258197413 Solution Manual

Answers to End-of-Chapter Questions1. Howcanglobalizationandinternationaleconomicintegrationbemeasured?

Answer: Thechapteroffersthreewaystomeasureglobalizationandeconomicintegration:(1)tradeflows;(2)factormovements;and(3)convergenceofprices(goods,factors,andassets).

2. InwhatsenseistheU.S.economymoreintegratedwiththeworldtodaythanitwasacenturyago?Inwhatwaysisitlessintegrated?

Answer: TheWTOsTradeProfilefortheUnitedStatesgivesanaveragetradetoGDPratioof28.3for20092011.ThatimpliesthattheUnitedStatesratioisabout150percentgreatertodaythanitwasin1913((28.311.2)/11.21.53).

Atthesametime,thecompositionofgoodstradedhaschangedfromagriculturaloutputtomanufacturedgoods.Thisisconsistentwiththeobservationthatworldtradehasbeengrowingfasterthanworldoutput,atleastsince1950.Muchofthegrowthintradesincethen,however,simplybroughtusbacktowherewewerebeforeWorldWarII.

Intermsoflaborflows,theUnitedStatesisprobablylessintegratedwiththeworldeconomythanitwasin1890or1900.Duringthattimewehadanopendoorimmigrationpolicy(forallbutChinesecitizens),andalargershareofourpopulationwasforeignborn(14.5in1890versuslessthan8percentin1990and12percenttoday).

Capitalflowsaremoredifficulttogeneralizesincetheycanbemeasuredseveralways.Whiletheabsolutevolumeofcapitalflowshasincreaseddramatically,asashareofworldGDPitisprobablynomorethanitwasattheturnofthetwentiethcentury,anditmayevenbeless.Thelevelofinvestmentinnearlyallcountriesisstillhighlycorrelatedwithdomesticsavingsrates.Whatisdifferent,however,istheeasewithwhichcapitalcancrossinternationalboundaries(lowertransactioncosts)andthemuchgreatervarietyofassetsthataretraded.Theneedtoprotectagainstexchangerateriskisakeycomponentoftodaysinternationalfinancialmarketsandisaprimarydifferencefromthefixedexchangeratestandardofthepast.Theincidenceoffinancialcriseshasnotincreasedand,asametricofintegration,itimpliesnoincreaseincapitalmarketintegration.

Thegrowthofregionaltradeagreementsisalsoanindicatorofincreasedintegration.AgrowingroleforinternationalinstitutionssuchastheIMForWorldBankmayalsoindicateanincreaseininternationalintegration.

3. WhatdoesthetradetoGDPratiomeasure?Doesalowvalueindicatethatacountryisclosedtotradewiththeoutsideworld?

Answer: ThetradetoGDPratioisameasureoftherelativeimportanceoftradetoanationaleconomy.ItismeasuredbytheratioofexportsplusimportstoGDP.

Arelativelysmallratiodoesnotnecessarilymeanthataneconomyisintentionallyclosedtotheoutsideworld.LargecountriesliketheUnitedStateshavelargedomesticmarketsthatenablefirmstospecializeandproduceinvolumeinordertoattainanoptimalscale.Specializationandhighvolumeinmanufacturingisoftenassociatedwithincreasedproductivity,sofirmsinlargemarketscanachievethehighestpossiblelevelofproductivitywithouthavingtoselltoforeignmarkets.Firmslocatedinsmallercountries

2014PearsonEducation,Inc.

2Gerber InternationalEconomics,SixthEdition

havetotradetheiroutputacrossinternationalboundariesiftheywanttohavethesametechnologyandthesamelevelofproductivity.Consequently,largecountriestendtohavelowertradetoGDPratiosregardlessoftheirtradepolicies.

4. DescribethepatternoverthelastcenturyshownbythetradetoGDPratioforleadingindustrialeconomies.

Answer: Theratiofellbetween1913and1950,butthenbegantoriserelativelyrapidly.ThemaincausesofthepatternshowninFigure1.1arethetwoworldwarsandtheGreatDepressionofthe1930s,andchangesintradepolicyaccompanyingthatperiod.By2000,theratiosweremostlyhigherthantheywerebeforeWorldWarI.AnotherpatternthechapternotesisthattheratioissmallerforthelargepopulationcountriesofJapanandtheUnitedStates,andhigherforTheNetherlands,withitssmallpopulation.

5. Tradeandcapitalflowsweredescribedandmeasuredinrelativeratherthanabsoluteterms.Explainthedifference.Whichtermseemsmorevalidrelativeorabsolute?Why?

Answer: Absolutevaluesarethedollaramountsoftradeandcapitalflows.RelativevaluesaretheratioofdollarvaluestoGDP.Relativevaluesareabetterindicatoroftheimportanceoftradeandcapitalflowssincetheyareproportionaltothesizeofnationaleconomies.LargeeconomiesliketheUnitedStatesmayhavelargeexportandimportvalues,buttheimportanceoftradetothenationaleconomyisnotnearlyasgreatasitisforothereconomies.TheUnitedStatesisalargeexporterandimporter,butthenationaleconomyissolargethattradeismuchlessimportantfortheUnitedStatesthanitisformanysmallercountriessuchasCanada,Belgium,orTheNetherlands.

6. Inrelativeterms,internationalcapitalflowsmaynotbemuchgreatertodaythantheywereahundredyearsago,althoughtheyarecertainlygreaterthantheywerefiftyyearsago.Qualitatively,however,capitalflowsaredifferenttoday.Explain.

Answer: Majorqualitativedifferencebetweenlatenineteenthandlatetwentiethcenturycapitalflowsincludethefactthattherearemanymoretypesoffinancialinstrumentsavailablenowcomparedtoacenturyago.Theseinstrumentscanbefinelytailoredtotheincomeandriskpreferencesofinvestors.Secondly,alargeshareofthetotalflowofcapitalacrossbordersisrelatedtotheneedtoprotectagainstfluctuationsinthevalueofcurrencies.Thisuseofinternationalcapitalmarketswasnotasnecessarywhennationsoperatedwithinfixedexchangeratesystems.Third,thetransactioncostsofparticipatingininternationalcapitalmarketsaremuchlowertodaythanitwasacenturyago.

7. Whatarethenewissuesininternationaltradeandinvestment?Inwhatsensedotheyexposenationaleconomiestooutsideinfluences?

Answer: Thenewissuesinvolvepolicydifferencesbetweennationsthatuntilrecentlywereconsideredtheexclusiveresponsibilityoflocalornationalgovernments.Examplesincludelaborstandards,environmentalstandards,competitionorantitrustpolicies,andindustrialsupportpolicies.

Negotiationsbetweennationspotentiallygiveforeigninterestsavoiceinsettingdomesticpolicy.Thescopeandthedepthofthenegotiationsdeterminehowgreatavoiceforeignerswillhave.Itisoftenthecase,however,thatnegotiationseitheroccurorare


Chapter1 TheUnitedStatesinaGlobalEconomy 3

proposedbecausesomeaspectofdomesticpolicyisperceivedbyforeignersasabarriertotrade,andtheyseektoalterthedomesticpolicythatcreatedit.



8. Describethethreekindsofevidenceeconomistsusetosupporttheassertionthateconomiesopentotheworldgrowfasterthaneconomiesthatareclosed.

Answer: Theseare:(1)casualempiricalevidenceofhistoricalexperience;(2)economiclogicanddeductivereasoning;and(3)evidenceofstatisticalcomparisonsofcountries.

(1) Thehistoricalevidenceexaminestheexperiencesofcountriesthattriedtoisolatethemselvesfromtherestoftheworld.First,notonlydidtradeprotectionexacerbatetheDepressionofthe1930s,butitalsoledtothemiseryandtragedyofWorldWarII.Second,anexaminationofcountriessuchasformerEastandWestGermany,NorthandSouthKorea,andothercountrieswiththesamehistorical,economic,andethnicbackgroundthatweredividedbywar,indicatethatthosewhoclosedtheireconomiesfromtherestoftheworldsufferedintermsofprosperityandenvironmentaldegradation.EastAsiaexperiencedaneconomictakeoffwhenitdecidedtointegratewiththerestoftheworld,whileLatinAmerica,whichhadthesameeconomicbackgroundasEastAsiabutchosetoremainpartiallyclosed,experiencedmediocregrowth.

(2) Thelogicofeconomictheoryalsosuggestsastrongcausalrelationbetweentradeandfastereconomicgrowth.Thefollowingisasummaryofthislinkage:

FollowingAdamSmith,DavidRicardoprovedthatcomparativeadvantageleadstotradeandthisinturnleadstothereallocationofresourcesandtheimprovementofthestandardoflivingofanynation,largeorsmall.Moderntradetheoryalsomakesthecaseforexportsandopentradeasthecausesforeconomicexpansion.Exportsandopentradefostercompetition,innovation,andlearningbydoingandbringinternationalbestpracticestotheattentionofdomesticproducers,spurringgreaterefficiencyandexportexpansion.Thishelpsdomesticproducerstorealizeeconomiesofscalewhentheyattempttoproducefortheworldmarketratherthanfortheirownlimitedbaseofdomesticconsumers.Largermarketscreateincentivesforfirmstoengageinresearchanddevelopment,andallowcountriestoimportimportantproductioninputsandforeigncapitalbyminimizingforeignexchangeconstraints.Theyfacilitatethetransferoftechnologyandmanagerialskills.Itfollowsthatopentradeandexportsincreasethedemandforthecountrysoutputandthereforecontributestronglytopositiveeconomicgrowth.

(3) Eventhoughthestatisticalevidenceisnotquiteconclusive(mainlyduetomeasuringtradepolicy),theevidenceofstatisticalcomparisonofcountries(crosssectionaltimeseries)indicatesthatcountriesbenefitfromopentrade.



Ch2

Answers to End-of-Chapter Questions1. Whatisaninstitution?Giveexamplesofbothformalandinformalinstitutions.Explainhowthey

differfromorganizations.

