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International Economics, midsem Chapter 9 The Political Economy of Trade Policy 9.1 The Case for Free Trade 1) The efficiency case made for free trade is that as trade distortions such as tariffs are dismantled and removed, A) government tariff revenue will decrease, and therefore national economic welfare will decrease. B) government tariff revenue will decrease, and therefore national economic welfare will increase. C) deadweight losses for producers and consumers will decrease, hence increasing national economic welfare. D) deadweight losses for producers and consumers will decrease, hence decreasing national economic welfare. E) None of the above. Answer: C Question Status: Previous Edition 2) The opportunity to exploit economies of scale is one of the gains to be made from removing tariffs and other trade distortions. These gains will be found by a decrease in A) world prices of imports. B) the consumption distortion loss triangle. C) 1 the production distortion loss triangle. D) Both B and C. E) None of the above. Answer: E Question Status: Previous Edition 3) Judging by the changes in the height of tariff rates in major trading countries, the world has been experiencing a great A) trade liberalization. B) surge of protectionism. C) lack of progress in the trade-policy area. D) move towards regional integration. E) None of the above. Answer: A Question Status: Previous Edition 4) The World Trade Organization (WTO) was organized as a successor to the A) IMF. B) 2 UN. C) UNCTAD. D) GATT. E) the World Bank. Answer: D Question Status: Previous Edition 5) The WTO was established by the ________ of multilateral trade negotiations. A) Kennedy Round B) Tokyo Round C) Uruguay Round D) Dillon Round E) None of the above. Answer: C Question Status: Previous Edition 6) The Smoot-Hawley Tariff Act of 1930 has generally been associated with A) 3 falling tariffs. B) free trade. C) intensifying the worldwide depression. D) recovery from the worldwide depression. E) non-tariff barriers. Answer: C Question Status: Previous Edition 7) A trade policy designed to alleviate some domestic economic problem by exporting it to foreign countries is know as a(n) A) international dumping policy. B) countervailing tariff policy. C) beggar thy neighbor policy. D) trade adjustment assistance policy. E) None of the above. Answer: C Question Status: Previous Edition 8) Trade theory suggests that Japan would gain from a subsidy the United States provides its grain farmers if the gains to 4 Japanese consumers of wheat products more than offsets the losses to Japanese wheat farmers. This would occur as long as Japan A) is a net importer in bilateral trade flows with the United States. B) is a net importer of wheat. C) has a comparative advantage in wheat. D) has an absolute advantage in producing wheat. E) None of the above. Answer: B Question Status: Previous Edition 9) The World Trade Organization provides for all of the following except A) the usage of the most favored nation clause. B) assistance in the settlement of trade disagreements. C) bilateral tariff reductions. D) multilateral tariff reductions. E) None of the above. Answer: C Question Status: 5 Previous Edition 10) Which organization determines procedures for the settlement of international trade disputes? A) World Bank B) World Trade Organization C) International Monetary Organization D) International Bank for Reconstruction and Development E) The League of Nations Answer: B Question Status: Previous Edition 6 11) The WTO's intervention against clean air standards A) has earned it universal approval. B) was done in order to limit national sovereignty. C) has resulted in much criticism. D) has resulted in much criticism among professional economists. E) None of the above. Answer: C Question Status: Previous Edition 12) It is argued that the United States would be foolish to maintain a free-trade stance in a world in which all other countries exploit child or prisoner labor, or are protectionist. On the other hand, Ricardo's classic demonstration of the sources and effects of comparative advantage cogently demonstrates that regardless of other country policy, free trade remains the first best policy for a country to follow, since it will maximize its consumption possibilities (conditional upon other country policies). Explain. Discuss the contradiction with the argument in the preceding paragraph. Answer: In the context of the Ricardian model, it is true that gains from trade are strictly a result of world terms of trade, which differ from domestic marginal rates of substitution. In such a world, the reason why foreign goods are cheap is of no concern to domestic consumers. However, in a world which allows for large-scale labor migration, ignoring labor conditions abroad may ultimately result in living standards for domestic workers to be dragged down. Question Status: Previous Edition 9.2 National Welfare Arguments Against Free Trade 1) 7 The optimum tariff is A) the best tariff a country can obtain via a WTO negotiated round of compromises. B) the tariff, which maximizes the terms of trade gains. C) the tariff, which maximizes the difference between terms of trade gains and terms of trade loses. D) not practical for a small country due to the likelihood of retaliation. E) not practical for a large country due to the likelihood of retaliation. Answer: E Question Status: Previous Edition 2) The optimum tariff is most likely to apply to A) a small tariff imposed by a small country. B) a small tariff imposed by a large country. C) a large tariff imposed by a small country. D) a large tariff imposed by a large country. E) None of the above. Answer: B Question Status: 8 Previous Edition 3) The prohibitive tariff is a tariff