Project 3 20205 - International Economics and Business Dynamics

Floriana Guardini – Class 6 – 1716323

Question 1

a. Qs = 2P

QD = 300 - P

2P = 300 – P

P* = 100 Q* = 200

To solve for the equilibrium quantity and price, I equate the supply and demand equations and I

find the equilibrium price P* to be 100 and equilibrium quantity Q* to be 200.

b. Qs = 2P

QD = 300 – (P + T)

200; 100

0

50

100

150

200

250

300

350

0 100 200 300 400 500 600 700

P

Q

Supply Demand

2P = 300 – P - T

3P = 300 - T

PST = 100 – T/3 PD

T = (100 – T/3) + T = 100 + 2T/3

QT = 200 – 2T/3

After solving for the new equilibrium after the introduction of a tax T on buyers, I find that,

compared to the situation described in point (a), the price PST that the sellers receive is equal to

100 – T/3, or lower than before by T/3, the price PDT the buyers are paying is equal to PS

T + T, or

100 + 2T/3, or higher than before by 2T/3, quantity QT is now equal to 200 – 2T/3, overall it has

decreased by 2T/3 with respect to point (a).

Buyers are bearing 2/3 of the tax burden, while sellers are bearing 1/3.

The graph above depicts the equilibrium quantity and prices after the introduction of the tax T

as compared to the previous equilibrium price and quantity.

200; 100

0

50

100

150

200

250

300

350

0 100 200 300 400 500 600 700

P

Q

Supply Demand

PDT

PST

QT

P*; Q*

c. Given that QT = 200 – 2T/3, I find that Total Revenue TR is equal to:

TR = T*(200 – 2T/3) = 200T – (2/3)T2

The relationship between taxes and revenues has the following upside-down U shape:

This is an example of the Laffer curve. The increase in tax rates will at some point discourage

workers from working additional hours. At this point, revenue from taxes will actually decrease

if taxes are increased. In our case, this point is reached when tax level is T = 150, and at that

point tax revenues are maximized at TR = 15000. The point was found by solving for the

derivative of the TR equation and setting it equal to 0.

δTR/δT = 200 – 4T/3

200 – 4T/3 = 0 -> T = 150 TR = 15000

d. Using the previous definitions, deadweight loss can be computed as:

DWL = (Q*- QT)*T/2

Q* = 200 QT = 200 – 2T/3

DWL = (T^2)/2

150; 15000

0

3000

6000

9000

12000

15000

18000

0 30 60 90 120 150 180 210 240 270 300

TR

T

Tax Revenues

The following graph represent the relationship for T between 0 and 300. We can see that DWL

increases more than proportionally to the increase in taxes.

e. According to the results found for the previous questions:

f. As seen in point ( c), I cannot be sure that the raise in tax will also generate additional tax

revenues: this depends on whether the current tax level is on the upward or downward part of

the curve. I can be sure that the deadweight loss associated with the tax will raise as the tax

150; 7500

300; 30000

0

7500

15000

22500

30000

37500

0 30 60 90 120 150 180 210 240 270 300

DWL

T

Deadweight Loss

0

5000

10000

15000

20000

25000

30000

35000

0 3000 6000 9000 12000 15000 18000

DWL

TR

DWLT TR DWL

0 0 0 30 5400 300 60 9600 1200 90 12600 2700

120 14400 4800 150 15000 7500 180 14400 10800 210 12600 14700 240 9600 19200 270 5400 24300 300 0 30000

raises. Note that in the case of perfect inelasticity of demand or supply for gasoline there would

be no deadweight loss to begin with, therefore in this case it would not increase, as it remains 0:

a realistic assumption, however, is to assume that there is elasticity, and therefore there is a

deadweight loss when a tax on gasoline is introduced.

Problem 2 Good morning everyone and thank you for being here with us today during the last stage of our campaign.

I appreciate the support you have given to our team and me up to now, we could not have come this far

without you all. I am here today to address an issue that I believe is close to everyone’s heart: the health

of our region and the auto industry and its workforce.

