Problem Set III For International Trade

Center of Economic Research at ETH Zürich
ZUE F, 8092 Zürich
Dr. Christa Brunnschweiler
Problem Set III for International Trade

Spring Term 2010
MSc MTEC, MAS MTEC et al.
1 Import tariffs and quotas under perfect competi-

tion
1. Consider a large country applying a tariff t to imports of a good like that represented in
Figure 8.7.
(a) How does the export supply curve in panel (b) compare with that in the small-country
case? Explain why these are different.
Answer: The export supply curve is upward-sloping in the large-country case (it was
horizontal in the small-country case). In the small-country case, a horizontal export
supply curve means that the supply of exports from the rest of the world is infinitely
elastic. This corresponds to the price-taking assumption in perfect competition. In
contrast, an upward-sloping export supply curve means that the price of exports from
the rest of the world responds when the large country changes its import demand. For
instance, if the large-country importer applies a tariff that decreases its demand for
imports, the price charged by foreign exporters falls.
(b) Explain how the tariff affects the price paid by consumers in the importing country,
and the price received by producers in the exporting country. Use graphs to illustrate
how the prices are affected if (i) the export supply curve is very elastic (flat), or (ii)
the export supply curve is inelastic (steep).
Answer: Refer to Figure 8.5: in the small-country case (flat export supply curve), a
tariff increases the amount that consumers pay by exactly the amount of the tariff and
foreign exporters are paid the original world price, P ∗ ; the difference is collected by the
domestic government as tax revenue.
Refer to Figure 8.7: with an upward-sloping export supply curve (in the large-country
case), foreign exporters reduce their price due to a tariff; that is, foreign exporters
receive less than they did prior to the tariff. Domestic consumers pay more than
before, but by less than the full amount of the tariff. Again, the difference between
what consumers pay and what Foreign exporters receive is the amount of the tariff,
t, collected by the domestic government. In the large-country case, the incidence of
the tariff is shared by domestic consumers and foreign producers. Moreover, a steeper
foreign export supply curve implies that foreign exporters absorb more of the price
increase due to the tariff.
2. Rank the following in ascending order of Home welfare and justify your answers. If two
items are equivalent, indicate this accordingly.
(a) Tariff of t in a small country corresponding to the quantity of imports M.