that A) is so high that it eliminates imports. B) is so high that it causes undue harm to trade-partner economies. C) is so high that it causes undue harm to import competing sectors. D) is so low that the government prohibits its use since it would lose an important revenue source. E) None of the above. Answer: A Question Status: Previous Edition 9 4) The existence of marginal social benefits which are not marginal benefits for the industry producing the import substitutes A) is an argument supporting free trade and non-governmental involvement. B) is an argument supporting the use of an optimum tariff. C) is an argument supporting the use of market failures as a trade-policy strategy. D) is an argument rejecting free trade and supporting governmental involvement. E) None of the above. Answer: D Question Status: Previous Edition 5) The domestic market failure argument is a particular case of the theory of A) the optimum, or first-best. B) the second best. C) the third best. D) the sufficing principle. E) None of the above. Answer: 10 B Question Status: Previous Edition 6) The difficulty of ascertaining the right second-best trade policy to follow A) reinforces support for the third-best policy approach. B) reinforces support for increasing research capabilities of government agencies. C) reinforces support for abandoning trade policy as an option. D) reinforces support for free-trade options. E) None of the above. Answer: D Question Status: Previous Edition 7) The reason protectionism remains strong in the United States is that A) economists can produce any result they are hired to produce. B) economists cannot persuade the general public that free trade is beneficial. C) economists do not really understand how the real world works. D) the losses associated with protectionism are diffuse, making lobbying by the public impractical. E) 11 None of the above. Answer: D Question Status: Previous Edition 8) The United States appears at times to have a totally schizophrenic attitude toward protectionism. The United States was the country that proposed the establishment of the World Trade Organization as early as the late 1940s, and was also the only industrialized country that refused to ratify this at that time. The United States has consistently argued on the side of multinational free trade in GATT Rounds, and yet maintains many protectionist laws such as those which reserve oil shipments from Alaska to U.S. flag carriers. How can you explain this apparent lack of national consistency on this issue? Answer: This reflects the fact that international trade typically has many winners and relatively fewer, but politically powerful losers. Short of guaranteed (constitutional?) non-conditional compensatory mechanisms, the basic conflict between these two groups will always be there. Question Status: Previous Edition Assume that Boeing (U.S.) and Airbus (European Union) both wish to enter the Hungarian market with the next new generation airliner. They both have identical cost and demand conditions (as indicated in the graph above). 9) Refer to above figure. Assume that Boeing is the first to enter the Hungarian market. Without a government subsidy what price would they demand, and what would be their total profits? Answer: 12 $12 Million, $16. Question Status: Previous Edition 10) Refer to above figure. What is the consumer surplus enjoyed by Hungarian consumers of Boeing aircraft in the situation? Answer: $8 Million. Question Status: Previous Edition 11) Refer to above figure. Suppose the European government provides Airbus with a subsidy of $4 for each airplane sold, and that the subsidy convinces Boeing to exit the Hungarian market. Now Airbus would be the monopolist in this market. What price would they charge, and what would be their total profits? Answer: $10 Million, and $36 Million. Question Status: Previous Edition 12) Refer to above figure. What would be the cost of the subsidy to European taxpayers? Answer: $24 Million. Question Status: Previous Edition 13) Refer to above figure. What happens to the Consumer Surplus of Hungarian customers as a result of this subsidy? Answer: An increase of $10 Million. Question Status: Previous Edition 14) 13 Refer to above figure. What is the revenue gain or loss for Europe as a whole (including taxpayers)? Answer: A gain of $12 Million. Question Status: Previous Edition 14 9.3 Income Distribution and Trade Policy 1) It is argued that special interest groups are likely to take over and promote protectionist policies, which may lead to a decrease in national economic welfare. This argument leads to A) a presumption that in practice a free trade policy is likely to be better than alternatives. B) a presumption that trade policy should be shifted to Non-Governmental Organizations, so as to limit taxpayer burden. C) a presumption that free trade is generally a second-best policy, to be avoided if feasible alternatives are available. D) a presumption that free trade is the likely equilibrium solution if the government allows special interest groups to dictate its trade policy. E) None of the above. Answer: A Question Status: Previous Edition 2) The authors of the text believe that A) second-best policy is worse than optimal policy. B) special interest groups generally enhance national welfare. C) national welfare is likely to be enhanced by the imposition of an optimal tariff. D) market Failure arguments tend to support free-trade policy. 15 E) there is no such thing as national welfare. Answer: E Question Status: Previous Edition 3) The median voter model A) works well in the area of trade policy. B) is not intuitively reasonable. C) tends to result in biased tariff rates. D) does not work well in the area of trade policy. E) None of the above. Answer: D Question Status: Previous Edition 4) The fact that trade policy often imposes harm on large numbers of people, and benefits only a few may be explained by A) the lack of political involvement of the public. B) the power of advertisement. C) the problem of collective action. 