Question

Suppose in a small open economy, the demand, and supply functions are given below

D = 400-4P

S=-40+4P

If the world price is $40 and the country moves from no trade to trade, who losses and by how much?

consumers loss by $750

producers loss by $750

producers loss by $800

consumers loss by $800

Suppose in a small open economy, the demand, and supply functions are given below

D = 400-4P

S=-40+4P

If the world price is $40 and the country moves from no trade to trade, how does the country participate in international trade?

Group of answer choices

By importing the product because world price is smaller than home price

By exporting the product because world price is larger than home price

No trade participation because the world price is same as the home price

By importing the product because world price is larger than home price

Answer 1

Refer to the above diagram for better understanding.

When there is no trade, equilibrium price would be where quantity supplied exactly matches the quantity demanded.

D = 400-4P

S= -40+4P

Demand=supply

400-4P= -40+4P

440 = 8P

P = 55

Hence, the equilibrium price when there is no trade = $55

At price = $55, quantity demanded = quantity supplied = 400 - 4 * 55 (put value of P in either demand or supply equation)

Hence, equilibrium quantity when there is no trade = 180

If trade happens at world price = $40

When price = $40, quantity supplied = -40+4 * 40 = 120 (put value of price in supply equation)

When price = $40, quantity demanded = 400- 4* 40 = 240 (put value of price in demand equation)

Consumer surplus

It is measured as area below the demand curve and above the price line

Before trade, price line = $55, Counsumer surplus = A (see diagram)

After trade, price line = $40, Counsumer surplus = A+B+C (see diagram)

Hence, it is clear that consumer have gained something.

Producer surplus

It is measured as area below the price line and above the supply curve.

Before trade, price line = $55, producer surplus = B+C+F (see diagram)

After trade, price line = $40, producer surplus = C (see diagram)

Hence, it is clear that producers have lost B+C.

Calculation of loss of producer surplus

Area B = 120 * (55-40) = 120* 15 = 1800

Area C = 1/2 * (180-120) * (55-40) = 1/2 * 60 * 15 = 450

loss of producer surplus = 2250

Since the world price ($40) is less than the home price ($55), country imports (because it can not export a good higher than what the prices prevail in the world market).

Hence, the correct option is a) By importing the product because world price is smaller than home price