ECO 364: International Trade

Problem Set 5 Solution

Part (a)

Inverse demand and supply for Icecubes in country c ∈ {H, F } are given respectively by:

P c = aD D D
c − bc Q c (1)
Pc = aSc + bSc QSc (2)

Hence, the demand and supply functions are:

aD 1
QD
c =
c
D
− D Pc (3)
bc bc
S
a 1
QSc = − Sc + S Pc (4)
bc bc

In autarky, demand must equal supply within each country. Equating (3) and (4), we get:

aD 1 aSc 1
c
D
− D
P c = − S
+ S Pc (5)
bc bc bc bc

and solving for the market-clearing price gives us:

aD S S D
c b c + ac b c
Pc = (6)
bD
c + bc
S

Using the given numbers for the demand and supply function parameters for Home and
Foreign:

PH = 5 (7)
PF = 3 (8)

1
Next, substituting the solution for the autarky price (6) into either the demand equation (3)
or supply equation (4), we can solve for the quantity of Icecubes in autarky:

aD S
c − ac
Qc = (9)
bD S
c + bc

With the given numbers, we have:

1
QH = (10)
2
1
QF = (11)
2

Part (b)

Consumer surplus in country c ∈ {H, F } given consumption of quantity Q of Icecubes is:

Z Q
PHD (i) − PHD (Q) di (12)
 
CSc (Q) =
0

where PHD (·) is the inverse demand function specied by (1). This simplies to:
1
CSc (Q) = bD
c Q
2
(13)
2

Similarly, producer surplus in country c ∈ {H, F } given supply of quantity Q of Icecubes is:
Z Q
PHS (Q) − PHS (i) di (14)
 
P Sc (Q) ==
0

where PHS (·) is the inverse supply function specied by (2). This simplies to:
1
P Sc (Q) = bSc Q2 (15)
2

Substituting the values for equilibrium output under autarky found in part (a) into equations
(13) and (15), we have:
1 1
CSH = , CSF = (16)
4 4
1 1
P SH = , P SF = (17)
4 4

2
Part (c)

Under free trade, demand and supply in country c ∈ {H, F } are given by:

aD 1
QD
c =
c
D
− D PW (18)
bc bc
S
a 1
QSc = − Sc + S PW (19)
bc bc

In order for the world icecube market to clear, exports by Home must equal imports from
Foreign:
QSH − QD S D
(20)


H = − QF − QF

Substituting (18)-(19) into (20) and solving for PW we obtain:

aD D S S D D S S
H /bH + aH /bH + aF /bF + aF /bF
PW = (21)
1/bD S D S
H + 1/bH + 1/bF + 1/bF

=4 (22)

Part (d)

Substituting the solution for the world price under free trade found in part (c) into either
the demand equation (18) or supply equation (19), we can solve for equilibrium quantities
of Icecubes demanded and supplied in each country under free trade:

QD
H = 1, QSH = 0 (23)
QD
F = 0, QSF = 1 (24)

Notice that under free trade only Home consumes Icecubes, and only Foreign produces
Icecubes.

Part (e) Substituting the values for quantities demanded and supplied in each country
under free trade found in part (d) into the expressions for consumer surplus (13) and producer
surplus (15), we have:

CSH = 1, P SH = 0 (25)
CSF = 0, P SF = 1 (26)

Part (f ) Under either autarky or free trade, welfare in country c ∈ {H, F }, which we
denote by Wc , is equal to the sum of consumer and producer surplus. Under autarky, total

3
welfare values in Home and Foreign are given by the results from part (b) as:
1
WHaut = (27)
2
1
WFaut = (28)
2

Under free trade, these values are given by the results from part (e) as:

WHtrade = 1 (29)
WFtrade = 1 (30)

Hence, welfare increases by 12 for both Home and Foreign, and both countries benet from
being able to trade freely with each other.

Part (g) As before, demand and supply in country c ∈ {H, F } are given by equations (3)
and (4). Now, let us write all prices rst in terms of the Foreign country's price, PF . Hence,
with a Home tari of t, demand and supply in each country are:

aD 1
QD
H =
H
D
− D (PF + t) (31)
bH bH
S
a 1
QSH = − SH + S (PF + t) (32)
bH bH
aD 1
QD F
F = D − D PF (33)
bF bF
S
a 1
QSF = − SF + S PF (34)
bF bF

Substituting (31)-(34) into the market clearing condition (20), we can solve for PF as:

aD /bD + aS /bS + aD D S S
1/bD S
 
F /bF + aF /bF H + 1/bH
PF = H H D H SH − t (35)
1/bH + 1/bH + 1/bD S
F + 1/bF 1/bD S D S
H + 1/bH + 1/bF + 1/bF
1
=4− t (36)
2

Since the Home price is related to the Foreign price by PH = PF + t, then:

aD /bD + aS /bS + aD D S S
1/bD S
 
F /bF + aF /bF F + 1/bF
PH = H H D H SH + t (37)
1/bH + 1/bH + 1/bD S
F + 1/bF 1/bD S D S
H + 1/bH + 1/bF + 1/bF
1
=4+ t (38)
2

