Unformatted text preview: EC 340 Spring 2011 Problem Set 6 Suppose that Honduras is a small importer of corn and that the world price of corn is $5 per bushel. The Honduran demand and supply curves for corn are illustrated in the diagram to the right. Note that the supply curve is perfectly inelastic (that is, it is vertical). Suppose that Honduras limits imports of corn to 5 bushels. Use this information to answer questions 1 – 6. 1. What price will Honduran consumers have to pay for corn? The price will have to increase to $8 so that the quantity of imports demanded just matches the quantity of imports that are permitted. In this case, the quantity demanded at $8 is 20 bushels, while the quantity supplied is 15 bushels, so the quantity of imports demanded is 20 – 15 = 5. 2. What price will Honduran producers receive for corn? As explained in the answer to the first question, the price must increase enough to reduce imports to the quota‐restricted level. Honduran producers will receive $8 per bushel. 3. What is the size (measured in dollars) of the consumption distortion created by this import quota? The consumption distortion is represented by the area of the cross‐hatched triangle in the above diagram. This is essentially the loss to those consumers who no longer purchase corn because the price is higher than what they would be willing to pay. The triangle has a height of $3 and a base of 30 units, so the consumption distortion is ½ * $3 * 30 = $45. 4. What is the size (measured in dollars) of the production distortion created by this import quota? This is somewhat of a “trick” question. Since supply is completely inelastic, the higher price does not change the quantity supplied, so there is no production distortion. 5. How much quota rent does this import quota generate? Quota rent is represented by the yellow highlighted area in the above diagram. It is the profit per unit (buy corn on the world market for $5, sell it domestically for $8, making a profit of $3 per bushel) multiplied by the number of units imported. In this case, quota rent is $3 * 5 = $15. 6. Assuming that quota rents are earned by Hondurans, what is the effect of this import quota on Honduran welfare relative to free trade? The net effect is the loss of the production and consumption distortions. In this case, that would be a loss of $0 + $45 = $45. Suppose that Vietnam is a small exporter of rice and that the world price of rice is $6 per kilogram. Further suppose that the Vietnamese government offers Vietnamese farmers an export subsidy of $2 per kilogram. The Vietnamese demand and supply for rice are shown in the diagram to the right. Use this information to answer questions 7 – 11. 7. What price will Vietnamese consumers pay for rice? Vietnamese consumers will have to pay $8 per kilogram of rice. Suppose that they paid something less (e.g., $7). Vietnamese farmers always have the option of exporting anything that they produce. Doing so, they receive $6 from the foreign buyer and $2 from the government. But notice that they receive the subsidy ONLY if they EXPORT. So they can get $8 from exporting. There would be no reason to sell the rice on the domestic market if they could not also get $8 there. 8. How much rice will Vietnam export? Exports are the difference betweenquantity demanded and quantity supplied at a price of $8. In this case, quantity supplied is 14, quantity demanded is 2, so exports are 14 – 2 = 12. 9. What will this subsidy cost the Vietnamese government? The government pays $2 per kilogram exported. Since there will be 12 kilograms exported, the cost is $24. This is the area of the yellow highlighted rectangle in the supply and demand diagram. 10. What is the size (measured in dollars) of the production distortion created by this subsidy? The higher price induces farmers to produce too much rice, creating a production distortion. This is represented by the area of triangle b in the supply and demand diagram. This triangle has a height of $2 and a base of 4 kilograms, for an area of ½ * $2 * 4 = $4. 11. What is the size (measured in dollars) of the consumption distortion created by this subsidy? The higher price reduces the quantity demanded, creating a consumption distortion. This distortion is represented by the area of triangle d in the demand and supply diagram. This triangle has a height of $2 and a base of 4 kilograms, so the consumption distortion is ½ * $2 * 4 = $4. 12. What is the gain to the producer from this subsidy? The gain to the producer is represented by the area of the trapezoid that is bounded between $6 and $8 on the bottom and top, the price axis on the left, and the supply curve on the right. The area of this trapezoid can be calculated as the area of a rectangle (the gain to those producers who were growing rice when the price was $6 and continue to do so) and a triangle (the gain to those who now grow rice because of the higher price). In this case, the gain in producer surplus is ($2 * 10) + (½ * 2 * 4) = $24. 13. What is the net effect (relative to free trade) of this subsidy on Vietnamese welfare? The net effect is a loss that is equal in size to the areas of the two triangles b and d (the production and consumption distortions). In this case, that is a net loss of $8. ...
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 Spring '10
 BALLIE
 International Economics, Consumption distortion

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