(1) Write a maximum one-sentence answer for each of the following:

1(a) What do you mean by two goods being gross substitutes?

Two goods are considered gross substitutes if a decrease in price of one good causes
quantity demanded of the other good to fall .
1(b) For a Cobb-Douglas utility function of two consumable goods, these two goods will be net substitutes and gross
complements. True or False?

The statement is False because, according to the sources, goods described by a Cobb-Douglas utility function are net
substitutes and gross substitutes, not gross complements.

1(c) For a demand system based on the Cobb-Douglas utility function, will the budget shares of commodities
consumed be fixed or flexible with respect to income changes?

For a demand system based on the Cobb-Douglas utility function, the budget shares of commodities consumed will be fixed
with respect to income changes.

1(d) The GTAP CGE model employs within it the CDE (constant difference of elasticities) demand system. What
adjustment you will make in the model if you have to work with a demand system based on the CES utility function
instead of the CDE demand system.

To work with a demand system based on a CES utility function in the GTAP model instead of the CDE demand system, you
would adjust the CDE parameters by setting all income parameters (INCPAR) to 1 and setting all substitution parameters
(SUBPAR) to an identical value across all commodities and regions.

1(e) Define the elasticity of the export transformation parameter, σ^E.

The export transformation elasticity (σ^E) describes the technological ability of an industry to transform a given level of
output between the varieties sold in the domestic and export markets.

1(f) According to the Stolper-Samuelson theorem, the price of a factor used intensively in the production of goods
whose world (relative) price has risen, will increase or decrease.

According to the Stolper-Samuelson theorem, the price of the factor used intensively in the production of goods whose
relative world price has risen will increase.

1(g) According to Rybczynski theorem, what will happen to a country's terms of trade if the quantity of factor
endowment used extensively in its import goods increases.

According to the Rybczynski theorem, if the quantity of the factor endowment used intensively in a country's importable
goods increases, its terms of trade will improve.

1(h) How will you simulate the Dutch Disease effects of a booming manufacturing sector and shrinking agricultural
and services sectors in the GTAP CGE model US3x3 ?

To simulate the Dutch Disease effects of a booming manufacturing sector and shrinking agricultural and services sectors in
the GTAP CGE model US3x3, you would simulate an increase in the world price of manufacturing, which the model
predicts will cause its output to increase while agricultural and services output decreases.

1(i) How will a shock that increases the (international) trade margin affect production and import quantities in a
country?
A shock that increases the international trade margin, by raising the price of imports relative to the exporter's price, will cause
the quantity of imports to fall and domestic production to increase.

1(j) How will you implement a shock that increases the (international) trade margin in the GTAP model?

To implement a shock that increases the international trade margin in the GTAP model, you would simulate a decrease in the
productivity of trade margin services, typically represented by a variable such as atd or amsi,r,s.

1(k) Of the direct burden and the excess burden of a government subsidy, which one represents a loss due to
inefficiency?

The excess burden of a government subsidy represents the loss in economic efficiency.

1(l) Under what condition will the terms of trade gain arising from an export tax get nullified ?

The terms of trade gain arising from an export tax gets nullified if the exporting country is a "small" country facing a

horizontal world demand curve, as its export price will not rise.

2(a) (i) Explain briefly the key difference in the budget shares resulting from an income change and a price change in
CGE models with CES versus those with CDE utility functions.

For a CES utility function, budget shares are fixed with respect to income changes but are flexible with respect to relative
price changes. In contrast, for a CDE demand system, budget shares are flexible with respect to both income changes and
relative price changes.

2(a) (ii) Write and explain briefly the equation which describes the demand for home country's exports in
SingleCountry CGE models. Using the equation, explain briefly what is meant by a (i) small and a (ii) large country in
Single-Country CGE models.

In single-country CGE models, the demand for the home country’s exports is usually described by the equation: QE/QW =
(PXW/PWE), where QE is the country’s export quantity, QW is global trade in that good (so QE/QW is the country's market
share in world trade), PXW is the average world price, PWE is the fob world export price of the home country’s export
variety, and is the export demand elasticity parameter.