16 D) the basic impossibility of the democratic system to reach a fair solution. E) None of the above. Answer: C Question Status: Previous Edition 5) Protectionism tends to be concentrated in two sectors A) agriculture and clothing. B) high tech and national security sensitive industries. C) capital and skill intensive industries. D) industries concentrated in the South and in the Midwest of the country. E) None of the above. Answer: A Question Status: Previous Edition 17 6) Export embargoes cause greater losses to consumer surplus in the target country A) the lesser its initial dependence on foreign produced goods. B) the more elastic is the target country's demand schedule. C) the more elastic is the target country's domestic supply. D) the more inelastic the target country's supply. E) None of the above. Answer: D Question Status: Previous Edition 7) The strongest political pressure for a trade policy that results in higher protectionism comes from A) domestic workers lobbying for import restrictions. B) domestic workers lobbying for export restrictions. C) domestic workers lobbying for free trade. D) domestic consumers lobbying for export restrictions. E) domestic consumers lobbying for import restrictions. Answer: A Question Status: 18 Previous Edition 8) The average tariff rate to data on dutiable imports in the United States is approximately A) 5 % of the value of imports. B) 15% of the value of imports. C) 20 % of the value of imports. D) 25% of the value of imports. E) more than 25% of the value of imports. Answer: A Question Status: Previous Edition 9) In 1990 the United States imposed trade embargoes on Iraq's international trade. This would induce smaller losses in Iraq's consumer surplus the A) less elastic Iraq's demand schedule. B) more elastic Iraq's demand schedule. C) greater is Iraq's dependence on foreign products. D) more inelastic is Iraq's supply schedule. E) None of the above. Answer: 19 B Question Status: Previous Edition 10) Today U.S. protectionism is concentrated in A) high tech industries. B) labor-intensive industries. C) industries in which Japan has a comparative advantage. D) computer intensive industries. E) capital-intensive industries. Answer: B Question Status: Previous Edition 20 11) The quantitative importance of U.S. protection of the domestic clothing industry is best explained by the fact that A) this industry is an important employer of highly skilled labor. B) this industry is an important employer of low skilled labor. C) most of the exporters of clothing into the U.S. are poor countries. D) this industry is a politically well organized sector in the U.S. E) None of the above. Answer: D Question Status: Previous Edition 12) It may be demonstrated that any protectionist policy, which effectively shifts real resources to import competing industries or sectors will harm export industries or sectors. This may, for example, happen by the strengthening U.S. dollar in the foreign exchange market. Would you propose therefore that export industries lobby against protectionism in International Trade Commission proceedings? What of consumer advocates? Discuss the pros and the problems of such a suggestion. Answer: Actually this is an interesting idea. It is well known that the public interest is put on hold as the ITC considers only the squeaky wheels of those allegedly hurt by trade. While "consumers" may be too amorphous a group to successfully organize and pursue a political agenda, the exporters and consumer advocates may be able to form a counter weight to the import competing industries. Question Status: Previous Edition 9.4 International Negotiations and Trade Policy 1) 21 The simple model of competition among political parties long used by political scientists tends to lead to the practical solution of selecting the A) optimal tariff. B) prohibitive tariff. C) zero (free-trade) tariff. D) the tariff rate favored by the median voter. E) None of the above. Answer: D Question Status: Previous Edition 2) The General Agreement on Tariffs and Trade and the World Trade Organization have resulted in A) termination of export subsidies applied to manufactured goods. B) termination of import tariffs applied to manufactures. C) termination of import tariffs applied to agricultural commodities. D) termination of international theft of copyrights. E) None of the above. Answer: E Question Status: 22 Previous Edition 3) The General Agreement on Tariffs and Trade and the World Trade Organization have resulted in A) the establishment of universal trade adjustment assistance policies. B) the establishment of the European Union. C) the reciprocal trade clause. D) reductions in trade barriers via multilateral negotiations. E) None of the above. Answer: D Question Status: Previous Edition 23 4) Countervailing duties are intended to neutralize any unfair advantage that foreign exporters might gain because of foreign A) tariffs. B) subsidies. C) quotas. D) Local-Content legislation. E) None of the above. Answer: B Question Status: Previous Edition 5) In 1980 the United States announced an embargo on grain exports to the Soviet Union in response to the Soviet invasion of Afghanistan. This embargo was mainly resisted by A) U.S. grain consumers of bread. B) U.S. grain producers. C) foreign grain producers. D) U.S. communists. E) None of the above. Answer: 24 B Question Status: Previous Edition 6) Under U.S. commercial policy, the escape clause results in A) temporary quotas granted to firms injured by import competition. B) tariffs that