Practice Midterm 2 Answers (with Explanations)

1. B Consumer surplus for the market can be measured as the area between the demand
curve and market price for the 200 thousand products that are sold in the market. The
area of this triangle is equal to:
Consumer surplus=0.5∗( 150−70 )∗200,000Consumer surplus=$ 8,000,000
2. A Producer surplus for the market can be measured as the area between the market price
and the supply curve for the 200,000 products that are produced in the market. The area
of this triangle is equal to:
Producer surplus=0.5∗(70−10 )∗200,000 Producer surplus=$ 6,000,000

3. B We know that 3 conditions will have to hold in equilibrium:

Supply curve: Qs =−60+3∗P

Demand curve: Qd =390−2∗P
Markets clear: Qs =Qd =Q

We can impose the market clearing condition on the supply and demand curve and set the
supply and demand curves equal to each other. Then, we can solve for the equilibrium
price:
−60+3∗P=390−2∗P5∗P=450P=$ 90
4. C Given the $90 equilibrium price from the previous problem, we can plug the price into
either the supply or demand curves and solve for the equilibrium quantity:
Qd =390−2∗PQd =390−2∗90Qd =210
In equilibrium, the quantity demanded is equal to the equilibrium quantity.

5. A The price is now fixed at $75. To find the number of skateboards produced in the US
at this price, we can use the $75 price in the supply curve for the US:
Qs =−60+3∗PQs =−60+3∗75Qs =165
6. B We need to compute the quantity demanded of skateboards at a price of $75. We can
insert the $75 price into the demand curve for the US to figure out how many skateboards
will be demanded in the US:

Qd =390−2∗PQd =390−2∗75
Qd =240

7. C The number of skateboards imported into the country will be equal to the excess
demand (Qd −Qs ¿ of skateboards in the US. We know that 165 skateboards will be
supplied and 240 will be demanded from the previous problems. Then, imports will be:
Qd −Qs =240−165=75 skateboards

8. D Consumer surplus can be computed as the area between the demand curve and the
prevailing price in the market for each of the products sold in the economy. In general,
consumer surplus is equal to:
 Consumer Surplus=0.5∗(Crossing Pric e d−Prevailing Price)∗Qd
Crossing Pric e d : price at which the demand curve crossesthe vertical axis
The demand curve is given by:

Qd =390−2∗PP=195−0.5∗Qd The demand curve thus crosses the vertical axis at a

price of $195. Thus, at a market price of $90 and 210 skateboards sold without trade:

Consumer Surplus=0.5∗( 195−90 )∗210Consumer Surplus=$ 11,025

Producer surplus is given by:

Producer Surplus=0.5∗(Prevailing Price−Crossing Pric e s)∗Qs

Crossing Pric e s : price at which the supply curve crossesthe vertical axis
Rearranging the supply curve, we have:

Qs
Qs =−60+3∗P P= +20 The supply curve crosses the vertical axis at a price of $ 20.
3

Producer Surplus=0.5∗( 90−20 )∗210 Producer Surplus=$ 7,350

9. D Given a consumer surplus of $11,025 without trade from the last question, we can
compute consumer surplus with trade at a price of $75 and a quantity demanded of 240
skateboards:

Consumer Surplus=0.5∗(Crossing Pric e d−Prevailing Price)∗Qd

Consumer Surplus=0.5∗( 195−75 )∗240Consumer Surplus=$ 14,400
Consumer surplus increased by 14400-11025=$3,375 once trade opened.

10. B Given a producer surplus of $7,350 before trade opens, we can compute producer
surplus at the world price of $75 and a quantity supplied of 165 skateboards.

Producer Surplus=0.5∗( Prevailing Price−Crossing Pric es )∗Q s

Producer Surplus=0.5∗( 75−20 )∗165Producer Surplus=$ 4,537.5
Producer surplus decreased by 7350−4537.5=$ 2,812.50 after trade opened .

11. C The tariff is a tax on imported products. Generally, taxes will raise the price of
products. In practice, the tariff will increase the price of the product sold in the domestic
market and reduce the quantity of the product imported. In the importing country, the
higher price would lead to fewer sales (lower quantity demanded) and more domestic
production (higher quantity supplied).

