SPP/Econ 541

Fall Term 2012

Alan Deardorff
Final Exam - Answers
Page 1 of 7
Name_________________________________
UMID_________________________________

Final Exam
December 18, 2012
Answers
Answer on these sheets. Use the indicated point values as a guide to how extensively you should
answer each question, and budget your time accordingly. (Actually, they are all the same, 12
points each; so spend about the same amount of time on each.) The exam has a total of 60
points.

SPP/Econ 541
Fall Term 2012

Alan Deardorff
Final Exam - Answers
Page 2 of 7

1. (12 points) Your government has a tariff on imports of T-Shirts. It is contemplating

removing that tariff completely. A government analyst has used the perfectly competitive
model of a small country importing a homogeneous product to estimate the effects of this
tariff removal on items (i)-(vii) listed in the table below. How would these results be
changed if it were known that the country is large instead of small?
In the space below, draw an appropriate diagram with which to answer this question. Then
record in the table whether, if the country were large rather than small, the indicated changes
would be larger (+) or smaller () in absolute value, or would be no different (0) than the
government analyst has calculated. If the change could be either larger or smaller depending
on elasticities, then enter a question mark (?).
Ans: If the country is small, then price falls to P0W . If it is large, world price rises as shown
in the Import Mkt, and thus domestic price falls less, to P1W . As a result, and as shown in the
figure for the Domestic Mkt, imports fall less, domestic production falls less, producers lose
less in producer surplus and consumers gain less in consumer surplus. The dead weight loss
triangles, which constitute the net gain from tariff removal, also are smaller. The only thing
that is unchanged is the loss of tariff revenue, since that goes to zero in both cases.
iv.
v.
vi.
vii.

Small
c+h
a+e
a+b+c+d+e+f+g+h+i+j
b+d+f+g+i+j

| revenue |
| prod surp |
cons surp
welfare

Domes&c(Mkt(

PD

PM

Large
c+h
a
a+b+c+d
+(b+d)h

Import(Mkt(
SM

(1+ t)P0W
P1W
P0W

LS
0
e
(e+f+g+h+i+j)
(f+g+h+i+j)

a(
e(

b(
g(
f(

c(
h(

d(

P1W

i( j(

P0W
DD

DM

QD

i.
ii.
iii.
iv.
v.
vi.
vii.

Increase in quantity of imports

Decrease in domestic price of imports
Decrease in domestic production
Decrease in government revenue
Loss of producer surplus
Gain of consumer surplus
Net gain in welfare of country

QM

SPP/Econ 541
Fall Term 2012

Alan Deardorff
Final Exam - Answers
Page 3 of 7

2. (12 points) A small country produces (only) food and cloth and initially, under free trade, it
exports food and imports cloth.
a. Using the diagram of the Standard Model, illustrate this situation, indicating clearly in
your diagram the quantities of exports and imports and how the prices of food and cloth
enter the diagram.

C=Cloth%

Slope = (PF / PC )

Imports%%
of%Cloth%
Exports%%
of%Food%

F=Food%
b. Suppose now that the world relative price of food rises. What, if anything, will that do to
the following? Why?
i. the domestic relative price of food
Ans: It also rises, since it is equal to the world price.
ii. the output of cloth
Ans: It falls.
iii. the exports of food
Ans: It probably rises, and it certainly rises if preferences are such that relative
demands depend only on relative rice (homothetic). Otherwise there is a remote
possibility that the positive income effect of the improved terms of trade may increase
consumption of food more than production.
c. Suppose that this were the Heckscher-Ohlin trade model with factors of production land
and labor, and that the food sector uses comparatively more land, relative to labor, than is
used in the cloth sector. In this context
i. what would be the reason that the country exports food?
Ans: That its relative endowment of land compared to labor is higher than in the rest
of the world i.e., it is relatively abundant in land.
ii. how would the domestic price change that you found in part (b) be expected to
affect the wage paid to labor and the rental paid to land in the two sectors?
Ans: This rise in the relative price of land will increase the real rental and reduce
the real wage, according to the Stolper-Samuelson Theorem.

SPP/Econ 541
Fall Term 2012

Alan Deardorff
Final Exam - Answers
Page 4 of 7

3. (12 points) Suppose Country A imports from both Country B and Country C a good that it
does not produce itself, and that the products of countries B and C are imperfect substitutes
with infinitely elastic supplies (horizontal supply curves). Initially, Country A has the same
tariff on imports from both countries, but now it eliminates that tariff on imports from B but
not from C.
a. Explain in words and show in diagrams for the two import markets the effects of this
tariff removal on prices and quantities of both goods.
Ans: Elimination of the tariff on imports from B lowers their price from (1+ t)P0B to P0B ,
but leaves the domestic price of imports from C unchanged. Since the price of imports
from C is unchanged, demand for imports from B simply moves down its demand curve,
increasing its quantity of imports. But the demand curve for imports from C shifts left, as
shown, because of the fall in price of its substitute from country B. As a result, even
though the price of imports from C does not change, a smaller quantity is demanded and
therefore imported.

