Multiple Choice Questions 1. a. b. c. d. 2. a. b. c. d. 3. a. b. c. d.
4. a. b. c. d. 5. a. b. c. d. 6. a. b. c.
If a consumer's income doubles and she now purchases more of good X, we can infer that good X i __________ good. Luxury Normal Inferior Special ANSWER: B All of the following can lead to an increase in the demand for ice cream, a normal good, EXCEPT: A decrease in income. An increase in the price of popsicles. A new scientific study that finds eating ice cream does not cause weight gain. A 10% increase in population. ANSWER: A A decrease in supply will lead to: An increase in price. A increase in quantity. An increase in demand. An increase in sales. ANSWER: A Generally, with all else held constant, when the price of a good increases, consumers purchase: More of the good. Less of the good. The same amount of the good. None of the good. ANSWER: B An increase in demand will lead to: An increase in supply. A fall in quantity. An increase in price. A decrease in producer surplus. ANSWER: C Which of the following events would lead to an increase in demand for air travel? An increase in the number of people who are afraid to fly. A fall in the price of oil. An increase in the price of ground transportation.
d. 7. a. b. c. d.
A decrease in income levels. ANSWER: C Which of the following will cause a rightward shift of the market supply curve? An increase in the product price. A decrease in input costs. Change in consumers’ tastes. An increase in income. ANSWER: B
8. a.
If a 1% increase in the price of DVD’s leads to a 3% reduction in the sales of DVD’s, we can conclude that: DVD’s are normal goods.
b.
DVD’s are inferior goods. Demand for DVD’s is elastic.
c. d.
Demand for DVD’s is inelastic. ANSWER: C
9.
An increase in demand will lead to a higher increase in price; the: Greater is the price elasticity of demand. Greater is the population. Flatter is the supply curve. More inelastic is supply. ANSWER: D Producer surplus is: Found on a graph as the area under the equilibrium price and above the supply curve. The net gain in economic well-being associated with producing and selling the equilibrium quantity of a go Used to measure the impact of a change in price on the economic well-being of producers. All of the above. ANSWER: D
a. b. c. d. 10. a. b. c. d.
Figure 2.1
11. Referring to figure 2.1, at a price of $70, the amount of consumer surplus is: a. b. c. d. 12. a. b. c. d. 13. a. b. c. d. 14. a.
$6,000. $8,000. $15,000. $30,000. ANSWER: B Referring to figure 2.1, at a price of $70, the amount of producer surplus is: $6,000. $8,000. $15,000. $30,000. ANSWER: A The opening up of free trade brings gains to: All producers. Producers in export industries. Producers in import-competing industries. Workers in import-competing industries. ANSWER: B An increase in the imports of clothing into the United States will benefit __________ and hurt __________. U.S. clothing producers; foreign clothing producers
foreign clothing consumers; foreign clothing producers U.S. clothing consumers; foreign clothing producers d. U.S. clothing consumers; U.S. clothing producers b. c.
ANSWER:
D
15. Which of the following says that any dollar of gain or loss will be equally valued, regardless of who experi
it? Consumer surplus. b. Producer surplus. c. Arbitrage. d. One-dollar, one-vote metric. ANSWER: D a.
16. Consider a typical two-country model. In the exporting country, consumers will be __________ and pro a. b. c. d.
17. a. b. c. d. 18. a. b. c. d. 19.
will be __________ with the opening of international trade. Happy; happy Unhappy; happy Unhappy; unhappy Happy; unhappy ANSWER: B Use the following information to answer questions 17 thru 24: Suppose the domestic supply and demand curves for skateboards in the United States are given by the foll set of equations: QS = -60 + 3P QD = 390 – 2P In the absence of international trade in skateboards, what will the domestic price in the United States skateboards? $66 $90 $45 $150 ANSWER: B In the absence of international trade in skateboards how many skateboards will be sold in the United States 138 258 210 930 ANSWER: C If the United States could trade skateboards freely with the rest of the world at a price of $75, how skateboards would be produced in the United States?
165 240 c. 285 a. b.
d. 20. a. b. c. d.
It depends on foreign demand for skateboards. ANSWER: A If the United States could trade skateboards freely with the rest of the world at a price of $75, how skateboards would be purchased in the United States? 165 240 285 It depends on foreign supplies of skateboards. ANSWER:
B
21. If the United States could trade skateboards freely with the rest of the world at a price of $75, the a. b. c. d. 22. a. b. c. d. 23. a. b. c. d. 24. a. b. c. d.
States would import __________ skateboards and export __________ skateboards. 240; 165 0; 165 75; 0 240; 0 ANSWER: C In the absence of trade with the rest of the world, the amount of consumer surplus in the United Statesskate market is __________ and the amount of producer surplus in the United States skateboard market is______ $7,350; $11,025 $31,500; $9,450 $20,474; $7,350 $11,025; $7,350 ANSWER: D The opening of free trade with an international price for skateboards of $75 will lead to a change in con surplus of: +$2,812.50. -$2,812.50. +$6,300. +$3,375. ANSWER: D The opening of free trade with an international price for skateboards of $75 will lead to a change in pro surplus of: +$2,812.50. -$2,812.50. +$3,375. -$3,375. ANSWER: B Use the following information to answer questions 25 thru 31:
Suppose the domestic supply and demand curves for MP3 players in the United States are given by t he foll set of equations: QS = 25 + 10P QD = 925 – 5P 25. In the absence of international trade in MP3 players, what will the domestic price in the United States MP3 players? a. $60 b. $63.33 c. d. 26. a. b. c. d. 27. a. b. c. d. 28. a. b. c. d. 29. a. b. c. d.
$90 $180 ANSWER: A In the absence of international trade in MP3 players, how many MP3 players will be sold in the United Stat 1825 625 608 925 ANSWER: B If the United States could trade MP3 players freely with the rest of the world at a price of $90, how man players would be produced in the United States? 625 475 925 It depends on foreign demand MP3 players. ANSWER: C If the United States could trade MP3 players freely with the rest of the world at a price of $90, how man players will be purchased in the United States? 625 475 925 It depends on foreign supplies of MP3 players. ANSWER: B If the United States could trade MP3 players freely with the rest of the world at a price of $90 the States would import __________ MP3 players and export __________ MP3 players. 0; 450 450; 0 475; 925 0; 925 ANSWER:
A
30. In the absence of trade with the rest of the world, the amount of consumer surplus in the United States’ a. b. c. d. 31. a. b. c. d. 32. a. b. c. d. 33. a. b. c. d.
player market is __________ . $22,562.50 $30,062.50 $39,062.50 $19,500.00 ANSWER: C The opening of free trade with an international price for MP3 players of $90 will lead to a _______ the United States in the amount of __________. Gain; 2,625 MP3 players Gain: $6,750 Loss; 150 MP3 players Loss; $13,500 ANSWER: B During the time span 1960-2006, the Volume of World Trade has been: Growing at a lower rate compared to the World Production. Growing at the same rate as the World Production. Growing at a higher rate compared to the World Production. Declining due to the Cold War. ANSWER: C Compared to developing countries, industrialized countries: Export more primary products, especially fuels and ores. Export more textiles and clothing. Export more services. None of the above. ANSWER: C Use the following information to answer questions 34 thru 37: Suppose the domestic supply and demand curves for bicycles in the United States are given by the followi of equations: QS = 2P QD = 200 – 2P. Demand and supply in the Rest of the World is given by the equations: QS = P QD =160 – P. Quantities are measured in thousands and price in U.S. dollars.
34. In the absence of international trade, __________ thousand bicycles will be sold in the United States at a p a.
__________. 50; $50
b. c. d. 35. a. b. c. d.
100; $100 150; $50 100; $50 ANSWER: D In the absence of international trade, __________ thous and bicycles will be sold in the Rest of the Worl price of __________. 80; $80 100; $100 50; $100 100; $50 ANSWER:
A
36. After the opening of free trade with the Rest of the World, the world price establishes itself at a. b. c. d. 37. a. b. c. d.
TheU.S. __________ bicycles. Exports 40,000 Exports 60,000 Imports 60,000 Neither exports nor imports any bicycles ANSWER: A After the opening of free trade between the U.S. and the Rest of the World: Neither the U.S. nor the Rest of the World gain from trade. Both countries gain from trade, but the U.S. gains more. Both countries gain from trade, but the Rest of the World gains more. One cannot determine who gains more. ANSWER: C
True/False Questions 38. An increase in demand will lead to a larger increase in price the more elastic is supply.
ANSWER:
FALSE
39. A decrease in income will lead to an increase in the quantity demanded of an inferior good.
ANSWER:
TRUE
40. A simultaneous increase in supply and decrease in demand will lead to a higher equilibrium price.
ANSWER:
FALSE
41. If a 1% increase in price leads to a 5% decrease in quantity demanded, the good is considered to be a n
good. ANSWER:
FALSE
42. Consumer surplus is the amount of net economic benefit to consumers from being able to purchase in a mar
ANSWER:
TRUE
43. Everyone benefits in a country that was closed to world trade when it begins to freely trade with the rest
world. ANSWER: FALSE 44. While international trade will benefit both the importing and exporting country in a two-country world, the from trade in the exporting country will usually be greater than the gains from trade in the importing countr ANSWER: FALSE 45. The net national gain from trade can be measured by the change in consumer and producer surplus that r from trade. ANSWER: TRUE 46. The free-trade price of a good in an importing country is expected to be lower than the price of the good i
47. 48. 49. 50.
51. 52.
country before trade began. ANSWER: TRUE When free trade begins, producers in the importing nation gain while producers in the exporting nation lose ANSWER: FALSE Free trade is a zero-sum activity. That is, one county always gains and the other always loses from free trad ANSWER: FALSE The gains from trade are divided in proportion to the price changes that trade brings to the trading countries ANSWER: TRUE If the world price is higher than the no-trade domestic price, then domestic producers gain and do consumers lose as a result of free trade. ANSWER: TRUE The elasticity of demand measures the responsiveness of consumers to changes in the price of a product. ANSWER: TRUE Over the past half a century the World Trade Volume increased more than ten times. ANSWER: TRUE
Essay Questions 53. In a two-country world, the opening of free trade does not make everyone in the two countries better off.
assumption(s) must be made in order to make the claim that both countries do in fact benefit from the free t POSSIBLE RESPONSE: It is true that free trade does not benefit everyone within a country. However, accept the one-dollar-one-vote metric, and measure the national well-being of a country, we will find that are net national gains from trade. That means that the gainers are gaining more than the losers are losing. A the gainers are the consumers in the importing country, who enjoy lower prices, and possibly a wider vari the product, and the producers in the exporting country, who are expanding their production as they are rec a higher price in the international market. Among the losers are the consumers of the export-oriented in and the import-competing producers. 54. Assume that there are only two countries in the world, Pacifica and Atlantica. Both countries produc consume surfboards. The pre-trade price of surfboards in Atlantica is lower than the pre-trade price of surf in Pacifica. Draw a three-graph diagram to depict the Pacifica, Atlantica, and international markets for surf illustrating the pre-trade price differenc e. Now assume that free trade opens up between Pacifi
Atlantica. Depict a plausible world price in the graphs. Using what you have learned about consume producer surplus, describe what happens to consumers and producers in each country as a result of the m free trade. What happens to overall economic welfare in the two countries? Be sure to label and refer graphs in your answer. POSSIBLE RESPONSE: Pacifica (demand for imports)
The above graph illustrates a possible international price. The graph to the left represents demand and sup Atlantica, the graph in the middle the market in Pacifica, and the graph to the right the Wor ld marke international price of 60 is between the no-trade prices of 40 and 70. The international price is such a pric the excess supply in Atlantica matches the excess demand in Pacifica. As a result Atlantica exports 30 to Pacifica at a price of 60. Both countries gain from international trade. Atlantica gains area C in the right and Pacifica gains area P. 55. Carefully explain why nations gain from engaging in international trade. Do nations gain equally from trade? what determines which country gains more? (In your answer you can assume a two-country world.) POSSIBLE RESPONSE: Demand and supply differ in the two countries and so prices also differ if there international trade. With the opening of international trade arbitrage opportunities arise: opportunities to profit by buying the good cheaper in one country and selling it in another. Due to these opportunities the in the two countries equalize. The gain from trade in the importing country arises because consumers i country gain more than producers lose as a result of the reduced price. Conversely, the gain from trade exporting country exists because producers gain more than local consumers lose. In general, nations do no equally from trade. The country which experiences a larger change in its price stands to gain more. precisely, the national gain from trade is proportional to the change in the price that occurs due to the shif
no trade to free trade. 56. What is the logic of producing winter clothing n i countries whose residents have very little demand fo
clothing? POSSIBLE RESPONSE: A country might be interested in the production of winter clothing if this count export this good in exchange for other goods that cannot be produced at a low cost domestically in this countr might be due to the specificity of the technology in this country; this country might have an abundance of res that make the production of winter clothing efficient (low cost), whereas this country might be unable to pr other goods at such a low cost. 57. China produces shoes at a lower cost than the United States. As a result, most of the shoes purchased in the
States are made in China. Should this be a concern to anyone in the United States? If so, who should be con and why? If not, why not? POSSIBLE RESPONSE: As a result of the free trad e between China and the U.S., the price of sh the U.S. will be equal to the international price. What are the effects of free trade on producers and consu shoes in the United States? As a result of the imports of shoes from China, the price of shoes will be (compared to the situation of no trade). Consumers will gain additional consumer surplus due to the lower and the increased purchases of shoes (consumers’ total surplus is measured by the area below the demand for shoes and above the international price). Facing a lower price (the international price), the do producers of shoes in the United States will react by decreasing their production of shoes. Hence, there is l surplus to producers associated with the opening of trade. Some of the shoe producers might go out of bus which might create temporary unemployment in this industry which will last until the workers producing find employment in another sector of the economy. In general, consumers gain more than producers lo there is a net gain for the U.S. of opening to trade. 58. The difference in the prices of a good in two countries creates opportunities for arbitrage: traders buy the go low price in one country and sell it at a higher price in the other. When the difference in the prices vanishes, a world price is established in both countries, there is no scope for trade anymore because no trader will be will buy the good in one country and sell it in another. Discuss the validity of this statement. POSSIBLE RESPONSE: This is not a valid statement. Consider the countries A and B, and assume that trade the price of the good is Pa in country A and Pb in country B, where Pa< Pb. With the opening of free tra arbitrage possibilities will eliminate the difference in the prices in the two countries. So, the world price, establish itself between the two localprices: Pa
Multiple Choice Questions 1.
Based on mercantilist thinking, governments should:
a.
Subsidize and encourage imports.
b.
Subsidize and encourage exports.
c.
Allow for free trade unencumbered by government regulations and restrictions.
d.
Both (a) and (b).
2.
The author of the Wealth of Nations was:
a.
David Ricardo.
b.
Paul Samuelson.
c.
Adam Smith.
d.
Karl Marx.
3.
When Adam Smith presented his theory of absolute advantage, he thought that all value was measured in terms of the
ANSWER:
ANSWER:
B
C
amount of __________ used in the production of the good. a.
Land
b.
Labor
c.
Capital
d.
Money
4. a.
Labor productivity is: The number of units of output that a worker can produce in one hour.
b.
The total number of units that all workers in a firm produce in one day.
c.
The number of hours it takes a worker to produce one unit of output.
d.
The total number of hours it takes all the workers in a firm t o produce a day’s output.
5.
Which of the following is NOT true about mercantilism?
a.
Under mercantilism, exports were encouraged and imports were discouraged.
b.
Mercantilists believed that one country’s gains from trade came at the expense of another country or countries’ well
ANSWER:
ANSWER:
B
A
being. c.
Domestic producers were often hurt by mercantilism.
d.
Mercantilism focused on the accumulation of gold and silver bullion.
6.
If Britain’s labor productivity in the production of umbrellas is greater than the rest of the world’s labor productivity in
ANSWER:
C
umbrellas, we would say that Britain has a(n) __________ in the production of umbrellas. a.
Comparative advantage
b.
Absolute advantage
c.
Opportunity cost
d.
Superiority
7.
In the two-country, two-good model, which of the following is true?
ANSWER:
B
I. As a result of trade, at least one country is better off and that country’s gain does not reduce the economic welfare of
the other country.
II. Both countries can gain from trade by dividing the benefits of the enhanced global production. a. b.
I II
c.
Both I and II
d.
Neither I nor II ANSWER:
C
Table 3.1 In the United Kingdom
In the Rest of the World
Umbrellas per labor hour
1.00
0.50
Units of corn per labor hour
0.20
0.70
Productivity
8.
Refer to Table 3.1. The number of labor hours to make 1 umbrella in the United Kingdom is:
a.
0.5.
b.
1.
c. d.
1.43. 2.
9.
Refer to Table 3.1. The number of labor hours to produce 1 unit of corn in the Rest of the World is:
a.
0.5.
b.
1.
c.
1.43.
d.
2.
ANSWER:
ANSWER:
B
C
10. Refer to Table 3.1. Given the productivity information in Table 3.1, the Rest of the World has an absolute advantage in the production of __________ and the United Kingdom has an absolute advantage in the production of __________. a.
Umbrellas; corn
b.
Corn; umbrellas
c.
Corn; neither good
d.
Neither good; umbrellas ANSWER:
B
11. Refer to Table 3.1. If the United Kingdom shifts 1 hour of labor from the production of corn to the production of
umbrellas and the Rest of the World shifts 1 hour of labor from the production of umbrellas to the production of corn, total world production of corn will __________ by __________ units and total world production of umbrellas will __________ by __________. a.
Increase; 1; decrease; 1
b.
Increase; 1.43; increase 1
c.
Increase; 0.5; increase; 0.5
d.
Decrease; 0.5; increase; 0.7 ANSWER:
C
12. The theory of comparative advantage was first presented by: a. Adam Smith. b.
Karl Marx.
c.
David Ricardo.
d.
Eli Heckscher. ANSWER:
C
13. If a country exports the good that it can produce at a low opportunity cost and imports those goods that it would otherwise produce at a high opportunity cost, we say that such trade is based upon: a.
Absolute advantage.
b.
Arbitrage.
c.
Labor productivity differences.
d.
Comparative advantage. ANSWER:
D
Table 3.2 In the United Kingdom
In the Rest of the World
1 umbrella
3.00
2.00
1 unit of corn
1.00
0.25
Labor hours to make:
14. Refer to Table 3.2. The United Kingdom has an absolute advantage in the production of __________ and the Rest of the World has an absolute advantage in the production of __________. a.
Neither good; corn
b.
Neither good; both goods
c.
Both goods; neither goods
d.
Corn; umbrellas ANSWER:
B
15. Refer to Table 3.2. The United Kingdom has a comparative advantage in the production of __________ and the Rest of the World has a comparative advantage in the production of __________. a.
Neither good; corn
b.
Neither good; both goods
c.
Umbrellas; corn
d.
Corn; umbrellas ANSWER:
C
16. Refer to Table 3.2. The opportunity cost of producing a unit of corn in the United Kingdom is __________ umbrellas and the opportunity cost of producing a unit of corn in the Rest of the World is __________ umbrellas. a.
1/8; 1/3
b.
1/3; 1/8
c.
3; 8
d.
8; 3 ANSWER:
B
17. Refer to Table 3.2. The opportunity cost of producing an umbrella in the United Kingdom is __________ units of corn and the opportunity cost of producing an umbrella in the Rest of the World is __________ units of corn. a.
1/8; 1/3
b.
1/3; 1/8
c.
3; 8
d.
8; 3 ANSWER:
C
18. Refer to Table 3.2. Once trade is opened, we can anticipate that the international price of umbrellas will lie between __________ and __________. a.
1/3 of a unit of corn; 3 units of corn
b.
8 units of corn; 3 units of corn
c.
1/8 of a unit of corn; 1/3 of a unit of corn
d.
8 units of corn; 1/8 of a unit of corn ANSWER:
B
19. Refer to Table 3.2. Once trade is open, we can anticipate that the international price of corn will lie between __________ and __________. a.
1/3 of an umbrella; 3 umbrellas
b.
8 umbrellas; 3 umbrellas
c.
1/8 of an umbrella; 1/3 of an umbrella
d.
8 umbrellas; 1/8 of an umbrella ANSWER:
C
Table 3.3 In the United Kingdom
In the Rest of the World
Umbrellas per labor hour
6
1
Units of corn per labor hour
4
3
Productivity
20. Refer to Table 3.3. The United Kingdom has an absolute advantage in the production of __________ and the Rest of the World has an absolute advantage in the production of __________.
a.
Both goods; neither good
b.
Neither good; both goods
c.
Umbrellas; corn
d.
Corn; umbrellas ANSWER:
A
21. Refer to Table 3.3. The United Kingdom has a comparative advantage in the production of __________ and the Rest of the World has a comparative advantage in the production of __________. a.
Both goods; neither good
b. c.
Neither good; both goods Umbrellas; corn
d.
Corn; umbrellas ANSWER:
C
22. Refer to Table 3.3. The opportunity cost of producing a unit of corn in the United Kingdom is __________ umbrellas and the opportunity cost of producing a unit of corn in the Rest of the World is __________ umbrellas. a.
2/3; 3
b.
3; 2/3
c.
3/2; 1/3
d.
1/3; 3/2 ANSWER:
C
23. Refer to Table 3.3. The opportunity cost of producing an umbrella in the United Kingdom is __________ units of corn and the opportunity cost of producing an umbrella in the Rest of the World is __________ units of corn. a.
2/3; 3
b.
3; 2/3
c.
3/2; 1/3
d.
1/3; 3/2 ANSWER:
A
24. Refer to Table 3.3. Once trade is opened, we can anticipate that the international price of umbrellas will lie between __________ and __________. a.
2/3 of a unit of corn; 3 units of corn
b.
3/2 units of corn; 2/3 of a unit of corn
c.
3/2 of a unit of corn; 1/3 of a unit of corn
d.
3 units of corn; 1/3 of a unit of corn ANSWER:
A
25. Refer to Table 3.3. Once trade is open, we can anticipate that the international price of corn will lie between __________ and __________. a. b.
