SPP/Econ541 AlanDeardorffFallTerm2008 FinalExam–Answers Page1of8

FinalExam–AnswersDecember16,2008

Answerinbluebook.Usethepointvaluesasaguidetohowextensivelyyoushouldanswereachquestion,andbudgetyourtimeaccordingly.Theexamhasatotalof60points.1. (8points)InJulyof2008,theDohaRoundnegotiationsbrokedown.Intwo

paragraphs,describefirstthemajorissuesthathaddividedthecountriesthroughoutthenegotiations,andsecondthespecificissueonwhichtheirfailuretoagreeinJulyprecipitatedthebreakdown.

Throughoutthenegotiations,themajorissueswereagriculturalprotectionandsubsidiesintheUSandEU,ontheonehand,andhightariffsindevelopingcountriesonbothagricultureandmanufacturedgoodsontheother.DevelopingcountrieswantedtheUStoreduceitsagriculturalsubsidies,andtheEUtoreduceitsagriculturaltariffs,bothinordertobenefitdeveloping­countryfarmerswhosufferedfromlowworldpricesfortheirproducts.Inreturn,thedevelopedcountriesinsistedongreatermarketaccessintodevelopingcountriesfortheirexportsofagriculturalandmanufacturedgoods,aswellasofservices.InJuly,however,thestickingpointwasthetriggerfor“specialsafeguardsinagriculture.”Thiswasaprovisionthatwouldallowdevelopingcountriestoraisetariffsonagriculturalimportstoprotecttheirfarmers.Thesafeguardswouldbetriggeredbyanincreaseinimportsaboveacertainpercentage,andthedisagreementwasoverthatpercentage.TheUSwantedthattobeover40%,whichwouldmeanthatimportswouldneedtorisebythatamountatleastbeforethedevelopingcountriescouldraisetariffs.IndiaandChina,ontheotherhand,insistedthatthistriggershouldbesetmuchlower.2. (9points)Inthefigurebelowareshowndomesticdemandanddomestic

marginalcostinanindustryofasmallopeneconomythatfacesaworldprice

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PW ofthisgood.Themarginalcostcurvemayrepresentthatofaperfectlycompetitiveindustrywithlotsofdomesticfirms,inwhichcaseMCisthecompetitivesupplycurve.Or,inadifferentcase,MCmaybethemarginalcostofasinglefirm,theonlyfirmproducingthegoodinthecountry.Inbothcases,initiallythecountryislevyingatariffof

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t0 ,thedomesticpriceis

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PW + t0 whichhappenstobeattheintersectionofDandMC,andthecountryisthusbothproducingandconsumingthequantity

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Q0 .Supposenowthatthecountryincreasesitstarifftothelevel

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t1shown.Explainwhathappens,asaresult,first(Case1)undertheassumptionthattherearealargenumberofcompetitivedomesticfirmswithsupplycurveMC,and

SPP/Econ541 AlanDeardorffFallTerm2008 FinalExam–Answers Page2of8

second(Case2)undertheassumptionthatthereisonlyasingledomesticfirmwithmarginalcostcurveMC.Specifically,saywhathappensto

a. Domesticpriceb. Domesticproductionc. Domesticconsumptiond. Producerwelfaree. Consumerwelfaref. Governmentrevenueg. Welfareofthecountryasawhole

Case1:Herenothinghappens.Importsarealreadyzero,sothefactthat

consumerswouldhavetopayahigherprice,

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PW + t1,inordertoimportcan’tdiscouragethemanyfurther.Andthedomesticpricecannotriseabove

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PW + t0 ,sinceifitdidthecompetitivefirms,supplyingouttotheirsupplycurveMC,wouldproducemorethanisdemandedandforcepricebackdown.Thusallofthelistedvariablesremainunchanged.

Case2:Herethetariffincreasedoesmakeadifference,sinceitpermitsthesinglesuppliertochargeapriceashighas

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PW + t1withoutcompetitionfromimports.Itcannotchargeapricehigherthanthatbecausethenitwouldloseallsalestoimports.AnditdoesnotwanttochargeapricelowerthanthatsinceitisbelowthemonopolypriceshownasderivingfrommarginalrevenueMRandmarginalcost.Therefore,

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PW + t1becomesthenewdomesticprice.Thus,domesticpricerises,quantitiesproducedandconsumedbothfallto

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Q1 .Demanderslose

SPP/Econ541 AlanDeardorffFallTerm2008 FinalExam–Answers Page3of8

areas(a+b+c+d).Thesingleproducergainsrevenueof(a+b+c)whilelosingrevenueof(e+f+g)andgainingfromareductionintotalcostof(f+g).Thusthefirmhasanetgaininprofitof(a+b+c–e).Thereisnochangeingovernmentrevenue,sinceimportscontinuetobezero.Thuswelfareofthecountryasawholechangesby–(a+b+c+d)+(a+b+c–d)=–(d+e).

