Your boss has asked you to analyze the foreign exchange exposure of a subsidiary in Erehwon. The subsidiary sells exclusively in Erehwon, taking in revenues denominated in Erehwon grolsch. The market is strictly local, and the subsidiary does not compete in a world output market. However, the market is not perfectly competitive so the demand for the product is downward sloping. The costs of production are also strictly local, denominated in Erehwon grolsch, and marginal costs rise with the quantity produced. Prepare a diagram of marginal cost, demand, and marginal revenue curves with the U.S. dollar price on the vertical axis and quantity on the horizontal axis.
a. Show what the optimum quantity of output/sales is for the subsidiary, and what the optimum (U.S. dollar equivalent) price is.
b. Your boss is worried that the Erehwon grolsch will depreciate by 10 percent. Assuming that this is a self-contained subsidiary (as just explained), show what happens when there is a 10 percent depreciation of the grolsch in the diagram. What happens to the optimum quantity of output/sales for the subsidiary? What happens to the optimum (U.S. dollar equivalent) price following the 10 percent depreciation? What happens to the Erehwon grolsch price following the 10 percent depreciation?
Please see the attached file.
Pe and Qe represent the price and quantity demanded respectively. The optimal price and quantity can be determined at the point where MR = ...
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