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International Economics midsem Chapter 9 The Political Economy of Trade Policy 91 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 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 tradepolicy 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 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 SmootHawley Tariff Act of 1930 has generally been associated with A falling tariffs B free trade C intensifying the worldwide depression D recovery from the worldwide depression E nontariff 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 an 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 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 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 11 The WTO39s 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 freetrade stance in a world in which all other countries exploit child or prisoner labor or are protectionist On the other hand Ricardo39s 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 largescale labor migration ignoring labor conditions abroad may ultimately result in living standards for domestic workers to be dragged down Question Status Previous Edition 92 National Welfare Arguments Against Free Trade 1 The optimum tari 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 tari 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 Previous Edition 3 The prohibitive tari is a tariff that A is so high that it eliminates imports B is so high that it causes undue harm to tradepartner 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 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 nongovernmental involvement B is an argument supporting the use of an optimum tariff C is an argument supporting the use of market failures as a tradepolicy 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 firstbest B the second best C the third best D the su icing principle E None of the above Answer B Question Status Previous Edition 6 The difficulty of ascertaining the right secondbest trade policy to follow A reinforces support for the thirdbest 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 freetrade 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 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 US 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 nonconditional compensatory mechanisms the basic conflict between these two groups will always be there Question Status Previous Edition Hungarian Market 16 14 12 1O 8 M00 nc subsidy e 4 MC1 subsidy 2 MR Million 2 4 6 8 1O 12 14 16 Assume that Boeing US 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 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 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 93 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 NonGovernmental Organizations so as to limit taxpayer burden C a presumption that free trade is generally a secondbest 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 secondbest 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 freetrade policy 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 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 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 country39s demand schedule C the more elastic is the target country39s domestic supply D the more inelastic the target country39s 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 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 Iraq39s international trade This would induce smaller losses in Iraq39s consumer surplus the A less elastic Iraq39s demand schedule B more elastic Iraq39s demand schedule C greater is Iraq39s dependence on foreign products D more inelastic is Iraq39s supply schedule E None of the above Answer B Question Status Previous Edition 10 Today US protectionism is concentrated in A high tech industries B laborintensive industries C industries in which Japan has a comparative advantage D computer intensive industries E capitalintensive industries Answer B Question Status Previous Edition 11 The quantitative importance of US 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 US are poor countries D this industry is a politically well organized sector in the US 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 US 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 quotconsumersquot 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 94 International Negotiations and Trade Policy 1 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 freetrade 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 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 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 LocalContent 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 US grain consumers of bread B US grain producers C foreign grain producers D US communists E None of the above Answer B Question Status Previous Edition 6 Under US 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 US to extradite anyone who escaped political oppression D tax advantages extended to minorityowned exporting firms E tariff advantages extended to certain Caribbean countries in the US market Answer A Question Status Previous Edition 7 Under US 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 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 9 The political wisdom of choosing a tariff acceptable to the median US 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 gametheory 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 prisoner39s dilemma D benefitcost analysis E None of the above Answer C Question Status Previous Edition 11 When the US placed tariffs on French wine France placed high tariffs on US 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 zerotariff free trade policies is by definition not acting in the public39s 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 quotgamequot 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 US that would promote policies of protectionism within the US On the surface this appears to be totally illogical and counter intuitive as this would presumably lessen the possibilities of foreigners39 exports to the US 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 highend highly profitable automobiles This would be even more selfevident if the protectionism took the form of a Voluntary Export Restraint VER or a detailed formalized bilateral cartel such as the old MultiFibre Agreement Question Status Previous Edition 10 14 The US producer Boeing and the European Airbus are contemplating the next generation midsized 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 one39s 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 quotwinnerquot then may turn out to be that country whose voters are least sensitive to onthebooks 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 US placed quotas or protectionist tariffs on imported steel and imported microchips In both cases the damage to quotdownstreamquot industries was obvious to all and relatively easy to quantify and demonstrate Assuming that the US 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 95 The Doha Disappointment 1 For most developing countries A productivity is high among domestic workers B population growth and illiteracy rates are low C 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 exporters39 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 11 3 The US is probably the most open international market among the industrialized countries What then does the US have to gain by joining the WTO Answer There are two answers First the US exporters stand to gain profitable markets if foreign protectionism in areas of US comparative advantage e g soy is removed due to WTO efforts The second is that the WTO offers the US 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 quotour hands are tiedquot Question Status Previous Edition 96 Appendix to Chapter 9 Proving That the Optimum Tariff Is Positive 1 There are no questions for this section Answer TRUE Question Status 12 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 20th 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 What is the production possibilities curve This is a review question from Chapter 2 Given a set of numbers determine which country has a comparative advantage in which 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 U P 182 Chapter 11 The Balance of Payments 183 trading partners Show how trade affects the production possibilities curve What is intraindustry trade and why might it occur What determines the goods for which a country will have a comparative advantage 0 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 Brie y 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 Hpms Chapter 26 The Economics of International Trade latest revision July 2006 As the 20th century drew to a close news people devoted much time to remembering the significant events of the century Certainly one of the most significant occurrences of the 20th 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 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 183 Chapter 11 The Balance of Payments 184 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 in uenced 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 rst 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 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 184 Chapter 11 The Balance of Payments 185 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 Production Possibilities Curve Without Trade Wheat 16 185 Chapter 11 The Balance of Payments 186 12 B 4 c D 0 6 l 8 24 Computers 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 23 of a bushel of wheat that is the 2 hours needed to produce one computer would also have produced 23 of a bushel of wheat In the Rest of the World a computer requires the sacrifice of 12 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 112 Computers 32 In the Rest of the World a bushel of wheat requires the sacrifice of 2 computers 84 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 186 Chapter 11 The Balance of Payments 187 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 Production Possibilities Curve With Trade Wheat o o o O o o o o o Chapter 11 The Balance of Payments 188 4 C 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 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 188 Chapter 11 The Balance of Payments 189 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 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 bene t 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 189 Chapter 11 The Balance of Payments 190 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 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 286 of all of the world s resources It had the following percentages for the individual factors of production Physical Capital 336 Unskilled Labor 019 Skilled Labor 277 Arable Land 293 Semiskilled Labor 191 RampD Scientists 507 The United States is relatively abundant in which of the above factors of production The United States is relatively scarce in which of the above factors of production Go on the Internet What goods and services are the main exports of the United States Illustrate with numbers ie what percent of American exports does that good represent What goods and services are the main imports of the United States Again illustrate with numbers Is the trade pattern of the United States consistent with the HeckscherOhlin theory Explain why or why not 3 Making the Theory More Realistic From the theory of comparative advantage of Ricardo we should expect that countries that are similar would not trade with each other very much Most trade would occur between countries that are very different But this is not what we observe Most American trade is conducted with other industrialized countries whose economies are quite similar to the United States Indeed much trade between these industrialized countries is intraindustry trade trading the same or very similar goods For example in 1992 the United States imported almost 23 billion worth of computers and exported over 17 billion worth of computers How do we explain this result The answer is that the theory of Ricardo assumed perfect competition In perfect competition all products are assumed to be identical In reality most competition involves monopolistic competition Industries are competitive but the products traded are differentiated It is certainly understandable that the United States would export Ford automobiles to Germany and import BMWs Or that the United States would export strawberries grown in the spring and summer to Mexico while importing back from Mexico strawberries grown in the winter 190 Chapter 11 The Balance of Payments 191 4 Winners and Losers from Free Trade The conclusion that trade is beneficial to each country as a whole as well as to the world as a whole is widely accepted by most economists But this does not mean that trade is good for every person Within each country trade generates winners and losers The losers have often been strong opponents of policies that open trade between countries In many cases they have been able to prevent such opening Who are these winners and who are these losers from international trade As we have just seen if trade is free countries will export those goods that require the factors of production that are relatively abundant and import those that require the factors of production that are relatively scarce For the United States this means exporting goods that use large amounts of arable land capital and highly skilled labor It also means importing goods that require large amounts of unskilled labor Suppose as is likely to be the case that the United States has a comparative advantage in production of computer software The ability to trade and therefore to sell in foreign countries increases the demand for American computer software This increase in demand both increases the quantity of computer software products sold and also increases their prices Both the increased quantity sold and the increased prices will increase the shortrun profits of owners of computer software companies They will also increase the demand for labor increasing the number of people employed in the computer software industry as well as their wages Therefore the owners of computer software companies and their workers are both Winners On the other hand assume as is likely to be the case that the United States has a comparative disadvantage in textiles With free trade the United States will import textile products The imports increase the supply of textile products in the United States decreasing their prices The decrease in prices will reduce the profits of the owners of American textile companies in the shortrun The decrease in textile prices will also decrease the demand for American textile workers causing both the number of jobs for American textile workers and their wages to decrease Therefore the owners of American textile companies and their workers are losers from international trade In general for the United States free trade benefits owners of arable farmland as well as highly skilled workers and the companies that employ them Free trade hurts unskilled and semiskilled workers and the companies that employ them In a country such as Mexico the opposite is expected to occur In Mexico free trade should benefit unskilled and semiskilled workers as well as the owners of the companies that employ them In Mexico free trade should hurt highly skilled workers There is some question as to whether this actually occurs Certain owners of arable land in Mexico are winners for example those with land that can grow strawberries or bananas while owners of other arable land are losers for example those with land that can grow wheat 191 Chapter 11 The Balance of Payments 