Problem Set 3 - International Economics S2022 - Solutions

Problem 1. The domestic demand and supply for dumplings in a small open economy are given by:

D : Q = 120 − 4P

S : Q = 60 + 2P

Assume world demand is perfectly elastic.

a) The world price of dumplings is Pw  = 12.  Will the country import or export dumplings?  How many units?

b) Suppose a movie called ”Dumpling Story” is released in the country. The consumption of dumplings suddenly becomes ”more fashionable”.  This means that consumers in the country are willing to consume more dumplings for each price level. The supply function of dumplings remains the same and the world price of dumplings is still Pw  = 12

(i) Show this change in demand in a diagram.

(ii) What is the new demand function such that at Pw  there will be no excess demand or supply of dumplings?

(iii) What assumption are we implicitly making on the size of the country?

Solution. a) First, we derive the price and quantities under autarky: (Pa , Qa ) = (10, 80).

Since the world price is higher than the equilibrium price under autarky, the country will export dumplings. The quantity of dumplings exported can be found through the export function:

X (Pw ) = 60 + 2P − 120 + 4P = 6P − 60                                            (1) With Pw  = 12, X(12) = 6 × 12 − 60 = 12.

Therefore, the country will produce a total of 84 units of dumplings, exporting 12 of those units.

b) The diagram should show a rightward shift in the demand function. There shall be no change in the slope of the demand function.

What should be the new demand function? Since there will be no imports or exports, it must be the

case that the domestic price of dumplings should be the same as the world price, i.e., P = 12.               We know that the supply function remains the same. However, the demand function will have to change to reflect the new consumers’ taste.  The slope of the demand function does not change, as consumers are willing to consume more for each price level.  Therefore, what will have to change is the quantity level that is the quantity demanded when the price is zero (call it B ).

Then, we can find B as:

B − 4P = 60 + 2P                                                                 (2)

Since, P = 12, B = 132.

Therefore, the new demand function of dumplings after the release of the movie, such that the country stops exporting dumplings is:

D′ : Q = 132 − 4P                                                                 (3)

The assumption about the country’s economy is that it is not large enough for a shift in the demand curve for dumplings to change the equilibrium world price.

Problem 2. Consider a small open economy in which the domestic demand and supply functions for good X are:

DX  : PX  = 50 − 4QX

SX  : PX  = 10 + QX

a) What are the levels of domestic production, domestic consumption and exports (or imports) if the world price of good X is Pw  = 20?

b) Suppose that the government decides to subsidize production of good X in s = 1 per unit produced. What are the new domestic consumption, domestic production and exports levels, in this case? By how much is this subsidy going to impact on government finances?

Solution. a) First, we derive the price and quantities under autarky: (PX(a), QX(a)) = (18, 8).

Since the world price is higher than the equilibrium price under autarky, the country will export good X. The quantity of good X exported can be found through the export function:

X (Pw ) = Pw − 10 − 12.5 + 0.25Pw  = 1.25Pw − 22.5                                    (4)

With Pw  = 20, X(20) = 1.25 × 20 − 22.5 = 2.5.

Therefore, the country will produce a total of 10 units of good X, exporting 2.5 of those units.  Do- mestic consumption will now be 7.5.

b) Since the country is a small economy, we assume that the world price of good X will not change given the subsidy.  However, the subsidy has an impact on the supply function of domestic producers.

Which is now:

S : PX  = 10 − s + QX   ⇐⇒ PX  = 9 + QX                                                                   (5)

Since the subsidy will have no impact in the world price, the new quantities produced by domestic producers for that price are:

Q S(s)  = 20 − 9 = 11                                                              (6) Domestic consumption will remain the same:

D : Q D(s)  = 12.5 − 0.25Pw  = 7.5                                                    (7)

Exports will be

X (Pw  = 20) = 11 − 7.5 = 3.5                                                     (8)

The change in government revenue will be given by:

∆GR = −s × Q S(s)  = −11                                                         (9)

Domestic consumption will remain the same, at 7.5, domestic production will increase to 11, exports

will increase to 3.5, and government revenue will decrease by 11 units.