(b) Quota with the same imports M in a small country, with quota licenses distributed to
Home firms and no rent seeking.
(c) Quota of M in a small country with quota licenses auctioned to Home firms.
(d) Quota of M in a small country with the quota given to the exporting firms.
(e) Quota of M in a small country with quota licenses distributed to rent-seeking Home
firms.
Answer: d = e < a = b = c. A tariff t corresponding to imports M, and a quota
on M units of import corresponding to tariff t are equivalent in terms of welfare so
long as proceeds from quota rents remain in the Home country and are not squandered
by rent-seeking activities: a = b = c. When quota rents are either given away to
Foreign firms or are squandered completely by Home firms seeking access to rents,
Home welfare diminishes by an equal amount (the amount of the quota rents).
3. Suppose Home is a small country. Use the graphs below to answer the questions.
(a) Calculate Home consumer surplus and producer surplus in the absence of trade.
Answer: Total surplus in the absence of trade is 25.
Consumer surplus without tariff: CS = 1/2 · 5 · (14 − 9) = 12.5
Producer surplus without tariff: P S = 1/2 · 5 · (9 − 4) = 12.5
(b) Now suppose that Home engages in trade and faces the world price, P ∗ = $6. Deter-
mine the consumer and producer surplus under free trade. Does Home benefit from
trade? Explain.
Answer: Home is better off with trade because total surplus increases by 9 (i.e., total
surplus under trade is 34).
Consumer surplus under free trade: CS = 1/2 · 8 · (14 − 6) = 32
Producer surplus under free trade: P S = 1/2 · 2 · (6 − 4) = 2
(c) Concerned about the welfare of the local producers, the Home government imposes a
tariff in the amount of $2 (i.e., t = $2). Determine the net effect of the tariff on the
Home economy.
Answer: The net effect on Home welfare is −4.
Consumer surplus with tariff: CS = 1/2 · 6 · (14 − 8) = 18
Producer surplus with tariff: P S = 1/2 · 4 · (8 − 4) = 8
Government revenue with tariff: GR = (6 − 4) · (8 − 6) = 4
Adding up changes in CS, PS, and GR we get net effect on Home welfare: −14+6+4 =
−4
4. Explain the difference between a quota with a domestic import license auction and a Volun-
tary Export Restraint (VER). What are the domestic welfare effects in the case of a VER?
Why would a country choose to reduce imports via a VER? Name a practical example of a
VER.
Answer: A VER is a particular form of import quota which leads to the allocation of
quota rents to the exporters in the foreign countries rather than the importers in the home
country. Welfare implications for the home country with a VER are always worse than under
a domestic import quota, because a VER allows the foreign country to collect and benefit
from any quota rents. The foreign country benefits from any positive terms-of-trade effect,
while the home country suffers both a negative terms-of-trade effect and a negative volume-
of-trade effect (deadweight loss due to lower consumer surplus). Nevertheless, VERs are
often employed as an alternative to import quotas because they avoid retaliation from
trade partners. With other words, VERs can both appease domestic interest groups AND
foreign trade partners, with the added benefit of generally not violating multilateral trade
agreements, since VERs are voluntary. Examples of VERs are the Japanese-U.S. automobile
VER at the beginning of the 1980s, and the multilateral Multifiber Arrangement (MFA)
limiting textile trade, which ended in 2005.
2 Import tariffs and quotas under imperfect compe-

tition
1. Figure 9.1 shows the Home no-trade equilibrium under perfect competition (with the price
P C ), and under monopoly (with the price P M ). In this question, we compare the welfare
of Home consumers in these two situations.
(a) Under perfect competition, with the price P C , label the triangle of consumer surplus
and the triangle of producer surplus. Outline the area of total Home surplus (the sum
of consumer surplus and producer surplus).
Answer: Refer to Figure 9.1 (reproduced below): Consumer surplus is the area under
the demand curve D and above the market price, and producer surplus is the area above
the marginal cost curve MC and below the market price. Under perfect competition,
consumer surplus is P C BP D , where P D is the intersection of the demand curve with
the vertical axis. Producer surplus is P C BP M C , where P M C is the intersection of the
marginal cost curve with the vertical axis. Total surplus is thus represented by the
triangle P M C BP D .
(b) Under monopoly, with the price P M , label the consumer surplus and producer surplus
(note that producer surplus is the same as the profits earned by the monopolist).
Outline the area of total Home surplus with a Home monopoly.
Answer: Consumer surplus is the triangle P M AP D .
To measure producer surplus, label the point in the figure where the MR curve intersects
MC at point B’. For selling the units between zero and QM , marginal costs rise along the
MC curve, up to B’. The monopolist earns the difference between the price P M and MC
for each unit sold. Label the difference between the price and the MC curve as producer
surplus, or profits. Producer surplus is represented by the trapezoid P M AB 0 P M C .
Total surplus is represented by the trapezoid P D AB 0 P M C .
(c) Compare your answer with parts (a) and (b) and outline the difference between the
two areas showing Home surplus. What is this difference called?
Answer: That difference is called the deadweight loss due to monopoly. Refer to
the figure from part (b): The deadweight loss due to monopoly is represented by the
triangle ABB 0 .
2. In this problem, we analyze the effects of an import quota applied by a country facing a
Foreign monopolist and no own production. In Figure 9.10, suppose that the Home country
applies an import quota of X2 , meaning that the Foreign firm cannot sell any more than
that amount.
(a) To achieve exports sales of X2 , what is the highest price that the Foreign firm can
charge?
Answer: Refer to the following figure: To achieve export sales of exactly X2 , the
Foreign monopolist would charge P2 .
(b) At the price you have identified in part (a), what is the Home consumer surplus?
Answer: Refer to the figure in part (a): Home consumer surplus is represented by the
shaded triangle with area b.
(c) Compare the consumer surplus you identified in part (b) with the consumer surplus
under free trade. Therefore, outline in Figure 9.10 the Home losses due to the quota.
Hint: Remember that there is no Home firm, so you do not need to take into account
Home producer surplus or tariff revenue. Assume that quota rents go to Foreign firms.
Answer: Refer to the figure in part (a): Consumer surplus under free trade is a triangle
with area b + c + d. Under a quota, consumer surplus decreases by c + d. The Home
welfare loss due to the quota is thus area c + d.
(d) Based on your answer to (c), which has the greater loss to the Home country: a tariff
or a quota, leading to the same level of sales X2 by the Foreign firm?
Answer: Because there is no terms-of-trade gain associated with the quota, welfare is
lower under a quota regime relative to a tariff regime.
3. Rank the following in ascending order of Home welfare and justify your answers. If two
items are equivalent, indicate this accordingly.
(a) Tariff t in a small country with perfect competition.

