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CHAPTER 21 (17) Questions for Thought and Review 2. If Widgetland produces only widgets, it can make 240 of them and the opportunity cost is 1/1. If Wadgetland makes only wadgets could produce 720 of them at an opportunity cost of .25/1 (widgets to wadgets). Since the opportunity costs differ, there is a basis for trade in production. Widgetland should produce 240 widgets, and trade 60 of the widgets for 120 wadgets. Wadgetland should produce only 720 wadgets and trade 120 wadgets for 60 widgets. Both countries will be better off. 4. Traders get big gains from trade in newly opened markets. The more competition that exists in international trade, the more the traders’ gains will be reduced and the more gains are. Countries producing goods with economies of scale get a larger gain from trade. Trade allows an increase in production and if there are economies of scale, the increase can lower the average cost of production, and lower the price of the good in the producing country. 6. 8. Any three of the following ten would be correct: (1) Skills of the U.S. labor force, (2) U.S. governmental institutions, (3) U.S. physical and technological infrastructure, (4) English as the international language of business, (5) wealth from past production, (6) U.S. natural resources, (7) cachet, (8) inertia, (9) U.S. intellectual property rights, and (10) relatively open immigration policy. 10. The law of one price is that in a competitive market there will be pressure for equal factors to be priced equally. It is important to any discussion of the future of the U.S. economy because relative wages are higher in the United States than in most other countries. The U.S. faces forces that will adjust these wages until the relative prices are equal. This will likely happen by a combination of the following: (1) faster wage growth in other countries, (2) slower wage growth in the United States, and (3) a decline in the value of the dollar. 12. An equitable method might be to tax those who gain from the trade liberalization and give the proceeds to those who are hurt by it. Assuming the original distribution is equitable and the government is not trying to redistribute income, this method is equitable because the combined policies make everyone better off. The political problems with implementation includes: (1) Everyone will try to exaggerate the amount they are hurt and minimize the amount they are helped. Thus actually finding a tax that accomplishes the goal will be difficult. (2) Once the taxes and subsidies are in place, they may not be removed after the adjustment of displaced workers is complete. Losers will be overcompensated and gainers will be taxed too much. (3) Those who have big gains (big business) may have more political power and be able to prevent the implementation of this policy. 14. Economists support free trade because it forces domestic producers to operate efficiently and it increases consumer welfare. 15. Tariffs and quotas have similar effects on limiting trade (both shift the supply curve to the left). The big difference is who gets the revenue from the resulting increase in the price of imports. With a tariff the government gets the revenue. With a quota, the revenues accrue to the foreign producers. You can see this graphically in the margin graph on page 493 of the text. 16. Both increase the price of the import, helping the domestic producers. In the case of the voluntary restraint, increases in price result in increased revenue to foreign firms and increased demand is met entirely by the domestic market. In the case of the tariff, the revenue raised goes to the domestic government. 18. With a price floor, there is a loss of consumer surplus, higher prices and lower quantities. 20. The WTO is the successor to GATT. Both work toward agreements to reduce trade. WTO includes enforcement mechanisms that GATT did not have. Problems and Exercises 2. No. Both countries’ opportunity cost of producing pickles is 2/1 (they must give up 2 olives to get 1 pickle). Neither has a comparative advantage, so there is no basis for trade. If there are economies of scale, it definitely pays for both countries to specialize since doing so would lower total costs. Which one should specialize is an open question since neither has a comparative advantage. a. b. 4. a. Firms may produce in Germany, because (1) transportation costs in the other countries may be very high, so that if these costs are included, it would not be efficient to produce there; (2) there might be tariffs or quotas for imports into Germany that will prevent producing elsewhere; (3) the productivity of German labor may be so much higher that unit labor costs in Germany are the lowest; and (4) historical circumstances may have led to production in Germany and the cost of moving production may exceed potential gains. One would expect some short-run movement from Greece and Italy into Germany, but only in the long run will there be substantial movement. Social restrictions such as language and culture will limit labor mobility. With such high unemployment in Germany already, one would not expect much short-run movement. I would need to know how stable the political system is, what the worker productivity rates are, how sound the infrastructure (such as roads) is, and what the tax differences are between the two countries. b. c. a. Cars in thousands 6. The production possibility curve is shown in the accompanying graph. 