SPP/Econ541

FallTerm2008

AlanDeardorff
FinalExamAnswers
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FinalExamAnswers
December16,2008

Answerinbluebook.Usethepointvaluesasaguidetohowextensivelyyoushould
answereachquestion,andbudgetyourtimeaccordingly.Theexamhasatotalof60
points.

1. (8points)InJulyof2008,theDohaRoundnegotiationsbrokedown.Intwo
paragraphs,describefirstthemajorissuesthathaddividedthecountries
throughoutthenegotiations,andsecondthespecificissueonwhichtheirfailure
toagreeinJulyprecipitatedthebreakdown.

Throughoutthenegotiations,themajorissueswereagriculturalprotectionand
subsidiesintheUSandEU,ontheonehand,andhightariffsindevelopingcountrieson
bothagricultureandmanufacturedgoodsontheother.Developingcountrieswanted
theUStoreduceitsagriculturalsubsidies,andtheEUtoreduceitsagriculturaltariffs,
bothinordertobenefitdevelopingcountryfarmerswhosufferedfromlowworld
pricesfortheirproducts.Inreturn,thedevelopedcountriesinsistedongreatermarket
accessintodevelopingcountriesfortheirexportsofagriculturalandmanufactured
goods,aswellasofservices.

InJuly,however,thestickingpointwasthetriggerforspecialsafeguardsin
agriculture.Thiswasaprovisionthatwouldallowdevelopingcountriestoraise
tariffsonagriculturalimportstoprotecttheirfarmers.Thesafeguardswouldbe
triggeredbyanincreaseinimportsaboveacertainpercentage,andthedisagreement
wasoverthatpercentage.TheUSwantedthattobeover40%,whichwouldmean
thatimportswouldneedtorisebythatamountatleastbeforethedeveloping
countriescouldraisetariffs.IndiaandChina,ontheotherhand,insistedthatthis
triggershouldbesetmuchlower.

2. (9points)Inthefigurebelowareshowndomesticdemandanddomestic
marginalcostinanindustryofasmallopeneconomythatfacesaworldprice PW
ofthisgood.Themarginalcostcurvemayrepresentthatofaperfectly
competitiveindustrywithlotsofdomesticfirms,inwhichcaseMCisthe
competitivesupplycurve.Or,inadifferentcase,MCmaybethemarginalcostof

asinglefirm,theonlyfirmproducingthegoodinthecountry.Inbothcases,
initiallythecountryislevyingatariffof t 0 ,thedomesticpriceis PW + t 0 which
happenstobeattheintersectionofDandMC,andthecountryisthusboth
producingandconsumingthequantity Q0 .
Supposenowthatthecountryincreasesitstarifftothelevel t1 shown.

Explainwhathappens,asaresult,first(Case1)undertheassumptionthatthere
arealargenumberofcompetitivedomesticfirmswithsupplycurveMC,and

SPP/Econ541

AlanDeardorff
FallTerm2008

FinalExamAnswers

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second(Case2)undertheassumptionthatthereisonlyasingledomesticfirm
withmarginalcostcurveMC.Specifically,saywhathappensto
a. Domesticprice
b. Domesticproduction
c. Domesticconsumption
d. Producerwelfare
e. Consumerwelfare
f. Governmentrevenue
g. Welfareofthecountryasawhole

Case1:Herenothinghappens.Importsarealreadyzero,sothefactthat
consumerswouldhavetopayahigherprice, PW + t1 ,inordertoimportcant
discouragethemanyfurther.Andthedomesticpricecannotriseabove PW + t 0 ,
sinceifitdidthecompetitivefirms,supplyingouttotheirsupplycurveMC,would
producemorethanisdemandedandforcepricebackdown.Thusallofthelisted

variablesremainunchanged.

Case2:Herethetariffincreasedoesmakeadifference,sinceitpermitsthe
singlesuppliertochargeapriceashighas PW + t1 withoutcompetitionfrom
imports.Itcannotchargeapricehigherthanthatbecausethenitwouldloseall
salestoimports.Anditdoesnotwanttochargeapricelowerthanthatsinceitis
belowthemonopolypriceshownasderivingfrommarginalrevenueMRand

marginalcost.Therefore, PW + t1 becomesthenewdomesticprice.Thus,domestic
pricerises,quantitiesproducedandconsumedbothfallto Q1 .Demanderslose

SPP/Econ541

AlanDeardorff
FallTerm2008

FinalExamAnswers

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areas(a+b+c+d).Thesingleproducergainsrevenueof(a+b+c)whilelosing
revenueof(e+f+g)andgainingfromareductionintotalcostof(f+g).Thusthe
firmhasanetgaininprofitof(a+b+ce).Thereisnochangeingovernment
revenue,sinceimportscontinuetobezero.Thuswelfareofthecountryasawhole
changesby(a+b+c+d)+(a+b+cd)=(d+e).

