1 True/False
For each of the following statements say whether it is true or false and explain why using a couple
of sentences, graphs or equations.
(a) The World Trade Organization can impose fines on its member countries violating its trade
rules.
(b) The optimal tariff for a given good is larger for a large country than for a small country.
(c) If marginal cost of serving two markets is identical, then a profit maximizing firm with market
power would set the same price in both markets.
(d) When domestic and foreign firms compete as oligopolists, production subsidies are always
welfare-improving because they shift profits from foreign competitors to domestic firms.
(e) In trade negotiations a gain for one country is a loss for another country, so a multilateral
trade agreement cannot make all the parties better off.
2 Tariff for a Large Country
Consider a world composed of two large countries: Home and Foreign. Suppose the demand and
supply of cars in Home are, respectively:
D = 29 − p and Q = p − 1
In Foreign the demand and supply are:
D∗ = 11 − p and Q
∗ = p − 1
(a) Free trade
(i) What is the free trade price of cars pF T ?
(ii) How many cars does Home import?
(b) Now imagine that Home imposes a tariff t per car on imports from Foreign.
(i) Find the price of cars on the world market (call it pW ) and on the Home market (call it
pT ) as a function of the tariff t.
(ii) How many cars does Home import as a function of the tariff t?
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(iii) How large is the prohibitive tariff (i.e. tariff beyond which Home resorts to autarky)?
(iv) Calculate numerically the total change in welfare for Home (relative to free trade) as a
function of the tariff t. Plot this relationship in a figure.
(v) Find the optimum tariff, that is the tariff that allows Home to achieve the highest welfare.
(vi) In a graph with Home demand and Home supply show the net change in welfare associated
with the optimum tariff.
(c) Now suppose the Home government is not fully benevolent. It still cares about the consumers,
but puts a 25% higher weight on the welfare of car producers (who are more likely to make
political donations), and puts a 50% higher weight on its own revenue (which it can spend
in a way maximizing its reelection chances). Formally, the government maximizes its welfare
function WG (t) given by
WG (t) = CS (t) + 1.25P S (t) + 1.5GR (t),
where CS (t), P S (t), and GR (t) denotes the consumer surplus, producer surplus, and government revenue, respectively, all as a function of the tariff t.
(i) Find the tariff maximizing the government’s welfare function.
(ii) Is this politically optimal tariff higher or lower than the optimum tariff you have found
in part (b)? Provide an intuitive explanation for your finding.
3 Export Subsidies and Production Subsidies
In a small Home country market for a good is described by the following demand and supply curves:
Q
D = 150 − p
Q
S = p
Home can also sell to and buy from a world market at a world price of 100.
(a) Find the level of production, consumption, and exports of Home under free trade.
(b) Imagine now the government decides to boost domestic production by 20%, but is unsure
which policy to employ to help producers.
(i) Export subsidy
i. How large would the export subsidy need to be in order to increase domestic production by 20%?
ii. What effect would the export subsidy have on consumption and exports (relative to
free trade)?
iii. How large would be the net effect of export subsidy on Home welfare (relative to
free trade)?
(ii) Production subsidy
i. How large would the production subsidy need to be in order to increase domestic
production by 20%?
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ii. What effect would the production subsidy have on consumption and exports (relative
to free trade)?
iii. How large would be the net effect of production subsidy on Home welfare (relative
to free trade)?
(c) Based on your findings, which policy would you recommend to the government?
4 Tariff and Antidumping Duty with Foreign Monopoly
Demand for iPads in Home country is characterized by the following demand function:
Q = 12 − p.
The only supplier of iPads is Apple, a foreign monopoly with a constant marginal cost equal to 4.
Hint: If a monopolist faces a demand curve Q = A − Bp (where A and B are constants) then its
marginal revenue is MR =
A
B −
2
B Q.
(a) What price would Apple charge Home consumers under free trade? How many iPads would
the Home country import?
(b) Suppose Home government imposes a tariff t = 2 per iPad.
(i) How much would Home consumers now pay for iPads? How many would be purchased?
(ii) By how much would Home welfare increase or decrease due to the tariff?
(c) Suppose that instead of a tariff, Home government threatens to impose an antidumping duty
on Apple (because it noticed that iPads are sold at a higher price in Foreign). In response to
the threat Apple voluntarily raises its price to consumers by 2 (relative to the price it charges
under free trade).
(i) By how much would Home welfare increase or decrease due to the antidumping duty
threat?
(d) Which policy leaves Home better off: a tariff or an antidumping duty?
5 Trade Creation and Trade Diversion
Consider three countries: A, B and C. Country A is characterized by the following demand and
supply functions
Q
D = 28 − 2p
Q
S = 2p
Country B can sell any amount of a good at a constant price 4 while country C can sell any amount
at a constant price 3.
(a) Start from a case in which country A imposes a tariff t = 2 on imported goods no matter
where they are produced. How much will country A import from B and C?
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(b) Consider a free trade area (FTA) between country A and country B (country A maintains
a tariff on imports from country C). How much will country A import from country B and
country C once the FTA is formed?
(c) Calculate the change in welfare for country A going from the tariff to the FTA with country
B. Is country A better off or worse off after forming the FTA with B than with the tariff?
Explain your result.
6 Review
Write a short review of one of the group video presentations (not your own, obviously) posted on
the Video presentations forum on Canvas. All presentations should be available by 5pm on Friday
Nov 27th. Please address these points:
• What is the question the presentation tries to answer?
• What data does the group use to address this question?
• What modeling framework do they use to think about their problem?
• Do you find their analysis compelling? What can you see as the main shortcoming? How
would you improve on it?