Solutions

Practice Problem Set #5

ECO 3704: International Trade
Elias Dinopoulos

Problem 1
Foreigns demand curve for wheat is
D* = 80-20P.
Its supply curve is
S* = 40 + 20P.
Suppose Foreign is a small country
a. Graph the demand and supply curves.

S*
4

P* = 1.5
P=1
D*
Q
40 50

80

70

b. In the absence of trade, what would the price of wheat be in Foreign?

In the absence of trade:

D* = S*. Thus, 80 20P = 40 + 20P. This implies P = 1.
c. The price of wheat in the world market is 1.5. What is the free-trade equilibrium
price of wheat in Foreign?

Free-trade price in a small country = world price = 1.5.

d. Determine the amount of domestic production, domestic consumption, and
exports of wheat in Foreign under free trade.
Under free trade, P = P*(the world price) = 1.5.
Domestic production = 40 + 20*1.5 = 70.
Domestic consumption = 80 20*1.5 = 50.
Exports = Domestic production Domestic consumption = 70 50 = 20.

Problem 2
In the example of problem 1, suppose Foreign offers exporters a subsidy of 0.25 per unit.
a. Determine and graph the effects of the subsidy on the price of wheat and the
quantity of wheat supplied and demanded in Home.

S*
4
P = 1.75
P* = 1.5
P=1
D*
Q
40 45 50

70

75

80

Domestic price = P* + s = 1.5 + 0.25 = 1.75.

Domestic production = 40 + 20*1.75 = 75.
Domestic consumption = 80 20*1.75 = 45.

b. Determine using a graph the effect of the export subsidy on the welfare of each of
the following groups:

(1) Foreign wheat producers; (2) Foreign consumers; (3) the Foreign
government.

S*
4

P = 1.75
P* = 1.5

D
G

B
F

F
D*

40 45 50

70 75

80

(1) Foreign producers benefit from the export subsidy since producer surplus
increases from (F +G) to (B+C+D+F+G).
(2) Foreign consumers lose from the export subsidy since consumer surplus reduces
from (A+B+C) to A.
(3) Foreign government spends (C+D+E) to finance the export subsidy.

c. Calculate, using geometric techniques, the consumption distortion loss, the

production distortion loss, and the net welfare effect of the export subsidy.

(1.75 1.5)(50 45)

0.625 .
2
(1.75 1.5)(75 70)
Production distortion loss areaE
0.625 .
2
Net welfare loss areas(C E ) 1.25 .
Consumption distortion loss areaC

Problem 3
A large country may benefit from a tariff. True or false? Give a short explanation .
True. A large country may benefit from a tariff because the terms-of-trade gains from
the tariff may outweigh the distortion losses caused by the tariff.

Problem 4
At the price of $10 per bag of peanuts, Acirema imports 200 bags of peanuts. To find this
substitute the world price in the supply and demand curves and calculate the excess
demand curve: D S [400 10 P] [50 5P] 350 15P . A quota limiting the imports of
peanuts to 50 bags has the following affects:
a. The price of peanuts rises to $20 per bag. To find this calculate the excess demand
for peanuts and find the price which corresponds to an excess quantity demanded
of 50 bags ( i.e., D S 50 350 15P which implies P 300 /15 20 ).
b. The quota rents are ($20-$10)50 = $500.
c. The demand curve implies that an increase in the price of peanuts of $10
decreases the quantity demanded by 100 units. The consumption distortion loss is
equal to the area of the corresponding triangle: 0.5 (100 bags)($10 per bag)=$500.
d. The supply curve implies that an increase in the domestic price of $10 increases
the quantity supplied by 50 bags. The production distortion loss is equal to the
area of the corresponding triangle: 0.5 (50 bags)($10 per bag)=$250.

Problem 5
The import demand equation MD is found by subtracting the home supply equation from
the home demand equation: MD D S 100 20 P 20 20 P 80 40 P . Without trade
domestic prices and quantities adjust such as the excess (import) demand is zero:
80 40P . Thus, in the absence of trade, the home price is P=2.

Problem 6
a. The foreign (as opposed to home) export supply curve XS* is found by subtracting
from the foreign supply the foreign demand curve:
XS * S * D* 40 20 P [80 20 P ] 40 40 P .

In the absence of trade foreign does not export, so setting XS*=0 and solving for the
price yields 40=40P which generates the foreign autarkic price: P*=1
b. Under free trade, the amount of exports supplied XS* must be equal to the amount of
imports demanded MD. So, setting MD = XS* yields 80 40 P 40 40 P which in turn
generates the world price PW 1.5 . Substituting this price into the import demand (or
export supply) yields the volume of trade: 20 units. The following figure illustrates the
free-trade equilibrium.

XS*
P=2

PW 1.5

P=1
MD
Q

80

20