Determine the equilibrium allocation under free trade -

Question

Question 1. Trade Policy I The domestic demand for T-shirts is given by Q^D = 5000-100P, where P is the price measured in dollars and Q is the quantity measured in thousands of T-shirts per year. The domestic supply curve for T-shirts is given by Q = 150P. Answer the following questions:

(a) What is the autarkic equilibrium (i.e. without international trade) in the T-shirt market?

(b) Suppose T-shirts can now be imported from China at a given, fixed price of $10 per T-shirt. If trade were unencumbered, what would be the new market equilibrium? How many T-shirts would be imported?

(c) If domestic T-shirt producers succeeded in getting a $5 tariff implemented, how would this change the market equilibrium? How much would be collected in tariff revenues? How much consumer surplus would be transferred to domestic producers? What would the deadweight loss from the tariff be?

(d) After many complaints from the Chinese government, the domestic government has decided to change trade policy. As a result, it will remove the tariff because the Chinese government has agreed to restrict exports of T-shirts to 1,250,000 units per year. How does this choice affect domestic welfare (compute the actual figures)? Do you approve this policy or would you recommend a different one?

Question 2. Trade policy as a second best tool A small country can import a good at a world price of 10 per unit. The domestic supply curve of the good is given by Q^S = 50 + 5P, while the domestic demand curve is given by Q^D = 400 -10P. In addition, each unit of production yields a (constant) marginal social benefit of 10.

(a) Determine the equilibrium allocation under free trade.

(b) What is the total effect on welfare of a tariff of 5 units? (You need to compute the changes in welfare compared to the situation of autarky for all agents)

(c) Consider now a production subsidy of 5. What are the total effects of such a subsidy?

(d) Compare the overall effect of the subsidy to the overall effect of the tariff.Why does the production subsidy produce a greater gain in welfare than the tariff?

(e) What would be the optimal (i.e. welfare maximizing) production subsidy?

Question 3. Trade creation and trade diversion. Consider the situation described in Figure 1, where we have illustrated the market for apples in a world made up by three countries, A, B and C. Country A is the potentail importer of apples from countries B and C, which under free trade can supply any quantity of the product respectively at the price p_B and p_C. Answer the following questions:

(a) In the picture, identify the autarkic equilibrium, i.e. the situation in which the country does not trade with the rest of the world.

(b) Consider now the situation in which the Home country has a non- discriminatory, non-prohibitive tariff in place vis a vis the two potential trading partners, i.e. country B and C. From which country will Home end up importing part of her consumption of apples? Clearly identify in the picture the areas representing consumer surplus, producer surplus and tariff revenues in this circumstance.

(c) Consider now the situation in which Home, which had originally in place a non-discriminatory, non-prohibitive tariff vis a vis the rest of the world, has decided to form a free trade area with country B, and as a result it has decided to remove any tariff applied on imports from that country. From which country will Home import the apple she needs? What is the level of consumer surplus, producer surplus and tariff revenues associated to this outcome?

(d) Compare the outcomes in case (b) and in case (c). The creation of a free trade area with B has lead to both "trade creation" and "trade diversion". Which areas in your picture capture this phenomena? Explain the intuition and be specific.

Question 4. Strategic trade policy Airbus and Boeing compete over the Chinese aircraft market. Both of them share the same constant marginal cost of production m and China's inverse demand function for Airbus aircrafts is given by

Figure 1: Preferential Trade Liberalization

P_A = a-bX_A-cX_B         (1)

while China's inverse demand for Boeing aircraft is given by (1)

P_B = a-bX_B-cX_A         (2)

where b>c. Answer the following questions: (2)

(a) Assume that Airbus and Boeing compete as Cournot duopolists in the Chinese market. Write down the two firms best response functions. What is the output produced by each firm in equilibrium?

(b) Assume now that Airbus and Boeing compete instead as Bertrand duopolists in the Chinese market. Write down the best response functions for the two firms. What is the equilibrium price level for Airbus and Boeing airplanes in the Chinese market? How many aircrafts will each of the two manufacturer sell in China?

(c) We can now compare the equilibrium outcome under a Cournot and Bertrand duopoly. In what sense is the Betrand equilibrium ‘more competitive' than the Cournot equilibrium?