Question

1. Describe the sources of gains from trade for the consumer in the monopolistic competition model with differentiated products. Hint: there are two mechanisms at work. (3 points each).

2. Describe the gravity equation (for international trade, not physics) in detail and provide the formula (4 points).

Answer 1

1)

Monopolistic competition: In a monopolistic competition there are large number of sellers where they all will sell different products in the market to gain upper hand in the market. Product can be different either by the style of quality.

As there are large number of sellers in the market product differentiation plays a crucial in the market as they have to attract buyers to buy those products. So sometimes sellers will use the technqtec of price discrimination.

In this monopolistic competition model there will be low average cost of producing a good due to economic of sales thus increasing the size of market by exporting and importing.

So international trade will helps to enter new markets and sell their goods in other markets. Due to international trade there will be large number of sellers for limited buyers which will help the consumer to gain high quality products at low costs.

2) Gravity equation

Fij = (Mi Mi / Dij)G

I and J are the two countries in Trade

M is the economic mass which means GDP of two countries

G = Gravitational constant

D = distance between two countries

F = Trade flow between two countries

This model helps to understand the trade flow between two countries basing on their GDP and distance between those two countries.

Free trade agreements between countries are wide basing on this model. Using this model the transportation costs can be reduced, disposable income will be increased with buyers , consumer will have goods from other countries', GDP of both countries will grow.