CAP 10

Questão 1

Free trade means the unrestricted movement of goods and services among
countries and has huge advantages for small countries like Philippines. Even
though it might prove to hurt the small producers in the domestic market,
however, an increased competition, due to the free trade, helps in providing better
quality products to the consumers and, gives an incentive to produce high-quality
products to the producers.

The following are the arguments in favor of free trade: (1) Free trade influences
consumers and producers of Philippines decision of choice based on marginal
cost-benefit calculations. Their economic decisions are no more dithered by the
artificial control by government policies.

(2) Free trade will widen the domestic market of Philippines. Consumers of
Philippines can avail a wide range of goods and services which was not possible
in case of autarky.

(3) It offers more opportunities for innovation which might introduce economies
of scale in the process of production.

(4) Free trade has improved the domestic politics of trade. The domestic trade
policy of the country is linked with the politics of globalization. Free trade results
in a political cleavage between the supporters of free trade and those opposing
open trade.

Questão 2

(a) It is in favor of argument for tariff. United States being a large country has a
large share in the world oil market and thus can influence the world oil prices. If
the United States imposes tariff on oil, then its domestic price increases which
benefit the domestic producers of oil; thereby increasing oil production and
exploration which in turn, increases the domestic supply of oil in future. The
rationale behind the argument is that tariff restricts the current consumption of oil
(the domestic consumers suffer due to higher prices resulting from tariff) and thus
the United States can stock their oil inventories which minimizes the future
adverse shocks.

(b) The argument made is an invalid argument. This is because off- season fruits
are non-competing in nature. A sharp fall in its price does not affect the supplies
of domestic producers in United States. A sharp fall in prices benefits the
domestic consumers. Thus, any trade policy like tariff offsets the benefits of the
domestic consumers as tariff increases the domestic price of the fruits. In this
case only government will gain as it earns revenue.
(c) This is not a valid argument for export subsidy. Any trade policy like export
subsidy will increase the incomes of the U.S farmers. It also increases the
incomes of those who sell goods and services to the U.S farmers, but at the cost
of the welfare of the U.S consumers. It should be recalled that an export subsidy
always generates more cost than benefits. If government’s goal is to stimulate
the demand for the related goods of the farm sector, policies should target that
goal only.

(d) This is a valid argument. Production semiconductors are of national interest.

The domestic production of semiconductors leads to external economies. But,
gains to domestic producers come at the expense of higher cost to the consumers
who badly need the good. However, a direct subsidy to the domestic chip
production would be the best alternative policy.

(e) This is not a valid argument. This is because the thousands of timber workers
are buyers of the home who are benefitted from the cheap timber. The cheap
timber will benefit the home consumers and the users of timber. If the aim of the
policy is to reduce the pain of the timber workers, then the better policy is to make
direct aid payments to the timber account holder.
Questão 3

It is given that the world price of a good, represented by Pw, is 10 per unit.

Calculate the equilibrium price for the small country, before the imposition of a
tariff, as follows:

Calculate the equilibrium quantity at the autarky level as follows:

Therefore, the equilibrium price and quantity are 25.33 and 273.33, respectively.
Represent the demand and supply of the good, in absence of a tariff, as follows:

Now, calculate the amount of the good the country will have to import as follows:

a.

With imposition of a tariff of 5 per unit, the domestic price increases from 10 to
15.

Now, calculate the new demand and supply as follows:

here is an increase in domestic production from 120 to 170, that is, production
increases by 50 units. While there is reduction in demand from 350 to 325, that
is, demand falls by 25 units.

Calculate the welfare effect of the tariff as follows:

Thus, there is a total welfare benefit of 312.5 units.

b.

With a production subsidy of 5, the price that the seller receives is 15 per unit
instead of 10 per unit.

Calculate the new supply as follows:

The production rises to 170, that is, it increases by 50. But demand remains the
same at 350.

The consumer loss is eliminated as consumers can still consume at a price of 10.

Now, Calculate the total effect from subsidy as follows:

Thus, there is a gain in welfare of 375 units.

c.

The production subsidy produces a greater gain in welfare than the tariff because
it only affects the prices in the production side and not the demand side.
Consumers stay at the original consumption point and there is no distortion in the
quantity demanded. However, the supply increase. This leads to an increase in
the overall welfare.

On the other hand, tariff affects the prices in both the production and demand
side. Therefore, though the supply increases, there is a consequent fall in
demand. Thus, the net gain from tariff is less than a targeted policy.

d.

The optimal production subsidy can be calculated by setting a goal of maximizing

change in welfare of a country.

Represent change in the welfare of the country as follows:

Here, ?CS is the change in consumer surplus, ?PS is the change in production
surplus, ?GVT is the change in government expenditure, and ?SB is the change
in social benefit.