60 50 busytown 40 30 20 10 lazyasiwannabe 0 10 20 30 40 50 60 Meals in thousands b. c. 8. a. Since Busytown can produce more cars when all of its resources are devoted to producing cars, Busytown has an absolute advantage in producing cars. Neither has an absolute advantage in producing gourmet meals since if each devotes all of its resources to producing meals, each can produce 50, but Lazyasiwannabe has a comparative advantage in gourmet meals. It must give up 1 cars for each gourmet meal while Busytown must give up 1.2 cars for each gourmet meal. Busytown should produce 60,000 cars and Lazyasiwannabe should produce 50,000 meals. Lazyasiwannabe then offers Busytown 22,000 meals for 24,000 cars. Since Busytown must give up only 24,000 cars for 22,000 meals (instead of the 26,4,00 cars it would have to if it made 22,000 meals itself) it accepts this offer. Lazyasiwannabe ends up with 28,000 meals and 24,000 cars while Busytown ends up with 22,000 meals and 36,000 cars. With the quota, the quantity of clothes sold was fixed. Suppliers charged the price (P0) consumers were willing to pay for that quantity. With the removal of the quota, as the accompanying graph demonstrates, equilibrium quantity rose (to Q1) and equilibrium price fell (to P1). Price P0 P1 Demand Q1 Quantity Quota b. c. 10. a. b. Consumers benefited because they were able to buy a greater quantity at a lower price. Graphically this is shown by an increase in consumer surplus shown by the shaded region in the accompanying graph. The short-run effect of the removal of the quota is that profits declined because the equilibrium price declined. If economies of scale lower average total costs by more than the decline in equilibrium price, in the long run profits might increase with the removal of the quotas. Economists opposed the tariff because it creates dead weight loss and hurts the welfare of the whole society. The tariff shifts the supply of imports up, increasing equilibrium price to P 1 and lowering equilibrium quantity to Q1 as shown in the accompanying graph. Price S1 tax S0 P1 P0 Demand Q1 Q0 c. d. Quantity The tariff would help the economy by increasing the price of imported goods, making domestic goods relatively more competitive and allowing domestic producers to raise their prices if they chose to do so. It would also provide revenue for government that it could spend on consumption or investment goods, further stimulating the domestic economy. The macro economy would be worsened because a retaliatory tariff reduces the trade between countries, thereby hurting both of them. They do not benefit from the full extent of their comparative advantages. Web Questions 2. a. b. c. 4. Three trade barriers listed are biotechnology bans, quotas on lumber, and export control licensing. The biotechnology bans are implemented because of perceived health risks to genetically modified food. The lumber quotas are to save American jobs in the timber industry. Export control licensing of satellites has shifted from the Commerce Department for security reasons. The ban on genetically modified food is hurting the U.S. agriculture market. The import quota on lumber has led to a 35 percent increase in the price of U.S. lumber. We are losing business from China due to the change in license control. The answer to this question depends on the country chosen. Appendix A a. b. Thousands of pounds of Roquefort cheese 2. The opportunity cost for Greece of making 1 million olives is 1,000 pounds of cheese. The opportunity cost for France of making 1 million olives is 250 pounds of cheese. The opportunity cost for Greece of making 1,000 pounds of cheese is 1 million olives. The opportunity cost for France of making 1,000 pounds of cheese is 4 million olives. They are worse off since France has a comparative advantage in producing olives and Greece has a comparative advantage in producing cheese. Under the new law France produces 50,000 pounds of cheese and Greece produces 500 million olives—point A. They could have had a greater combination: 100,000 pounds of cheese produced by Greece and 600 million olives (200 million by France and 400 million by Greece)—point B. Their combined possibility curve if they were able to trade is the outermost production possibility curve shown. 700 600 Greece 500 400 Specialization & trade 300 200 100 France A B 0 0 0 0 0 0 0 0 10 20 30 40 50 60 70 Millions of oliv es c. See the accompanying graph. All the points in the shaded area were unattainable without specialization and trade.