PB

Imports(from(B(

PC

(1+ t)P0B

(1+ t)P0C

P0B

P0C

C
0

D (P , (1+ t)P )

Imports(from(C(

D C (P C , (1+ t)P0B )

D C (P C , P0B )

QB
b. Suppose that the government had been collecting equal total amounts of tariff revenue on
the imports from both countries. What can you say about the amount by which its tariff
revenue will fall when it eliminates the tariff on imports from Country B?
Ans: The tariff revenue on imports from B falls to zero. The tariff revenue on imports
from C also falls due to the decline in quantity of imports. So total tariff revenue falls to
less than half what it was before.

QC

SPP/Econ 541
Fall Term 2012

Alan Deardorff
Final Exam - Answers
Page 5 of 7

4. (12 points) Suppose a firm is the only producer of a good in its home market, where it faces a
linear demand curve and is protected by a prohibitive tariff. In addition to selling in its home
market, it can export all it wishes at a world price that does not depend on how much it sells.
Its marginal cost of production is an increasing function of its output.
a. Show in a diagram how much it will produce, how much it will sell in its home market
and at what price, and how much it will export.
Ans: As shown, the firm will produce Q0
where marginal cost equals the world
price. Since the marginal cost of selling
an extra unit on the domestic market is
what it could have sold for as an export, it
sets domestic sales where marginal
revenue, MR, equals P0W and charges the
price at which that quantity will be
demanded on the domestic demand curve,
P0D . It exports what it doesnt sell
domestically: Q = Q0 Q
X
0

D
o

P"

P0D
P1D

MC"

P0W
P1W

D"

Q1X MR"
Q0D Q1D Q1
Q0X

Q0

b. Suppose now that the world price falls.

How will each of these quantities, and the price, change?
Ans: The fall in world price, as shown by the shift to the dashed line at P1W , causes the
firm to reduce output to Q1 , moving along its MC curve. But that fall in world price also
reduces the marginal cost of selling domestically, so it increases sales to Q1D , and that
requires that it lower its domestic price, to P1D . Since output falls and domestic sales
rise, exports fall to Q1X .
c. By what definition is this firm dumping? How does the fall in world price change its
dumping margin?
Ans: This is dumping under the price discrimination definition of dumping. That is, the
firm is selling its export for a lower price than it charges at home. The dumping margin
is the size of this price difference, shown as the arrow in the figure.
When world price falls, the firm reduces its domestic price, but since the MR curve is
twice as steep as the demand curve, the drop in domestic price is smaller than the drop in
world price. Therefore the dumping margin increases.

SPP/Econ 541
Fall Term 2012

Alan Deardorff
Final Exam - Answers
Page 6 of 7

5. (12 points) You are the government of a country where a domestic industry is experiencing
increased competition from imports. What are some of the policy options that you have for
dealing with this, and to what extent are they allowed by your commitments as a member of
the WTO?
Ans: Some of the policies that you might consider are the following:
Increase your MFN import tariff on the good produced by the industry. This will be
legal under the WTO if your countrys tariff binding is higher than the applied tariff,
and you do not increase the tariff beyond that bound level.
Impose a temporary safeguard tariff on the good, after first confirming that there is
sufficient injury caused by imports. This will be legal under the WTO safeguards
clause.
Impose an anti-dumping duty on imports of the good, after first confirming that the
imports satisfy one of the definitions of dumping and that they are causing injury.
This will be legal under the WTO if proper procedures are followed.
Impose a countervailing duty on imports of the good, after first confirming that the
imports are subsidized and that they are causing injury. This will be legal under the
WTO if proper procedures are followed.
Provide a subsidy to production by the domestic industry. This may or may not be
legal under the WTO, depending on the reason that you give for the subsidy. But if it
is acknowledged to be in response to the increase in imports, then it is likely to be
struck down.
Provide trade adjustment assistance to displaced workers (and firms) in the industry,
including extended unemployment compensation, retraining and relocation
allowances, etc. This is perfectly OK under the WTO.
Provide wage insurance to workers displaced in the industry, paying them a
fraction of any fall in wage that they experience when they take another job. This too
is OK under the WTO.
Do nothing. That too is allowed, of course.

SPP/Econ 541
Fall Term 2012

Alan Deardorff
Final Exam - Answers
Page 7 of 7
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