3. (10points)Usethemonopolisticcompetitionmodel(reminder:it’sthemodel

whosediagramappearsbelow)toshowwhatwillhappen…a. Iftwoidenticalcountriesmovefromautarkytofreetrade

i. Toprice;ii. Tothenumberoffirmsfromwhichconsumerscanbuy;andiii. Tothenumberoffirmsineachcountry.

b. If,startingfromfreetrade,thereisafallinthemarginalcostofproduction(thesameineachfirm)

i. Toprice;ii. Tothenumberoffirms.

TheCCcurveshowsaveragecost

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AC = n F /S( ) + c wherenisthenumberoffirms,Fisfixedcostperfirm,Sisthesizeofthemarket,andcismarginalcost.ThustheCCcurvehasverticalinterceptcandslopeF/S.

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ThePPcurveshowshowtheprofitmaximizingmarkupovermarginalcost(andhenceprice)fallsasthenumberofcompetitorsincreases:

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P = 1/bn( ) + c wherebistheparameterofthedemandfunctionindicatinghowdemandforafirm’sproductvarieswithitspricerelativetotheaveragepriceofallfirms. InitialequilibriumineachoftheidenticalcountriesinautarkyistheintersectionofCCandPP,thuspriceP0andnumberoffirmsn0.Whenthetwocountriesengageinfreetrade,theresultisaworldeconomywithtwicethemarketeachhadbefore,thus2SinsteadofS.ThisleavesthePPcurveunchangedbutrotatestheCCcurvetohavehalftheslopeithadbefore,thereforepassingthroughthepoint(2n0,P0)asshown.ThenewequilibriumintersectionisthereforeatthelowerpriceP1andanumberoffirms,n1,thatishigherthaneachfirmhadinautarky,butlowerthantheircombinedautarkytotal2n1.Thustherearemorefirmsintheworldthaneachcountryhadbefore,andconsumersgettochooseamongthemall.Buteachcountryhasfewerfirmsthanbefore. Ifnowthemarginalcost,c,fallsinallfirms,thisshiftsboththeCCcurveandthePPcurvedownbythesameamount(thechangeinc).Idon’tbothertodrawthat,sinceitclearlyreducestheequilibriumpricebytheamountofthefallinc,whileleavingthenumberoffirmsunchanged.

SPP/Econ541 AlanDeardorffFallTerm2008 FinalExam–Answers Page5of84. (9points)Consideradomesticmonopolythatisprotectedbyaveryhightariff

fromcompetitionfromacompetitiveforeignmarket,sothatitcanchargeonepriceinitshomemarketandanotherabroad.Assumethatthefirm’smarginalcostisconstantandthatallsupplyanddemandcurvesarelinear.

a. Showanequilibriuminwhichthefirmengagesindumping.

b. Ifthefirmwerenowconfrontedwithananti‐dumpingstatuteandit

wishedtoavoidbeingsubjectedtoananti‐dumpingduty,howwoulditalteritsbehavior?Besuretoshowacaseinwhichitcontinuestoservebothmarkets.

SPP/Econ541 AlanDeardorffFallTerm2008 FinalExam–Answers Page6of85. (24points)SupposeyouaretheUSITCtryingtodecideasafeguardcaseinthe

UnitedStatesbroomindustry.YousomehowknowthatsupplyelasticityoftheUSbroommanufacturers(whoarenumerousandplausiblyperfectlycompetitive)is+2.0,butyouhavebeengiventwodifferentestimatesoftheUSelasticityofdemandforbrooms:–1.0and–3.0.Theworldpriceofbroomshasrecentlyfallenfrom$5.00to$4.00,atwhichpricetheindustryisnowproducing8.0millionbroomsdomesticallyandimporting72.0millionbrooms.Assumethatdomesticandimportedbroomsareidenticaland,exceptwheretoldotherwise,thatthesequantitiesareanegligiblepartoftheworldmarketforbrooms.