4
Part (h) Substituting the solutions for prices found in part (g) into the supply and demand
functions (31)-(34), we obtain:
1 1
QD
H = 1 − t, QSH = t (39)
4 4
1 1
D
QF = t, QSF = 1 − t (40)
4 4

Part (i) Substituting the solutions for quantities found in part (h) into the consumer and
producer surplus equations (13)-(15), we obtain:
 2
1 1
CSH = 1 − t , P SH = t2 (41)
4 16
 2
1 2 1
CSF = t, P SF = 1 − t (42)
16 4

To compute tari revenue for the Home government, rst note that the quantity of imports
by Home consumers is:

MH = QD S
H − QH (43)
1
=1− t (44)
2

Hence, tari revenue for the Home government is:

T RH = tMH (45)
 
1
=t 1− t (46)
2

Part (j) Total welfare in Home under a tari of t is:

WH = CSH + P SH + T RH (47)
3 1
= − t2 + t + 1 (48)
8 2

Notice that equation (48) takes the form of a quadratic equation with a unique maximum.
The optimal value of the tari t∗ must thus satisfy dWdtH = 0, which implies:

2
t∗ = (49)
3

5
Part (k) Substituting the value for the optimal Home tari found in part (j) into the
expressions for Foreign consumer and producer surplus in part (i), we get:
1
CSF = (50)
36
25
P SF = (51)
36

Hence, total welfare is:

13
WF = (52)
18
Clearly, Foreign is worse o under the Home tari than under free trade (but is still better
o relative to autarky).

Part (l)

If the Foreign monopolist chooses to supply QH units of Icecubes to Home, its revenue
is:

R = PH QH (53)
= aD D 2
H QH − bH QH (54)

Since the Foreign monopolist produces with a constant marginal cost c, its total cost from
producing QH units of Icecubes is simply:

T C = cQH (55)

Combining (54) and (55), we can write prots for the Foreign rm as:

π = R − TC (56)
= aD D 2
H QH − bH QH − cQH (57)

Taking the derivative of the prot equation (57) with respect to QH , we get:

aD D
H − c − 2bH QH = 0 (58)

Solving for QH , we have:

1
aD (59)


QH = D H −c
2bH

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With the given parameter values, optimal output for the Foreign rm is therefore:

QH = 1 (60)

Part (m)

Given the optimal quantity chosen by the Foreign monopolist in part (l), we can recover
the equilibrium price of Icecubes from the demand function (1) for Home as:

PH = 4 (61)

Notice that this is the same as the equilibrium price under free trade with perfect competition
found in part (c).

Part (n)

Suppose Home imposes a tari of t. If the Foreign monopolist chooses to supply QH

units of Icecubes to Home, its revenue is now:

R = (PH − t) QH (62)
= aD D 2
H QH − bH QH − tQH (63)

Notice that even though Home consumers pay PH per unit of the good, this price includes
the tari, which is collected by the Home government. Therefore, what the Foreign rm
actually receives is PH − t per unit of the good sold. As before, total cost for the Foreign
rm from producing QH units of Icecubes is simply:

T C = cQH (64)

Combining (63) and (64), we can now write prots for the Foreign rm as:

π = R − TC (65)
= aD D 2
H QH − bH QH − (c + t) QH (66)

Equation (66) makes it clear that we can also think of the eect of the Home tari as raising
the eective marginal cost of the Foreign rm from c to c + t.
Taking the derivative of the prot equation (66) with respect to QH , we get:

aD D
H − (c + t) − 2bH QH = 0 (67)

7
Solving for QH , we have:
1
aD (68)


QH = D H −c−t
2bH
With the given parameter values, optimal output for the Foreign rm is therefore:
1
QH = 1 − t (69)
4

Therefore, the Home tari reduces output relative to the value found in part (l).

Part (o)

From equation (13), we know that consumer surplus in Home from consuming QH units
of Icecubes is:
1
CSH = bH 2
D QH (70)
2
D , we get:
Substituting the solution for QH from part (n) as well as the given value of bH
 2
1
CSH = 1− t (71)
4

The total tari revenue raised by the Home government is simply:

T RH = tQH (72)
 
1
=t 1− t (73)
4

Part (p)

Home welfare is given by the sum of consumer surplus (71) and government tari revenue
(73):

WH = CSH + GRH (74)

 2  
1 1
= 1− t +t 1− t (75)
4 4
1 3
= 1 + t − t2 (76)
2 16

Note that (76) is a quadratic function in t with a unique maximum. At this maximum point,
the derivative dWdtH must be equal to zero. Hence:

1 3
− t=0 (77)
2 8

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Solving for t, we nd that the optimal tari value for the Home government is:
4
t= (78)
3

Notice that this is larger than the optimal tari found in part (j) under perfect competition,
even though the price in Home under free trade is the same in the two scenarios. This shows
that the underlying market structure matters for the optimal tari.