2/3 of an umbrella; 3 umbrellas 3/2 umbrellas; 2/3 of an umbrella
c.
3/2 umbrellas; 1/3 of an umbrella
d.
3 umbrellas; 3/2 umbrellas ANSWER:
C
Table 3.4 In the United States
In France
1 gallon of Wine
4.00
1.00
1 pound of Cheese
1.00
2.00
Labor hours to make:
26. Refer to Table 3.4 and assume the United States and France trade only with each other. The United States has an absolute advantage in the production of __________ and France has an absolute advantage in the production of __________. a.
Neither good; wine
b.
Cheese; neither good
c.
Wine; cheese
d.
Cheese; wine
ANSWER:
D
27. Refer to Table 3.4. What is the relative price of cheese (the price of cheese in terms of wine) in France if it does not engage in trade? a.
2 gallons of wine per pound.
b.
1 gallon of wine per pound.
c.
0.5 gallons of wine per pound.
d.
0.25 gallons of wine per pound.
ANSWER: A 28. Refer to table 3.4. The opportunity cost of cheese in France is __________ and the opportunity cost of cheese in the United States is __________. a.
1 gallon of wine; 0.5 gallons of wine
b.
2 gallons of wine; 1 gallon of wine
c.
2 gallons of wine; 0.25 gallons of wine
d.
0.5 gallons of wine; 4 gallons of wine ANSWER:
C
29. Refer to Table 3.4 and assume the United States and France trade only with each other. The United States has a comparative advantage in the production of __________ and France has a comparative advantage in the production of __________. a.
Both goods; neither good
b.
Cheese; wine
c.
Wine; cheese
d.
Neither good; both goods
ANSWER:
B
30. Refer to Table 3.4. Once trade between the United States and France opens, we can anticipate that the international
price of wine will be between __________ and __________. a.
1 pound of cheese; 4 pounds of cheese
b.
0.5 pounds of cheese; 4 pounds of cheese
c.
1 pound of cheese; 2 pounds of cheese
d.
0.5 pounds of cheese; 2 pounds of cheese ANSWER:
B
31. Refer to Table 3.4. Once trade between the United States and France opens, we can anticipate that the international price of cheese will be between __________ and __________. a. b.
1 gallon of wine; 0.5 gallons of wine 2 gallons of wine; 4 gallons of wine
c.
2 gallons of wine; 0.25 gallons of wine
d.
1 gallon of wine; 4 gallons of wine ANSWER:
C
32. Which of the following is NOT true about a nation’s production-possibility curve? a.
The production-possibility curve shows all the amounts of different products that an economy can produce when its resources are fully employed.
b.
Points inside the production-possibility curve are feasible, but may represent unemployment of some of the economy’s resources.
c.
Points outside the production-possibility curve are not feasible production points given the resources in the economy.
d.
The production-possibility curve shows how the country gains from trade.
ANSWER:
D
33. Which of the following is NOT true about a constant cost production possibilities curve? a.
A constant cost production possibilities curve is drawn as a straight line.
b.
Along a constant cost production possibilities curve opportunity cost is constant.
c.
The opening up of free trade causes a constant cost production possibilities curve to shift to the right.
d.
Constant cost production possibilities curves can lead to complete specialization when free trade opens. ANSWER:
C
Figure 3.1
34. Refer to Figure 3.1. The opportunity cost of one unit of corn production in Canada is __________ liters of maple syrup and in the Rest of the World is __________ liters of maple syrup. a.
9/7; 2
b.
7/9; 2
c.
9/7; 1/2
d.
7/9; 1/2 ANSWER:
C
35. Refer to Figure 3.1. The opportunity cost of one liter of maple syrup production in Canada is __________ units of corn a.
and in the Rest of the World is __________ units of corn. 9/7; 2
b.
7/9; 2
c.
9/7; 1/2
d.
7/9; 1/2 ANSWER:
B
36. Refer to Figure 3.1. After the opening of free trade between Canada and the Rest of the World at the world price of 1 corn per unit of maple syrup, Canada will produce __________ units of corn and __________ liters of maple syrup. The Rest of the World will produce __________ units of corn and __________ liters of maple syrup. a.
35; 45; 35; 32.5
b.
70; 90; 100; 50
c.
0; 90; 100; 0 d.
70; 0; 0; 50 ANSWER:
C
37. Refer to Figure 3.1. Which of the following terms of trade is a plausible terms of trade for the two-country, two-good model depicted in the figure? a.
3/2 units of corn trades for 1 liter of maple syrup.
b.
1 unit of corn trades for 1/4 liter of maple syrup.
c.
3 units of corn trades for 1 liter of maple syrup.
d.
10 liters of maple syrup trades for 2 units of corn. ANSWER:
A
38. Products produced by high-wage workers in developed countries can compete with those produced by low-wage workers in less-developed countries because: a.
High-wage workers tend to be less productive than low-wage workers.
b.
High-wage workers tend to be more productive than low-wage workers.
c.
High-wage workers tend to put more time into the production of their goods.
d.
Products produced by high-wage workers in developed countries can not compete with those produced by low-wage workers in less-developed countries. ANSWER: B
39. A bottle of wine can be produced in France with 2 labor hours, and in the United States with 4 labor hours. A pound of
beef can be produced in France with 1 labor hour, and in the United States with ½ labor hour. a.
France has a comparative advantage in the production of beef.
b.
France has an absolute advantage in the production of beef.
c.
The United States has an absolute, but not a comparative advantage in the production of beef.
d.
The United States has both a comparative and an absolute advantage in the production of beef. ANSWER:
D
Use the following information to answer the questions 40 and 41. Vintland and Moonited Republic produce wine and cheese. The opportunity cost for the production of a bottle of wine in Vintland is 2 pounds of cheese, and in theMoonited Republic is 2.5 pounds of cheese. 40. Based on the above information it can be concluded that: a.
Trade between the two countries based on comparative advantage is not possible.
b.
Vintland has a comparative advantage in the production of wine and Moonited has a comparative advantage in the production of cheese.
c.
Vintland has a comparative advantage in the production of cheese and Moonited has a comparative advantage in the production of wine.
d.
Vintland has an absolute disadvantage in the production of both goods. ANSWER:
B
41. Based on the above information, the international equilibrium price ratio can be: a.
2/5 bottles of wine for a pound of cheese.
b.
3/5 bottles of wine for a pound of cheese.
c.
4/5 bottle of wine for a pound of cheese.
d.
1 bottle of wine for a pound of cheese. ANSWER:
A
42. In the two-country-two-good model, if a country has a comparative advantage in the production of a certain good, that means that this country: a.
Also has an absolute advantage in the production of this good.
b.
Will start importing this good.
c.
Can produce this good at a lower opportunity cost.
d.
Can produce this good at the same opportunity cost. ANSWER:
C
43. In the two-country, two-good model, if a country has an absolute advantage in the production of a certain good, that means that: a.
It is not possible that this country will start importing this good from the other country.
b.
This country also has a comparative advantage in the production of this good.
c.
Trade based on comparative advantage will not be possible.
d.
This country has a higher labor productivity in the production of this good. ANSWER: D
True/False Questions
44. David Ricardo is the author of the Wealth of Nations. ANSWER:
FALSE
45. Adam Smith’s theory of absolute advantage relied on the labor theory of value. ANSWER:
TRUE
46. Mercantilists believe that when one country benefited from international trade it was at the expense of another country or countries. ANSWER:
TRUE
47. If Country X has a higher level of labor productivity than the rest of the world in the production of a good, then Country X has a comparative advantage in the production of the good. ANSWER: FALSE 48. In order for trade to occur, both countries must be made better off as a result of trade. ANSWER:
FALSE
49. If a country does not have an absolute advantage in the production of a least one good, then trade will not take place. ANSWER:
FALSE
50. In Country X, the opportunity cost of producing an additional unit of Good A is the amount of Good B given up. ANSWER:
TRUE
51. In the Wealth of Nations, Adam Smith presented his theory of comparative advantage. ANSWER:
FALSE
52. If Country A is more productive than Country B in the production of both Good X and Good Y, then economists expect that Country A will produce everything and export both Good X and Good Y to Country B. ANSWER:
FALSE
53. In the two-country, two-good model, both countries can gain from trade as long as their relative advantages and disadvantages in producing different goods are different. ANSWER:
TRUE
54. According to the theory of comparative advantage, countries will export those goods for which they have a lower opportunity cost and import those goods for which they have a higher opportunity cost than the rest of the world. ANSWER:
TRUE
55. The act of buying at a low price in one place and selling at a high price in another place is called relative pricing. ANSWER:
FALSE
56. Arbitrage is the act of buying at one place and selling at another place in order to profit from the price differences that exist between the two places. ANSWER:
TRUE
57. In the two-country, two-good model, international trade will cause the two national prices that existed in autarky to move towards a new worldwide equilibrium price. ANSWER: TRUE 58. A nation’s production-possibility curve shows the amounts of different products that an economy can produce if all of its resources are fully employed. ANSWER:
TRUE
59. Straight-line production-possibility curves reflect that the opportunity cost of producing additional units of each good is constant. ANSWER:
TRUE
60. The production-possibility curve shows various bundles of consumption quantities that lead to the same level of well being. ANSWER:
FALSE
61. Free trade with constant-cost production-possibility curves usually leads to partial production specialization. ANSWER:
FALSE
62. In the two-country, two-good model, the relative price that will exist in the international markets for a good following the emergence of free trade will necessarily lie in the range bracketed by the autarky relative prices for the good in the two countries. ANSWER:
TRUE
63. According to the theory of comparative advantage, trade will not occur if one country is less efficient in the production of all products. ANSWER:
FALSE
64. A country has a comparative advantage in the production of a good if it can produce more of the good than another country. ANSWER:
FALSE
65. In Ricardo’s model, if labor productivity is constant, the production possibilities curve will look like a straight line. ANSWER:
TRUE
66. Ricardo’s theory of comparative advantage tells us that, if opportunity costs differ and labor productivities are constant, free trade will lead at least one country to a complete production specialization. ANSWER:
TRUE
67. The opportunity cost measures the amount of labor necessary for the production of one unit of a good. ANSWER:
FALSE
Essay Questions 68. Explain how a country can have an absolute advantage in the production of both goods in the two-country, two-good model and one country can have the comparative advantage in the production of one good and the other country will have a comparative advantage in the production of the other good. POSSIBLE RESPONSE: Let us begin with Adam Smith’s theory of absolute adva ntage. Imagine that two countries, A
and B, use only labor to produce wheat and cloth. We say that one country, say A, has an absolute advantage in the production of one of the goods, say wheat, if this country can produce more units of wheat per labor hour. If Country A can also produce more units of cloth per labor hour than Country B, then Country A will also have an absolute advantage in the production of cloth. So what kind of advantage can Country B then have? It seems that this country is less efficient in the production of both goods. To answer this question, we look at the opportunity cost of production. Now we present David Ricardo’s theory of comparative advantage. We ask the question, how many units of wheat
must Country B forego in order to produce one more unit of cloth? If Country B must forego fewer units of wheat in order to produce one more unit of cloth compared to Country A, we say that Country B has a lower opportunity cost in
the production of cloth. That implies that Country B has a comparative advantage in the production of cloth; production of cloth requires a lower sacrifice of production of wheat in Country B. 69. Using graphs, illustrate a two-country, two-good model in which one country has an absolute advantage in the production of both goods, but a comparative advantage in the production of only one good. POSSIBLE RESPONSE:
Assume Countries A and B have the same endowment of labor, and let labor be the sole factor of production. Country B has an absolute advantage in the production of wheat as with the same resources Country B can produce 60 units. Country A can produce only 40 units. Country B has also an absolute advantage in the production of Cloth (80>40). The opportunity cost in Country A for the production of one unit of wheat is 40/40=1C/W. The opportunity cost in Country B is 80/60=(4/3) C/W. Country A has a lower opportunity cost in the production of wheat, hence Country A has a comparative advantage in the production of wheat. 70. Suppose labor productivity in France is such that one hour of labor is required to produce one gallon of wine while two hours of labor are required to produce one pound of cheese. Assuming the availability of 1 million labor hours, draw a constant cost production possibilities curve for France with cheese on the vertical axis and wine on the horizontal axis. If France has a comparative advantage in the production of wine, show where, with free trade, France will produce on its production possibilities curve. If the free trade price of wine is two pounds of cheese per gallon, draw a trade line and use it to illustrate how France can gain from trade. POSSIBLE RESPONSE:
Wine (millions gallons)
If France produces only cheese, with 1 million labor hours France will be able to produce half a million pounds of cheese. If France produces only wine, France will be able produce 1 million gallons of wine. The production possibilities curve for France is a straight line as is shown in the graph. The opportunity cost of one gallon of wine in France is half a pound cheese. The international price of a gallon of wine is two pounds of cheese, which is higher than the opportunity cost of wine production in France. That means it will be beneficial for France to produce only wine and trade it for cheese instead of producing cheese itself. With free trade France can consume any combination of quantities of wine and cheese lying on the trade line shown in the graph. France gains from trade because these combinations are clearly outside of France’s production possibilities curve, so that is they are unattainable without trade. 71. Explain how products produced by high-wage workers in the United States can compete in countries whose workers earn much lower wages. POSSIBLE RESPONSE: To answer this question let us focus on the basis for trade between the United States and the other countries: the comparative advantage of the United States in the production of some products and the comparative advantage of the other countries in the production of another set of products. To determine whether theUnited States has a comparative advantage in a particular product we need to compare the worker productivity and wages in the United States to the productivity and wages in the other countries. Although worker wages in the United States are higher, the United States will have a comparative advantage if the U.S. workers are sufficiently productive. If the productivity advantage is large enough, the cost of manufacturing the product in the U.S. will be lower despite the high wages. The U.S. will be able to successfully export this product and import the products for which it does not have a comparative advantage. 72. According to Ricardo’s theory, countries will specialize in the production of the good in which they have a comparative advantage, and the specialization will be complete if free-trade relative prices differ from no-trade relative prices. Yet,
the real world fails to show total specialization. Explain the reasons for this discrepancy. POSSIBLE RESPONSE: Ricardo’s theory is based on the a ssumption of constant labor productivity for each good.
This assumption means that the labor input necessary for the production of each additional unit of the good does not depend on how much is produced. Because of this assumption, the opportunity cost —the amount of the other product foregone in order to produce one more unit of the good —is constant. A country will produce only the good with a lower opportunity cost, and will find it beneficial to trade it for the other at a relative price higher than this opportunity cost. The specialization will be full. In reality, goods are produced with several other factors besides labor, and the productivity of these production factors is not constant. As a result, in reality the production possibilities curve will be bowed out, and complete specialization will not be an optimal choice for the country, even if free-trade prices differ from no-trade prices.
Multiple Choice Questions 1. Constant cost production possibility curves lead to __________ specialization. Increasing cost production possibility curves lead to __________ specialization. a. no; partial b. complete; no c. complete; partial d. partial; complete ANSWER: C 2. Which of the following statements is true about production possibility curves? I. Constant cost production possibility curves are straight lines and lead to complete specialization. II. Bowed-out production possibility curves are associated with partial specialization, but the opportunity cost of producing each good is constant along the curve. a. I b. II c. I and II d. None of the above. ANSWER: A 3. Which of the following are reasons why increasing marginal costs of production arise? I. Different products use inputsto production in different proportions. II. Different inputs are better utilized inthe production of different products. III. Different countries have different endowments of the different factors of production. a. III b. II and III c. I and II and III d. I and II ANSWER: D 4.
Assume that Country X produces two goods—sugar and shoes—and that the country’s production possibility curve is “bowed -out”. As the country produces more sugar:
a. The opportunity cost of sugar in terms of shoes foregone will increase. b. The opportunity cost of sugar in terms of shoes foregone will decrease. c. The opportunity cost of shoes in terms of sugar foregone will increase. d. The opportunity cost of sugar in terms of shoes foregone will be the same. ANSWER: A 5. In the two-country, two-good model with an increasing-cost production-possibility curve, the amount of both goods that are produced in the economy in autarky is determined by: a. Relative prices.
b. Factor endowments. c. Community indifference curves. d. Labor productivity. ANSWER: A
6. Refer to Figure 4.1. In autarky Canada will produce at point __________ and consume at point __________. a.
S1; C1
b. S0; C0 c. S1; C0 d. S0; C1 ANSWER:
B
7. Refer to Figure 4.1. After the opening up of international trade, Canada will produce at point __________ and consume at point __________. a.
S1; C1
b. S0; C0 c.
S1; C0
d. S0; C1 ANSWER:
A
8. Refer to Figure 4.1. Canada has a comparative advantage in which good? a.
Wheat.
b. Cloth. c.
Both wheat and cloth.
d. Neither wheat nor cloth. ANSWER:
A
9. Refer to Figure 4.1. After the opening up of international trade, Canada will export __________ units of wheat and import __________ units of cloth. a.
0; 0
b. 20; 80 c.
20; 5
d. 60; 15 ANSWER:
B
10. Refer to Figure 4.1. After the opening up of international trade, Canada will import __________ units of wheat and export __________ units of cloth. a. 0; 0 b. 25; 25 c.
30; 65
d. 65; 65 ANSWER:
A
11. Refer to Figure 4.1. Before the opening up of international trade, 1 unit of wheat will trade for __________ units of cloth. After the opening up of international trade 1 unit of wheat will trade for __________ units of cloth. a.
1; 0.25
b. 4; 1. c.
1; 4.
d. 0; 2.5. ANSWER:
C
12. Refer to Figure 4.2. Before trade opens, the Rest of the World produces __________ yards of cloth and __________ units of wheat; while consuming __________ yards of cloth and __________ units of wheat. a. 10; 8; 8; 10 b. 4; 16; 8; 10 c. 8; 10; 12; 8 d. 8; 10; 8; 10 ANSWER: D 13. Refer to Figure 4.2. After trade, Canada produces __________ yards of cloth and __________ units of wheat and consumes __________ yards of cloth and __________ units of wheat. a. 20; 3; 12; 11 b. 12; 11; 12; 11 c. 20; 3; 20; 3 d. 16; 6; 12; 11 ANSWER: A 14. Refer to Figure 4.2. In autarky, the Rest of the World produces and consumes __________ yards of cloth and __________ units of wheat. In autarky Canada produces and consumes __________ yards of cloth and __________ units of wheat.
a. 8; 10; 20; 3 b. 8; 10; 16; 6 c. 4; 16; 20; 3 d. 12; 8; 12; 11 ANSWER: B Figure 4.2
15. Refer to Figure 4.2. Before trade, the total amount of cloth produced in the world was __________ yards and the total amount of wheat produced in the world was __________. a. 24; 19 b. 24; 16 c. 19; 24 d. 16; 24 ANSWER: B 16. Refer to Figure 4.2. As a result of specialization and trade, cloth production in the world is increased by __________ yards and wheat production is increased by __________ units.
a. 0; 3 b. 0; 0 c. 24; 19 d. 3; 0 ANSWER: A 17. Which of the following can explain why product prices in two countries will differ in a world with no trade? I.
Production conditions in the two countries are different and therefore the production-possibility curves in the two countries are different.
II.
Consumption conditions are different in the two countries and therefore the community indifference
curves in the two countries are different. III.
Trade would not be possible because the international price ratio would be the same in the two countries.
a. I and III b. II c. I and II d. I and II and III ANSWER:
C
18. A country whose ratio of capital to other factors of production is greater than the rest of the world’s ratio of capital to other factors of production is: a.
Relatively capital-intensive.
b. Relatively capital-abundant. c.
Running a trade deficit.
d. Operating at a point inside its production possibilities curve. ANSWER:
B
19. The United States is relatively capital-abundant because: a.
Capital costs more in the United States than in the rest of the world.
b. The United States has more capital than the rest of the world. c.
The United States produces more high-tech goods than the rest of the world.
d. The ratio of capital to other factors of production is greater in the United States than the rest of the world’s ratio of capital to other factors of production.
ANSWER:
D
20. Which of the following theories predicts that a country will export those goods that use the country’s abundant factor(s) intensively in production and import those goods that use the country’s scarce factor(s) intensively in
production? a. Absolute advantage. b. Comparative advantage. c. Heckscher-Ohlin theory. d. The production differentiation model. ANSWER:
C
21. If Country A is labor-abundant and capital-scarce, Country B is labor-scarce and capital-abundant, Good X is produced in a labor-intensive process, and Good Y is produced in a capital-intensive process, we would expect that: a. Country A would export Good X. b. Country B would import Good Y. c. Country A would import Good X. d. Country B would import bothGood X and Good Y. ANSWER: A 22. China has 20% of the world’s population but only 10% of the world’s farmable land. The Heckscher-Ohlin theory of
trade would predict which of the following for China following the opening of trade? a.
China will export land-intensive goods like wheat and import labor-intensive goods like clothing.
b. China will shift resources into the production of agricultural goods and away from manufactured goods. c.
China will shift resources out of the production of agricultural goods and into the production of laborintensive goods.
d. China will export capital-intensive goods like automobiles and import labor-intensive goods like clothing. ANSWER:
C
23. A product is relatively __________ if labor costs are a greater proportion of the product’s value than they are the value of other products. a. Capital-abundant b. Labor-abundant c. Capital-intensive d. Labor-intensive ANSWER: D 24. If Country A has a relatively higher ratio of labor to the other factors of production than does Country B, then: a. Country A is labor-abundant. b. Country A is labor-scarce. c. Country A is labor-intensive. d. Country B is labor-intensive. ANSWER: A 25. Given the following relationship: (U.K. land supply)
< (Rest of the world’s land supply)
(U.K. labor supply)
>
(Rest of the world’s labor supply)
One can conclude that: a. The U.K is labor abundant. b. The U.K. is labor intensive. c. The Rest of the World is labor abundant. d. The Rest of the World is land intensive. ANSWER: A 26. Which of the following economists proposed an international trade model that explains international trade patterns using factor proportions? a. Adam Smith b. David Ricardo c. Eli Heckscher and Bertil Ohlin d. Joseph Stiglitz ANSWER: C 27. Assume a two-country, two-good, two-factor of production world with the countries being the United States and the Rest of the World, the two goods being steel and wheat, and the two factors of production being capital and
land. If the United States was capital-abundant and steel production was capital-intensive, the Heckscher-Ohlin model would predict that the United States would export __________ and import __________. a.