3. (10points)Usethemonopolisticcompetitionmodel(reminder:itsthemodel
whosediagramappearsbelow)toshowwhatwillhappen
a. Iftwoidenticalcountriesmovefromautarkytofreetrade
i. Toprice;
ii. Tothenumberoffirmsfromwhichconsumerscanbuy;and
iii. Tothenumberoffirmsineachcountry.
b. If,startingfromfreetrade,thereisafallinthemarginalcostof
production(thesameineachfirm)
i. Toprice;
ii. Tothenumberoffirms.

TheCCcurveshowsaveragecost
AC = n ( F /S ) + c

wherenisthenumberoffirms,Fisfixedcostperfirm,Sisthesizeofthe
market,andcismarginalcost.ThustheCCcurvehasverticalinterceptcand
slopeF/S.

SPP/Econ541

AlanDeardorff
FallTerm2008

FinalExamAnswers

Page4of8
ThePPcurveshowshowtheprofitmaximizingmarkupovermarginal
cost(andhenceprice)fallsasthenumberofcompetitorsincreases:
P = (1/bn ) + c

wherebistheparameterofthedemandfunctionindicatinghowdemandfora
firmsproductvarieswithitspricerelativetotheaveragepriceofallfirms.

Initialequilibriumineachoftheidenticalcountriesinautarkyisthe
intersectionofCCandPP,thuspriceP andnumberoffirmsn .Whenthetwo
0
0
countriesengageinfreetrade,theresultisaworldeconomywithtwicethe
marketeachhadbefore,thus2SinsteadofS.ThisleavesthePPcurve
unchangedbutrotatestheCCcurvetohavehalftheslopeithadbefore,
thereforepassingthroughthepoint(2n0,P0)asshown.Thenewequilibrium
intersectionisthereforeatthelowerpriceP1andanumberoffirms,n1,thatis
higherthaneachfirmhadinautarky,butlowerthantheircombinedautarky
total2n1.Thustherearemorefirmsintheworldthaneachcountryhadbefore,
andconsumersgettochooseamongthemall.Buteachcountryhasfewerfirms
thanbefore.

Ifnowthemarginalcost,c,fallsinallfirms,thisshiftsboththeCCcurve
andthePPcurvedownbythesameamount(thechangeinc).Idontbotherto
drawthat,sinceitclearlyreducestheequilibriumpricebytheamountofthe
fallinc,whileleavingthenumberoffirmsunchanged.

SPP/Econ541

AlanDeardorff
FallTerm2008

FinalExamAnswers

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4. (9points)Consideradomesticmonopolythatisprotectedbyaveryhightariff
fromcompetitionfromacompetitiveforeignmarket,sothatitcanchargeone
priceinitshomemarketandanotherabroad.Assumethatthefirmsmarginal
costisconstantandthatallsupplyanddemandcurvesarelinear.

a. Showanequilibriuminwhichthefirmengagesindumping.

b. Ifthefirmwerenowconfrontedwithanantidumpingstatuteandit
wishedtoavoidbeingsubjectedtoanantidumpingduty,howwould
italteritsbehavior?Besuretoshowacaseinwhichitcontinuesto
servebothmarkets.

SPP/Econ541

AlanDeardorff
FallTerm2008

FinalExamAnswers

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5. (24points)SupposeyouaretheUSITCtryingtodecideasafeguardcaseinthe
UnitedStatesbroomindustry.Yousomehowknowthatsupplyelasticityofthe
USbroommanufacturers(whoarenumerousandplausiblyperfectly
competitive)is+2.0,butyouhavebeengiventwodifferentestimatesoftheUS
elasticityofdemandforbrooms:1.0and3.0.Theworldpriceofbroomshas
recentlyfallenfrom$5.00to$4.00,atwhichpricetheindustryisnowproducing
8.0millionbroomsdomesticallyandimporting72.0millionbrooms.Assume
thatdomesticandimportedbroomsareidenticaland,exceptwheretold
otherwise,thatthesequantitiesareanegligiblepartoftheworldmarketfor
brooms.
Answerthefollowingquestions,givingtwoanswerstoeachiftheydepend
upontheelasticityofdemand,oneforeachofthetwoelasticitiesabove.(Ifyou
havetroublewithpartsofthequestion,goaheadandanswerotherpartsevenif
youneedtomakeupanswerstoworkwith.Iwillthengradebasedonthose
madeuporincorrectanswers.)

a. Assumingthatemploymentintheindustryisproportionaltooutput,
bywhatpercentagedidemploymentrecentlydrop?

Pricefellby20%.Withasupplyelasticityof2.0,outputandthus
employmentwouldhavedroppedtwicethis,or40%.Thisanswerdoes
notdependonthedemandelasticity.

b. WhatsizeadvaloremtariffshouldtheITCrecommendifitwishesto
restoreemploymenttowhatitwasbefore?Howwouldyouranswer
differifyouthoughtthatUSdemandforbroomswasalargepartof
theworldmarket?

