Project 3

20205 - International Economics and Business Dynamics Floriana Guardini Class 6 1716323

Question 1
a. Qs = 2P QD = 300 - P

2P = 300 P P* = 100 Q* = 200

To solve for the equilibrium quantity and price, I equate the supply and demand equations and I find the equilibrium price P* to be 100 and equilibrium quantity Q* to be 200.

P
350 300 250 200 150 200; 100

100
50 0 0 100 200 300 Supply 400 500 600 700

Demand

b. Qs = 2P QD = 300 (P + T)

2P = 300 P - T 3P = 300 - T PST = 100 T/3 PDT = (100 T/3) + T = 100 + 2T/3 QT = 200 2T/3 After solving for the new equilibrium after the introduction of a tax T on buyers, I find that, compared to the situation described in point (a), the price PST that the sellers receive is equal to 100 T/3, or lower than before by T/3, the price PDT the buyers are paying is equal to PST + T, or 100 + 2T/3, or higher than before by 2T/3, quantity QT is now equal to 200 2T/3, overall it has decreased by 2T/3 with respect to point (a). Buyers are bearing 2/3 of the tax burden, while sellers are bearing 1/3.

P
350 300

PDT 250
200

P*; Q*
200; 100

150
100

PST

50 0 0

100

200

300 Supply

400

500

600

700

Demand

The graph above depicts the equilibrium quantity and prices after the introduction of the tax T as compared to the previous equilibrium price and quantity.

c. Given that QT = 200 2T/3, I find that Total Revenue TR is equal to: TR = T*(200 2T/3) = 200T (2/3)T2 The relationship between taxes and revenues has the following upside-down U shape:

TR
18000 15000

Tax Revenues
150; 15000

12000
9000 6000 3000 0 0 30 60 90 120 150 180 210 240 270 300

This is an example of the Laffer curve. The increase in tax rates will at some point discourage workers from working additional hours. At this point, revenue from taxes will actually decrease if taxes are increased. In our case, this point is reached when tax level is T = 150, and at that point tax revenues are maximized at TR = 15000. The point was found by solving for the derivative of the TR equation and setting it equal to 0. TR/T = 200 4T/3 200 4T/3 = 0 -> T = 150 TR = 15000

d. Using the previous definitions, deadweight loss can be computed as: DWL = (Q*- QT)*T/2 Q* = 200 DWL = (T^2)/2 QT = 200 2T/3

The following graph represent the relationship for T between 0 and 300. We can see that DWL increases more than proportionally to the increase in taxes.

DWL
37500

Deadweight Loss
300; 30000

30000

22500
15000 150; 7500 7500 0 0 30 60 90 120 150 180 210 240 270 300

e. According to the results found for the previous questions: T

0 30 60 90 120 150 180 210 240 270 300

TR
0 5400 9600 12600 14400 15000 14400 12600 9600 5400 0

DWL
0 300 1200 2700 4800 7500 10800 14700 19200 24300 30000

DWL
35000 30000 25000 20000 15000 10000

DWL

5000
0 0 3000 6000 9000 12000 15000

TR
18000

f.

As seen in point ( c), I cannot be sure that the raise in tax will also generate additional tax revenues: this depends on whether the current tax level is on the upward or downward part of the curve. I can be sure that the deadweight loss associated with the tax will raise as the tax

raises. Note that in the case of perfect inelasticity of demand or supply for gasoline there would be no deadweight loss to begin with, therefore in this case it would not increase, as it remains 0: a realistic assumption, however, is to assume that there is elasticity, and therefore there is a deadweight loss when a tax on gasoline is introduced.

Problem 2
Good morning everyone and thank you for being here with us today during the last stage of our campaign. I appreciate the support you have given to our team and me up to now, we could not have come this far without you all. I am here today to address an issue that I believe is close to everyones heart: the health of our region and the auto industry and its workforce. It is undeniable; we are indeed facing tough, maybe the toughest, times in our automotive industry. Unemployment is rising, the recession has hit the car industry harder than many others, and our families are bearing the burden of the crisis. Some say, Its inevitable, its the competition, let it go, leave them with their problems, but this is not what we believe. Manufacturing is the core of our local economy, we take pride in our cars, what counts in the end is the quality of our production. The government has not acted promptly, and I am here to change this. It is not only the automotive sector at stake; the whole regions economy cannot prosper otherwise. We need an economic plan to sustain growth, not suffocate businesses, dumping the consequences of wrong choices onto the people and families here. We need to sustain the production and trade of our cars, within our country and outside, in order to bring domestic manufacturers back on the competitive track. We start from within, by levying fewer taxes simplifying the contribution system, to optimize the production and capital costs, to boost competitiveness. But we will not cut the services granted to citizens,

we will optimize government spending and guarantee everyone their fair share of welfare. Next, we invest in the workers, with training and ad-hoc programs, but we also invest in future workers and managers, by funding school programs to engage our students in the industry, and in the future, they will be able to contribute with their innovation and capabilities. I will push forward, at national level, policies to protect trade from unfair competition: I do believe in open markets, but we must protect local manufacturers, our technology and patents must be kept safe, and people must be ensured the products they have access to meet a standard of quality. Government must give local businesses the tools to compete strongly abroad: it must intervene to subsidize companies that export and simplify the legal processing at customs. Once we regain competitiveness in the automotive sector, thanks to the reliability and high quality of our cars, our economy will regain energy, everyone will benefit from it. I hope I will be able to come back as your Representative in the Parliament. Thank you!

Problem 3
The assertion that exports in one country suffer as a consequence of the appreciation in real terms of the local currency against foreign currencies, as well as the opposite, is motivated by the nature of real exchange rates. The real exchange rate tells you how expensive goods are in different countries, and this is a reflection of the competitive advantage of one countrys exports against the others. We can think of a very simple example to explain the logic behind real exchange rates: let s assume one bottle of water costs 1 in Italy and 2$ in the United States and the nominal exchange rate is 0,73/$ (actual rate at 23 December 2013: 1,37/$). An American going to Italy, with 2$ will be able to get roughly 1,46, so he can, in this example, buy more coffee than in the US. The real exchange rate can be computed as:

Real Exchange Rate = (0,73/$) * (2$/) = 1,46 The dollar is worth more in Europe: with the same dollar, we can buy more coffee in Europe than in the United States. An American tourist might come back to the US and say that Europe is cheap in comparison. Note that the real exchange rate is a unit-less concept. In real life, the case of coffee is generalized to all the goods in an economy. Consequently, when dealing in international markets, having a currency priced higher compared to those of other countries makes the goods from that country more expensive than the goods in other countries. It is important to remember that the real exchange rate reflects the overall price level of a country. In this situation, foreign goods are cheaper compared to the local goods. There are however other elements influencing competitiveness in international trade, such as transportation costs, custom costs, and pricing strategies of the single businesses. These factors can positively or negatively influence the trade level of an economy; if they affect it positively, they can offset at least partially the effects of appreciation of the currency in real terms. However, the general rule is that, everything else equal, the appreciation of the currency will make the goods less appealing on the international market and therefore negatively affect exporters. Finally, due to factors such as the stickiness of prices in the economy, the effects of fluctuations in the real exchange rate cannot be seen in the short run, but they rather appear clearly in the long run. In real life, for instance, even if the currency depreciates businesses might have obligations to stick to previously stated prices. Economists refer to this behavior of exports as the J curve: from the time of depreciation, exports balance first worsens, and then starts gradually improving, along a line shaped like a J.