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Answers_Problem4 - Prof. Anca Cristea Problem Set 4...

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Unformatted text preview: Prof. Anca Cristea Problem Set 4 Due Date: February 24 EC 481/581 Winter 2011 PART A: Multiple Choice 1. In monopolistic competition, when trade is opened, if the national have similar tastes, technology, products, and costs, the firms will have an incentive to: a. lower prices to get new consumers and increase market share b. raise prices to take advantage of a lucrative situation c. cut corners in manufacturing to boost profits d. raise quality, so they can charge a higher price than the competition. 2. In the long ­run monopolistic competition with trade, the equilibrium number of firms: a. lies below that of either country in autarky b. lies between the number of firms in the two countries in autarky c. lies above the total number of firms in either country in autarky d. lies above the number of firms in the two countries in autarky 3. In the long run, prices in monopolistically competitive industry will be _____________________ prices without trade. a. higher than b. lower than c. equal to d. difficult to compare with 4. With increasing returns (falling average costs), in the long run, as the remaining firms expand, the demand curve becomes ____________ due to foreign competition, and firms must ______________. a. steeper; raise price. b. Flatter; lower price. c. Flatter; raise price. d. Steeper; lower price. 5. Larger countries trade more with each other. This is empirically supported by: a. intra ­industry trade b. increasing returns to scale c. gravity equation d. comparative advantage. PART B: Problems INCREASING RETURS TO SCALE: 1. Suppose the Home firm is considering whether to enter the Foreign market. Assume that the Home firm has the following cost and demand: Fixed cost = $ 140 Marginal cost = $ 10 Prof. Anca Cristea EC 481/581 Winter 2011 Local price = $ 25 Local quantity = 20 Export price = $ 15 Export quantity = 10 a. Calculate the firm’s total cost from selling only in the local market. b. What is the firm’s average cost of selling only in the local market? c. Calculate the firm’s profit from selling only in the local market. d. Should the Home firm enter the Foreign market? Briefly explain why. e. Calculate the firm’s profit from selling to both markets. f. Is the home firm dumping? Briefly explain. 2. Calculate the intra ­industry trade index for rice (HS 1006) and paintings (HS9701) in 2005. To obtain the export and import values, access the U.S. Trade Stats Express website at Prof. Anca Cristea EC 481/581 Winter 2011 hht://tse.export.gov/. Click on “National Trade Data” then “Global Patterns of U.S. Merchandise Trade.” Under the “Product” section, change the item to rice, or paintings. Which product did you expect to have a higher index of intra ­industry trade? Why? Rice (HS 1006): Exports = 1,274,865,880 Imports = 217,639,275 Index of IITRice = Paintings (HS 9701): € Exports = 3,316,290,555 Imports = 3,263,674,163 Index of IITPaintings = 217, 639, 275 = 0.2916 or 29.16% 0.5 * (1, 274, 865, 880 + 217, 639, 275) 3, 263, 674,163 = 0.9920 or 99.20% 0.5 * ( 3, 316, 290, 555 + 3, 263, 674,163) € OUTSOURCING: 3. Consider an outsourcing model in which Home’s skilled labor has a higher relative wage than Foreign’s skilled labor and in which the cost of capital and trade are uniform across production activities. a. Will Home’s outsourced production activities be high or low on the value chain for a given product? That is, will Home outsource production activities that are skilled ­labor intensive or unskilled labor intensive? Explain. b. Suppose that home uniformly increases its tariff level, effectively increasing the cost of importing all goods and services from abroad. How does this affect the slicing of the value chain? Prof. Anca Cristea EC 481/581 Winter 2011 c. Draw the relative labor supply and demand diagrams for Home and Foreign showing the effect of this change. What happened to the relative wage in each country? 4. Consider a U.S. firm’s production of automobiles, including R&D and component production. a. Starting from the no trade equilibrium in a PPF diagram, illustrate the gains from outsourcing if the U.S. has comparative advantage in component production. Prof. Anca Cristea EC 481/581 Winter 2011 b. Now suppose that advances in engineering abroad decreases the relative price of R&D. Illustrate this change on your diagram and state the implications for production in the U.S. c. Does the U.S. firm gain from advances in R&D abroad? Explain why or why not. PART B: Short Answers For each question, provide a brief explanation. 1. Explain how increasing returns to scale in production can be a basis for trade. 2. Define intra-industry trade. Why is it a puzzling phenomenon when viewed from the perspective of the Ricardian or Heckscher-Ohlin models? Answer: When countries both import and export different varieties of the same differentiated good, we call this intra-industry trade. This is a puzzling phenomenon viewed from the perspective of classical models of trade (Ricardian or Heckscher-Ohlin models) because in those models the goods traded are homogeneous and only one country can have comparative advantage in producing, and therefore exporting, that good to the rest of the world. Prof. Anca Cristea EC 481/581 Winter 2011 3. In the monopolistic competition model of trade, is it correct to claim that consumers gain from trade even if foreign and domestic prices are equal? Answer: The statement is true. International trade increases the available set of varieties and lowers the price paid for each variety consumed, leading to gains from trade. 4. Suppose a firm is a monopolist in its home market (faces a downward sloping demand curve), but a price taker on world markets. Explain/show why this firm might be accused of dumping its goods abroad. Answer: See Figure 6-10 in the text, reproduced below: The monopolist can sell as much as it wants at the world market price, so the intersection of world demand (which is identical to the marginal revenue curve) and the firm’s marginal cost curve will determine its total quantity sold (Q1 on the diagram), the price it sells on world markets, and its marginal cost. Since the firm has market power at home, it chooses a quantity such that marginal revenue = marginal cost (point C on the diagram). At this quantity, home consumers are willing to pay a higher price (P* on the diagram). The point is this: prices are higher in the domestic market because the firm is sticking it to the domestic consumers and selling cheaply on world markets. This meets the technical definition of illegal dumping (selling abroad at a lower price than you charge in your domestic market). However it is very different from predatory pricing, which is the reason dumping is illegal. 5. Why is it relatively easier for a developing country to export service activities through outsourcing than to participate in the global economy by producing manufacturing components? Prof. Anca Cristea EC 481/581 Winter 2011 PART C: Reading Read the attached article “The world economy calls: Will improved communications attract call centers to Africa?” from the Economist magazine. Then answer the following questions: 1. List at least three factors that make Kenya an attractive site for business process outsourcing (BPO). i. reduced cost of telecom links due to international fibre-optic cables reaching Kenya ii. good quality workforce: educated, hard-working, closer to customers in Europe or America iii. high probability of workforce retention (due to low opportunity costs, few job prospects) 2. What are the explanations for the high trade costs associated with outsourcing business services to Kenya. i. high operational costs (social unrest, jammed roads, etc.) ii. political risk, instability iii. unfriendly tax code iv. poor infrastructure (e.g., electricity disruptions) ...
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