Suppose now that there is a negative production externality in country B. This externality arises from less strict environmental regulations in country B. [Country A does not have a production externality because it uses a “clean” production technology.] In what follows we investigate the question if free trade improves welfare when negative externalities are present.

Demand and Supply Country B "poor country" P= 100-9Q P= Q

Question 1 For country B, use the demand and supply of P=100-9Q P=Q and a world price of 25. Draw a diagram where there is a negative production externality with a constant value of 15 for every unit produced. Suppose that the government does not intervene in the market. Compute country B’s welfare under autarky and free trade with the negative production externality. Briefly explain if country A’s welfare is affected by the production externality in B . Do you agree with the claim that welfare under free trade (compared to autarky) improves in both countries when a negative production externality is present? Briefly explain why (not).

Question 2 - Suppose that the government does not intervene in the market. Compute country B’s welfare under autarky and free trade with the negative production externality. Briefly explain if country A’s welfare is affected by the production externality in B . Do you agree with the claim that welfare under free trade (compared to autarky) improves in both countries when a negative production externality is present ? Briefly explain why (not) .

Question 3 Suppose the negative production externality was 5 instead of 15. Does your qualitative (not quantitative) answer about whether free trade improves welfare in both countries or not (i.e., the last two questions in Question 2) depend on the size of the externality ? Explain why your answer is economically and politically significant (2 marks)

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Answer Externalities have a negative impact if its occurs when the production or consumption of products and services has a negative influence on a th... View the full answer