Answerthefollowingquestions,givingtwoanswerstoeachiftheydependupontheelasticityofdemand,oneforeachofthetwoelasticitiesabove.(Ifyouhavetroublewithpartsofthequestion,goaheadandanswerotherpartsevenifyouneedtomakeupanswerstoworkwith.Iwillthengradebasedonthosemade‐uporincorrectanswers.)

a. Assumingthatemploymentintheindustryisproportionaltooutput,

bywhatpercentagedidemploymentrecentlydrop?Pricefellby20%.Withasupplyelasticityof2.0,outputandthusemploymentwouldhavedroppedtwicethis,or40%.Thisanswerdoesnotdependonthedemandelasticity.

b. WhatsizeadvaloremtariffshouldtheITCrecommendifitwishestorestoreemploymenttowhatitwasbefore?HowwouldyouranswerdifferifyouthoughtthatUSdemandforbroomswasalargepartoftheworldmarket?Itneedstoraisethepricebackupto$5.00.Ifthesmallcountryassumptionisvalid,thena25%tariffwilladd$1.00tothe$4.00priceofimportsandachievethisresult.Ifinsteadthelargecountryassumptionisneeded,thena25%tariffwillraisethedomesticpricebylessthanthis,asitwillinsteaddrivedowntheworldprice.Thusatarifflargerthan25%wouldbeneeded.Noneofthisdependsonthedemandelasticity.

c. Usingthetariffyouspecifiedinthefirstpartof(b),bywhatpercentagedoesthedemandforbroomsdeclineasaresultofthetariff?Also,bywhatpercentagedoestheUSdemandforimportsofbroomsdeclineasaresultofthetariff?The25%tarifffrompart(b)willcausedemandforbroomstofallby25%ifthedemandelasticityis1.0andby75%ifthedemandelasticityis3.0.Demandatthe$4.00pricewas80.0millionbrooms(domestic

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supplyplusimports).Sodemandfallseitherby20.0millionto60.0million,orby60.0millionto20.0million.Atthesametime,withthesupplyelasticityof2.0,supplyisincreasingbytwice25%,from8.0to12.0millionbrooms.Thusimportsfallfrom72.00milliontoeither60–12=48or20–12=8.Thatis,importsfallbyeither(72–48)/72=1/3=33.3%iftheelasticityofdemandforbroomsis1.0orby(72–8)/72=8/9=88.9%

d. Fromyouranswertopart(c),whatistheelasticityofdemandforimports?Howdoesitcomparetotheunderlyingelasticitiesofsupplyanddemand,andwhy?Thedemandelasticityforimportsisthepercentchangeinimportsdividedbythepercentchangeinprice,whichisthereforeeither–.33/.25=–1.33(ifthedemandelasticityforbroomsis1.0)or–.889/.25=–3.56(ifthedemandelasticityforbroomsis3.0).Theelasticityofdemandforimportsinbothcasesislargerthaneithertheelasticityofsupplyortheelasticityofdemand.Thisisnormal,sincedemandforimportsisanexcessdemand.Thusthechangeinquantityislarger,beingthesumofchangesinsupplyanddemand,whiletheinitialquantity(whatitisapercentageof)issmallerthantheinitialquantitydemanded.

e. Againusingthetarifffromthefirstpartof(b),calculatethechangeinconsumersurplusduetothetariff.Explainwhyconsumersarehurtlessinoneelasticitycasethanintheother.Thetariffcausespricetoriseby$1andthequantitydemandedtofallfrom80milliontoeither60or20million.Thelossofconsumersurplusis$1×(80+60)/2=$70millionor$1×(80+20)/2=$50million.Consumersloselesswhentheelasticityishigh,becausetheyavoidmoreofthecostofthetariffbysubstitutingawaytowardothergoods.

f. Whatisthenetwelfarecosttothecountryofusingthistariff?Again,explainwhythecountryishurtlessinoneelasticitycasethanintheother.Thisisthedeadweightlossduetothetariff,whichisthetwousualtriangleswhosebasesarethechangesinsupplyanddemandandwhoseheightisthe$1priceincrease.Thusthedeadweightlossiseither$1×(4+20)/2=$12million(withelasticity1.0)or$1×(4+60)/2=$32million(withelasticity3.0).

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Thelossisgreaterwiththelargerelasticitybecauseitmakesdemandchangemoreandthusincreasesthesizeofthedemanddistortion.

g. Whatpolicy,otherthanatariff,couldachievethesamerestorationofbroom‐industryemploymentbutatlowercosttotheeconomyasawhole?A25%subsidytoproductionwouldcausethesameincreaseinoutputandthusemployment,butwithadeadweightlossofonly$1×4/2=$2million.

h. Discussbrieflytwootherpolicies,bothofwhichappearatleasttosomedegreeinUSlaw,bywhichthisdisruptiontothebroomindustrymightbedealtwith.TradeAdjustmentAssistanceprovidessupplementalunemploymentcompensationandassistancefortrainingandrelocationfortrade­displacedworkers.Wageinsurance(calledAlternativeTradeAdjustmentAssistanceinUSlaw)temporarilygivessometrade­displacedworkersaportionofanydropinwageswhentheytakeanewjob.Bothoftheseareviewedaspreferabletoasafeguardstariff,inthattheyhelpworkerstoadjusttothenewsituationratherthandiscouragingthatadjustment,andtheyavoidthedead­weightlossesfromtheotherpolicies.