Represent the new price as follows:

Substitute PNew in the supply equation as follows:

Now, calculate the change in producer surplus as follows:

Calculate the change in government expenditure as follows:

Calculate the change in social benefit as follows:

Substitute the value in the equation for maximum change in welfare as follows:

Calculate the derivative for the above equation as follows:

Therefore, .

Questão 4

The objective of the government is to maximize consumer surplus, its own

revenue, and triple the amount of producer’s surplus. As per problem 3, the effect
of tariff on supply and demand is: S =170D = 325. Government’s objective
function is:Max W = CS + 3PS +GVT(Note social benefit is not given and that
producers income is thrice as high as consumer income)Since CS is made up of
the higher price on all units still consumed plus the dead weight loss from
consumption,

CS = - = -1625 – 62.5 =- 1687

Since PS is the higher price received on each unit sold minus the dead weight

loss from inefficient production,PS = = 850 – 125 = 725

But producer income is valued three times more, so PS = 725×3 = 2175

Since the trade volume is 155, so, government revenue from tariff is 5×155=
775.A tariff of 5 per unit worsens consumer surplus by 1687, improves producer
income by 2175, and enables government revenue of 775.
So, the change in government’s objective function due to the tariff is :

W = -1687 + 2175 + 775 =

Questão 4

The objective of the government is to maximize consumer surplus, its own

revenue, and triple the amount of producer’s surplus. As per problem 3, the effect
of tariff on supply and demand is: S =170D = 325

Government’s objective function is:Max W = CS + 3PS +GVT(Note social benefit

is not given and that producers income is thrice as high as consumer
income)Since CS is made up of the higher price on all units still consumed plus
the dead weight loss from consumption,

CS = - = -1625 – 62.5 =- 1687

Since PS is the higher price received on each unit sold minus the dead weight

loss from inefficient production,PS = = 850 – 125 = 725

But producer income is valued three times more, so PS = 725×3 = 2175

Since the trade volume is 155, so, government revenue from tariff is 5×155=
775.A tariff of 5 per unit worsens consumer surplus by 1687, improves producer
income by 2175, and enables government revenue of 775.

So, the change in government’s objective function due to the tariff is :

W = -1687 + 2175 + 775 =

Questão 5

If Poland enters into to the European Union to which Germany is also a member,
then the case for trade creation or trade diversion depends on the cost of
automobile production in each country and the tariff rate imposed on Japan’s
imports.

Given,

Cost of automobile production in Poland = €20,000

Cost of automobile production in Germany = €30,000

a.

Given the cost of automobile production in Japan= Y= €18,000

Tariff rate imposed on Japan’s import:

If Germany imposes a tariff of €9,000 (50% of €18,000), the cost of imports from
Japan = €18,000 + €9,000

= €27,000

The cost of imports from Poland = €20,000 (in the absence of any tariff between
EU members)

So, we can say there is trade diversion.

Since Germany and Poland are a part of custom union, so, tariff on Poland
automobiles is eliminated (cost of automobile production in Poland will be the
original cost of €20,000), imports from Japan will be replaced by imports from
Poland (€20,000< €27,000). So, we can say there is trade diversion.

If Poland imposes a tariff of €9,000 the cost of production in Japan= €27,000

the cost of production in Germany= €39,000

Now, even if tariff on Germany automobiles is eliminated (cost of automobile

production in Germany will be the original cost of €30,000), Poland will replace
imports from Japan by its own production because Poland’s cost of production is
less than that of Germany (€20,000<€30,000) and Japan (€20,000< €27,000).

b.

Given Y = €18,000,

X = 100%

If Germany imposes a tariff of €18,000 (100% of €18,000), the cost of imports

from Japan = €18,000 + €18,000= €36,000

The cost of production in Poland= €20,000+€18,000= €38,000

Since Germany and Poland are a part of custom union, so, tariff on Poland
automobiles is eliminated (cost of automobile production in Poland will be the
original cost of €20,000), imports from Japan will be replaced by imports from
Poland (€20,000< €36,000). So we can say there is trade diversion.

If Poland imposes a tariff of €18,000, the cost of production in Japan= €36,000

the cost of production in Germany= €48,000

Now, even if tariff on Germany automobiles is eliminated (cost of automobile

production in Germany will be the original cost of €30,000), Poland will replace
imports from Japan by its own production because Poland’s cost of production is
less than that of Germany (€20,000<€30,000) and Japan (€20,000< €36,000).
c.

Given Y= €12,000,

X=100%If Germany imposes a tariff of €12,000 (100% of €18,000),

the cost of imports from Japan = €18,000 + €12,000

= €30,000

The cost of production in Poland= €20,000+€12,000

=€32,000

Since Germany and Poland are a part of custom union, so, tariff on Poland
automobiles is eliminated (cost of automobile production in Poland will be the
original cost of €20,000), imports from Japan will be replaced by imports from
Poland (€20,000< €30,000). So we can say there is trade diversion.