(i) A small country is assumed to face a horizontal world demand curve for its exports, meaning any change in its
export quantity is too small to affect the global price level (PXW remains fixed). In the equation, this is represented by
the export demand elasticity (denoted by ) approaching infinity, so even a small deviation in its export price relative to the
world price results in large changes in export quantity and market share.

(ii) A large country is assumed to have a low export demand elasticity (), meaning its world export price can affect the
world price level, and a change in its world price relative to the average world price causes only a small change in its market
share.

2(b)
Consider a utility function, U=QA0.5QO0.5; where QA is the amount of apples consumed and QO is the amount of oranges
consumed. Price of apples (PA) and oranges (PO) is Rs 4 and Rs 2 respectively. Total expenditure, Y, is Rs 100. An economic
shock causes the apple price (PA) to fall to Rs 2 but does not affect the orange price (PO) and total expenditure (Y). Calculate
(i) the real consumption (RC) measure of welfare, (ii) the equivalent variation (EV) measure of welfare.
Here's the calculation of the Real Consumption (RC) and Equivalent Variation (EV) measures of welfare based on the
provided scenario:

The utility function is given as U = Q A^0.5 Q O^0.5, which is a Cobb-Douglas utility function. This function implies
specific demand functions where the budget share for each good is fixed. For apples, the budget share (α) is 0.5, and for
oranges, it is (1-α) = 0.5. The demand functions are QA = 0.5(Y/PA) and QO = 0.5(Y/PO).

Initial Conditions:

• Initial Apple Price (PA1) = Rs 4

• Initial Orange Price (PO1) = Rs 2
• Initial Total Expenditure (Y1) = Rs 100

Initial Equilibrium:

• Initial Quantity of Apples (QA1) = 0.5 * (100 / 4) = 12.5

• Initial Quantity of Oranges (QO1) = 0.5 * (100 / 2) = 25.0
• Initial Utility (U1) = 12.5^0.5 * 25.0^0.5 = (12.5 * 25)^0.5 = (312.5)^0.5 ≈ 17.7 Shock:

• New Apple Price (PA2) = Rs 2

• Orange Price (PO2) = Rs 2 (unchanged)
• Total Expenditure (Y2) = Rs 100 (unchanged)

New Equilibrium:

• New Quantity of Apples (QA2) = 0.5 * (100 / 2) = 25.0

• New Quantity of Oranges (QO2) = 0.5 * (100 / 2) = 25.0
• New Utility (U2) = 25.0^0.5 * 25.0^0.5 = (25.0 * 25.0)^0.5 = (625)^0.5 = 25.0

(i) Real Consumption (RC) Measure of Welfare The RC welfare measure is calculated as the difference between the
cost of the new basket (Q2) and the initial basket (Q1), valuing both baskets at the initial prices (P1).

• Cost of Q2 at P1 prices = (PA1 * QA2) + (PO1 * QO2) = (4 * 25.0) + (2 * 25.0) = 100 + 50 = Rs 150
• Cost of Q1 at P1 prices = (PA1 * QA1) + (PO1 * QO1) = (4 * 12.5) + (2 * 25.0) = 50 + 50 = Rs 100
• RC welfare = (Cost of Q2 at P1) - (Cost of Q1 at P1) = 150 - 100 = Rs 50

The real consumption measure of welfare is Rs 50.

(ii) Equivalent Variation (EV) Measure of Welfare The EV welfare measure is the change in income required to
achieve the new utility level (U2) at the base year prices (P1).

We need to find the expenditure (Y_EV) such that, at prices PA1 = 4 and PO1 = 2, the consumer achieves U2 = 25.0.

• EV welfare = Y_EV - Y1 = 141.6 - 100 = Rs 41.6

The equivalent variation measure of welfare is Rs 41.6.