Answer: Aninstitutionisasetofrulesofbehavior.Itsetslimitsorconstraintsonsocial,political,andeconomicinteraction.Therulescanbeformallyrecognizedinacodeoflaws,clubrules,oranorganizationsstandardsofbehavior.Therulesofaninstitutionmayalsobeinformalasinthecaseoftablemannersorsocialcustoms.Examplesofformalinstitutionsincludecivilcodes,commercialcodes,anduniversitystandardsofbehavior(e.g.,regardingplagiarismorsexualharassment).Examplesofinformalinstitutionsincludegiftexchangesonbirthdays,eatingsaladwiththesmallfork,andgivingupyourseattoanelderlypersononacrowdedbus.

InstitutionsdifferfromorganizationsinthesamewaythatthegovernmentoftheUnitedStatesdiffersfromtheConstitution.Thelatteristhesetofrulesthatgovernstheformer.Organizationsareassociationsofindividualsorgroups,institutionsaretherulesthatdeterminethelimitsandimperativesoftheirbehavior.

2. Whataretheargumentsinfavorofinternationalorganizations?Whataretheargumentsagainstthem?Whichdoyouthinkarestronger?

Answer: Argumentsinfavor:Internationalorganizationsareessentialforthecontainmentofnationalorregionalcrisesandtheavoidanceoftheirpropagationinternationally.Byprovidingasetofrules(institutions)whicharecertainandknown(transparent),theyreduceuncertaintyandincreasestability.Inmanyinstances,theyovercomeproblemsoffreeridingintheinternationaleconomyinordertoinsuretheprovisionof(international)publicgoodssuchaslenderoflastresortfinancingforresolvingaliquiditycrisis,oropenmarketsinarecession.

Argumentsagainst:Thetextdescribestheproblemswithinstitutionsintermsofissuesofsovereignty(mayforceadoptionofdomesticpoliciesagainstnationswillorinterests),transparency(decisionmakingatinstitutionsmaybedominatedbyotherspursuingtheirowninterests),ideology(advicemaybebadorbiased),andimplementationandadjustmentcosts(asymmetriesinnegotiationpowerandinabilitytoabsorbcostsimposed).Overall,criticsquestionwhetherinstitutionsgenerateeconomicinequalityandcompoundriskstovulnerablegroups.

Theissueofwhichargumentsarestrongerisambiguous.Eithercanbeviewedasmorecogent.Thekeyisthatstudentsunderstandbothargumentsandthattheydevelopasetofreasonstosupporttheirviews.



3. Givetheargumentsforandagainstfreetradeagreements.HowmightthesigningofafreetradeagreementbetweentheUnitedStates,CentralAmerica,andtheDominicanRepublichaveharmedBangladesh?

Answer: ProponentsofRTAsviewthemasbuildingblocksforfreer,moreopen,worldtrade.Theyareabletoperformthisfunctionbecauseitiseasierforafewcountriestoreachagreementondifficulttrademattersthanitisforalargenumberofcountriestoreachthesameagreements.Furthermore,thedomesticeffectsofareductionoftradebarriersarelessdramaticsincefewercountriesareinvolved.Importflowsandjoblossesanddisplacementsaresmallerandmoreeasilymanaged.Inaddition,RTAmemberscanexperimentwithnewagreements,suchaslaborandenvironmentalstandardsthataretoocontentiousinalargersetofnegotiations.OpponentsquestiontheseassumptionsandarguethatRTAsundermineprogresstowardmultilateralagreements,suchastheDohaRoundoftheWTO.TheyarguethatRTAspolarizecountriesbecausetheyarediscriminatoryagainstnonmembersandbecausetheydisadvantagesmallercountriesthatenterintoagreementswithlargeones,sincethesmallcountrieslacktheabilitytonegotiateeffectivelyandtheyareoftenunabletotakeadvantageofthemarketopeningofthelargercountryduetotheirlimitedinfrastructureandotherresources.

BangladeshmaybehurtbyafreetradeagreementbetweentheUnitedStatesandCentralAmericaduetothetradediversionthatmightresult.IfBangladeshisthelowestcostproducerofapparel,forexample,thenaloweringofU.S.tariffsagainstCentralAmericacouldresultinproductionfortheU.S.marketshiftingfromBangladeshtoCentralAmerica.

4. Whatarepublicgoodsandhowdotheydifferfromprivateones?Giveexamplesofeach.

Answer: Publicgoodsarenondiminishableandnonexcludable.Privategoodsgenerallyshareneitherofthesecharacteristics.Privategoodsincludemostthingsthatareboughtandsoldinprivatemarkets(restaurantmeals,clothing,houses,cars,etc.)whilepublicgoodsareoftenprovidedcollectively.Publicgoodsincludenationaldefense,publicairways,civilandcommercialcodes,andsoforth.

5. Whatarethemaintasksorfunctionsof(1)theInternationalMonetaryFund,(2)theWorldBank,(3)theGeneralAgreementonTariffsandTrade,and(4)theWorldTradeOrganization?

Answers: (1) TheIMFsroleistoactasalenderoflastresortinthecaseofadebtcrisisorforeignexchangecrisis.Itprovidestechnicalexpertiseandadviceandassistsnationalgovernmentswithnecessarybutdifficultreorganizationsoftheirnationaleconomies.

(2) TheWorldBanksmission,ingeneralterms,istoassisttheeconomicdevelopmentofnationsthroughtheprovisionofloans,technicalexpertise,andadvice.

(3) GATTisaseriesofmultilateraltradenegotiationsandresultingtreatieswhichbindsthetariffsandtradepoliciesofnationsandlimitstheirabilitytoarbitrarilychangethem.Itsmissionistokeepmarketsforgoodsopenandtoensurethatnationsfollowasetofrulesgoverningfairtrade.



(4) TheWTOisanumbrellaorganizationcreatedbytheUruguayroundofGATT.ItsroleissimilartoGATTs,butithasexpandeditsfunctiontoincludeagreementsonservices,agriculture,andtextilesandapparel,allofwhichwereomittedfromthepreviousroundsofGATT.Inaddition,itprovidesrulesfortheresolutionoftradedisputesbetweennationsandactsasaforumforthediscussionandimplementationoffurtherreductionsintradebarriers.

6. WhennationssigntheGATTagreement,theybindtheirtariffsattheircurrentlevel,orlower.Tariffbindingmeansthattheyagreenottoraisethemexceptunderunusualcircumstances.ExplainhowtariffbindingintheGATTpreventsfreeridingduringaglobalslowdown.

Answer: Duringaglobalslowdown,nationsmaybetemptedtoraisebarrierstoimports.Thehopeisthatreducedimportswillprovidegreaterincentivefordomesticproductionandaddjobsinimportcompetingindustries.Thispartofthestrategyusuallyworksbutatthecostofthelossofjobsinexportindustries.Exportindustriesarehurtifothernationsretaliateandimposesimilarbarrierstoimports.

Theproblemisthateverycountrywantstolettheothersbetheonestokeeptheirmarketsopen.Thefreeriderproblemoccursbecausenationsthatimposeimportbarriersarefreeridingonthepoliciesofnationsthatdonotsimilarlyimposebarriers.Tariffbindingeliminatesthispossibility.

7. KindlebergersstudyoftheGreatDepressionofthe1930sledhimtobelievethatmarketeconomiesaresometimesunstableandthatnationscangetlockedintoprolongeddownturns.Othereconomistsarenotconvinced.SupposethatyoudisagreewithKindlebergerandthatyoubelievethatmarketbasedeconomiesareinherentlystable.HowwouldyouviewtheneedforinternationalinstitutionstoaddresstheprovisionofeachofthepublicgoodsinTable2.5?

Answer: Iftheinternationaleconomyisinherentlystable,thentheneedforinternationalinstitutionsdecreases.MostofthecaseswherethereisafailuretoprovidethepublicgoodsinTable2.3areaconsequenceofthefailuregovernmentstoimplementsoundeconomicpolicies.

Governmentsmaytrytoclosemarketsduringarecessionbutenlightenedgovernmentsrecognizethisasselfdefeatingsinceothernationswillretaliate.Governmentclosureofmarketsisagovernmentalfailure,notamarketfailure.

Privatecapitalmarketswillchannelfundstodevelopingcountriesifthesecountrieshavetherightpolicies.Again,theproblemofcapitalshortagesindevelopingcountriesmaybeasmuchafailureofthedevelopingcountryseconomicpoliciesasitisafailureofmarkets.

Privatemarketswillseekoutpaymentmethodsthatareacceptabletoallthepartiesinvolved.

Financialcrisescausedbyashortageofliquidityareanindicatorofdeeperproblems.Attimes,itisnecessarytoletbadfirmsfail.Thesetypesofcriseswillburnthemselvesoutandleavelittlelastingimpactontheinternationaleconomy.



8. Whatarethefivemaintypesofregionaltradeagreementsandwhataretheirprimarycharacteristics?

Answer: Thefivemaintypesofregionaltradeagreementsare:(1)apartialtradeagreement;(2)afreetradearea;(3)acustomsunion;(4)acommonmarket;and(5)aneconomicunion.

(1) Apartialtradeagreementfreesuptradebetweentwoormorecountriesinafewgoods.AnexampleistheU.S.CanadaAutoPactwhichcreatedfreetradeincarsandcarpartsinthe1960s.ItlaterformedthebasisfortheU.S.Canadafreetradeagreement.

(2) Afreetradeareaallowsgoodsandservicestocrossinternationalborderswithoutpayingatariffandwithoutlimitationsimposedbyquotas.Manyitems,suchaslaborandenvironmentalissues,areusuallyleftoutoftheagreement.Example:NAFTA.

(3) Acustomsunionisafreetradeareaplusacommonsetoftariffstowardnonmembers.Inthissituation,membershavefreetradewitheachotherandagreetolevythesametariffonimportsfromnonmembers.Examples:MERCOSUR,andfromthemid1970stoearly1990s,theEuropeanUnion.

(4) Acommonmarketisacustomsunionplusanagreementtoallowthefreemobilityofinputssuchaslaborandcapital.Example:theEuropeanUnioninthe1990s.

(5) Aneconomicunionisacommonmarketwithsubstantialcoordinationofmacroeconomicpolicies,includingacommoncurrency,andharmonizationofstandardsandregulations.Example:the12EuropeanUnionmembersthatparticipateintheeuro.

