Nguyen Van Long
Exercise 1
Given: (1) two nations (A and B) which have the same technology but different factor
endowments and taste ; (2)two commodities (X and Y) produced under increasing costs
condition, and (3) no transportation costs, tariffs or other obstructions to trade.
Prove geometrically that matually advantages trade between two nations is possible.
Assumption (Note your answer should show the autarky and free trade points of production
and consumption for each nation, the gains from trade of each nation and express the
equilibrium condiontion that should prevail when trade stops expanding)
We have two nations (A and B) which have the same technology but different factor
endowment They different PPF curve. There is different taste PA and PB are different (A
capital-intensive, B labor-intensive). UA and UB could be representative indifference curves for
the utility functions of A and B, respectively.
Y PA
Figure 1a: Mutual gains from trade
UA UA’
Ya
Q*
export
A’
import A
Yb B’
UB’
B
import UB
Q PB
export
P*
The autarky positions for countries A and B are A and B, respectively, and the autarky
0 are PA and PB
price lines X
Xa Xb
We have
Y PA > PB. Nation A has a comparative advantage in commodity Y and Nation B in
commodity X. Figure 1b: Mutual gains from trade
P*
UA’
Ya opening of trade(Figure
With the 1a of Figure 1b), Nation A specializes in the production of Y
(and moves upQitsA own production frontier), while nation B specializes in X (and moves down
export
its production frontier).ASpecialization
A’ continues until PX/PY (P*) is the same in both nations
and trade is balance (PB < P* < PA). This occurs at P* = 1. Nation A, produces at QA and
consumes atimport
A’(UA’) and Nation B, production at QB and consumes at B’.(UB’)
Yb
The countries A and B have mutual gains B’ from trade.
UB’
Exercise 2 import B
Given: (1) two nations, nations A (the capital-abundant nation) and nation B (the labor-
abundant nation); (2)two commodities, Y (the QB
capital-intensive commodity) and X (the labor-
export
intensive commodity), and (3) free trade
Show graphically with P*
(a) production possibilities curve and community indifference curves and
0 X
Xa Xb
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Nguyen Van Long
(b) offer curves the effect of capital-biased technical progress in nation B on the
nation B’s term of trade when all else remains constant in both nations
Sovle
- We have two nations (A and B). Nation A is the capital-abundant nation and Nation B
is the labor-abundant nation. We have two commodities, Y (the capital-intensive commodity)
and X (the labor-intensive commodity)
Y
Nation B Y
Offer curve of Nation B
E
P*=1
F E
PF=1/2
B
G H PF=1/2
F PB=1/4
C D
P*=1
(a) X (b) X
Figure 2
- In the Figure 2a. Nation B starts at pretrade-equilibrium point B. If trade takes place at
P*= 1, Nation B moves to point D in production, and reaches point E. This gives point E in the
Figure 2b. At PF =1/2 in the Figure 2a, Nation B would move instead from point B to point H
in production, and reach point F. This gives point F in the Figure 2b.
- Joining the origin with points H and E in the Figure 2b, we generate Nation B’s offer
curve. This shows how much imports of commodity Y Nation B requires to be willing to
export various quantities of commodity X
Exercise
P 3
I. Home’s demand curve for wheat is D = 100 – 20P. Its supply curve is S = 20 +20P.
Derive and graph home’s import demand schedule. PWhat would the price of wheat be in the
absence of trade ?
5
We have equilibrium condition D = S 100 – 20P = 20 + 20P
S 80 = 40 P P = 2
Let home’s import demand is fimport
fimport = D – S = 100 -20P – 20 – 20P = 80 - 40Ph = D’
2 2
D’
D
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20 100 Q 80 Q
Nguyen Van Long
(a) 60 (b)
Figure 3
II. Now add Foreign, which has a demand curve D* = 80 -20P and supply curve S* =
40 + 20P
1. Derive and graph Foreign’s export supply curve and find the price of
wheat that would prevail in Foreign in the absence of trade
2. Now allow Foreign and Home to trade will each other, at zero
transportation cost. Find and graph the euilibrium under free trade.
What is the world price? What is the volume of trade?
Sovle
1. D* = 80 -20P
S* = 40 + 20P
We have equilibrium condition D* = S* 80 – 20P = 40 + 20P
40 = 40P P=1
Let Foreign’s export supply is fexport
fexport = S* - D* = 40 + 20P – 80 + 20P= -40 + 40Pf = S’
P P
4 S’
S*
1 1
D*
Q
40 60 80 Q
(b)
(a)
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Nguyen Van Long
2. Trade with each other, at zero transportation cost.
Trade equilibrium condition
fimport = fexport
80 - 40Ph = -40 + 40Pf Pw = 3/2 = 1.5
Home’ demand and suppy at Pw = 1.5 are D = 100 – 20P = 70 and S = 20 + 20P = 50.
So the volume of import is Q = 70 – 50 = 20 (Non tariff)
From Figure 3b. and Figure 4b. we have graph
P
S’
The world price P = 1.5
The volume of trade Q = 20
2
1.5 Figure 5
1
D’
Q
III. Home imposes 80
20 an Ad valorem tariff of 10% on wheat imports
1. Determine and graph the effects of the tariff on the following: (a) the price
of each country; (b) the quantity of wheat supplied and demanded in each
country; (c) the volume of trade
2. Determine the effect of the tariff on the welfare of each of the following
groups: (a) Home import-competing producers; (b) Home consumers; (c)
the Home government
P Foreign market P International P Home market
market S
3. Show graphically and calculate the term of trade gain the efficiency loss,
and theS*
total effect on welfare of the tariff.