192 In summary owners of factors of production specific to export industries tend to gain from international trade while owners of factors of production specific to importcompeting industries lose But for this statement to be true it must be assumed that the factors of production are specific and not general This means that the factors of production cannot easily shift from one employment to another American textile workers would not be hurt if they could shift easily to work in the computer software industry But for many workers and for most capital such a shift is very difficult and costly The analysis of the benefits of free trade shows clearly that the gain to the winners from free trade exceeds the harm to the losers We know this because we showed that the United States as a whole and the world as a whole is better off with free trade Yet in political decisionmaking the losers are often able to prevent policies that promote free trade To understand why policies that are good for the country as a whole are not enacted review the section on Public Choice in Chapter 11 In this case the bene ts from free trade are widespread many workers and owners increase their incomes plus consumers have more consumer goods available while the costs of free trade are concentrated certain workers and owners lose their jobs or have their incomes reduced 5 Tariffs As just stated those who lose from free trade are often able to obtain government policies that restrict trade The most common of these restrictions is a tarif a tax on imported goods or services Let us show this on the familiar demand and supply graph In the graph below assume that if there were no trade the price of automobiles would be 25000 per automobile The world price is 20000 With free trade buyers would be able to buy 20 million automobiles at the world price of 20000 Given the costs of making automobiles American automobile companies would produce only 10 million automobiles at the world price of 20000 The other 10 million automobiles would be imported Price 000 S ply Curve of American Companies 192 Chapter 11 The Balance of Payments 193 25 20 World Price Demand Curve of American Buyers 0 10 17 20 Quantity of Automobiles Millions Now imagine there is a tariff enacted that raises the price in the United States to 25000 First what are the effects on American consumers American consumers will now buy 17 million automobiles per year instead of 20 million Therefore they lose the satisfaction they would have gained from 3 million new automobiles And American consumers will now pay 25000 per automobile instead of 20000 This extra 5000 per automobile applies to all automobiles not just to the imported ones American consumers will now pay 425 billion for their automobiles 25000 times 17 million instead of 400 billion 20000 times 20 million They will be paying more receiving fewer automobiles and have less choice and variety Second what are the effects of the tariff on American producers By raising the price of foreign automobiles the tariff causes American buyers to shift to American automobiles The prices of American automobiles rise to 25000 This stimulates American automobiles companies to produce more automobiles Therefore American producers gain both from the higher prices and from the additional automobiles produced In the graph they would produce 7 million additional automobiles as a result of the tariff 17 million instead of 10 million and charge 5000 more for their automobiles 25000 instead of 20000 The American automobile companies would be able to charge a higher price because the tariff makes foreign automobiles a substitute more expensive Notice that the American automobile producers gain the benefit of the higher prices on the automobiles they produce But American consumers pay the higher prices not only on the American automobiles but also on the foreign automobiles Therefore the loss to American consumers must be greater than the gain to the American producers As a whole Americans are worseoff This conclusion holds even if we consider the tariff revenue collected by the government as part of the national gain This analysis of the effects of a tariff has thus far assumed that the United States cannot affect the world price of automobiles 20000 by its tariff policies For small countries this is likely to be true But for large countries such as the United States this may not be true If 193 Chapter 11 The Balance of Payments 194 American purchases of automobiles can indeed affect the world price we may have the case of the optimal tariff discussed in Chapter 7 In the case on page 11 the United States imposed a tariff and the American automobile buyers shifted their purchases to American automobiles Now suppose that facing a major loss in sales the foreign automobile producers are forced to lower their prices The world automobile price decreases In effect foreign automobile producers are paying part of the tariff Indeed if the world price fell from 20000 to 15000 foreign automobile producers would be paying the entire tariff Tariffs still cause overall losses But now the United States is able to shift some of the losses on to foreigners For this result to occur the American demand must be able to in uence the world price that is foreign producers must be dependent on American buyers and American buyers must respond strongly to changes in the relative prices of foreign and American products the demand for foreign products must be very elastic Our analysis indicates that the United States as a whole loses when it imposes a tariff But we need to know if tariffs and other forms of protection against imported products impose large or small losses on the United States There have been several studies designed to answer this question The conclusion from these studies is that as a percent of American total income tariffs impose a very small cost A typical estimate would be that American total income is reduced perhaps 01 as a result of tariffs This result occurs because tariffs are imposed on few products But for those products on which tariffs are imposed the burden can be high One study in 1990 for 23 industries on which there were tariffs concluded that Americans lose 149 for each 100 gained by the protected industry The other 049 is pure loss to the United States Political battles as to whether trade should be free or should be protected against imports can be battles over billions of dollars in total 1ncome 6 Arguments for Trade Protection It has been stated several times that most economists support free trade and oppose policies of protection There are however some significant economic arguments made by those who do support policies of trade protection such as tariffs First and foremost there is the infant industry argument If a domestic industry is new it will produce a small quantity of the product As we know from Chapter 15 producing a small quantity will cause costs of production to be high As the companies in the domestic industry increase production they will be able to produce at a lower cost because of economies of scale They may also be able to gain dynamic increasing returns to scale As we saw in Chapter 15 this means that the companies can learn by doing and therefore nd ways to lower their costs Finally the companies in the domestic industry may be able to gain economies of scope Again as we saw in Chapter 15 this means that by producing several products the companies can produce each one at a lower cost The point is that once the companies in the domestic industry sell enough of the products they will be able to produce at a cost that will enable them to 194 Chapter 11 The Balance of Payments 195 compete with the foreign companies At that time the tariff protection would no longer be needed This infant industry argument was used by Alexander Hamilton in a 1791 report that formed the basis for 19th century American trade policies see below In recent times it was used by the Japanese government who protected their domestic steel shipbuilding automobile electronics and computer industries before they became strong international competitors A related argument made for trade protection involves the fact that in some industries trade comes to be dominated by very few companies This of course is oligopoly So for example commercial aircraft is dominated by Boeing and Airbus and microprocessors are dominated by Intel and Motorola There are several industries such as automobiles and steel in which more than half of world trade is conducted by five or fewer companies Why does this occur The answer takes us back to economies of scale When fixed costs are high an increase in the quantity sold by a company will lower the cost per unit of producing the average total cost1 Because of economies of scale the industry will become an oligopoly Review the explanation of natural monopoly from Chapter 19 to be sure you understand the reasons for this Oligopoly companies can earn significant economic profits from their export sales Because of this it matters greatly to a country where the production takes place If these oligopoly companies are located in the United States their economic profits will add to American income at the expense of foreigners Because they can produce at a lower cost it will be very hard for companies in other countries to be able to compete with them They would have what are called first mover advantages This means that the companies that produce first will have cost advantages that make it very difficult for others to begin to compete with them These economic profits will persist Undertaking policies to assure that these particular companies are located in the United States has been called strategic trade policy Companies in high technology industries are especially likely to have such firstmover advantages As we saw in Chapter 19 in high technology companies often experience very high fixed costs but low perhaps zero marginal costs This combination causes them to become oligopolies Because their products are in great demand they can earn great economic profits Several economists who ultimately became important advisors to President Clinton had been advocates of a strategic trade policy toward high technology industries in order to assure that the companies in such industries would earn their economic profits within the boundaries of the United States 1Economies of scale may also occur for the industry as a whole This could occur because one large company brings enough specialized labor into the area to lower the costs of labor for other companies Or it could occur because one large company allows product and production technology to diffuse quickly to other companies in the same area Silicon Valley would be an example of this point A third argument made for trade protection is that domestic production in certain industries provides social benefits that will not be provided if the products are imported For example a growing computer industry provides knowledge that is important for companies 195 Chapter 11 The Balance of Payments 196 that produce computerrelated products and for companies that use the computer services Those who make this point argue that the benefits from expanded computer production do not easily spill over national boundaries The growth of American computer chips led to the growth of an American software industry It did not help the software industry of France A fourth argument made for trade protection involves contracting industries Suppose that the United States develops a comparative advantage in computer and computer products and loses its comparative advantage in production of steel Under free trade the United States will increase its production of computers and computer products and decrease its production of steel The argument of Ricardo assumed that workers would simply shift from steel production to computer production In a world when most workers were unskilled this assumption may not have been too bad But as noted earlier workers usually have specific skills that will be lost if they shift to other industries And because workers have ties to the place in which they live being forced to move will be a large burden for them Tariffs can prevent these very large costs being imposed on these workers For this reason trade that is within an industry commonly has less political opposition than trade between industries It is virtually impossible for a textile worker to become a highly skilled computer professional But it is not as difficult for a worker on a Pontiac to become a worker for Honda in Ohio One study found that 63 of the workers who lost jobs between 1979 and 1999 in import competing industries eventually found another job On average they suffered a 13 pay cut But a quarter of these people took a pay cut of 30 or more There are many people who argue that we should provide aid to these people in finding jobs and wage insurance to make up some of the difference in pay A fifth argument made for trade protection involves the distribution of income As we saw above free trade in the United States increases the incomes of highly skilled workers as well as the incomes of owners of certain types of capital goods It also decreases the incomes of less skilled workers To some people this seems unfair since less skilled workers are likely to have relatively low incomes In this argument a tariff would act to make the distribution of income more equal by increasing the incomes of those whose incomes are likely to be near the bottom of the income distribution Of course there may be better ways to deal with inequality than imposing tariffs A sixth argument made for trade protection involves the environment Indeed many environmental groups are commonly against policies to make international trade freer The main argument of environmentalists is that developing countries such as Mexico either have more lax environmental laws or do not enforce their environmental laws very well There are two ways to make products cheaper improve efficiency or externalize costs impose the costs on others In competitive markets companies will look to lower costs and will therefore externalize costs if they can get away with it Allowing free trade between these countries allows American companies to locate in countries where they can get away with it 1We will 196 Chapter 11 The Balance of Payments 197 examine this argument in the section on NAFTA below A related argument is that free trade also allows American companies to locate production in countries where they can force workers to work many hours per day for very low wages An example of the environmental effects of free trade involves the fact that under the modern method of fishing for tuna called purseseine large numbers of dolphins are killed Since this method of fishing for tuna came into use around 1960 over 6 million dolphins have been killed Most Mexican fishers of tuna continue to use this method of fishing In 1991 the United States banned imports of tuna from Mexico Mexico protested arguing that the United States was simply using the killing of dolphins as a way to protect its own tuna industry The organization that heard the case then called the General Agreement on Tariffs and Trade GATT and now called the World Trade Organization WTO agreed with Mexico and forced the United States to remove its ban This case made many environmental groups suspicious of free trade agreements Free trade they argue creates a separation between the consumption of goods and the environmental damage If buying certain goods oil for example would damage the beaches of California many people will be mobilized to do something to protect the beaches But if eating a hamburger at McDonald s damages the rainforest of Brazil few Californians are likely to know or even