Class 6

1. Class 6

2. Question 1 Home’s demand curve for wheat is: D=100-20P It’s supply curve is: S=20+20P • What would the price of wheat be in the absence of trade? • Derive and graph Home’s import demand schedule.

3. Solutions a) D=S 100-20P = 20+20P P=2 b) Home import demand curve (MD) is equal to : MD=D-S =100-20P –(20+ 20P)=80-40P

4. Question 2 Now add Foreign, which has a demand curve D*= 80 - 20P and a supply curve S* = 40 + 20P a) Derive and graph Foreign’s export supply curve. Label the curve “EX”. What would be the price of wheat that would prevail in Foreign in the absence of trade?

5. Solutions a) Foreign’s export supply curve (EX) is equal to: EX = S* - D* = 40+20P – (80-20P) = 40P -40 In the absence of trade the price of wheat that would prevail in Foreign is equal to: 80 - 20P= 40 + 20P P*=1

6. Question 3 Now allow Foreign and Home to trade with each other, at zero transportation cost. a) What is the price of wheat with free trade? b) What is the volume of trade?

7. Solutions • MD= EX D - S = S*- D* 80 – 40 P = 40P – 40 Pw = 1.5 b) QEX = 40 Pw- 40 = 40 *1.5 – 40 = 20 or QMD = 80 – 40 Pw= 80 – 40 * 1.5 = 20

8. Question 4 Suppose that Home imposes a specific tariff of $ 0.5 on wheat. • Show the price that Home’s consumers pay for wheat. Draw a horizontal line at the correct price. Label the line PT • Show Foreign’s export price of wheat. Draw a horizontal line at the correct price. Label the line PT* • Indicate the quantity supplied by Home. Label this point QS • Indicate the quantity demanded by Home. Label the point QD • Examine the welfare effects of the tariff

9. Solutions a) 80 – 40 (PT* + 0.5) = 40 PT* - 40 PT*= 1.25 • PT = PT* + 1.25 = 1.25 + 0.5 = 1.75 • QS = 20 + 20 PT = 20 + 20 * 1.75 = 55 • QD = 100 – 20 PT= 100 – 20 * 1.75= 65

10. Solutions d)

11. Solutions d) Loss of consumer surplus: a+b+c+d = 16.875 Gain in producer surplus: d = 13.125 Government revenue: b+e = 5 The net effect of a tariff on welfare is given by: Loss of consumer surplus - Gain in producer surplus – government revenue = = a + c – e = 1.25 – 2.5 = - 1.25 “a” is consumption distortion loss, resulting from the fact that the tariff leads consumers to consume too little of the good “c” is production distortion loss, resulting from the fact that the tariff leads producers to produce too much of the good “a+c” is the efficiency loss that arises because a tariff distorts incentives to consume and to produce. They are the negative effects of the tariff. “e” is the terms of trade gain that arises because a tariff lowers foreign export prices. It is the positive effect of a tariff. In this case Home is not a small country, because it affects foreign prices, thus generating a gain from the terms of trade “e”. In this specific case the net effect of a tariff on welfare is positive, because its benefits (terms of trade gain) exceeds its costs (efficiency loss).

12. Question 5 Suppose that Foreign pays a subsidy of $0.50 per unit of wheat it exports. • Graph both the demand and the supply curve in Foreign. • Show the domestic price of wheat in Foreign. Draw a horizontal line at the correct price. Label this line PS* • Show the price the Home importers pay for wheat. Draw a horizontal line at the correct price. Label this line PS • Indicate the quantity supplied by Foreign. Label this point QS • Indicate the quantity demanded by Foreign. Label this point QD • Examine the welfare effects of the subsidy on Foreign

13. Question 6 The nation of Acirema is “small” and unable to affect world prices. It imports peanuts at the price of $10 per bag. The demand curve is: D = 400 – 10P The supply curve is: S = 50 + 5P • Determine the free trade equilibrium. • Calculate and graph the following effects of an import quota that limits imports to 50 bags. 1) The increase in the domestic price 2) The quota rents 3) The consumption distortion loss 4) The production distortion loss