12. B The tariff causes the price of products sold in the domestic country to be higher. The
increase in price compared to free trade without the tariff is either equal to the size of the
tariff (if the importing country is small) or smaller than the size of the tariff (if the
 importing country is large). In either case, the exporting country producers don’t receive
a higher price for their products because of the tariff. However, since the importing
country producers don’t have to pay the tariff, they receive higher prices for their
products. Because of the higher prices, they can increase their production.

13. C A small country cannot affect the world price of a product through its policies since it
is small and an insignificant share of the world market.

14. B When a large country imposes a tariff and prices rise in the country, there is a
noticeable reduction in the global demand (quantity demanded) of the product. This
reduction in global demand causes world prices to fall by the law of demand.

15. A According to the diagram, at a world price of $2,000, 200 thousand computers are
demanded and 100 thousand computers are supplied in the market. 200-100=100
thousand computers are imported. At the price with the tariff of $2,400, 190 thousand
computers are sold and 120 thousand are supplied. 190-120=70 thousand computers are
imported.

16. C You don’t necessarily need to compute producer surplus for each case to solve this
problem. You need to solve for the area in blue below, which represents the gains to
producer surplus from the rising prices caused by the tariff.

The size of this area is equal to:

Gain ¿ producer surplus=100∗( 2400−2000 ) +0.5∗( 2400−2000 )∗( 120−100 )
Gain ¿ producer surplus=$ 44,000Since quantities are measured in thousands of units, we
need to multiply this gain by 1,000 to get the true gain to producer surplus:
$44,000*1000=$44,000,000.

17. D The loss to consumer surplus from the rising price after the tariff is equal to the area
shaded in red below:
 This area is equal to:

Gain ¿ consumer surplus=190∗( 2400−2000 )+ 0.5∗( 2400−2000 )∗( 200−190 )

Gain ¿ consumer surplus=$ 78,000 Since quantities are measured in thousands of units, we need
to multiply this gain by 1,000 to get the true gain to consumer surplus:
$78,000*1000=$78,000,000.

18. C The tariff is $400 since the price of the computers rises by $400 in the US after the
tariff is imposed, and there’s no change to world prices. After the tariff, 70,000
computers are imported. Thus, the government earns $400*70,000=$28,000,000 from
the tariff. Graphically, the tariff is the area shaded in brown below:

19. B The overall change to surplus caused by the tariff can be computed as the change in
consumer surplus plus the change in producer surplus plus the change in tax revenue.
Given the values from the previous problems, we have:

Change∈surplus=$ 44,000,000−$ 78,000,000+ $ 28,000,000

Overall, surplus falls $6,000,000 because of the tariff.

20. D Overall, the world will still lose from the tariff. A large country could potentially gain
from a tariff. The nationally optimal tariff for a country is one that maximizes the surplus
it receives overall. There will be deadweight loss from lost trading opportunities from
 the tariff, but the tariff also causes the world price to fall, which allows the large
importing country to capture some of the surplus that would otherwise go to the exporting
country. The large country gains overall since the gains from the seized surplus exceed
the deadweight loss to the importing country from the tariff.

21. A The World Trade Organization was created after the Uruguay round of negotiations
under the General Agreement on Tariffs and Trade. It is the successor organization to
GATT.

22. B The General Agreement on Tariffs and Trade preceded the World Trade Organization
as the framework under which negations on tariffs and other trade barriers were
conducted.

23. C Since the world price falls after the tariff is put into place, the exporting country’s
producers suffer (lower prices, production, producer surplus).

24. A The tariff causes overall surplus to fall in the importing country. While the tariff
raises some tax revenue and increases the price at which domestic producers are able to
sell their product (higher producer surplus), the higher prices and fewer imports cause
overall surplus to fall.

25. B Many nontariff barriers have very similar effects as tariffs in practice: they raise
prices in the importing country and protect the importing country’s producers at the
expense of large losses to the importing country’s consumers.