Steel; wheat
b. Wheat; steel c.
Steel; steel
d. Wheat; wheat ANSWER:
A
28. Assume a two-country, two-good, two-factor of production world with the countries being the United States and the Rest of the World, the two goods being steel and wheat, and the two factors of production being capital and land. If the United States was capital-abundant and steel production was capital-intensive, the Heckscher-Ohlin model would predict that the Rest of the World would export __________ and import __________. a.
Steel; wheat
b. Wheat; steel c.
Steel; steel
d. Wheat; wheat ANSWER:
B
Use the following information to answer questions 29 thru 35. Assume a two-country, two-good, two-factor of production world where the following relationships hold: (K/L)US > (K/L)ROW (K/L)automobiles
> (K/L)shoes
Where (K/L)US is the capital-labor ratio in the UnitedStates, (K/L)ROW is the capital-labor ratio in the Rest of the World, (K/L)automobilesis the capital-labor ratio in the production of automobiles, and (K/L)shoes is the capital-labor ratio in the production of shoes. Assume further that technology and tastes are the same in the United States and the Rest of the World. 29. The relationships shown above indicate that the United States is: a.
A capital-intensive country.
b. Scarce in land. c.
A labor-abundant country.
d. A capital-abundant country. ANSWER:
D
30. The relationships shown above indicate that the production of shoes is: a.
Capital-intensive.
b. Labor-intensive. c.
Labor-abundant.
d. Capital-abundant. ANSWER: B 31. The relationships shown above indicate that in the United States the price of automobiles relative to shoes is: a.
Higher than in the Rest of the World.
b. Lower than in the Rest of the World. c.
The same as in the Rest of the World.
d. It is impossible to compare the prices with the information provided. ANSWER:
B
32. The relationships shown above indicate that the United States has a comparative advantage in the production of __________ while the Rest of the World has a comparative advantage in the production of __________. a.
Both goods; neither good
b. Shoes; automobiles c. Automobiles; shoes d. Neither good; both goods ANSWER:
C
33. According to the Heckscher-Ohlin model, the opening of trade between the United States and the Rest of the World should cause theUnited States to export __________ and import __________. a.
Both goods; neither good
b. Shoes; automobiles c.
Automobiles; shoes
d. Neither good; both goods ANSWER:
C
34. According to the Heckscher-Ohlin model, the opening of trade between the United States and the Rest of the World should cause the Rest of the World to export __________ and import __________. a.
Both goods; neither good
b. Shoes; automobiles c.
Automobiles; shoes
d. Neither good; both goods
ANSWER:
B
35. Trade between the United States and the Rest of the World would lead to: a.
An improvement in economic well-being in the United States but deterioration in economic well-being in the Rest of the World.
b. No change in economic well-being in the United States but an improvement in economic well-being in the Rest of the World. c.
An improvement in economic well-being in both the United States and in the Rest of the World.
d. Deterioration in economic well-being in the United States but an improvement in economic well-being in the Rest of the World. ANSWER:
C
Use the information below to answer questions 36 thru 38. The following cost data is for the mythical land of Painduvin where they produce nothing but bread and wine using only land and labor as inputs. 1 unit of Bread
1 unit of Cheese
Labor Input
5 dollars
20 dollars
Land Input
4 dollars
10 dollars
36. In Painduvin, bread is __________ and cheese is __________. a.
Labor-intensive; land-intensive
b. Land-intensive; labor-intensive c.
Labor-abundant; land-abundant
d. Land-abundant; labor-abundant ANSWER:
B
37. If Painduvin were land-abundant, the opening up of free trade would cause the price of bread relative to cheese to: a. Rise. b. Fall. c.
Stay the same.
d. Unable to answer with the information provided. ANSWER:
A
38. If Painduvin were land-abundant, the opening up of free trade would cause the production of bread to __________ and the production of cheese to __________. a.
Rise; rise
b. Rise; fall c.
Fall; fall
d. Fall; rise ANSWER:
B
Use the following information to answer questions 39 and 40. Puglia has 15 thousand acres of land and 45 thousand laborers, whereas the Rest of the World has 100 thousand acres of land 200 thousand laborers. These countries produce the labor intensive good A, and the land intensive good B. 39. Based on the above information, Pugelovia is relatively: a.
Labor-abundant.
b. Labor-intensive. c.
Land-abundant.
d. Land-intensive. ANSWER:
A
40. Based on the above information, Pugelovia will: a.
Not trade with the Rest of the World.
b. Export good B, and import good A. c.
Export good A, and import good B.
d. Import both good A and good B. ANSWER:
C
International Price = 1 C/W
41. Figure 4.2 illustrates the production possibilities curve of Pugelovia. This country can produce only wine and cheese, and trade these products with the rest of the world. Pugelovia’s production possibilities curve indicates
that this country has __________ marginal costs of production. a.
Constant
b. Increasing c.
Decreasing
d. Progressive ANSWER:
B
42. Refer to Figure 4.2. Pugelovia imports: a.
20 units of wine.
b. 20 units of cheese. c.
50 units of wine.
d. 80 units of cheese. ANSWER:
B
43. Refer to Figure 4.2. Pugelovia exports: a.
50 units of wine.
b. 50 units of cheese. c. 30 units of wine. d. 80 units of cheese.
ANSWER:
B
True/False Questions 44. Increasing-cost production-possibility curves are bowed out from the srcin. ANSWER:
TRUE
45. Increasing-cost production-possibility curves lead to partial specialization. ANSWER:
TRUE
46. In the two-country, two-good model, the opening of trade will necessarily lead to complete specialization in the production of one good by one country and complete specialization in the production of the other good by the other country. ANSWER: FALSE 47. Increasing marginal costs of production arise as a result of the fact that different inputs to production are used in different proportions in the production of different goods. ANSWER:
TRUE
48. As a country moves up along its “bowed -out” production possibility curve, the opportunity cost of producing more of the good on the y-axis decreases. ANSWER:
FALSE
49. The production-possibility curve does not provide enough information to determine the amount of each good produced by the economy. ANSWER:
TRUE
50. The comparison of the production-possibility curves of the two countries in the two-country, two-good model with constant-cost production-possibility curves is sufficient to determine the specialization point, but insufficient to determine the specialization point with increasing-cost production-possibility curves. ANSWER:
TRUE
51. Indifference curves show the various bundles of consumption quantities that lead to the same level of well-being. ANSWER:
TRUE
52. Heckscher-Ohlin theory relies upon the factor proportions used in the production of different goods and differences in the endowments of different factors in different countries to explain international trade patterns. ANSWER:
TRUE
53. If the proportion of labor to capital in a country is greater than the proportion of labor to capital in the rest of the world, we can conclude that the country is labor abundant and will have a comparative advantage in the production of goods that use capital intensively. ANSWER:
FALSE
54. If Country A is relatively abundant in labor and Country B is relatively abundant in capital, Heckscher-Ohlin’s theory predicts that Country A will export relatively labor-intensive goods and Country B will export relatively capitalintensive goods. ANSWER: TRUE 55. If Country A is relatively land-abundant and Country B is relatively labor-abundant, Heckscher-Ohlin theory predicts that Country A will export textiles (a relatively labor-intensive good) and Country B will export corn (a relatively
land-intensive good). ANSWER: FALSE 56. The Heckscher-Ohlin theory of trade differs from the Ricardian model by assuming that there are only two goods. ANSWER:
FALSE
57. In contrast to the Ricardian model, the Heckscher-Ohlin model assumes that production has increasing marginal costs. ANSWER:
TRUE
58. The community indifference curves illustrate the technological capabilities of a country. ANSWER: FALSE 59. The production possibilities curve illustrates the consumption preferences of a country’s population, and explains why all people prefer to be employed rather than unemployed. ANSWER:
FALSE
60. According to the Heckscher-Ohlin model, countries will engage in trade only if they have different production technologies. ANSWER:
FALSE
Essay Questions 61. Explain the differences between the two-country two-good model with constant costs of production and the model with increasing costs of production. Adequately describe the production possibilities curves for each country in each case. Describe production, consumption, and the degree of specialization in each country under both cost situations. POSSIBLE RESPONSE: If the cost of production of each good is constant, the opportunity cost of production of one good (in terms of production foregone of the other good) is also constant. In an economy with constant cost of production, the production possibilities curve (ppc) is a straight line. In such a situation it is beneficial for a country to fully specialize in the production of one good, and export this good in exchange for imports of the other good. The good that will be produced is the good with an opportunity cost that is lower than the relative international price of this good (the price of the good expressed in units of the other good). Conversely, the good with an opportunity cost higher than the international price will be imported. The result is complete specialization. This reasoning is behind Ricardo’s idea of comparative advantage and complete specialization. Ricardo assumed
that all goods are produced with one factor of production – labor, and in order to double the production of a –the labor hours. Realistically, however, product, a producer just needs to double the amount of the input factor
production requires a variety of factor inputs: land, skilled labor, unskilled labor, capital, etc., and different products use factor inputs in different proportions. The basic variation of these inputs leads to an increasing cost of production. That means the production possibilities curve is bowed out. In other words, the opportunity cost of production of one good is not constant but rather increasing with the increased production of this good. When a country is opened to trade only a partial specialization will be observed. 62. Explain why constant costs of production result in complete specialization and why increasing costs of production result in partial specialization. POSSIBLE RESPONSE: Constant cost of production implies constant opportunity cost, which is the amount of the
other good that must be foregone to increase the production of a certain good with one unit. If a good has a higher opportunity cost compared to the relative international price of this good, then it is beneficial for a country to produce the other good and export it in exchange for imports of this good. Because the opportunity cost does not change with the increased production of the other good, it will be beneficial for the country to completely specialize in the good with opportunity cost lower than the international price, and import the other good. With increasing cost of production, the opportunity cost of a good is increasing with the increased production. Optimally, the country will produce the two goods in such a proportion, that the opportunity cost is equal to the international price ratio. With increasing opportunity cost this implies a partial specialization. 63. Is the following statement true or false and why? “In the two-good, two-country model with increasing costs, the degree of specialization is determined only by considering society’s preferences as illustrated with indifference
curves. However, in the same model, it is possible to determine the post-trade consumption point in each country without indifference curves.” POSSIBLE RESPONSE: The community indifference curves reflect the preferences of the country’s consumers for
consumption of both goods. With or without trade, the production decision of a country will depend on the technology and the available factors of production (production possibilities curve), on the one hand, and the preferences of the consumers toward the consumption of the two goods (indifference curves) on the other hand. Without a free trade the consumption point coincides with the production. When international trade is allowed, the consumption point does not coincide with the production point anymore, but reflects both production and trade. It is not possible to determine post-trade consumption in each country without indifference curves as we will not know which consumption point is preferred by the consumers in the country. 64. Assume a two-country, two-good, two-factor of production world with the countries being the United States and the Rest of the World, the two goods being steel and wheat, and the two factors of production being capital and land. Further assume that the United States is capital-abundant and steel production is capital-intensive. Suppose that in autarky the United States operates at a point on its production possibilities curve where it produces 20 units of wheat and 20 units of steel. Once international trade opens, the international price of one unit of steel is two units of wheat. In response to the opening of trade the United States moves along its production possibilities curve to a new point where it produces 30 units of steel and 10 units of wheat. Is the United States better-off following the opening of trade? Provide a logical proof of your answer. POSSIBLE RESPONSE: The opening of trade allows the United States to (partially) specialize in the production of steel because steel is capital intensive and the United States is capital abundant. We need to compare the wellbeing of the United States in the case of autarky to the case of free trade. In autarky the United States would consume 20 units of steel and 20 units of wheat. When free trade is allowed, the United States can extend the production of steel to 30 units, that is, by 10 units. The foregone wheat is also 10 units; the production of wheat goes down from 20 to 10 units. But the United States can exchange steel for wheat in the proportion 1 unit of steel for 2 units of wheat. If the United States would sell the 10 more units of steel produced for 20 units of wheat, the United States would end up in a situation in which it consumes 30 units of wheat and 20 units of steel. This is better than the autarky situation of only 20 units of wheat and 20 units of steel. The country is thus better off in the case of free trade.
65. As a result of the North American Free Trade Agreement (NAFTA), trade restrictions between Canada, the United States, and Mexicowere eased and cross-border trade increased. What predictions would the Heckscher-Ohlin model make concerning the changes in labor-intensive industries such as textiles in both Mexico and the United States and in capital-intensive-industries such as steel production in both Mexico and the United States as a result of NAFTA? POSSIBLE RESPONSE: The Heckscher-Ohlin model predicts that free trade will allow countries to specialize in the production of goods that intensively use their relatively abundant factors of production. Applied to NAFTA, the Heckscher-Ohlin model implies thatMexico will extend its production in industries such as textiles as they require the intensive use of labor. The United States, on the other hand, will expand its production of steel, which is a capital-intensive industry. 66. Explain how tastes or preferences can reverse the predictions made by the Heckscher-Ohlin trade model so that, for example, labor-abundant countries import labor-intensive goods. POSSIBLE RESPONSE: The production decision of a country depends not only on the available factors of production, but also on the technology of the country, and the preferences of the consumers within the country. The preferences of consumers of this country as well as other countries define the international demand for a product. Conversely, factor availability, and technology define the international supply of a product. If consumers within a country value labor-intensive goods so much that the marginal satisfaction of this product is higher than the opportunity cost of production, then it possible that this country consumes more than their own production of labor-intensive goods, which means the country is importing these goods from other countries. 67. Using the concepts of community indifference curves and production possibilities frontier, explain how the international price of a good is determined in the Heckscher-Ohlin two goods model. What is the unit of measurement for the price of a good in this model? POSSIBLE RESPONSE: The production possibilities curve (ppc) illustrates the maximal quantities of two goods that a country can produce with full employment of its resources. What combination of quantities along the ppc producers will eventually decide to produce depends on the relative price of the good (the price is expressed in units of the other good). A community indifference curve indicates all combinations of quantities of the two goods, which provide the same satisfaction to the community. The ppc can be used to derive the marginal cost of a product (expressed in units of the other product to be given up), which defines the supply of this product. The system of indifference curves can be used to derive the demand of the product. The international price of a good in the Hecksher-Olin model is determined in such a way, that the excess supply in one of the countries is matched by the shortage (excess demand) in the other country. The first country exports the good in exchange for importing the other good. 68. Explain why the Heckscher-Olin model predicts only partial specialization in the production of two goods, while Ricardo’s comparative advantage model predicts full specialization.
POSSIBLE RESPONSE: Ricardo considered only labor as a production resource and believed that production has constant costs. That is, to double production, the producer just needs to employ twice as much labor. The opportunity cost in Ricardo’s model is constant, which implies that the production possibilities curve is a straight line. Assume that a country faces a relative international price of a product that is, let’s say, lower than the
opportunity cost of production of that product. That means, it is cheaper to buy that product at international market in exchange for the other product rather than use their own labor for producing it. Their own labor will be more efficiently employed in the production of the other product. Because the marginal cost is the same no matter how much of both products is produced, the country specializes fully in the production of the product that has a lower opportunity cost compared to the international price, and exchanges it for the other at the international market. This is the major difference to the Heckscher-Ohlin model. In this model, opportunity cost is increasing, so there will be a certain quantity combination of the two goods along the production possibilities curve, for which opportunity cost matches the relative (international) price. This is the optimal combination of production quantities for the country.
Multiple Choice Questions 1. Which of the following is NOT trueabout trade? a.
Trade will cause expansion in the export-oriented sector.
b.
Trade will cause contraction in the import-competing sector.
c.
Trade occurs because of similarities in the availability of factor inputs across countries and differences in the proportions of those factors that are used in producing different products.
d.
None of the above.
ANSWER: 2.
a.
Workers can change jobs but will receive the same wage.
b.
Workers will suffer from lower wages but land owners will benefit from higher rents.
c.
All groups tied to declining sectors of the economy will suffer from lower returns.
d.
Output remains constant.
ANSWER: 3.
C
According to the Stolper-Samuelson theorem, in the short-run, following the opening of trade:
C
According to the Heckscher-Ohlin theorem, in the short-run, following the opening of trade: a.
Inputs are mobile across sectors, but input returns remain constant.
b. Capital and labor will move to better-paying sectors. c.
Land owners will benefit from higher rents.
d. Workers will experience lower wages due to cheap imports. 4.
ANSWER: B The theory that predicts that trade occurs because of differences in the availability of factor inputs across countries and the differences in the proportions in which the factor inputs are used in producing different products is called: a.
The Stolper-Samuelson theory.
b. The Heckscher-Ohlin theory. c.
Comparative advantage.
d. Absolute advantage. ANSWER: 5.
B
Trade occurs because of __________ in the availability of factor inputs across countries and the differences in the proportions of those factors that are used in producing different goods. Trade causes __________ in the export-oriented sector and __________ in the importcompeting sector. a.
differences; expansion; contraction
b. similarities; expansion; contraction c.
similarities; contraction; expansion
d. differences; contraction; expansion ANSWER: 6.
A
In the long-run, following the opening of trade, a labor-abundant country will: a.
Employ less labor than it did pre-trade.
b. Produce goods using a higher land to labor ratio than it did pre-trade. c.
Produce goods using a lower land to labor ratio than it did pre-trade.
d. Experience higher rents and wages. ANSWER: 7.
C
The opening of trade between a land-abundant country and a labor-abundant country should lead to: a.
Higher rents and wages in both countries.
b. Lower rents and wages in both countries. c.
Higher rents in the labor-abundant country and higher wages in the land-abundant country.
d. Lower rents in the labor-abundant country and lower wages in the land-abundant country. ANSWER: 8.
D
Given the assumptions of theHeckscher-Ohlin model, the opening of trade in a land-abundant country will cause the domestic price of wheat to: a.
Fall.
b. Rise. c.
Be unaffected.
d. At first rise but then fall back to its srcinal level. ANSWER: 9.
B
The Stolper-Samuelson theorem states that given certain assumptions and conditions: a.
The real return to the factor used intensively in the import-competing industry will rise in the long-run.
b. The real return to the factor used intensively in the export industry will fall in the longrun. c.
The real return to the factor used in the rising price industry will rise in the long-run.
d. The real return to the factor used intensively in the export industry will rise in the longrun. ANSWER: 10.
D
If the domestic country is labor abundant, which of the following groups will gain in the shortrun, but lose in the long-run? b.
Domestic landowners in the farming sector. Domestic landowners in the cloth-making sector.
c.
Foreign landowners in the farming sector.
a.
d.
Foreign workers in the cloth-making sector.
ANSWER: 11.
B
The Stolper-Samuelson theorem would predict that trade between the United States, a capitalabundant country, and Mexico, a labor-abundant country, should lead to: a.
Higher wages in both countries.
b. Lower wages in both countries. c.
Higher wages in Mexico.
d. Lower wages in Mexico. 12.
ANSWER: C According to the factor-price-equalization theorem, free trade equalizes: a.
Product prices as well as the prices of individual factors of production between two countries.
b. Product prices between two countries but not the prices of individual factors of production. c.
Product prices between two countries and factor prices within each country but not between countries.
d. Product prices and factor prices within each country but not between countries. ANSWER: 13.
A
The factor-price-equalization theorem tells us that free trade between two countries should lead to: a.
All workers in the two countries earning the same wage rate.
b. All workers in the two countries having the same skill level. c.
All workers of the same skill level earning the same wage rate in the two countries.
d. All factors of production earning the same amount within each country. ANSWER: 14.
C
According to the Stolper-Samuelsom theorem , an increase in the price of a country’s imports would: a.
Lower the returns to all factors of production within the country.
b. Raise the returns to all factors of production within the country. c.
Lower the returns to the factor of production used relatively intensively in the importcompeting industry.
d. Raise the returns to the factor of production used relatively intensively in the importcompeting industry. ANSWER: 15.
D
According to the Stolper-Samuelsom theorem, a decreasein the price of a country’s exports would: e. Lower the returns to all factors of production within the country. a.
Raise the returns to all factors of production within the country.
b. Lower the returns to the factor of production used relatively intensively in the export industry. c.
Raise the returns to the factor of production used relatively intensively in the export industry.
ANSWER: 16.
C
With free trade, if Country X is relatively labor abundant and relatively land scarce and Country Y is relatively labor scarce and relatively land abundant, the factor-price equalization theorem predicts that: a. Land rents will rise in Country X and fall in Country Y until they equalize. b. Land rents will fall in Country X and rise in Country Y until they equalize. c.
Wages will rise in Country X and fall in Country Y until they equalize.
d. Both a and c. ANSWER:
A
Use the following information to answer questions 17 thru 22. The following cost data is for the mythical land of Painduvin, a capital-abundant country where they produce nothing but bread and wine using only capital and labor as inputs. 1 unit of Bread
17.
1 unit of Wine
Capital Input
5 euros
20 euros
Labor Input
4 euros
10 euros
Based on the information above, bread is __________ intensive and wine is __________ intensive? a.
Capital; labor
b. Capital; capital c.
Labor; capital
d. Labor; labor ANSWER: 18.
C
Painduvin has a comparative advantage in the production of: a.
Both bread and wine.
b. Neither bread nor wine. c.
Wine.
d. Bread. ANSWER: 19.
C
The opening up of free trade would cause the price of bread to __________ and the domestic price of wine to __________ in Painduvin. a.
Rise; fall
b. Fall; rise c. Rise; rise d. Fall; fall
ANSWER: 20.
B
Following the opening of trade, Painduvin would export __________ and import __________. a.
Bread; wine
b. Wine; bread c.
Both goods; neither good
d. Neither good; both goods ANSWER: 21.
B
If capital and labor were completelyimmobile within Painduvin (a short-run assumption), which group(s) in France would gain and which group(s) would lose from going from a situation of no trade to a situation of free trade? a.
Both capital and labor would gain.
b. Both capital and labor would lose. c.