offset export subsidies granted to foreign producers. C) a refusal of the U.S. to extradite anyone who escaped political oppression. D) tax advantages extended to minority-owned exporting firms. E) tariff advantages extended to certain Caribbean countries in the U.S. market. Answer: A Question Status: Previous Edition 7) Under U.S. commercial policy, which clause permits the modification of a trade liberalization agreement on a temporary basis if serious injury occurs to domestic producers as a result of the agreement? A) adjustment assistance clause B) escape clause C) most favored nation clause D) prohibitive tariff clause E) 25 None of the above. Answer: B Question Status: Previous Edition 8) An issue never confronted effectively by GATT, but considered an important issue for WTO is that of A) the promotion of freer World trade. B) the promotion of freer World commodity trade. C) the promotion of freer World services trade. D) the lowering of tariff rates. E) None of the above. Answer: C Question Status: Previous Edition 26 9) The political wisdom of choosing a tariff acceptable to the median U.S. voter is A) a good example of the principle of the second best. B) a good example of the way in which actual tariff policies are determined. C) a good example of the principle of political negotiation. D) not evident in actual tariff determination. E) None of the above. Answer: D Question Status: Previous Edition 10) A game-theory explanation of the paradox that even though all countries would benefit if each chose free trade, in fact each tends to follow protectionist policies is A) trade war. B) collective action. C) prisoner's dilemma. D) benefit-cost analysis. E) None of the above. Answer: 27 C Question Status: Previous Edition 11) When the U.S. placed tariffs on French wine, France placed high tariffs on U.S. chickens. This is an example of A) deadweight losses. B) multilateral negotiations. C) bilateral trade negotiations. D) international market failures. E) None of the above. Answer: E Question Status: Previous Edition 12) Presumably, since the United States is a large country in many of its international markets, a positive optimum tariff exists for this country. It follows therefore that when any legislator or government official who promotes zero-tariff free trade policies, is by definition not acting in the public's best interest. Discuss. Answer: Technically this is true. However, this is true only within the context of a generally myopic view of international relations. If the tariff imposing country is large enough to make a substantial difference in its welfare by seeking an optimum tariff, then it cannot hope to remain invisible, as its policies are substantially harming its trade partners. Foreign repercussions are almost a certainty. In such a "game" it is not at all certain that seeking the optimum tariff dominates alternative strategies. Question Status: Previous Edition 13) It has been claimed that foreign governments have attempted to influence votes in the U.S. that would promote policies of 28 protectionism within the U.S. On the surface this appears to be totally illogical and counter intuitive, as this would presumably lessen the possibilities of foreigners' exports to the U.S. Answer: This would make sense only if the form of protectionism is a tariff. However, if it is a quota, then the scarcity rents may be captured by established foreign producers. Hence, the reaction of the Japanese to automobile quotas was to dramatically increase the high-end, highly profitable automobiles. This would be even more self-evident if the protectionism took the form of a Voluntary Export Restraint (VER), or a detailed formalized bilateral cartel, such as the old Multi-Fibre Agreement. Question Status: Previous Edition 29 14) The U.S. producer Boeing, and the European Airbus are contemplating the next generation mid-sized fuel efficient generation of air carrier. If both produce their respective models, then each would lose $50 million (because the world market is just not large enough to enable either to capture potential scale economies if they had to share the world market). If neither produce, then each one's net gain would of course be zero. If either one produces while the other does not, then the producer will gain $500 million. (a) What is the correct strategy for either company? (b) What is the correct strategy for a government seeking to maximize national economic welfare? (c) If a national government decides to subsidize its aircraft producer, how high should be the subsidy? Answer: (a) enter the market first. Then the other company knows that if it also enters, it will not be able to cover costs. (b) Subsidize its producer. If this allows it to enter first, then we get the same solution as answer (a) above. (c) Any figure above $50 million (e.g. $55 million). This would promise positive profits regardless of the decision of the competitor. The "winner" then may turn out to be that country whose voters are least sensitive to on-the-books, transparent subsidies given to rich corporations (these subsidies will have to continue year after year until the other country stops its subsidies). Question Status: Previous Edition 15) In recent cases, the U.S. placed quotas or protectionist tariffs on imported steel and imported microchips. In both cases the damage to "downstream" industries was obvious to all and relatively easy to quantify and demonstrate. Assuming that the U.S. lawmakers are not plain dumb, why did they enact these protectionist policies? Answer: The system by which these protectionist policies are set into law is biased in favor of the producers of import competitive goods. Other sectors of the economy that may be affected are not parties in the petitions made to the ITC seeking