3(a)
In CGE models for climate change, a KE nest is usually added to the value-added (L-KE)
production function. This technique allows modelers to describe K and E as overall complements
while still allowing for a realistic substitution between them. How ? Explain briefly. [Note: K:
Capital, E: Energy, L: Labor.]

In CGE models for climate change, adding a Capital-Energy (KE) nest within the Value-Added (VA) production function
allows for a more nuanced description of how capital (K) and energy (E) interact. Producers first combine K and E into a KE
bundle based on the substitution elasticity within the KE nest (σKE) [76, 77, Figure 5.7]. This KE bundle is then combined
with labor (L) in the VA nest, governed by the VA substitution elasticity (σVA) [76, 77, Figure 5.7]. While K and E are
substitutes within their specific KE nest (meaning producers can substitute between them when their relative prices change),
a shock like an increase in the price of energy raises the price of the composite KE bundle. If the substitution effect in the
higher-level VA nest dominates (i.e., producers substitute away from the now more expensive KE bundle towards labor), the
demand for the KE bundle falls, which in turn reduces demand for both K and E (as components of the bundle), making them
overall complements. This nesting allows for the model to capture that, despite some ability to substitute between K and E in
specific applications, they may function as complements in the overall production process.

3(b)
The net effect of a factor's productivity change on its demand in the economy is the sum of the
three effects: (i) substitution effect, (ii) output effect, (iii) productivity effect. Explain briefly
with reference to an increase in labor productivity.
Illustrate these three effects using numbers generated through an experiment based on the GTAP
CGE model US3x3.
(Note: You can use a fictitious but realistic set of numbers for the illustration.)

The net effect of a factor's productivity change on demand for that factor in the economy is the sum of three components: the
substitution effect, the output effect, and the productivity effect.

Using the example of an increase in labor productivity:

1. Substitution effect: An increase in labor productivity means the same quantity of labor can produce more,
effectively lowering the cost of labor per unit of output. This fall in the effective wage motivates producers to use
more of the relatively cheaper factor (labor) and less of other factors (like capital) to produce any given level of
output, assuming technology allows for substitution. This is represented by movement along an isoquant towards the
factor whose effective price has fallen.
2. Output effect: Lower production costs due to increased productivity are typically passed on to consumers through
lower product prices in competitive markets. This lower price stimulates consumer demand, leading to higher output
levels for industries using the more productive labor. This increase in output, in turn, requires a proportionate increase
in demand for all inputs, including labor and capital, holding relative factor prices constant.
3. Productivity effect: For the factor whose productivity has increased (labor in this case), the increased efficiency
means that fewer units of that factor are needed to produce the same level of output. This effect, holding output
constant, directly reduces the demand for actual workers.

The overall change in demand for the factor is the combined result of these three effects.

To illustrate these effects using a fictitious but realistic set of numbers generated through an experiment based on the GTAP
CGE model US3x3, we can draw on the structure of results shown in the sources:

Consider a hypothetical 10% increase in labor productivity in the U.S. Services industry in the GTAP US3x3 model. The
resulting changes in demand for Labor and Capital in the Services industry might look like this (numbers are illustrative and
based on the structure of Table 6.4):

Input Substitution Effect (% Output Effect (% Productivity Effect (% Total Input Demand (%
Change) Change) Change) Change)

Labor 2.9 7.6 -10.0 0.5

Capital -7.6 7.6 0.0 0.0

• Labor Demand: The hypothetical results show that the substitution effect causes producers to use 2.9% more labor
(as it's effectively cheaper) for a given output, and the output effect causes demand for labor to rise by 7.6% due to
increased services production. However, the 10% labor productivity increase means 10% less labor is needed per unit
 of output (the productivity effect). Summing these (2.9 + 7.6 - 10.0) results in a net increase in demand for actual
labor by 0.5%.
• Capital Demand: As labor becomes effectively cheaper, producers substitute away from capital, leading to a
hypothetical -7.6% change in capital demand due to the substitution effect for a given output. The output effect (due
to increased services production) increases demand for capital by 7.6% (the same as for labor, as it's an expansion of
output). Since capital productivity did not change, the productivity effect for capital is 0%. Summing these (-7.6 + 7.6

+ 0.0) results in a net change in demand for capital by 0.0%.