Sincemostformalagreementscombineincompleteelements,thisclassificationismoreclearcutthanthemessierreality.

9. CriticsoftheglobalinstitutionshaveavarietyofcomplaintsabouttheWTO,theIMF,andtheWorldBank.Explainthemaincategoriesofcomplaints.

Answer: Thetextdescribestheproblemswithinstitutionsintermsofissuesofsovereignty(mayforceadoptionofdomesticpoliciesagainstnationswillorinterests),transparency(decisionmakingatinstitutionsmaybedominatedbyotherspursuingtheirowninterests),ideology(advicemaybebadorbiased),andimplementationandadjustmentcosts(asymmetriesinnegotiationpowerandinabilitytoabsorbcostsimposed).TheyespeciallyquestionthedominanceoftheUnitedStatesandindustrializednationsindeterminingthepoliciesinstitutionssetforclientcountries,sincethosepoliciesmaybewrongorbiasedorimposeparticularharmtosomegroupsintheclientnationspopulations.Overall,criticsquestionwhetherinstitutionsgenerateeconomicinequalityandcompoundriskstovulnerablegroups.

Ch3

Answers to End-of-Chapter Questions1. UsetheinformationinthetableonlaborproductivitiesinFranceandGermanytoanswerquestionsa

throughf.



OutputperHourWorkedFrance Germany

Cheese 2kilograms 1kilogramCars 0.25 0.5

a. Whichcountryhasanabsoluteadvantageincheese?Incars?b. WhatistherelativepriceofcheeseinFranceifitdoesnottrade?InGermany?c. WhatisopportunitycostofcheeseinFrance?InGermany?d. Whichcountryhasacomparativeadvantageincheese?Incars?Explainyouranswer.e. Whataretheupperandlowerboundsforthetradepriceofcheese?f . DrawahypotheticalPPCforFranceandlabelitsslope.SupposethatFrancefollowsits

comparativeadvantageindecidingwheretoproduceonitsPPC.Labelitsproductionpoint.Ifthetradepriceofcarsis5kilogramsofcheesepercar,drawatradeline(CPC)showinghowFrancecangainfromtrade.

Answers:a. FrancehastheabsoluteadvantageincheeseandGermanyincars.ThisfollowsbecauseFrances

productivityishigherincheeseandGermanysishigherincars.b. TheautarkicrelativepriceofcheeseinFranceisoneeighthcarperkilogram;inGermanyitis

onehalfcar.



c. Opportunitycostsareequaltorelativeprices.d. Francehasacomparativeadvantageincheesebecauseitsopportunitycostislower(oneeighth

carversusonehalfcarinGermany).Bythesamereasoning,Germanyhasacomparativeadvantageincars.

e. Thetradepriceofcheesewillsettlebetweenoneeighthandonehalfcarperkilo.f.

2. SupposethetableinProblem1looksasfollows.Usetheinformationtoanswerquestionsathroughf.

OutputperHourWorked

France Germany

Cheese 1kilogram 2kilograms

Cars 0.25car 2cars

Answers:a. Germanyhasanabsoluteadvantageinbothcheeseandcars.b. 1cheese0.25carinFrance;1cheese1carinGermanyc. sameasPart(b).d. Francehasacomparativeadvantageincheesebecauseitsopportunitycostintermsof

carsislower(0.25carvs.1car);Germanyhasacomparativeadvantageincarproduction(1cheesevs.4cheese).



e. Thetradepriceofcheesewillsettlebetween0.25carand1car.f.

3. Explainhowanationcangainfromtradeeventhoughnoteveryoneismadebetteroff.Isthisacontradiction?

Answer: Thisisnotacontradiction.Thegainsfromtradeimplythatthewinnerscouldcompensatetheloserscompletelyandstillhavegainsleftover.Somepeoplemaylosejobs(intheexampleinthetext,astheUnitedStatesmovedtowardspecializationinsteel,Americanworkerswereshiftedoutofthebreadindustryandintothesteelindustry),butothersbenefitfromthehigherdemandfortheirproduct(workersinthesteelindustry).Aslongasthewinnersgainsaregreaterthantheloserslosses,wecanconcludethatthenationwins.

4. Economicnationalistsindevelopedcountriesworrythatinternationaltradeisdestroyingthenationaleconomy.Acommoncomplaintisthattradeagreementsopentheeconomytoincreasedtradewithcountrieswhereworkersarepaidafractionofwhattheyearnathome.Explainthefaultylogicofthisargument.

Answer: Theerrorinlogicisthefailuretotakeintoaccountthedifferencesinproductivity.Thelowwageworkersinlessdevelopedcountriesingeneralarepaidlessbecausetheyproducelessoutputduringeachhouroflabor.Furthermore,thedevelopednationsandthelessdevelopednationsarenotincompetitionforeconomicgrowth.Growthinonecountrybenefitstheotherthroughanincreaseinthedemandforitsproducts.Economicnationaliststendtoviewtradeasazerosumgameinwhichonesidelosesandtheotherwins.

5. Manypeoplebelievethatthegoalofinternationaltradeshouldbetocreatejobs.Consequently,whentheyseeworkerslaidoffduetoafirmsinabilitytocompeteagainstcheaperandbetterimports,theyassumethattrademustbebadfortheeconomy.Isthisassumptioncorrect?Why,orwhynot?

Answer: Thegoaloftradeistoimproveanationsallocationofitsresourcessotheyaredirectedtotheirmostvaluableuse.Tradeisnotaboutcreatingjobs,butisaboutraisingthestandardoflivingthroughamoreefficientallocationofresources.Trademaycauseworkerstobecomelaidoffiftheyareininefficientindustriesthatdonotproduceaccordingtothenationalcomparativeadvantage.Whilethismaybehardonthepeoplewholosetheirjobs,italsofreesuplaborandcapitalsoitcanbedirectedtobetteruses.



6. SupposethatGermanydecidestobecomeselfsufficientinbananasandeventoexportthem.Inordertoaccomplishthis,largetaxincentivesaregrantedtocompaniesthatwillinvestinbananaproduction.Soon,theGermanindustryiscompetitiveandabletosellbananasatthelowestpriceanywhere.DoesGermanyhaveacomparativeadvantage?Why,orwhynot?Whataretheconsequencesfortheoveralleconomy?

Answer: Governmentsubsidiescanlowerthecostofproductionbuttheywillnotchangetheproductivityofbananaproduction.Thelaborandcapitalthatispulledintobananaproductionarepulledoutoftheproductionofsomeothergood.Thereisnothinginthetaxincentivesthatchangestherelativepriceoropportunitycostofbananas.HenceGermanydoesnothaveacomparativeadvantageeventhoughthetaxincentivesallowfirmstoselltheiroutputatcompetitiveprices.TheconsequencefortheeconomyisthatlaborandcapitalareusedupinarelativelyinefficientendeavorandarelessavailableforuseintheproductionofgoodswhereGermanydoeshaveacomparativeadvantage.Henceoveralleconomicwelfarefalls,eventhoughthebananaproducersaredoingwell.Resourcesthatareusedforthetaxincentivesaredivertedfromsomeotherprogram,creatinganadditionalopportunitycost.

Answers to End-of-Chapter Questions1. Accordingtothefollowingtable,whichcountryisrelativelymorelaborabundant?Explainyour

answer.Whichisrelativelymorecapitalabundant?

UnitedStates Canada

Capital 40machines 10machines

Labor 200workers 60workers

Answer: Thecapitallaborratiosare1/5and1/6fortheUnitedStatesandCanada.Since1/5isgreaterthan1/6,theUnitedStatesiscapitalabundant.Bythesamereasoning,thelaborcapitalratioishigherinCanada,soitislaborabundant.

2. SupposethattheUnitedStatesandCanadahavethefactorendowmentsgiveninthetableinQuestion1.Supposefurtherthattheproductionrequirementsforaunitofsteelis2machinesand8workers,andtherequirementforaunitofbreadis1machineand8workers.a. Whichgood,breadorsteel,isrelativelycapitalintensive?Laborintensive?Explainyouranswer.b. Whichcountrywouldexportbread?Why?

Answers:a. Thecapitallaborratiotomakesteelis1/4;tomakebreaditis1/8.Hencesteelismorecapital

intensiveandbreadismorelaborintensive.b. SincetheUnitedStatesiscapitalabundantandsteeliscapitalintensive,accordingtothe

HeckscherOhlintrademodel,theUnitedStateswillexportsteelandCanadawillexportbread.


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3. Supposethatbeforetradetakesplace,theUnitedStatesisatapointonitsPPCwhereitproduces20loavesofbreadand20unitsofsteel.Oncetradebecomespossible,thepriceofaunitofsteelis2unitsofbread.Inresponse,theUnitedStatesmovesalongitsPPCtoanewpointwhereitisproducing30unitsofsteeland10loavesofbread.Isthecountrybetteroff?Howdoyouknow?

Answer: TheUnitedStatesisdefinitelybetteroffbecauseitcanconsumeagreaterquantityofbothgoods.Ifittradedfivesteelfor10breaditwouldhave20breadand25steel.Thisisthesameamountofbreadasbeforetrade,andfivemoreunitsofsteel.Itcankeeptheextrafivesteel,ortradesomeorallofthemforadditionalbread.Ineithercase,theconsumptionbundleisgreaterthanitwasbeforetrade.

4. GiventheinformationinQuestions1and2,explainwhathappenstothereturnstocapitalandlaborineachcountryaftertradebegins.

Answer: Thechangesinthereturnstocapitalaredifferentbycountry.IntheUnitedStates,thedemandforcapitalincreasesbecausemoresteelwillbeproduced;conversely,thedemandforlaborfallsbecauseofthedropinbreadproduction.Ownersofcapitalbenefitfromtheincreaseindemandfortheirinputs,whileownersoflaborsufferadeclineintheirreturns(wages).InCanada,theeffectsarereversed.



