*CHAPTER 2(Core Chapter)COMPARATIVE ADVANTAGEANSWERS TO REVIEW QUESTIONS AND PROBLEMS1. The mercantilists believed that the way for a nation to become rich and powerful was toexport more than it imported. The resulting export surplus would then be settled by an inflow of gold and silver and the more gold and silver a nation had, the richer and more powerful it was. Thus, the government had to do all in its power to stimulate th e nation’s exports and discourage and restrict imports. However, since all nations could not simultaneously have an export surplus and the amount of gold and silver was fixed at any particular point in time, one nation could gain only at the expense of other nations. The mercantilists thus preached economic nationalism, believing that national interests were basically in conflict.Adam Smith, on the other hand, believed that free trade would make all nations better off.All of this is relevant today because many of the arguments made in favor of restricting international trade to protect domestic jobs are very similar to the mercantilists arguments made three or four centuries ago. That is why we can say that “mercantilism is alive and well in the twenty-fi rst century”. Thus we have to be prepared to answer anddemonstrate that these arguments are basically wrong.2. According to Adam Smith, the basis for trade was absolute advantage, or one country beingmore productive or efficient in the production of some commodities and other countries being more productive in the production of other commodities.The gains from trade arise as each country specialized in the production of the commodities in which it had an absolute advantage and importing those commodities in which the nation had an absolute disadvantage.Adam Smith believed in free trade and laissez-faire, or as little government interference with the economic system as possible. There were to be only a few exceptions to this policy of laissez-faire and free trade. One of these was the protection of industries important for national defense.3. Ricardo’s law of comparative advantage is superior to Smith’s theory of absolute advantagein that it showed that even if a nation is less efficient than or has an absolute disadvantage in the production of all commodities with respect to the other nations, there is still a basis forbeneficial trade for all nations.The gains from trade arise from the increased production of all commodities that arises when each country specializes in the production of and exports the commoditiesof its comparative advantage and imports the other commodities.A nation that is less efficient than others will be able to export the commodities of itscomparative advantage by having its wages and other costs sufficiently lower than in othernations so as to make the commodities of its comparative advantage cheaper in terms of the same currency with respect to the other nations.4. a. In case A, the United States has an absolute and a comparative advantage in wheat andthe United Kingdom in cloth. In case B, the United States has an absolute advantage (so that the United Kingdom has an absolute disadvantage) in both commodities. In case C, theUnited States has an absolute advantage in wheat but has neither an absolute advantage nor disadvantage in cloth. In case D, the United States has an absolute advantage over theUnited Kingdom in both commodities.b. In case A, the United States has a comparative advantage in wheat and the UnitedKingdom in cloth. In case B, the United States has a comparative advantage in wheat and the United Kingdom in cloth. In case C, the United States has a comparative advantage in wheat and the United Kingdom in cloth. In case D, the United States and the United Kingdom havea comparative advantage in neither commodities.5. a. The United States gains 1C.b. The United Kingdom gains 4C.c. 3C < 4W < 8C.d. The United States would gain 3C while the United Kingdom would gain 2C.6. a. The cost in terms of labor content of producing wheat is 1/4 in the United States and 1 inthe United Kingdom, while the cost in terms of labor content of producing cloth is 1/3 in the United States and 1/2 in the United Kingdom.b. In the United States, Pw=$1.50 and Pc=$2.00.c. In the United Kingdom, Pw=£1.00 and Pc=£0.50.7. The United States has a comparative disadvantage in the production of textiles. Restrictingtextile imports would keep U.S. workers from eventually moving into industries in which the United States has a comparative advantage and in which wages are higher.8. Ricardo’s explanation of the law of comparative is unacceptable because it is based on thelabor theory of value, which is not an acceptable theory of value.The explanation of the law of comparative advantage can be based on the opportunity cost doctrine, which is an acceptable theory of value.9. The production possibilities frontier reflects the opportunity costs of producing bothcommodities in the nation.The production possibilities frontier under constant costs is a (negatively sloped) straight line.The absolute slope of the production possibilities frontier reflects or gives the price of the commodity plotted along the horizontal axis in relation to the commodity plotted along the vertical axis.10. a. See Figure 1.1.b. In the United