redress. Question Status: Previous Edition 9.5 The Doha Disappointment 1) For most developing countries A) productivity is high among domestic workers. B) population growth and illiteracy rates are low. C) 30 saving and investment levels are high. D) agricultural goods and raw materials constitute a high proportion of domestic output. E) None of the above. Answer: D Question Status: Previous Edition 2) Developing countries have often attempted to establish cartels so as to counter the actual or perceived inexorable downward push on the prices of their exported commodities. OPEC is the best well known of these. How are such cartels expected to help the developing countries? At times importing countries profess support for such schemes. Can you think of any logical basis for such support? How are cartels like monopolies, and how are they different from monopolies. Why is there a presupposition among economists that such schemes are not likely to succeed in the long run? Answer: Such cartels are expected to shift the exporters' terms of trade in their favor. Also they are expected to produce the maximum profit, which the market will bear. Importing countries may benefit from the price stability generated by the cartel. Cartels are like monopolies in that their total output is the same as that which would be generated by a single monopoly. They differ from monopolies in that the monopoly profits need to be divided among the producing countries, which have different cost structures. Question Status: Previous Edition 31 3) The U.S. is probably the most open international market among the industrialized countries. What then does the U.S. have to gain by joining the WTO? Answer: There are two answers. First, the U.S. exporters stand to gain profitable markets if foreign protectionism in areas of U.S. comparative advantage (e.g. soy) is removed due to WTO efforts. The second is that the WTO offers the U.S. government administration a counterweight to regional and sectoral interests demanding protection. It is always politically easier to bring about more efficient resource allocations if the complaints of the losers may be deflected by the presence of a binding treaty with an international organization ("our hands are tied"). Question Status: Previous Edition 9.6 Appendix to Chapter 9: Proving That the Optimum Tariff Is Positive 1) There are no questions for this section. Answer: TRUE Question Status: 32 New How to Study for Chapter 26 International Trade Chapter 26 discusses the theories involving international trade and considers the arguments both for and against free trade. It also discusses recent changes in the trade relations between nations. You will need to review the concepts of production possibilities curve from Chapter 2 and the concepts of absolute advantage and comparative advantage from Chapter 3. 1. Begin by looking over the Objectives listed below. This will tell you the main points you should be looking for as you read the chapter. 2. New words or definitions and certain key points are highlighted in italics in the text and in red color. Other key points are highlighted in bold type and in blue color. 3. You will be given an In Class Assignment and a Homework assignment to illustrate the main concepts of this chapter. 4. There are a few new words in this chapter. Be sure to spend time on the various definitions. There are no new graphs. But there is a review of the production possibilities curve, first presented in Chapter 2. The numerical example illustrating comparative advantage is complicated. Go over it slowly and be sure you understand how each number was derived. The calculations are reinforced in the In Class Assignment and the Homework Assignment. 5. The teacher will focus on the main technical parts of this chapter. You are also responsible for the cases and the ways by which each case illustrates a main principle. You are especially responsible for the way by which the case study of the NAFTA illustrates the principles of the chapter. 6. When you have finished the text, the Test Your Understanding questions, and the assignments, go back to the Objectives. See if you can answer the questions without looking back at the text. If not, go back and reread that part of the text. When you are ready, take the Practice Quiz for Chapter 26. Objectives for Chapter 26 International Trade At the end of Chapter 26, you will be able to answer the following questions: 1. What happened to the importance of international trade in the 20 century? Why? 2. What is meant by “international competitiveness”? 3. What is meant by “absolute advantage” What is meant by “comparative advantage”? (This is a review question from Chapter 3.) 4. What is the production possibilities curve? (This is a review question from Chapter 2) 5. Given a set of numbers, determine which country has a comparative advantage in which 182 Chapter 11: The Balance of Payments 183 goods. Therefore, determine which goods will be exported and which imported. 6. Using a set of numbers, show why trade increases the standard of living in both of the trading partners. 7. Show how trade affects the production possibilities curve. 8. What is “intraindustry trade” and why might it occur? 9. What determines the goods for which a country will have a comparative advantage? 10. Who are the people who “win” from free trade (and why do they “win”) and who are the people who “lose” (and why do they “lose”). 11. Analyze the effects of a tariff. Explain why tariffs impose overall losses on the country imposing the tariff as well as the other trading partner. 12. Explain the “optimal tariff”. Under what conditions does it exist? 13. Name at least three of the arguments in favor of trade protection and then explain each argument. 