26. B The one major advantage of quotas over tariffs is that the tariffs cause imports to be
limited to a specific number. Realistically, policy makers don’t necessarily know the
supply and demand conditions in the domestic and world markets for a product, and
without knowing the supply and demand conditions, it is difficult for policy makers to set
a tariff to limit trade to a certain amount.

27. C This is the definition of a quota. The quota will have similar effects as a tariff: in a
small country, world prices won’t be affect, and domestic prices will rise. In a large
country, the quota will cause world prices to fall but domestic prices to rise.

28. A With the fixed favoritism method of allocating import licenses, a country assigns
licenses to firms, likely in proportion to their share of imports before the quota is put into
place. The import licenses are issued based on past performance, not based on
competition or negotiation.

29. B At the price with the quota of $90, 17 million MP3 players are demanded while 12
million are supplied. This means 17-12=5 million MP3 players are imported.

30. C Domestic producers gain from the higher prices. The total gain in producer surplus is
equal to the area shaded in blue below:
 Gain∈ producer surplus= ( 90−80 )∗10,000,000+ 0.5∗( 90−80 )∗( 12,000,000−10,000,000)
Gain∈ producer surplus=$ 110,000,000

31. D Domestic consumers suffer from the higher prices. The loss in consumer surplus is
equal to the area highlighted in red below:

Loss ¿ consumer surplus=( 90−80 )∗17,000,000+ 0.5∗( 90−80 )∗(22,000,000−17,000,000)

Loss ¿ consumer surplus=$ 195,000,000

32. B After the quota, 5 million MP3 players are imported. With import licenses, the
government is able to capture the increase in prices domestically from the quota. Thus,
the government charges $10 (=90-80) per imported MP3 player. The government thus
receives $10*5,000,000=$50,000,000 from the sale of the import licenses. The increased
tax revenue is highlighted in brown in the diagram below:
33. A The change in national well-being (total surplus) from the import licenses is equal to
the change in consumer surplus plus the change in producer surplus plus the import
licenses revenue for the importing country. This change is equal to:

Change∈total surplus=−$ 195,000,000+$ 110,000,000+ $ 50,000,000

Change∈total surplus=−$ 35,000,000

34. C If the licenses are allocated using a “resource-using” procedure, the administrative,
monitoring, and other costs to running the license program add to the losses from the
quota.

35. C With a voluntary export restraint, the exporting country’s producers capture the gains
from the higher prices in the importing country, and the government no longer generates
revenue from taxes. The change in total surplus compared to free trade for the importing
country would be:
Change∈total surplus=−$ 195,000,000+$ 110,000,000=−$ 85,000,000.

36. D With a voluntary export restraint, the exporting country’s producers capture the gains
from the higher prices in the importing country since they’re able to charge higher prices
for their exported products.

37. B This is the definition of a mixing requirement. This is different than the domestic
content requirement since under the domestic content requirement, a percentage of the
value-added of each product has to be produced in the importing country. With mixing, a
certain percentage of the products offered by a company has to be produced domestically.

38. C With an import quota, the importing country may be able to charge money for import
licenses.

39. A This is a definition. Technically, there are two definitions: selling an exported
product at a lower price than in the home market (older, traditional definition) and selling
 an exported product at less than the full average cost of production (newer, more
technical definition).

40. B For the importing country producers, they benefit since the price of moped rises from
$750 to $800. The gain in producer surplus is highlighted in the blue area below:

Gain∈ producer surplus= ( 800−750 )∗500,000+0.5∗( 800−750 )∗100,000

Gain∈ producer surplus=$ 27,500,000

41. C Consumers lose with the tariff since prices rise. The loss in consumer surplus is equal
to the red shaded area in the diagram below:

Loss ¿ consumer surplus=( 800−750 )∗1,500,000+0.5∗( 800−750 )∗( 1,800,000−1,500,000 )

Loss ¿ consumer surplus=$ 82,500,000

42. C The government pockets the full difference between the domestic price with the quota
($800) and the new world price with the quota ($715) for each of the imported products.
 The full tax revenue that the government raises is equal to:
Tax Revenue=$ 85∗( 1,500,000−600,000 ) =$ 76,500 , 00