States Pw/Pc=3/4, while in the United Kingdom, Pw/Pc=2.c. In the United States Pc/Pw=4/3, while in the United Kingdom Pc/Pw=1/2.d. See Figure 1.2.The autarky points are A and A' in the United States and the United Kingdom, respectively.The points of production with trade are B and B' in the United States and the United Kingdom, respectively.The points of consumption are E and E' in the United States and the United Kingdom, respectively. The gains from trade are shown by E > A for the U.S. and E' > A' for the U.K.ANSWERS TO REVIEW QUESTIONS AND PROBLEMS1. a. Increasing opportunity costs arise because resources or factors of production are nothomogeneous (i.e., all units of the same factor are not identical or of the same quality) and not used in the same fixed proportion or intensity in the production of all commodities.This means that as the nation produces more of a commodity; it must utilize resources that become progressively less efficient or less suited for the production of that commodity. As a result, the nation must give up more and more of the second commodity to release justenough resources to produce each additional unit of the first commodity (i.e., it facesincreasing costs).b. In the real world, the production frontiers of different nations will usually differ becauseof differences in factor endowments and technology.2. a. See Figure3.1.b. The slope of the transformationcurve increases as the nationproduces more of X and decreasesas the nation produces more of Y.These reflect increasingopportunity costs as the nationproduces more of X or Y.3. a. See Figures 3.2a and 3.2b.b. Nation 1 has a comparative advantage in X and Nation 2 in Y.c. If the relative commodity price line in autarky has equal slope in both nations. This is rare.4. a. See Figures 3.3a and 3.3 b. Points B and B’ are the production points in Nations 1 and 2,respectively, with specialization and trade and E and E’ are the consumption points.b. Nation 1 gains by the amount by which community indifference curve III (point E) isabove indifference curve I (point A). Nation 2 gains to the extent that community indifference curve III’ (point E’) is above indifference curve I’ (point A).5. a. The equilibrium-relative commodity price in isolation is the relative price that prevailsin the nation without trade or in autarky.b. The equilibrium-relative commodity price in isolation for the commodity plotted alongthe horizontal axis is given by the (absolute) slope of the tangent of the production frontier and the community indifference curve at the point of production and consumption in thenation in isolation.c. The nation with the lower equilibrium relative commodity price in isolation or autarkyhas a comparative advantage in the commodity measured along the commodity axis and a comparative disadvantage in the commodity measured along the vertical axis.6. a. Nation 1 is better off at point E’ than at point A’ because point E’ is on higher communityindifference curve III than at point A, which is on lower community indifference curve I.b. Nation 1 consumes less of commodity Y at point E’ (40Y) than at point A’ (60Y) becauseP Y/P X is much higher at point E’ (P B’ =1) than at point A’ (P A’ =1/4, the inverse of P X/P Y=4).7. a. The reason for incomplete specialization under increasing costs is that as each nationspecializes in the production of the commodity of its comparative advantage, the relative commodity price in each nation moves toward each other (i.e., become less unequal) until they are identical in both nations. At that point, it does not pay for either nation to continue to expand the production of the commodity of its initial comparative advantage. This occurs before either nation has completely specialized in production.b. Under constant costs, each nation specializes completely in production of thecommodity of its comparative advantage (i.e., produces only that commodity). The reason is that since it pays for the nation to obtain some of the commodity of its comparativedisadvantage from the other nation, then it pays for the nation to get all of the commodity of its comparative disadvantage from the other nation (i.e., to specialize completely in the production of the commodity of its comparative advantage).8. See Figure 3.5 (Please disregard Figure 3.4, which shows how to derive the demand andsupply curve for commodity X for Nation 1 and Nation 2 that are used to show how theequilibrium relative commodity price is determined with trade – a topic that is covered inAppendix A3.1.Nations 1 and 2 have identical production frontiers (shown by a single curve) but different tastes (indifference curves). In isolation, Nation 1 produces and consumes at point A and Nation 2 at point A’. Since P A < P A’, Nation 1 has a comparative advantage in X and Nation2 in Y.With trade, Nation 1 specializes in the production of X and produces at B, while Nation 2 specializes in Y and produces at B’ (which coincides with B). By exchanging BC = C’E’ of X for CE = C’B of Y with each other (see trade triangles BCE and B’C’E’), Nation 1 ends up consuming at E on indifference curve III (higher than indifference curve I at point A) and Nation 2 consumes at on indifference curve III’ (higher than indifference curve I’ at po int A’).9. a. If