Consider Krugman’s duopoly framework. To start with, label the horizontal as “X”: this axis will represent the home firm’s sales of good X. Also label the vertical axis as “X*”: this axis will represent the foreign firm’s sales of good X.
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Draw in the home firm’s reaction function, and label it “H.” Why is it downward-sloping?
Draw in the foreign firm’s reaction function, and label it “F.” Make sure that this reaction function is flatter than the home firm’s.
What is the equilibrium level of sales for the home firm and for the foreign firm? Label these quantities x1 and x*1.
Suppose now that the home firm reduces its import tariff on this product. What will happen to the home and foreign firms’ reaction functions? Label the new home firm reaction function H5 and the new foreign firm reaction function F5. Why will the reaction functions move in this way?
Label the new equilibrium level of sales for the home firm and for the foreign firm as x2 and x*2.
How has the home country’s new free-trade stance affected the home country firm?
Suppose Xzbrikistan imports lemons from Grthipistan and exports oranges to that country. Draw a diagram with both countries’ offer curves, placing lemons on the horizontal axis and oranges on the vertical axis. Label Xzbrikistan’s offer curve “OCx1” and Grthipistan’s offer curve “OCg1.”
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Draw in the line, the slope of which represents the terms of trade. Which country’s terms of trade does the slope of this line represent?
Mark the volume of trade in lemons as “L1,” and the volume of trade in oranges as “O1.”
Suppose Xzbrikistan wishes to impose a tariff in order to improve its terms of trade. Mark Xzbrikistan’s new offer curve as “OCx2.” Will this strategy work?
Suppose now that Grthipistan imposes a tariff as retaliation for Xzbrikistan’s tariff. Mark Grthipistan’s new offer curve as “OCg2.”
What is the overall effect on Xzbrikistan’s terms of trade and on the volume of trade? Is Xzbrikistan strategy likely to succeed in the end?
This exercise involves the notion that a tariff may improve a country’s welfare if the foreign supplier is a monopolist in the imposing country’s market. Draw a graph similar to Figure 2 in Chapter 15 of the Appleyard, Field, and Cobb text. In particular,
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Label the vertical axis “price” and the horizontal axis “quantity.”
Graph the demand curve P = 12 - Q and label it “D.” Mark this line’s vertical and horizontal intercepts.
Graph the marginal revenue curve P = 12 - 2Q and label it “MR.” Mark this line’s vertical and horizontal intercepts.
Draw a line horizontal at P = 2 and label it “MC1=AC1.” What quantity will this monopolist produce? What price will it charge? Mark these on your graph.
What is the consumer surplus in this situation?
Suppose now the importing country imposes a $2 specific tariff, causing the MC=AC line to shift upward to $4. Label this new line “MC2=AC2.” What quantity will this monopolist now produce? What price will it now charge? Mark these on your graph.
How does consumer surplus change? How much revenue does the imposing country collect from this tariff? Will the tariff improve the imposing country’s welfare?