43. D The importing country’s total surplus is equal to the change in consumer surplus plus
the change in producer surplus plus the change in tax revenue from the quota and import
licenses.
Change∈total surplus=−$ 82,500,000+ $ 27,500,000+ $ 76,500,000
Change∈total surplus=$ 21,500,000The large importing country actually gains in this
case as a result of the quota for the same reason it could gain as a result of the tariff: the
quota causes the world price of mopeds to fall, allowing the importing country to seize
some of the surplus from the exporting country from the import licenses.

44. A Generally, a free trade area has free trade between member nations. It is the weakest
of the economic blocs that we looked at in terms of unity.

45. D A full economic union is the strongest of the economic blocs that we looked at in
terms of unity. All economic policies are unified in members of a full economic union.

46. B A customs union has common trade policy in addition to free trade amongst the
members. Typically, a customs union will feature common external tariffs amongst other
forms of common trade policy.

47. D Trade blocs tend to benefit member nations because restrictions to free trade tend to
hurt countries overall.

48. C This is the definition of the most favored nation principle. It was also an important
part of the General Agreement on Tariffs and Trade.
49. C Rules of origin help prevent businesses from shipping products to countries in a free
trade area with low tariffs in order to reach higher tariff destinations.

50. D An embargo is more likely to be effective if the target country does not have as much
time to adjust to the lost trade (finding products through other sources, for example).

51. C Countries do not raise tax revenue or seize each others’ surplus as a result of
embargoes. Rather, they simply lose the gains to trade that they experienced by trading
with each other. As a result, all countries lose overall from an embargo.

52. D This is a definition. Note that there does not have to be regular seasonal demand or
supply changes that drive the excess inventories. Any selling of excess inventories in
other countries by lowering prices would be termed seasonal dumping.

53. A This is a definition. The market power ensures that firms have the ability to set
different prices in different markets. Something prevents arbitrage from evening out
prices between markets.

54. B A is incorrect since the subsidy encourages exports and can push an import to an
export, not the other way around.

55. C The $160 world price intercepts the supply curve at Q = 120, so the quantity supplied
is 120 (million) bushels of wheat. The quantity demanded is 60 million bushels of wheat
(where the $160 price intercepts the demand curve. The quantity imported is Qm = Qd –
Qs = 120-60 = 60 million bushels of wheat

56. D After the subsidy is in place with a $180 price, the quantity supplied is 150 million
bushels of wheat, and the quantity demanded is 40 million bushels of wheat. The
quantity exported is then Qx = Qs-Qd = 150-40 =110 million bushels of wheat. Each
export received a subsidy of $20, so the total cost of the subsidy is $20 * 110,000,000 =
$2,200,000,000.

57. C The gain to producer surplus from the subsidy and the price increase from $160 to
$180 is below:
 This area is equal to (180-160) * (150,000,000 + 120,000,000)/2 = $2,700,000,000

The rising prices cause a loss to consumer surplus of the area highlighted in green, which
is equal to (180-160) * (60,000,000 + 40,000,000)/2 = $1,000,000,000. The cost of the
subsidy is $2,200,000,000 from the previous problem.

The overall effect on total surplus is then:

Change∈TS=Change∈CS+Change∈PS +Change∈TR ( Subsidy Cost )

Change∈TS=$ 2,700,000,000−$ 1,000,000,000−$ 2,200,000,000=$ 500,000,000
58. D Subsidies that encourage research and development can be allowed, and support for
disadvantaged regions that creates indirect subsidies are allowed. Also, there are
provisions for some environmental subsidies. However, direct subsidies by richer nations
are forbidden. Developing countries (especially those with $1,000 per capita income or
less) have more leeway in providing subsidies.

59. A If the export subsidy is offset by the countervailing duty, then there will be no net
effect on prices and quantities compared to free trade. The only effect will be a transfer
of money from the exporting to importing countries’ governments. The countervailing
duty effectively seizes the subsidy money with no resulting effects on world surpluses or
 welfare.