14. What is meant by a “strategic trade policy”? What is an “infant industry”? What is a “first mover advantage”? 15. Briefly describe American trade policies over the past 150 years. What has happened to American tariff rates since 1945? In what cases does the American government tend to interfere with free trade? Why does it do so? 16. What was the General Agreement on Tariffs and Trade (GATT)? What is Most Favored Nation Status (MFN)? What is the World Trade Organization (WTO)? 17. Describe the North American Free Trade Agreement (NAFTA). Name at least three of its main provisions? 18. What were the benefits to the United States and to Mexico from the NAFTA? In each country, who would gain and who would lose? 19. Name three of the main arguments made against having the NAFTA passed into law? Chapter 26 The Economics of International Trade (latest revision July 2006) th As the 20 century drew to a close, news people devoted much time to remembering the th significant events of the century. Certainly, one of the most significant occurrences of the 20 century was the growth of a “global economy”. Throughout the century, and especially throughout the second half of the century, countries became economically interdependent as they had never been before. Today, almost every important aspect of a nation’s economy is linked to events in other countries. In particular, a much greater share of the national production is sold to foreigners (exported) than ever before. And a much greater share of those goods that people buy are bought from foreigners (imported) than ever before. This increase in economic interdependence occurred for most of the countries of the world, including the United States. For example, in 2005, about 10% of all of the goods and services Chapter 11: The Balance of Payments 184 produced in the United States were sold to buyers in other countries compared to only about 4% in 1959. From 1959 to 2003, American exports increased over 1400% in constant dollars. Over the same time period, American purchases of goods and services from other countries increased approximately 1500%, again in constant dollars. Today, about one out of every four Americans has a job that is closely linked to international trade. And it has been estimated that 70% of American manufacturing companies now face significant competition from companies in other countries. This rise in the importance of international trade is not an accident. It is mainly the result of the enacting of policies to make trade between countries much freer than it was at the end of World War II. Most of these policies were initiated by the United States government. We shall consider below one illustration of the policies initiated to promote free trade: the North American Free Trade Agreement (NAFTA). In developing policies to promote free trade between nations, the United States and other governments have been especially influenced by economists. While there are many things on which economists disagree, the desirability of free trade between countries is a view held by the large majority of economists. However, many noneconomists (and some economists) have opposed policies to free trade between countries. We will consider both the arguments in support of and the arguments against free trade below. A major topic of discussion in the late twentieth century was “international competitiveness”. This involves the ability of a nation to design, produce, and market goods and services that are better or cheaper than those of other countries. Through much of the 1980s and early 1990s, some people claimed that the United States was losing its international competitiveness, especially in relation to Japan. Many different remedies were proposed. From Chapter 3, we know that the United States will not be able to produce “better or cheaper” for all products. So, let us first consider which goods will be produced and which goods will be imported. In doing so, we return to the principle of comparative advantage, first introduced in Chapter 3. This will allow us to present the reasons that so many economists believe that free trade is highly beneficial for the United States and for the world as a whole. 1. The Economists’ Case for Free Trade In Chapter 3, we discussed Adam Smith’s theory of absolute advantage and David Ricardo’s theory of comparative advantage in relation to families. Both of these early economists applied the same reasoning to nations. As Adam Smith put it, “what is prudence in the conduct of every private family can scarce be folly in that of a great kingdom”. Here let us focus on Ricardo’s argument, as this has been the heart of the economists’ defense of free trade. This argument dates to the 1830s. In his text, Ricardo made several simplifying assumptions and we will do the same here. He assumed that there are only two countries; let Chapter 11: The Balance of Payments 185 us call them the United States and Rest of World. He assumed that there are only two products: let us call them agricultural products and manufactured products. To simplify, we will represent agricultural products by wheat and we shall represent manufactured products by computers. Ricardo assumed that the cost of making a unit of a product is determined by the amount of labor time that must be used to produce it and that this cost would not change as the quantity produced is increased. Finally, he assumed that product quality is the same in both countries, that there is no technological change, that there are no transportation costs, and that there is perfect competition in all markets. The chart below shows an illustration, based on Ricardo, of the labor time to produce a unit of each product in each country. In the United States In the Rest of the World Labor Cost Required: 1 bushel of wheat 3 hours 