ANSWERS FINAL 342 VERSION 1 Question 1: Suppose Boeing and Airbus are deciding whether to invest in R&D to improve the quality of their medium-capacity planes. i. Given the following payoff matrix in millions of dollars, what is the Nash equilibrium of the game? Answer: The two Nash equilibriums are Boeing does not invest while Airbus invests and Boeing invests while Airbus does not invest. ii. Suppose 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. Redraw the payoff matrix and find the Nash equilibrium.
Answer: See above for the new matrix. 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. iii. Is the subsidy successful in increasing European welfare? Explain. 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. 2. Suppose Home is a small country trading with a large 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.e., the price level without the subsidy). i. What is a countervailing duty? Define briefly. ii. iii. iv. 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). 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). 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: If Home levies a countervailing duty that raises the import price back to PW, producers would experience a gain equal to area a, whereas the loss to consumers is given by areas a+ b+c+ d. The government receives area c in tariff revenue with the countervailing duty. Therefore, the ranking is as follows from best to worst in terms of Home s welfare: (2)> (3)> (1). 3. Determine the net impact on Home s welfare when it imposes a tariff of $2 on the Foreign monopolist using the following figure. Price 11 10 9 c e d 6 mc+t 4 mc D 7 10 Quantity i. The change in consumer surplus is equal to: 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: -8.50 ii. The change in producer surplus is equal to: zero since we are dealing with a foreign firm. iii. The change in government revenue is equal to: +14= (11-9)x2 iv The change in welfare is therefore equal to: Net change in Home welfare: +6.50 Therefore, the net change in Home welfare is positive. 4. 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. Assume the world price is PW = $5. Determine the consumer and producer surplus under free trade. Answer: Consumer surplus under free trade: CS=1/2x 12x (16-5)= 66. The producer surplus is equal to PS=(1/2)x(5-1)x4=8. ii. Suppose the government at Home government imposes a tariff in the amount of $4 (i.e., t= $4).What is the new Home price? What is the price received by the foreign exporters? Answer: 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 whereas the price received by the Foreign exporters is $2. iii. Determine the terms of trade for Home with the tariff. Answer: Home s terms-of-trade gain is denoted by area e in the figure. Namely it is equal to 4=(8-6)(5-3). iv. Does Home welfare increase or decrease due to the tariff? Explain. Answer: 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 (c), whereas areas b + d equal 6, then Home is worse off with a tariff of $4. v. At what amount would the tariff be considered prohibitive? Explain. Answer: 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. True/False/Uncertain. 5.1 `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: 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.
5.2 The role of the most-favored nation clause is to help eliminating discriminatory treatment in international commerce. Answer: 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. 5.3 If the Foreign export supply is perfectly elastic, a positive optimal tariff of the Home country should maximize its welfare. Answer: 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.