Economics Exam

Question 1:

Part A:

FALSE: France has absolute advantage in production of both cars and apples.

Explanation: Unit labor requirement is the number of hours of labor for producing one unit of output. The unit labor requirement for apples is 8 hours for France and 24 hours for China for producing one apple. In case of cars, it takes 16 hours to produce one car in France and 60 hours for producing one car in China. The economy’ total resources are defined as L i.e. total labor supply for France is 96 hours and total labor supply for China is 120 hours.

A country has the absolute advantage in producing one good if it has the lower unit labor requirement than the other country in same good.

In the given case, France has absolute advantage in both goods i.e. apples and cars. France is more productive in the production of apples as it takes only 8 hours to produce apples as compared to 24 hours of China. Similarly, it has absolute advantage in cars production too as it takes 16 hours to produce 1 car in France while 60 hours in China. Beneficial trade is possible.

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Part B:

True: China has comparative advantage in producing apples and France has comparative advantage in producing Cars.  

Explanation: A country has the comparative advantage in production of good if the opportunity cost of producing the good in terms of the other good is lower in the country as compared to other country.

Given that L is total labor supply, C is cars and A is apple;

France_lc / France_la = 16/8 = 2 opportunity cost

China_lc / China_la = 60/24 = 2.5 opportunity cost        

France has lower opportunity cost (2) of cars in terms of apples than China (2.5). Hence, it should produce cars.

France_la / France_lc = 8/16 = 0.5 opportunity cost

China_la / China_lc = 24/60 = 0.4 opportunity cost        

China has lower opportunity cost (0.4) of apples in terms of cars than France (0.5). Hence, it should produce apples.

Part C:

False: It will lead to decrease in MPL in agriculture sector. 

Explanation: When only price of agriculture rises, labor shifts from manufacturing sector to agriculture sector and the output of agriculture rises while that of manufacturing falls. The wage rate doesn’t rise as much as the price of agriculture products since agriculture employment increases and thus the MPL in the agriculture sector falls.

The increase in price of agriculture good will increase the wage in the agriculture sector. Now the workers are able to buy more manufacturing goods but less agriculture goods as compared to before due to rise in price. Since workers are moving from manufacturing to agriculture, so MPL_A decreases.

Part D:

True: If the net gains from trade in a country are positive, in the short run everyone in the country is better off with trade liberalisation. 

Explanation: Trade liberalization involves removal of trade barriers between different countries and encouraging the free trade by reducing tariffs, eliminating quotas and reducing non-tariff barriers. Essentially, free-trade ends up in increased exports, higher economies of scale, lower consumer prices and lower tariffs. Hence, economic agents become better off and end up in positive net gains from trade.

Question 2:

Part A:

Total Cost = 1000 + 4qi…… (eq1)

Whereas, q_i =  = …. (eq2)

Therefore,

Average Cost = Total Cost / Quantity

Dividing eq 1 by quantity

(Total Cost/Quantity) = (1000/q) + (4Q/Q)

We will get;

Average Cost =  + 4 ….. (eq3)

Substituting eq 2 and eq 3.

Average Cost   = (1000 x

=(

= 0.2n + 4 …. (eq4)

Hence Proved: CC Curve:

Part B:

The cookie industry has the increasing returns to scale because the Average Cost is falling with the quantity.  Increasing returns to scale implies decreasing average cost with increase in the output.

Part C:

Given that PP Curve . (eq5)

At the equilibrium level, the CC and PP curve would interact as

PP Curve = CC Curve…. (eq6)

Price = Average Cost

Putting the eq4 from part A and eq 5 in eq 6.

6 – 0.3n = 0.2 n + 4

6 – 4 = 0.2n + 0.3n

2 = 0.5n

n = 4

Putting the value of n in eq5 and eq 4

Price = 6 – 0.3 (4) = 4.8

Average Cost = 0.2 (4) + 4 = 4.8

Hence Proved that PP Curve = CC Curve

 

Part D:

With trading with the identical country

S = S₁ + S₂ = 5000 + 5000 = 10,000

CC Curve = Average Cost =  x n + 4

CC Curve = Average Cost = 0.1n + 4 …..(eq7)

Finding equilibrium at this point, by using eq7 and eq5

PP Curve = CC Curve

6 – 0.3n = 0.1n + 4

6 – 4 = 0.1n + 0.3n

2 = 0.4n

Hence n = 5

Putting the value of n in eq5 and eq 4

Price = 6 – 0.3 (5) = 4.5

Average Cost = 0.1 (5) + 4 = 4.5

Hence Proved that PP Curve = CC Curve

 

Part E:

Trade will be generating gains because;

4. The price has fallen from 4.8 to 4.5 and
5. Firm will be able to serve wider market and take benefit of the economies of scale

Question 3:

Part A:

In the Trade theoretical concepts, a “small” nation is the one that usually have no impact on worldwide free trade prices. Tariff is defined as the tax that is placed on the imported goods and is used for reducing imports of certain items. For the current case, government has used tariff for reducing the solar panel imports. The graph below shows the country’s market for solar panel.