the terms of trade of a nation improved from 100 to 110 over a given period of time, theterms of trade of the trade partner would deteriorate by about 9 percent over the same period of time [(100-110)/110 = -0.09 =0.9%].b. A deterioration in the terms of trade of the trade partner can be said to be unfavorable to thetrade partner because the trade partner must pay a higher price for its imports in terms of its exports.c. This does not necessarily mean that the welfare of the trade partner has decreased becausethe deterioration in its terms of trade may have resulted from an increase in productivity that is shared with the other nation.10. It is true that Mexico's wages are much lower than U.S. wages (they are about one fifth of theaverage wage in the United States), but labor productivity is much higher in the United Statesand so labor costs are not necessarily higher than in Mexico. In any event, trade can still be based on comparative advantage.*CHAPTER 4(Core Chapter)THE HECKSCHER-OHLIN AND OTHER TRADE THEORIES ANSWERS TO REVIEW QUESTIONS AND PROBLEMS1. a. The Heckscher–Ohlin (H-0) theorem postulates that a nation will export thosecommodi ties whose production requires the intensive use of the nation’s relativelyabundant and cheap factor and import the commodities whose production requires theintensive use of the nation’s relatively scarce and expensive factor. In short, the relatively labor-rich nation exports relatively labor-intensive commodities and imports the relatively capital-intensive commodities.b. Heckscher and Ohlin identify the relative difference in factor endowments amongnations as the basic determinant of comparative advantage and international trade.c. The H-O Theory represents an extension of the standard trade model because itexplains the basis for comparative advantage (classical economists, such as Ricardo hadassumed it) and examines the effect of international trade on factor prices and incomedistribution (which classical economists had left unanswered).2. See Figure 4.1.3. a. The factor–price equalization theorem postulates that international trade will bringabout the equalization of the returns to homogeneous or identical factors across nations.b. The Stopler-Samuelson theorem postulates that free international trade reduces the realincome of the nation’s relatively scarce factor and increases the real income of the nation’s relatively abundant factor.c. The specific-factors model postulates that the opening of trade (1) benefits the specificfactor used in the production of t he nation’s export commodity, (2) harms the specific factor used in the production of the nation’s import-competing industry, and (3) leads to anambiguous effect (i.e., it may benefit or harm) the mobile factor.d. Trade acts as a substitute for the international mobility of factors of production in itseffect on factor prices. With perfect mobility, labor would migrate from the low-wagenation to the high-wage nation until wages in the two nations are equalized. Similarly,capital would move from the low-interest to the high-interest nation until the rate ofinterest was equalized in the two nations.4. a. The Leontief paradox refers to the original Leontief’s finding that U.S. importsubstitutes were more K-intensive than U.S. exports. This was the opposite of what the H-O theorem postulated.b. The Leontief paradox was resolved by including human capital into the calculationsand excluding industries based on natural resources. Recent research using data on many sectors, for many countries, over many years, and considering that countries couldspecialize in a particular subset or group of commodities that were best suited to theirspecific factor endowments, provides strong support for the H-O theorem.c. The Hecksher-Olhin theory remains the centerpiece of modern trade theory for explaininginternational trade today. To be sure, there are other forces (such as economies of scale,product differentiation, and technological differences across countries) that provide additional reasons and explanations for some international trade not explained by the basic H-O model.These other trade theories complement the basic H-O model in explaining the pattern ofinternational trade in the world today.5. International trade with developing economies, especially newly industrializing economies(NIEs), contributed in two ways to increased wage inequalities between skilled and unskilled workers in the United States during the past two decades. Directly, by reducing the demand for unskilled workers as a result of increased U.S. imports of labor-intensive manufactures and, indirectly, by speeding up the introduction of labor-saving innovations, which furtherreduced the U.S. demand for unskilled workers. International trade, however, was only asmall cause of increased wage inequalities in the United States. The most important causewas technological change.6. a. Economies of scale refer to the production situation where output grows proportionatelymore than the increase in inputs or factors of production. For example, output may morethan double with a doubling of inputs.b. Even if two nations were identical in every respect, there is still a basis for mutuallybeneficial trade based on economies of scale. When each nation