Capital and labor in the bread industry would gain while capital and labor in the wine industry would lose.
d. Capital and labor in the bread industry would lose while capital and labor in the wine industry would gain. ANSWER: 22.
D
If capital and labor were completelymobile within Painduvin (a long-run assumption), which group(s) in France would gain and which group(s) would lose from going from a situation of no trade to a situation of free trade? a.
Capital would gain while labor would lose.
b. Capital would lose while labor would gain. c.
Capital and labor in the bread industry would gain while capital and labor in the wine industry would lose.
d. Capital and labor in the bread industry would lose while capital and labor in the wine industry would gain. ANSWER: 23.
A
When Wassily Leontief tested the predictions of the Heckscher-Ohlin theory, he found that in 1947 the United States was exporting relatively labor-intensive goods and importing relatively capital-intensive goods. This finding: a.
Contradicted the Heckscher-Ohlin theory as the United States was relatively capitalabundant.
b. Contradicted the Heckscher-Ohlin theory as the United States was relatively laborabundant. c.
Was never duplicated by other studies and has thus been labeled a paradox.
d. Fit the predictions of the Heckscher-Ohlin theory concerning the trading patterns of a capital-abundant country. ANSWER:
A
24.
Which of these facts contradicts the predictions of the Heckscher-Ohlin theory? a.
The United States is a net exporter of products that use highly skilled labor relatively intensively.
b. The United States is a net exporter of products that use farmland relatively intensively. c.
The United States is a net importer of certain natural resources such as petroleum.
d. The United States is a net importer of products that use capital relatively intensively. ANSWER: 25.
D
China is a net importer of: a. Shoes and other footwear. b. Scientific equipment. c.
Toys.
d. Clothing and accessories. ANSWERS:
B
Use the following information to answer questions 26 thru 34. Assume the standard trade model with two countries (Alpha and Beta), two goods (food and drink), and two factors of production (land and labor). Further assume that Alpha is relatively laborabundant and drink is relatively labor-intensive. 26.
The pre-trade relative wage rate (relative to land rents) in Alpha is __________ than the relative wage rate in Beta. a.
Greater
b. Less c.
Relative wages are the same in the two countries.
d. There is not enough information to answer. ANSWER: 27.
B
The pre-trade price of food in Alpha is __________ than the price of drink in Alpha while the pre-trade price of food in Beta is __________ than the price of drink in Beta. a.
Greater; greater
b. Less; less c.
Greater; less
d. Less; greater ANSWER: 28.
C
Alpha has a comparative advantage in the production of: a.
Drink.
b. Food. c.
Both goods.
d. Neither good. ANSWER: B 29.
Beta has a comparative advantage in the production of:
a.
Drink.
b. Food. c.
Both goods.
d. Neither good. ANSWER: 30.
A
When trade opens, Alpha will export __________ and import __________. a.
Food; drink
b. Drink; food c. Both goods; neither good d. Neither good; both goods ANSWER: 31.
B
When trade opens, Beta will export __________ and import __________. a.
Food; drink
b. Drink; food c.
Both goods; neither good
d. Neither good; both goods ANSWER: 32.
A
When trade opens, the price of food will __________ in Alpha and __________ in Beta. a.
Rise; rise
b. Rise; fall c.
Fall; fall
d. Fall; rise ANSWER: 33.
D
Which groups gain and which groups lose in the short-run following the opening of trade? a.
Workers in both countries gain while land owners in both countries lose.
b. Workers in both countries lose while land owners in both countries gain. c.
Workers and land owners in the food industry gain in Beta while workers and landowners in the drink industry lose in Beta.
d. Workers and land owners in the food industry gain in Alpha while workers and landowners in the drink industry lose in Alpha. ANSWER: 34.
C
Which groups gain and which groups l, ose in the long-run following the opening of trade? a.
<, /S, PAN>Workers in Alpha gain while land owners in Alpha lose.
b. Workers in Beta gain while land owners in Beta lose. c.
Workers and land owners in the food industry gain in Beta while workers and
landowners in the drink industry lose in Beta. d. Workers and land owners in the food industry gain in Alpha while workers and landowners in the drink industry lose in Alpha.
ANSWER: 35.
A
If the price of corn increases by 15% and the price of shoes remains constant, the StolperSamuelson theorem predicts that: a.
The rental rate of land increases by 15%.
b. The rental rate of land increases by more than 15%. c.
The wage rate will increase.
d. The wage rate will stay the same. ANSWER:
A
The following equations describe the long-run situation for prices and costs, where the numbers indicate the amounts of labor and land needed to produce a unit of wheat and cloth. w is the wage rate and r is the rental rate. Price of wheat = 1w + 2r Price of cloth = 2w + 1r 36.
The production of wheat is __________ intensive and the production of cloth is__________ intensive. a.
land; labor
b.
labor; land
c.
land; land
d.
labor, labor
ANSWER:
A
Assume that initially the price of wheat is $3 and the price of cloth is also $3. 37.
The wage rate w is __________ and the rental rate r is __________. a.
1; 1
b.
1; 2
c.
1/2; 1
d.
1/2; 1/2
ANSWER: 38.
A
The labor cost per unit of cloth output is __________ and the rental cost per unit of cloth output is __________. a.
3/2; 1/2
b.
1/2; 1
c.
2; 1
d.
1; 1
ANSWER: 39.
C
The labor cost per unit of wheat output is__________ and the rental cost per unit of wheat output is __________. a. 1/2; 3/2 b.
1; 1/2
c.
1; 2
d.
2; 2
ANSWER:
C
As a result of international trade the price of cloth now increases to $4. The price of wheat stays the same. Factor prices adjust to the new long-run situation. 40.
The new value for the wage rate w is __________ and the new value for the rental rate r is __________. a.
3/8; 7/8
b. c.
1/5; 2/5 5/3; 2/3
d.
4/7; 3/7
ANSWER: 41.
C
As a result of the change in the price of cloth, the purchasing power of labor income: a. Rises with respect to wheat and falls with respect to cloth. b. Rises with respect to both goods. c. Falls with respect to both goods. d.
Rises with respect to cloth and falls with respect to wheat.
ANSWER: 42.
B
As a result of the change in the price of cloth, the purchasing power of land income: a.
Rises with respect to automobiles and falls with respect to oranges.
b. Rises with respect to both goods. c.
Falls with respect to both goods.
d. Rises with respect to oranges and falls with respect to automobiles. ANSWER:
C
True/False Questions 43.
When factors of production move to better-paying sectors of the economy following the opening of trade, wages and rents will be bid back to their pre-trade levels.
ANSWER: 44.
FALSE
According to the Stolper-Samuelson theorem, the opening of trade will lead to lower real wages in a land-abundant country.
ANSWER: 45.
FALSE:
Trade makes some people absolutely better off and others absolutely worse off in each of the trading countries. However, the gainers and losers in the short-run are somewhat different from those in the long-run, because more adjustment can occur in the long-run.
ANSWER: 46.
TRUE
The factor-price equalization theorem implies that laborers will end up earning the same wage rate in all countries only if migration between the countries is allowed.
ANSWER:
FALSE
47.
International trade patterns are broadly consistent with the Heckscher-Ohlin prediction that nations tend to export the products that use their abundant factors intensively.
ANSWER: 48.
TRUE
While China’s exports are consistent with the predictions of the Heckscher -Ohlin theory, her imports are not.
ANSWER: 49.
FALSE
In the short-run after trade opens, wages and land rents can be expected to rise in the expanding sector.
ANSWER: TRUE 50. Free trade can be expected to cause a decrease in the real incomes of the owners of the factor used intensively in the import-competing industry. ANSWER: 51.
TRUE
Factor-price equalization theory predicts that the price of labor and land within a country will equalize.
ANSWER: 52.
ANSWER: 53.
FALSE
The United States is a net exporter of skilled labor. TRUE
The factor-price equalization theorem states that, with the opening of trade, wages across countries will equalize even though workers are not allowed to migrate.
ANSWER: 54.
TRUE
According to the specialized-factor patter, the more a factor is concentrated in the production of a product, the more it stands to gain from an increase of the price of this product.
ANSWER: 55.
TRUE
According to the Stolper-Samuelson theorem, there are gainers and loser within a country as a result of opening of free trade.
ANSWER: 56.
TRUE
According to the Stolper-Samuelson theorem, workers gain from opening of free trade only in the long run, and not in the short run, because wages will adjust only in the long run.
ANSWER: 57.
FALSE
In the long run, gainers and loser of trade are defined by the product sector they are employed in, rather than the factors of production they own.
ANSWER:
FALSE
Essay Questions 58.
Hollywoodland, being self-sufficient in most products, trades only two goods with the Rest of the World (ROW), movies and automobiles. Both of these goods are produced using skilled labor (L) and capital (K) with the returns to capital assumed to be the interest rate (r) and the returns to skilled labor being the wage rate (w). The production of automobiles is capital intensive relative to the production of movies and Hollywoodland is skilled-labor abundant
relative to the ROW. a.
State the Heckscher-Ohlin Theorem and use it to predict the pattern of trade between Hollywoodland and the ROW. POSSIBLE RESPONSE: According to the Heckscher-Ohlin theory, Hollywoodland will export movies, the relatively skilled-labor intensive product, and will import automobiles, the relatively capital intensive product. This is because Hollywoodland is rich in skilled labor and scarce in capital.
b. If the price of imports coming into Hollywoodland were to rise, what would happen to the factor returns in Hollywoodland? State the theorem used to come up with your answer and, briefly, the intuition behind the theorem. POSSIBLE RESPONSE: The effects of the rising price of imports are described by the Stolper-Samuelson theorem. When the price of automobiles rises, in long-run equilibrium, the real return to the factor used intensively in the rising-price industry (in this case capital) will rise, and the real return of the other factor (skilled labor) will fall. What is the intuition behind this theorem? When the price of automobiles rises, this will bid up the returns of at least one of the factors employed in the automobile industry. It is likely to raise the interest rate because capital is used intensively in the production of cars. On the other hand, the price of movies remains the same, and since the price reflects the returns on capital and skilled labor, the real wage must decrease. 59.
As a result of the North America Free Trade Agreement (NAFTA), the United States and Canadahave shifted to free trade with Mexico. Assuming that Mexico has an abundance of unskilled labor while the United States and Canada have an abundance of skilled labor, according to the Stolper-Samuelson theorem, how should this shift have affected the real wage of unskilled labor in Mexico and the real wage of unskilled labor in the United States and Canada? How should it have affected the real wage of skilled labor in Mexico and skilled labor in the United States and Canada? Clearly explain why wages will change in the way you have suggested. POSSIBLE RESPONSE: The North American Free Trade Agreement removes the trade barriers between Mexico, the United States, and Canada. The shift to free trade with Mexicoleads to an equalization of the product prices in these countries. The change in the product prices leads to a change in the prices of factors of production. Each country will export the goods which intensively use its abundant factors of production, and import the goods which use its scarce factors of production. In this particular case, Mexico will export goods which require the intensive use of unskilled labor, and will import the goods which require skilled labor in their production. Compared to the situation before the opening of trade, the price goods requiring the intensive use of unskilled labor will go up, and price of goods requiring intensive use of unskilled labor will go down. In the long run this will cause an adjustment in the return of the different factors of production. The Stolper-Samuelson theorem asserts that
wages of unskilled labor will increase in Mexico, and wages of skilled workers will decrease. The United States and Canada will experience the opposite trend. In its strong version, the Stolper-Samuelson theorem predicts that wages of skilled and unskilled workers will equalize across countries in the long run. 60.
The following equations describe the long-run situation for prices and costs, where the numbers indicate the amounts of labor and land needed to produce a unit of corn and toys. Pcorn = 80w + 40r Ptoys = 100w + 30r a.
If the price of corn is initially 200 and the price of toys is initially 200, what are the values for the wage rate w and the rental rate r? What is the labor cost per unit of corn output? Per unit of toys? What is the rental cost per unit of corn? Per unit of toys? POSSIBLE RESPONSE: To answer this question we need to simultaneously solve the equations: 200 = 80w + 40r 200 = 100w + 30r The solution is w=1.25 and r=2.5. The labor cost per unit of corn output is 80 x 1.25=100, and the labor cost per unit of toys is 100 x 1.25=125. The rental cost per unit of corn is 100, and the rental cost per unit of toys is 75.
b. The price of corn now increases to 240. The price of toys stays the same. What are the new values for w and r after adjustment to the new long-run situation? POSSIBLE RESPONSE: To answer this question we need now to simultaneously solve the equations: 240 = 80w + 40r 200 = 100w + 30r The solution is w=0.5 and r=5. c.
What is the change in the real wage (purchasing power of labor income) with respect to each good? Is the real wage higher or lower "on average"? What is the change in the real rental rate (purchasing power of land income) with respect to each good? Is the real rental rate higher or lower "on average"? POSSIBLE RESPONSE: When the initial value of the two goods is 200, the real wage with respect to corn is 1.25/200=0.0075, and with respect to toys is 1.25/200=0.0075. With the new value of corn being 240, the real wage with respect to corn is 0.5/240=0.002 and with respect to toys is 0.5/200=0.0025. The purchasing power of labor income decreases in terms of both goods. When the initial value of the two goods is 200, the real rental rate buys 2.5/200=0.0125 units of corn and 2.5/200=0.0125 units of toys. With the new value of corn being 240, the real rental rate buys 5/240=0.02 units of corn and 0.025 units of toys. The purchasing power of land income increases with respect to both goods.
d. Relate your conclusions in part c to the Stolper-Samuelson theorem. POSSIBLE RESPONSE: Our findings are consistent with the Stolper-Samuelson theorem. This theorem asserts that, as the price of corn increases, the real return (rent) of the factor used intensively in the production of corn (land) increases, and the real return (wage) of the factor used intensively in the production of toys (labor) falls. 61.
Outsourcing, the exporting of jobs from one country to another, was not an issue when the factorprice-equalization theory was developed. Does the existence of outsourcing change the implications of the theory? Why or why not? POSSIBLE RESPONSE: The theory of Heckscher and Ohlin, and the subsequent theory of Stolper and Samuelson did not assume that factors of production are mobile across countries. Yet, this is not the essence of their theory. The main objective of this theory is to demonstrate that factor prices (in particular, wages) will equalize across countries even if factors of production do not migrate from one country to another. Free trade alone is capable of generating this effect of factor price equalization. The new phenomenon of international outsourcing reinforces rather than contradicts this theory. International outsourcing, which is a process of shifting business activities abroad, can be considered a form of international trade whereby industrialized countries import services such as bookkeeping, call centers, software development, etc. from countries such as India and China. These countries are rich in factor intensively used in the production of these services (workers with particular skills). And just as the theory of Stolper and Samuelson predicts, the real wages of workers employed by those sectors in the U.S. will decrease, and the real wage of workers inChina and India will increase. This is the type of trend observed since international outsourcing leapt into prominence in the early 2000s.
62.
Country X is relatively labor abundant and relatively land scarce. Country Y is relatively labor scarce and relatively land abundant. The production of corn is relatively land intensive. The production of shoes is relatively labor intensive. Explain the short- and long-run effects on the incomes of: workers employed in the production of corn in each country, workers employed in the production of shoes in each country, land used in the production of corn in each country, and land used in the production of shoes in each country. POSSIBLE RESPONSE: The effect that will be observed in the short run as a result of opening to international trade is the equalization of the product prices in the two countries. Once prices have responded to free trade, the production in the two countries will respond to the new prices. Country X will extend its production of shoes and Country Y will extend its production of corn. In the short run, the resources in Country X involved in the production of shoes gain, and the resources involved in the production of corn lose. In Country Y the reverse trend is observed. The resources involved in the production of shoes lose, and the resources involved in the production of corn gain. In the long run, there will be change in the national factor markets in the two countries.
Because Country X exports shoes, and the production of shoes is labor-intensive, wages in Country X rise, and rent falls. In Country Y again the reverse trend is observed: wages will fall and rents will go up. 63.
Explain the weak and the strong form of the factor-price equalization theory of Heckscher and Ohlin, and discuss its real world relevance. POSSIBLE RESPONSE: According to the Heckscher-Ohlin theory, factor prices will equalize across countries as a result of free trade. That is, wages will become equal across countries, and the returns on capital will also equalize. There is little evidence in the world of this strong form of factor-price equality. The reason is that many assumptions of this model are not satisfied. Countries use different production technologies, trade is not completely free, e.g. countries impose different barriers to free trade (tariffs, quotas, etc.), and not all goods and services are traded internationally (e.g. haircuts, health care, etc.). The weak form of this theorem states that, as a result of opening of free trade, factor prices will tend to converge over time across countries. There is much more evidence for this form of factor price convergence. For instance, wage rates in the industrialized countries of Asia (e.g Singapore,South Korea) are approaching the ones in the Western countries for comparable types of worker skills.
Multiple Choice Questions 1. Comparative-advantage theory predicts that trade between similar industrialized countries should: a.
Be much greater than trade between dissimilar countries.
b. Be rather limited in size. c.
Consist mainly of high-technology goods.
d. Be bidirectional with one country exporting products to the other countries and simultaneously importing the same products from them. ANSWER:
B
2. Which of the following is two-way trade in which the country both exports and imports products that are the same or similar? a.
Net trade
b. Product differentiation trade. c.
Intra-industry trade.
d. Internal trade. ANSWER:
C
3. Which of the following is the formula for a product’s intra -industry trade (IIT) share? a.
1– X
b. 1 c.
M
(X + M)
1–[ X
M / (X + M)]
d. 1 – [ X + M / (X ANSWER: C
M)]
4. If the amount of exports of machinery from industrialized countries to the rest of the world equals 60 and the amount of imports of machinery into industrialized countries from the rest of the world is 40, the intra-industry trade share for machinery is: a.
0.2
b. 0.8 c.
1.5
d. .67 ANSWER:
B
5. Intra-Industry Trade: a.
Is mostly based on the differences stressed in the Heckscher-Ohlin trade theory.
b. Is rarely observed in the world today. c.
Occurs when the United States exports Ford automobiles and simultaneously imports Honda automobiles.
d. Occurs when the United States exports Ford automobiles and simultaneously imports
petroleum. ANSWER:
C
6. Which of the following can help explain the rise of intra-industry trade? a.
Recent recessions and increases in the price of oil have led to lower national income levels.
b. Demand for product variety has increased. c.
The evolution of service-based economies has led to smaller national manufacturing bases.
d. None of the above as intra-industry trade is decreasing, not increasing. ANSWER:
B
7. Which of the following is the value of the difference between exports and imports for a product? a. Net trade. b. Intra-industry trade. c.
Product differentiation.
d. Returns to scale. ANSWER:
A
8. Scale economies are present when: a.
An increase in output leads to an increase in average cost.
b. An increase in output has no impact on average cost. c.
An increase in output leads to a decrease in average cost.
d. Production is spread over many firms in an industry. ANSWER:
C
9. Internal scale economies occur when: a.
Firm growth leads to more specialization by workers.
b. Industry growth gives rise to better input markets. c.
Industry growth leads to a greater diffusion of knowledge among firms.
d. Firm growth drives up prices of some of the firm’s inputs. ANSWER:
A
10. When company X doubled its output, it found that its cost per unit had fallen by 10%. We can therefore conclude: a.
It enjoys external scale economies.
b. It enjoys internal scale economies. c.
Demand for its product is elastic.
d. It has a comparative advantage in production. ANSWER:
B
11. When the average cost of the typical firm declines as the output of the industry within a geographic area increases we call that: a. Internal scale economies. b. External scale economies. c.
Product differentiation.
d. Constant returns to scale. ANSWER:
B
12. The clustering of some industries, such as banking and finance in New York City and hightechnology computer production in Silicon Valley, can be explained by: a.
External scale economies.
b. Monopolistic competition. c.
Intra-industry trade.
d. The demand for variety. ANSWER: A 13. Which of the following is a market structure in which a large number of firms compete vigorously with each other in producing and selling varieties of a basic product? a.
Perfect competition.
b. Monopoly. c.
Oligopoly.
d. Monopolistic competition. ANSWER:
D
14. A monopolistically competitive firm: a.
Can expect to earn zero economic profits in the long-run.
b. Has the power to set its own price. c.
Produces a product that is different from that of its competitors.
d. All of the above are features of monopolistic competition. ANSWER:
D
15. After full adjustment to the opening of trade, a monopolistically competitive firm which enjoys scale economies will: a.
Get a higher price for its product.
b. Get a lower price for its product. c.
Ultimately earn higher profits.
d. Ultimately go out of business. ANSWER:
B
16. In a monopolistically competitive market, as the number of varieties increases, the price __________ because the demand for each variety becomes more __________. a.
increases; elastic
b. decreases; elastic c.
increases; inelastic
d. decreases; inelastic ANSWER: B 17. Which of the following is the basis for trade in a monopolistically competitive market? a.
External scale economies.
b. Comparative advantage. c.
Product differentiation.
d. Constant returns to scale. ANSWER:
C
18. In the case where trade is based on product differentiation: a.
The basis for exporting is the domestic production of unique models or varieties demanded by some consumers in foreign markets.
b. The basis for importing is that the price of the imports is the same as the price of domestic c.
products. The basis for importing is that foreign firms benefit from external scale economies.
d. Both (a) and (b) are correct. ANSWER:
A
19. Which of the following is NOT an effect of intra-industry trade with a monopolistically competitive market? a.
There are considerable national gains that arise from trade because there is an increase in the number of varieties of products available in the country.
b. There are national gains because the trade results in lower prices of domestic varieties. c.
Total output of the domestic industry increases as a result of trade.
d. There are few shifts in production between industries that would affect factor prices. ANSWER:
C
20. Which trade model posits that trade flows between countries will be larger as the economic sizes of the two countries are larger and the geographic distance between the two countries is smaller? a.
The Heckscher-Ohlin model.
b. The product differentiation model. c.
The gravity model.
d. The Stolper-Samuelson model. ANSWER:
C
21. The gravity model of international trade would predict larger trade flows between countries that: a.
Are more similar in population.
b. Are geographically farther from each other. c.
