Consider a model with two countries, Home and Foreign, and two goods, X and Y. The demand curve for each good in each country is given by:
D = 50 - P,
Where D is the quantity supplied and P is the price. The supply curve for Y in Home and for X in Foreign is given by:
QS = P,
While the supply curve for X in Home and for Y in Foreign is given by:
QS = 4 +P,
Where in each case (f stands for the quantity supplied.
(a) Use the spreadsheet "optimal tariffs.xls" to find the Nash equilibrium tariffs for each country for this model.
(b) Calculate the change in social welfare in each country if we move from Nash equilibrium tariffs to free trade. Illustrate with a diagram.
(c) Given your results, would Home and Foreign prefer to negotiate trade policy, or would they prefer to maintain their sovereignty and discretion by leaving each country to set its trade policy on its own?