Problem 3. Consider a small open economy that produces good X, for which domestic demand and supply functions are:

DX  : QX  = 200 − 4PX

SX  : QX  = 90 + 6PX

a) Suppose the international price of good X is given by Pw  = 8. How many units of good X will the country import under free trade?

b) Consider the case in which the country imposes an import quota of 10 units of X. By how much would the domestic price of X increase?

c) Imagine you are the politician responsible for arguing in favor of the import quota in subquestion (b) and need to attribute a weight to the producers’ gains (PG) and to the consumers’ losses (CL). What is the ratio between these weights for you to consider the quota to have PG exactly compensate CL? [Hint: Compute CL (consumer losses) and PG (producer gain), disregarding government revenue. If the weight given to CL were to be equal to the weight given to PG, would there be a net gain or loss? Hence . . .]

d) Discuss in which way the welfare effects of trade quotas differ from or are similar to those associated with imposing tariffs.

Solution. a) First, we derive the price and quantities under autarky:  (PX(a), QX(a)) = (11, 156).

We can start by constructing an import demand function, which is simply the difference between

MX (Pw ) = 110 − 10Pw                                                                                        (10)

With Pw  = 8:

Imports will be given by:

MX (8) = 110 − 10 × 8 = 30                                                    (11)

The country will import 30 units of good X.

b) Without the import quota, imports of X would be 30. With an import quota of 10 units, imports would be lower than what would be possible for the world price of PW  = 8. Thus, there would be excess demand for good X. In order for there to be an equilibrium it must be that the price with the quota (Pq ) is such that:

M (Pq ) = 110 − 10 × Pq  = 10 ⇐⇒ Pq  = 10                                        (12)

Therefore, the price of good X in the country with an import quota of 10 units would be Pq  = 10, below the autarky price, but above the free trade price. The price would increase by 25% relative to the free trade price.

c) First, one needs to compute the level of consumption and production of X with Pq . In this case:

DX(q)  = 200 − 4 × 10 = 160

Under free trade:

DX(f)  = 200 − 4 × 8 = 168

On the other hand, domestic production under the quota is:

SX(q)  = 90 + 6 × 10 = 150

Whereas under free trade:

SX(f)  = 90 + 6 × 8 = 138

The change in price by imposing the quota is ∆p  = 2.

If producers’ gains and consumer’s losses are equally valued, then:

CL = × (DX(q)  + DX(f)) × ∆p  = 328

PG = × (SX(q)  + SX(f)) × ∆p  = 288

We disregard the possible government revenue from imposing the quota. For the net effect on national welfare to be considered null:

βPG = CL

(13)

(14)

(15)

(16)

(17)

(18)

(19)

Where β is the factor by how much producers’ gains are valued relative to consumers. In this case:

β ≈ 1.139                                                                  (20)

d) Tariffs and quotas are two policy instruments which allow for restricting foreign competition: they both result in an increase of the domestic price and a reduction of imports.  The welfare effects are similar:  both lead to a decrease of domestic consumer surplus, a decrease in foreign producer surplus, and an increase in domestic producer surplus.

The main advantage of a tariff is that it generates revenues for the government.  Especially in de- veloping countries, tariffs can be an important source of government revenue. Theoretically, quotas can also be used to create government revenue (e.g. via the allocation of production rights through auctions) but this is more complicated and requires a lot of market knowledge that the government may not have. Thus, if the government is not able to extract quota rents, then quotas will typically cause higher welfare loss than tariffs.

Problem 4. Consider the following questions about tariffs and quotas.  For each one present succinct definitions of the concepts and justify your answers.

a) What is a tariff equivalent? What may be the advantages of using a tariff equivalent different than an import quota?

b) What was the“Smoot-Hawley Tariff Act”? What were the political and economic objectives behind such policy? Was it successful in reaching its objectives?

Solution. a) A tariff equivalent corresponds to the replacement of an import quota with (or the imple- mentation of) a tariff that restricts imports to the same level that the import quota would.

An equivalent tariff has multiple advantages. First, under the World Trade Organization rules, tariffs are legal policy trade instruments, whereas quotas are illegal.  Second, calculating the tariff equivalent is easy to do.  Third, tariffs are less restrictive to the domestic market, when domestic demand for the good increases. When demand increases, consumer losses are much larger in the case of a quota than in the case of a tariff.

b) The “Smoot-Hawley Tariff Act”was a protectionist law implemented in 1930 in the United States. Its main purpose was to help the American primary sector, by limiting foreign competition and raising government revenues.  The tariff came as an electoral concession to the agricultural sectors.  However, those in manufacturing also demanded protectionism for themselves. The real effect was a depression of

American trade due to other countries retaliation.