care Brazilians who are affects may be powerless to stop the production that damages their forests 1 This situation was common in American history For example until the 1930s policies were governed mainly at the state level This made it very difficult to pass laws to eliminate child labor Northern companies especially in textiles had more capital and better technology Southern states would allow child labor because the cheap labor allowed their companies to compete with the northern companies Northern states would not pass restrictions on child labor because doing so would hurt their companies Until the national government passed laws on the matter child labor was common in American manufacturing Likewise dealing with environmental externalities may be very hard to do at the level of the nation it may require international agreements Finally there are other noneconomic arguments made for trade protection Some products it is argued should be produced domestically because they are sources of national pride For example most Latin American countries have national orchestras Trade theory would dictate that these countries focus on exports of wool or beef and import better symphonies from Europe These Latin American countries believe that their communities are enriched by having their own orchestras And some products it is argued need to be produced domestically because they are essential to the national defense It is also argued that free trade causes individual nations to lose the ability to control their economic lives Most economists take these arguments for protection quite seriously As is often the case there are good arguments on both sides of this issue Test Your Understanding In November of 1999 the World Trade Organization WTO met in Seattle There were about 50000 protestors there There was destruction and some arrests 1 What does the World Trade Organization WTO do You will need to get information from 197 Chapter 11 The Balance of Payments 198 the Internet or newspapers 2 Choose one of the following groups who opposed the World Trade Organization WTO In each case explain the reasons that the group opposes the WTO How does it want the WTO to change You will get the information you need from the Internet or from newspapers a The AFL CIO or any particular labor union b Any Environmental group who opposed the WTO such as the Sierra Club 0 Any other political group who opposed the WTO In this case find some group who was in Seattle to protest but who was not affiliated with a labor union or environmental group 3 Present arguments made by people in support of the World Trade Organization WTO Who are the people supporting the WTO What arguments do they make that it has been good for the world economy You will get the information you need from the Internet or from newspaper accounts 7 American Trade Policies Since the end of World War II the United States has been the leading proponent of free trade around the world But it was not always so For the century and a half up to World War II the United States was basically a protectionist country Over that entire period American tariffs averaged just about 30 This is equivalent to a 30 sales tax on imported products Particularly noteworthy were the socalled Tariff of Abominations of 1828 in which the tariff on imported woolen products reached over 80 and the SmootHawley Tariff of 1930 Tariffs were so high for two reasons First the money raised was a major source of revenue for the federal government And second there was strong pressure for protection from New England producers of manufactured goods As with all tariffs the United States paid a cost for its protectionist policy Because the tariff was high on imported capital goods to protect the New England manufacturers it raised the prices in the United States of all capital goods whether imported or produced at home With higher prices buyers bought fewer capital goods Since capital goods are those that are used in production fewer goods and services were produced in the United States prior to World War II than could have been produced had there been no tariffs Since World War II the United States government has relied much more on income taxes and much less on tariffs for its revenues And American manufacturers found exporting more important than restricting imports In 1947 the United States entered the General Agreement on Tariffs and Trade GA T T The purpose of GATT was to find ways for countries to negotiate bilateral reductions in their tariffs that is both countries agreeing to reduce tariffs As part of GATT the member countries agreed to the Most Favored Nation MFN principle This meant that each country would have a tariff rate for all member countries that was the same as that of the most favored nation the nation that received the lowest tariff rate Over the years tariff rates between most of the industrial countries have been lowered in a series of steps As of now the overall American tariff rate averages only about 3 In the 198 Chapter 11 The Balance of Payments 199 mid1990s the GATT was replaced by the World Trade Organization WTO with the same goals Despite being the leading proponent of free trade over the past 50 years the United States government has still interfered in international trade on several occasions Most of this intervention has been to try to offset the decline of an American industry For example the American steel and automobile companies had once dominated the world But over the 1960s and 1970s they continually lost their share of the world market and even the American market to Japanese companies The key reason for their decline was their inability to raise productivity as much as the Japanese could This made them high cost producers For both industries the United States government intervened to help prevent the decline The tariffs against Japanese steel were discussed in Chapter 16 on Dumping And the Voluntary Export Restraints against Japanese automobiles in the 19805 were discussed in Chapter 7 In a Voluntary Export Restraint the United States government pressured the foreign government to volunteer to limit the sales of a given product in the United States Government loans were also made to the Chrysler Corporation to help it make changes that would allow it to survive The apparel industry in the United States based as it is on unskilled labor also has been in decline for many years To slow this decline there has been a Voluntary Export Restraint against imports of apparel from Asia since 1962 and a MultiFiber Agreement limiting the importation of foreignmade textile products The United States government has also intervened as its electronics and semiconductor industries lost world market share For these industries the intervention mainly involved suits and negotiations with foreign governments to change practices in the foreign country especially Japan While much of the intervention of the American government has involved declining American industries some has not The very high tariff on imported sugar was discussed in Chapter 11 There are restrictions on importing many agricultural products The American government also has provided large subsidies to Boeing to help stimulate sales of commercial aircraft in foreign markets Test Your Understanding The text refers to a paradox On the one hand since the end of World War II the government of the United States has been the leading proponent of free trade around the world Many actions have been taken by the American government to promote free trade Yet on the other hand the American government has imposed trade restrictions on Japanese steel Japanese automobiles textiles agricultural products and so forth The American government has also subsidized certain companies such as Boeing to aid them in international competition How do you explain this paradox You may want to review the section on Public Choice before answering Case Study The North American Free Trade Agreement of 1994 NAFTA From the 1950s until the early 1980s Mexico pursued a development strategy called importsubstitution industrialization This meant that Mexico attempted to avoid dependence on international trade in its pursuit of economic growth and development As late as 1971 199 Chapter 11 The Balance of Payments 200 only about 6 of goods bought by Mexicans were imported Even by 1988 this figure had risen to only 107 Imports and exports were less significant for Mexico than for the United States and much less significant than for the countries of East Asia or Europe Although its trade was limited Mexico was very dependent on the United States as a very high proportion of Mexican exports and imports involved the United States By contrast America was not very dependent on Mexico only about 5 of American imports came from Mexico The Mexican import substitution strategy had been designed to protect domestic Mexican producers against foreign competition The strategy saw exports as necessary only to earn the dollars necessary to be able to buy the capital goods and raw materials needed for industrialization Imports were limited to those capital goods and raw materials through a system of licenses and high tariffs There were restrictions on foreigners owning companies in Mexico The protected market was designed to give Mexican producers the time to grow so that they could become competitive with American European and Japanese manufacturers This is the infantindustry argument discussed above Under pressure from the United States government following its debt crisis of 1982 Mexico shifted away from its importsubstitution industrialization strategy and toward a policy of freer trade called quotliberalization quot The use of licenses to limit imports was virtually eliminated Tariffs were reduced significantly Most of Mexico39s industries were opened to foreign investors In 1986 Mexico joined the GATT Mexican exports expanded greatly in the 1980s and 1990s rising from the 20 billion to about 50 billion by 1994 Most of these Mexican exports were sold to the United States As dependent as it was becoming on trade with the United States Mexico felt threatened by rising trade protectionist sentiments in the United States Beginning in 1990 Mexican President Salinas requested discussions with the United States to create a North American Free Trade Agreement NAFTA In August of 1992 the United States Mexico and Canada signed the agreement to form a North American Free Trade Area NAFTA Canada and the United States had already formed a free trade area in 1989 In a Free Trade Area there are no tariffs between the countries In the agreement all tariffs and duties were to be phasedout over 15 years The agreement was historic there had never been such an agreement between countries with such disparate standards of living The Free Trade Area took effect on January 1 1994 The agreement was and still is a source of considerable controversy in the United States To understand this controversy let us first look at the effects of the agreement on the American economy The main purpose of the free trade agreement was to expand trade and American investment in Mexico Most studies have indicated that the NAFTA did indeed expand trade In 1994 exports among the three countries grew by 19 American exports of a large number of products expanded significantly field crops corn wheat and soybeans and 200 Chapter 11 The Balance of Payments 201 processed foods chemical products plastics pharmaceuticals highgrade steel automobiles and automobile parts machinery and products related to high technology American imports of several products expanded as well crude and refined petroleum fruits and vegetables apparel and textiles footwear and trucking services Imports of cars produced in Mexico also rose In general one would expect American exports of capital or technologyintensive products to expand and Mexican exports of laborintensive products to expand Despite the financial crisis in Mexico in 1995 and the recession of 2001 this seems to be what has occurred One area of concern for both countries was agriculture As discussed in an earlier chapter agriculture has been a highly subsidized and protected industry in most countries The United States had low tariffs 4 on average in 1990 covering 25 of agricultural imports from Mexico but many nontariff barriers Mexico had higher tariffs 11 and import licensing requirements for many products representing over 50 of Mexican agricultural imports from the United States Agriculture has provided the livelihood for more than one quarter of the Mexican labor force Thus Mexico had an interest in slowing the liberalization of agricultural trade Under the NAFTA half of the agricultural goods imported into Mexico from the United States immediately became tarifffree Other tariffs were to be phased out over 15 years However when imports cause an enormous burden of adjustment tariffs are allowed to rise So the United States has restrictions against Mexican sugar peanuts corn beans and winter vegetables In the United States grain farmers and livestock producers should see the market for their products expand Grain especially corn farmers in Mexico should lose some of their market these are typically the small and poor farmers in the south of Mexico Other the other hand American fruit and vegetable farmers should lose some of their market as imports from Mexico increase Those who grow citrus in Florida should lose more than those who grow citrus in California because Mexican imports compete mainly in the winter months Fruit and vegetable farmers in Mexico should gain markets these are the richer commercial farmers in the north of Mexico Another trade issue of concern especially to American automobile and textile companies involved rules of origin The concern here was that other countries especially Japan could ship goods through Mexico or have a small portion of the good produced in Mexico in order to avoid American and Canadian tariffs In the NAFTA it was agreed that cars and light trucks must have 625 58 of the value of their parts and labor be produced in North America in order to qualify for the tarifffree status In addition for several years the advantage of tarifffree status went only to firms that already had assembly plants in Mexico General Motors Ford Chrysler Nissan and Volkswagen A similar provision was adopted for textiles tarifffree status was granted only to goods made with yarn and fabric produced in North America 201 Chapter 11 The Balance of Payments 202 There has been great concern in the United States about the effects of the NAFTA on the American labor market Nearly all studies indicated that there would be a net job gain for the United States Because the NAFTA was expected to generate more American exports to Mexico than American imports it was expected to create more new jobs than would be lost Remember that American tariff rates were already low while Mexican tariff rates were not And those jobs that would be lost would be lost over several years even further reducing the burden of adjustment But there certainly has been hardship on some families as a result of the NAFTA The highest estimate of job losses due to NAFTA is 420000 the American labor force totaled over 146000000 at the end of 2005 Those workers became eligible for employment services training and income support for up to 78 weeks Those Americans most at risk are those who work in the laborintensive manufacturing industries such as textiles and apparel and laborintensive agricultural goods such as sugar fruits and vegetables Most job losers will be noncollege educated workers who tend to be at the lower end of the wage distribution Most job gainers will be more educated workers whose wages are normally at the high end of the distribution But the striking conclusion of the