1.    Questions of international trade are now before Congress, as they always are.  Politicians say “I am in favor of free trade, but it must be fair trade.  If our competitors will not raise their environmental regulations, lower their tariffs on our goods, and reduce their export subsidies, we should retaliate similarly.”  (Chapter 9)

1.a) The implications of a foreign country that exports to the USA lowering its costs of production through lesser stringency in environmental regulations and direct subsidisation is a reduction in the export price of the good. Therefore for consumers in the USA, the product can be imported at a lower price. Thus there will be a gain in consumers’ surplus. On the other hand the domestic import substituting industries will be hurt as the price of imports has now fallen and thus the demand for the import substitutes will fall. Thus it will depend on the relative strengths of these effects whether there can be a net benefit for the USA as a whole. However, since the lax environmental regulations imply a degradation of environment which will be damaging to the entire world as a whole, if we consider this damage along with the losses of the local producers, there is a possibility that there will be in truth a loss on the net for the U.S economy.

 1.b) The policy burden will be on the taxpayers. Since subsidisation will be undertaken as a government expense and government raises its expenses through taxes, the burden will have to be borne by the taxpayers.

The effect for the US economy will be similar to the case discussed above. An export subsidy in the foreign country will imply reduced prices for imports in the USA. Thus there will be a gain in consumers’ surplus. However, the problem will be that, with unchanged exports this will imply deterioration in the trade balance. Further, as the imports become cheaper, consumers who erstwhile consumed import substitutes will increase consumption of imports. So, domestic industries will be hurt.

1.c) A tariff is a trade barrier that is imposed upon imports such that the per unit price of the product increases by the imposed amount in the domestic market of the tariff imposing country.

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A tariff in essence raises the price of imports and thereby causes a loss in consumer surplus while on the other hand as a result of the tariff, provided it is high enough, domestic products are promoted as the prices of these products are relatively  cheaper than the import. So this generates a producers’ surplus.

Finally, a tariff also generates a revenue for the government as the per unit additional price paid by the consumers are obtained by the government.

However, if a tariff is imposed as retaliation, chances are that the policy will lead to a reduced welfare for the economy as a whole. The main principle behind this is that if to raise welfare through altering export-import terms of trade an economy impose tariffs on imports, and if the country on which tariff is imposed, retaliates to gain in terms of individual welfare through shifting the terms of trade back to its favour, this process will go on with both nations retaliating and the final outcome will find reduced welfare levels compared to the period before the initiation of this “tariff war”.

1.d) An import quota is a physical restriction imposed upon imports . It sets the limit on the amount that can be imported. However, the effects of a quota are almost similar to those of a tariff. Due to the reduced availability of the import, the price of the good rises in the domestic market. Due to the set ceiling, a part of the demand is left open to the domestic producers. However the substantial difference lies in that the revenue generated from a tariff does not exist in case of a quota.

1.e) I would say it was wise as it reflected a movement towards freer trade. The quota is fundamentally more restrictive than the tariff as a trade barrier as it is not flexible. In case of a tariff, the option of still purchasing the import exists though a higher price has to be paid. However, in case of a quota the option of purchasing beyond the ceiling does not exist. Thus a tariff fundamentally resembles a freer trade practice compared to an equivalent quota. Further, the agreement spoke of first converting the quotas into tariffs and then gradually reducing the amount of tariffs imposed which therefore represented a gradual conversion to free trade for the agreeing members of the agreement.

1.f )

·         In situations of adverse balance of payments, implementing tariffs on imports leads to reduction in imports while at the same time through making the relative price of exports lower stimulates increased exports. This results in improved BOP conditions.

·         The next argument in favour of trade restrictions is the infant industry argument. It is posited that the nascent industries in developing nations should be protected from global competition and nurtured till they become competitive.

·         Tariffs also serve in generating revenues for government spending which can be utilised in various sectors where the government has to participate in subsidisation or active buying.

·         Since integration of global markets leads to increased competition, exposure to such markets for developing nations has dual effects. While, cheaper availability of a variety of products is a blessing for consumers, the enhanced competition has adverse consequences for domestic producers. With industries being potentially outcompeted, opening up to foreign trade too early may have adverse consequences on the interlinked processes of economic growth and development.

·         It is observed that while developed nations specialise and export primarily manufactured products due to the relative abundance of capital, developing nations have comparative advantages in production of agriculture based labour intensive products and specialise in these. But to participate in this form of trade would be counter-beneficial to developing countries as this would imply that the basic features of such economies such as low wages, extreme poverty and high population growth would be sustained over the long run and the economy would remain trapped in the low-level equilibrium trap. For progressive development, these nations need to become efficient in the production of manufactures and advanced industries. But with the present patterns of primary exportation, the purpose is defeated and participation in free trade reinforces the global inequalities in terms of development.

However, a number of economists choose to disagree with such arguments. Trade barriers, they argue not only fail to address the pith of the problems but are potentially harmful for all concerned parties. For instance, in case of the BOP argument, it is pointed out that although unilaterally a tariff is welfare generating, this holds true only until the trading partner does not retaliate. If the partner retaliates with a tariff imposition the benefits are no longer accrued and moreover as discussed earlier such steps may well lead to a tariff war. Further, it is also pointed out that the efficacy of a tariff is entirely dependent of the price elasticity of demand of the import. If the demand is inelastic, then imposing a tariff simply puts greater pressure on the balance of payments. In that case an import quota should be preferred although such practices have been observed to lead to black marketing with pent up demands being available to cater to.

Against the infant industry argument, it is also pointed out that by insulating domestic industries in such a manner, growth of competitiveness is prevented. Instead if these industries are exposed to foreign competition, to survive they have to become competitive and utilise resources efficiently which actually serves the cause of development better.