These fictitious results illustrate how the three effects combine to determine the final change in demand for both the factor
whose productivity changed (labor) and other factors (capital).

4(a)
Write the three definitions of exchange rate employed in open economy CGE models. Explain
briefly how depreciation in each one of them in the home country leads to a rise in its exports and
a decline in its imports.

In open economy CGE models, the concept of the exchange rate and its effect on trade flows can be represented in a few
ways, based on the model's structure and assumptions. The sources highlight three related concepts:

1. Nominal Exchange Rate: This variable describes the rate at which currencies are exchanged for one another,
typically expressed as units of domestic currency per unit of foreign currency. In models where country SAMs are in
different currencies, the initial value is the market rate, but in single-country models or multi-country models with
SAMs in the same currency (e.g., USD), the initial value is often set to one.

o Depreciation: A rise in a country's nominal exchange rate signals home currency depreciation because more
domestic currency is needed for the same foreign currency amount.
o Effect on Trade: Depreciation affects the domestic prices of traded goods.
▪ On the import side, assuming fixed world prices for imports (PWX) in foreign currency, a
depreciation (rise in EXR) increases the domestic consumer import price (PM = EXR * PWX). Since
the price of domestically produced varieties (PD) does not change, the ratio of domestic to import
prices (PD/PM) falls. Depending on the Armington import substitution elasticity, this causes
consumers to shift away from imports towards the domestically produced variety, leading to a
decline in import quantities.
▪ On the export side, assuming a fixed world price for exports (PXW) in foreign currency, a
depreciation (rise in EXR) increases the fob export price received by domestic producers in domestic
currency (PWE = EXR * PXW). Since the producer price of domestically sold goods (PDS) does not
change, the ratio of domestic sales price to export price (PDS/PWE) falls. Depending on the export
transformation elasticity, producers are incentivized to shift production towards the relatively more
profitable export market, leading to an increase in export quantities.
o In models where a flexible exchange rate adjusts to maintain a fixed current account balance, an event that
worsens the current account (like increased imports) will cause the exchange rate variable to depreciate,
leading to increased exports and dampening the initial increase in imports until the balance is restored.
2. Real Exchange Rate: While the nominal exchange rate is a financial variable, standard "real" CGE models without
financial assets use it as a variable that determines the real exchange rate. The real exchange rate is defined as the
relative price of traded goods to non-traded goods.

o Depreciation: A nominal exchange rate depreciation changes the relative prices of traded to non-traded
goods. A 10% depreciation, for instance, increases the import price of all imported goods and the export price
of all exported goods by 10% relative to domestically produced (non-traded) goods.
o Effect on Trade: This change in relative prices encourages domestic consumers to substitute away from
relatively more expensive imports toward relatively cheaper domestically produced goods, leading to a
decline in imports. Simultaneously, the country's exports become cheaper for foreign consumers relative to
 their own domestic goods, causing foreign consumers to shift their consumption bundles toward the
depreciating country's exports, leading to an increase in exports for the home country.

3. GTAP pfactor: Some CGE models, such as the GTAP model, do not have an explicit nominal exchange rate variable
but include a mechanism equivalent to the real exchange rate. In GTAP, the pfactor variable describes the percent
change in an index of a country's factor prices relative to the world average factor price (which serves as the
numeraire). Changes in factor prices are assumed to cause changes in goods prices in competitive markets.

o Depreciation (equivalent): A decrease in a country's pfactor variable is similar to a real exchange rate
depreciation.
o Effect on Trade: A decrease in factor prices (represented by a fall in the pfactor) causes the price of
domestically produced goods to increase relative to imports in the home market. This encourages domestic
consumers to shift away from imports, leading to a decline in imports. It also causes the price of the
country's exports to decrease relative to the price of domestically produced goods in its trade partner's
market. Like a real exchange rate depreciation, this causes foreign consumers to shift their consumption
bundle towards the exports from the country experiencing the decline in pfactor, leading to an increase in
exports.