vast majority of studies indicates that the effect on the American labor market has been small Another labor market issue involved labor practices in Mexico It was argued that Mexico allows quotsweatshopquot conditions and therefore gains a labor market advantage in an unacceptable way Mexican labor laws protecting worker rights are similar to the American laws But the enforcement is very weak The North American Agreement on Labor Cooperation NAALC was established to monitor labor issues and address complaints about nonenforcement of labor laws As of this writing it does not have enforcement powers Another fear of many people was that the NAFTA would contribute to worsening environmental problems The argument was that many American companies would locate in Mexico in order to escape from American environmental laws As with worker protection laws Mexican environmental laws are not significantly different from those of the United States however Mexican environmental laws are often poorly enforced due to a lack of enforcement personnel and to corruption In recent years Mexico has increased its efforts at environmental protection It should be stressed however that for American companies to locate in Mexico to take advantage of weak enforcement of environmental laws three conditions must be met 1 the costs of meeting American environmental laws must be high in relation to the total cost of production otherwise it is not worth the cost of the move 2 the industry must have had significant trade protection otherwise the companies would already have located plants in Mexico and 3 the company must be able to relocate production relatively easily The number of companies that meet these conditions is likely to be small Of 442 American industries only 11 meet the first two conditions Of these several are not easily relocated Therefore the cost of American environmental regulations is NOT likely to be a significant incentive for relocation to Mexico 202 Chapter 11 The Balance of Payments 203 Another environmental issue involves food safety standards which are much stricter in the United States Under the NAFTA the United States may prohibit imports of fruits and vegetables from Mexico that do not meet American safety standards Some argue that this raises the possibility of setting the standards so high that environmental standards are in fact a form of trade protection For example in 1996 there was a major dispute over the importation of avocados from Mexico American avocado growers claimed that Mexican avocados brought with them a disease that could destroy local crops Mexican producers believed that their avocados were safe and saw the American claim as a form of trade protection Yet a third environmental issue involves infrastructure along the border roads railways airports and so forth The increase in trade creates bottlenecks along the border A North American Development Bank was created in 1994 with 3 billion in capital provided by both the United States and Mexico to provide financing for border environmental projects both for cleanup and for new infrastructure As of this writing it has done little The evidence above provides what is generally a supportive view of the NAFTA Yet the agreement has been very controversial Let us summarize some of the main arguments used by opponents of the agreement First many opponents of NAFTA focused on the loss of jobs and the decline in wages Most agreed that in the aggregate the effects of the agreement on the American labor market are small But to those who lose their jobs this is no consolation Job losses will cause considerable pain specifically to those people who are least able to adjust They believed that the American program of Trade Adjustment Assistance is insufficient to cope with the problem Second many opponents believed that the NAFTA encourages greater American direct investment in Mexico as it was intended to do This means that more American companies are likely to open companies in Mexico American companies they argued are more willing to invest in Mexico because of the assurance that goods produced in Mexico will have open access to the United States and because under the NAFTA they must be treated the same as Mexican companies The ability of American companies to relocate to Mexico could weaken the power of American labor unions to gain higher wages and better working conditions for their workers It could also weaken the power of American local governments as the companies could use the threat of movement to Mexico to extract certain benefits from the local government agencies Third opponents argued that NAFTA ultimately will reduce American international competitiveness NAFTA they argued allows companies to continue to rely on lowwage labor If this lowwage labor were not available it is possible that these companies would develop new machines and new technologies to be able to continue production These new machines and new technologies would ultimately make workers more productive and therefore lead to higher wages Fourth many opponents believed that the NAFTA would lead to environmental degradation especially along the border This argument was considered above 203 Chapter 11 The Balance of Payments 204 If one believes the majority of studies it appears that there are net benefits to the United States from the NAFTA the benefits exceed the costs for the nation as a whole Over the long term the NAFTA should increase American economic growth should create more jobs than are lost and may improve the American trade balance But the burden of adjustment will fall disproportionately on American lowwage low skilled workers The American distribution of income will become more unequal And there is the potential for greater environmental problems There are benefits from the NAFTA for Mexico as well Mexican businesses gained a secure access to the American and Canadian markets Correspondingly Mexican exports to the United States and Canada have risen significantly The increase in American investment in Mexico brings Mexico more modern machinery and new technology When 1992 presidential candidate Ross Perot announced that he was against the NAFTA the Mexican stock market plunged When he dropped out of the American presidential race it rose significantly Increased competition from American companies should force the Mexican companies to become more productive Lowskilled Mexican workers should benefit either from more jobs being available or from higher wages Higher skilled workers in Mexico should be hurt by the competition with the United States although the evidence so far indicates that they are not being hurt Many Mexican businesses will not be able to compete with the American imports or with the Americanowned companies in Mexico And when agriculture is fully liberalized many small farmers will not be able to compete with the American products The NAFTA will require considerable adjustment within Mexico as well as within the United States NAFTA was an historical document that sought to overcome many difficulties It sought to increase the economic integration of countries that are very different not only in standard of living but also in culture in language and in their legal and accounting systems It will be decades before a full assessment of the NAFTA can be made Yet the NAFTA is here to stay And the main focus today is to advance the principle of economic integration Since 1997 there has been a move to add a fourth country to the NAFTA Chile In 2005 a similar Free Trade Area was agreed to with Central America the Central American Free Trade Area or CAFTA This agreement includes the United States as well as Costa Rica Honduras Guatemala Nicaragua and the Dominican Republic And presently there is a movement to create a free trade area over all of North America Central America and South America a Free Trade Area of the Americas FTAA At this writing President Bush has affirmed his desire to build the Free Trade Area of the Americas building on an initiative introduced by his father in 1990 Whether this will occur remains to be seen Test Your Understanding 1 The North American Free Trade Agreement NAFTA was described in the chapter It created a Free Trade Area between the United States Canada and Mexico Assume now that there is a proposal to extend the Agreement to become the Free Trade Area of the Americas FTAA This 204 Chapter 11 The Balance of Payments 205 means that there would be a Free Trade Area covering all of the Americas North America Central America and South America Debate whether the American Free Trade Agreement should be passed Half of you will be assigned to debate in favor of an American Free Trade Agreement The other half will be assigned to debate against an American Free Trade Agreement 2 The NAFTA was passed in 1992 and went into effect in 1994 Pick a company located in San Diego County It may be a place at which you work or not Your task is to discover how this company has been affected by the NAFTA You may get your information by interviewing people in the company who would be able to know how the company has been affected You may also read articles in a newspaper San Diego Union Tribune North County Times etc or on the Internet Write a short essay describing how this San Diego County company has been affected by the NAFTA 3 As of the summer of 2001 there is a recurrence of a dispute over the ability to Mexican trucks to ship inside the United States The NAFTA provision allowed them this right But the United States government has not allowed it Go to newspapers or the Internet Use sources from the summer of 2001 What are the arguments made by people that Mexican trucks should not be allowed to ship in the United States see the site for the Teamsters Union especially What are the arguments made by people that Mexican trucks should be allowed to ship in the United States What is your conclusion 8 Summary and Conclusion What have we learned in this chapter First we have tried to understand the economists intellectual argument in favor of free trade It is an argument that is two centuries old As part of this argument we have seen that tariffs and other restrictions to free trade make both the country that restricts trade and its trading partner worseoff economically than they otherwise would be Second we have seen that while free trade enhances the well being of all countries it does not enhance the well being of all individuals Free trade creates many winners but it also creates many losers And third we have seen that as with most debates there are good arguments on both sides both in favor of free trade and also against free trade The arguments in favor of free trade have had enormous in uence in the second half of the twentieth century Until World War II the United States was mainly a country that restricted trade Since the end of World War II the United States has become a country that is for the most part open to trade The same opening to trade has occurred throughout the world Western Europe began to open to trade after World War II and is now in the process of becoming an integrated economy Its integration the European Union is a much more complete economic integration than in the NAFTA Trade for the former communist countries and the developing countries had been very small until 1980 Now this trade is becoming significant We saw this change in our case study on the NAFTA Companies now locate various parts of their production around the world Indeed much of our trade simply takes place within various parts of the same company As we enter the 21st century we are indeed becoming a global economy Your study of this chapter will provide you a greater ability to assess to what extent this shift to a global economy is indeed a good thing 205 Chapter 11 The Balance of Payments 206 Practice Quiz on Chapter 26 1 In the United States In the Rest of the World Labor Cost Required 1 Unit of Agricultural Products 6 hours 8 hours 1 Unit of Manufactured Products 2 hours 12 hours Using these numbers the United States has an absolute advantage in a Agricultural Products Only c Both Agricultural Products and Manufactured Products b Manufactured Products Only d Neither Agricultural Products nor Manufactured Products 2 Using the numbers in question 1 the United States has a comparative advantage in a Agricultural Products Only c Both Agricultural Products and Manufactured Products b Manufactured Products Only d Neither Agricultural Products nor Manufactured Products 3 An increase in international trade Will cause the production possibilities curve to a shift out to the right b shift in to the left c become upward sloping d not change 4 A country Will have a comparative advantage in a those products Which require factors of production that are relatively scarce b those products that require factors of production that are relatively abundant c all products for Which it also has an absolute advantage 206 Chapter 11 The Balance of Payments 207 THOSE PRODUCTS FOR WHICH IT CHOOSES TO HAVE A COMPARATIVE CHAPTER 11 THE BALANCE OF PAYMENTS MULTIPLECHOICE QUESTIONS 1 On the balanceofpayments statements merchandise imports are classi ed in the a Current account b Capital account c Unilateral transfer account d Of cial settlements account 2 The balance of international indebtedness is a record of a country s international a Investment position over a period of time b Investment position at a fixed point in time c Trade position over a period of time d Trade position at a fixed point in time 3 Which balanceofpayments item does not directly enter into the calculation of the US gross domestic product a Merchandise imports b Shipping and transportation receipts c Direct foreign investment d Service exports 4 Which of the following is considered a capital in ow a A sale of US financial assets to a foreign buyer b A loan from a US bank to a foreign borrower c A purchase of foreign nancial assets by a US buyer d A US citizen s repayment of a loan from a foreign bank 5 Which of the following would call for inpayments to the United States a American imports of German steel b Gold owing out of the United States c American unilateral transfers to lessdeveloped countries d American firms selling insurance to British shipping companies 207 Chapter 11 The Balance of Payments 208 6 In a country s balance of payments which of the following transactions are debits a b c d Domestic bank balances owned by foreigners are decreased Foreign bank balances owned by domestic residents are decreased Assets owned by domestic residents are sold to nonresidents Securities are sold by domestic residents to nonresidents 7 Which of the following is classi ed as a credit in the US balance of payments a b c d US exports US gifts to other countries A ow of gold out of the US Foreign loans made by US companies Table 111 gives hypothetical figures for US International Transactions On the basis of this information answer Questions 8 and 9 Table 111 US International Transactions Amount Transaction billions of dollars Merchandise imports l 10 Military transactions net 5 Remittances pensions transfers 20 US private assets abroad 50 Merchandise exports 115 Investment income net 15 US government grants excluding military Foreign private assets in the US 25 Compensation of employees 5 Allocation of SDRs 5 Travel and transportation receipts net 20 8 Based on the information provided in Table 111 the goods and services balance equals a b c d 5 billion 15 billion 20 billion 25 billion 9 Based on the information provided in Table 111 the current account balance equals a b c d 5 billion 10 billion 15 billion 20 billion 208 Chapter 11 The Balance of Payments 209 10 Unlike the balance of payments the balance of international indebtedness indicates the international a Investment position