Itneedstoraisethepricebackupto$5.00.Ifthesmallcountry
assumptionisvalid,thena25%tariffwilladd$1.00tothe$4.00priceof
importsandachievethisresult.

Ifinsteadthelargecountryassumptionisneeded,thena25%tariffwill
raisethedomesticpricebylessthanthis,asitwillinsteaddrivedown
theworldprice.Thusatarifflargerthan25%wouldbeneeded.None
ofthisdependsonthedemandelasticity.

c. Usingthetariffyouspecifiedinthefirstpartof(b),bywhat
percentagedoesthedemandforbroomsdeclineasaresultofthe
tariff?Also,bywhatpercentagedoestheUSdemandforimportsof
broomsdeclineasaresultofthetariff?

The25%tarifffrompart(b)willcausedemandforbroomstofallby
25%ifthedemandelasticityis1.0andby75%ifthedemandelasticity
is3.0.Demandatthe$4.00pricewas80.0millionbrooms(domestic

SPP/Econ541

AlanDeardorff
FallTerm2008

FinalExamAnswers

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supplyplusimports).Sodemandfallseitherby20.0millionto60.0
million,orby60.0millionto20.0million.

Atthesametime,withthesupplyelasticityof2.0,supplyisincreasingby
twice25%,from8.0to12.0millionbrooms.Thusimportsfallfrom
72.00milliontoeither6012=48or2012=8.Thatis,importsfallby
either(7248)/72=1/3=33.3%iftheelasticityofdemandforbrooms
is1.0orby(728)/72=8/9=88.9%

d. Fromyouranswertopart(c),whatistheelasticityofdemandfor
imports?Howdoesitcomparetotheunderlyingelasticitiesofsupply
anddemand,andwhy?

Thedemandelasticityforimportsisthepercentchangeinimports
dividedbythepercentchangeinprice,whichisthereforeeither.33/.25
=1.33(ifthedemandelasticityforbroomsis1.0)or.889/.25=3.56
(ifthedemandelasticityforbroomsis3.0).

Theelasticityofdemandforimportsinbothcasesislargerthaneither
theelasticityofsupplyortheelasticityofdemand.Thisisnormal,since
demandforimportsisanexcessdemand.Thusthechangeinquantityis
larger,beingthesumofchangesinsupplyanddemand,whiletheinitial
quantity(whatitisapercentageof)issmallerthantheinitialquantity
demanded.

e. Againusingthetarifffromthefirstpartof(b),calculatethechangein
consumersurplusduetothetariff.Explainwhyconsumersarehurt
lessinoneelasticitycasethanintheother.

Thetariffcausespricetoriseby$1andthequantitydemandedtofall
from80milliontoeither60or20million.Thelossofconsumersurplus
is$1(80+60)/2=$70millionor$1(80+20)/2=$50million.

Consumersloselesswhentheelasticityishigh,becausetheyavoidmore
ofthecostofthetariffbysubstitutingawaytowardothergoods.

f. Whatisthenetwelfarecosttothecountryofusingthistariff?Again,
explainwhythecountryishurtlessinoneelasticitycasethaninthe
other.

Thisisthedeadweightlossduetothetariff,whichisthetwousual
triangleswhosebasesarethechangesinsupplyanddemandandwhose
heightisthe$1priceincrease.Thusthedeadweightlossiseither
$1(4+20)/2=$12million(withelasticity1.0)or$1(4+60)/2=$32
million(withelasticity3.0).

SPP/Econ541

AlanDeardorff
FallTerm2008

FinalExamAnswers

Page8of8

Thelossisgreaterwiththelargerelasticitybecauseitmakesdemand
changemoreandthusincreasesthesizeofthedemanddistortion.

g. Whatpolicy,otherthanatariff,couldachievethesamerestorationof
broomindustryemploymentbutatlowercosttotheeconomyasa
whole?

A25%subsidytoproductionwouldcausethesameincreaseinoutput
andthusemployment,butwithadeadweightlossofonly$14/2=$2
million.

h. Discussbrieflytwootherpolicies,bothofwhichappearatleastto
somedegreeinUSlaw,bywhichthisdisruptiontothebroom
industrymightbedealtwith.

TradeAdjustmentAssistanceprovidessupplementalunemployment
compensationandassistancefortrainingandrelocationfortrade
displacedworkers.Wageinsurance(calledAlternativeTrade
AdjustmentAssistanceinUSlaw)temporarilygivessometrade
displacedworkersaportionofanydropinwageswhentheytakeanew
job.Bothoftheseareviewedaspreferabletoasafeguardstariff,inthat
theyhelpworkerstoadjusttothenewsituationratherthan
discouragingthatadjustment,andtheyavoidthedeadweightlosses
fromtheotherpolicies.