5. Supposethattherearethreefactors:capital,labor,andland.Breadrequiresinputsoflandandlabor,andsteelrequirescapitalandlabor.a. Whichfactorsarevariable,andwhicharespecific?b. SupposeCanadasendowmentsoflandandcapitalare10capitaland100land,andthe

UnitedStatesare50capitaland100land.Whichgooddoeseachcountryexport?c. Howdoestradeaffectthereturnstoland,labor,andcapitalintheUnitedStatesandinCanada?

Answers:a. Laboristhevariablefactorandcapitalandlandarespecific.b. CanadaislandabundantrelativetotheUnitedStates(100/10isgreaterthan100/50),so

Canadascomparativeadvantageisintheexportofbread,thegoodwiththespecificinputofland.TheUnitedStatescomparativeadvantageissteel.

c. IntheUnitedStates,ownersoflandarehurtbytrade,ownersofcapitalbenefit,andtheeffectsonlaborareindeterminate.Thelattereffectdependsonlaborspreferenceforbreadandsteel.IntheUnitedStates,breadpricesfall,butsteelpricesrise.InCanada,ownersoflandbenefitfromtrade,ownersofcapitalarehurt,andtheeffectsonlaborareindeterminate.Thelattereffectdependsonlaborspreferenceforbreadandsteel.InCanada,breadpricesrise,butsteelpricesfall.

6. Describethechangesinproductionrequirementsandthelocationofproductionthattakeplaceoverthethreephasesoftheproductcycle.

Answer: Inthefirstphase,allproductionisinhighincomecountries.Theinputrequirementsincluderelativelylargeamountsofscientificandengineeringskills,marketingexpertise,andaccesstoriskcapital.Experimentationwithnewproductsdependsonaccesstohighincomeconsumers,andcompetitivepressuresrequireaquickfeedbackfromconsumerstoproducers.Thenewproductstendtobehighlyvariableintheirdesignandperformancecharacteristics,andexperimentationisimportantinfindingtherightcombinationofprices,options,andquality.

Inthesecondphase,somestandardizationistakingplace,alongwithsomesalesoftheproductindevelopingcountries.Theearlyperiodofintenseexperimentationisoverandfirmsarebeginningtosettleonthelowestcostproductiontechnologies.Productionismigratingoverseas,wherelaborcostsarelower.

Inthefinalphase,experimentationwithdesignandmanufacturingtechnologiesisover,theproductiscompletelystandardized,andtheinputrequirementsaremoreheavilybiasedtowardsunskilledorsemiskilledlabor.Muchoftheproductioncanbeaccomplishedinassemblyoperations,whichcanbelocatedinlowwagecountries.Bythethirdphase,mostoftheproductionhasleftthehighincomecountriesexceptinthecaseswhereproductdifferentiationcancontinue.

7. Doesintrafirmtradecontradictthetheoryofcomparativeadvantage?Whyorwhynot?

Answer: No,ingeneralitdoesnot,butitmayinsomecases.Mostintrafirmtradecanbeunderstoodasafirmthatcutsupitsproductionprocessintoseveraldistinctstages,andthenrelocatessomeorallofthestagestodifferentcountrieswherethefactorendowmentsareconsistentwiththeproductionrequirementsofeachstage.Laborintensiveproductionstageswillberelocatedtolaborabundantcountries,andsoforth.



Inthiscase,firmsaretakingadvantageofthecomparativeadvantageofdifferentnationsinordertoproducetheirgoodsatthelowestoverallcost.

Insomecases,however,theremaybeothermotivesforlocatingaproductionstageinanothercountry.Thesemotivesincludethedesiretoavoidtradebarriersbyproducingallorpartofagoodinsidethecountrywheresalesareanticipated,thedesiretoescapetaxation,theattempttodetermarketentrybyarivalfirm,andasinsuranceagainstunforeseenevents(e.g.,politicalinstability).

8. GeneralMotorsisaU.S.basedmultinational,butitisalsooneofthelargestcarmanufacturersinEuropeandSouthAmerica.HowmightDunningsOLItheoryexplainthetradeoffsGMfacedasitdecidedwhethertoexporttothosetwomarketsortoproduceinthem?

Answer: Transportationcostsaresignificantintheautosector,meaningthatproducingclosetothefinalmarketcanhavecostadvantages.TheEuropeanmarketmayhavedesignpreferencesthataredifferentfromtheU.S.market(i.e.,drivingontherightsideoftheroad,fueleconomygivenhighergasprices,higherspeedlimits,andtheneedforpoweronhighways).Thiswouldgiveadvantagestoaproductionlocationwithmoredirectaccesstothefinalmarket.OtherautomanufacturersthatcouldhandleproductionareGMsdirectcompetition,makingGMunlikelytochooselicensingandasharingofitsmanufacturing,design,andtechnology.

9. Manydomesticallyownedapparelmanufacturersbuytheirgarmentsoverseas,sewtheirlabelsintothem,andthensellthemabroadorbackintothehomemarket.Whataresomeoftheconsiderationsthataclothingmanufacturermightgothroughtochoosethisstrategyinsteadofproducingathomeandexporting?

Answer: Thesefirmsperceivetheirassettobetheirbrand.Thismayinvolvesomeelementsofdesign(orderingspecificoutputfromforeignsuppliers)butalsocouldinvolvequality.Itcanbebasedstrictlyonmarketingandadvertising,creatinganimagefromsomethingthatisintheendrelativelycheapandeasytocreate.Allowingforeignfirmstheabilitytobrandtheclothesthroughlicensingmakesthemlosecontrolofthisasset.Sewinglabelsinallowssomeelementofqualitycontrolwhilereducingproductioncosts.Garmentassemblyisrelativelylaborintenseandlowskill,makingitmorelikelytooccurinlessdeveloped,laborabundantcountries.Design,marketing,andaccesstohighspendingconsumersaremorelikelytobeassetsoffirmsindevelopedcountries.Owninganassemblyoperationdirectlyisnotnecessaryforthemtopreservethisassetaslongastheyhaveultimatecontroloverwhattheyputtheirnameonandhowthatproductisdistributedandmarketed.



10. SupposeSpainweretoopenitsdoorstoalargenumberofunskilledAfricansseekingtoimmigrate.Ingeneral,whateffectswouldyouexpecttoseeinSpainstradepatternsanditscomparativeadvantage?

Answer: Intheory,laborbecomesmoreabundantandSpainscomparativeadvantagecouldshifttomoreunskilled,laborintenseproduction.Inpractice,thislaborinflowmaybeusedtoproduceservicesthatarenottraded.Theymayfreeupcitizenstoworkinthealreadyexistingexportsectorandhavelittleeffectoncomparativeadvantage.

Answers to End-of-Chapter Questions1. Whatisintraindustrytradeandhowdoesitdifferfrominterindustrytrade?Arethegainsfromtrade

similar?

Answer: Intraindustryisinternationaltradeofproductsmadewithinthesameorsimilarindustries,forexample,carforcar,beerforbeer,etc.Differentiatedproducts,whicharecharacteristicsofmonopolisticcompetitionandoftenoligopoly,leadtotradebetweennationswithcommoditiesinthesameindustry.Homogeneousgoods,therefore,wouldnotmakeanysenseforintraindustrytrade.

Interindustrytradeisinternationaltradeoftwoormoredifferentproducts,forexample,carforbread.Interindustrytradecanbeexplainedbycomparativeadvantage.Oneofthedistinguishingcharacteristicsofintraindustrytradeisthepresenceofinternaleconomiesofscalewithfallingaveragecostsoverarelativelylargerangeofoutput.

Thepresenceofinternaleconomiesofscaleiswhyfirmswanttoenterexportmarkets.Exportsenablefirmstorealizeloweraveragecostsandbecompetitivebothinternallyandexternally.Thisisoneofthegainsfromintraindustrytrade,andthisgaincontrastswithcomparativeadvantagebasedtradebecausedomesticconsumersoftheexportedproductalsogain.Consumersgainsincecompetitionforcesfirmstopassontheirlowercoststothem.Intraindustrytradewouldalsoexpandthenumberoffirms,therebyenhancingcompetitionandthevarietyofgoodsavailableforconsumers.


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Itmaybeusefultointroducethetradeclassificationsystemsforstudentsandinstructorsthatwantmoredetail.TheNAICS(NorthAmerica)andSITC(morecommon)systemsareavailabletoviewontheCensuswebsite:NAICS:http://www.census.gov/foreigntrade/reference/codes/naics/naicsmst.txtSITC:http://www.census.gov/foreigntrade/reference/codes/sitc/sitcmstr.txtAquicklookattheactualcodeshelpsstudentsintuitivelyunderstandthatthemoredetailedaproductclassification,thelessintraindustrytradethereis(e.g.,officeequipmentversuspencilsharpeners).Acompleteguidetoallclassificationsystemsisavailableat:http://www.census.gov/foreigntrade/guide/sec2.html#classification.



2. ComparingU.S.tradewithGermanyandBrazil,istradewithGermanymorelikelytobebasedoncomparativeadvantageoreconomiesofscale?Why?

Answer: TradewithGermanyismorelikelytobebasedoneconomiesofscalesinceitconsistsoftheexportandimportofsimilarproductsandoccursmostlyincountriesthathavesimilarproductivity,technology,andfactorendowments.TradewithBrazilislikelytobebasedoncomparativeadvantagesinceBrazilsproductivity,technology,andfactorendowmentsarenotsimilartotheUnitedStates.

3. Whatarethedifferencesbetweenexternalandinternaleconomiesofscalewithrespectto(i)thesizeoffirms,(ii)marketstructure,and(iii)gainsfromtrade?