of a country at a given moment in time b Investment position of a country over a oneyear period c Trade position of a country at a given moment in time d Trade position of a country over a oneyear period 11 Which of the following indicates the international investment position of a country at a given moment in time a The balance of payments b The capital account of the balance of payments c The current account of the balance of payments d The balance of international indebtedness 12 Concerning the US balance of payments which account is de ned in essentially the same way as the net export of goods and services which comprises part of the country s gross domestic product a Merchandise trade account b Goods and services account c Current account d Capital account 13 If an American receives dividends from the shares of stock she or he owns in Toyota Inc a Japanese firm the transaction would be recorded on the US balance of payments as a a Capital account debit b Capital account credit c Current account debit d Current account credit 14 If the United States government sells military hardware to Saudi Arabia the transaction would be recorded on the US balance of payments as a a Current account debit b Current account credit c Capital account debit d Capital account credit 15 The US balance of trade is determined by a Exchange rates b Growth of economies overseas c Relative prices in world markets d All of the above 16 US military aid granted to foreign countries is entered in the a Merchandise trade account b Capital account c Current account d Of cial settlements account 209 Chapter 11 The Balance of Payments 210 17 If the US faces a balanceofpayments de cit on the current account it must run a surplus on a The of cial settlements account b The capital account c Either the of cial settlements account or the capital account d Both the of cial settlements account and the capital account 18 The current account of the US balance of payments does not include a Investment income b Merchandise exports and imports c The sale of securities to foreigners d Unilateral transfers 19 The US has a balance of trade de cit when its a Merchandise exports exceed its merchandise imports b Merchandise imports exceed its merchandise exports c Goods and services exports exceed its goods and services imports d Goods and services imports exceed its goods and services exports 20 The value to American residents of income earned from overseas investments shows up in which account in the US balance of payments a Current account b Trade account c Unilateral transfers account d Capital account Using the data of Table 112 answer Question 21 Table 112 International Investment Position of the United States US assets abroad US government assets 800 billion US private assets 200 billion Foreign assets in the US Foreign official assets 600 billion Foreign private assets 300 billion 21 Consider Table 112 The US balance of international indebtedness suggests that the United States is a net a Debtor b Creditor c Spender d Exporter 210 Chapter 11 The Balance of Payments 22 23 24 25 26 27 28 29 211 For the first time since World War I in 1985 the United States became a net international a Exporter b Importer c Debtor d Creditor A country that is a net international debtor initially experiences a An augmented savings pool available to finance domestic spending b A higher interest rate which leads to lower domestic investment c A loss of funds to trading partners overseas d A decrease in its services exports to other countries Credit items in the balance of payments correspond to anything that a Involves receipts from foreigners b Involves payments to foreigners c Decreases the domestic money supply d Increases the demand for foreign exchange Debt items in the balance of payments correspond to anything that a Involves receipts from foreigners b Involves payments to foreigners c Increases the domestic money supply d Decreases the demand for foreign exchange When all of the debit or credit items in the balance of payments are combined a Merchandise imports equal merchandise exports b Capital imports equal capital exports c Services exports equal services imports d The total surplus or de cit equals zero In the balance of payments the statistical discrepancy is used to a Ensure that the sum of all debits matches the sum of all credits b Ensure that trade imports equal the value of trade exports c Obtain an accurate account of a balanceofpayments deficit d Obtain an accurate account of a balanceofpayments surplus All of the following are credit items in the balance of payments except a Investment in ows b Merchandise exports c Payments for American services to foreigners d Private gifts to foreign residents All of the following are debit items in the balance of payments except Capital out ows b Merchandise exports c Private gifts to foreigners d Foreign aid granted to other nations 5 211 Chapter 11 The Balance of Payments 30 31 32 33 34 35 36 212 The role of is to direct one nation s savings into another nation s investments a Merchandise trade ows b Services ows c Current account ows d Capital ows When a country realizes a deficit on its current account a Its net foreign investment position becomes positive b It becomes a net demander of funds from other countries c It realizes an excess of imports over exports on goods and services d It becomes a net supplier of funds to other countries Reducing a current account deficit requires a country to a Increase private saving relative to investment b Increase private consumption relative to saving c Increase private investment relative to consumption d Increase private investment relative to saving Reducing a current account de cit requires a country to a Increase the govemment s deficit and increase private investment relative to saving b Increase the govemment s deficit and decrease private investment relative to saving c Decrease the govemment s de cit increase private investment relative to saving d Decrease the government s de cit and decrease private investment relative to saving Reducing a current account surplus requires a country to a Increase the govemment s deficit and increase private investment relative to saving b Increase the govemment s deficit and decrease private investment relative to saving c Decrease the government s de cit and increase private investment relative to saving d Decrease the government s de cit and decrease private investment relative to saving Concerning a country s business cycle rapid growth of production and employment is commonly associated with a Large or growing trade deficits and current account deficits b Large or growing trade deficits and current account surpluses c Small or shrinking trade deficits and current account deficits d Small or shrinking trade deficits and current account surpluses The burden of a current account deficit would be the least if a nation uses what it borrows to finance a Unemployment compensation bene ts b Social Security bene ts c Expenditures on food and recreation d Investment on plant and equipment 212 Chapter 11 The Balance of Payments 213 37 Concerning a country s business cycle account deficits a b c d Rapid growth rates of production and employment Slow growth rates of production and employment Falling interest rates on government securities Falling interest rates on corporate securities is commonly associated with large or growing current 38 According to researchers at the Federal Reserve the loss of jobs associated with a de cit in the current account tends to be Offset by the increase of jobs associated with a surplus in the capital account Reinforced by the decrease of jobs associated with a surplus in the capital account A threat to the level of employment for the economy as a whole Of no longrun economic consequence for workers who lose their jobs a b c d TRUEFALSE QUESTIONS Table 113 shows hypothetical transactions in billions of US dollars that took place during a year Answer the next seven questions on the basis of this information Table 113 International Transactions of the United States Amount Transaction billions of dollars Allocation of SDRs 10 Changes in US assets abroad 100 Statistical discrepancy 15 Merchandise imports 400 Payments on foreign assets in US 20 Remittances pensions transfers 60 Travel and transportation receipts net 30 Military transactions net 10 Investment income net 100 Merchandise exports 350 US government grants excluding military Changes in foreign assets in the US 190 20 Other services net 80 Receipts on US investments abroad 30 Compensation of employees 10 T F 1 Consider Table 113 The merchandisetrade balance registered a deficit of 50 billion 213 Chapter 11 The Balance of Payments 214 Consider Table 113 The services balance registered a surplus of 100 billion Consider Table 113 The goodsandservices balance registered a surplus of 50 billion Consider Table 113 The unilateraltransfers balance registered a de cit of 40 billion Consider Table 113 The currentaccount balance registered a surplus of 30 billion Consider Table 113 The net exports component of the US gross domestic product registered 1 10 billion Consider Table 113 The payments data suggest that the United States was a net demander of 30 billion from the rest of the world The balance of payments refers to the stock of trade and investment transactions that exists at a particular point in time Referring to the balanceofpayments statement an international transaction refers to the exchange of goods services and assets between residents of one country and those abroad The balance of payments includes international transactions of households and businesses but not government Because the balance of payments utilizes doubleentry accounting merchandise exports will always be in balance with merchandise imports On the US balanceofpayments statement the following transactions are credits leading to the receipt of dollars from foreigners merchandise exports transportation receipts income received from investments abroad and investments in the United States by foreign residents On the US balance of payments the following transactions are debits leading to payments to foreigners merchandise imports travel expenditures gifts to foreign residents and overseas investments by US residents The goods and services account of the balance of payments shows the monetary value of international ows associated with transactions in goods services and unilateral transfers An increase in import restrictions by the US government tends to promote a merchandise trade surplus Services transactions on Canada s balanceofpayments statement would include Canadian ships transporting lumber to Japan foreign tourists spending money in Canada and Canadian engineers designing bridges in China On the balanceofpayments statement dividend and interest income are classified as capital account transactions 214 Chapter 11 The Balance of Payments T F T F T F T F T F T F T F T F T F T F T F T F T F T F T F T F 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 21 5 A surplus on Germany s goodsandservices balance indicates that Germany has sold more goods and services to foreigners than it has bought from them over a oneyear period The merchandisetrade account on the balanceofpayments statement is defined the same way as net exports which constitutes part of the nation s gross domestic product A positive balance on the goodsandservices account of the balance of payments indicates an excess of exports over imports which must be added to the nation s gross domestic product For the United States merchandise trade has generally constituted the largest portion of its goodsandservices account Unilateral transfers refer to twosided transactions re ecting the movement of goods and services in one direction with corresponding payments in the other direction Unilateral transfers consist of privatesector transfers such as church contributions to alleviate starvation in Africa as well as governmental transfers such as foreign aid Currentaccount transactions include direct foreign investment purchases of foreign government securities and commercial bank loans made abroad On the US balanceofpayments statement a capital in ow would occur if a Swiss resident purchases the securities of the US government If Toyota Inc of Japan builds an automobile assembly plant in the United States the Japanese capital account would register an out ow If Bank of America receives repayment for a loan it made to a Mexican firm the US capital account would register an in ow On the balanceofpayments statement a capital in ow can be likened to the import of goods and services The capital account of the balance of payments includes privatesector transactions as well as of cialsettlements transactions of the home country s central bank If the current account of the balance of payments registers a de cit the capital account registers a surplus and vice versa Concerning the balance of payments a currentaccount surplus means an excess of exports over imports of goods services investment income and unilateral transfers If a country realizes a currentaccount deficit in its balance of payments it becomes a net supplier of funds to the rest of the world Concerning the balance of payments a currentaccount deficit results in a worsening of a country s net foreign investment position 215 Chapter 11 The Balance of Payments T F T F T F T F T F T F T F T F T F T F T F T F T F T F T F 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 216 In the balanceofpayments statement statistical discrepancy is treated as part of the merchandise trade account because merchandise transactions are generally the most frequent source of error Because a large number of international transactions fail to get recorded statisticians insert a residual known as statistical discrepancy to ensure that total debits equal total credits Concerning the balance of payments the goodsandservices balance is commonly referred to as the trade balance by the news media Since the 1970s the merchandise trade account of the US balance of payments has registered de cit Although the United States has realized merchandise trade deficits since the early 1970s its goodsandservices balance has always registered surplus In the past two decades the US services balance has generally registered surplus The US unilateraltransfers balance has consistently registered surplus in the past two decades Because the balance of payments is a record of the economic transactions of a country over a period of time it is a ow concept The United States would be a net creditor if the value of US assets abroad exceeded the value of foreign assets in the United States If a country consistently realizes a currentaccount surplus in its balance of payments it likely will become a net debtor in its balance of international indebtedness By the mid1980s the United States had evolved from the status of a netcreditor nation to a netdebtor nation in its balance of international indebtedness The netdebtor status that the United States achieved in its balance of international indebtedness by the mid1980s re ected the continuous currentaccount surplus that the United States attained in its balance of payments during the 1970s Although a netdebtor country may initially benefit from an in ow of savings from abroad over the long run continued borrowing results in growing dividend payments to foreigners and a drain on the debtor country s economic resources The official reserve assets of the United States consist of holdings of gold and foreign corporate securities That US importers purchase bananas from Brazil constitutes a debit transaction on the US balance of payments 216 Chapter 11 The Balance of Payments T F T F T F T F T F T F T F T F T F 49 50 51 52 53 54 55 56 57 217 