i) increase the number of ﬁrms and raise the price per unit. ❏ ii) decrease the number of ﬁrms and raise the price per unit. ❏ iii) increase the number of ﬁrms and lower the price per unit. ❏ iv) decrease the number of ﬁrms and lower the price per unit. ❏ v) None of the above. ❏ Answer:iii) d) Intra-industry trade is most common in the trade patterns of i) developing countries of Asia and Africa. ❏ ii) industrial countries of Western Europe. ❏ iii) all countries. ❏ iv) North-South trade. ❏ v) None of the above. ❏ Answer:ii) e) If a good is imported into (large) country H from country F, then the imposition of a tariﬀ in country H i) raises the price of the good in both countries. ❏ ii) raises the price in country H and cannot aﬀect its price in country F. ❏ iii) lowers the price of the good in both countries. ❏ iv) lowers the price of the good in H and could raise it in F. ❏ v) raises the price of the good in H and lowers it in F. ❏