Trade Problem Set 100 3-2

1. Consider a perfectly competitive market for steel in a small exporting country. Suppose that steel production causes local air and water pollution. Assume that the larger is steel output, the higher is the social cost of pollution, thus, steel production creates a negative externality.

A. Explain what type of trade tax or subsidy policy could be used to reduce the negative effects of pollution. Demonstrate the welfare effects using a partial equilibrium diagram. Assume that your policy reduces social costs by R dollars. Under what condition would the policy raise national welfare?

B. Explain what type of purely domestic policy could be used to reduce the pollution. Use a partial equilibrium diagram to demonstrate the welfare effects of this policy. Again assume that your policy reduces social costs by R dollars.

C. Explain why the purely domestic policy may be superior to the trade policy.

International Trade Theory and Policy - Chapter 100: Last Updated on 1/07/08