Thursday, 10/18/01
Problem 4 - We showed that a country could benefit from trade if the world price is below the equilibrium price. The purpose of this question is to show that a country would gain from trade if the world price is above the equilibrium price. You should present and discuss one diagram as part of your answer to the question.
I am not sure why Dr. Schwab mentions perfect competition in part a because we have not covered monopoly in lecture yet. Just take this as our ordinary looking market without any kind of restrictions at first. When trade is not possible, that just means you are looking at domestic consumers and domestic firms - our ordinary looking supply and demand curves since we didn't tell you anything about elasticity.
For part b, remember what information is in the supply and demand curves. If you give me a price, I can tell you exactly what quantity of steel is demanded by consumers by looking at the demand curve and I can tell you exactly what quantity of steel is supplied by domestic firms by looking at the supply curve. Do you use the domestic equilibrium price or do you use the world price? When trade opens up a country, you always use the world price.
For parts c and d, you should be able to use our concepts of surplus from before. First you want to do the no trade situation. You know what the equilibrium price is when there are onyl domestic firms and consumers active in the market. You know what quantity of steel Q1 that consumers will demand at this no trade equilibrium price P1. How much happiness did they get from those Q1 units of steel? How much total expenditure did they spend on those Q1 units of steel? Using those two pieces of information, you can tell me exactly what consumer surplus is.
Now consider the open trade situation. You know what quantity consumers actually buy at the world price. How much happiness do they get from that quantity of steel? How much did they pay for that quantity of steel? Using those two pieces of information off the diagram, you can tell me exactly what consumer surplus is under open trade. You can repeat both of these for suppliers (What is their total revenue? What is their cost of production? How much of the revenue was bonus above and beyond their costs?).
For part e, what you want to do is exactly what we did for problem 3 in this problem set. Label each "section" of the diagram and show a "no trade" before, an "open trade" after, and the change between the two states of the world.
Problem 5 - In lecture, we focused on harmful externalities that arise in the production of goods. Some externalities, however, are beneficial. Consider, for example, the birds and the bees. Suppose you raise bees that produce honey and I grow apples. Your bees will pollinate my apple trees, and consequently the social cost of honey is less than the private cost of honey.
In part a, you want to be drawing a diagram like the one from discussion. What's the externality here? It's a cost reducing externality. What does that mean? It means the Social Cost curve and the Private Cost curve will not be the same. The 64 dollar question is this: is the private cost curve above the social cost curve or is it the other way around?
Externalities cause deadweight loss because somebody - either firms or consumers - are not taking into account the effect their actions have on everyone else in the society. When you are looking for a deadweight loss due to externality, you are looking for one of two things:
This is why it is crucial that you get part a correct. If you don't know whether too many or too few units are being traded in this market, then you don't know what kind of deadweight loss you are looking for. Are there good trades not being made or are there bad trades that we would like to prevent? When Dr. Schwab did the example in class, we had a case where the socially optimal quantity was less than the quantity actually being traded - so there were some bad trades we would have liked to prevent.
How did we prevent those bad trades? The externality causes a problem because the private agent does not take into account his full impact on society. If we implement a policy that brings that private agent's payoffs in line with society's payoffs, then we have "fixed" the externality problem. In the example from lecture, we slapped a tax on production, raising firms' costs from B to A. At that point, the firms' private costs are exactly identical to the true social cost of their actions - the externality problem was "fixed."
What is a subsidy? It is like a negative tax. How could a subsidy be used in this particular case of the honey bees to bring private costs in line with true social costs?
Problem 6 - a. Metro charges higher fares at rush hour. Why might these higher fares be required for efficiency? b. We do not have congestion tolls on roads in Washington. Is it possible that efficiency might require lower rush hour fares on Metro?
The 64 dollar question in part a: Is there an externality here? During rush hour, Metro gets really crowded (try it sometime... ride Red Line near Judiciary Square and Gallery Place-Chinatown at about 8 in the morning... it sucks). When Metro is crowded and more people get on the train, does that affect the quality of the ride for the people who were already on the train?
In part b, you want to think about what happens if we prevent people from riding Metro. Part a implies that we don't want too many people on Metro (Law of Demand: higher fare is a higher price, meaning lower demand for Metro rides during rush hour). What will these people do? Obviously, they still need to get to work or school. Where will they go? One thing they might do is drive their car to work.
Roads without congestion tolls can get pretty crowded during rush hour too. When we throw more cars onto the streets when it's already crowded, does that affect the quality of the drive for the people already driving to work? The 64 dollar question we want to ask is if the externality losses from Metro congestion is more or less than the externality losses from Road congestion.