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Unformatted text preview: UNIVERSITY OF SOUTHERN CALIFORNIA
Marshall School of Business
FBE 462 – International Trade & Commercial Policy Answers to Problem Set #3
1. A. With imposition of tariff: domestic price rises from PWo to (1+.3)PWo; quantity
produced domestically rises from zero to Q2; quantity consumed domestically falls
from Q4 to Q3; quantity imported falls from Q4 to (Q3 - Q2); consumer surplus falls
by a+b+c+d; domestic producer surplus rises by a; government tariff revenue is c;
deadweight loss due to the excess cost of inefficient domestic production is b; and
deadweight loss due to consumers who are squeezed out of this market (lost
consumer surplus on units not consumed) is d. Areas a and c are transfers (income
redistribution); areas b and d are economic inefficiencies and represent the cost to
Canadian national well-being—the economic cost of the tariff to society. B. An infant industry is currently inefficient by world standards, but, according to the
argument, could grow up to become competitive. Protection in infancy permits
domestic production to start. Over time the industry can learn to produce at lower
unit cost. After the industry has grown up, the tariff can be removed, and the country
will have an industry whose production is competitive by world standards.
Several types of questions should be asked before offering protection based on the
infant industry argument. First, how likely is it that this industry will actually grow
up, so the tariff can be removed? What is the competitive pressure for improvement?
Perhaps, for instance, the tariff rate should decline over time according to a
Second, if the industry will grow up, why are private capital markets not supporting
it? A standard function of private capital markets is to finance current "loss-making"
projects in anticipation of future returns. Nonetheless, if the future returns do not FBE 462 Problem Set #3 Answers accrue to the firms doing the initial investments (that is, the returns are external to
these initial firms), or if private capital markets are imperfect, there can still be a case
for government policy intervention.
Third, are there economically less costly ways to encourage initial production? For
instance, a subsidy to production is probably less costly, because it could promote
early domestic production without penalizing domestic consumers (so the loss of
area d does not occur).
Fourth, the government policy intervention itself (e.g., tariff or production subsidy)
must also be subjected to an investment-type analysis. Are the future national
benefits of earning producer surplus from domestic production that is efficient by
world standards sufficient to justify the initial national costs (various inefficiencies)
imposed by the government policy? The national costs generally occur immediately
and with certainty, while the future benefits are uncertain if there is any question
about whether or not the infant industry will grow up. 2. A. The VER quantity is Qq. Free trade can be contrasted with the VER equilibrium:
Free Trade VER
P' Domestic Price
Q4 - Q1 Q2
Q3 - Q2 = Qq Imposing the VER causes the following changes and inefficiencies:
loss = M+N+RR+T
gain = M
Gain to foreign clothespin producers (assuming they raise their price to P') = RR
Production inefficiency (excess cost of inefficient domestic production) = N
2 FBE 462 Problem Set #3 Answers Consumption inefficiency (lost consumer surplus for those consumers who are squeezed
out of the market) = T.
B. With the decline in demand to Dd' :
Domestic price falls to P"
Domestic production falls to Q5
Domestic consumption falls to Q6
Imports are Q6 - Q5 = Qq (assuming the VER is still binding)
Each of the areas M, N, RR, T are smaller: smaller redistributions and smaller
C. If a tariff had been used, the effects of imposing a tariff on price, quantities, surpluses, and
inefficiencies are the same as those reported in the answer to (A), except that RR would be
government tariff revenue. If a tariff is used and then domestic demand declines:
Domestic price does not change—it remains P’ (assuming imports are still greater
Domestic production does not change—it remains Q2
Domestic consumption falls to Q7 (<Q6)
Imports fall to Q7 - Q2 (<Qq)
Areas M and N unchanged 3 FBE 462 Problem Set #3 Answers Area RR is smaller—it declines to R”R” (because of the fall in import quantity)
Area T is approximately unchanged in size.
Thus the two inefficiencies (the triangles) basically do not become smaller. 3. As a representative of the developing countries, I am interested in both the level of the
developing country exports of socks (the volume of trade) and the price received for sock
exports by the developing countries.
