1. (22 points) Suppose it is costly to transport exports. Let this cost be equal to some number T per unit. We are going to investigate some features of how the presence of T impacts the monopolistic competition model with trade. Assume all firms are the same in each country, and that each country is the same size.

The problem is written to help guide you to the solution in a series of (hopefully) not too demanding steps. (Most of these steps I sort of do for you.)

A) Let P_hh be the price a home firm charges in the home country, P_hf be the price a home firm charges in the foreign country, P_fh be the price a foreign firm charges in the home country, and P_ff be the price a foreign firm charges in the foreign country.

B) Also adopt notation where X_hh is the quantity of beer a home country sells at home, with other Xs defined the same way.

C) (4 points) A firm considering the prices to charge in each market will evaluate each market separately, since the trade cost introduces a friction that makes each market imperfectly integrated. When we had no transaction costs, we found in lecture that . The term equalled 1/n since we had total symmetry, which was nice.Since firms now need to charge different prices in each country, this new asymmetry will not allow for the same simplification here. Write out four MR relationships. For instance, MR_hh will be

D) (4 points) Set the MRs equal to MC. Note that when a firm is exporting, the MC=C+T.

E) (4 points) Calculate the Markup over MCs for the Home firm in both markets.For instance,

F) (4 points) Will the markup be larger for the home firm when selling at home or foreign? Why? [Hint: Think about what will happen to its market share in foreign now that it has to pay a transportation cost.]

G) (2 points) Given your answer to g, write down an inequality relating how the value P_hh compares to the P_hf minus transport costs.

H) (4 points) The result for g describes a phenomenon called "dumping."The price charged by the home country firm in the foreign market, minus the cost of transport, is actually lower than the price the firm charges at home. "Dumping" is frowned upon by many governments. Suggest a couple reasons why. As an economist, what is your view?