60. A The export subsidy can be beneficial in less than competitive markets if there are large
up-front costs of production, and the only way that the market could exist is with the
subsidy (else no one would enter the market, and the product wouldn’t exist).

61. The statement is based on the premise that more domestic

production is better than less. Also, the statement fails to account for
the well-being of other agents in the economy who are not producers:
the consumers who are better off if the price of the good is low, and
the government, which collects the tariff revenue. Let us focus first on
the decision of producers. It is true that the higher the tariff the
higher will be the quantity supplied by domestic producers. However,
for the society as a whole this production might be too costly. It
involves valuable resources that can have a better use in other
industries.

A prohibitive tariff will definitely be to the disadvantage of consumers

because the consumers will not be able to consume the imported
goods at all. The loss associated with the reduced consumption is the
consumption effect. For the government, a prohibitive tariff generates
no revenue as imports will fall to zero. Overall, a prohibitive tariff
means that the country is giving up all the gains from trade in this
product.

62. An optimal tariff is a tariff which maximizes the well-being of a

country. It is measured by the gain in tariff revenue that is essentially
paid by the foreign exporters to the government of the importing
country minus the loss associated with the consumption and
production effects arising from the tariff. A country can gain by a
tariff only if the country is large enough to influence the international
price of the imported product by restricting its imports. In other
words, the country must collectively have monopsony power (it is
large), even in cases in which no individual buyer within the nation
has it. By imposing a tariff the country can improve its terms of trade,
and may experience a net gain. One needs to exert caution when
advising government officials on the implementation of a tariff. Such a
decision should incorporate the eventuality that the trading partners
of this country may retaliate by imposing trade restrictions on its
exports.

63. The allocation of import licenses on the basis of fixed favoritism

implies that the government simply assigns the licenses to firms
without competition, applications, or negotiations. In this case the
importers who receive the licenses realize gains from the difference
between the domestic and the international price of the product. This
 method does not create any additional inefficiency beyond the
deadweight loss from the production effect and the consumption of
the quota. Also, it does not generate revenue for the government.

Revenue for the government will be generated if the licenses are

allocated through an auction. The auction is a bidding process in
which firms compete for the licenses by specifying the amount they
want to pay, and the licenses are awarded to the highest bidders.
Importing firms are willing to pay in order to acquire licenses because
they will realize gains from the difference between the domestic and
the international price of the imported product. For this method, there
is also little or no additional inefficiency beyond the deadweight loss
from the production and consumption effects of the quota.

Instead of holding an auction, the government can also require that

firms compete for the licenses in some way other than simple bidding
or bribing. Resource-using application procedures include allocating
the quota licenses on a first-come-first-serve basis, on the basis of
demonstrating need, worthiness, negotiations, etc. Resource-using
procedures encourage rent-seeking activities and are wasteful. For
the country as a whole, resource-using procedures are the most
inefficient method because the resources used in rent-seeking are
drawn away from producing something that is truly valuable for
society, in addition to the inefficiency from the production and
consumption effects of the quota.

64.
Price

Sd
Sd + Qf

Domestic price
a b c d
World price
Dd

Quantity
0 S S' C' C
Figure 1 (a) According to the
figure, the domestic price was equal to the world price and the
quantity imported of this country was represented by the distance SC
in the absence of any trade barriers. However, after the government
 restricts imports, by imposing a quota, to the amount represented by
the distance S’C’, the domestic price of the good increases, as shown
by the domestic price line. Consequently, domestic production
increase to 0S’ and domestic consumption declines to 0C’. The loss in
consumer surplus due to an increase in the price of the product is
given by the sum of the areas a, b, c, and d. The producer surplus on
the other hand increases by the area a. If the government allocates
the licenses based in fixed favoritism, area c is obtained by the license
holders, who can now sell the imported good at a higher price. The
economic cost of a quota arises from the production and the
consumption effects resulting from the change in the domestic price
of the product. The consumption effect, area d, is the deadweight loss
associated with the lower consumption of the good due to the
increased price in the domestic market. The production effect, area b,
is the deadweight loss arising from the replacement of some low-cost
imports with high-cost production in the domestic economy. Thus, a
quota imposed by a small importing country will result in a net
welfare loss for the country given by the sum of the triangles b and d.