Problem 5. Governments often protect some domestic economic sectors or firms from competition in

international markets or from competition with other firms in the domestic market.

a) Which factors increase the probability that a a given industry would receive a higher level of protection? Briefly explain.

b) The United States steel industry is a paradigmatic case of a highly protected industry. Find another case of a given industry in a given country of your choice that has a high level of protection from trade.  Describe the type of protection the industry receives and show which factors, from those in the answer to subquestion (a) help explain high levels of protection. [In your answer, always remember to cite your sources.]

Solution. a) Industries that have a higher level of protection are typically:

• Larger in size and big employers. Large industries that are more important to a given economy, and are large employers of the country’s population are more likely to receive protection than smaller, less important industries.  Furthermore, if the industry is regionally concentrated and unionized, workers are able to lobby more effectively for protection.

• Few number of firms.   The fewer firms competing in a given industry, the higher the level of market concentration, and the more likely it is for these firms to organize and lobby the domestic government for protection.

• Intermediate product sectors.  Firms producing intermediate products are more likely to be pro- tected, as consumers and voters are less likely to directly notice the potential negative effects of such protection, such as price increases.

• Comparative disadvantage.  Firms that have more to lose from free trade have a higher incentive to lobby in favor of more protection.

b) Individual solutions.

The United States steel industry has historically received high levels of protection. It is large in terms of output and employment; highly unionized; highly concentrated; and it is an intermediate product.

Problem 6. Consider the following questions about the World Trade Organization (WTO).

a) What is the WTO? How was the WTO founded? What is its relationship with the GATT?

b) How are decisions taken within the WTO?

c) What happens when there is a dispute between two countries?

d) If country A breaks WTO law (e.g.  by imposing a quota on car imports from country B, illegal under WTO law), and country B can prove that it has suffered a prejudice from it, then the WTO may give country B the right to retaliate, even in another product category. Hence, country B may end up imposing a tariff on cheese from country A (in order to exert pressure on country A and incentivize it to comply with WTO law). What do you think about this retaliation mechanism and especially its impact on the economy’s welfare?

Solution. a) From 1947 to 1994, the General Agreement on Tariffs and Trade (GATT) formed the back- bone of international trade.  During several rounds of negotiations, tariffs and other trade restrictions were progressively reduced.  1995 marked the birth of the World Trade Organization (WTO), an inter- national institution with headquarters in Geneva. A major event was China’s accession to the WTO in 2001. Since then there have only been smaller steps made in deepening international trade relations; the Doha round (from 2001) is known as a failure.

b) The WTO is“owned by its members”and decisions are taken by consensus. All member countries have to agree when a new country joins, for instance. This has often led to a paralysis of decision-making in the past. Recently, there has been a lot of talk about the regionalization of trade (i.e. via the regional free trade agreements we have discussed earlier) which could lead to the WTO becoming less and less important.

c) The WTO provides an elaborate dispute settlement mechanism. If countries disagree, a panel of law experts will be created that consults the countries involved in the dispute and issues its evaluations and recommendations.  ”Out of court” settlements are highly encouraged by the WTO secretariate.  If there is no ”out of court” settlement and after several stages of negotiations and consultations, the dis- pute settlement body will adopt a recommendation and ask the losing country to implement it.  Upon non-implementation, the winning country is given the right to ”retaliate”. i.e. if the US accuses the EU

of unfairly barring US beef imports and wins the case in the WTO it may be given the right to impose a tariff on cheese imports from the EU.

d) From an economic point of view, this mechanism is not optimal.  Retaliation generally leads to distortions and inefficiencies in even more markets, if it is not an effective deterrent to the initial barrier. Ultimately, this may lead to social welfare losses, especially in the case of countries that are price-takers in these markets.

Problem 7. After Croatia joined the EU in 2013, European Union (EU) enlargement halted.  Balkan states Albania, Bosnia-Herzegovina, Kosovo, Montenegro, North Macedonia and Serbia are eager to join the union and continue working on meeting the political and economic requirements for many years. Turkey’s application has been in progress for a long time too. Recently, Ukraine, Moldova and Georgia joined the lot of countries applying to join the EU.

See, for instance, the articles, ”Gerogia and Moldova apply to join EU” (Financial Times, 3 March

2022) and ”Ukraine War Forces a Question:  How Far East Does Europe Go?”  (The New York Times,

26 February 2022), both available on Brightspace.

a) Briefly define the concept of free trade area, customs union, common market and economic union in your own words. Give at least one example for each concept.

b) Why do so many countries want to join the EU? List and explain some benefits of being part of a free trade area, customs union and political and economic union like the EU.

c) What are the requirements these countries have to meet for joining the European Union? What is the economic rationale behind it?

d) Some countries within the EU have adopted a common currency: what benefits can be achieved in adopting the Euro? Why have some countries such as Denmark and Sweden chosen to opt out of the single currency?