4(b)
Define terms of trade. How do changes in terms of trade occur ? What is the insight developed by
Brown (1987) on changes in terms of trade in multi-country CGE models, Explain briefly with an
example.

Drawing on the provided sources, here is an explanation of the terms of trade in open economy CGE models, how they
change, and the insight developed by Brown (1987).

Terms of trade measure the import purchasing power of a country's exports. They are calculated as the ratio of the price of
a country's export good to the price of its import good. This ratio is typically based on FOB (Free On Board) prices,
excluding trade margins and import tariffs. A change in the terms of trade affects an economy's well-being, or welfare, by
changing its consumption possibilities.

For countries that export and import many types of goods with various trade partners, the terms of trade can be calculated as a
trade-weighted price index. This index is the ratio of a weighted sum of the home country's bilateral (FOB) export prices to
a weighted sum of the FOB prices of its imports, using quantity shares of trade partners as weights.

Changes in a country's terms of trade can occur due to various economic shocks and policy changes in open economy CGE
models:

• Changes in factor endowments: An increase in the supply of a factor used intensively in the exportable good can
lead to an increase in export supply, causing the world price of the exportable to fall, and consequently, the country's
terms of trade to decline. Conversely, an increase in a factor used intensively in the importable good can reduce
export supply and increase importable production, potentially leading to an improvement in terms of trade. This
mechanism is related to the Rybczynski theorem.
• Changes in world prices: Exogenous changes in world import or export prices can directly affect a country's terms
of trade, particularly for small countries that take world prices as given. Large changes in the world price of a
country's main export, such as in natural resource booms or busts, can trigger the phenomenon known as Dutch Disease,
which involves significant changes in the country's terms of trade and industry structure.
• Trade taxes: Imposing import tariffs or export taxes can affect a country's terms of trade, especially for large
countries that can influence world prices. An import tariff by a large country can reduce its import demand,
potentially causing its import price to fall and leading to a terms-of-trade gain. An export tax by a large country can
reduce its export supply, potentially causing its export price to rise, also leading to a terms-of-trade gain.
 • Regulations: Regulations, particularly non-tariff measures (NTMs), can also influence terms of trade. Removing
NTMs modeled as trade efficiency gains can potentially benefit exporters through a terms-of-trade gain.
• Preferential Trade Agreements (PTAs): PTAs can cause changes in a member's demand for imports from partners
and nonmembers, leading to changes in import and export prices and resulting in terms-of-trade gains or losses for
members and nonmembers.

In multi-country CGE models, particularly those using the Armington assumption that products are differentiated by country
of origin, an important insight regarding terms-of-trade changes was developed by Brown (1987). Brown studied terms-of-
trade effects and found that they are usually due to larger changes in countries' export prices than in their import prices.

This occurs because the Armington assumption implies that each country is the monopoly supplier of its specific,
differentiated product in the world market. Therefore, even a country that is otherwise considered "small" in the global market
can be "large" in its own export market. A change in the quantity of its exports can significantly impact the world price of
that specific export variety. Conversely, when importing, that country is just one customer among many buyers of another
country's differentiated product. Thus, a change in its import demand will have a less pronounced effect on the price charged
by its foreign suppliers.

Illustrative Example (based on U.S. tariff experiment in sources):

Consider a hypothetical experiment from a multi-country GTAP CGE model (like the US 3x3 database used in the sources)
where the U.S. imposes a tariff on manufactured imports from the rest of the world.

