4. Use a model of internal economies of scale, but now allow for firms to have...

4. Use a model of internal economies of scale, but now allow for firms to have different marginal costs (c ).

a) Explain why opening up to trade results in the lowest cost firms expanding and the highest cost firms shutting down. Draw one or more diagrams to help you explain your points. Is this consistent with empirical evidence on how firms react to trade openness? Assume that there are no trade costs for part a.

b) Now assume that some trade cost (t) exists in order for a firm to export, per unit. How will increasing the trade cost t affect which types of firms export and which do not? From your answer, how would you conclude Canadian firms and consumers might be affected by a potential collapse of the North American Free Trade Agreement (NAFTA)? You may want to draw a diagram to help make your points in the first part of the question, although it is not absolutely necessary.

Expert Solution

a). Opening up of firms to trade helps the low cost firms to expand as compared to the firms with high marginal cost because low cost firms can easily expand their level of production to meet the increased demand due to trade openness as they get a benefit of low marginal cost whereas high cost firms find it difficult to increase their level of production due to relatively high marginal cost. Thus trade openness helps the low cost firms to expand more as compared to high cost firms.

b). Introduction of trade cost (t) for export, per unit will affect the low cost firms more as compared to the high cost firms. This is so because low cost firms export more as compared to the high cost firms, so per unit export tax will have more impact on the low cost firms.

Canadian firms and consumers may be highly affected by the collapse of NAFTA because this may lead to rise in prices of consumer goods due to weaker exchange rate for the Canadian dollar and modestly higher tariffs. According to reports, due to collapse of NAFTA, it is estimated that for every 1 percent increase in tarrifs, retailers would see their cost increase by atleast $1 billion in direct impacts alone, indirect impacts would increase this cost figure.

Rahul Sunny answered 2 years ago

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