• Answer ALL questions in Part B.
• Please show all workings. Round your answers to two decimal places.
• Fully label your graphs, if you are required to draw one.
• Questions in Part B carry marks as indicated.
B1. (24 marks)
Suppose that fixed costs for a firm in the air-conditioning manufacturing industry (start-up costs of factories, automation chain, etc.) are $6.9 billion, and that
variable costs are $15,000 per finished air- con. Suppose that the air-con market is monopolistically competitive, and firms are identical. More firms increase
competition, and so the market price falls as more firms enter the market, making the market price to be = 15,000 + 200/ , where represents the number of
firms in the market. Assume that there are three countries in the world: Ascalonia, Bretonnia, and Carlia, with the market size being 400 million, 550 million,
and 200 million, respectively.
a. (2 marks) Calculate the equilibrium number of firms in Ascalonia air-con markets in autarky.
b. (2 marks) What is the equilibrium price of automobiles in Ascalonia if there is no international trade?
c. (7 marks) Now suppose that the three countries join to form a free trade area, and assume no transportation costs. How many firms will there be in the
combined market? What will be the new equilibrium price, and average cost for each air-con?
d. (7 marks) Suppose instead that a revolution now closed Carlia off from the rest of the world, so that the free trade area now only consists of Ascalonia and
Bretonnia. Calculate the number of firms, the equilibrium price, and average cost for each air-con in this combined market.
e. (6 marks) Compare the number of firms, and the price that Ascalonian consumers pay for each air- con between the scenarios in (b), (c) and (d). In which
scenario would Ascalonian consumers benefit the most, and explain why.
B2. (24 marks)
Suppose there are three countries in the world: Australia, New Zealand, and Vietnam. Australia’s domestic demand for headphone follows
= 100 −
while its domestic supply of headphone follows
= 0.4 − 4
where , refer to Quantities Demanded and Supplied in Australia at the domestic price , respectively. The unit cost of headphone production in Vietnam is $30,
while it is $40 in New Zealand. Currently, there is a 100% tariff on headphone imports into Australia.
a. (4 marks) What is the price of headphone in Australia? How many headphones will Australia import, and how much tariff revenue will the Australian
government collect?
Suppose now that Australia signs a free trade agreement (FTA) with New Zealand.
b. (4 marks) How many headphones will Australia import, and from which country?
c. (4 marks) Is this the case of trade creation or trade diversion as a result of Australia forming an FTA with New Zealand? Explain why.
d. (6 marks) Calculate the amount of trade diversion loss/trade creation gain from the Australia-New Zealand FTA.
e. (6 marks) Calculate the total welfare gain/loss to Australia as a result of the Australia-New Zealand FTA.
B3. (12 marks)
a. (4 marks) Explain, using the gravity model of trade, why the volume of trade between the U.S and the European Union may be higher than the volume of
trade between the U.S. and Canada, even though the U.S. and Canada share a border.
b. (4 marks) According to the Heckscher-Ohlin model, free trade would lead to an equalization of wage rate internationally. Explain why we do not observe
that result in the real world, where, for instance, there is great discrepancy in wage rate between developed and developing countries.
c. (4 marks) Why do countries persist in using protectionism even though most economists believe that tariffs and quotas yield welfare losses to
consumers?
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