If Poland imposes a tariff of €12,000 the cost of production in Japan= €30,000

the cost of production in Germany= €42,000

Now, even if tariff on Germany automobiles is eliminated (cost of automobile

production in Germany will be the original cost of €30,000), Poland will replace
imports from Japan by its own production because Poland’s cost of production is
less than that of Germany (€20,000<€30,000) and Japan (€20,000< €30,000).

Questão 6
Skeptics views about free trade that have been gaining influence over the past
decade in United States. Its trade relation with Japan and Europe has been
troubled since 1990s. America continued to be concerned about Japanese
barriers to a variety of U.S imports including agricultural goods, autos and auto
parts. It even claimed charges of dumping of steel on Japan. America continued
to press Japan to deregulate various sectors of its economy. From American point
of view, free trade had created enormous harm to its labor market. There is large
scale unemployment in the economy. If trade policy were made on purely
domestic basis, progress towards free trade would have been very difficult to
achieve. Not only this, America being a major economy in the world trade is trying
to dictate the trade policies of its trading partners. This politics of trade policy is
determined by American domestic considerations. This approach of America
seems to yield unrealistic predictions for trade policies, which typically favors the
interest of small groups that are well organized at the expense of the general
public.
Questão 7
Optimal tariff is the best trade tariff that derives the maximum welfare to the
nation. Note that it does not follow any considerations in fixing the optimal tariff.

The following graph shows the optimal tariff of a country:

Observe that graph, take national welfare on the vertical axis, and take tariff rate
on the horizontal axis. Point ‘a’ indicates the optimal tariff as it derives the
maximum national welfare. A tariff always improves the terms of trade of a large
country that can influence the world prices but at the same time distorts
production and consumption. For an Influencing-exporting county, a tariff pulls
down the price of imports and this in turn develops terms of trade benefit. It also
distorts production and consumption incentives, these regard as the cost of tariff.
At point ’a’ on the curve, corresponding to the tariff rate, we obtain higher national
welfare. The tariff rate to that maximizes national welfare is the optimum tariff.
Therefore, for a large country, the marginal gain from improved terms of trade just
equals the marginal efficiency loss from production and consumption distortion at
an optimum tariff.
Questão 8
Trade is one of the most important sources of growth. Trade helps the economy
to specialize in what they produce more efficiently and allow them to sell it to the
customers who valued them most. This ensures lower cost of production and
higher profit margins. Trade also enables the economy to consume beyond its
productive capacity. Hence, trade increases country’s income and ensures faster
growth. When governments make trade, policies based on national economic
welfare, there is less scope for free trade and countries run the risk of trade
warfare of the kind illustrated by the Prisoner’s dilemma. Imagine that there are
only two countries 1 and 2 and that these countries have only two policy choices,
free trade or protection. For convenience let us assume that governments of
country 1 and country 2 can assign definite numerical values to the two-policy
choice as given below:

Prisoner’s Dilemma

So, to maximize the welfare of the country the government should take the policy
of free trade. This will increase the payoff compared to the protectionism Nash
equilibrium describe in the game above. It is shown in the above table that they
would be both better off if both chose free trade. In this game theory, the situation
is known as a Prisoner’s dilemma.

If the government take policy addressing free trade to maximize welfare the
problem of trade warfare is not represented by the game above.

The solution of the game would be both nation pay free trade and have payoff
(10,10).

If the game is repeated for infinite period and any country defect from the
cooperation of free trade, the other country will act to play tit-for-tat and choose
to counteract by protectionism. This will move both countries to the Nash
equilibrium where both countries play protectionism. Both countries need to
negotiate or establish an agreement to refrain from protection.

Questão 9

Trade relations between United States and China have reached high scales.
During the last few decades, United States has a flow of imports of Chinese
goods and more recently U.S is facing a bilateral trade deficit with respect to
China. As a result, United States became more careful with respect to the quality
standards of the Chinese goods. United States has adopted the method of
protectionism from Chinese surge of imports. It imposed import restrictions on
Chinese goods on the basis of health standards like the toys containing lead and
seafood. Because of these restriction people in concern started claiming that
United States should also impose restriction on Chinese imports on the basis of
labor standards. China is being accused of low wage rate in its labor market. It is
a fact that China has abundance in labor supply and the market forces drive down
the domestic wage rate. Thus, making the goods cheaper, and so, the imports of
such goods. However, China is not complying with the international labor
standard. There is low level of wage rate, poor working conditions and low level
of protection to the laborers. On these grounds opinions have been generated on
banning of imports of cheap Chinese goods. But, it should be borne in mind that
restricting imports of Chinese goods on health standards which directly affects
the American consumers sounds rationale than restricting imports on the basis
of labor standards which is purely domestic and democratic in nature.