specializes in theproduction of one commodity, the combined total world output of both commodities will be greater than without specialization when economies of scale are present. With trade, each nation then shares in these gains.c. The new international economies of scale refers to the increase in productivity resultingfrom firms purchasing parts and components from nations where they are made cheaper and better, and by establishing production facilities abroad.7. a. Product differentiation refers to products that are similar, but not identical.Intra-industry trade refers to trade in differentiated products, as opposed to inter-industry trade in completely different products.b. Intra-industry trade arises in order to take advantage of important economies of scale inproduction. That is, with intra-industry trade each firm or plant in industrial countries can specialize in the production of only one, or at most a few, varieties and styles of the same product rather than many different varieties and styles of a product and achieve economies of scale.c. With few varieties and styles, more specialized and faster machinery can be developedfor a continuous operation and a longer production run. The nation then imports othervarieties and styles from other nations. Intra-industry trade benefits consumers because of the wider range of choices (i.e., the greater variety of differentiated products) available at the lower prices made possible by economies of scale in production.*CHAPTER 5(Core Chapter)TRADE RESTRICTIONS: TARIFFSANSWERS TO REVIEW QUESTIONS AND PROBLEMS1. a. See Figure 5.1.b. Consumption is 70X, production is 50X and imports are 20X.c. The consumption effect is –30X, the production effect is +30X, the trade effect is –60X,and the revenue effect is $30 (see Figure 5.1).2. a. The consumer surplus is $250 without and $l22.50 with the tariff (see Figure 5.1).b. Of the increase in the revenue of producers with the tariff (as compared with theirrevenues under free trade), $22.50 represents the increase in production costs and another $22.50 represents the increase in rent or producer surplus (see Figure 5.1).c. The dollar value or the protection cost of the tariff is $45 (see Figure 5.1).3.The dollar value or the protection cost of the tariff is $45 (see Figure 5.2).4.The dollar value or the protection cost of the tariff is $45 (see Figure5.3).5. The optimum tariff is the tariff that maximizes the net benefit resulting from theimprovement in the nation’s terms of trade against the negative effect resulting fromreduction in the volume of trade.6. a. When a nation imposes an optimum tariff, the trad e partner’s welfare declines becauseof the lower volume of trade and the deterioration in its terms of trade.b. The trade partner is likely to retaliate and in the end both nations are likely to losebecause of the reduction in the volume of trade.7. Even when the trade partner does not retaliate when one nation imposes the optimum tariff,the gains of the tariff-imposing nation are less than the losses of the trade partner, so thatthe world as a whole is worse off than under free trade. It is in this sense that free trademaximizes world welfare.8. a. The nominal tariff is calculated on the market price of the product or service. The rateof effective protection, on the other hand, is calculated on the value added in the nation. It is equal to the value of the price of the commodity or service minus the value of theimported inputs used in the production of the commodity or service.b. The nominal tariff is important to consumers because it determines by how much theprice of the imported commodity increases. The rate of effective protection is important for domestic producers because it determines the actual rate of protection provided by thetariff to domestic processing.9. a. Rates of effective protection in industrial nations are generally much higher than thecorresponding nominal rates and increase with the degree of processing.b. The tariff structure of developed nations is of great concern for developing nationsbecause it discourages manufacturing production in developing nations.10. If a nation reduces the nominal tariff on the importation of the raw materials required toproduce a commodity but does not reduce the tariff on the importation of the finalcommodity produced with the imported raw material, then the effective tariff rates willincrease relative to the nominal tariff rate on the commodity.*CHAPTER 6(Core Chapter)NONTARIFF TRADE BARRIERS ANDTHE POLITICAL ECONOMY OF PROTECTIONISMANSWERS TO REVIEW QUESTIONS AND PROBLEMS1. a. An import quota will increase the price of the product to domestic consumers, reducethe domestic consumption of the good, increase domestic production, and result in aprotection or deadweight loss to the economy.b. The effects of an import quota are identical to those of an equivalent import tariff,except that with a quota the government does not collect a tariff revenue (unless it auctions off import quotas to the highest bidder). The import quota is also more restrictive than an equivalent import tariff because foreign producers cannot increase their exports bylowering their prices.2.By penciling in D”X in Figure 1, we can see that the effects of the import quota are:P