That German investors collect interest income on their holdings of US Treasury bills constitutes a credit transaction on the US balance of payments That US charities donate funds to combat starvation in Africa constitutes a debit transaction on the US balance of payments To reduce a current account deficit a country should either decrease the budget deficit of its government or reduce investment spending relative to saving Most economists belief that in the 1980s a massive out ow of capital caused a current account de cit for the United States A current account deficit for the United States necessarily reduces the standard of living for American households Rapid growth of production and employment is commonly associated with large or growing trade surpluses and current account surpluses Often countries realizing rapid economic growth rates possess longrun current account de cits For the United States a consequence of its current account deficit is a growing foreign ownership of the capital stock of the United States and a rising fraction of US income that must be diverted abroad in the form of interest and dividends to foreigners Most economists contend that any reduction in the current account deficit is better achieved through increased national saving than through reduced domestic investment 217 Chapter 11 The Balance of Payments ANSWERS Answers to MultipleChoice Questions Answers to TrueFalse Questions W QP PWPf W QP PWPf Oh gh c HHHHHHHHHHHHEHEHHEHHHEHGEEEHHHH 9 10 11 12 13 14 15 16 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 nnrnrnmn EHHEEEHHHHHHGHEHHEHEHHHHHE 17 18 19 20 21 22 23 24 h U c GG 218 218 25 26 27 28 29 30 31 32 9939799915 33 34 35 36 37 38 9999999999 Chapter 11 The Balance of Payments 219 steel made in Japan d a a higher price for Japanese steel c a lower standard of living in the United States adva b a higher price for American steel d all of the above ntag e 7 When Japanese autos are sold in the United States and American autos are sold in Japan we have 5 If the a free trade b quotas c intraindustry trade d tariffs United States 8 Which of the following is an argument for trade protection engages in a the infant industry argument greater b Chapter 5 international trade those who are likely to lose are a skilled workers in the United States c owners of capital goods in the United States b unskille d workers in the United States d compute r experts in the United States 6 Which of the following would result if a tariff is imposed on 219 Chapter 11 The Balance of Payments 220 The Standard Trade Model 51 A Standard Model of a Trading Economy 1 The concept quotterms of tradequot means A the amount of exports sold by a country B the price conditions bargained for in international markets C the price of a country39s exports divided by the price of its imports D the quantities of imports received in free trade E None of the above Answer C Question Status Previous Edition 2 A country cannot produce a mix of products with a higher value than where A the isovalue line intersects the production possibility frontier B the isovalue line is tangent to the production possibility frontier C the isovalue line is above the production possibility frontier D the isovalue line is below the production possibility frontier E the isovalue line is tangent with the indifference curve Answer B Question Status Previous Edition 3 Tastes of individuals are represented by A the production possibility frontier B the isovalue line C the indifference curve D the production function E None of the above Answer C Question Status Previous Edition 4 If PCPF were to increase in the international marketplace then A all countries would be better off B the terms of trade of cloth exporters improve C the terms of trade of food exporters improve D the terms of trade of all countries improve E None of the above Answer B Question Status Previous Edition 5 If PCPF were to increase A the cloth exporter would increase the quantity of cloth exports B the cloth exporter would increase the quantity of cloth produced C the food exporter would increase the quantity of food exports D Both A and C E None of the above Answer B Question Status Previous Edition 220 Chapter 11 The Balance of Payments 221 6 If PCPF were to increase A world relative quantity of cloth supplied and demanded would increase B world relative quantity of cloth supplied and demanded would decrease C world relative quantity of cloth supplied would increase D world relative quantity of cloth demanded would decrease E None of the above Answer C Question Status Previous Edition 7 A country will be able to consume a bundle which is not attainable solely from domestic production only if A the world terms of trade differ from its domestic relative costs B the country specializes in one product C the country avoids international trade D the world terms of trade equal the domestic relative costs E None of the above Answer A Question Status Previous Edition 8 Terms of trade refers to A what goods are imported B what goods are exported C the volume of trade D the prices at which trade occurs E None of the above Answer D Question Status Previous Edition 9 If points A and B are both on the production possibility frontier of a country then A consumers are indifferent between the two bundles B producers are indifferent between the two bundles C at any point in time the country could produce both D Both cost the same E The country could produce either of the two bundles Answer E Question Status Previous Edition 10 If the economy is producing at point a on its production possibility frontier then A all of the country39s workers are specialized in one product B all of the county39s capital is used for one product C all of the county39s workers are employed D all of its capital is used but not efficiently E None of the above Answer C Question Status Previous Edition 221 Chapter 11 The Balance of Payments 222 11 If at point A on the production possibility frontier and the community indifference curve cuts through point a from northwest to southeast then the optimal autarky production bundle is A at point A B to the right of point A C to the left of point A D to the northeast of point A E to the southwest of point A Answer B Question Status Previous Edition 12 If two countries with diminishing returns and different marginal rates of substitution between two products were to engage in trade then A the shapes of their respective production possibility frontiers would change B the marginal rates of substitution of both would become equal C the larger of the two countries would dominate their trade D the country with relatively elastic supplies would export more E None of the above Answer B Question Status Previous Edition 13 If a country began exporting product A and importing product B then as compared to the autarky no trade situation the marginal cost of product A will A increase B decrease C shift outward D shift inward E None of the above Answer A Question Status Previous Edition 14 If a small country were to levy a tariff on its imports then this would A have no effect on that country39s economic welfare B increase the country39s economic welfare C decrease the country39s economic welfare D change the terms of trade E None of the above Answer C Question Status Previous Edition 15 An increase in a country39s net commodity terms of trade will always A increase the country39s economic welfare B increase the country39s real income C increase the country39s quantity of exports D increase the country39s production of its import competing good E None of the above Answer E Question Status Previous Edition 222 Chapter 11 The Balance of Payments 223 16 If the United States exports skilledlabor intensive products and services then we should expect unions representing skilled labor to A lobby in favor of tariffs B lobby against the imposition of tariffs C be indifferent to the issue of tariffs D lobby in favor of improved terms of trade E Not enough information Answer E Question Status Previous Edition 17 Suppose now that Home experiences growth strongly biased toward its export cloth A this will tend to worsen Home39s terms of trade B this will tend to improve Home39s terms of trade C this will tend to worsen Foreign39s terms of trade D this will have no effect on Foreign39s terms of trade E None of the above Answer A Question Status New 18 Suppose that Home is a quotsmall countryquot and it experiences growth strongly biased toward its export cloth A this will tend to worsen Home39s terms of trade B this will tend to improve Home39s terms of trade C this will tend to worsen Foreign39s terms of trade D this will have no effect on Foreign39s terms of trade E None of the above Answer D Question Status New 19 Other things being equal a rise in a country39s terms of trade increases its welfare What would happen if we relax the ceteris paribus assumption and allow for the law of demand to operate internationally Answer Let us assume that the terms of trade or technically the net commodity terms of trade improve thus the relative price of a country39s exports increase This would logically lead to a shift away by world consumers to substitute goods If the demand for a country39s exports is elastic the quantity decrease would be proportionally larger than the per unit price increase This term of trade effect would actually lower the country39s real income and economic welfare Question Status Previous Edition 223 Chapter 11 The Balance of Payments 224 A B 20 Refer to above figure Albania refused to engage in international trade for ideological reasons To maximize its economic welfare it would choose to produce at which point in the diagram above Suppose the P APB at point a was equal to 1 Given this information in which good A or B does Albania enjoy a comparative advantage Now that the Cold War is over Albania is interested in obtaining economic welfare gains from trade The relevant international relative price is P APB 2 Albania would therefore choose to produce at which point a b or c Given this additional information in which good does Albania enjoy a comparative advantage Answer Albania would choose to produce at point a With no reference to world terms of trade one cannot establish Albania39s comparative advantage Later when Albania discovers that the relative price of A equals twice the price of B it knows that it has a comparative advantage in A Therefore Albania would produce at production point b Question Status Previous Edition 21 Refer to above figure Now suppose that the relative price of A is actually not higher than Albania39s autarkic level of 1 but quite the opposite eg P APB 05 Would Albania still be able to gain from trade If so where would be its production point Given the information in this question where is Albania39s comparative advantage Answer Yes As long as the world39s terms of trade differed from those of Albania that country stands to gain from international trade In this particular case its point of production with trade would be at point c Question Status Previous Edition 52 International Transfers of Income Shifting of the RD Curve 1 When the production possibility frontier shifts out relatively more in one direction we have A biased growth B unbiased growth C immiserizing growth D balanced growth E imbalanced growth Answer A Question Status Previous Edition 224 Chapter 11 The Balance of Payments 225 2 Exportbiased growth in Country H will A improve the terms of trade of Country H B trigger antibias regulations of the WTO C worsen the terms of trade of Country F the trade partner D improve the terms of trade of Country F E decrease economic welfare in Country H Answer D Question Status Previous Edition 3 Immiserizing growth is A likely to occur if the exporting country is poor B likely to occur if the exporting country is rich C likely to occur when terms of trade change D likely to occur if relative supplies are elastic E None of the above Answer E Question Status Previous Edition 4 If the poor USAID recipient countries have a higher marginal propensity to consume each and every product than does the United States then such aid will A worsen the US terms of trade B improve the US terms of trade C leave the world terms of trade unaffected D worsen the terms of trade of both donor and recipient countries E None of the above Answer B Question Status Previous Edition 5 If the US has a higher marginal propensity to consume MPC imports as compared to both its MPC for exportables and nontradables then such aid will A worsen the US terms of trade B improve the US terms of trade C leave the world terms of trade unaffected D worsen the terms of trade of both donor and recipient countries E None of the above Answer B Question Status Previous Edition 6 If beginning from a free trade equilibrium the net barter terms of trade improve for a country then it will A increase production of its import competing good B increase consumption of its export good C increase the quantity of its imports D experience an exportbiased shift in its production possibility frontier E None of the above Answer C Question Status Previous Edition 225 Chapter 11 The Balance of Payments 226 7 After WWI Germany was forced to make large reparationstransfers of real income to France If the marginal propensity to consume was equal in both countries and if France39s demand was biased toward food relative to Germany39s demand pattern then we would expect to find A the world39s relative price for food remains unchanged B the world39s relative price for food increase C the world39s relative price for food decrease D the world relative price for both food and nonfood rise E None of the above Answer B Question Status Previous Edition 8 If France exported manufactures whereas Germany exported food then the reparations from Germany to France would A improve France39s international terms of trade B cause France39 terms of trade to deteriorate C cause both France39 and Germany39s terms of trade to deteriorate D cause both France39 and Germany39s terms of trade to improve E None of the above Answer B Question Status Previous Edition 9 If a country lent money to another this must A lower the terms of trade of the recipient country B lower the terms of trade of both countries C improve the terms of trade of the recipient country D improve the terms of trade of the donor country E None of the above Answer E Question Status Previous Edition 10 During the 19th Century economic growth of the major trading countries was biased toward manufactures and away from food The less developed countries of that time were net exporters of food From this information we would expect to have observed A falling terms of trade for the less developed countries B improving rising terms of trade for the less developed countries C no change at all in the terms of trade of the less developed countries D a decrease in the relative price of food E None of the above Answer B Question Status Previous Edition 11 Immiserizing growth could occur to A a poor country experiencing exportbiased economic growth B a poor country experiencing importbiased economic growth C a poor country experiencing growth in its nontraded sector D a poor country experiencing capitalintensive biased growth E None of the above Answer A Question Status Previous Edition 226 Chapter 11 The Balance of Payments 227 12 A large country experiencing importbiased economic growth will tend to experience A positive terms of trade B deteriorating terms of trade C improving terms of trade D immiserizing terms of trade E None of the above Answer C Question Status Previous Edition 13 In the period preceding the recent Financial Crisis in Asia the South East Asian countries were receiving large inflows of financial capital Following John Maynard Keynes39 