(b) Tariff t in a small country with a Home monopoly.
(c) Quota with the same imports M in a small country, with a Home monopoly.
(d) Tariff t in a country facing a Foreign monopoly
Answer: c < a = b < d. A small country with free trade has equivalent levels of
welfare under either perfect competition or monopoly. Adding a tariff in either case
reduces welfare due to the deadweight loss associated with the tariff, but does not
reintroduce any additional deadweight losses due to monopoly. Thus, a = b. A quota
in a country with a monopoly maintains the market power of the monopolist, and the
deadweight loss due to monopoly is additive to the deadweight loss due to the quota,
such that: c < a = b. Finally, a tariff with a Foreign monopoly can actually increase
welfare because it generates a terms-of-trade gain, and hence: a = b < d.
4. Why is it necessary to use a market failure to justify the use of infant industry protection?
Answer: If all markets are working perfectly, there is no reason why a potentially successful
fledgling industry cannot survive without government intervention. Let us consider the two
justifications for using an infant industry tariff. The first is that the industry will learn over
time, which will drive down its average costs to the point where it is competitive; if credit
markets were working perfectly, that industry could borrow against future profitability to
keep it in business until that time. The second justification explicitly assumes a market
imperfection: A positive externality in production implies that the socially optimal level of
infant industry output is above that determined by the market equilibrium.
5. What is a positive externality? Explain the argument of knowledge spillovers as a potential

reason for infant industry protection.
Answer: A positive externality exists in this case when the increase in production by one
firm generates benefits to other firms by lowering industry or production costs. By imposing
the tariff, the government could nurture the infant industry because the increase in output
allows the firms to reduce their future costs by learning from each other. Without the
protection, each firm on its own would lack the incentive to invest in learning through
increasing its current production.
3 Export subsidies in agriculture and high-technology