Solution. a) A free trade area is created by countries which agree to eliminate ”substantially all” tariff and non-tariff barriers to trade among themselves.   An example would be the European Free Trade Association (EFTA) which comprises Iceland, Liechtenstein, Norway and Switzerland.  Other examples are possible.

A customs union is one further step of economic integration: member countries also apply the same tariff schedule to third countries. A largest customs union in the world is the European Union (EU).

A common market goes even one step further in integration by allowing for full labor mobility among member countries. Again, the European Union’s common market is the most obvious example.

Finally, an economic union is a free trade area, customs union and common market with some shared government fiscal and monetary policies. The Eurozone, consisting of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Nether- lands, Portugal, Slovakia, Slovenia, and Spain is the best example. Other EU countries have obtained a so-called opt-out and have maintained their own currency and an independent monetary policy.

b) Most countries have benefited economically from EU membership.  Reasons include the facilita-  tion of trade and FDI flows from the industrially strong member states to the ”new members states” which often have lower labor and production costs. Another reason is that EU law has led to a unifica-  tion of national law and increased security and transparency for companies that want to invest abroad.  Freedom of movement is a great opportunity for citizens who can easily travel and work abroad.  The

EU also makes substantial investments in its poorer member countries and regions, through relatively

well-endowed funds for structural development. The EU has also done a lot for enhancing citizens’ and consumer rights.

c) Countries have to meet several criteria to access the EU. These requirements are set out in the Copenhagen Criteria, signed in 1993.  The main requirements are:  i) stable and functional democratic institutions, ensuring the rule of law, with separation of the executive and judicial powers, as well as respect for human rights and the protection of minorities; ii) a functioning market economy, with ca- pacity to cope with competition and market forces within the EU, as well as a set of convergence and exchange rate criteria for countries that are also willing to join the Eurozone; iii) legislative alignment with the body of European law and ability to take on the obligations of EU membership, according to the treaties. On top of these criteia, accession depends on long negotiations with the applicant countries.

Given market integration (both in terms of capital and labor mobility) it is crucial that countries are aligned in terms of their laws, with a strong alignment in terms of their fundamental values regarding social and human well-being. For instance, a common framework for human rights and labor legislation prevents industries in non-biding countries to engage in unfair competition, by exploiting substandard labor practices. A common body of laws permits countries in the union to trade without fear of retalia- tion and without spending resources and social welfare in trade disputes. Integration in terms of labor mobility, also implies that economies can more easily explore their comparative advantages, by being able to recruit workers and attract capital from a wider pool of applicants and investors.

d) A single currency has many advantages but it also comes at a cost. The main advantage—and the main reason for the creation of the euro—is that countries that trade a lot among each other benefit from limiting exchange rate fluctuations.  Less uncertainty for businesses is likely to increase the volume of trade. This facilitates economic growth and integration. Furthermore, the currency is likely to be more stable vis-a-vis other currencies as well.  The European Central Bank (ECB) is an independent central bank and enjoys high levels of trust by financial markets, which is why euro-denominated loans may be cheaper than loans denominated in smaller national currencies which may be less trusted internationally. For the consumer, prices are more transparent and easier to compare.  The biggest disadvantage of a single currency and the main reason why Denmark and Sweden have not joined the Eurozone is the loss of an autonomous monetary policy. Economic and political integration in the Eurozone is not perfect and countries may benefit from adjusting their monetary policy individually. E.g. if Sweden is experiencing a recession it can implement an expansionary monetary policy on its own. If Italy finds itself in the same

situation, it cannot do so without the consent of the other euro countries - monetary policy is in the hands of the ECB in Frankfurt. In a nutshell, a state’s hands are tied when in a currency union; it can no longer fully exploit monetary policy as an economic policy tool.

Problem 8. Explain what rules of origin are. Mention as many reasons as you can think of about why countries have them. Why are they so important in the context of a Regional Trade Agreement? Explain what is trade deflection and why rules of origin are important to avoid it.

Solution. The determination of what country actually produced an imported good is known as the rules of origin. They are necessary for several reasons:

• To report statistical data on trade flows.