8 hours 1 computer 2 hours 4 hours In this madeup example, the United States has an absolute advantage in the production of both agricultural goods and manufactured goods. This means that the United States can produce both agricultural goods manufactured goods at a lower cost than the Rest of the World. The Rest of the World has an absolute disadvantage in the production of both goods. But as was shown in Chapter 3, there is a benefit to trading, even if one country can produce all products at lower cost than the other country. Assume that there are 48 hours of labor available in each country and no trade is possible. If the United States devoted all of its hours to wheat, it could produce 16 (48 divided by 3) bushels of wheat (point A). If it devoted all of its hours to computers, it could produce 24 (48 divided by 2) computers (point D). Or it could produce some combination in between for example, 4 bushels of wheat and 18 computers (point C) or 12 bushels of wheat and 6 computers (point B). The choices that are available are shown in the production possibilities curve below. The production possibilities curve was introduced in Chapter 2. It shows all combinations of goods that can be produced. Points inside the curve are inefficient, as more goods are capable of being produced. Points outside the curve are not attainable. The production possibilities curve is drawn as a straight line because Ricardo assumed that the costs of producing are constant (that is, no matter how many bushels of wheat have been produced, another unit will still take 3 hours and no matter how many computers we have produced, another unit will still take 2 hours). We know from the discussion in Chapter 14 that costs of production actually rise as the quantity produced increased. However, Ricardo’s assumption makes the analysis easier and does not alter the ultimate conclusion of his analysis. Chapter 11: The Balance of Payments 186 Production Possibilities Curve Without Trade Wheat 16 A 12 B 4 C D 0 6 18 24 Computers Chapter 11: The Balance of Payments 187 Now assume that the two countries can trade freely. As we know from Chapter 3, countries will be best off if they specialize in those goods for which they have a comparative advantage (not an absolute advantage). Comparative advantage occurs where the opportunity cost of producing is lowest. In the United States, a computer requires the sacrifice of 2/3 of a bushel of wheat (that is, the 2 hours needed to produce one computer would also have produced 2/3 of a bushel of wheat). In the Rest of the World, a computer requires the sacrifice of ½ of a bushel of wheat. (In each case, you should be able to explain why.) Therefore, the Rest of the World has a lower opportunity cost for computers. In the United States, a bushel of wheat requires the sacrifice of 1½ Computers (3/2). In the Rest of the World, a bushel of wheat requires the sacrifice of 2 computers (8/4). Therefore, the United States has a lower opportunity cost for agricultural goods. Even though the United States has an absolute advantage in both products, it has a comparative advantage only in wheat. In this example, the United States should specialize in wheat and trade for computers. To illustrate why international trade is seen as desirable, begin with Point B on the production possibilities curve on the previous page. It shows that, with no trade, the United States can produce 12 bushels of wheat and 6 computers. Now assume the United States specializes completely in wheat. Point A shows that the United States can produce 16 bushels of wheat. Suppose that the United States trades 4 of these bushels to the Rest of the World in exchange for computers. How much will the United States get in return? The answer is 8 computers. Test Your Understanding Explain why each bushel of wheat traded will bring back 2 computers from the Rest of the World. The United States will have the same amount of wheat (12 bushels) and more computers (8) if trade occurs. It is better off! The Rest of the World is also better off. Examine to the production possibilities curve below. The solid line indicates the combinations without trade, and is repeated from above. The dashed line indicates the combinations with trade. If the United States specializes in wheat and trades, it can have 12 bushels of wheat and 8 computers, 4 bushels of wheat and 24 computers, or 0 bushels of wheat and 32 computers. This occurs because each bushel of wheat traded will bring back 2 computers from the Rest of the World. Go over these numbers carefully to be sure you understand how each was derived. The production possibilities curve has shifted out to the right. More goods are possible with trade. The United States as a whole is unambiguously better off. So is the Rest of the World. Chapter 11: The Balance of Payments 188 Production Possibilities Curve With Trade Wheat 16 A 12 B B’ 4 C C’ D D’ 0 6 8 18 24 32 Manufactured Goods Test Your Understanding The text does the case for the United States. Here, do the case for the Rest of the World. 