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Unformatted text preview: EC 271 International Economic Relations Answers to Problem Set #3 Prof. Murphy Chapter 8 – Krugman and Obstfeld 1. The import demand equation, MD , is found by subtracting the home supply equation from the home demand equation. This results in MD = 80 – 40 × P. Without trade, domestic prices and quantities adjust such that import demand is zero. Thus, the price in the absence of trade is 2. 2. (a) Foreign’s export supply curve, XS , is XS = –40 + 40 × P. In the absence of trade, the price is 1. (b) When trade occurs export supply is equal to import demand, XS = MD . Thus, using the equations from problems 1 and 2a, P = 1.50, and the volume of trade is 20. 3. (a) The new MD curve is 80 – 40 × (P + t) where t is the specific tariff rate, equal to 0.5. (Note: in solving these problems you should be careful about whether a specific tariff or ad valorem tariff is imposed. With an ad valorem tariff, the MD equation would be expressed as MD = 80 – 40 × (1 + t)P). The equation for the export supply curve by the foreign country is unchanged. Solving, we find that the world price is $1.25, and thus the internal price at home is $1.75. The volume of trade has been reduced to 10, and the total demand for wheat at home has fallen to 65 (from the free trade level of 70). The total demand for wheat in Foreign has gone up from 50 to 55. (b) and (c) The welfare of the home country is best studied using the combined numerical and graphical solutions presented below in Figure 8.1. Home Supply Home Demand a b c d e P T =1.75 50 55 60 70 Quantity Price P W =1.50 P T* =1.25 Figure 8.1 where the areas in the figure are: a: 55(1.75 – 1.50) –0.5(55 – 50)(1.75 – 1.50) = 13.125 b: 0.5(55 – 50)(1.75 – 1.50) = 0.625 c: (65 – 55)(1.75 – 1.50) = 2.50 d: 0.5(70 – 65)(1.75 – 1.50) = 0.625 e: (65 – 55)(1.50 – 1.25) = 2.50 EC 271 Answers to Problem Set #3 2 Consumer surplus change: –(a + b + c + d) = –16.875. Producer surplus change: a = 13.125. Government revenue change: c + e = 5. Efficiency losses b + d are exceeded by terms of trade gain e. [Note: in the calculations for the a, b, and d areas a figure of 0.5 shows up. This is because we are measuring the area of a triangle, which is onehalf of the area of the rectangle defined by the product of the horizontal and vertical sides.] 4. Using the same solution methodology as in problem 3, when the home country is very small relative to the foreign country, its effects on the terms of trade are expected to be much less. The small country is much more likely to be hurt by its imposition of a tariff. Indeed, this intuition is shown in this problem. The free trade equilibrium is now at the price $1.09 and the trade volume is now $36.40....
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 Spring '10
 Harry

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