Simon Fraser University Department of Economics. Econ342: International Trade. Final Examination. Instructor: N. Schmitt

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1 Simon Fraser University Department of Economics Econ342: International Trade Final Examination Fall 2009 Instructor: N. Schmitt Student Last Name: Student First Name: Student ID #: Tutorial #: Tutorial Day/Time: TA s Name: Problem 1 Problem 2 Problem 3 Problem 4 Problem 5 Problem 6 Total:

2 Instructions: Answer ALL questions. The total number of marks for this exam is 100. The total time for this exam is 110 minutes. The exam starts at 12:30 and ends at 2:20pm. Allocate your time accordingly. Write your answers with pens. 1. (16 marks) Suppose Boeing and Airbus are deciding whether to invest in R&D to improve the quality of their medium-capacity planes. Boeing Airbus Invest No Invest Invest 70; ; 80 No Invest 90; ; 80 i. (4) Given the following payoff matrix in millions of dollars, what is (are) the Nash equilibrium (equilibria) of the game? Explain. Answer: The two Nash equilibriums are Boeing does not invest while Airbus invests and Boeing invests while Airbus does not invest. This is the case because in each equilibrium no one has an incentive to deviate given the strategy of the other firm. For instance when Boeing does not invest and Airbus invests, then Boeing would get 70<90 if it did invest, and Airbus would earn 80<100 if it did not invest given that Boeing does not invest. Similarly for the other Nash equilibrium. ii. Boeing (4) Fill the table below assuming that the governments of Europe seek to expand Airbus international market share by providing the European aircraft producer with a subsidy of $40 million for R&D. Airbus Invest No Invest Invest 70; ; 80 No Invest 90; ; 80 iii. (4) What is (are) the Nash equilibrium (equilibria) of the game illustrated by (ii)? Explain. Answer: With the $40 million subsidy for R&D, the dominant strategy for Airbus is to invest. Now there is only one Nash equilibrium, in which Boeing will not invest while Airbus invests. The payoffs are $90 million for Boeing and $140 for Airbus. iv. (4) Is the subsidy increasing or decreasing European welfare and by how much? Explain your reasoning. Answer: After subtracting the $40 million in subsidy from Airbus profit we see that the net gain in European welfare is zero. Therefore, the subsidy did not increase European welfare.

3 2. (15 marks) Suppose Home is a small country buying from a large foreign exporter. The supply and demand curve for Home is illustrated by the following figure, where P W denotes the free-trade world price. Assume that the Foreign government supports its producer with an export subsidy that lowers the world price to P*. We would like to know whether Home should consider levying a countervailing duty that would raise the import price back to P W. i. (3) What is a countervailing duty? Define briefly. A countervailing duty is a tax on imports (or a tariff) levied by a government to compensate an export subsidy provided by a foreign country. It is countervailing because its purpose is to neutralize the competitive advantage provided by such subsidy. ii. (4) If Home without the Foreign export subsidy is the benchmark (case 1), what is the change in Home welfare when Home faces the Foreign export subsidy (case 2)? Make sure to provide total welfare changes and the decomposition with respect to all the relevant components (consumer surplus, producer surplus, cost or revenue of the Home policy). Change in CS: +(a+b+c+d) Change in PS: -a Change in welfare: +(b+c+d) iii. (4) If Home without the Foreign export subsidy is the benchmark (case 1), what is the change in Home welfare when Home faces the Foreign export subsidy and Home imposes a countervailing duty (case 3)? Make sure to provide total welfare changes and the decomposition with respect to all the relevant components (consumer surplus, producer surplus, cost or revenue of the Home policy).