Are more dissimilar in economic size.
d. Are larger in combined economic size. ANSWER:
D
22. An oligopoly exists when: a.
A few firms supply much of the market.
b. A single firm supplies most of the market. c. Many small firms supply the market. d. Scale economies exist and are external to the firm, not internal to the firm.
ANSWER:
A
23. A major difference between trade with increasing costs and trade with external scale economies is that: a.
Consumers of imports lose with external scale economies and gain with increasing costs.
b. Consumers of imports gain with external scale economies and lose with increasing costs. c.
Consumers of exports lose with external scale economies and gain with increasing costs.
d. Consumers of exports gain with external scale economies and lose with increasing costs. ANSWER:
D
24. Which of the following statements about economic welfare in an industry with external economies after the initiation of trade is LEAST accurate? a.
Consumers in the exporting country lose consumer surplus.
b. Producers in importing countries lose producer surplus. c.
Consumers in the importing country gain consumer surplus.
d. Producers in the exporting country gain producer surplus. ANSWER:
A
25. In a prisoners’ dilemma for oligopoly pricing, firms: a.
Cooperate to maximize profits.
b. Cooperate to minimize losses. c.
Compete aggressively and earn high profits.
d. Compete aggressively and earn low profits. ANSWER:
D
26. Cooperation between firms is difficult because: a.
Firms gain more through competition.
b. Firms rarely have mutual interests. c.
Each firm has an incentive to “cheat” on the agreements made.
d. Product differentiation implies a different customer base. ANSWER:
C
27. Given established production at other locations, production of a product produced by a global oligopoly may not develop at a potentially lower-cost location because: a.
The production level at the new location would have to be large enough to gain the cost benefits of the scale economies.
b. Established firms at other locations may fight the entrant using various business strategies. c.
Gaining necessary market share may not be possible without an extended period of losses for the entrant.
d. All of the above. ANSWER: D 28. When external scale economies exist in an industry, new export opportunities will cause consumers in the exporting country to __________ surplus and consumers in the importing
country to __________ surplus. a.
Gain; gain
b. Gain; lose c.
Lose; lose
d. Lose; gain ANSWER:
A
29. When external scale economies exist in an industry, new export opportunities will probably cause producers in the exporting country to __________ surplus and producers in the importing country to __________ surplus. a. Gain; gain b. Gain; lose c.
Lose; lose
d. Lose; gain ANSWER:
B
30. Consumers of the exportable product in the exporting country gain when trade is based on: a.
Different national factor endowments.
b. Technological differences. c.
External scale economies.
d. None of the above. ANSWER:
C
31. Consumers of the importable product in the importing country gain when trade is based on: a.
Different national factor endowments.
b. Technological differences. c.
Internal scale economies.
d. All of the above. ANSWER:
D
32. Relative to standard competitive trade, trade based on monopolistic competition has __________ of an impact on producing firms and factor incomes. a.
More
b. Less c.
The same amount
d. An uncertain amount ANSWER:
B
33. Internal scale economies tend to lead to industries populated by __________ firms; external scale economies (with no internal scale economies) tend to lead to industries populated by __________ firms. a. Few; few b. Many; many
c.
Few; many
d. Many; many ANSWER:
C
Questions 34 thru 38 are based on the following information for the exports and imports of two imaginary countries (Pugelovia and Lindertania). Clothing
Exports ($billions)
Imports ($billions)
Automobiles
20
40
Pharmaceuticals 40
30 0
30
Lindertania:
Exports ($billions)
Imports ($billions)
Automobiles
0
20
Pharmaceuticals
40
40
Clothing
45
35
Pugelovia:
34. The weighted-average of the intra-industry trade (IIT) shares for Pugelovia’s trade in automobiles, pharmaceuticals and clothing is: a.
0.625
b. 2.000 c.
0.375
d. 1.286 ANSWER:
A
35. The weighted average of the intra-industry trade (IIT) shares for Lindertania’s tradein automobiles, pharmaceuticals and clothing is: a.
0.750
b. 2.000 c.
1.353
d. 0.250 ANSWER:
A
36. Lindertania has a higher intra-industry trade (IIT) share compared to Pugelovia for: a.
Automobiles only.
b. Pharmaceuticals only. c.
Clothing only.
d. Both pharmaceuticals and clothing. ANSWER:
C
37. In Lindertania, the product with the highest intra-industry trade (IIT) share is __________ and the product with the lowest IIT share is __________. a.
automobiles; pharmaceuticals
b. pharmaceuticals; automobiles c.
clothing; automobiles
d. clothing, pharmaceuticals ANSWER:
B
38. In Pugelovia, the product with the highest intra-industry trade (IIT) share is __________ and the product with the lowest IIT share is __________. a.
automobiles; pharmaceuticals
b. pharmaceuticals; clothing c. clothing; automobiles d. clothing, pharmaceuticals ANSWER:
B
True/False Questions 39. According to comparative-advantage theory, nations that are similar in their production-side capabilities (and in their general demand patterns) should trade little with each other. ANSWER:
TRUE
40. A large amount of intra-industry trade is not compatible with the comparative-advantage based theory of trade. ANSWER:
TRUE
41. Over time, Intra-Industry Trade has become smaller and smaller as a percentage of overall trade. ANSWER:
FALSE
42. Scale economies help explain why products are produced in a limited number of varieties. ANSWER:
TRUE
43. Exploiting substantial scale economies is an explanation of why some industries come to be categorized as monopolistic competition. ANSWER:
FALSE
44. If scale economies are substantial over a large range of output, we are likely to see a form of competition called “monopolistic competition.” ANSWER: FALSE 45. It is possible for the opening of trade to lead to lower prices charged by the exporting firm. ANSWER:
TRUE
46. Studies using the gravity model have found that countries that have a common currency trade more with each other. ANSWER:
TRUE
47. A significant gain from trade in an oligopolistic market results from the increase in the number of product varieties that trade brings. ANSWER: FALSE 48. If substantial scale economies exist, production tends to be concentrated in only a few countries. ANSWER:
TRUE
49. Countries that share a common language trade more with each other. ANSWER:
TRUE
50. Countries that have a higher degree of corruption trade more with other countries. ANSWER:
FALSE
51. Net trade for a product is the value of the difference between exports and imports for that product. ANSWER:
TRUE
52. In an oligopoly market firms vigorously compete with each other by selling different varieties of the same product. ANSWER: FALSE 53. The gravity model of international trade posits that trade flows between two countries will be larger, the larger the distance between the two countries, and the smaller the economic size of the two countries. ANSWER:
FALSE
Essay Questions 54. Carefully explain how, and under what conditions, an increase in foreign markets available toUnited States computer producers would lead to an increase in economic welfare for consumers of computers inside the United States. POSSIBLE RESPONSE: According to the standard competitive model of trade consumers in theU.S. cannot gain if U.S. computer producers start to export their product outside of the U.S. In fact, according to this model consumers will lose welfare as they will have to pay the higher international price for a computer. Chapter 6 introduces two explanations of why consumers of computers inside the United States can realize welfare gains due to the foreign markets available to the United States. The first explanation rests on the assumption that the computer industry is a monopolistically competitive one. The opening of trade in this industry leads to a greater variety of the computers available to U.S. consumers, and possibly lower prices caused by the additional competition from outside the United States. The second explanation rests on the assumption that there are external economies of scale in the computer industry. As the local computer industry expands, the production cost of computer decreases which eventually leads to a decline in the price of a computer that the U.S. consumer will pay. 55. Explain whether and why you would expect each of the following groups to gain or lose from trade with standard competition, monopolistic competition, and external scale economies. (A) The exporting country, overall POSSIBLE RESPONSE: Under all three forms of competition the exporting country gains because there is a net gain in surplus for the country. (B) Producers in the exporting country POSSIBLE RESPONSE: Under standard competition and external scale economies producing
firms gain. Under monopolistic competition producers might gain or lose, and this depends on the competition they face from foreign producers, including the loss of some domestic buyers who shift to buying foreign varieties. (C) Consumers in the exporting country POSSIBLE RESPONSE: Consumers of exported goods lose in the case of standard competition and gain in the case of monopolistic competition and external economies. (D) The importing country, overall POSSIBLE RESPONSE: The importing country stands to gain net surplus for all three kinds of trade. (E) Import-competing producers POSSIBLE RESPONSE: These producers lose in the cases of both standard competition and external scale economies. The effect is ambiguous in the case of monopolistic competition, because import-competing producers may also be able to export to foreign buyers. Their gain from selling to foreign customers might be larger or smaller compared to their losses to foreign competitors in the domestic market. (F) Consumers in the importing country POSSIBLE RESPONSE: Consumers in theimporting country gain for allthese kinds of trade. (G) The world as a whole POSSIBLE RESPONSE: The world as a whole gains for all these kinds of trade. 56. What role does luck or government policy play in determining which countries are exporters and which countries are importers in a global market with significant external scale economies? POSSIBLE RESPONSE: External scale economies exist when the average cost of a firm declines with the size of the entire industry within a specific geographic area. When external scale economies are present in an industry it is not easy to predict which areas will grow and export and which areas will shrink and cease production. Often historical luck and government policies play an important role in determining which location will develop to capture export markets and become the low-cost producer. 57. What is intra-industry trade? Is intra-industry trade consistent with the predictions of the Heckscher-Ohlin theory? Clearly explain why it is or is not consistent with Heckscher-Ohlin. POSSIBLE RESPONSE: Intra industry trade is a trade in which a country both exports and imports the same or a very similar product. Intra-industry trade is not generally consistent with the Heckscher-Ohlin theory. The Heckscher-Ohlin theory predicts that countries will export goods that extensively use their abundant resources and will import goods that extensively use their scarce resource. The Heckscher-Ohlin theory is suited to explain trade between developing and industrialized countries because they differ in their endowments of production resources. The Heckscher-Ohlin theory fails to explain why we observe so much trade among industrialized countries: 70% of the exports of industrialized countries go to other industrialized countries.
58. Explain the concept of scale economies. Explain the difference between internal and external scale economies. What are the consequences of opening trade in those industries with substantial external scale economies? POSSIBLE RESPONSE: Scale economies are realized when the increase in output outpaces the increase in the expenditures on all inputs in the production process. As an example, if we double all input factors, with scale economies the output will more than double. As a consequence, the average cost of production (cost per unit) will decline as output increases. Internal scale economies are observed when the expansion of the size of thefirm is the basis for the decline in its product’s average cost. In contrast, external scale economies arise if the average cost of production declines with an increase in the size of the entire industry within a specific geographic area. The presence of substantial external scale economies in an industry typically leads to the clustering of the production in specific geographical areas. Examples are the concentration of the banking and finance industries in London and New York City, the production of stylish clothing, shoes and accessories in Italy, watches in Switzerland, etc. External scale economies generally depend on the size of the entire industry in the location. Which are the locations that will prosper is difficult to predict and depends on factors such as domestic market size, history, government intervention, etc.
Multiple Choice Questions 1. A tax on imports that is stipulated as a money amount per unit is called: a.
A specific tariff.
b. An ad valorem tariff. c.
An effective tariff.
d. An optimal tariff. ANSWER:
A
2. A tariff generally __________ domestic producers of import-competing products and ____ domestic consumers of imports and import-competing goods. a.
Helps; helps
b. Hurts; hurts c.
Helps; hurts
d. Hurts; helps ANSWER:
C
3. A tariff allows domestic producers of import-competing goods to: I. Expand their own production and sales. II. Raise the price they charge. III. Begin to export their product. a.
I
b. I and II c. I, II, and III d. I and III ANSWER:
B
4. If a small country imposes a tariff on imported motorcycles, the world price of motorcycles will __________ and the domestic price of motorcycles will __________. a.
Rise; rise
b. Fall; rise c.
Stay constant; rise
d. Stay constant; fall ANSWER:
C
5. If a small country imposes a tariff on imported motorcycles, the surplus of domestic producers of motorcycles will __________ and the surplus of domestic consumers of motorcycles will __________. a.
Rise; rise
b. Fall; fall c.
Fall; rise
d. Rise; fall ANSWER:
D
6. Which of the following refers to the loss consumers in the importing country suffer based on their reduction in the consumption of a good after a tariff is imposed on that good? a.
Production effect.
b. Consumption effect. c.
Deadweight loss.
d. Consumer surplus. ANSWER: B 7. Which of the following refers to the extra cost of shifting to more expensive home production following the imposition of a tariff? a.
Production effect.
b. Consumption effect. c.
Deadweight loss.
d. Producer surplus. ANSWER:
A
Figure 8.1: The U.S. Market for Shoes Price
8. Referring to Figure 8.1, the impact of a tariff on shoes on the amount of domestic producer surplus is a __________ measured by area __________. a.
Gain; a
b. Loss; a c.
Gain; (a+b)
d. Loss; (a+b) ANSWER:
A
9. Referring to Figure 8.1, the impact of a tariff on shoes on the amount of domestic consumer surplus is a __________ measured by area __________. a.
Gain; d
b. Loss; d c.
loss; (a+b+c+d)
d. Loss; (b+d) ANSWER: C 10. Referring to Figure 8.1, the revenue collected by the U.S. government as a result of the tariff on shoes is shown by area __________. a.
a
b. a + b c.
c
d. b + c + d ANSWER:
C
11. Referring to Figure 8.1, the imposition of a tariff on shoes caused economic welfare in the U.S. to __________ by an amount measured by area __________. a.
Fall; c
b. Fall; (b+d) c.
Fall; (b+c+d)
d. Rise; (a+c) ANSWER:
B
12. Referring to Figure 8.1, what area measures the production effect of the tariff on shoes? a.
a
b. b c.
c
d. d ANSWER:
B
13. Referring to Figure 8.1, what area measures the consumption effect of the tariff on shoes? a.
a
b. b c.
c
d. d ANSWER:
D
Figure 8.2: The U.S. Market for Computers Price
$2,400
$2,000
14. Referring to Figure 8.2, under free-trade the U.S. imported __________ computers, but after imposing a tariff the U.S. imported __________ computers. a.
100,000; 70,000
b. 70,000; 100,000 c.
200,000; 190,000
d. 90,000; 100,000 ANSWER:
A
15. Referring to Figure 8.2, the imposition of a tariff on computers caused producer surplus to __________ by __________. a.
Rise; 20,000 computers
b. Rise; $44,000 c.
Rise; $44 million
d. Fall; $48 million ANSWER:
C
16. Referring to Figure 8.2, the imposition of a tariff on computers caused consumer surplus to __________ by __________.
a.
Fall; 10,000 computers
b. Fall; $40,000 c.
Rise; $76 million
d. Fall; $78 million ANSWER:
D
17. Referring to Figure 8.2, how much revenue will the U.S. government collect as a result of the tariff on computers? a.
$400,000
b. $40 million c.
$28 million
d. $76 million ANSWER: C 18. Referring to Figure 8.2, the imposition of a tariff on computers caused economic welfare in theU.S. to __________ by __________.
a.
Fall; 30,000 computers
b. Fall; $6 million c.
Rise; $34 million
d. Fall; $34 million ANSWER:
B
19. Referring to Figure 8.2, what is the production effect of the tariff on computers? a.
$48 million.
b. $4 million. c. $28 million. d. $44 million. ANSWER:
B
20. Referring to Figure 8.2, what is the consumption effect of the tariff on computers? a.
$2 million.
b. $4 million. c.
$76 million.
d. $78 million. ANSWER:
A
Use the following information to answer questions 21 thru 27. A small country is considering imposing a $5 per bottle tariff on imported wine. Economists have estimated the following figures based on this tariff amount: World price of wine (free trade): Domestic production (free trade): Domestic production (after tariff): Domestic consumption (free trade): Domestic consumption (after tariff):
$20 500,000 600,000 750,000 650,000
21. With no tariff on imported wine, the country’s imports__________ bottles of wine, but after imposing the tariff the country will import __________ bottles of wine. a.
100,000; 100,000
b. 250,000; 50,000 c.
150,000; 50,000
d. 750,000; 650,000 ANSWER:
B
22. The imposition of the tariff on wine will cause domestic producer surplus to __________ by __________: a.
Rise; 100,000 bottles
b. Rise; $500,000 c. Fall; $2.5 million d. Rise; $2.75 million
ANSWER:
D
23. The imposition of the tariff on wine will cause domestic consumer surplus to __________ by __________: a.
Fall; 100,000 bottles
b. Fall; $250,000 c.
Fall; $3.5 million
d. Rise; $3.5 million ANSWER:
C
24. The imposition of the tariff on wine will cause government tariff revenue to rise by how much? a. $250,000 b. $1.25 million c.
$3.5 million
d. $500,000 ANSWER:
A
25. The imposition of the tariff on wine will cause the country’s economic well -being to __________ by __________. a.
Fall; $0.5 million
b. Rise; $0.75 million c.
Fall; 100,000 bottles of wine
d. Fall; $0.75 million ANSWER:
A
26. What would be the production effect of the tariff on wine? a.
$250,000
b. $500,000 c.
$2.5 million
d. $2.75 million ANSWER:
A
27. What would be the consumption effect of the tariff on wine? a.
$250,000
b. $500,000 c.
$3.5 million
d. $2.75 million ANSWER:
A
28. Which of the following is a change in the ratio of international prices of a large country's exports to the international price of the large country's imports resulting from the imposition of a tariff in the country? a. One-dollar, one-vote. b. Production effect.
c.
Consumption effect.
d. Terms-of-trade effect. ANSWER:
D
29. Which of the following refers to the percentage by which a nation's trade barriers raise an industry's value added per unit of output? a.
One-dollar, one-vote.
b. Optimal tariff. c.
Effective tariff.
d. Terms-of-trade effect. ANSWER: C 30. Given the following information about domestic lamp production, what is the effective rate of protection afforded to the domestic lamp industry by a 20% tariff on lamps? With free trade: Unit value (price) of a lamp = $175.00 Unit cost of lamp inputs = $100.00 With 20% tariff on lamps: Unit value (price) of a lamp = $210.00 Unit cost of lamp inputs = $100.00 a.
20%
b. 46⅔% c.
110%
d. 102⅔% ANSWER:
B
31. At free-trade prices, a tennis racquet sells for $100 and contains $40 worth of aluminum inputs and $30 worth of plastic. In Country A, the nominal tariff rates are 40% on tennis racquets, 20% on aluminum, and 10% on plastic. Given these rates, what is the effective rate of protection on racquets in Country A? a.
40%
b. 63⅓% c.
10%
d. 96⅔% ANSWER:
D
32. Which of the following statements is accurate? I. Tariffs are likely to decrease world economic well-being. II. A tariff helps producers and hurts consumers in the country imposing the tariff. III. A tariff always decreases economic domestic well-being if imposed in a small country and may increase, decrease, or leave unchanged the economic well-being if imposed in a large country.
a.
I and II
b. I and III c.
II and III
d. I, II, and III ANSWER:
D
33. If a country with monopsony power imposes a tariff on imported farm equipment, the world price of farm equipment will: a.
Fall.
b. Rise. c. Be unaffected. d. Become equal to the domestic price of farm equipment. ANSWER:
A
34. An optimal tariff is __________ the more __________ the foreign export supply. a.
Higher; elastic
b. Lower; rigid c. d.
Higher; inelastic , ;&nbs, p;
Lower; inelastic
ANSWER:
C
35. A nation can gain from imposing a tariff if: a.
The tariff is a prohibitive tariff.
b. The tariff is an ad valorem tariff. c.
The tariff causes the world price to fall to such a degree that the amount of the tariff paid by foreign exporters exceeds the losses caused by the production and consumption effects.
d. The tariff causes the tariff revenue collected by the domestic government to exceed the losses caused by the production and consumption effects. ANSWER:
C
36. At free-trade prices, a bicycle sells for $100 and contains $90 worth of inputs. Country X has a nominal tariff rate of 15% on bicycles, and 10% on the inputs. Given these rates, what is the effective rate of protection of bicycles in Country X? a.
10%
b. 60% c.
5%
d. 15% ANSWER:
B
Use the following information to answer questions 37 thru 39. With free trade, a big country produces 1 million bikes per year and imports another 2 million bikes per year at the (world) price of $60 per bike. Assume that the country imposes a specific tariff of $5 per bike. As a result, the world price of a bike decreases to $58; the import of bicycles drops down to 1.6 million
bikes; and the domestic production increases to 1.1 million bikes. 37. After the country imposes the tariff, domestic consumers are paying a price of __________ for a bike. a.
$60
b. $70 c.
$63
d. $65 ANSWER:
C
38. As a result of the tariff, the government collects an amount of __________ million dollars in tax revenue. a.
2
b. 4 c.
6
d. 8 ANSWER:
D
39. As a result of the imposed tariff: a. The country gains national well-being because the tariff encourages production. b. The country loses national well-being because the tariff hurts consumers. c.
The country loses national well-being because tariffs always lead to a welfare loss.
d. The country gains national well-being because the amount of the tariff revenue paid by the exporting country more than offsets the consumption and the production effect. ANSWER:
D
40. The nationally optimal tariff is the tariff for which: a. The production effect is equal to the consumption effect. b.
The government collects the highest revenue.
c.
The highest difference between the government tariff revenue and the sum of consumption and production effect is attained.
d. The highest difference between the part of the tariff revenue paid by the exporting country and the welfare loss associated with the consumption and production effects is attained. ANSWER:
D
41. Which of the following has overseen the global rules of government policy toward international trade since 1995? a.
World Trade Organization.
b. General Agreement on Tariffs and Trade. c.