theory this should have caused A a glut in their banking asset situation B an improvement in their terms of trade C deterioration in their terms of trade D a fluctuation upward and then downward in their terms of trade E None of the above Answer B Question Status Previous Edition 14 If a there are no international loans or capital flows then if a country39s terms of trade improve we would find that A the value of its exports exceeds the value of its imports B the value of its exports becomes less than that of its imports C the value of its exports exactly equals that of its imports D the quantity of its exports equals that of its imports E None of the above Answer C Question Status Previous Edition 15 If the US Agency for International Development transfers funds to poor countries in SubSaharan Africa the conventional assumption following Keynes39 analysis would presume that this would tend to A worsen the US terms of trade B improve the US terms of trade C worsen the terms of trade of the African aid recipients D improve the terms of trade of the African aid recipients E None of the above Answer A Question Status Previous Edition 16 If a country39s growth is biased in favor of its import this should unequivocally improve its terms of trade and its economic welfare Discuss Answer Suppose Japan experiences economic growth biased in favor of its import substitutes For example assume that Japan imports components and exports final goods but that it experiences a major growth in its components manufacture sector Since Japan is internationally a large country in these markets this would tend to hurt its component supplier39s terms of trade and help Japan39s However such a bias in economic growth may tend to lessen the volume of international trade At an extreme Japan may become an exporter of components and an importer of final goods If the result is a lessening of specialization and of the volume of trade then this effect will lower Japan39s welfare associated with gains from trade If an actual change in the pattern of comparative advantage occurs a possibility this may cause dynamic dislocations whose harm overpowers static gains for a relatively long period of time Question Status Previous Edition 227 Chapter 11 The Balance of Payments 228 17 It is impossible for economic growth in a small country to lower that country39s economic welfare regardless of the bias of the growth Explain Answer This is a true statement The reason economic growth may hurt a country is if the terms of trade effect counters and dominates the growth effect In the case of the small country there is no terms of trade effect Question Status Previous Edition 18 At the conclusion of World War I Germany as a punishment was obliged to make a large transfer to France in the form of reparations Is it possible that the actual reparations may have improved Germany39s economic welfare Answer Such a result is not likely However theoretically if France39s income elasticity of demand for Germany39s exports was higher than Germany39s income elasticity of demand for its own exportable then the real income transfer associated with these reparations may have improved Germany39s terms of trade and improved its balance of payments thus helping Germany in manner unanticipated in the Treaty of Verssaille Explain Question Status Previous Edition 19 If a country39s net barter terms of trade improve increase it is possible that this could decrease the value of its exports demanded and hence harm its economic welfare Discuss this possibility What alternative measure for quotterms of tradequot does this suggest Answer An quotimprovementquot in the terms of trade occurs when the price of a country39s exports rises by more than the price of its imports If demand for this country39s exports is inelastic then this could decrease demand for its exports in the world This is treated under the topics of the MarshalLerner conditions for the effects of a depreciation on the balance of payments This suggests that we may wish to use some kind of quotincome terms of tradequot the would explicitly consider both changes in relative tradables prices and also quantities of export the latter not dealt with by the net barter terms of trade Question Status Previous Edition 53 Tariffs and Export Subsidies Simultaneous Shifts in RS and RD 1 If the US a large country imposes a tariff on its imported good this will tend to A have no effect on terms of trade B improve the terms of trade of all countries C improve the terms of trade of the United States D cause a deterioration of US terms of trade E raise the world price of the good imported by the United States Answer C Question Status Previous Edition 2 If Slovenia is a small country in world trade terms then if it imposes a large series of tariffs on many of its imports this would A have no effect on its terms of trade B improve its terms of trade C deteriorate its terms of trade D decrease its marginal propensity to consume E None of the above Answer A Question Status Previous Edition 228 Chapter 11 The Balance of Payments 229 3 If Slovenia is a large country in world trade then if it imposes a large set of tariffs on many of its imports this would A have no effect on its terms of trade B improve its terms of trade C deteriorate its terms of trade D decrease its marginal propensity to consume E None of the above Answer B Question Status Previous Edition 4 If Slovenia were a large country in world trade then if it imposes a large set of tariffs on its imports this must A cause retaliation on the part of its trade partners B harm Slovenia39s real income C improve Slovenia39s real income D improve the real income of its trade partners E None of the above Answer E Question Status Previous Edition 5 If Slovenia were a large country in world trade then if it instituted a large set of subsidies for its exports this must A have no effect on its terms of trade B improve its terms of trade C deteriorate its terms of trade D decrease its marginal propensity to consume E None of the above Answer C Question Status Previous Edition 6 If Slovenia were a large country in world trade then if it instituted a large set of subsidies for its exports this must A cause retaliation on the part of its trade partners B harm Slovenia39s real income C improve Slovenia39s real income D improve the real income of its trade partners E None of the above Answer D Question Status Previous Edition 7 An export subsidy has the opposite effect on terms of trade to the effect of an import tariff Domestically a tariff will raise the price of the import good deteriorating the domestic terms of trade A production subsidy for the export product will lower the local price of the export good lowering the domestic terms of trade for the country Hence the export subsidy and the import tariff have the same effect This analysis seems to contradict the first sentence in this paragraph Discuss this paradox Answer While this Lerner equivalence may well occur domestically internationally the tariff will improve a country39s terms of trade An export subsidy on the other hand will in fact lower the international price of the now readily available export good hence hurting a country39s terms of trade Question Status Previous Edition 229 Chapter 11 The Balance of Payments 230 A d B 8 Suppose as a result of various dynamic factors associated with exposure to international competition Albania39s economy grew and is now represented by the rightmost production possibility frontier in the figure above If its point of production with trade was point c would you consider this growth to be export biased or import biased If Albania were a large country with respect to the world trade of A and B how would this growth affect Albania39s terms of trade Its real income Answer If point c is the production point with trade then Albania has a comparative advantage in good B Therefore from the shape of the new production possibility frontier as compared to the original one this is clearly an exportbiased growth This ceteris paribus would tend to worsen Albania39s terms of trade The terms of trade effect would again ceteris paribus worsen its real income However the growth itself acts in the opposite direction Question Status Previous Edition 9 Suppose as a result of various dynamic factors associated with exposure to international competition Albania39s economy grew and is now represented by the rightmost production possibility frontier in the figure above If its point of production with trade was point b would you consider this growth to be export biased or import biased If Albania were a large country with respect to the world trade of A and B how would this growth affect Albania39s terms of trade Its real income What if Albania were a small country Answer If the production with trade point was point b then the observed growth is a case of importbiased growth and would improve Albania39s terms of trade If Albania were a small country the world39s terms of trade would not change at all In such a case economic growth with no induced change in income distributions would always increase its real income Question Status Previous Edition 10 Suppose Albania is exporting product B and experienced economic growth biased in favor of product B as seen in the figure above We are also told that Albania39s new consumption point is at point d Would you still consider the economic growth which took place biased in favor of B If Albania were a large country how would this growth affect its terms of trade Answer This is a relatively difficult case On the one hand the growth is still technically export biased However Albania39s consumption clearly shifted in favor of its import product A In this case the deterioration in the terms of trade would be much more pronounced than before and may lead to a case of immiserizing growth However for this to occur there must have been a major shift in the taste patterns the old community indifference map is not longer applicable Therefore when we try to judge the direction and magnitude of the welfare change we are comparing the old versus new taste preferences which raises the classic index number problem Question Status Previous Edition 230 Chapter 11 The Balance of Payments 231 54 Appendix to Chapter 5 Representing International Equilibrium with Other Curves 1 Home39s offer curve shows A how Home39s desired exports vary with biased growth in Foreign B how Foreign39s desired imports vary with Home s level of exports C how Home39s desired exports vary with the terms of trade D how Foreign39s desired imports vary with the relative price E None of the above Answer C Question Status New 2 As one moves from the origin up Home39s offer curve Foreign39s terms of trade A remain constant B worsen C improve D may improve or worsen E None of the above Answer B Question Status New 3 If a straight line a ray from the origin does not cross through the point where the offer curves of the two trading countries intersect then A there will be an excess demand for both products B there will be an excess supply of both products C there will be an excess demand for one of the traded products D the terms of trade represented by the slope of the ray will represent the equilibrium terms of trade E None of the above Answer C Question Status 231 New c domestic companies may social benefits that will not be provided if the goods are imported d all of the above 9 The organization that now makes rules regarding international trade is called the a GATT b WTO c Congress of the United States d IMF 10 When the United States Canada and Mexico agreed to end tariffs between their countries they created a a common market b a single country c a free trade area d an economic union Answers1C 2B 3A 4B 5B 6D 7C 8D 9B10C CHAPTER 2 FOUNDATIONS OF MODERN TRADE THEORY MULTIPLECHOICE QUESTIONS 1 The mercantilists would have objected to a Export promotion policies initiated by the government b The use of tariffs or quotas to restrict imports c Trade policies designed to accumulate gold and other precious metals d International trade based on open markets 2 Unlike the mercantilists Adam Smith maintained that a Trade bene ts one nation only at the expense of another nation b Government control of trade leads to maximum economic welfare c All nations can gain from free international trade d The world s output of goods must remain constant over time 52 Chapter 2 Foundations of Modern Trade Theory 53 3 The trading principle formulated by Adam Smith maintained that a International prices are determined from the demand side of the market b Differences in resource endowments determine comparative advantage c Differences in income levels govern world trade patterns d Absolute cost differences determine the immediate basis for trade 4 Unlike Adam Smith David Ricardo s trading principle emphasizes the a Demand side of the market b Supply side of the market c Role of comparative costs d Role of absolute costs 5 When a nation requires fewer resources than another nation to produce a product the nation is said to have a an a Absolute advantage in the production of the product b Comparative advantage in the production of the product c Lower marginal rate of transformation for the product d Lower opportunity cost of producing the product 6 According to the principle of comparative advantage specialization and trade increase a nation s total output since a Resources are directed to their highest productivity b The output of the nation s trading partner declines c The nation can produce outside of its production possibilities curve d The problem of unemployment is eliminated 7 In a twoproduct twocountry world international trade can lead to increases in a Consumer welfare only if output of both products is increased b Output of both products and consumer welfare in both countries c Total production of both products but not consumer welfare in both countries d Consumer welfare in both countries but not total production of both products 8 As a result of international trade specialization in production tends to be a Complete with constant costs complete with increasing costs b Complete with constant costs incomplete with increasing costs c Incomplete with constant costs complete with increasing costs d Incomplete with constant costs incomplete with increasing costs 9 A nation that gains from trade will find its consumption point being located a Inside its production possibilities curve b Along its production possibilities curve c Outside its production possibilities curve d None of the above Using the data of Table 21 answer Questions 10 through 15 53 Chapter 2 Foundations of Modern Trade Theory 54 10 11 12 13 14 15 Table 21 Output Possibilities for the US and the UK Output per Worker per Dav Country Tons of Steel Televisions United States 5 45 United Kingdom 10 20 Refer to Table 21 The United States has the absolute advantage in the production of a Steel b Televisions c Both steel and televisions d Neither steel nor televisions Refer to Table 21 The United Kingdom has a comparative advantage in the production of a Steel b Televisions c Both steel and televisions d Neither steel nor televisions Refer to Table 21 If trade opens up between the United States and the United Kingdom American rms should specialize in producing a Steel b Televisions c Both steel and televisions d Neither steel nor televisions Refer to Table 21 The opportunity cost of producing one ton of steel in the United States is a 3 televisions b 10 televisions c 20 televisions d 45 televisions Refer to Table 21 Mutually advantageous trade will occur between the United States and the United Kingdom so long as one ton of steel trades for a At least 1 television but no more than 2 televisions b At least 2 televisions but no more than 3 televisions c