Finally, it is also argued that impositions of trade barriers to improve BOP situations or protect domestic industries are attempts to treat the effects without focusing on the causes. Instead of such barriers focus in making domestic industries more globally efficient and competitive serves both causes better. With exportable industries becoming efficient, the demands for such exports are likely to rise. Further with cheap resources available without restrictions, domestic industries can look to grow more profitably.

2.    a) The program of media campaigns and labelling requirements reduce the demand for cigarettes.. Again the price support program for the tobacco farmers implies that the costs of cigarette producers rises due to increased input prices. So, at each price lesser number of cigarettes will be supplied and the supply curve shifts leftward. Due to the reinforcing nature of both impacts the equilibrium quantity consumed will fall.

2.    b) The impact of these policies on the equilibrium price however remains ambiguous. While the awareness programs that reduce demand exert a downward pressure on the prices, the fall in supply due to the above equilibrium ceiling of tobacco prices shall exert an upward pressure on the price. Finally it will depend upon the relative strengths of these counteracting forces. If the former is stronger, the price will fall, if the latter is stronger the price will rise and if the effects counterbalance one another, the price will remain unchanged.

2.  c) The high taxation will increase the effective price that a consumer has to pay for cigarettes per unit. However, that does not necessarily imply reduction in consumption given the addictive nature of the product. Since consumers are often addicts, the demands are inelastic and in such cases the increased expenses due to the taxes shall affect the consumer’s allocation of income to other products. The excess shall most probably be adjusted through reduced consumption of other goods. However, for the casual smoker who is not an addict, such taxes will reduce consumption.

Given the transferable nature of sales taxes, producers are likely to be affected only if consumption falls by a significant amount which is not very likely given that the majority of the cigarette consuming population are addicts.

2. d) Although tobacco prices are maintained through the price support program the income of the tobacco farmers is likely to fall as the demand for tobacco reduces. As a result the opportunity cost for the land is likely to rise. Further the demand for such land is also likely to fall. Thus the price of such land may fall if the reduction in demand for tobacco is significant.

2. e) Overall the tobacco industry is likely to shrink if the fall in demand for tobacco is significant which will then definitely result is reduced value of all capital specific to the industry including machines. Further, the wages of the workers are also likely to fall if they are not rigid in the downward direction subject to trade unions or legislations or minimum wage restrictions.

2.  f) The cigarette consumers are bearing the burdens of the tax on cigarettes and thus it is this population that actually pays for the school books.

3. a) In a market of pure competition the largesse of the number of buyers and sellers coupled with product homogeneity ensures that individual buying and selling decisions do not influence the market price so that it remains constant. The result of this is that the price equals to the marginal revenue at all output levels for participant firms in a market of pure competition.  The equilibrium amount of output for an individual firm or the profit maximising amount is determined by the equality between marginal revenue and marginal cost curves where the marginal costs are upward rising.  So, by parametrically changing the price, and observing the profit maximising output we can determine the amount supplied by a firm at each price.

In the diagram above, it is shown how the short run marginal cost curve (SMC) translates into the supply function in a market for pure competition. Assume that P1 is the initial price in the market. Then the rising SMC curve intersects the MR curve for output level Q1 determining it to be the optimum output level for this price. So we get Q1 as the output supply for price P1. Similarly changing the price to P2 and P3, we obtain Q2 and Q3 as the supplied amounts corresponding to these prices. It is pertinent to note that P1 is the shutdown price and the firm will not supply any amount for any price below it. Therefore, the portion of the MC lying above the minimum point of the short run average variable cost curve (SAVC) denotes the supply function of the firm under pure competition.

3.    b) In a market of pure competition homogenous products are bought and sold by so large a number of buyers and sellers so that individual buyers and sellers have no influence on the market price. The buyers can sell any amount at the market price and the market demand curve is thus infinitely elastic.

However, in markets with lesser competitiveness, to secure additional sales, the producers have to reduce price. As a result the demand curve is downward sloping.

Due to this difference in shape of the market demand and consequentially, MR curves, it is pointed out that the resource utilisation of imperfectly competitive markets are sub-optimal.

Pure competition equilibrium is characterised by P = MC which is identified as allocative efficiency with the goods being priced at their marginal cost. Due to the flat AR= MR curve under pure competition, the long run equilibrium occurs at the minimum point of the long run average cost curve which is identified as the efficiency point. This is known as productive efficiency since firms produce at the lowest possible average cost. Given the homogenous nature products, there are no advertising costs involved and thus resources are not wasted. The firms earn normal profits and provide products to consumers at the minimum possible costs which also imply enhanced social equality.

However in other market forms which are less competitive, equilibrium prices are greater than the MC.  Equilibrium is attained by equating MC to MR but the price lies higher than the MR implying P> MC.  Further attaining the efficient point is not possible given the downward slope of the demand curve. As a result, the productive and allocative efficiency is not maximised in these market forms. Also due to differentiation, often firms have to resort to advertising which thereby diverts resources away and hinders productive efficiency.

3.c) “Consumer sovereignty” is one of the fundamental arguments in support of a free market economy. In a free market although producers are free to choose what and how much to produce and using what technology, to maximise profits these decisions must be taken subject to consumer preferences. Diverting production away from consumer preferences will simply lead to losses. The consumer is free to determine his consumption by type and amount and these preferences determine the market demand for any product. Producers respond to these by producing products that cater to these demands. Therefore it is the consumers’ preferences that finally determine the products as well as the amounts they are to be produced in. However, the producer’s prerogative is to cater to these demands as efficiently possible and thus the choice of technology which determines the number of people employed rests with the producers.


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