Assume a large world economy with several countries. There is a good that can be

Question

Assume a large world economy with several countries. There is a good that can be produced domestically by every country in the absence of trade. Suppose Country 1 has the following demand and supply curves for this good: D1= 28-2P and S1= 2P-4. For the rest of the world (without Country 1) demand and supply curves are Dw1= 500-25P And Sw1 = 100P. Answer the following questions (where necessary, round to two decimal places). (a) If Country 1 initially does not trade with the rest of the world, what are its equilibrium price and quantity? (b) Find consumer surplus for Country 1 when it does not trade. (c) Show why Country 1 will become an importer of the good, once we allow international trade. (d) With free international trade what are the world price and quantity Country 1 imports? (e) After intensive lobbying efforts domestic producers in Country 1 get some protection in a form of a $1.00 tariff What are the domestic price in Country 1 and price on the world market? (f) How do imports of Country 1 change? By how much? (g) By how much does consumer surplus change as a result of tariff? (h) What is the net effect of the tariff on Country 1? (i) Would you recommend for Country 1 to repeal the tariff? Why or why not?

Explanation / Answer

(a) Calculating equilibrium price and quantity of country 1 when it does not trade with rest of the world -

Demand curve of Country 1 is as follows -

D1 = 28 - 2P

Supply curve of Country 1 is as follows -

S1 = 2P - 4

Equilibrium is attained when demand equals supply.

Equanting demand and supply -

28 - 2P = 2P - 4

4P = 32

P = 8

The equilibrium price is $8 per unit.

Putting value of P in demand curve to determine equilibrium quantity

D1 = 28 - 2P = 28 - 2*8 = 28 - 16 = 12 units

The equilibrium quantity is 12 units.

Thus, equilibrium price is $8 per unit and equilibrium quantity is 12 units of country 1 when it does not trade with rest of the world.

(b) Calculating consumer surplus for country 1 when it does not trade -

Equilibrium price = $8 per unit

Equilibrium quantity = 12 units

Calculating Price in country 1 when quantity demand in 0 -

D1 = 28 - 2P

0 = 28 - 2P

2P = 28

P = 14

Calculate consumer surplus -

CS = 1/2 * ( Price when quantity demanded is zero - Equilibrium price) * Equilibrium quantity

     = 1/2 * (14 - 8) * 12

     = 1/2 * 6 * 12

     = $36

Thus, the consumer surplus for country 1 when it does not trade is $36.

(c) Calculating equilibrium price for rest of the world -

Demand curve for rest of the world is as follows -

Dw1 = 500 - 25P

Supply curve of the rest of the world is as follows -

Sw1 = 100P

Equating demand and supply to ascertain equilibrium price -

500 - 25P = 100P

125P = 500

P = $4

The price per unit in rest of the world is $4.

The price in country 1 without trade is $8 per unit. As world price (price in rest of the world) is lower than the price prevailing in country1, it can procure the good at lower price than producing domestically and thus it will become an net importer of the good, once we allow international trade.

(d) If country1 engages in international trade then in that case, world price will prevail in country 1 as well. The world price (as calculated in part c) is $4 per unit.

Calculating domestic demand at $4 per unit -

D1 = 28 - 2P = 28 - 2*4 = 20

The domestic demand at $4 per unit is 20 units.

Calculating domestic supply at $4 per unit -

S1 = 2P - 4 = 2*4 - 4 = 4

The domestic supply at $4 per unit is 4 units.

Calculate quantity of imports -

Quantity of imports = Domestic demand - Domestic supply

                            = 20 units - 4 units

                            = 16 units

The quantity country 1 import will be 16 units.

Thus, with free international trade the world price is $4 per unit and quantity country 1 imports is 16 units.

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