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Problem Set 3_Answers


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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 P Wo to (1+.3)P Wo ; quantity produced domestically rises from zero to Q 2 ; quantity consumed domestically falls from Q 4 to Q 3 ; quantity imported falls from Q 4 to (Q 3 - Q 2 ); 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 predetermined schedule. 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
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FBE 462 Problem Set #3 Answers 2 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).
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