Answers:i. Anexternaleconomyofscaleexistswhenthefallintheaveragecostsoftheindustrylowersthe

averagecostsofthetypicalfirm.Withexternaleconomies,thesizeorscaleeffectsarelocatedintheindustry,andNOTTHEFIRM.Thus,eventhoughthesizeofeachfirmintheindustrydoesnotincrease,theindustryexpandsduetodecliningcosts.Therearejustmorefirmsintheexpandingindustry.Thiscouldbeduetotheentryofmorefirmsasexistingfirmsrealizeeconomicprofits,oritcouldbeduetothesplittingofexistingfirmsintodifferentfirmswithincreasinglynarrowspecialization.Thuswithexternaleconomiesofscale,thefirmsareexpectedtobesmallinsize.Withinternaleconomiesofscale,thecausefortheexpansionofafirmssizeisitsowndecliningaveragecosts.Thatis,thesizeorscaleeffectsarelocatedinthefirm,andNOTINTHEINDUSTRY.Averagecostsofthefirmdeclineasoutputexpands.Thisusuallyleadstolargerfirmsbecausesizeconfersacompetitiveadvantageintheformofloweraveragecosts.

ii. Asmentionedabove,withexternaleconomiesofscalethescaleeffectsarelocatedwithintheindustry,andnotwithinthefirm.Thepotentialforexternaleconomiesofscalegainsleadsfirmstoconcentrateinspecificregions.Themarketstructureinthiscaseisagglomerations.Ontheotherhand,decliningaveragecostswithininternaleconomiesofscaleinviteoutsiderstoentertheindustry.Withinternaleconomiesofscale,thereisalsothepotentialforproductstobesimilarbutdifferentiated.Thisindustrystructure,calledmonopolisticcompetition,existswhenalargenumberoffirmscompetewitheachothertoproduceavarietyofgoods.Monopolisticallycompetitivestructuresmayalsobetheresultofmodestgainsfrominternaleconomiesofscale.Ontheotherhand,thescaleeconomiescouldbesubstantialwithinternaleconomiesofscale.Ifso,somefirmshaveroomtogrowsincetheywouldbeabletoexploitthissituationforfurtherexpansion,marketcontrol,andevendomination.Therefore,internaleconomiesofscalemayleadtoanoligopolymarketstructure.Ontheextreme,asinglefirmmayservetheentire(world)market.Thiskindofmarketstructureiscalledamonopoly.Thissuggeststhepossibilityofmorethanonelongrunindustryequilibriumcondition(multipleequilibria).



iii. Intraindustrytradeisabyproductofinternaleconomiesofscale.Asexplainedinthetext,thebenefitsinclude:(a)lowerpricespassedontoconsumersbymonopolisticallycompetitivefirmsenjoyingeconomiesofscale;(b)lowerpricespassedontoconsumerswheninternationaltradeleadstoanincreaseinfirms;(c)increasesinconsumerchoiceduetointernationaltrade,etc.Unfortunately,thegainsfromtradearelesscertain(evenharmful)withexternaleconomiesofscale,whichhypotheticallycouldlockinproductioninlessefficientcountriesandpreventthedevelopmentofproductioninamoreefficientcountry.Thisispartlyduetohistoricalaccidentsratherthanefficiencyadvantagesintradepatterns.

4. Whatarethethreekeyincentivesforfirmsinaparticularindustrytoclustertogetheringeographicalregion?

Answer: Theseare:(1)largepoolofskilledlabor,whichreducesthesearchcostsandencourageshighdegreesoflaborspecialization,(2)specializedsuppliersofinputs,whichhelpsfirmsholddowntheircostsbyreducingtheirtransportationandinformationalcosts,and(3)knowledgespilloversduetoinformationexchangethroughformalandinformalnetworksofpeople.

5. Howmighttradehurtacountryifitimportsgoodsthatareproducedunderconditionsofexternaleconomiesofscale?

Answer: Trademaystiflethedevelopmentofnewindustriesthatcouldbemoreefficientthantheexistingones,reducingglobalefficiency.Thiscouldbeduetoahistoricalaccidentofaninitialheadstart,ortradeotherwisegivesascaleadvantagetoalreadyexistingfirmsinonecountry.Theinitialheadstartcreatesefficiencyadvantagesfortheexistingfirms.Thishappensforanumberofreasons,suchas(a)betterdevelopedlinkagebetweenthealreadyexistingproducersandtheirsuppliers,and(b)lowerpricesofferedbythefirmsenjoyingexternaleconomiesofscale.

6. WhentheUnitedStatessignedafreetradeagreementwithCanada(1989),nooneintheUnitedStatesthoughttwice.WhentheagreementwithMexicowassigned(1994),therewassignificantopposition.Usetheconceptsofinterindustryandintraindustrytradetoexplainthedifferencesinoppositiontothetwotradeagreements.

Answer: Canadianproductivity,technology,andfactorendowmentsaremoreorlesscomparablewiththoseoftheUnitedStates.Consequently,tradebetweentheUnitedStatesandCanadaisintraindustryratherthaninterindustrytrade.AsshowninQuestion3,therearequiteafewbenefitsfromintraindustrytrade.Ontheotherhand,tradewithMexicoislikelytobebasedoncomparativeadvantage(interindustrytrade)sinceMexicosproductivity,technology,andfactorendowmentsarenotsimilartothoseoftheUnitedStates.Consequently,therewerepossibilitiesforCanadaandMexicotoloseintheproductionofgoodsandservicesforindustriesinwhichthattheydidnthavecomparativeadvantage.SinceunskilledlaborisrelativelyscarceintheUnitedStates,jobsthatdidnotrequirehighskilledlabor,abundantcapital,andsophisticatedtechnologywouldhavegonetoMexico.ThiswasoneofthefundamentalreasonswhypeopleintheUnitedStateswereagainstNAFTA.Ontopofthis,politiciansincorrectlyportrayedNAFTA,despitethefactthattradecancreateaswellasdestroyjobs.Further,theUnitedStatesbenefitedfromtheproductionofgoodsandservicesthatrequiredskilledlabor,abundantcapital,andsophisticatedtechnology.SomeMexicanssawthisasunfair,andrebelled.



7. Whatarethetheoreticaljustificationsfortargetingthedevelopmentofspecificindustries?

Answer: Theprimaryjustificationistocounteractamarketfailure.Althoughmarketfailurescomeinallshapesandsizes,allimplythatmarketsdonotresultintheoptimalallocationofresourceseitherproducingtoomuchortoolittle.Industrialpoliciesaremostlyconcernedwithcaseswheretoolittle(ornone)ofagoodisproduced.Marketfailuresalsoimplythatthesocialreturnsofanactivityarenotthesameastheprivatereturns.Whenmarketsproducetoolittle,socialreturnsaregreaterthanprivatereturnsandthesocialoptimuminvolveshigherlevelsofoutput.

Theoretically,thereasonsfortoolittleproductionmaybeduetothefollowing:(1)whenskillsand/ortechnologiesspilloverintotheeconomybeyondthefirmsthatcreatethem.Thisoccurswheninformationleaksoutofthefirstentrantfirmsaboutproduction,technological,andmarketingfeasibilities.Whenthisoccurs,thesocialreturnsarehigherthanprivatereturns.(2)whencapitalmarketimperfectionsresultininadequateinvestmentcapital.Accordingtothisargument,newfirmsmayfacedifficultiesinattractingsufficientnewstartupcapital.Theyalsofaceinadequatefinancingopportunitiesforresearchanddevelopment.Targetingspecificindustries,therefore,isimportant.

Asecondjustificationforindustrialpoliciesisstrategictradepolicy,whereitistheoreticallypossibletocaptureabovenormalprofitsearnedbyaforeignfirm.Inorderforstrategictradetoberelevant,theindustrymusthaveverystrongeconomiesofscaleandfirmsmusthavemarketpower.



8. Whataresomeofthecommonproblemsinimplementingindustrialpolicies?

Answer: Theyare:(1)thedifficultyofobtaininginformationnecessarytomeasuretheextentofmarketfailure,andchoosingwhichindustrytotarget;(2)knowingtheoptimumamountofresources(costs)toprovidethetargetedindustry;(3)encouragingrentseekingbehavior(whichmayrequirethehiringoflobbyists,economists,etc.)byfirmsinotherindustries.Thisactivityusesupresourceswithoutaddingtototaloutput.(4)containingtheexternalbenefitsofR&Dspendingwithinnationalboundaries.IfthebenefitsofR&Dspendingarenotkeptwithinnationalboundaries,thebenefitsarepartlycapturedbyforeignfirms.

9. Figure5.3inthetextillustratesthecaseofanindustrythatgeneratesexternalsocialbenefitswithitsproduction.Drawasupplyanddemandgraphforanindustrythatcreatesexternalcostswithitsproduction.Compareandcontrastthemarketdeterminedpriceandoutputlevelwiththesociallyoptimalpriceandoutputlevels.

Answer: Inanegativeexternalitythesocialreturnsarelessthanprivatereturns,soafreemarketproducesmorethantheoptimalamount(Q2insteadofQ1inFigure5.1).Thisisbecauseproducersfailtotakeintoaccounttheexternalcostswhencalculatingtheircostsofproduction(andiftheydo,theywillproducelessthantheoptimalamount).Asaresult,themarginalprivatecostislessthanthemarginalsocialcost.Consequently,SprivinFigure5.1shouldbelabeledasSsocandthetwowayarrowlineconnectingthetwosupplycurvesmustbelabeledasExternalCosts.ProducerschargeP2insteadofP1.

Answers to End-of-Chapter Questions1. Graphthesupplyanddemandofagoodthatisbothproduceddomesticallyandimported.Assume

thatthecountryisnotlargeenoughtoaffecttheworldprice.Illustratetheeffectsofatariffonimports.Discussthefollowing:


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a. Incomedistributioneffectsb. Resourceallocationeffectsc. Domesticproductionandconsumptioneffectsd. Governmentrevenueeffectse. Priceofthegoodeffects

Answers:SeeFigure6.3inthetext.a. Theincomedistributioneffectsarealossinconsumersurplus,someofwhichisdestroyed,but

otherpartsofwhicharetransferredtoproducersandthegovernment.b. Theresourceallocationeffectsincludeaproductioninefficiencyfromtheexpansionofrelatively

highercostdomesticproduction.Theconsumptionsidealsoexperiencesareductioninefficiencyduetosqueezingconsumers,whovaluethegoodmorethanitcoststobuyit,outofthemarket.

c. Domesticproductionrises,consumptionfalls.d. Governmentrevenuerisesbytheamountofthetarifftimesthenumberofunitsimported.e. Thepricerisesbytheamountofthetariff.