4 Change in CS: 0 Change in PS: 0 Change in revenue: + c Change in welfare: +c iv. (4) Rank Case 1 (Home without the Foreign export subsidy), Case 2 (Home faces the Foreign export subsidy), and Case 3 (Home faces the Foreign export subsidy and Home imposes a countervailing duty) from highest to lowest Home welfare. Be sure to justify your ranking. Answer: Since both changes are positive with respect to the benchmark, the benchmark is the worst case, while facing the foreign export subsidy is the best and imposing a countervailing duty with an export subsidy represents the intermediate case. Conclusion: the ranking in terms of welfare is: (2)> (3)> (1). 3. (8 marks) Consider the following graph reflecting the case of a Home country facing a Foreign monopolist. We want to determine the net impact on Home s welfare when it imposes a tariff of $2 on the Foreign monopolist. Price c e d 6 mc+t 4 mc D 7 10 Quantity i. (2) The change in consumer surplus is equal to: -(c+d) and thus area c= 7 x (11-10)=7; area e = 7 x (10-9)=7 area d=1/2x (11-10)x (10-7)= 1.50 Fall in Home consumer surplus: ii. (2) The change in producer surplus is equal to: zero since we are dealing with a foreign firm. iii. iv. (2) The change in government revenue is equal to: +14= (11-9)x7 (2) The change in welfare is therefore equal to: Net change in Home welfare: Therefore, the net change in Home welfare is positive.

5 4. (17 marks) In this question, we would consider the effect on US welfare, a large country, when a foreign exporter dumps a product in the U.S. market. The US market is given by the left of the following figure. i. (5) Assume the world price is P W = $5. Compute (in $) the level of consumer and producer surplus under free trade. The US consumer surplus under free trade is equal to: CS=1/2x 12x (16-5)= 66. The US producer surplus under free trade is equal to: PS=(1/2)x(5-1)x4=8. ii. (3) Suppose the US government imposes a tariff in the amount of $4 (i.e., t= $4). What is the new Home price and what is the price received by the foreign exporters? The new Home price is equal to: Because Home is a large country, it does not face a horizontal export supply curve. Rather, Home is able to have an impact on the world price. With a tariff of $4, the new Home price is $7 The price received by the foreign exporters is equal to: The price received by the Foreign exporters is $3 ($7-$4). iii. (3) Determine the terms of trade impact (in $) of the tariff on the Home country. In terms of the figure above, the terms of trade impact of the tariff on the Home country is equal to: Home s terms-of-trade gain is denoted by area e in the figure. Namely it is equal to 4=(8-6)(5-3). Does this correspond to a gain or to a loss in welfare for the Home country? Explain. This is a gain as this represents a transfer from the foreign country to the domestic country as the domestic country knows pays a lower price for its imports than without the tariff.

6 iv. (3) Does the overall Home welfare increase or decrease due to the tariff? Compute the total welfare effect of the tariff with respect to free trade. Explain. To determine whether Home welfare increases or decreases, we need to compare the terms-of-trade gain with the deadweight loss that results from the tariff (i.e., Home is better off if area e is greater than areas (b + d). Areas b + d= 1/2x (6-4) x (7-5)+ 1/2x(12-8)x (7-5)=6 Because area e equals 4 in part (iii), whereas areas b + d equal 6, then Home is worse off with a tariff of $4. v. (3) At what amount would the tariff be considered prohibitive? Explain what a prohibitive tariff means and indicate its level. A tariff in the amount of $6 would be prohibitive because it would raise the price paid by consumers to the no-trade equilibrium level. As a result, imports would be zero. 5. (20 marks) This question is composed of several True/False/Uncertain sub-questions. Each sub-question should be answered separately. Points will be given for explanations only. i. (5) `It is more efficient for the government of a small country to impose an import tariff than a production subsidy to stimulate output because it does not have to pay the producers directly. Answer: False Unlike an import tariff, a production subsidy does not alter consumption because the price faced by the consumers remains unchanged. Therefore, a production subsidy is more efficient because it does not create a consumption loss. Similar to an import tariff, a production subsidy results in a production loss or efficiency loss for the economy. ii. (5) `The role of the most-favored nation clause is to help eliminating discriminatory treatment in international commerce. Make sure to explain what `the most-favored nation clause means. Answer: True Article I of the key provisions of the GATT states that nations must apply the same tariff to all members of the WTO. This most-favored nation clause helps to eliminate discriminatory practices by requiring that all WTO countries be treated equally. Namely, a country must extend the same tariff to all members of the WTO as it would to its most-favored trading partner. iii. (5) `If the Foreign export supply is perfectly elastic, then a positive optimal tariff in the Home country should maximize its welfare. Answer: False A perfectly elastic Foreign export supply curve implies that the importing country is small. Therefore, the optimal tariff for Home is to set the tariff to zero (i.e., not impose an import tax) because it does not have a terms-of-trade gain but suffers a deadweight loss.