1. The tariff makes imports relatively more expensive for U.S. consumers and producers, causing them to substitute
towards the domestically produced variety. This reduces U.S. demand for manufactured imports.
2. The reduced import demand frees up factors of production (like labor and capital) that were previously used to
produce goods to pay for those imports.
3. As these factors are reallocated within the U.S. economy, they can shift towards sectors producing for the domestic
market (like manufacturing) or export markets. Source explains that the increase in domestic demand for the U.S.
variety leads to a reduction in the supply available for export.
4. With reduced U.S. manufactured export supply, and because the U.S. is effectively a monopoly supplier of "U.S.
manufactured goods" under the Armington assumption, the world price for U.S. manufactured exports tends to
increase.
5. Simultaneously, the reduction in U.S. import demand may cause the world price of the manufactured imports from
the rest of the world to decrease, but typically by a smaller amount, as the U.S. is only one customer among many for
the rest of the world's manufactured goods.
6. The U.S. terms of trade (ratio of U.S. export price to U.S. import price) will improve because its export price rises,
and its import price falls. As shown in Table 7.5 and explained in, this terms-of-trade gain for the U.S. is largely
attributable to the increase in the U.S. export price, illustrating Brown's insight that the export price side often drives
terms-of-trade changes in multi-country CGE models with Armington differentiation.
5(a) (i)

What are the three effects which an import tariff has on an importing country? Explain briefly.
Do all the three effects matter for the change in national welfare of the importing country ?
Why or Why not ?

Based on the sources, an import tariff has three main effects on the importing country in a CGE model, particularly when the
country is large enough to affect world prices.

Here are the three effects:

1. Direct burden (Tariff Revenue): This is the amount of tax revenue paid by consumers to the government on the quantity
of imports consumed after the tariff is imposed. Figure 8.1 shows this as area a + c. This represents a redistribution of
purchasing power from consumers to the government.
2. Excess burden (Efficiency effect): This represents a loss in consumption efficiency. It occurs because consumers reduce
their consumption of imports due to the higher domestic price caused by the tariff. Consumers who were willing to pay a
price between the initial price and the new higher price for units of imports are no longer able to do so, resulting in a loss
of consumer surplus that is not recouped elsewhere in the economy. Figure 8.1 shows this as area b.
3. Terms-of-trade effect: For a large importing country, the decline in its import demand caused by the tariff can lead to a
fall in the world import price (the price the exporter receives, excluding the tariff and trade margins). This reduction in
the price of imports relative to the price of exports is a terms-of-trade gain for the importing country, as it increases the
import purchasing power of its exports. Figure 8.1 shows this gain as area c.

Regarding whether all three effects matter for the change in national welfare:

In standard CGE models, the change in national welfare includes only the excess burden (efficiency effect) and the termsof-
trade effect.

Here's why:

• The direct burden (tariff revenue) does not affect national welfare in standard CGE models. This is because tariff
revenue simply redistributes national income from domestic consumers to the domestic government. Since standard
CGE models typically assume that income has the same value regardless of its distribution among domestic agents
(consumers, government), this redistribution does not change the total value of national income or welfare.
• The excess burden does affect national welfare. This area represents a deadweight loss or efficiency loss, a loss in
consumer surplus that is not gained by anyone else in the economy. It reflects a consumption inefficiency caused by
the distortionary effect of the tariff on relative prices and consumer choices.
• The terms-of-trade effect does affect national welfare. A terms-of-trade gain means the country's exports can
purchase more imports, which improves its consumption possibilities and overall well-being. While a terms-of-trade
gain for one country is a loss for its trading partner, resulting in no change in global welfare from this effect, it is a
direct component of the national welfare change for the importing country.

Therefore, the net effect on the importer's welfare depends on whether its consumption efficiency loss (area b) is greater than
its terms-of-trade gain (area c).

5(a) (ii)
What is the direct burden and the excess burden of an ad-valorem production tax ? When is
the burden of paying the production tax borne (i) solely by the producer and (ii) solely by
the consumer

Drawing on the provided sources, here is an explanation of the direct burden and excess burden of an ad-valorem production
tax and how the burden of paying this tax is shared between producers and consumers.

Figure 8.3. (a) Market effects of an ad valorem production tax.