2. Supposetheworldpriceforagoodis40andthedomesticdemandandsupplycurvesaregivenbythefollowingequations:

Demand:P802QSupply:P53Q

a. Howmuchisconsumed?b. Howmuchisproducedathome?c. Whatarethevaluesofconsumerandproducersurplus?d. Ifatariffof10percentisimposed,byhowmuchdoconsumptionand

domesticproductionchange?e. Whatisthechangeinconsumerandproducersurplus?f. Howmuchrevenuedoesthegovernmentearnfromthetariff?g. Whatisthenetnationalcostofthetariff?

Answers:a. Usingthedemandcurvetodetermineconsumption,40802Q,orQ20.b. Usingthesupplycurvetodetermineproduction,4053Q,orQ11.67.c. Consumersurplusisgivenby20(8040)1/2400;producersurplus

is11.67(405)1/2204.17.d. A10percenttariffraisespricesby4,from40to44.Consumptionmovesalong

thedemandcurve:44802Q,orQ18.Productionmovesupthesupplycurve:4453Q,orQ13.



e. Thenewvalueforconsumersurplusis18(8044)1/2,or324;henceithasfallenby76.Producersurplusis13(445)1/2253.5;henceithasgrownby49.33.

f. Tariffrevenueis5420.g. Thenetnationalcostofthetariffisthecombinationoftheefficiencylossandtheconsumption

deadweightloss.Itisequaltothelostconsumersurplusminusthetransfertoproducersandthegovernment,or7649.33206.67.

3. Underwhatconditionsmayatariffactuallymakeacountrybetteroff?

Answer: Itispossibleforalargecountrytoimprovenationalwelfarebylevyingatariff.Theconditionsthatmustholdarethatthecountryislargeenoughtoaffecttheworldpricewhenitimposesatariff,andothernationsmustnotretaliate.Itispossibleunderthesecircumstancestodesignatariffthatraisesnationalwelfarebycausingthepriceofimportstofall.Aslongasthegainsfromthecheaperimportsaregreaterthantheproductionandconsumptionsidelosses,thenationalwelfareimproves.

4. Inadditiontotheproductionandconsumptionsidedeadweightlosses,whataresomeoftheotherpotentialcostsoftariffs?

Answer: Otherpotentialcostsoftariffsincludethethreatofretaliationandthepotentiallossofexportsmarkets,thestiflingoftheincentivetoinnovate,andtheencouragementofrentseeking.

5. TheUruguayRoundoftheGATTbeganaprocessofphasingouttheuseofvoluntaryexportrestraints.Whydidtheycomeintowidespreaduseinthe1980s?Forexample,giventhatVERsareaformofquotas,andthattheycreatequotarentsandalargerreductioninnationalwelfarethantariffs,whydidnationsusetheminsteadoftariffs?

Answer: VoluntaryexportrestraintsavoidtheobligationsnationsshareundertherulesoftheGATTtonotraisetariffs.Theydonotrequirelegislativeactiontoimplement.Furthermore,VERspermittedpoliticianstoclaimtheysupportedfreetradewhileatthesametimeofferingprotectiontospecialinterests.

6. TheGATTstronglyfavorstariffsasaprotectivemeasureoverquotasorothernontariffmeasures.Itencouragesnewmemberstoconvertquotastotheirtariffequivalents.Oneofthemainreasonstariffsarepreferredisbecausetheyaremoretransparent,particularlybycomparisontonontariffmeasures.Explaintheideaoftransparency,andhownontariffmeasuresmaybenontransparent.

Answer: Transparencyreferstotheabilityofeveryonetoeasilydiscoverandunderstandtherules.Tariffsaretransparentbecausetheyusuallyarenotassociatedwithspecialcircumstancesknownonlytoaselectfew.Nontariffbarrierslikeanoutrightquotamayormaynotbetransparent.Quotasmayvaryaccordingtothecountrytryingtoexport;theymayalsobeimplementedintheformofimportlicensesthatinvolvelargeamountsofredtapeandunknownavailability.Nontariffmeasuressuchashealthandsafetycodes,productstandards,ortestingrequirementscanbeevenlesswelldefinedandposeanevengreateruncertaintyforfirmstryingtoenterthemarket.



7. SupposethatbicyclesaremadeintheUnitedStatesoutofacombinationofdomesticandforeignparts.a. Ifabikesellsfor$500butrequires$300ofimportedparts,whatisthedomesticvalueadded?b. Ifa20percenttariffisleviedonbikesofthesamequalityandwiththesamefeatures,howdo

thepriceandthedomesticvalueaddedchange?(AssumetheUnitedStatescannotcausetheworldpricetochange.)

c. Whatistheeffectiverateofprotection?d. Ifinadditiontothe20percenttariffonthefinalgood,a20percenttariffonimportedpartsis

alsolevied,whatistheeffectiverateofprotectionforU.S.bikemanufacturers?

Answers:a. Valueaddedis$500$300$200.b. Thedomesticpricerisesby20percentto$600;thevalueaddedis$600$300$300,

henceithasrisen$100.c. Theeffectiverateofprotectionis(300200)/2000.550percent.d. Thecostofinputsrisesfrom$300to$360,sovalueaddedis$600$360$240.

Theeffectiverateofprotectionisnow(240200)/2000.220percent.

Answers to End-of-Chapter Questions1. WhichindustriesaremoreheavilyprotectedintheUnitedStatesandJapan?Arehighincomeor

lowincomenationsmoreaffectedbyAmericanandJapanesetradebarriers?Explain.

Answer: IntheUnitedStates,themostheavilyprotectedindustriesaretextileandapparelproducersand,toalesserdegree,agriculture.InJapan,protectionisconcentratedonagricultureandthefoodandbeverageindustry.Protectioninbothcountriesisinolder,laborintensiveindustrieswherethecountriesnolongerhavecomparativeadvantages.Theeffectsaregreatestonlowincomecountriessincethesearetheindustrieswheretheydohaveacomparativeadvantage.ThefailureoftheUnitedStates,Japan,andotherindustrialnationstoopentheirmarketstotheagriculturalproductsandapparelfromdevelopingcountrieshasdeprivedthosenationsofpotentialexportmarkets.

2. WhatnewareasoftradeandinvestmentreceivedcoverageundertheagreementsignedintheUruguayRoundoftheGeneralAgreementonTariffsandTrade?

Answer: TheUruguayRoundextendedtheGATTandcreatedseveralnewagreements.GATTnowcoversagriculture,textiles,andapparel,andnewagreementsweresignedforthefirsttimeintheareasoftradeinservices,treatmentofforeigninvestment,andtheprotectionofintellectualpropertyrights.Inaddition,theagreementcreatedtheumbrellaorganizationcalledtheWorldTradeOrganizationthatwilloverseetheGATTandrelatedagreements.TheWTOalsoconductsperiodicreviewsofeachnationstradepolicies,andhascreatedastreamlineddisputeresolutionprocedure.

3. Giventhattariffsandquotascostconsumersandthattheyaregrosslyinefficientmeansforcreatingorpreservingjobs,whydocitizensallowthesepoliciestoexist?


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Answer: Thecostsoftariffsandquotasarediffusedthroughoutanentirenation,whilethebenefitsareconcentrated.Thiscreatesanasymmetricsetofincentivestoorganizearoundtheissueoftradepolicy.Beneficiariesofprotectionstandtogainagreatdealandconsequentlyfinditeconomicallyworthwhiletoorganizeinordertoreceiveprotection.Individualconsumerslosejustalittle,sothereisonlyasmalleconomicincentivetoorganizeagainstprotectionistpolicies.

4. Whatarethemainargumentsusedbynationstojustifyprotectionforparticularindustries?Whichareeconomic,andwhicharenoneconomic?

Answer: Theargumentsare(1)revenue,(2)thelaborargument,(3)theinfantindustryargument,(4)thenationalsecurityargument,(5)culturalprotection,and(6)theretaliationargument.Thefirstthreeargumentsareaboutgovernmentrevenue,jobs,andmanufacturing,sotheyareeconomicarguments.Arguments4and5haveeconomiccomponents,butareprimarilybasedonnoneconomicconsiderations.Theretaliationargumentisperhapsmoreexplicitlyeconomicaswell.



5. Evaluatethelaborandinfantindustryargumentsforprotection.

Answer: Thelaborargumentisbasedonthefalseassumptionthatlowerwagesautomaticallyconferacompetitiveadvantagetoanation.Lowerwagesarethemostvisibleindicatoroflowerproductivities.Theproponentsofthepauperlaborargumentfailtocompletelyconsiderthecausesoflowerwagesandtheirconsequencesfortrade.Theadvantagesoflowerwagesareoffsetbythelowerproductivitythatinevitablyaccompaniesthem.

Theinfantindustryargumentrequiresthreeconditionsinorderforittobevalid.First,theremustbeatechnologicalexternalitythatcannotbecapturedbythefirmsthatproduceit.Second,theprotectionmustbelimitedintime.Third,itmustenablethefirmsreceivingittoexperiencefallingcostssothattheinitiallyhighercostsdisappearandthelowornegativeratesofreturnareconvertedintonormalreturns.Thelatterconditionisequivalenttorequiringthepolicytopayforitselfinthelongrun.



6. Aretariffsjustifiedasaretaliatorymeasureagainstothernations?Justifyyouranswer.

Answer: Thereisnoagreementamongeconomistsonthisissue.Oneschoolsaysthattariffsmakeuslessefficient,sotheyareunwarranted.Ifotherschoosetohurttheirowneconomies,whyshouldwefollowsuit?Anotherschoolsaystariffsarejustifiediftheycausetheoffendingnationtoopenitsmarkets.Tradeisbeneficialforall,soiftheycanleadtoincreasedtrade,theyarewarranted.Thethirdgroupseesthemaswarrantedbecausetheyworryabouttheunfairadvantagetheymaygrantthenationlevyingthetariff,particularlyinhightechindustrieswherescaleeconomiesareimportant.Tariffsshutoutforeigncompetitionandgrantthefirmsinthecountryaccesstoalargermarkettheirowndomesticmarketplusforeignmarkets.Thismaybeaneconomicadvantageinsomeindustries.

7. WhatarethefourlegalproceduresthatAmericanfirmshaveattheirdisposalforseekingprotection?Whataretheconditionsthatwouldgeneratearequestforeachkindofprotection?