• To enforce health, sanitary, and technical regulations within a country.

• If the goods are classified as originated in a country that does not belong to the WTO, the importing country can enforce higher tariffs or import restrictions on them.

• To administer antidumping and countervailing duties on imported goods.

• In the case of the U.S. administration of quotas on textiles or agricultural products requires the determination of country of origin.

• The administration of trade sanctions such as those the U.S. have against Cuba, requires knowledge of the country of origin.

Trade deflection occurs when a good that is really produced in a country that does not receive the reduced tariffs from a FTA is shipped to a country that does receive the reduced tariffs for minimal processing in order to qualify for duty-free treatment.  For this reason, it is common for the rules of origin to be more restrictive for preferential trade agreements than it is for imports from countries not being granted some form of preferential status.

Problem 9. Welfare effects of custom unions.  Assume that the world is composed of three countries: Mexico, the U.S., and Japan. Now, suppose that the U.S. and Mexico decide to form a customs union and Japan is a nonmember.  In addition, assume that Mexico is a small country relative to Japan and the U.S.

The following equations describe the demand and supply for cars in Mexico:

Dc  : Q = 200 − 2Pc

Sc  : Q = 38 + 4Pc

Assume that Japan is the most efficient supplier of cars at a free-trade price of Pj  = 20 while the US supplies car at a free-trade price of Pus  = 22.

a) Assume that before entering the customs union, Mexico imposes a tariff of 3 on every car imported. From which country will Mexico import cars? How many? Which price will consumers in Mexico have to pay? How many cars will Mexican producers supply for the home market?

b) Now the customs union comes into place and the tariff on imports from the US is abolished. From which country will Mexico now import their cars?   How many and at which price?   Does the quantity of cars supplied by Mexico producers for the home market change?

c) The customs union increases the purchases of cars in Mexico. By how much does consumer welfare in Mexico change? Why?

d) Do Mexican producers gain or lose from the customs union? By how much? Explain.

e) Provide a definition of the term ”trade diversion” in your own words.  Show the extent of trade diversion in this example. (You may consider using a graph as addition to your algebraic analysis). Will the custom union increase the welfare of its members, as well as the rest of the world?

Solution.

a) First, we derive the price and quantities under autarky: (Pa , Qc(a)) = (27, 146).

Japanese cars are clearly cheaper than cars from the US. Moreover, both Japanese and US cars are

cheaper than the autarky price even after the tariff is imposed (Pus + tariff = 25 < 27, Pj + tariff = 23 < 27). Hence, Mexico will import cars from Japan (23 < 25). Due to the tariff, Mexican customers will have to pay $23 per car. They will then demand Qc (23) = 200 − 2 × 23 = 154 cars in total out of which

24 will be imported from Japan (M(23) = 200 − 2 × 23 − 38 − 4 × 23 = 24). This means that 130 cars will be produced at home in Mexico.

b) Without tariff, the US price of car (22) is is smaller than the Japanese price augmented by the tariff (23).  Therefore, Mexico will now import their cars from the US . At Pus = $22, demand will be Qc (22) = 200 − 2 × 22 = 156 units. Imports will amount to M(22) = 200 − 2 × 22 − 38 − 4 × 22 = 30 units and 126 cars will be produced at home in Mexico.  Therefore, yes, home production is affected by this new trade policy: since price is now lower than before the union was formed, home production decreases.

c) Consumer welfare in Mexico increases because (1) consumers pay a lower price (22  < 23) and

(2) consume a higher quantity of cars (156 > 154). The increase in welfare associated with an increase in consumption can be described by triangle a in Figure 1 below.  Its height is $1 and its length is 2 (Q4 − Q3  = 156 − 154), hence the area is 1. The welfare gain associated with consumers paying a lower price is ∆p  × Q3  = 1 ∗ 154. Total increase in consumer welfare is: 154+1=155 1.

d) Mexican producers lose from its countries’ accession to the customs union because (1) they now

receive a lower price (22 < 23) and (2) they sell a lower quantity of cars in the home market (126 < 130). The decrease in welfare due to the decrease in the quantity produced has the same area as triangle b:

Its height is $1 and its length is 4 (Q2  − Q1  = 130 − 126), hence the area is 2. The decrease in welfare due to lower price is ∆p  × Q1  = 1 ∗ 126 = 126. Therefore, total decrease in welfare is 126+2=128 2.

Figure 1: Welfare change from custom union.