International Monetary Fund.
d. World Bank. ANSWER: A
True/False Questions
42. When a tariff is imposed, it is expected that domestic producers will raise their price to the same level as the price of the imported product after the tariff is imposed. ANSWER:
TRUE
43. A tariff always lowers the well-being of each nation, including the nation imposing the tariff. ANSWER:
FALSE
44. A tariff imposed by a small country hurts the tariff imposing country but brings gains to the rest of the world. ANSWER:
FALSE
45. The consumption effect shows the welfare loss to the economy resulting from consumers shifting from imports to more expensive domestic production. ANSWER:
FALSE
46. The one-dollar, one-vote metric says that every dollar of gain is more important than every dollar of loss, regardless of who the gainers or losers are. ANSWER:
FALSE
47. A nationally optimal tariff causes no production or consumption effects. ANSWER:
FALSE
48. The United Nations oversees global rules of government policy toward international trade. ANSWER:
FALSE
49. It is possible for a large country to be better off, worse off, or no better off/no worse off as a result of a tariff being imposed. ANSWER:
TRUE
50. For a small country, the consumption effect plus the production effect represent the loss in economic welfare that results from the imposition of the tariff. ANSWER:
TRUE
51. Monopsony power is a change in the ratio of international prices of a large country's exports to the international price of the large country's imports resulting from the imposition of a tariff by the country. ANSWER:
FALSE
52. A nationally optimal tariff is a tariff that creates the largest net gain for the country imposing it. ANSWER:
TRUE
53. Within a country, a tariff causes a redistribution of well being between domestic producers and the government only. ANSWER:
FALSE
54. A small country always stands to lose by imposing a tariff because the tariff will not have an impact on its terms of trade. ANSWER: TRUE 55. The effective rate of protection of a productmeasures how a country’s entire set of trade barriers
affects the value added per unit of output of this product. ANSWER:
TRUE
56. An ad valorem tariff is formulated as a money amount per unit of import that is due when the good reaches the importing country. ANSWER:
FALSE
57. The production effect measures the welfare gain of domestic producers which can sell their product at a higher price as a result of the imposed tariff. ANSWER:
FALSE
Essay Questions
58. Suppose that the world price of automobiles is $20,000 and domestic producers of automobiles use $10,000 worth of imported inputs and no domestic inputs. What is the effective rate of protection in the domestic automobile industry if there is a 25% tariff on imported automobiles and a 50% tariff on imported inputs? POSSIBLE RESPONSE: The effective rate of protection for an industry is measured as the percentage change in the unit value added which results from all protective measures on inputs and the final good. With free trade, the value added for an automobile is $20,000-$10,000=$10,000. With a 25% tariff on imported automobiles, the new price for an automobile rises to $25,000. Accounting for the tariff on imported inputs, the new value of the inputs is $15,000. The new value added for an automobile is $25,000-$15,000=$10,000. The effective rate of protection is then ($10,000$10,000)/$10,000=0%. 59. Compare and contrast the effects of a tariff on prices and national well-being imposed in a small country with the effects of a tariff imposed in a large country. Be sure to include carefully drawn graphs. POSSIBLE RESPONSE: Tariff by a small country
Tariff by a large country
A tariff imposed by a small country will not have an impact on the world price of the good. That is, the domestic price will rise by the amount of the tariff. A small country cannot gain by imposing a tariff. The welfare loss resulting from the tariff is measured by the sum of the production effect (area b) and the consumption effect (area d). As a result of the tariff, consumers lose the area (a+b+c+d), producers gain area (a), and the government collects the area (c) in tariff revenues. A tariff imposed by a large country will have an effect on the world price. As shown in the second graph, the world price will decrease once the tariff is imposed. The resulting effects on consumers and producers will essentially be the same as the above described effects. The difference (compared to the case of a small country) is the area (e) which measures the portion of the government tariff revenues that are effectively paid by foreigners. The burden of this part of the government tariff revenues is carried by the foreign producers who now export to the country at a lower price. Whether a large country eventually gains or loses from the tariff depends on whether
the gained area (e) is larger or smaller than the welfare loss associated with the area (b+d). 60. You are given the following information about copper in the United States: Situation
Situation
With Tariff World Price
Without Tariff
$0.40 per lb.
$0.50 per lb.
Tariff (specific)
$0.20 per lb.
0
U.S. Domestic Price
$0.60 per lb.
$0.50 per lb.
U.S. Consumption
210 million lb.
250 million lb.
U.S. Production 140 million lb. 100 million lb. a. Calculate the loss to U.S. consumers of copper from imposing the tariff. b.
Calculate the gain to U.S. producers of copper from imposing the tariff.
c.
Calculate the gain in tariff revenue to the U.S. government from imposing the tariff.
d.
Calculate the net gain or loss to the U.S. economy as a whole from imposing the tariff. POSSIBLE RESPONSE:
a.
As a result of the tariff the domestic price rises by $0.10 (from $0.50 to $0.60) per pound. Consumers consume 250-210=40 million pounds less. The consumption effect is ½ x $0.10 x 40 million = $2 million. Consumers lose additionally $0.10 x 210 million = $21 million due to the higher price they pay for their consumption after the tariff is imposed. They lose a total of $23 million.
b.
U.S. producers charge $0.10 more per pound and expand their production by 40 million pounds. Their gain of producer surplus from expanding the production quantity is ½ x $0.10 x 40 million= $2 million. Their gain from selling the production quantity they used to sell before the tariff now at a $0.10 higher price is 100 million x $0.10=$10 million. Their gain totals $12 million.
c.
The tariff revenue to the U.S. government equals the product of the imported quantity and the tariff per unit. After imposing the tariff the U.S. imports 210-140=70 million pounds. The U.S.revenue is $0.20 x 70 million= $14 million.
d.
The net gain of the U.S. as a whole is $14 million in government revenue minus $23 million in consumer loss, plus $12 million in producer gain, which equals $3 million.
61. A country can actually improve its well being if it is in a position to implement an “optimal tariff”. Explain what an optimal tariff is, what conditions must be in place in order to implement an optimal tariff, and how such a tariff will increase national welfare. Assuming your country could implement an optimal tariff, would you suggest it do so? Why or why not? POSSIBLE RESPONSE: An optimal tariff is a tariff which maximizes the welfare of a country as measured by the gain in tariff revenue that is essentially paid by foreigners to the government minus the loss associated with the consumption and production effects arising from the tariff. A country can gain by a tariff only if it is large enough to have an impact on the international price of the product. By imposing a tariff the country can improve its terms of trade, and may experience a net gain. One needs to exert caution when advising government officials on the
implementation of a tariff. Such a decision should incorporate the eventuality that importing countries retaliate by imposing trade restrictions on your country’s exports. . “The higher the tariff, the more domestic production is increased. Thus, a prohibitive tariff is socially optimal.” Comment on this statement drawing on all you have learned in the course up to now. POSSIBLE RESPONSE: The statement is based on the (false) premise that more domestic production is better than less. Also, the statement fails to account for the well-being of other agents in the economy who are not producers: the consumers who are interested in a lower price of the good, and the government, which is collecting revenue. Let us focus first on the decision of producers. It is true that the higher the tariff the higher the quantity supplied by domestic producers. However, for the society as a whole this production might be too costly. It involves valuable resources that can have a better use in other industries. The loss associated with such an inefficient production is the production effect. A prohibitive tariff will definitely be to the disadvantage of consumers because the consumers will not be able to consume imports at all. The consumption effect is the loss for consumers who buy less of the product. For the government, a prohibitive tariff generates no government revenues as there will be no imports of the good. 63. When a small country imposes a tariff, the domestic price of the good increases. This causes a “production” and a “consumption” effect. Explain carefully these two effects, and discuss whether they increase or decrease the country’s well-being. POSSIBLE RESPONSE: Small countries cannot affect the international prices of goods when they impose tariffs or other trade barriers. If a small country imposes a tariff, the domestic price of the product increases by the size of the tariff. This will have an effect on the decisions of domestic producers and consumers. Producers will start to produce more because they can now sell the product domestically at a higher price. Although producers stand to gain, this gain is at the expense of consumers who are paying a higher price. From the viewpoint of the society as a whole, this increase of production is a loss. The increased production costs more resources to make at home than to import from abroad. This loss is called the “production effect”. Consumers will start to consume less of the product due to its higher price although they value the product more than its international price (without the tariff). This is the source of the “consumption effect”, which is again a loss for the country.
Multiple Choice Questions 1. Protecting domestic producers against import competition: a.
Helps those producers.
b. Helps domestic consumers of the product. c.
Probably helps the importing nation as a whole.
d. All of the above. ANSWER:
A
2. A nontariff barrier operates by: a.
Limiting the quantity of imports.
b. Increasing the cost of getting imports to market. c.
Creating uncertainty about the conditions under which imports will be permitted.
d. All of the above. ANSWER:
D
3. One of the reasons that protectionists and government officials may favor using a quota instead of a tariff is: a.
Quotas generate more revenue for the government than do tariffs.
b. A quota ensures that the quantity of imports is strictly limited. c.
Quotas create less market distortions than do tariffs.
d. Quotas give less power to politicians than do tariffs. ANSWER:
B
4. A quota: a. Causes domestic prices to fall. b. Causes world prices to rise. c.
Restricts the quantity of a good that can be imported.
d. Is always more efficient than a tariff. ANSWER:
C
5. In the case of a small country, a quota and a tariff are (almost) identical if: a.
The government allocates licenses for free to importers using a rule or process that involves (almost) no resource cost.
b. The government auctions off licenses to the highest bidder. c.
The government allocates licenses to importers through application and selection procedures that require the use of substantial resources.
d. The government allocates import licenses directly to the public using a free lottery system. ANSWER:
B
6. Which of the following is a means of allocating import licenses by assigning the licenses without competition, applications, or negotiation?
a.
Fixed favoritism.
b. Resource-using application procedures. c.
Import-license auctions.
d. Domestic content requirements. ANSWER:
A
7. Which of the following requires that an import distributor buy a certain percentage of the product locally? a.
An import quota.
b. A mixing requirement. c. A voluntary export restraint. d. A domestic content requirement. ANSWER:
B
Figure 9.1: The. Market for MP3 Players in a Small Country Price
$90 $80
8. Referring to Figure 9.1, what is the amount allowed in the quota on MP3 players? a.
2 million MP3 players.
b. 5 million MP3 players. c.
12 million MP3 players.
d. 17 million MP3 players. ANSWER:
B
9. Referring to Figure 9.1, the quota on MP3 players will cause domestic producers to: a.
Gain $10 million.
b. Lose $10 million. c.
Gain $110 million.
d. Gain $120 million. ANSWER:
C
10. Referring to Figure 9.1, the quota on MP3 players will cause domestic consumers to: a.
Lose $25 million.
b. Gain $25 million. c.
Lose $170 million.
d. Lose $195 million. ANSWER:
D
11. Referring to Figure 9.1, with a competitive auction, how much revenue can the government expect to receive? a.
$20 million.
b. $50 million. c. $120 million. d. $170 million. ANSWER:
B
12. Referring to Figure 9.1, given that a competitive auction is used by the government to allocate import licenses, the quota on MP3 players will cause a __________ to the nation of __________. a.
Loss; $35 million
b. Loss; $85 million c.
Gain; $35 million
d. Loss; $195 million ANSWER:
A
13. Referring to Figure 9.1, if import licenses are allocated based on a resource-using application procedure, the loss to the economy will be: a.
$35 million.
b. $50 million. c.
$85 million.
d. $195 million. ANSWER:
C
14. Referring to Figure 9.1, if instead of using a quota to limit imports they were limited by a voluntary export restraint (VER), the loss to the nation would be: a.
$35 million.
b. $50 million. c.
$85 million.
d. $195 million. ANSWER:
C
15. A small country imports T-shirts. With free trade at a world price of $10, domestic production is 10 million T-shirts and domestic consumption is 42 million Tshirts. The country’s government now decides to impose a quota to limit T-shirt imports to 20 million per year. With the import quota in place, the domestic price rises to $12 per T-shirt and domestic production rises to 15 million T-shirts per year. This quota on T-shirts causes domestic producers to: a.
Gain $5 million.
b. Lose $5 million. c.
Gain $25 million.
d. Gain $30 million. ANSWER:
C
16. A small country imports T-shirts. With free trade at a world price of $10, domestic production is 10 million T-shirts and domestic consumption is 42 million T-shirts. The cou ntry’s government now decides to impose a quota to limit T-shirt imports to 20 million per year. With the import quota in place, the domestic price rises to $12 per T-shirt and domestic production rises to 15 million T-shirts per year. This quota on T-shirts causes domestic consumers to: a. Gain $7 million. b. Lose $7 million. c.
Lose $70 million.
d. Lose $77 million. ANSWER:
D
17. A small country imports T-shirts. With free trade at a world price of $10, domestic production is 10 million T-shirts and domestic consumption is 42 million Tshirts. The country’s government now decides to impose a quota to limit T-shirt imports to 20 million per year. With the import quota in place, the domestic price rises to $12 per T-shirt and domestic production rises to 15 million T-shirts per year. If the government uses a competitive auction to allocate import licenses, it will collect approximately how much in revenue? a.
$40 million.
<, ;, P class=MsoNormal style="MARGIN-LEFT: 54pt; TEXT-INDENT: -18pt; tab-stops: list 54.0pt; mso-list: l7 level2 lfo1">b.
$70 million. c.
$200 million.
d. $240 million. ANSWER:
A
18. A small country imports T-shirts. With free trade at a world price of $10, domestic production is 10 million T-shirts and domestic consumption is 42 million Tshirts. The country’s government now decides to impose a quota to limit T-shirt imports to 20 million per year. With the import quota in place, the domestic price rises to $12 per T-shirt and domestic production rises to 15 million T-shirts per year. This quota on T-shirts causes a __________ to the nation in the amount of __________. a.
Gain; $40 million
b. Loss; $12 million c.
Gain; $65 million
d. Loss; $5 million ANSWER: B 19. A small country imports T-shirts. With free trade at a world price of $10, domestic production is
10 million T-shirts and domestic consumption is 42 million Tshirts. The country’s government now decides to impose a quota to limit T-shirt imports to 20 million per year. With the import quota in place, the domestic price rises to $12 per T-shirt and domestic production rises to 15 million T-shirts per year. If import licenses are allocated based on fixed favoritism, how much will be gained by the holders of the import licenses? a.
$40 million.
b. $70 million. c.
$200 million.
d. $240 million. ANSWER: A 20. A small country imports T-shirts. With free trade at a world price of $10, domestic production is 10 million T-shirts and domestic consumption is 42 million Tshirts. The country’s government, in an attempt to protect domestic T-shirt producers, pressures foreign exporters to voluntarily restrict their exports of T-shirts to 20 million T-shirts per year. With the VER in place, the domestic price rises to $12 per T-shirt and domestic production rises to 15 million T-shirts per year. How much does the importing nation lose as a result of this VER? a.
$12 million.
b. $20 million. c.
$52 million.
d. $240 million. ANSWER:
C
21. A domestic monopoly would rather be protected with a quota than with a tariff because: a.
The deadweight loss will be smaller with a quota.
b. The monopolist can collect more from selling import licenses than it can from a tariff. c.
A quota is more efficient and thus lowers the cost s of the monopolist.
d. A quota allows the firm to assert its monopoly power. ANSWER:
D
22. An import quota is worse than a tariff under which of the following cases? I. If the quota licenses are allocated through resource using application procedures. II. If a dominant domestic firm can use the quota to assert its monopoly pricing power. III. If the domestic industry in the importing country is highly competitive. a.
I only
b. II only c.
I and II
d. I and III ANSWER: C 23. The least efficient method a government can use in allocating import licenses is:
a.
Fixed favoritism.
b. A competitive auction. c.
Resource-using application procedures.
d. A free lottery. ANSWER:
C
24. When a large country imposes an import quota: a.
World prices rise.
b. World prices fall. c. Domestic prices fall. d. Domestic production falls. ANSWER:
B
Figure 9.2: The. Market for Mopeds in a Large Country (a) The national market for Mopeds Price
$800 $750 $715
(b) The market for moped imports Price
$800 $750 $715
25. Referring to Figure 9.2, the illustrated quota on imported mopeds will cause domestic moped producers to gain: a.
$2.5 million.
b. $27.5 million.
c.
$42.5 million.
d. $80 million. ANSWER:
B
26. Referring to Figure 9.2, the illustrated quota on imported mopeds will cause domestic moped consumers to lose: a.
$7.5 million.
b. $21.25 million. c.
$82.5 million.
d. $97.75 million. ANSWER: C 27. Referring to Figure 9.2, if the government allocated import licenses using a competitive auction, the government will gain how much in license revenue? a.
$31.5 million.
b. $45 million. c.
$76.5 million.
d. $720 million. ANSWER:
C
28. Referring to Figure 9.2, the illustrated quota on imported mopeds will cause the importing nation to: a.
Lose $10 million.
b. Lose $29.75 million. c.
Gain $31.5 million.
d. Gain $21.5 million. ANSWER:
D
29. Referring to Figure 9.2, the illustrated quota on imported mopeds will cause the world to lose: a.
$7 million.
b. $10 million. c.
$17 million.
d. $31.5 million. ANSWER:
A
30. A voluntary export restraint (VER): a.
Ensures foreign exporting firms are unable to exercise monopoly power.
b. Usually requires the foreign exporting firms act like a cartel, restricting sales and raising prices. c.
Raises more revenue for the government than a tariff or quota.
d. Lowers world prices. ANSWER: B 31. With a voluntary export restraint (VER), the economic rent created by the quantitative limit on
trade is collected by: a.
The government of the importing county.
b. Consumers in the importing country. c.
Producers in the importing country.
d. Exporting firms in the exporting country. ANSWER:
D
32. Suppose a country sets all of its tariffs at 40% which causes a reduction in imports of 20%. If the total imports affected by the tariffs are 40% of GDP, the net national loss from the tariffs as a percentage of GDP is: a. 1.6%. b. 8%. c.
16%.
d. 160%. ANSWER:
A
33. Which of the following allows the pre, sident of t, he United States to negotiate to eliminate unfair trade practices put in place by foreign governments? a.
World Trade Organization.
b. General Agreement on Tariffs and Trade. c.
Section 301.
d. United Nations. ANSWER:
C
34. Which of the following is an effect of the Uruguay Round? I. The Uruguay Round included provisions for future negotiations to liberalize trade in services. II. The Uruguay Round included agreement requiring member countries to protect intellectual property. III. The Uruguay Round included the conversion of import quotas in agricultural products to import tariffs. a.
I
b. I and II c.
II and III
d. I, II, and III ANSWER:
D
35. The cost of protection as a percentage of GDP is often calculated by the following formula:
a.
. This formula illustrates: The monetary payment that a country has to make for the imported goods.
b. The loss to domestic producers due to the reduction in domestic production as a result of
the imports. c.
The production and the consumption effects.
d. The tariff revenue of the government. ANSWER:
C
36. If calculated by the formula:
,
the cost of protection as a percentage of GDP can be underestimated because the formula does not consider: a. The production effect. b. The consumption effect. c.
The tariff revenue of the government.
d. The enforcement cost of the government. ANSWER:
D
37. Which one of the following measures is not classified as an NTB? a.
Import quota.
b. Voluntary export restraint. c.
Tariff.
d. Domestic content requirement. ANSWER:
C
38. A country might prefer to use a tariff instead of a quota because: a.
The tariff ensures that the quantity of the imports is strictly limited.
b. The tariff gives a higher leverage of the country to improve its terms of trade. c. The tariff favors domestic producers more than the quota. d. The tariff gives government officials less power which they can use to collect bribes. ANSWER:
D
39. Governments choose to use Voluntary Export Restraints rather than tariffs because: a.
Voluntary Export Restraints have the potential to generate higher revenue.
b. Voluntary Export Restraints do not create consumption and production effects. c.
Tariffs might violate the international rules of the WTO.
d. When Voluntary Export Restraints are used, the actions of all economic agents are voluntary. ANSWER:
C
True/False Questions 40. As tariffs have declined, the use of nontariff import barriers to provide protection has increased. ANSWER:
TRUE
41. Unlike a tariff, a quota does not cause either a production effect or a consumption effect. ANSWER: FALSE 42. A tariff allows a domestic monopolist to assert its monopoly power. A quota does not.
ANSWER:
FALSE
43. Exporting firms suffer greatly when hit with voluntary export restraints. ANSWER:
FALSE
44. The mark-up revenue from a quota will be captured by the government if the government auctions off import licenses. ANSWER:
TRUE
45. For a country trying to reduce the levels of imports in an economy, an import tariff is likely to have less negative economic welfare effects than a voluntary export restraint. ANSWER: TRUE 46. While a large country can be either better off or worse off as a result of the imposition of a tariff, that same country will necessarily be worse off as a result of imposing an equivalent import quota. ANSWER:
FALSE
47. Resource-using application procedures will allow the government to assign import licenses in such a way as to recoup most of the revenue that the government would have otherwise received if a tariff had been imposed rather than the import quota. ANSWER:
FALSE
48. Section 301 allows the president to negotiate to eliminate unfair trade practices of foreign governments. ANSWER:
TRUE
49. Compared to a tariff, a quota gives the government a better control over the quantity of imports. ANSWER:
TRUE
50. Voluntary Export Restraints bring the importing country a bigger national gain than a tariff. ANSWER:
FALSE
51. Section 301 gives the president of the United States the right to impose trade restrictions on other countries if they are considered beneficial to the U.S. economy. ANSWER:
FALSE
52. The use of quotas and tariffs can inhibit the incentive of domestic producers to innovate and reduce the variety of products available in the domestic market. ANSWER:
TRUE
53. The use of a trade restriction by one country can cause other countries to retaliate, and may lead to a trade war in which all countries use high import barriers. ANSWER:
TRUE
54. Tarrification is the process of converting non-tariff barriers to trade, e.g. quotas, into tariff rates. ANSWER:
TRUE
Essay Questions 55. Why is the true cost of import protection generally larger than what is shown in the simple graphs from your textbook or as calculated by the net national loss formula derived in your textbook? POSSIBLE RESPONSE: The formula and the graph in the textbook describe only the direct costs
associated with the production and the consumption effect. These effects result from the rise in the domestic price of the product associated with the tariff, and reduce a country’s well -being. Imposing the tariff, however, can bring about additional, indirect effects. First, imposing a tariff might cause some countries exporting the product to retaliate and erect trade barriers on their own. In the worst scenario this can lead to a trade war in which all countries maintain high entry barriers. Second, maintaining the trade barriers is associated with enforcement and rent-seeking costs within the country. Third, in the case of Voluntary Export Restraints, foreign exporters are allowed to charge a higher price for their product, thus putting domestic consumers at a further disadvantage. Finally, the (over) protection of domestic producers might lead to a lack of innovation and eventually a decrease in the variety of the products available in the domestic market. 56. Your government is presently deciding whether or not to protect the domestic automobile industry. Are domestic steel-producing firms in favor of policies designed to protect the local automobile producers? Why or why not? POSSIBLE RESPONSE: Steel is a major input in the automotive industry. The automobile industry is a major consumer of steel, so the demand for steel is linked to the demand for automobiles. In particular, it can be expected that the protection of local automotive producers will keep the local production of automobiles high, which means there will be a high demand for steel locally. This benefits domestic steel-producing firms, so they will be in favor of such government policy. 57. If there is only one domestic automobile producer will there be a difference in terms of national economic well-being between using a tariff and using a quota to protect the producer? If so, what is the difference? Clearly explain your answer. POSSIBLE RESPONSE: With free trade the monopolist will lose its monopoly power completely. Facing perfect competition from foreign producers, the monopoly will turn into a price taker that charges the international price. To what extent do an import quota and a tariff restore the monopoly position of the single domestic producer? If a tariff is imposed, the domestic producer will be able to charge a price equal to the world price plus the markup associated with the tariff, but the producer will still to be a price taker. When an import quota is used, the domestic producer will be able to determine the domestic price of the product by deciding how much to produce. A profit maximizing monopoly will decide on its production quantity in such a way that the marginal revenue from the last unit produced equals the marginal cost of production. In comparison to a tariff which brings the same quantity of imports, the quota is more beneficial to the monopolist. It will, however lead to a higher price for domestic consumers and a higher deadweight loss to the society. 58. If the government decides to use a quota, what method do you think the government should use to allocate import licenses:a fixed favoritism, acompetitive auction, or sometype of resourceusing allocation process? Clearly explain your reasoning being sure to articulate the differences in these allocation schemes.
