Economics 1535

International Trade and Investment

Fall 2015
Pol Antràs

Problem Set 5
This problem set is due on Monday, November 16th.

Exercise 1
Download the Excel spreadsheet available at:
[Link]
The sheet include data on U.S. imports from and exports to the U.K. from 2003
through 2007.

1. Using the formula provided in Lecture 15 (slide 30), compute the share of intra-
industry trade between the U.S. and the U.K. for each industry and each year.
Which industries have the highest shares of intra-industry trade? Which have
the lowest ones? Do these numbers make sense?

2. Compute the aggregate share of intraindustry trade between the U.S. and the
U.K. for each year. To do this, aggregate jIM P EXP j and (IM P + EXP )
across industries and compute
X
jIM Pi EXPi j
VI I =1 Xi ,
(IM Pi + EXPi )
i

where i indexes industries. Comment on the magnitude and any trend in this
aggregate index.

Exercise 2
1. For each of the following example, explain whether this is a case of external or
internal economies of scale.

1
 a) Most musical wind instrument in the USA are produced by more than a dozen
factories in Elkhart, U.S.
b) All Hondas sold in the United States are either imported or produced in
Marysville, Ohio.
c) All airframes for Airbus (Europe’s only producer of large aircraft) are assem-
bled in Toulouse, France.
d) Hartford, Connecticut, is the insurance capital of the northeastern United
States.

2. Evaluate the relative importance of economies of scale and comparative advantage

in causing the following:
a) Most of the world’s aluminum is smelted in Norway or Canada.
b) Half of the world’s large jet aircraft are assembled in Seattle.
c) Most semiconductors are manufactured in either the United States of Japan.
d) Most Scotch whiskey come from Scotland.
e) Much of the world’s best wine comes from France.

Exercise 3
Consider the same monopolistic competition model as developed in class (Lecture 15)
and in the textbook, but now let the demand function faced by a producer of di¤eren-
tiated varieties be given by:
2
S P
Q= ; (1)
n P
where P is the average price in the industry. Each …rm has a …xed cost of production
equal to F and a constant marginal cost c.

1. What is the market share of each …rm in a symmetric equilibrium in which all
…rms charge the same price?

2. Use (1), without imposing symmetry, to express P as a function of Q, S, n, and

P.

3. Use this expression to compute the partial derivative of P with respect to Q, i.e.,
P 0 (Q). Use the expression you derived in 1: to express P 0 (Q) Q as a function
of P (Q) only.

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 4. Use your result in 3. to express M R = P (Q) + P 0 (Q) Q as a function of P (Q)
only.

5. Use the optimality condition M R = M C, to express the optimal price as a

function c only. By how much do prices go up when the marginal cost doubles?
Compare your result to those obtained in class (see equation (P P ) on slide 17).
What explains the di¤erence?

6. Assume that you are in a symmetric equilibrium in which P = P . Use (1) to

express average costs in a symmetric equilibrium as a function of F , c, S, and n.

7. Use your answers in parts 5: and 6: to derive the equilibrium values of n and P
in a long-run symmetric equilibrium in which free entry drives each …rm’s price
down to the value of average cost.

8. Solve for the implied sales Q by each …rm as a function of F and c.

9. Discuss the e¤ects of an trade integration (and increase in S) on the equilibrium

values of n, P , and Q. How are these e¤ects di¤erent from the ones derived in
class? What explains the di¤erence?

10. Discuss the welfare e¤ects of trade integration assuming that consumers value
being able to consume a larger number of varieties.

Exercise 4
Consider an industry (say the cocoa industry) where a monopolist is the unique pro-
ducer in the Home country. Home demand for cocoa is given by the following linear
inverse demand function
P = a bQ,
where P is the price of cocoa and Q is the quantity demanded. The monopolist faces
a marginal cost of production equal to c. Assume that a > c.

1. Set up the problem of choosing the pro…t-maximizing level of production Q for

the monopolist. Solve for the optimal Q.

2. Solve for the implied optimal monopoly price and represent it graphically in a
manner analogous to slide 8 of Lecture 15 (ignoring the AC curve).

3. Compute the di¤erence P c. Is this positive or negative? Why?

4. Compare the monopolist output level Q to that prevailing under perfect compe-
tition (where P = c).

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 5. What is deadweight loss associated with the monopoly distortion? Hint: see
Varian, p. 432.
Now suppose that there is a second country, Foreign, which is identical to Home
and in which cocoa is also produced by a monopolist facing the same inverse
demand function P = a bQ and the same marginal cost c. Assume that the
cocoa produced by the two …rms is identical from the point of view of consumers.
Initially, there are prohibitive trade barriers between the two countries, so the
equilibrium in each market is as described above, and hence the equilibrium price
is identical in both markets.

6. Now suppose that a process of trade integration removes all trade barriers. Will
the Foreign cocoa producer have an incentive to also sell cocoa in the Home
market?
Denote by Q the quantity sold by the Foreign cocoa producer in the Home
market and by Q the quantity sold by the Home cocoa producer in the Home
market. Let us focus for now on the equilibrium in the Home market.

7. Set up the problem of choosing the pro…t-maximizing level of production Q for

the Home …rm. Make the “Nash” assumption that the Home Firm takes Q
as an exogenous parameter when maximizing pro…ts. Express the optimal Q as
a function of parameters and Q . Hint: the inverse demand function is now
P = a b (Q + Q ).

8. Set up the problem of choosing the pro…t-maximizing level of production Q for

the Foreign …rm. Following the same steps as in 7:, express the optimal Q as a
function of parameters and Q.

9. Using your answers in 7: and 8:, solve for Q, Q , and P .

10. Interpret the e¤ects of trade integration from the point of view of consumer
welfare at Home.

11. What happens in the Foreign market? Solve for the equilibrium price and quan-
tities sold in that market.

12. Interpret the e¤ects of trade integration from the point of view of world aggregate
welfare. What happens the aggregate welfare in each country?