Question

Suppose the aggregate demand for honey in a small country is given by Q^D = 100 − P and the aggregate supply is Q^S = P. The international price of honey is P^I = 60, and the world market is willing to buy or sell any amount at that price. Let all quantities be given in gallons and all prices in dollars per gallon. Suppose the country initially starts out with closed borders, and cannot import or export at all

Suppose now the country enters into an international free trade deal. The deal eliminates all subsidies and price supports, and the country opens up to import and export from the world market.

(j) What is the equilibrium domestic price, production, and consumption in the honey market with free trade? Depict it graphically. Will the country be an importer or exporter of honey?

(k) Which groups are better off with free trade relative to autarky (with no subsidies/price restrictions)? Which are worse off?

(l) Does total surplus increase or decrease relative to the competitive equilibrium with no trade. Can you find a set of transfers that would make everybody at least as well off as in the no-trade equilibrium?

Answer 1

Closed economy equilibrium price is $50 and quantity is 50 gallons

Open economy equilibrium price = world price for honey = $60 and quantity demanded at home at this price = 40 gallons while quantity supplied is 60 gallons. This makes the country an exporter of honey and it exports 20 gallons at the international price of $60 per gallon

j) Price = $60. Consumption = 40 gallons, Production = 60 gallons, Country becomes an exporter of honey and it exports 20 gallons at the international price of $60 per gallon. Graph is shown below

K) Producers are better off as their surplus is increased. Consumers are worse off as their surplus is reduced with free trade compared to autarky

I) With no trade, total surplus = 0.5*(100 - 0)*50 = 2500 (area between demand and supply curves). Total surplus after trade = CS + PS where CS = 0.5*(100 - 60)*40 = 800 and PS = 0.5*(60 - 0)*60 = 1800. Hence total surplus increases after trade and becomes 2600, a value higher than the no trade surplus by $100

Note that consumers surffered a loss of 1250 - 800 = 450 while producers gain a surplus of 1800 - 1250 = 550. Hence, any transfer of money between 450 and 550 from producers to consumers will make everyone better off.