Before the tariff implementation, the country was importing the solar panels equivalent to Q₁^D – Q₁^S. The domestic demand was at Q₁^D and the domestic supply was at Q₁^S_. In this case, the yellow area is given for the consumer surplus and the red area represents the producer surplus before tariff. There was no Government Revenue before tariff and the total welfare is given by both yellow and red areas i.e. consumer surplus (yellow area) + producer surplus (red area).

Now after the government implements the tariff on solar panel imports, the impact will be as follows;

1. For consumer surplus, the consumers of the product in the small importing country will become worse off due to tariffs. There will be rise in domestic prices of imported and domestic solar panels substitutes that will reduce the consumer surplus in the market. In above diagram, the consumer surplus will be A+B after tariff as compared to A+B+C+D+E+F before tariff. Hence the consumer surplus has fallen (yellow area).
2. For producer surplus, the producers will be better off as a result of tariffs. There will be rise in price of the solar panel that will raise producer surplus in industry. The rising price will also push an increase in output of solar panel firms (can also attract more firms in industry) while rising employment, increasing profits and payments. In the above diagram, the producer surplus after tariff has risen to C+G as compared to before tariff of G (red area).

• For government, the revenue will incur due to tariff. Sheer benefit of the revenue will be dependent on how Government utilizes and spends it. These funds can help the government in supporting different programs within the country that will in end reap the benefit of the revenues. The government revenue is given by E in above diagram (green area).

1. Aggregate welfare effect of the country will be found by summing up the gains and the losses to government, consumer and producers. The net welfare will be made up of negative production efficiency loss and negative consumption efficiency loss. Both of these are combined together to form deadweight loss (area D and F blue in color). Since there are more negative elements in welfare change, hence the net national welfare effect of tariff imposition on solar panels will be negative. Hence, tariff implementation by small importing country will end up in reduction of national welfare.

Summary	Before Tariff	After Tarff	Change
Consumer Surplus	A+B+C+D+E+F	A+B	Reduced -(C+D+E+F)
Producer Surplus	G	C+G	Increased +C
Government Revenue	None	E	Increased +E
Total Welfare	A+B+C+D+E+F+G	A+B+C+E+G	Reduced due to deadweight loss -(D+F)

 

Part B:

In trade, a large economy is considered to be one that has an effect on the world price. Lowering the imports can reduce the world prices and larger imports leads to higher world prices. When the country will impose the tariff on solar panels, it will cause an increase in price of solar panel in domestic market and decrease price in rest of the world. The graph of small nation above will be same for large country in absence of tariffs. However, the new graph is shown below for explaining the changes in the consumer surplus, producer surplus, government revenue and economic welfare.

In above diagram, after tariff has been imposed, the world price has dropped (orange line) as the country is large. The imports have squeezed from Q₁^D – Q₁^S to Q₂^D – Q₂^S.

1. For consumer surplus, the consumers of the product in the large importing country will face low consumer surplus because the price for consumers does not increase as much as for the case of small nation. There will be rise in domestic prices of imported and domestic solar panels substitutes that will reduce the consumer surplus in the market. In above diagram, the consumer surplus will be A+B after tariff as compared to A+B+C+D+E₁+F before tariff. Hence the consumer surplus has fallen (yellow area).
2. For producer surplus, the producers will be better off as a result of tariffs. There will be rise in price of the solar panel that will raise producer surplus in industry. As the price for consumers does not increase as much as for the case of small nation, so the producer surplus will be lesser than the smaller nation. The rising price will also push an increase in output of solar panel firms (can also attract more firms in industry) while rising employment, increasing profits and payments. In the above diagram, the producer surplus after tariff has risen to C+G as compared to before tariff of G (red area).

• For government, the revenue will incur due to tariff. Sheer benefit of the revenue will be dependent on how Government utilizes and spends it. These funds can help the government in supporting different programs within the country that will in end reap the benefit of the revenues. The government revenue is given by E₁ and E₂ in above diagram (green area).

1. Aggregate welfare effect of the country will be found by summing up the gains and the losses to government, consumer and producers. In this case, the net welfare will be positive. Country’s total surplus will increase by E₂ – D – F.

Summary	Before Tariff	After Tarff	Change
Consumer Surplus	A+B+C+D+E1+F	A+B	Reduced -(C+D+E+F)
Producer Surplus	G	C+G	Increased +C
Government Revenue	None	E1 + E­2	Increased + E1 + E­2
Total Welfare	A+B+C+D+E1+F+G	A+B+C+E1+ E2+G	Increased (+E2 – B – D)

 

Comparison of Small Vs Large Nation:

It can be said that the welfare for smaller nation is negative due to deadlight loss of B+D (in graphs above). However, for the large nation the deadweight loss is offset due to extra trade gain of E₂ due to reduction in world price. The aggregate welfare effect for both countries was calculated by summing gains and losses to consumers, producers and government revenues. From above we can say that;

• When country is large and implements a small tariff, it will likely raise the national welfare (+E₂ – B – D).
• When country is small, tariff imposition will definitely reduce the national welfare due to deadweight losses (- B – D).