industries
1. What are export subsidies and why do countries use them? Name some examples of such
support programs.
Answer: An export subsidy is a payment given by the government to firms for every unit
exported. By subsidizing the firm, the government encourages the firm to produce more in
a particular industry. Examples include the payment of 50 euros per ton of harvested sugar
beets to European farmers by the Common Agricultural Policy, the payments received by US
cotton farmers for the production of cotton, and the subsidies given to aircraft producers.
2. Consider a small exporting country. Compare the cost to the government and the net effect
on welfare between an export and production subsidy in the amount of s per unit. Illustrate
your points graphically.
Answer: With an export subsidy, the loss in consumer surplus is equal to the areas a +
b because the price in the domestic market increases to P W + s, leading the quantity
demanded to drop to D1 from D2 . The gain to the producers is equal to areas a + b + c,
whereas the cost to the government from the export subsidy is given by areas b+c+d. The
net effect of the export subsidy is the sum of the losses to the consumers and government
minus the producers’ gain. Namely, the small country experiences a loss equal to areas
b+dwith an export subsidy. By contrast, a production subsidy would not raise the domestic
price, so there are no changes to the consumer welfare. The gain to the producer with the
production subsidy is the same as the export subsidy (i.e., areas a + b + c).The payment
of the production subsidy is equal to areas a + b + c + d. Thus, the net effect of the
production subsidy is the loss denoted by area d. Although the cost of the production
subsidy to government is larger relative to an export subsidy, the net effect of the former
is smaller on the country because consumption is unaltered, unlike that with the latter.
3. Describe the impact of each of the following goals from the Hong Kong WTO meeting on
(i) domestic prices and welfare of the country taking the action and (ii) world prices and
welfare for the partner countries.
(a) Elimination of agriculture export subsidies.

Answer: Agriculture export subsidies in a small country have the effect of raising do-
mestic prices. Export subsidies in a large country have the effect of raising domestic
prices and lowering foreign prices. As such, any country abolishing an export subsidy
would decrease domestic prices.The associated decrease in deadweight loss would in-
crease domestic welfare (even more so in a large country in which the abolition of
the subsidy improves its terms of trade as well). In the rest of the world, importers
no longer derive a terms-of-trade benefit from the export country’s subsidization pro-
gram; therefore, they import at higher prices and have lower welfare after subsidies are
abolished. Foreign exporters, on the other hand, enjoy a terms-of-trade and welfare
gain.
(b) Reduction of agricultural tariffs.
Answer: Agriculture tariffs in a small country also have the effect of raising domestic
prices.Tariffs in a large country have the effect of raising domestic prices and lowering
foreign prices. As such, any country abolishing an agricultural tariff would decrease
domestic prices. The associated decrease in deadweight loss would increase domestic
welfare in a small country, but welfare would decrease in a large country due to worsen-
ing terms of trade. In the rest of the world, exporters no longer suffer a terms-of-trade
loss from the import country’s tariff regime; therefore, they export at higher prices and
have higher welfare after tariffs are abolished. Foreign importers, on the other hand,
suffer a terms-of-trade and welfare loss.
(c) Duty-free, quota-free access for 97% of goods originating in the world’s least developed
countries.
Answer: As in part (b), removing tariffs and quotas decreases prices and deadweight
losses in the import market. The exporting LDCs will benefit due to higher export
prices and will enjoy a gain in welfare as a result. Conversely, importing LDCs will
face higher world prices and have lower welfare.The welfare calculation for other poor
countries not included among the LDCs is more complex because trade may be diverted
to the LDCs from lower cost producers that are still subject to trade barriers.
4. Consider a large country with export subsidies in place for agriculture. Suppose the country
changes its policy and decides to cut its subsidies in half.
(a) Are there gains or losses to the large country, or is it ambiguous? What is the impact
on domestic prices for agriculture and on the world price?
Answer: There are clear gains to the large exporting country. Not only do deadweight
losses decrease but terms-of-trade losses due to the subsidy are also diminished.
(b) Suppose a small food-importing country abroad responds to the lowered subsidies by
lowering its tariffs on agriculture by the same amount.Are there gains or losses to the
small country, or is it ambiguous? Explain.
Answer: From our discussion of small-country tariffs, the optimal tariff level is zero.
Hence, the small food importer gains from reducing its tariff as deadweight losses
decrease.
(c) Suppose a large food-importing country abroad reciprocates by lowering its tariffs on
agricultural goods by the same amount. Are there gains or losses to this large country,
or is it ambiguous? Explain.
Answer: From our discussion of large-country tariffs, the optimal tariff level is positive
because (for small tariffs) terms-of-trade gains exceed deadweight losses. If we assume
that the (tariff-reducing) country was previously at its optimal tariff, then welfare is
reduced by cutting its tariff, but there is still an overall gain from the bilateral reduction
in subsidies and tariffs. Because terms-of-trade gains for one party are terms-of-trade
losses for the other, we can measure the net overall benefits of bilateral trade barrier
removal as the reduction in both countries’ deadweight losses.
5. Additional question: Here we examine the effects of domestic sales taxes on the market
for exports as an example of the “targeting principle”. For example, in the domestic U.S.
market, there are heavy taxes on the purchase of cigarettes. Meanwhile, the United States
has several very large cigarette companies that export their products abroad.
(a) What is the effect of the sales tax on the quantity of cigarette exports from the United
States? Hint: You can compare your answer to the case of a production subsidy in a
small country.
Answer: Putting a tax on consumers reduces domestic quantity demanded while leav-
ing domestic production unchanged. The resulting level of exports is higher than it
was before the consumption tax. This is somewhat similar to providing a subsidy to
domestic production: the subsidy boosts the amount of domestic production while
leaving quantity demanded unchanged, and therefore also ends up increasing exports.
(b) How does the change in exports, if any, due to the sales tax compare with the effect
of an export subsidy on cigarettes?
Answer: Exports under the consumption tax are higher than under free trade, although
not as high as they would be under an export-subsidy regime. Under an export-subsidy
regime, exports increase due to a drop in quantity demanded and an increase in domestic
production.
4 Multiple Choice
Mark the correct answer with a cross (only one answer is correct). Hint: Each correctly
answered question gives one point. For each falsely answered question, one point will be
deducted. Unanswered questions give no points. All in all, this exercise will not be rated with
a negative score, i.e. at the least zero points will be allocated.
a) If a tariff is prohibitive, government revenue will