Answer: Thefourproceduresare(1)countervailingduties,(2)antidumpingduties,(3)escapeclauserelief,and(4)Section301retaliation.Countervailingdutiesaregrantedinresponsetoforeignsubsidies;antidumpingdutiesaregrantedwhenaforeignfirmsellsinthedomesticmarketatapricethatisconsideredtoolow(lessthanfairvalue);escapeclausereliefisgrantedasatemporaryprotectionagainstsuddensurgesinimports;andSection301retaliationisusedtopunishanationforsomeothertypeofpracticethatisperceivedasconferringanunfairadvantageonitsfirms,orinresponsetoalackofopennesstoAmericangoods.

Answers to End-of-Chapter Questions1. Whatarethethreewaysforcountriestohandledifferentstandardsabroad?Dostandardshavetobe

thesameforcountriestobeintegrated?

Answer: Thethreewaysforcountriestohandledifferentstandardsareharmonization,mutualrecognition,andseparatestandards.Countriesdonothavetohavethesamestandardstobeeconomicallyintegrated.Infact,requiringthesamestandardsmayposepotentialproblems.Harmonizationstandards,forexample,mightleadtotheadoptionofinferiorstandardsandmayfailtotakeintoaccountincomedifferences.Byimposingunduestandardrequirements,acountrymayalsofailtoachieveallthatispossibleofitstradingpartners.Itisgenerallybetterfortradingcountriestorecognizeeachothersstandardsormaintainseparatestandardswhenthelevelofeconomicdevelopmentdiffers.


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2. Whataretheadvantagesanddisadvantagesforcountriesthatadoptthesamestandards?

Answer: Advantages:Onepossibleadvantageisthegainineconomicefficiencyfromsharingthesamestandard.Sharedstandardspermitmanufacturerstoproduceasinglestandardratherthanmultiplestandards,andthismayallowfirmstocaptureeconomiesofscale.Also,commonstandardshavethepotentialtoincreaseandexpandthecommercialtiesbetweentwoormorecountries.

Disadvantages:a. Requiringthesamestandardsmaycausealossofefficiencyiftheadoptionofa

commonstandardresultsinalockingofaninferiorstandard.b. Foratleasttworeasonsitmaybeextremelydifficult,costly,orevenimpossibleto

adoptthesamestandards.First,theremaybethousands(hundredsofthousandsinthecaseofafullyintegratedcommonmarketliketheEU,forexample)ofgoodsthatwouldrequireharmonizationand/ortheadoptionofthesamestandards.Thisinturnwouldrequirethehiringofalargenumberofboardsandcommitteesofexpertstobothdeterminethebestcompromisebetweentheexistingindividualnationalstandardsanddeveloponenationalstandard.Second,culturalissuesmaybeinvolvedintheharmonizationofstandards.Thismakestheissuepoliticalandeconomicaswellastechnical.

3. Whenhighdefinitiontelevision(HDTV)wasfirstconsideredapossibilityintheUnitedStates,theU.S.governmentheldacompetitiontoselectthetechnicalstandardsthatwouldbeusednationwide.WhywouldthegovernmentseeanadvantagetosettingonestandardforHDTV,andwhataretheprosandconsfortheprivatebusinessesthatwereinterestedinproducingHDTVfortheU.S.market?

Answer: Thereareefficiencygainswhentwoormorecountriesadoptthesamestandards.Forexample,sincesharedstandardspermitmanufacturerstocaptureeconomiesofscale,wewouldexpectall50U.S.statestoadoptthesamestandards.Further,theadoptionofcommonstandardsallowsstatesorcountriestoworktogetherandincreasetheircommercialties.Topreventlockingintooradoptinginferiorstandards,theU.S.governmentmightalsoholdacompetitiontoselectthetechnicalstandards.

Onthedownside,sharingandadoptingonestandarddoeshaveitscosts.Choosingonestandardhastheunintendedeffectoflesseningthedifferencesbetweennations,thereforedestroyingsomesourcesofcomparativeadvantage.Thecosttosocietywouldbeevengreaterifthecountryisdealingwithanewlyintroducedproduct(suchasHDTV).Inthesituationofunknownbeststandards,itmaybewiseforregulatorstoleavetheiroptionsopenoradoptacompetitionoffuturestandards.

ConcerningthespecificHDTVexample,privatebusinessesthatproducedthefirstHDTVshaveanadvantageoverotherssimplybecausetheirproductcouldbeadoptedasthestandard.Whilethiscouldbeveryprofitableforthesefirms,ifaninferiorstandardislockedin,thiscouldharmtosocietyasawhole.

(Note:ThecaseofHDTVwasnotexplicitlyconsideredinthischapter!)



4. Whydostandardsvaryacrosscountries?Illustrateyouranswerwithexamplesintheareaoflaborstandards.

Answer: Standardsingeneral,andlaborstandardsinparticular,varygreatly.Theyrangefrombasicstandardrightssuchastherighttobefreefromforcedlaborandtherighttorepresentationinaunion,tomorecontentiousrightssuchasuniversalstandardsforminimumwages,limitsonthenumberofhourssomeonecanworkinaday,healthandsafetystandards,etc.Ofcourse,laborstandardsaredifficulttodefinegiventhewidevariationinincomesandlivingstandardsaroundtheworld.Forexample,iflowincomecountries(withrelativelyabundantunskilledlabor)wereforcedtopayaminimumwagehighenoughtosatisfycriticsinhighincomecountries,lowincomecountrieswouldsufferwhenthehighwageratesforceemployerstoclosedowntheirproduction.Consequently,unemploymentwouldrise.

5. Whatarelaborstandards,andwhyareargumentsaboutlaborstandardsconfinedprimarilytoargumentsbetweenhighincomecountriesontheonehand,andlowandmiddleincomecountriesontheother?

Answer: Asmentionedinthetext,defininglaborstandardsisdifficultgiventhewidevariationinincomesandlivingstandardsaroundtheworld.Eventhoughthereisafairamountofambiguityattachedtolaborstandards,mostpeoplewouldprobablyagreewiththestandardsproposedbytheILOandOECD,whichare:(1)prohibitionofforcedlabor;(2)freedomofassociation;(3)therighttoorganizeandbargaincollectively;(4)anendtoexploitationofchildlabor;and(5)nondiscriminationinemployment.

Argumentsaboutlaborstandardsareconfinedprimarilytoargumentsbetweenhighincomeandlowincomecountriesbecausetheconditionsandlivingstandardsindevelopingcountriesarestarklydifferentfromthoseinhighincomecountries.Laborandenvironmentalstandardsandtheenforcementofexistinglawstendtobelowerindevelopingcountriesthaninhighincomecountries.Mostcountriestendtoplacehighervaluesonbetterpayandgreenerenvironmentalpoliciesastheireconomiesdevelop.Whenlowandhighincomenationsbegintotrade,andthepricesofthegoodsimportedfromdevelopingcountriesarelowerthantheirhighincomecounterparts,peopleinhighincomecountrieshavemanyquestions.Theytendtoassociatethelowerpriceswithsuchthingsasexploitationofchildlabor,unsafeworkingconditions,lesserornopollutioncontrols,etc.



6. Discussthereasonswhyusingtradebarrierstoenforcelabororenvironmentalstandardsmaybelessefficientthanothermeasures.

Answer: First,aswasshowninChapter7,imposingtradebarriersisverycostly.Theycreatedeadweightlossesathomeinconsumptionandproduction.Second,onlylargecountries,ifanyatall,couldusetradebarrierssuccessfullytostoptheoffendingcountry.Evenalargecountrymaybeunabletousetradebarrierseffectivelyunlessalargenumberofcountriesjointogethertoimposethetradesanctions.Convincingothernationstotakepartinthesanctionshasproveddifficultinthepast.Moreover,imposingtradebarriersmaymakeconditionsworseratherthanbetter,sincesomeproducersmaymovetheirfacilitiesintotheinformalsectoroftheeconomy.Ifsanctionsagainstacountrycreateincentivesforbusinessestoavoidthescrutinyoflaborinspectors,thenalargershareoftheworkingpopulationcouldfindthemselvesdealingwithworseconditions.Third,thereisalsotheborderlinebetweenprotectionismandconcern.Incountriesthatusetradebarriersasanenforcementmechanismitisnothardtofindspecialinterestgroupsusingtradebarriersasameanstojustifytheirrealgoalobtainingprotectionagainstforeigncompetition.Giventhatindustrializedcountriesprotectagriculturalandtextile/apparelproducts(twoindustriesinwhichdevelopingcountrieshaveacomparativeadvantage),developingcountriesarehighlyreluctanttogiveintothesanctions.Fourth,sincechildlaborlawsarevagueandvaryaccordingtotheincomelevelofeachcountry,thereisnointernationalagreementforuniversalchildlaborlaws.Lastbutnotleast,theuseoftradebarriersmayleadtoretaliationandlargertradewars,whichcouldbeverycostlytoallcountriesinvolved.

7. Whataretheargumentsinfavorofusingtradebarrierstoenforcelaborandenvironmentalstandards?Assesseachargument.

Answer: Laborandenvironmentalactivistsadvocatefortheuseoftradebarriers(tariffs,quotas,oroutrightlimitationofimports)toenforcelaborstandards.Theyarguethatpressuringacountrycouldalteritslaborstandards.Tradeeconomistsareskepticalabouttheefficacyoftradebarriersastoolsforoverturningforeignlaborpracticesonseveraltheoreticalandempiricalgrounds(seealsoQuestion6).Therearenoclearstandardsthatcouldbeuniversallyadoptedandenforcedinbothlaborandenvironmentstandards.

8. OnecommoncritiqueoftheWTOisthatitoverturnsnationalenvironmentalprotections,andforcescountriestolowertheirstandards.Forexample,whentheUnitedStatestriedtoprotectendangeredseaturtles,theWTOpreventedit.Assessthisclaim.

