Question

Suppose a small country producing cars (C) and food (F) is closed to free trade. Its production possibilities frontier (PPF) reflects increasing costs (it’s bowed out). Finally, preferences in this country are such that consumers like both goods equally: U(DC , DF ) = D 1 2 CD 1 2 F . (a) Using graphs, show the autarky equilibrium in this country. Show both (i) a graph of the PPF and indifference curve, and (ii) a graph of relative demand and relative supply. Put F on the y-axis of your graphs. (b) Now assume this economy opens to free trade, and faces a price p T > pA, where p T is the free trade price and p A is the autarky price. Show the new (long-run) equilibrium in (i) a graph of the PPF and indifference curves, and (ii) a graph of world relative demand and relative supply. Which good does the country export, and which good does it import? (c) Suppose individuals in this economy can be either car producers or food producers. Which group do you think will benefit the most from opening to free trade? (d) Suppose now that this country also puts in place a number of economic reforms, such that rapid economic growth starts taking place. As a result, this country now becomes large, capable of affecting international trade prices. Again using graphs, show the new free trade equilibrium. Assume this country’s growth is unbiased. What happens to the terms of trade? (e) Suppose producers of C are unhappy with the terms of trade consequences of economic growth and ask for an export subsidy. Starting from the equilibrium in (d), show the effects of this kind of subsidy on a PPF graph and a world relative supply and demand graph. What happens to the terms of trade? (f) What will be the welfare consequences of this export subsidy on this country as a whole?

Answer 1

A closed economy does no trading activity with outside economies. The closed economy is self-sufficient i.e. no imports and exports.The purpose of a closed economy is to provide domestic consumers with everything they need from within the country's borders.

• The combination where x and y is maximum is the PPF.
• P_{a is} autarky equilibrium

U₀ is the indifference curve

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