It is undeniable; we are indeed facing tough, maybe the toughest, times in our automotive industry.

Unemployment is rising, the recession has hit the car industry harder than many others, and our families

are bearing the burden of the crisis.

Some say, “It’s inevitable, it’s the competition, let it go, leave them with their problems”, but this is not

what we believe. Manufacturing is the core of our local economy, we take pride in our cars, what counts

in the end is the quality of our production. The government has not acted promptly, and I am here to

change this. It is not only the automotive sector at stake; the whole region’s economy cannot prosper

otherwise.

We need an economic plan to sustain growth, not suffocate businesses, dumping the consequences of

wrong choices onto the people and families here. We need to sustain the production and trade of our

cars, within our country and outside, in order to bring domestic manufacturers back on the competitive

track.

We start from within, by levying fewer taxes simplifying the contribution system, to optimize the

production and capital costs, to boost competitiveness. But we will not cut the services granted to citizens,

we will optimize government spending and guarantee everyone their fair share of welfare. Next, we invest

in the workers, with training and ad-hoc programs, but we also invest in future workers and managers, by

funding school programs to engage our students in the industry, and in the future, they will be able to

contribute with their innovation and capabilities.

I will push forward, at national level, policies to protect trade from unfair competition: I do believe in open

markets, but we must protect local manufacturers, our technology and patents must be kept safe, and

people must be ensured the products they have access to meet a standard of quality. Government must

give local businesses the tools to compete strongly abroad: it must intervene to subsidize companies that

export and simplify the legal processing at customs.

Once we regain competitiveness in the automotive sector, thanks to the reliability and high quality of our

cars, our economy will regain energy, everyone will benefit from it.

I hope I will be able to come back as your Representative in the Parliament. Thank you!

Problem 3 The assertion that exports in one country suffer as a consequence of the appreciation in real terms of the

local currency against foreign currencies, as well as the opposite, is motivated by the nature of real

exchange rates. The real exchange rate tells you how expensive goods are in different countries, and this

is a reflection of the competitive advantage of one country’s exports against the others.

We can think of a very simple example to explain the logic behind real exchange rates: let’s assume one

bottle of water costs 1€ in Italy and 2$ in the United States and the nominal exchange rate is 0,73€/$

(actual rate at 23 December 2013: 1,37€/$). An American going to Italy, with 2$ will be able to get roughly

1,46€, so he can, in this example, buy more coffee than in the US. The real exchange rate can be computed

as:

Real Exchange Rate = (0,73€/$) * (2$/€) = 1,46

The dollar is “worth more” in Europe: with the same dollar, we can buy more coffee in Europe than in the

United States. An American tourist might come back to the US and say that Europe is cheap in comparison.

Note that the real exchange rate is a unit-less concept. In real life, the case of coffee is generalized to all

the goods in an economy.

Consequently, when dealing in international markets, having a currency priced higher compared to those

of other countries makes the goods from that country more expensive than the goods in other countries.

It is important to remember that the real exchange rate reflects the overall price level of a country. In this

situation, foreign goods are cheaper compared to the local goods.

There are however other elements influencing competitiveness in international trade, such as

transportation costs, custom costs, and pricing strategies of the single businesses. These factors can

positively or negatively influence the trade level of an economy; if they affect it positively, they can offset

at least partially the effects of appreciation of the currency in real terms. However, the general rule is

that, everything else equal, the appreciation of the currency will make the goods less appealing on the

international market and therefore negatively affect exporters.

Finally, due to factors such as the stickiness of prices in the economy, the effects of fluctuations in the real

exchange rate cannot be seen in the short run, but they rather appear clearly in the long run. In real life,

for instance, even if the currency depreciates businesses might have obligations to stick to previously

stated prices. Economists refer to this behavior of exports as the “J curve”: from the time of depreciation,

exports balance first worsens, and then starts gradually improving, along a line shaped like a J.