7 iv. (5) `If a country like Canada wants to develop a high tech industry, it should impose a barrier to imports in this industry. Generally false. This is the infant-industry argument and it is rarely the case that from an economic standpoint a barrier to import is the best policy. One needs to identify the reason why the private sector would not be able to grow. If it is because firms have a difficult time to borrow, a production subsidy might be the trick, if it is because they cannot find competent people, then a subsidy on labor might do the trick. A barrier to trade is a very indirect and distorting policy to implement with respect to policy that is targeted to the problem preventing high tech firms to grow. 6. (24 marks) Suppose that (i) the capital-labor ratio to produce one unit of a car is lower than the capital labor ratio to produce one unit of wheat in both Canada and the US; (ii) the ratio of total capital to total labor available in the US is greater than in Canada; (iii) the tastes for wheat and for car is the same in both countries; (iv) the same technology is available in both countries. i. (5) Draw both the US and the Canadian production possibility curves on the graph below where the quantity of cars is on the horizontal axis and the quantity of wheat is on the vertical axis. Make sure to explain how these two production possibility curves differ. Wheat Cars ii. (5) Which country in isolation (i.e. without trade) will have the lower equilibrium price ratio p car /p wheat? Justify your answer. Canada has the lower price ratio p car /p wheat To see this draw indifference curves to the PPF in each country; if one draws one indifference curve tangent to Canada PPF, then along the same line going from the origin through this production point then it must cut the US PPF at a point where an indifference curve cut the US PPF from below. Thus the tangency point of an indifference curve on the US PPF must be north-west indicating that the price ratio must be unambiguously

8 higher than in Canada. Another way of explaining this is to argue that Canada is labor abundant relative to the US and thus it must be relatively efficient in the production of the labor-intensive product which in this example is Car (relative to wheat). iii. (5) In which country is the price of capital, r, relative to the price of labor, w, lower without international trade? Justify your answer. The US has a lower price of capital relative to labor than in Canada. There is a variety of way of showing this. By using the Stolper-Samuelson line; an upward sloping line on a graph with w/r on the vertical axis and p car /p wheat on the horizontal axis. Or one can use the same graph as Feenstra with relative demand for labor in a graph with w/r on the vertical axis and L/K on the horizontal axis. From an economic standpoint, the fact that the US is capital abundant indicates that it will have a lower relative price of capital than Canada iv. (4) What is the pattern of free trade between Canada and the US? Explain. US exports the capital intensive product, wheat, and imports Car. Canada exports the labor intensive product, cars and imports wheat. This is an application of the Heckscher-Ohlin Theorem v. (5) Explain precisely how trade causes a reduction in the difference in r and in w between the US and Canada. Use the Stolper-Samuelson line to argue that the international price will be between the two autarkic prices. Since both countries face the same Stolper-Samuelson line (they have the same technology), a given international price leads to the same w/r in both countries. This can only be achieved if w falls (r rises) in the US and w rises (r falls) in Canada. This is coming from the fact that each country relatively specializes in the product they have a comparative advantage which means that Canada by producing more of the labor intensive product forces the price of labor to rise. One can also show the same thing with the graph that Feenstra uses (relative labor demands).