i) be welfare-maximizing for the Home country. o
ii) be zero. X
iii) exactly offset the loss in consumer surplus. o
iv) be equal to producer surplus. o
v) none of the above. o
b) If a small country with perfect competition imposes a tariff, then
i) the producers must suffer a loss. o
ii) the consumers must suffer a loss. X
iii) the demand curve must shift to the left. o
iv) the government revenue must suffer a loss. o
c) If a good is imported into (small) country H from country F, then the imposition
of a tariff in country H
i) raises the price of the good in both countries. o
ii) raises the price in country H and does not affect its price in country F. X
iii) lowers the price of the good in both countries. o
iv) lowers the price of the good in H and could raise it in F. o
v) raises the price of the good in H and lowers it in F. o
d) Consider a small open economy with perfect competition that wants to boost
agricultural production. It is considering an export subsidy and a production
subsidy. Which of the following statements is true?
i) The export subsidy leads to higher net Home welfare than the production o
subsidy.
ii) Both an export subsidy and a production subsidy would increase Home o
demand for agricultural products.
iii) The export subsidy would lead to a gain for Foreign consumers. o
iv) The production subsidy leads to higher net Home welfare than an export X
subsidy.
v) None of the above. o
e) When there is imperfect competition, an export subsidy could lead to welfare

gains for the exporting country if
i) increased profits for the subsidized firm outweigh the costs of the subsidy. X
ii) the subsidized firm does not become a global monopolist producer. o
iii) the countries that buy the goods produced by the subsidized firm end up o
paying lower prices.
iv) the Home consumers end up paying lower prices. o
f) Non-tariff trade policies include

i) export subsidies. o
ii) Voluntary Export Restraints (VERs). o
iii) local content requirements. o
iv) national procurement regulations. o
v) all of the above. X
g) How is the amount of the antidumping duty determined?

i) It is the difference between the domestic producer’s price and the world o
price.
ii) It is the difference between the foreign firm’s local price and its export price. X
iii) It is set through lobbying by domestic producers. o
iv) It is set by the WTO. o
v) None of the above. o

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Center of Economic Research at ETH Zürich

ZUE F, 8092 Zürich

Dr. Christa Brunnschweiler