Assignment Task
Gains from Trade
Consider two economies, Home (H) and Foreign (F), producing two goods Bananas (B) and Soybeans (S). Labor (L) is the only factor of production for the two goods in (H) and (F), and the countries’ endowments of the labor in (H) and (F) are LH = LH = 60 units. In (H), it takes 5 labor-units to produce one unit of (B) and 1 labor-unit to produce one unit of (S). In (F), it takes 1 labor-unit to produce one unit of (B) and 2 labor-units to produce one unit of (S). Suppose that in all cases, i.e., autarky or free trade, the price of good (S) is PS = €1.
a. Autarky: Suppose that at the prevailing prices, the residents of each country consume the two goods in equal amounts. For each country, please determine:
(i) The production/consumption possibilities line QS i = QS I (QB i , Li , LB i , LS i ), where i = H, F. Also, LB and respectively are the labor-units required to produce one unit of (B) and (S) in the two countries, while QB I and QS i respectively are the amounts of total production of goods (B) and (S) in the two countries, respectively.
(ii) The total amounts of (B) and (S) produced and consumed.
(iii) The nominal wage in each sector and the nominal unit cost (€) of producing (B) and (S).
b. International Trade:
Allow for international trade to commence between the two countries, at which 2 units of (S) exchange for 1 unit of (B), and 15 units of B exchange between the two countries. Determine:
(i) The levels of production and consumption in each country, and the levels of exports and imports between them.
(ii) What are the gains from trade for each country? Briefly comment on your answer.
(iii) Suppose now that transporting one unit of (B) or (S) entails a 5 percent (5%) loss (damage) per unit of the product shipped from one country to the other. Under what condition does each country retain its comparative advantage, so that free trade between them continues to be mutually beneficial? Verify the validity of the condition that you found [Hint: Use your calculations from (a.iii). Then, for a country to retain its original comparative advantage, the cost of a unit of exports, accounting for the transportation cost, must be smaller than the cost of producing one unit of the same good in the other country.
2. Foreign Direct Investment and Alternatives
Assume a Swedish firm that sells product S in the local market and considers sales to the USA. If the Swedish firm enters the American market it will compete in prices against an incumbent US firm that produces a similar (but not identical) product A. The Swedish (indicated by subscript S) and the American (indicated by subscript A) firms face the following demand functions: QS = 2,000 − 20PS + 10PA and QA = 4,000 − 40PA + 5PS , respectively, where QS (QA) and PS(PA) is the quantity and price of the Swedish (American) firm in the US market. The Swedish and the American firms face the following total cost functions when operating a plant: TCS = 15QS and TCA = 10QA. The Swedish firm has the option to either invest directly in operating a plant in the US, bearing an extra fixed cost of F = $3,000, or use its already existing production facilities in Sweden, shipping its product to the US with an additional transportation cost of $5/unit.
a) Find the price of S and A in the US, the profits of the Swedish and American firm and examine whether the Swedish firm would prefer to export S or produce it domestically in the US market.
b) Calculate the fixed cost F that would make the Swedish firm indifferent between FDI and exports and explain the effect that this fixed cost would have on prices.
c) How would your answer to part (a) change if the Swedish firm sets its price after observing the price of the American firm?
3. Protectionism
Consider a small open economy trading Cloth (C) with the rest of the world. In the country, demand for (C) is given by D = 1,000 − 10p and supply of (C) by S = −200 + 20p, p is the domestic price of (C).
a) Autarky: Calculate the equilibrium price and quantity of (C) in the country and its level of welfare.
b) Free trade: The country enters to free trade at a world price of p = €20. Calculate the emerging change in the country’s level of welfare due to its entering free trade. Is the country better/worse-off in free trade relative to autarky? Briefly explain your answer.
c) Trade Policy: Producers of good (C) in the country are unhappy because of the loss in their income due to the opening to free trade. They campaign for protection by the government, which contemplates the alternative imposition of the following measures:
(c.i) A tariff t = €5 per unit of imports of (C), or
(c.ii) An import quota that generates the same imports as the tariff of t = €5, or
(c.iii) A direct subsidy of equal amount, i.e., s = €5, to producers per unit of (C) produced
Calculate and discuss the implications of these three policy choices on the country’s consumers and producers. Welfare-wise which of the three policies should the government opt for? Briefly comment on your answers