S’
Sovle Export
2 2 A’
1.5 1.5
E D
1 Import
A D’
D*
Q Page -4- Q Q
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Nguyen Van Long
- We have the world price is $1.5
If the government impose an Ad valorem tariff of 10% on wheat import
The wheat’s import price is 1.5 * 10% + 1.5 = $1.65 = Ph
fimport (Home) = 80 – 40Ph = 80 – 40*1.65 = 14
- We have fimport = fexport fexport (Foreign) = -40 + 40Pf =14
Pf = $1.35
The quantity of wheat supplied and demanded in each country
- Home market
D (Home) = 100 – 20 * 1.65 = 67 unit
S (Home) = 20 + 20 * 1.65 = 53 unit
- Foreign market
D* (Foreign) = 80 – 20 * 1.35 = 53 unit
S* (Foreign) = 40 + 20 *1.35 = 67 unit
P P
Home Market
Foreign Market
D
S
D*
S*
Pw+t
1.65
1.5 Pw
1.35
Q
40 53 60 67 80 Q 20 53 60 67 100
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Nguyen Van Long
2. Determine the effect of the tariff on the welfare of each of the following group: (a)
Home import-copeting producers; (b) Home consumers; (c) the Home government.
D
Figure 8
A E
2
F Domestic price with tariff
1.65 H G
1.5 C
B D I R World price
20 50 53 60 67 70 100 Q
+ Home consumer( this reduces the consumer surplus)
If there were no tariff, product X would be imported freely at the world price of $1.5.
Competition between foreign and comparable domestic would make the domestic market also
settle at a price of $1.5. At this price consumers would buy 50 unit X from domestic supplies
and would buy import 20 (70-50) unit X, buying D = 50 + 20=70.How much a tariff would cut
their gains. When the government imposes tax 10%, the price of product X will increase to
$1.65. The net loss to comsumers from the tariff can compute the areas of the rectangle HFRB
and the triangle area FRC. (HFRB + FRC = HFCB)
CS = SHFCB = 0.15*(70 + 67)/2 = $10.27
+ Home import – competing producers
A tariff brings gains for domestic producers who face import competition, by taxing
only the foreign product. The more it costs consumers to buy the foreign product, the more
they will turn to domestic suppliers, who get the benefit of extra sales and higher prices thanks
to the tariff. The tariff raises profits in the domestic industry only by the amount of area of the
HGDB.
PS = SHGDB = 0.15*(50 + 53)/2 = 7.72
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Nguyen Van Long
+ Home government
The effects of a tariff on the well-being of consumers and producers do not exhaust its
effects on the importing nation. As long as the tariff is not so high as to prohibit all imports, it
also brings revenue to the government. This revenue equals the unit amount of the tariff times
the volume of imports with the tariff, of area IGFR in Figure 8
Government = SIGFR = 14*0.15 = 2.1
3. Show graphically and calculate the term of trade gain, the efficiency loss, and the
total effect on welfare on the tariff.
P P Figure 9
b+ d
a c Tariff c Demand curve for import
fimport = D - S
b d
Q Q
A tariff brings a net nation loss. What it costs consumers is greater than what it brings
producer plus the governement’s tariff revenue. The two reasons for the net loss are
summarized in the areas b and d (Figure 9). Area b (the production effect) represents the loss
from making at higher marginal cost what could have been bought for less abroad. Area d (the
consumption effect) represents the loss from discouraging import consumption that was worth
more than what it cost the nation.
Caculate (We have Figure 8)
+ The total effect on welfare on the tariff is
Figure 9 Consumer loss Area a + b + c + d
Producers gain Area a
Government collects Area c in tariff revenue
Net nation loss from the tariff b +d
+ The efficiency loss is : (Figure 8)
SDGI + SRFC = (0.15*3)/2 + (0.15*3)/2 = 0.44 = b+ d (Figure 9)
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Nguyen Van Long
IV. Suppose that Foreign had been a much larger country, with domestic demamd:
D*= 800 – 200P, S* = 400 + 200P ( Notice that this implies that the foreign price of wheat in the
absence of trade would have been the same as in part II ).
Recaculate the free trade equilirium and the effect of a 10% Ad valorem tariff by home.
Let home’s import demand is fimport
fimport = D – S = 100 -20P – 20 – 20P = 80 - 40Ph = D’
Let Foreign’s export supply is Fexport
D* = 800 – 200P ; S* = 400 + 200P
Fexport = S* - D* = 400 + 200P – 800 + 200P= -400 + 400PF = S’
Trade equilibrium condition
fimport (Home) = Fexport (Foreign)
80 – 40 Ph = -400 + 400 PF Pw = 480/400 = 1.2
Home’ demand and suppy at Pw = 1.2 are D = 100 – 20P = 76 and S = 20 + 20P = 44.
So the volume of import is Q = 76 – 44 = 32 (Non tariff)
If the government impose an Ad valorem tariff of 10% on wheat import
The wheat’s import price is 1.2 * 10% + 1.2 = $1.32 = Ph
fimport (Home) = 80 – 40Ph = 80 – 40*1.32 = 27.2 unit
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