An ad valorem production tax is a tax levied as a percentage of the value of a producer's output. These taxes are part of
producers' costs of production. When an ad valorem production tax is introduced, it shifts the industry supply curve leftward.
This results in a higher market equilibrium price for consumers and a lower after-tax price for producers, leading to a fall in
the equilibrium quantity of supply and demand.

1. Direct burden (Tax Revenue): This is the amount of tax revenue paid by producers to the government. In Figure
8.3a, this is shown as area a + c. This represents a transfer of spending power from the producer to the government.
2. Excess burden (Efficiency effect): This represents the loss in economic efficiency when producers and consumers
change the quantities they produce or consume to avoid paying the tax. For an ad-valorem production tax, the excess
burden is the combined loss in consumption efficiency and production efficiency. In Figure 8.3a, this is shown as

area b + d. These losses occur because the marginal benefit to consumers of foregone units exceeds the marginal cost
of their production. The excess burden is considered a "deadweight loss" because these foregone opportunities are not
recouped elsewhere in the economy.

Regarding when the burden of paying the production tax is borne solely by the producer or solely by the consumer:

Although the production tax is paid by the producer to the government, the burden of paying for it can be shared with
consumers. This sharing of the burden is called tax incidence and is determined by the slopes (or elasticities) of the supply
and demand curves.

(i) Burden borne solely by the producer: This occurs when the demand curve is perfectly elastic (a horizontal
demand curve). In this scenario, consumers will not pay a higher price regardless of the quantity supplied. Therefore,
producers cannot pass any of the tax onto consumers and must absorb the full cost of the tax themselves.
(ii) Burden borne solely by the consumer: This occurs when the supply curve is perfectly elastic (a horizontal supply
curve). In this case, producers are willing to supply any quantity at a given price (before the tax). When the tax is introduced,
producers require a higher price (including the tax) to maintain their desired after-tax price. Since supply is perfectly elastic,
the quantity supplied only changes if the consumer price changes. With a fixed supply price for the producer, consumers must
absorb the full cost of the tax, and the market price paid by consumers will rise by the full amount of the tax.

5(b)
Show how in a PTA (Preferential Trade Agreement) between countries A and B there will be
a net welfare gain for country A through (i) trade creation, and (ii) trade diversion.

Based on the sources, a Preferential Trade Agreement (PTA) between countries A and B involves reducing or eliminating
trade barriers between them while maintaining barriers against non-members. The welfare effect of a PTA on a member
country is described as the sum of the efficiency gains or losses from trade creation and trade diversion, plus its terms-oftrade
change.

Here's how a net welfare gain for country A can occur through the processes of trade creation and trade diversion:

(i) Trade Creation

• Trade creation is defined as the shift in the volume of production of a traded good from a high-cost producer in the
pact to a lower-cost member, combined with the expansion of consumption as prices within the union fall. It
unambiguously increases global welfare.
• In the context of a PTA between A and B, when A eliminates a tariff on imports from B, the domestic price of imports
from B falls for country A. This leads to an increase in A's imports from B.
• This process generates efficiency gains for country A: o Production efficiency gain: As the price of the imported
good from B falls, country A's domestic production of that good declines, being replaced by lower-cost imports from
B. This shift to a more efficient source of supply yields a welfare gain (shown as area 'a' in Figure 8.7).
o Consumption efficiency gain: The fall in the domestic price in country A leads to an expansion in
consumption of the good. This expansion increases consumer surplus, representing a gain in consumption
efficiency (shown as area 'c' in Figure 8.7).
• These efficiency gains from trade creation contribute positively to country A's national welfare.
DA: is the demand in country A for a composite product that is satisfied through a combination of the domestically produced
and imported varieties.