1. First, in the space below, draw the production possibilities curve for the Rest of the World, assuming that there are only 48 hours of labor time available. Remember that the production Chapter 11: The Balance of Payments 189 possibilities curve shows all possible combinations of goods that can be produced. If all of the hours are devoted to agricultural goods, Rest of the World can produce _____ units. If all of the hours are devoted to manufactured goods, Rest of the World can produce _____ units. If 40 hours were devoted to agricultural goods and 8 hours to manufactured goods, Rest of the World can produce ____ units of agricultural goods and ____ units of manufactured goods. If 24 hours were devoted to agricultural goods and 24 hours to manufactured goods, Rest of the World can produce ____ units of agricultural goods and ____ units of manufactured goods. Show these on the graph below. Show the production possibilities curve as a solid line. 2. Second, in Rest of the World, each hour devoted to manufactured goods requires the sacrifice of ___ unit of agricultural goods. This is the opportunity cost. In the United States, each hour devoted to manufactured goods requires the sacrifice of ___ unit of agricultural goods. This is the opportunity cost. Rest of the World has the absolute advantage in ______________. The United States has the absolute advantage in _______________. (Choose agricultural goods, manufactured goods, both, or neither). Rest of the World has the comparative advantage in ______________. The United States has the comparative advantage in _______________. (Choose agricultural goods or manufactured goods). Rest of the World should export __________________ goods and it should import ________________ goods. 3. Third, imagine that rest of the World specialized completely in manufactured goods. All 48 hours were used to produce manufactured goods. Rest of the World then trades 6 units of manufactured goods to the United States. In return, it gets back _____ units of agricultural goods from the United States. Is Rest of the World betteroff with trade? Why? _____________________________ 4. Finally, show the production possibilities curve with trade on the graph. Show the new production possibilities curve as a dashed line. That the United States specializes in wheat in this example, while the Rest of the World specializes in computers, does not occur just because it is desirable. The action of markets brings about this result. To illustrate this, let us convert the analysis into money terms. Assume that workers are paid $15 per hour in the United States and $7 per hour in the Rest of the World. (Wages must be lower in the Rest of the World because their workers are less productive.) The costs of making products in the two countries are shown below (assuming again that labor in the only cost): United States Rest of the World Agricultural Goods $45 $56 Manufactured Goods $30 $28 People in both countries will buy wheat from the United States because it is cheaper. And people in both countries will buy computers from the Rest of the World because they are cheaper. Chapter 11: The Balance of Payments 190 The example created here is based on the example provided by Ricardo in the 1830s. In his example, he showed that there were gains to trading English cloth for Portuguese wine even though Portugal could produce both products at lower cost (but was especially better at producing wine). His example is quite simplistic, as we noted above. But even if we make the illustration more realistic, the basic conclusion is not changed. This basic conclusion is that, even if a country can produce all goods at a lower cost than another country, there are gains from specializing in those goods for which there is a comparative advantage and trading for those goods in which there is a comparative disadvantage. Since comparative advantage depends on relative costs, it is impossible for a nation to have no comparative advantage at all. All countries benefit from trade because they have more goods and services with trade than without it. This conclusion has been one of the most important intellectual arguments of the past two centuries. 2. What Determines Comparative Advantage? The above example was made up so that the United States had a comparative advantage in wheat production. But, in reality, what does determine the comparative advantage that a country will have? The most important theory to answer this question came from two Swedish economists, Eli Heckscher (1919) and his student, Bertil Ohlin (1933). Their theory has two aspects. First, countries have abundant amounts of certain factors of production and lesser amounts of other factors of production. So, the United States has abundant agricultural land while, in Sweden, agricultural land is very scarce. The United States has abundant capital and skilled labor while, in China, both are relatively scarce. But China has abundant unskilled labor while, in the United States, such labor is relatively scarce. The second aspect of the theory is that certain goods require certain factors of production. Thus, automobile production is capitalintensive, wheat production is landintensive, textile production is laborintensive, computer software production is technologyintensive, and so forth. The HeckscherOhlin theory says, in Ohlin’s words, “Commodities requiring for their production much of the abundant factors of production and little of the scarce factors of production are exported in exchange for goods that call for factors in the opposite proportions.” In the madeup example above, the United States would export wheat because of its abundant land. The Rest of the World would export computers either because of more abundant capital or more abundant labor (most likely the latter). Chapter 11: The Balance of Payments 191 Do the actual patterns of trade fit the predictions of the HeckscherOhlin theory? The answer seems to be “basically yes”. Most of American trade, as well as that of other countries, seems to be consistent with this theory. However, there is some trade that cannot be explained in this way. Test Your Understanding According to a study for the year 1980, the United States had 28.6% of all of the world’s resources. It had the following percentages for the individual factors of production: Physical Capital 33.6% Unskilled Labor 0.19% Skilled Labor 27.7% Arable Land 29.3% Semiskilled Labor 19.1% R&D Scientists 50.7% The United S
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