POSSIBLE RESPONSE: The allocation of import licenses on the basis of fixed favoritism means that the government simply assigns the licenses to firms without competition, applications or negotiations. In this case the importers who receive the licenses realize gains from the difference between the domestic and the international price of the product. This method does not create any additional inefficiency beyond the deadweight loss associated with the tariff. Yet, it also does not generate revenue for the government. Revenue for the government will be generated if the licenses are allocated in an auction. The auction is a bidding process in which firms compete for the licenses by specifying the amount they want to pay, and the licenses are awarded to the highest bidders. Importing firms are willing to pay in order to acquire licenses because they will realize gains from the difference between the domestic and the international price of the imported product. Instead of holding an auction the government can also require that firms compete for the licenses in some way other than simple bidding or bribing. Resource-using application procedures include allocating the quota licenses on a first-come-first-serve basis, on the basis of demonstrating need, worthiness, negotiations, etc. Resource-using procedures encourage rent-seeking activities and are wasteful. For the country as a whole, resource-using procedures are the most inefficient method because the resources used in rent-seeking are drawn away from producing something that is truly valuable for society. 59. Explain how the cost of a tariff for a country is calculated as a percentage of GDP. Which effects are captured in the formula presented in your textbook? Discuss the additional costs which might arise for a county besides the ones captured by the formula. POSSIBLE RESPONSE: The immediate economic cost of a tariff arises from the production and the consumption effects resulting from the change in the domestic price of the product. The consumption effect is the deadweight loss associated with the lower consumption of the good due to the increased price. The production effect is the additional inefficiency arising due to the shift of production from abroad to the domestic market. If demand and supply are assumed to be straight lines, the production and the consumption effect have the form of a triangle. Their areas can be measured as one half times the product of the base and the height of each triangle. The base of these triangles is the change in the production and consumption of the product, and the height is the size of the tariff (in dollars). The formula gives an estimate of the deadweight loss as a percentage of GDP. There might be additional indirect costs that arise in the country imposing a tariff. Such a tariff might lead to a retaliation by countries against which the tariff is imposed, and eventually to trade wars in which all countries use high protective measures. Other costs are, for example, the enforcement cost and the rent-seeking cost. These activities associated with the tariff take productive resources that can potentially be employed elsewhere. Additionally, the use of tariffs might cause a slowdown of innovation, and a reduced variety of the product available in the domestic market.
Multiple Choice Questions 1. Which of the following is NOT an expected effect of a tariff or nontariff barrier (NTB) on a product? a.
An increase in domestic production of the product.
b. An increase in the employment of labor and other resources used in the domestic production of the product on which the tariff or NTB is being imposed. c. An increase in domestic consumption of the product. d. An increase in government revenue. ANSWER:
C
2. If there is something extra bad about local consumption of a product, then a tariff can be good for the country because: a.
The tariff makes all residents richer.
b. The tariff brings down the domestic price of the product. c.
The tariff leads to higher domestic prices for the product.
d. The tariff revenue is invested in the production of substitute products. ANSWER:
C
3. In a “first-best” world: a.
Free trade is not optimal.
b. Free trade is economically efficient. c.
Free trade benefits everyone.
d. Free trade harms everyone. ANSWER:
B
4. A “first-best” world is one in which:
a.
Social marginal benefit(SMB) > Price (P) = Buyer’s private marginal benefit (MB) = Seller’s private marginal cost (MC) = Social marginal cost (SMC)
b. Social marginal cost (SMC) > Price (P) = Buyer’s private marginal benefit (MB) = Seller’s private marginal cost (MC) = Social marginal benefit (SMB) c.
Price (P) = Buyer’s private marginal benefit (MB) = Seller’s private marginal cost (MC) = Social marginal cost (SMC) = Social marginal benefit (SMB)
d. Social marginal benefit (SMB) > Social marginal cost (SMC) ANSWER:
C
5. If Social marginal cost (SMC) > Price (P) = Buyer’s private marginal benefit (MB) = Seller’s private marginal cost (MC) = Social marginal benefit (SMB): a.
Too much is supplied.
b. Too little is supplied. c.
The socially optimal amount is supplied.
d. Firms are not maximizing profits. ANSWER:
A
6. If Social marginal benefit (SMB) > Price (P) = Buyer’s private marginal benefit (MB) = Seller’s private marginal cost (MC) = Social marginal cost (SMC): a.
Too much is supplied.
b. Too little is supplied. c.
The socially optimal amount is supplied.
d. Firms are not maximizing profits. ANSWER:
B
7. In a “second-best” world: a.
Tariffs are economically optimal.
b. Private actions are dictated by government agencies. c.
Private marginal cost exceeds private marginal benefit.
d. Private actions will not lead to the best possible outcomes for society. ANSWER:
D
8. In a second-best world, there are: a.
Incentive distortions.
b. Externalities. c.
Spillover effects.
d. All of the above. ANSWER:
D
9. Which of the following statements reflects a situation in which there are external benefits? I. John's decision to get vaccinated for smallpox reduces the chances that his neighbor Pete will get smallpox. II. John pays for a professional fireworks show for his family. The neighbors also enjoy the show.
III. John paints his house and cleans his brushes in the stream. The solvent John uses to clean his brushes kills the fish and fishermen who previously had enjoyed fishing from the stream are unable to catch any fish. a.
I only.
b. II only. c.
I and II only.
d. I, II, and III. ANSWER:
C
10. Which of the following statements reflects a situation in which there are external costs? I. John has a birthday party in his dorm room. His loud music keeps his neighbor awake all night causing him to fail a midterm the next day. II. John paints his house and landscapes his yard. His newly beautified house and yard help his neighbors sell their house for more than the asking price. III. John paints his house and cleans his brushes in the stream. The solvent John uses to clean his brushes kills the fish and fishermen who previously had enjoyed fishing from the stream are unable to catch any fish. a.
I only.
b. II only. c.
I and II only.
d. I, II, and III. ANSWER:
D
11. Which of the following is a plausible solution to a distortion? I. Impose a tax or subsidy in order to adjust for the fact that either SMB or SMC exceeds price. II. Rearrange property rights in order to make the decision makers consider the distorting effects when making their decisions. III. Impose an importation ban. a.
I only
b. II only. c.
I and II
d. I, II, and III ANSWER:
C
12. Suppose that an unfortunate side-effect of the production of paper is ground water pollution. One possible policy that could be employed to fix this externality is: a.
A subsidy for the production of paper.
b. A tax on the production of paper. c. A tariff on paper imports. d. Private ownership of paper mills. ANSWER:
B
13. Suppose that the domestic production of computer games not only creates enjoyment for those who play the games, it also creates knowledge that spills into and positively impacts many other industries. One possible policy that could be employed to encourage increased production of computer games is: a.
Tariff on computer game imports.
b. A tax on the production of computer games. c.
A tax on the consumption of computer games.
d. The elimination of all restrictions on the importation of computer games. ANSWER: A 14. The __________ states that if a distortion is present,, the most effi, cient way to eliminate the discrepancy between social and private benefits or costs is to use a policy tool that is directed at the source of the distortion. a.
Direction rule.
b. Spillover effect. c.
Distortion incentive.
d. Specificity rule. ANSWER:
D
15. Suppose that the training, skills, and attitudes received by employees in the computer gaming development industry have positive spillover effects as workers leave the industry and move on to other jobs. The specificity rule suggests that the best way to achieve more employment in this industry is to: a.
Impose a tariff on the importation of computer games.
b. Remove all sales taxes from the purchases of computer games. c.
Give computer game developers a subsidy tied to their level of employment.
d. Subsidize production of computer games. ANSWER:
C
Figure 10.1: The. Market for Mopeds (a) The national market for mopeds Price
800 750
(b) The marginal benefits from domestic moped production Marginal Benefit $140 $125
16. Refer to Figure 10.1 and assume that a $50 per unit tariff is imposed on imported mopeds. What is the production effect caused by the tariff? a.
$14 million.
b. $2.5 million. c.
$5 million.
d. $7.5 million. ANSWER:
B
17. Refer to Figure 10.1 and assume that a $50 per unit tariff is imposed on imported mopeds. What is the consumpti on ef fect caused by the tariff? a. $14 million. b. $2.5 million. c.
$5 million.
d. $7.5 million. ANSWER:
C
18. Referring to Figure 10.1, if a $50 per unit tariff on imported mopeds were imposed, the marginal benefit to the nation of the increased production of moped is: a.
$14 million.
b. $2.5 million. c.
$5 million.
d. $7.5 million. ANSWER:
A
19. Referring to Figure 10.1, if a $50 per unit tariff on imported mopeds were imposed, the overall impact on the nation would be: a.
A gain of $14 million.
b. A loss of $21.5 million. c.
A gain of $6.5 million.
d. A loss of $7.5 million. ANSWER:
C
20. Referring to Figure 10.1, if a $50 per unit subsidy was given to domestic producers of mopeds, production would increase by: a.
100,000 units.
b. 500,000 units. c. 600,000 units. d. 1.2 million units. ANSWER:
A
21. Referring to Figure 10.1, if a $50 per unit subsidy was given to domestic producers of mopeds, consumption of mopeds would fall by: a.
100,000 units.
b. 200,000 units. c.
600,000 units.
d. Consumption would not change as a result of the subsidy. ANSWER:
D
22. Referring to Figure 10.1, in comparing a $50 per unit tariff on imported mopeds with a $50 per unit subsidy on domestic production of mopeds, we can conclude that the nation is __________ better-off with a __________. a.
$2.5 million; tariff
b. $2.5 million; subsidy c.
$14 million; subsidy
d. $7.5 million; subsidy ANSWER:
B
23. Which of the following arguments for protection postures that temporary protection is needed for an industry with initially high costs and lower costs in the long run? a.
The developing government argument.
b. The infant industry argument. c.
The dying industry argument.
d. The national defense argument. ANSWER:
B
24. Subsidies mean that infant industry firms can likely charge: a.
Higher prices while competing with foreign firms.
b. Higher prices than foreign firms are able to receive. c. A price equal to the world price and still earn a profit. d. The foreign tariff to other customers of the foreign firm.
ANSWER:
C
25. Which of the following distortions makes the infant industry argument for protection valid? a.
Imperfections in developing financial markets might mean that banks and other institutions are unwilling to provide funding to firms in an infant industry.
b. The benefits from the early business investments do not accrue to the firms making these early investments. c.
Young firms that produce important military hardware cannot be established without government support.
d. Both (a) and (b). ANSWER: D 26. Which of the following statements is true? I. If young firms are struggling to obtain funding from underdeveloped financial markets, the most efficient policy solution would be a production subsidy. II. If young firms are struggling to retain their trained workers, then government should offer a subsidy to offset the costs of training workers. III. Infant industry tariffs are less likely to be removed than infant industry subsidies. a.
I only
b. I and II c.
II and III
d. II only ANSWER:
C
27. Which of the following arguments for protection states that import-competing firms that are struggling to stay in business should be provided protection in order to maintain jobs and continue domestic production? a.
The developing government argument.
b. The infant industry argument. c.
The dying industry argument.
d. The national defense argument. ANSWER:
C
28. Which of the following statements is true? I. In a first-best world, import-competing firms that were struggling to stay in business would be allowed to go out of business and workers would find jobs in other industries. II. In a second-best world, the most efficient way for government to correct for workers being displaced when industries die being unable to find jobs in the resulting congested labor markets is to provide subsidies for those workers to move to areas where there are jobs. III. In a second-best world, if workers do not have the skills for new jobs after they lose their jobs in dying import-competing industries, the most efficient government policy would be subsidies to pay for retraining those displaced workers.
a.
I and II
b. I and III c.
II and III
d. I, II, and III ANSWER:
D
29. In the U.S., trade adjustment assistance: a.
Will provide workers who have been displaced from import-competing firms with an additional 12 to 18 months of unemployment compensation as well as being eligible for
retraining programs and subsidies for job search and moving costs. b. Is optimal in both a first-best and second-best environment. c.
Provides incentives for workers to search for new jobs outside the import-competing industry prior to them losing their jobs in the import-competing industry.
d. All of the above. ANSWER:
A
30. Tariffs imposed by a developing country: a.
May benefit the country because they represent an efficient mechanism for collecting revenue, but are unlikely to benefit the rest of the world.
b. Can benefit both the country and the rest of the world by creating net social gains. Such tariffs likely represent the most efficient means of government revenue for a country with limited means of collecting income or sales taxes. c.
Will be as inefficient as tariffs imposed by developed countries.
d. Are likely to represent only a very small fraction of government revenues because the volume of imports to developing countries is relatively small. ANSWER:
B
31. Which of the following arguments for protection derives from the fact that funding of public goods in some countries is difficult given little or no means to collect income or sales taxes? a.
The developing government argument.
b. The infant industry argument. c.
The dying industry argument.
d. The national defense argument. ANSWER:
A
32. The French highly value domestic production of traditional French cheeses made by high-cost, traditional production methods. The most efficient policy tool to protect this traditional industry in a second-best world would be: a.
A production subsidy.
b. An import tariff on cheeses produced outside of France. c. An import ban on cheeses produced outside of France. d. Free trade since no protectionist policy would be efficient in a second-best world.
ANSWER:
A
33. The United States produces some of the electronic components for use in its fighter planes, but due to the limited number of companies that produce these items it is forced to import these parts from Japan as well. There is concern that in the case of a prolonged war, these important imports may not be available. Fearing that the air force may be unable to fulfill its tasks in the case of a long war, the United States should: a.
Ban the importation of these electronics parts in order to ensure the vitality of the domestic means of electronics production.
b. Impose tariffs on the imports of these electronic parts. c. Subsidize the domestic production of these electronics parts. d. Tax private consumers of these electronics parts. ANSWER:
C
34. Direct democracy makes tariffs less likely to be voted into law because: a.
The size of the individual losses to each voter would be larger than the individual losses to each of the winners from any potential protectionist measure.
b. The majority of voters recognizes that tariffs are inefficient and therefore would vote for a production subsidy instead of an import tariff. c.
“Free riders” would ensure that everyone got to the polls to vote.
d. The number of people who are hurt by protectionist measures exceeds the number of people who gain from protectionist measures. ANSWER:
D
35. Tariffs are more likely to be imposed when: a.
Voters in the country are asked to make the determination.
b. The average gain per proponent far exceeds the average cost per opponent and the costs of lobbying policy makers are high. c.
The number of people who are hurt by protectionist measures exceeds the number of people who gain from protectionist measures and those who are harmed are highly organized.
d. Import-competing producers are unorganized. ANSWER:
B
36. According to the specificity rule: a.
Tariffs should be placed only on specific products.
b. Government policy should target as closely as possible the source of the distortion that separates private and social benefits (or costs). c.
The tariff favors only specific interest groups within a country.
d. Only specific industries are allowed to participate in government lobbying. ANSWER: B 37. Instead of placing a tariff on the imports of steel, a government has decided to offer steel workers
a trade adjustment assistance which will allow them to prequalify. Such a policy is consistent with: a.
The dying industry argument.
b. The specificity rule. c.
The infant industry argument.
d. The national pride argument. ANSWER:
B
38. Tariff rates are typically higher on final consumption goods than on intermediate goods and raw materials sold to producing firms. This tendency is known as: a. The tariff escalation pattern. b. The free rider problem. c.
The democratic vote problem.
d. The second-best world. ANSWER:
A
39. The tax-or-subsidy approach for solving externality problems was developed by: a.
Arthur Pigou
b. Ronald Coase c.
Eli Heckscher
d. Bertil Ohlin ANSWER:
A
40. Tariffs are more likely to be imposed when: a.
Consumers can act together and eliminate the free-rider problem.
b. Producers are a dispersed group and are unable to define their joint interests. c.
Producers are a well-organized group with substantial resources to use for political lobbying.
d. The government is corrupt. ANSWER:
C
True/False Questions 41. Free trade is economically efficient in a first-best world. ANSWER:
TRUE
42. In a first-best world, price, marginal benefit, marginal cost, marginal social benefit, and marginal social cost are all equal at the margin. ANSWER:
TRUE
43. While trade restrictions do provide gains to certain segments in the economy, such restrictions will always be a net negative for the nation as a whole. ANSWER:
FALSE
44. If Social marginal cost (SMC) > Price (P) = Buyer’s private marginal benefit (MB) = Seller’s private marginal cost (MC) = Social marginal benefit (SMB) too little is supplied. ANSWER:
FALSE
45. In the absence of any other distortion, a tariff will create a distortion, but a government subsidy will not create a distortion. ANSWER:
FALSE
46. The specificity rule states that the most efficient way to correct a distortion is to use a government policy tool that is directed at the source of the distortion. ANSWER:
TRUE
47. If additional domestic production will lead to positive spillover effects, then an import tariff aimed at increasing domestic production would better adhere to the specificity rule than a government subsidy aimed at increasing domestic production. ANSWER: FALSE 48. Government loans are more efficient than production subsidies if a young industry faces financial markets that are unwilling to provide funding to the industry due to the high risk. ANSWER:
TRUE
49. Import tariffs are efficient second-best policy solutions for many developing countries where government revenue is difficult to obtain by other means such as an income or sales tax. ANSWER:
TRUE
50. In a representative democracy, it is likely that consumers will be able to keep protectionist measures from becoming law because consumers have more to lose and they are a larger group than the potential winners from any protectionist measure. ANSWER:
FALSE
51. The national defense argument justifies the use of import barriers on goods that would be important in the case of a military emergency. ANSWER:
TRUE
52. Arthur Pigou put forward the idea that positive and negative externalities can be resolved by creating new private property institutions. ANSWER:
FALSE
53. External effects arise because there is a misalignment between private and social benefits or costs. ANSWER:
TRUE
54. The dying industry argument suggests that industries in decline should not be protected because they cannot contribute to a country’s prosperity anymore. ANSWER:
FALSE
55. Tariffs and quotas are one-size-fits-all measures that always work as a tool to internalize external effects. ANSWER:
FALSE
Essay Questions 56. Studies based on 1990 data show that in the United States, consumers paid an average of about $169,000 per job per year maintained by import protection. Given that these employees earned much less than $169,000 per year, it would be much cheaper to simply pay these workers not to work and
impose no import restrictions. How can you explain the logic of maintaining such restrictions? POSSIBLE RESPONSE: The findings of the study are consistent with the idea that the cost of protection often exceeds the benefit, and overall a country loses from import restrictions. Among the losers are the final consumers, and among the gainers are the firms and the workers in the protected industries. Import restrictions are often imposed by politicians under the pressure of lobbying groups. Producer groups are more effective than consumer groups when it comes to political lobbying. The producer groups are small and concentrated groups which can better solve the free rider problem. Consumer groups, in contrast, are large, anonymous, and dispersed groups that are unable to effectively resolve the free rider problem within the group. Therefore, politicians who answer to well-organized import-competing producer groups are more likely to use restrictions to trade although this is not beneficial to the well-being of the country as a whole 57. The United States has recently begun building a new type of flat panel 3-dimensional television (FP3D). Unfortunately for U.S.producers, Japanese firms have been producing FP3D’s longer than U.S. firms so they are more efficient and more competitive. Should the United States impose temporary protection in the form of a tariff on this product to protect the domestic industry until it is competitive with Japanese producers? Why or why not? POSSIBLE RESPONSE: This question is about the infant industry argument for protection. The infant industry argument asserts that a protection is justified temporarily until domestic producers learn how to produce at low enough cost, and eventually be able to compete without a tariff. To be able to answer the question the government should compare the future producer surplus to the cost to consumers while the tariff is in place. The problem for the government is in assessing whether the U.S. producers will eventually become so efficient that they are able to compete internationally and realize surpluses. According to the infant industry argument firms make losses when they begin operation and then become profitable later on. But isn’t this a feature that describes almos t every business? Is a protection at all needed? The protection would be the right choice under two circumstances. One would be the circumstance in which there are imperfections in the financial markets and firms do not have access to financial capital. U.S. firms are unlikely to suffer from this problem as the U.S. has well-developed financial markets. The second circumstance would be the case in which the early business investments accrue to the firms making these investments. Again, this is unlikely to happen in the U.S. due to the well development patent laws. Should this be a concern, there will be a case for a temporary industry protection. 58. Suppose Russia can produce automobiles relatively cheaply, but they have poor gas mileage and create a great deal of air pollution. The U.S. government, concerned about the quality of air, would like to see fewer Russian automobiles and more cleaner-running American automobiles on the road. a.