SA: is the supply curve for production in A

SB: is the supply curve for the import from B

SBt: is the import supply curve from B inclusive of A’s initial, per-unit import tariff

(ii) Trade Diversion

• Trade diversion occurs when a member country shifts its source of imports from a lower-cost country outside the
PTA to a higher-cost partner country within the pact. This shift can reduce production efficiency.
• In a PTA between A and B, if country C is a lower-cost supplier than B before tariffs are considered, A might initially
import from C (after applying tariffs to both B and C). When A removes the tariff on B but keeps it on C, B's duty-
free price might become lower than C's tariff-inclusive price, causing A to shift imports from C to B, even if B is a
higher-cost producer than C before tariffs.
• Trade diversion can lead to efficiency losses for country A, particularly a production efficiency loss on the diverted
volume of trade if the PTA partner (B) is a higher-cost producer than the non-member (C) (shown as area 'd' in Figure
8.8).
• Additionally, A's increased demand for B's goods can cause B's export price to rise, resulting in a terms-of-trade loss
for A on imports from B (shown as area 'c' in Figure 8.8).
• However, trade diversion can also lead to a consumption efficiency gain if the shift in sourcing from C to B still
results in a lower domestic price for A's consumers, leading to an expansion of consumption (shown as area 'b' in
Figure 8.8).

Net Welfare Gain

Whether country A experiences a net welfare gain depends on the combined effect of trade creation and trade diversion,
along with terms-of-trade changes.
 • The net effect on A's welfare is the sum of its efficiency gains from trade creation (area 'a' + 'c' in Figure 8.7), plus
any consumption efficiency gains in the trade diversion scenario (area 'b' in Figure 8.8), minus its production
efficiency loss from trade diversion (area 'd' in Figure 8.8), plus or minus terms-of-trade changes (which include
losses to partner B (area 'e' in Figure 8.7 / area 'c' in Figure 8.8) and potential gains from non-members C if A's
reduced demand causes C's export prices to fall).
• A PTA is welfare-improving for a member country if the positive effects (mainly the efficiency gains from trade
creation and consumption expansion) outweigh the negative effects (efficiency losses from trade diversion and
termsof-trade deterioration). It must be net trade-creating in terms of welfare effects. The direct burden (lost tariff
revenue) does not affect national welfare as it's a domestic redistribution.

Therefore, a net welfare gain for country A occurs not solely through trade diversion, which can entail efficiency and termsof-
trade losses, but through the overall effect where the positive welfare contributions of trade creation, potentially coupled with
consumption gains from diversion, exceed the welfare losses associated with trade diversion (production efficiency loss and
terms-of-trade loss to the partner). The specific outcome must be analyzed empirically on a case-by-case basis.

Cameroon

Nest I: Composite Output (Qi)

• Purpose: Combines domestic and imported goods to produce the final good.

• Function Type: CES (Constant Elasticity of Substitution)

Nest II: Output Allocation (Xi)

• Purpose: Allocates output between domestic sales and exports.

• Function Type: CET (Constant Elasticity of Transformation)

Nest III: Production Function (Output Generation)

• Purpose: Determines how output is produced from value-added and intermediate inputs.

• Function Type: Generally additive or nested CES

Nest IV: Capital-Labor Combination (VAi)

• Purpose: Combines capital and labor to produce value-added.

• Function Type: CES or Cobb-Douglas

📘 Interpretation and Implications

• Flexibility: The nested structure allows for different degrees of substitutability between inputs at each level.

• Policy Insights:

o Trade policy affects Nest I and II (import vs. domestic and export vs. domestic allocation).

o Labor market and capital policy affect Nest IV.

o Input policies (e.g., raw material subsidies) affect Nest III.

 • Sectoral Differentiation: Each sector can have its own parameters, allowing simulation of labor-intensive vs.
capital-intensive industries.

Nest Level Focus Function Key Decision

Nest I Composite Output (Qi) CES Substitution: Domestic vs. Imported goods

Nest II Output Allocation (Xi) CET Allocation: Domestic sales vs. Exports

Nest III Output from Inputs Functional form Contribution of value-added & inputs

Nest IV Capital-Labor (VAi) CES or Cobb-Douglas Substitution: Capital vs. Labor