1. A tariff of T per unit imported raises the domestic U.S. price of both foreignproduced and domestically produced socks to PWo + T. The quantity of imports falls
from Q4 - Q1 to Q3 - Q2. The price received by the developing countries for their
exports remains unchanged at PWo. 2. To raise the U.S. market price to PWo + T (to induce production at Q2), foreign
suppliers must restrict their exports to Q3 - Q2. This VER is equivalent to the tariff,
except that area G, which under the tariff accrues to the U.S. government, accrues to
either the foreign government or foreign producers, assuming that foreign suppliers
raise their prices when they are told to organize themselves to restrict their exports. In conclusion, both policies would reduce the volume of developing countries’ exports by
the same amount. The VER is the policy that would enhance the price that they receive for
their exports, so this policy should be preferred by the developing country exporters. 4 FBE 462 Problem Set #3 Answers 4. A. False. Persistent dumping is the practice of price discrimination in which the foreign
exporting firm charges a high price in its home market and a lower price on its export
sales. This is a pricing strategy to increase total profits, as the exporting firm exploits
differences in demand elasticities between the home market (lower price elasticity) and
the export market (higher price elasticity). Although it looks like the exports have low
profitability, the firm earns a higher global profit than it would earn if it charged one
price to all buyers. The key is to use the elasticity differences to earn high profits at
home, and some profit on export sales.
B. False. The countervailing duty reduces the importing country's welfare by raising the
domestic price. The higher domestic price squeezes some domestic buyers out of the market
who are willing to pay the price that foreign suppliers are actually charging, and it
encourages some domestic production that has a higher cost than the cost of simply
acquiring imports at the price that foreign suppliers are actually charging. Taken together,
these consumption and production effects create triangles of surplus loss. Thus, a clear
economic case for imposing countervailing duties may not exist, from the importing
country's point of view. (Why complain if foreigners want to sell to us cheaply?)
C. False. For a large country, a tariff can increase national well-being, by lowering the
price paid to foreign exporters (improving the country’s international terms of trade).
The optimal tariff is the tariff that makes national well-being as high as possible
(assuming that the foreign country is passive). The tariff rate that results in almost no
imports is not (likely to be) optimal. Although this nearly prohibitive tariff would greatly
reduce the country’s demand for imports, and thus greatly reduce the price paid to
foreign exporters, there would be almost no imports on which to take the benefits of this
large improvement in the international terms of trade. Mostly, the country would have
lost the general gains from trade, if it almost returns to no trade. 5 FBE 462 Problem Set #3 Answers 5) Which one of the following cannot be the argument for using the export tariff?
a) The export tariff will cause deadweight loss to a nation.
b) The export tariff will reduce the domestic price of the good that is to be exported and thus
encourage the development of the domestic processing industries.
c) The export tariff is an important revenue source for some countries.
d) The export tariff will ensure that the domestic price is lower so that the product is affordable
to people. 6) The optimal tariff rate of a large country is
c) a positive number.
d) the same as the effective rate of protection. 7) An export duty will
a) increase the export.
b) increase the domestic production of the exportable goods.
c) decrease the domestic consumption of the exportable goods.
d) decrease the export. 8) Which of the following is an argument for trade protection?
a) Free trade will lead to efficiency gains to a nation.
b) Industries in a development country need time to gain efficiency to compete in the
c) With trade protection, the market gets smaller.
d) There will be less technological transfer with trade protection. 9) Which one of the following correctly describes the “Dutch Disease”?
a) It is a disease that destroys the elm trees. The consequence of this disease is to lower
national income and thus result in social instability.
b) When the Dutch discovered the natural gas in the North Sea, its natural gas related
industry expands resulting in the depreciation of its currency, and thus leading to the
increased competitiveness of its traditional industries.
c) When the Dutch discovered the natural gas in the North Sea, its natural gas related
industry shrinks resulting the appreciation of its currency, and thus leading to the
decreased competitiveness of its traditional industries.
d) When the Dutch discovered the natural gas in the North Sea, its natural gas related
industry expands resulting in the appreciation of its currency, and thus leading to
the decreased competitiveness of its traditional industries. 6 ...
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This note was uploaded on 02/15/2011 for the course FBE 462 at USC.