What is the nature of the market failure that would justify the U.S. government taking
some action against the importation of Russian automobiles? POSSIBLE RESPONSE: The market failure in this case is a negative external effect that arises because of the air pollution. There is misalignment between the marginal private cost of the individual consumer who purchases a Russian car, and the marginal social cost (the damage) from air pollution. In the presence of such external cost, U.S. government action is warranted. b. Explain why imposing a tariff is a second best policy to employ in this case and what policy choice would be more efficient. POSSIBLE RESPONSE: Imposing a tariff has to reduce the number of Russian cars on the streets down to the efficient number for which the marginal social benefit equals the marginal cost of a car. As an alternative to a tariff, the government can use a tax or a subsidy. The tax-or-subsidy approach requires the identifying of distortions in people’s and firms’ private incentives and the designing of a policy that corrects for thesencentives i by levying taxes or giving subsidies. In the particular example, the government should impose a tax on air pollution. That means, car drivers who drive Russian cars should pay a tax that is commensurate to the damage to the society they cause due to the air pollution. 59. What is the dying industry argument for establishing barriers to, imports? What are, its merits and weaknesses? What measure(s) are more efficient than an import tariff if the intention is to help workers who would be displaced from a dying industry? Why? What measure(s) are more efficient than an import tariff if maintaining current production levels is the intention of government policy? POSSIBLE RESPONSE: The dying industry argument is based on the assertion that production resources such as workers, managers, capital and land cannot quickly be reemployed to other uses. Especially for workers there are significant extra costs associated with their prequalification should they be forced to switch to jobs in other industries. Because this transition cannot take place smoothly, there is a case for government intervention in industries which lose their competitiveness to foreign producers. A temporary trade barrier that keeps these jobs can serve as a protection of the economy from unemployment. It helps prevent the job market from “congestion,” the situation in which many workers do not have the skills that match the available jobs. There might be circumstances in which government protection indeed causes less damage than just keeping the resources idle. Using a tariff on imports is not the most efficient measure for a government. According to the specificity rule, the government should use policies that target as directly as possible the source of distortion. If the goal of the government is to help workers, the government should use policies such as trade adjustment assistance which smooth workers’ transition to other occupations. The trade adjustment assistance provides workers with an unemployment compensation that gives them income during the time they need to acquire the skills to be successful in their new employment. If the country is just interested in keeping the current production level, the country
can grant subsidies to producers. This measure will bring down the cost of domestic production, and will prevent the crowding out of domestic products by cheaper imports. 60. Give as many scenarios as you can in which it is good to protect domestic production for a nation as a whole (not just for workers and firms receiving protection). Explain why your arguments are valid in a second best world. POSSIBLE RESPONSE: The case for protection can be made when there is a discrepancy between social and private benefits or cost from an activity. If this activity is a domestic production of a good, there is a case for protecting the domestic producers. Protection of domestic production might be desirable in situations in which domestic production creates positive external effects such as the following: The production in one industry creates know-how or management techniques that can be used in other industries. Workers in the industry are acquiring skills and attitudes that can be useful in other industries. The country and its citizens can take pride from producing the product locally, or the product is essential to national defense. Protecting domestic production can also be beneficial in the following circumstances: It is expected that firms in the industry can lower their costs over time. Workers face high cost if they are forced to switch to a job in a different industry.
Multiple Choice Questions 1. Dumping is defined as: a.
Selling exports at a price that is below normal value.
b. Selling exports that are of a substandard quality. c.
Selling exports at a price that is higher in foreign markets than the price charged to domestic consumers.
d. International price discrimination favoring domestic consumers over foreign consumers. ANSWER:
A
2. Which of the following is occurring when a firm is selling its product for a low price in a foreign market, with the purpose of driving its foreign competitors out of business? a.
Persistent dumping.
b. Cyclical dumping. c.
Predatory dumping.
d. Seasonal dumping. ANSWER:
C
3. Which of the following is occurring when a firm lowers its price to limit the decline in the quantity sold during a period of recession? a.
Persistent dumping.
b. Cyclical dumping. c.
Predatory dumping.
d. Seasonal dumping. ANSWER:
B
4. Which of the following is occurring when a firm lowers its price in order to sell off excess inventories of a product? a.
Persistent dumping.
b. Cyclical dumping. c.
Predatory dumping.
d. Seasonal dumping. ANSWER:
D
5. Which of the following is occurring when a firm with market power uses price discrimination between markets to increase its total profit? a. Persistent dumping. b. Cyclical dumping. c.
Predatory dumping.
d. Seasonal dumping. ANSWER:
A
6. A firm maximizes profits by charging a lower price to foreign buyers if: a.
It has more monopoly power in the foreign market than it has in its home market.
b. Foreign demand is more elastic than is domestic demand. c.
Buyers in the home country have access to cheap imports from the rest of the world.
d. All of the above. ANSWER:
B
7. Persistent dumping can be if the firm faces __________ elastic demand in the home market and a __________ market in the foreign country. a.
Less; less competitive
b. More; less competitive c.
Less; more competitive
d. More; more competitive ANSWER:
C
8. Which of the following statements about dumping is inaccurate? I. Consumers and import-competing producers are both hurt by dumping. II. Predatory dumping is frequent. III. The process for deciding whether to impose antidumping duties is biased toward finding dumping and imposing antidumping duties. a.
I only
b. II only c.
I and II
d. I, II, and III ANSWER:
C
9. Which of the following is NOT a way in which the safeguard policy is superior to antidumping policies? a.
Firms and governments do not need to show that foreign exporters have done anything unfair.
b. There is pressure for import-competing firms to adjust their production in order to be more competitive with foreign exporters. c.
The interests of consumers can be disregarded since they do not play a role in determining whether to invoke a safeguard policy.
d. None of the above. ANSWER:
C
10. Which of the following statements about export subsidies is accurate? I. Overall, export subsidies usually hurt the exporting country and help the foreign country. II. Export subsidies reduce the amount produced domestically in the exporting country and
increase the amount imported by the foreign country. III. An export subsidy increases the price paid by foreign buyers for the product and reduces the price that consumers in the exporting country pay for the product. a.
I only
b. I and II c.
I and III
d. II and III ANSWER:
A
11. Which of the following subsidies is prohibited under WTO rules? a. Subsidies to research and development. b. Subsidies to assist disadvantaged regions within the exporting country. c.
Subsidies that are used to assist firms in meeting environmental regulations.
d. Subsidies that are used to encourage firms to export more. ANSWER:
D
Figure 11.1: The U.S. Market for Wheat Price $/ton
$180
$160
12. Referring to Figure 11.1, with free trade and a world price of $160 per ton, the United States produced __________ tons of grain, consumed __________ tons of grain, and exported __________ tons of grain. a.
60; 120; 60
b. 60; 120; 120 c.
120; 60; 60
d. 120; 40; 60 ANSWER: C 13. Referring to Figure 11.1, following the imposition of a $20 per ton export subsidy on U.S. grain
exports, the United States produced __________ tons of grain, consumed __________ tons of grain, and exported __________ tons of grain. a.
150; 40; 110
b. 150; 60; 110 c.
60; 40; 150
d. 100; 40; 120 ANSWER:
A
14. Referring to Figure 11.1, the production effect of the subsidy is: a. $200 million. b. $300 million. c.
$1 billion.
d. $2.2 billion. ANSWER:
B
15. Referring to Figure 11.1, the consumption effect of the subsidy is: a.
$200 million.
b. $300 million. c.
$1 billion.
d. $2.2 billion. ANSWER:
A
16. Referring to Figure 11.1, the cost to the government of the subsidy is: a.
$1 billion.
b. $3 billion. c.
$600 million.
d. $2.2 billion. ANSWER:
D
17. Referring to Figure 11.1, the net loss in national well-being as a result of the subsidy is: a. &, amp;, nbsp; $200 million. b. $300 million. c.
$500 million.
d. $2.2 billion. ANSWER:
C
18. Which of the following countries provides government supports to its farmers? a.
The United States.
b. Japan. c.
The European Union.
d. All of the above. ANSWER: D 19. Assume that Country A imposes an export subsidy and Country B imposes a countervailing duty
(of the same magnitude as the export subsidy). Which of the following statements is true? I. In terms of overall economic well-being in the domestic economy, Country B would be better off to allow the export subsidy to be in place and not impose the countervailing duty. II. In terms of overall economic well-being in the domestic economy, Country B would be better off with a combination of an export subsidy imposed by Country A and a countervailing duty than with free trade. a.
I only
b. II only c. I and II d. None are true. ANSWER:
C
Figure 11.2: The U.S. Market for Steel Imports from Korea Price $/ton
$400 $375
20. Referring to Figure 11.2, what is the change in national welfare in the United States as a result of the $25 export subsidy on steel? a.
An increase of $375 million.
b. An increase of $3.75 billion. c.
An increase of $4.125 billion.
d. An increase of $4.5 billion. ANSWER:
C
21. Referring to Figure 11.2, what is the change in national welfare in Korea as a result of the $25 export subsidy on steel? a.
A loss of $375 million.
b. An increase of $3.75 billion. c. A loss of $4.125 billion. d. A loss of $4.5 billion. ANSWER:
D
22. Referring to Figure 11.2, what is the change in the world’s welfare as a re sult of the $25 export subsidy on steel? a.
A loss of $375 million.
b. An increase of $3.75 billion. c.
A loss of $4.125 billion.
d. A loss of $4.5 billion. ANSWER:
A
23. Refer to Figure 11.2 as the initial situation. Suppose the United States now imposes a countervailing duty in the amount of $25 perton of steel. What is the impact of this countervailing duty on U.S. national welfare? a.
A loss of $375 million.
b. An increase of $3.375 billion. c.
An increase of $3.75 billion.
d. A loss of $4.125 billion. ANSWER:
A
24. Refer to Figure 11.2 as the initial situation. Suppose the United States now imposes a countervailing duty in theamount of $25 per ton of steel. What is the impact of this countervailing duty on Korean national welfare? a.
A loss of $375 million.
b. An increase of $750 million. c.
A loss of $3.75 billion.
d. An increase of $4.5 billion. ANSWER:
B
25. Referring to Figure 11.2, the combined net effect of the subsidy and the countervailing duty on theUnited States is a gain of __________ and the net effect on Korea is a loss of __________. a.
$375 million; $375 million
b. $375 million; $3.75 billion c.
$3.75 billion; $3.75 billion
d. $375 billion; $375 million ANSWER:
C
26. The impact on world welfare of an export subsidy and a countervailing duty (of the same size as the subsidy) is: a.
There is no impact, either positive or negative.
b. Negative due to overproduction. c.
Negative due to under-consumption.
d. Negative due to increased tax collections. ANSWER: A
Figure 11.3: A large-country imposes an export s ubsidy Price
Domestic price with subsidy
27. Referring to Figure 11.3, the cost to the government of the indicated subsidy is shown by area(s): a.
c
b. c + h c.
b+c+d
d. b + c + d + f + g + h + i + j ANSWER:
D
28. Referring to Figure 11.3, the change in consumer well-being as a result of the indicated subsidy is shown by area(s): a. a b. –(a + b) c.
–(a + b + e + f + g)
d. –(a + b + c) ANSWER:
B
29. Referring to Figure 11.3, the change in producer well-being as a result of the indicated subsidy is shown by area(s): a.
a+b
b. a + b + c + d c.
a+b+c+e+f+g+h
d. a + b + c ANSWER:
D
30. Referring to Figure 11.3, the production effect of the indicated subsidy is shown by area(s): a. b b. d
c.
d+i+j
d. b + f + g ANSWER:
B
31. Referring to Figure 11.3, the consumption effect of the indicated subsidy is shown by area(s): a.
b
b. d c.
d+i+j
d. b + f + g ANSWER: A 32. Referring to Figure 11.3, the change in national welfare as a result of the indicated subsidy is shown by area(s): a.
c
b. –(b + d) c.
–(b + d + f + g + i +j)
d. –(b + d + f + g + h + i + j) ANSWER:
D
33. An export subsidy imposed by a large country can be more damaging to national welfare than an export subsidy imposed by a small country because: a.
The production effect is larger with the large country.
b. The consumption effect is larger with the large country. c.
The terms of trade worsen for the large country but not for the small country.
d. Export subsidies are more damaging to a small country than a large country. ANSWER:
C
34. An export subsidy can be good for a country if: a.
The subsidy allows the exporting firm(s) to capture more monopoly profits in foreign markets.
b. The subsidy decreases the export price so the export quantity increases. c.
The subsidy is offset by a countervailing duty.
d. The international market for the export product is highly competitive. ANSWER:
A
35. A problem with the use of strategic trade policy is: a.
The analysis requires more information than is likely to be available.
b. There is the risk of foreign retaliation. c.
Policies cannot be looked at in isolation. A policy that gives a strategic advantage in one industry may give a strategic disadvantage to another due to the higher costs faced as
resources are drawn to the subsidized industry. d. All of the above. ANSWER:
D
36. Since 1990 the number of countries who adopted antidumping laws _________ significantly, and by 2008 there were __________ countries with antidumping laws in effect. a.
decreased, less than 50
b. increased, more than 100 c.
decreased, close to 100
d. increased, close to 50 ANSWER:
B
37. Which country had no antidumping cases until the early 1990s, but became a top initiator of antidumping cases for the time period 2002-2006? a. China. b. India. c.
United Kingdom.
d. United States. ANSWER:
B
38. Which industry accounts for the largest share of antidumping cases filed in the United States in the 1990s and 2000s? a.
Textile.
b. Chemicals. c.
Steel.
d. Apparel. ANSWER:
C
39. Consider the example of the rivalry game between Airbus and Boeing presented in Figure 11.7 on page 254 in your textbook. If governments do not provide subsidies to the firms: a.
It is optimal for Boeing to produce if Airbus does not produce.
b. Both firms might decide not to produce because they fear that the other firm will produce. c.
It is optimal for Airbus not to produce if Boeing does not produce.
d. Both a and b. ANSWER:
D
40. Consider the example of the rivalry game between Airbus and Boeing presented in Figure 11.8 on page 255 in your textbook. The European Union’s decision to subsidize Airbus: a.
Might be good for the European Union because Boeing will decide not to produce.
b. Will be good for the European Union only if the U.S. government decides to subsidize Boeing. c.
It can never be optimal for the European Government to subsidize Airbus.
d. Both a and b. ANSWER:
A
True/False Questions 41. Firms that are participating in persistent dumping will sell less in the foreign market and charge a
higher price than in the home market. ANSWER:
FALSE
42. Firms that are participating in persistent dumping need to be able to prevent resale between the foreign and domestic markets. ANSWER:
TRUE
43. If markets are competitive, policies that restrict imports are usually harmful to the importing country while policies that encourage exports are usually beneficial to the exporting country. ANSWER:
FALSE
44. Antidumping duties increase economic well-being in the United States by protecting importcompeting firms. ANSWER:
FALSE
45. It is generally the case that imposing a countervailing duty in response to a foreign export subsidy provides less welfare gain for a country than had it not imposed the countervailing duty. ANSWER:
TRUE
46. While the United States makes very few claims of dumping, most of their claims are upheld by the International Trade Commission. ANSWER:
FALSE
47. More price supports and subsidies are provided to agriculture worldwide than any other sector of the economy. ANSWER:
TRUE
48. An export subsidy imposed in a large exporting country will cause the country's international terms of trade to increase. ANSWER:
FALSE
49. A large enough production subsidy can turn an imported product into export product. ANSWER:
TRUE
50. Strategic trade policy is a government policy whereby a subsidy is provided in order to help the domestic firm win a trade battle in an oligopolistic market. ANSWER:
TRUE
51. A price support on agricultural products is a minimum domestic price set by the government. The government outlaws transaction below the price support, but usually has no commitment to buy any amounts that farmers cannot sell at this price. ANSWER:
FALSE
52. Giving export subsidies is good for a country when they switch agricultural products from being importable to being exported. ANSWER:
FALSE
53. A major reason why agricultural products are heavily subsidized in the European Union is because farmers have strong political lobbies. ANSWER:
TRUE
54. One of the proposals for reforms in the area of dumping is to replace antidumping policies by safeguard policies. A safeguard is a temporary import protection which allows local importcompeting producers to adjust. ANSWER:
TRUE
Essay Questions 55. How likely is dumping to be predatory? Discuss. POSSIBLE RESPONSE: Predatory dumping occurs when a foreign firm temporarily charges a low price with the intention to drive local firms out of business, and eventually attain monopoly power and raises prices. Predatory dumping is likely to be rare in modern markets. An exporting company will engage in predatory dumping only if the profits in the distant future outweigh the current losses associated with the temporary reduction in price. Yet, the future profits are likely to be quite uncertain. Even if the firm succeeds to drive current competitors out of business, once prices are raised, new firms will enter the industry as competitors, and prices will not continue to be high for very long. 56. Milton Friedman has often written that instead of imposing countervailing duties on subsidized foreign goods, the United States should write a note of thanks to foreign taxpayers. Do you agree? Why or why not? Illustrate your answer with a simple diagram. POSSIBLE RESPONSE: To evalua te Milton Friedman’s statement let us look at the diagram below which illustrates the U.S. market for steel. 210 Domestic price with subsidy Price $/ton $300 $250
Let us assume that the current world price is $300 per ton. Assume now that Brazil introduces an export subsidy to its production of steel. As a result the export price drops to $250 per ton. Domestic consumers in the U.S. gain an additional (consumer) surplus equal to v + w + y + z. Producers lose a surplus equal to v. So, the benefit to the U.S. equals w + y + z. What happens if the U.S. imposes a countervailing duty? In this case the world price climbs back to the srcinal level of $300. Domestic producers gain back area v, and domestic consumers lose back v + w + y + z. The U.S. collects a dollar amount equal to the area y in countervailing duties. As can be seen, the countervailing duty
diminishes the total welfare of the U.S. by w + z. Thus we agree with Friedman’s statement that imposing a countervailing duty is not benef icial to theU.S. The U.S. should send a thank-you note to Brazilian taxpayers because the reduction in the world price is indeed financed by the Brazilian government and the Brazilian taxpayers in particular. This tax money finances the subsidy granted to Brazilian steel producers. 57. What is the economic definition of dumping? If the importing country suspects dumping, what action can be taken? POSSIBLE RESPONSE: Dumping is selling exports at a price below the normal va lu e (or fair normal va lu e. The traditional definition of normal value is market value). There are two definitions of the price charged in the home market. Dumping in this case means international price
discrimination. The second definition of normal value is the average cost of production. Under this second definition dumping is selling goods abroad at a price below average production cost. If a country can show foreign producers dump into their market and injury results, the country can impose antidumping measures. 58. Thai farmers grow and sell 100 units of rice at a price of $100 per unit. Of the 100 units, 20 are exported. If urban consumers succeed in getting the Thai government to ban all exports of rice, the domestic price of rice would drop to $80 per unit and farmers would grow and sell 80 units. How much loss would the export ban bring to Thai farmers? POSSIBLE RESPONSE: This problem is illustrated in the following graph.
Price
$100 $80
The initial situation defines a producer surplus measured by the area w + v. The ban on the exports of rise lowers the price to $80, and the new producer surplus is given by area w. The loss is area v, which can be calculated as (v + x)– x = (100 - 80) x 100– (100 - 80) x (100 - 80)/2 = 2000– 200 = 1800. 59. The United States demand and supply for grain are: QD = 150 – 0.6P QS = 40 + 0.5P where QD and QS are in millions of tons and P is $ per ton. The world price of grain is $200 per ton.
a.
In a situation of free trade, how much grain would be produced, consumed, and traded in theUnited States? POSSIBLE RESPONSE: At the price of $200, the quantity supplied of grain by U.S.producers is 60 and the quantity demanded of grain in the U.S. is 30. Thus, 60 million tons will be produced, 30 million tons will be consumed, and 30 million tons will be exported
(see the graph). b. As a response to alleged unfair foreign practices, U.S. farmers successfully lobby for a $20 export subsidy perunit of U.S. grain exported. Assume thatthe United Statesis a “small country” in worldgrain markets and illustrate the U.S. export subsidy and calculate the impact on U.S. prices, consumption, production, and exports of grain. Also calculate the welfare effects on producers, consumers, the cost of the subsidy to the government, and the overall welfare effect on the U.S. POSSIBLE RESPONSE: As the United States is assumed to be a “small country” when it comes to grain production, there will be no effect on the world price. For U.S. farmers revenue per unit exported rises to $220, and the exporting firms must receive this amount as the selling price from domestic buyers as well. Domestic production rises from 60 to 70 million tons, domestic consumption falls from 30 to 18 million tons, and the country exports increases from 30 million tons to 70-18=52 million tons. Domestic producers gain surplus equal to the area e+f+g , domestic consumers lose surplus equal to the area e+f and the cost of the government of paying the export subsidy is area f+g+h . The net loss in national well being resulting from the export subsidy equals the sum of the areas f and h . 60. Explain why strategic export subsidies could be good for a country. For this purpose use the two
firm rivalry game between Airbus and Boeing presented in your textbook. Discuss the differences between the game in which no subsidies are given, the game in which only Airbus receives a subsidy, and the game in which both firms are subsidized. POSSIBLE RESPONSE: The rivalry game without subsidies has no clear cut result. If one of the firms decides to produce, it is best for the other firm not to produce. Each firm would like to be the only producer, but if both produce both will lose. If the firms are unable to coordinate, both firms could decide not to produce, which is suboptimal for at least one of them. By giving a subsidy, the European Union could give Airbus incentives to produce independent of whether Boeing produces or not. Knowing that Airbus will produce, Boeing will find it best not to produce, and Airbus will serve the entire market. Airbus, the European Union, and the world as a whole would win, compared to no production by either firm. If both countries subsidize their producers, both firms will end up producing airplanes. In this situation the market is too small to accommodate two producers, so each operates at a loss net of its subsidy. The effects on national and world well-being depend onwhether sufficient consumer surplus is created toovercome the producers losses netof the subsidies. (The subsidies are transfers that do not directly count as net gains or net losses.)