At least 3 televisions but no more than 4 televisions d At least 4 televisions but no more than 5 televisions Refer to Table 21 The United Kingdom gains most from trade if a 1 ton of steel trades for 2 televisions b 1 ton of steel trades for 3 televisions c 2 tons of steel trade for 4 televisions d 2 tons of steel trade for 5 televisions 54 Chapter 2 Foundations of Modern Trade Theory 55 16 17 18 19 20 Concerning international trade restrictions which of the following is false Trade restrictions a Limit specialization and the division of labor b Reduce the volume of trade and the gains from trade c Cause nations to produce inside their production possibilities curves d May result in a country producing some of the product of its comparative disadvantage If a production possibilities curve is bowed out ie concave in appearance production occurs under conditions of a Constant opportunity costs b Increasing opportunity costs c Decreasing opportunity costs d Zero opportunity costs Increasing opportunity costs suggest that a Resources are not perfectly shiftable between the production of two goods b Resources are fully shiftable between the production of two goods c A country s production possibilities curve appears as a straight line d A country s production possibilities curve is bowed inward ie convex in appearance The tradingtriangle concept is used to indicate a nation s a Exports marginal rate of transformation terms of trade b Imports terms of trade marginal rate of transformation c Marginal rate of transformation imports exports d Terms of trade exports imports Assuming increasing cost conditions trade between two countries would not be likely if they have a Identical demand conditions but different supply conditions b Identical supply conditions but different demand conditions c Different supply conditions and different demand conditions d Identical demand conditions and identical supply conditions Use the data in Table 22 to answer Questions 21 through 26 21 Table 22 Output Possibilities for South Korea and Japan Output per Worker per Day Country Tons of Steel VCRs South Korea 80 40 Japan 20 20 Refer to Table 22 The opportunity cost of one VCR in Japan is a 1 ton of steel b 2 tons of steel c 3 tons of steel d 4 tons of steel 55 Chapter 2 Foundations of Modern Trade Theory 56 22 23 24 25 26 27 28 Refer to Table 22 The opportunity cost of one VCR in South Korea is a 12 ton of steel b 1 ton of steel c 112 tons of steel d 2 tons of steel Refer to Table 22 According to the principle of absolute advantage Japan should a Export steel b Export VCRs c Export steel and VCRs d None of the above there is no basis for gainful trade Refer to Table 22 According to the principle of comparative advantage a South Korea should export steel b South Korea should export steel and VCRs c Japan should export steel d Japan should export steel and VCRs Refer to Table 22 With international trade what would be the maximum amount of steel that South Korea would be willing to export to Japan in exchange for each VCR a 12 ton of steel b 1 ton of steel c 112 tons of steel d 2 tons of steel Refer to Table 22 With international trade what would be the maximum number of VCRs that Japan would be willing to export to South Korea in exchange for each ton of steel a 1 VCR b 2 VCRs c 3 VCRs d 4 VCRs The earliest statement of the principle of comparative advantage is associated with a Adam Smith b David Ricardo c Eli Heckscher d Bertil Ohlin If Hong Kong and Taiwan had identical labor costs but were subject to increasing costs of production a Trade would depend on differences in demand conditions b Trade would depend on economies of largescale production c Trade would depend on the use of different currencies d There would be no basis for gainful trade 56 Chapter 2 Foundations of Modern Trade Theory 57 29 If the international terms of trade settle at a level that is between each country s opportunity cost a b c d There is no basis for gainful trade for either country Both countries gain from trade Only one country gains from trade One country gains and the other country loses from trade 30 International trade is based on the notion that a b c d Different currencies are an obstacle to international trade Goods are more mobile internationally than are resources Resources are more mobile internationally than are goods A country s exports should always exceed its imports 31 Refer to Figure 21 The relative cost of steel in terms of aluminum is a b c d 40 tons 20 tons 05 tons 025 tons Production Possibilities Schedule Figure 21 Tons of Aluminum 2000 000 2000 4000 Tons of Steel 32 Refer to Figure 21 The relative cost of aluminum in terms of steel is a b c d 40 tons 20 tons 05 tons 025 tons 57 Chapter 2 Foundations of Modern Trade Theory 58 33 34 35 36 37 38 39 Refer to Figure 21 If the relative cost of steel were to rise then the production possibilities schedule would a Become steeper b Become atter c Shift inward in a parallel manner d Shift outward in a parallel manner Refer to Figure 21 If the relative cost of aluminum were to rise then the production possibilities schedule would a Become steeper b Become atter c Shift inward in a parallel manner d Shift outward in a parallel manner When a nation achieves autarky equilibrium a b c d Input price equals nal product price Labor productivity equals the wage rate Imports equal exports Production equals consumption When a nation is in autarky and maximizes its living standard its consumption and production points are a b c d Along the production possibilities schedule Above the production possibilities schedule Beneath the production possibilities schedule Any of the above If Canada experiences increasing opportunity costs its supply schedule of steel will be a b c d Downwardsloping Upwardsloping Horizontal Vertical If Canada experiences constant opportunity costs its supply schedule of steel will be a b c d Downwardsloping Upwardsloping Horizontal Vertical The gains from international trade increase as a b c d A nation consumes inside of its production possibilities schedule A nation consumes along its production possibilities schedule The international terms of trade rises above the nation s autarky price The international terms of trade approaches the nation s autarky price 58 Chapter 2 Foundations of Modern Trade Theory 59 40 41 42 43 44 45 In a twocountry twoproduct world the statement Japan enjoys a comparative advantage over France in steel relative to bicycles is equivalent to a France having a comparative advantage over Japan in bicycles relative to steel b France having a comparative disadvantage against Japan in bicycles and steel c Japan having a comparative advantage over France in steel and bicycles d Japan having a comparative disadvantage against Japan in bicycles and steel Ricardo s theory of comparative advantage was of limited realworld validity because it was founded on the Labor theory of value Capital theory of value Land theory of value Entrepreneur theory of value 999 Assume that labor is the only factor of production and that wages in the United States equal 20 per hour while wages in the United Kingdom equal 10 per hour Production costs would be lower in the United States than the United Kingdom if a US labor productivity equaled 40 units per hour while UK labor productivity equaled 15 units per hour b US labor productivity equaled 30 units per hour while UK labor productivity equaled 20 units per hour c US labor productivity equaled 20 units per hour while UK labor productivity equaled 30 units per hour d US labor productivity equaled 15 units per hour while UK labor productivity equaled 25 units per hour According to Ricardo a country will have a comparative advantage in the product in which its a Labor productivity is relatively low b Labor productivity is relatively high c Labor mobility is relatively low d Labor mobility is relatively high The Ricardian model of comparative advantage is based on all of the following assumptions except a Only two nations and two products b Product quality varies among nations c Labor is the only factor of production d Labor can move freely within a nation The writings of G D A MacDougall emphasized which of the following as an explanation of a country s competitive position a National income levels b Relative endowments of natural resources c Domestic tastes and preferences d Labor compensation and productivity levels 59 Chapter 2 Foundations of Modern Trade Theory 60 TRUEFALSE QUESTIONS T F l T F 2 T F 3 T F 4 T F 5 T F 6 T F 7 T F 8 T F 9 T F 10 T F 11 T F 12 T F 13 T F 14 According to the mercantilists a nation s welfare would improve if it maintained a surplus of exports over imports The mercantilists maintained that a freetrade policy best enhances a nation s welfare The mercantilists contended that because one nation s gains from trade come the expense of its trading partners not all nations could simultaneously realize gains from trade According to the pricespecie ow doctrine a tradesurplus nation would experience gold out ows a decrease in its money supply and a fall in its price level The trade theories of Adam Smith and David Ricardo viewed the determination of competitiveness from the demand side of the market According to the principle of absolute advantage international trade is beneficial to the world if one nation has an absolute cost advantage in the production of one good while the other nation has an absolute cost advantage in the other good The principle of absolute advantage asserts that mutually beneficial trade can occur even if one nation is absolutely more ef cient in the production of all goods The basis for trade is explained by the principle of absolute advantage according to David Ricardo and the principle of comparative advantage according to Adam Smith The principle of comparative advantage contends that a nation should specialize in and export the good in which its absolute advantage is smallest or its absolute disadvantage is greatest The Ricardian theory of comparative advantage assumes only two nations and two products labor can move freely within a nation and perfect competition exists in all markets Assume that the United States is more efficient than the United Kingdom in the production of all goods Mutually beneficial trade is possible according to the principle of absolute advantage but is impossible according to the principle of comparative advantage It is possible for a nation not to have an absolute advantage in anything but it is not possible for one nation to have a comparative advantage in everything and the other nation to have a comparative advantage in nothing Ricardo s theory of comparative advantage was of limited relevance to the real world since it assumed that labor was only one of several factors of production Compared to Ricardian trade theory modern trade theory provides a more general view of comparative advantage since it is based on all factors of production rather than just labor 60 Chapter 2 Foundations of Modern Trade Theory T F 15 T F 16 T F 17 T F 18 T F 19 T F 20 T F 21 T F 22 T F 23 T F 24 T F 25 T F 26 T F 27 T F 28 61 Constant opportunity costs suggest that the relative cost of producing one product in terms of the other will remain the same no matter where a nation chooses to locate on its production possibilities schedule There are two explanations of constant opportunity costs 1 factors of production are imperfect substitutes for each other 2 all units of a given factor have different qualities With increasing opportunity costs a nation totally specializes in the production of the commodity of its comparative advantage with constant opportunity costs a nation partially specializes in the production of the commodity of its comparative advantage A nation s trade triangle denotes its exports imports and terms of trade International trade leads to increased welfare if a nation can achieve a posttrade consumption point lying inside of its productionpossibilities schedule If the US posttrade consumption point lies along its production possibilities schedule the United States achieves a higher level of welfare with trade than without trade If productivity in the German computer industry grows faster than it does in the Japanese computer industry the opportunity cost of each computer produced in Japan increases relative to the opportunity cost of a computer produced in Germany If Japan loses competitiveness in computers Japanese computer workers lose jobs to foreign computer workers and the wages of Japanese computer workers tend to fall relative to the wages of foreign computer workers With constant opportunity costs a nation will achieve the greatest possible gains from trade if it partially specializes in the production of the commodity of its comparative disadvantage By reducing the overall volume of trade import restrictions tend to reduce a nation s gains from trade With increasing opportunity costs comparative advantage depends on a nation s supply conditions and demand conditions with constant opportunity costs comparative advantage depends only on demand conditions According to the principle of comparative advantage an open trading system results in resources being channeled from uses of low productivity to those of high productivity The existence of exit barriers tends to delay the closing of inefficient firms that face international competitive disadvantages MacDougall s empirical study of comparative advantage was based on the notion that a product s labor cost is underlaid by labor productivity and the wage rate 61 Chapter 2 Foundations of Modern Trade Theory T F 29 T F 30 T F 31 T F 32 T F 33 T F 34 T F 35 T F 36 T F 37 T F 38 T F 39 T F 40 ANSWERS 62 The MacDougall study of comparative advantage hypothesized that in those industries in which US labor productivity was relatively high US exports to the world should be lower than UK exports to the world after adjusting for wage differentials The basic idea of mercantilism was that wealth consisted of the goods and services produced by a nation According to Adam Smith international trade was a winwin situation since all nations could enjoy gains from trade The pricespecie ow mechanism illustrated why one nation s gains from trade were accompanied by another country s losses Complete specialization usually occurs under the assumption of increasing opportunity costs Adam Smith contended that gold silver and other precious metals constituted the wealth of a nation The pricespecie ow mechanism illustrated why nations could not maintain trade surpluses or trade deficits over the long run The marginal rate of transformation equals the absolute slope of a country s production possibilities schedule Assume that Germany has higher labor productivity and higher wage levels than France Germany can produce a commodity more cheaply than France if its productivity differential more than offsets its wage differential Ricardo s theory of comparative advantage does not take into account demand conditions when determining relative commodity prices If Canada has a higher wage level and higher labor productivity than Mexico Canada will necessarily produce a good at a higher labor cost than Mexico If Argentina has a comparative advantage over Brazil in beef relative to coffee Argentina will specialize in beef production Answers to MultipleChoice Questions P eP PE manna 6 a 11 a 16 c 21 a 7 b 12 b 17 b 22 d 8 b 13 a 18 a 23 d 9 c 14 b 19 d 24 a 10 c 15 b 20 d 25 d 62 Chapter 2 Foundations of Modern Trade Theory 26 27 28 29 Answers to TrueFalse Questions WWWWWWWWWWNNJNNNNNNNHHHHHHHr kr kr k ppms999wNEQPWNQMWNEQPWNQMWNEQP WNP P PWP 7995 aweaaewwwewweaeweweawaawwaawwwawwwewwewa 30 31 32 33 35quot 34 35 36 37 39995 63 38 39 40 41 h n 42 43 44 45 9778 63 Chapter 2 Foundations of Modern Trade Theory 64 64