65. Nontariff barriers to imports (NTBs) are government policies

other than taxes on imports that reduce imports below their free-trade
levels. In addition to quotas and voluntary export restraints (VERs),
there are many other kinds of NTBs. Here are three.

- A government can write product standards in ways that protect

local producers. Such standards can be noble efforts to enhance
society’s well-being, by addressing market failures that lead to
unsafe conditions and environmental degradation. But such
standards can also be specified so that they can be met more easily
by local products than by imported products. For instance, the
standards can be tailored to fit local products, but to require costly
modifications to foreign products. Or, the standards can be higher
for imported products or enforced more strictly. Or, the testing and
certification procedures can be more costly, slower, or more
uncertain for foreign products.

- A domestic content requirement mandates that a product produced

and sold in a country must have a specified minimum amount of
domestic production value, in the form of wages paid to local
workers or materials and components produced within the country.
Domestic content requirements can create import protection at two
levels. They can be a barrier to imports of the products that do not
meet the content rules. And they can limit the import of materials
and components that otherwise would have been used in domestic
production of the products.
 - Government procurement practices can be another form of
nontariff barrier to imports if the purchasing processes are biased
against foreign products, as they often are. In many countries the
governments buy relatively few imported products and instead buy
mostly locally produced products.
66. In general, the formation of trade blocs does not always lead to
an improvement of economic well-being worldwide, or even in the
member countries. On the one hand, the formation of trade blocs
seems to imply a removal of trade barriers and thus a step toward free
trade. This can be beneficial to the country if it leads to lowering of
domestic prices, higher trade volumes, and higher surplus (trade
creation gain). On the other hand, the formation of trade blocs can
lead to shifting of imports to less efficient foreign producers who gain
an advantage over more efficient producers in countries that are not
members of the trade bloc. This shifting of imports is called trade
diversion and creates a welfare loss for the member country. Whether
or not a country gains from joining a trade bloc depends on the
benefits from trade creation, the losses from trade diversion, and the
possible gains from an array of other effects that may be difficult to
quantify.

These additional possible sources of benefits include the following.

- First, an increase in competition can reduce prices. If before the

formation of the bloc firms in the different countries had monopoly
power in each national market, when national markets are joined
in a bloc-wide market, firms must compete with each other. Prices
are likely to move closer to marginal costs.

- Second, an increase in competition can lower costs of production.

The increased level of competition increases the pressure on firms
to implement new technologies and minimize costs.

- Third, firms can lower costs by expanding their scale of production.

Before the formation of a bloc, each firm may have been limited to
serving only its national market. If scale economies are substantial,
the expansion of firm sales in the bloc-wide market can lower its
cost of production.

- Finally, forming a trade bloc might lead to additional opportunities

for business investments. By expanding the market that can be
served, a trade bloc might be able to attract more foreign direct
investment into the member countries.

67. An economic embargo is a trade policy of a country or a group of

countries which imposes restrictions or bans on economic exchange
with another country (the target country). The economic embargo,
being a trade restriction, is associated with welfare losses both for the
target country and the countries imposing the embargo. An embargo
is more likely to succeed if it causes high damages to the country
which is the target of the embargo and has low costs to the countries
imposing the embargo. The effect of the embargo on the target
country depends on the elasticity of the import demand curve of the
target country and the elasticity of non-embargo supplies. The
damage to the target country will be high when the elasticity of
demand of the target country is low and the elasticity of alternative
supplies is low. Sanctions are more likely to be successful, i.e. they
are more likely to achieve their goal, when they are extreme and
sudden when first imposed. They also appear to be more effective
when the target is a democracy, as the citizens who are hurt by the
embargo can exert pressure on political leaders. Embargoes are less
effective in dictatorships as the ruling dictator can stay in power
despite the embargo.