Answer: TheUnitedStatessoughttoprotectendangeredseaturtlesthatwereharmedbyshrimptrawlersthatdonotuseturtleexcluderdevices(TEDs)ontheirnets.In1987,theUnitedStatesissuedguidelinesrequiringshrimptrawlerstouseTEDsontheirnets.Itthenannouncedin1989thatitwouldbanshrimpimportsbeginningMay1991fromcountriesthatwerenotcertified.TheguidelinesappliedonlytotheCaribbeanandWesternAtlantic.By1996,moreconditionswereplacedandtheguidelineswereextendedworldwide.India,Malaysia,Pakistan,andThailandprotestedtotheWTO,arguingthattheyweregivenonlyfourmonthstocomply,whileCaribbeancountriesweregiventhreeyearsandtechnicalassistance.Inaddition,theycomplainedthattheGATTrulesforbiddiscriminationagainstimportsbasedontheprocessofproduction.InMay1998,theWTOruledagainsttheUnitedStatescitingthatitignoreditsobligationtoconsultandnegotiatebeforetakingaction.



TheUnitedStatesappealedthecaseandthedecisionwaspartiallyreversedbytheWTOAppealsBodystatingthattheU.S.importbarriersarepotentiallyallowablebutthatthefailuretonegotiateorconferwiththeaffectedcountriesplaceditinviolationofWTOrules.Thatis,theWTOreversedoneofthetworulingsthatwerepassedagainsttheUnitedStates.Ineffect,thisWTOdecisionendedupbeingmultilateralinnaturebecauseitallowedtheUnitedStatestoextenditsprotectionwhileallowingtheSouthAsianfishingfleetstoremaincommerciallyviable.

Thisepisoderaisesthequestionabouttheconnectionbetweentheenvironmentallawsofanindividualcountryandtradelaws.EventhoughtheWTOrulesendedupbeingmultilateralandatleastpartiallykepttheinterestsofbothparties,thereisacombinationoftradeandnontradeissueshere.Becauseofdifferencesinincomesandstandardsofliving,laborandenvironmentalstandardshavebecome(andwillcontinuetobecome)apointofconflictbetweentradingnations.



9. Whatarethealternativestotrademeasuresforraisinglaborandenvironmentalstandards?Whatarethestrengthsandweaknessesofeachone?

Answers: Theseare:(1)Labelsforexports:thisisacertificationprocessproducingalabelthatisattachedtothegoodwhenitisproducedandhasbeenpartiallysuccessfulintellingconsumersthatthegoodisproducedinhumaneandenvironmentallyfriendlyways.Eventhoughthismechanismplaysanimportantroleinalleviatingconflictsbetweentradingcountries,ithasitsownproblems.First,ithasbeenacauseofconflictbetweenlaborandmanagementwhenforeigninspectorsareallowedtointrude.Second,manycountriesconsiderforeignintrusionasaninfringementoftheirsovereignty.Itmaybehardtoconvinceconsumerstotrustthelabelinginformationaslabelingbecomesmorewidespread.(2)Requiringhomecountrystandards:Thismeasurerequiresfirmsthatopenoperationsinforeigncountriestoholdtheseoperationstothesamestandardsastheirdomestic,orhome,operations.Inotherwords,afirmcannottrytocutcornersorsavemoneybyallowingitsforeignholdingstooperateaccordingtoforeignsubstandards.Thereareafewadvantagesofthismeasure:(a)iteliminatesthefearofaracetothebottombymakingitimpossibleforhomebasedcompaniestoexploitlowstandards;(b)itshiftsthecostsofimprovedstandardstofirmsandconsumersinhighincomecountries;(c)itremovesthethreatthatdomesticfirmswillrelocateabroadandensuresthatanyrelocationthattakesplaceisduetoforeigncomparativeadvantage;and(d)itavoidstheproblemsofhighincomecountriesdictatingwhichstandardsareused.Therequirementofhomecountrystandardsforcesfirmswithcrossnationalboundariestoconformtowhicheverstandardsarehigher.Oneweaknessofthisapproach,ofcourse,isthatitonlyaddressestheproblemoffirmsinhighstandardscountriesthatgoabroadtopotentiallylowstandardcountries,andnotviceversa.(3)Increasinginternationalnegotiations,possiblyusingtheILOforlaborandcreatingnewagreementsfortheenvironment.



Answers to End-of-Chapter Questions1. Usethefollowinginformationtoanswerthequestionsbelow.Assumethatthecapitalaccountis

equalto0.

Netunilateraltransfers 50

Exportsofgoodsandservices 500

NetincreaseintheU.S.governmentsnonreserveforeignassets 30

NetincreaseinforeignownershipofU.S.basednonreserveassets 400

NetincreaseinU.S.privateassetsabroad 250

InvestincomereceivedintheUnitedStates 200

NetincreaseinU.S.ownershipofofficialreserveassets 20

Importsofgoodsandservices 600

NetincreaseinforeignownershipofU.S.basedreserveassets 100

InvestmentincomepaidabroadbytheUnitedStates 300

a. Whatisthecurrentaccountbalance?b. Doesthecapitalaccountequalthecurrentaccount?c. Whatisthestatisticaldiscrepancy?

Answers:a. Thecurrentaccountis500200600300+250250b. Thecapitalaccountis1004002030250200c. Thestatisticaldiscrepancyis1(250200)250

2. LookateachofthecasesbelowfromthepointofviewofthebalanceofpaymentsfortheUnitedStates.Determinethesubcategoryofthecurrentaccountorfinancialaccountthateachtransactionwouldbeclassifiedin,andstatewhetheritwouldenterasacreditordebit.a. TheU.S.governmentsellsgoldfordollars.b. AmigrantworkerinCaliforniasends$500hometohisvillageinMexico.c. AnAmericanmutualfundmanagerusesthedepositsofhisfundinvestorstobuyBrazilian

telecommunicationstocks.d. AJapanesefirminTennesseebuyscarpartsfromasubsidiaryinMalaysia.e. AnAmericanchurchdonatesfivetonsofricetotheSudantohelpwithfaminerelief.f. AnAmericanretiredcouplefliesfromSeattletoTokyoonJapanAirlines.g. TheMexicangovernmentsellspesostotheUnitedStatesTreasuryandbuysdollars.


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Answers:a. TheUnitedStatesexportsofficialreserveassets;itisacreditinthecapitalaccount.b. AresidentoftheUnitedStatesunilaterallytransfersmoneytoaforeignlocale;itisadebitinthe

currentaccount.c. Thereisanimportofforeignassets;itisadebitinthecapitalaccountunderthecategoryofa

netchangeinU.S.privateassetsabroad.d. AnAmericanbasedproducerimportsgoods;itisadebitinthecurrentaccount.e. ThereisaunilateraltransferfromtheUnitedStatestoabroadforeigncountry;itisadebitinthe

currentaccount.f. Americanresidentspurchaseaservicefromaforeignfirm;itisadebitinthecurrentaccount.g. ThereisanetincreaseinnonreserveforeignassetsheldbytheU.S.government;itisadebitin

thecapitalaccount.

3. Weightheprosandconsofalargetradedeficit.

Answer: Tradedeficitsaregenerallyconsideredanegativeforacountry,buttherealityismoresubtle.Onthenegativeside,largedeficitssignalthatacountryisaccumulatingforeigndebtthatcanbedifficulttoserviceiftheexcessimportsarenotusedtoenhancenationalproductivity.Furthermore,tradedeficitsrequirecapitalinflows.Ifforeigninvestorsloseconfidence,itmaybedifficulttosearchthenecessaryforeignreserves.ThisispartlywhathappenedtoMexicoin1994andThailandandIndonesiain1997.

Onthepositiveside,alargetradedeficitcanalsosignalthatforeignershaveconfidenceinthecurrentsetofeconomicpoliciesandthefutureprospectsoftheeconomy.Furthermore,andmostimportantly,alargetradedeficitandtheattendantcapitalinflowsallowahigherlevelofinvestmentthanwouldbepossiblesolelyonthebasisofdomesticsavings.

4. Isthebudgetdeficitofacountrylinkedtoitscurrentaccountbalance?Howso?ExplainhowitispossiblefortheUnitedStatescurrentaccountdeficittogrowwhilethebudgetdeficithasdisappeared.

Answer: Thebudgetdeficitandthecurrentaccountarelinkedbuttherearetheothervariablesofdomesticprivatesavingsanddomesticinvestmentthatarealsojoinedinthesavingsinvestmentbalance.Forthisreason,thereisnosuchthingasaonetoonecorrespondencebetweenbudgetandtradebalances.Thebasicrelationshipiscapturedintheequation(4binthetext):SpgovernmentbudgetIcurrentaccount.Fromthisitcanbeseenthatasthegovernmentbudgetwenttozeroandthecurrentaccountbecamemorenegative,eithersavingsfell,investmentrose,orsomecombinationofthetwooccurred.

5. Compareandcontrastportfoliocapitalflowswithdirectinvestmentcapitalflows.

Answer: Thesetwotypesofcapitalflowsaresimilarinthattheybothprovideanationwiththeuseofforeignsavings.Thatis,theybothrepresentcapitalflowsthatareanetincreaseintheamountofresourcesavailableforinvestment.Ontheotherhand,theyareverydifferentinthetimedimensionsthattheyrepresentandintheirliquidity.FDIisilliquidandgenerallyrepresentsfundswithalongertimehorizonthanportfoliocapital.Portfolioinvestmentcanmoveinoroutofanationextremelyquicklyandisthemainfocusofconcernsaboutthedestabilizingeffectsofforeigninvestment.



6. Whyisacurrentaccountsurplusequivalenttoforeigninvestment?

Answer: Acurrentaccountsurplusleadstothenetaccumulationofforeignassets,whetherrealorfinancial.Ineithercase,thereistheprospectofafuturestreamofrevenuethatwillbegeneratedfromtheassets.

Anotherwaytolookatitistoconsiderthatinordertoexportagreatervaluethanimports,anationmustnotconsumesomeofitsincome(production).Instead,thegoodsandservicesaresentabroad.Theeffectisthesameasdomesticinvestment:Consumptionoutofcurrentperiodproductionispostponeduntilafuturedate,andtheexcessoutputisusedtoincreasethecapacityoftheeconomytogenerateafuturestreamofincome(production).


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