x=$2.00 and consumption is 60X, of which 40X are produced domestically and 20X areimported; by auctioning off import licenses, the revenue effect would be $20.3.The effects of an export quota of 20X are identical to those of an import quota of 20X or a100 percent import tariff on commodity X, except that the revenue effect is collected by the exporters, rather than by the domestic importers or their government.7. a. The infant-industry argument postulates that temporary protection may be justified inorder to allow a developing nation to develop an industry in which it has a potentialcomparative advantage. Temporary trade protection is then justified to establish and protect the domestic industr y during its “infancy” until it can grow and meet foreign competition.For this argument to be valid, however, protection must be temporary and the return in the grown-up industry must be sufficiently high to also offset the higher prices paid bydomestic consumers of the commodity during the period of infancy.b. The infant-industry argument must be qualified in several important ways to beacceptable. First, this argument is more justified for developing nations (where capitalmarkets may not function properly) than for industrial nations. Second, it is usuallydifficult to identify which industry or potential industry qualifies for this treatment, andexperience has shown that protection, once given, is difficult to remove. Third, and most important, what trade protection (say in the form of an import tariff) can do, an equivalent production subsidy to the infant industry can do better.8. a. According to strategic industrial trade policy a nation can create a comparativeadvantage (through temporary trade protection, subsidies, tax benefits, and cooperativegovernment–industry programs) in a high-technology field deemed crucial to future growth in the nation.b. There are also serious difficulties in carrying strategic industrial and trade policies.First, it is extremely difficult to pick winners (i.e., choose the industries that will contribute significantly to growth in the future). Second, if most leading nations undertake strategictrade policies at the same time, their efforts are largely neutralized. Third, when a country does achieve substantial success with a strategic trade policy, this comes at the expense of other countries (i.e., it is a beggar-thy-neighbor policy), which are, therefore, likely to retaliate. Faced with all these practical difficulties, even supporters of strategic trade policy grudgingly acknowledge that free trade is still the best policy, after all.*CHAPTER 7(Core Chapter)ECONOMIC INTEGRATIONANSWERS TO REVIEW QUESTIONS AND PROBLEMS1.If Nation A imposes a 100 percent ad valorem tariff on imports of commodity X fromNation B and Nation C, Nation A will produce commodity X domestically because thedomestic price of commodity X is $10 as compared with the tariff-inclusive price of $16 if Nation A imported commodity X from Nation B and $12 if Nation A imported commodity X from nation C.2. a. If Nation A forms a customs union with Nation B, Nation A will import commodity Xfrom Nation B at the price of $8 instead of producing it itself at $10 or importing it fromNation C at the tariff-inclusive price of $12.b. The formation by Nation A of a customs union with Nation B leads to trade creationonly because Nation A replaces the domestic production of commodity X at Px=$10 with tariff-free imports of commodity X from Nation B at Px=$8.3.If Nation A imposes a 50 percent ad valorem tariff on imports of commodity X fromNation B and Nation C, Nation A will import commodity X from nation C at thetariff-inclusive price of $9 instead of producing commodity X itself or importing it from Nation B at the tariff-inclusive price of $12.4. a. If Nation A forms a customs union with Nation B, Nation A will import commodity Xfrom Nation B at the price of $8 instead of importing it from Nation C at the tariff-inclusive price of $9.b. The formation by Nation A of a customs union with Nation B leads not only to tradecreation but also to trade diversion because it replaces lower-cost imports of commodity X of $6 (from the point of view of Nation A as a whole) with higher priced imports ofCommodity X from Nation B at $8.Specifically, Nation A's importers do not import commodity X from Nation C because the tariff-inclusive price of commodity X from Nation C is $9 as compared with the no-tariff price of $8 for imports of commodity X from Nation B. However, since the government of Nation A collects the $3 tariff per unit on imports of commodity X fromNation C, the net effective price for imports of commodity X from Nation C is really $6 for Nation A as a whole.5. a. See Figure 7.1.b. The net gain from the trade-diverting customs union shown in Figure 1 is given byC'JJ'+B'HH'-MJ'H'N. As contrasted with the case in Figure 7-1 in the text, however, the sum of the areas of the two triangles (measuring gains) is here greater than the area therectangle (measuring the loss). Thus, the nation would now gain from the formation of acustom union. Had we drawn the figure on graph paper, we would have been able tomeasure the net gain in monetary terms also.6. A customs union that leads to both trade creation and trade diversion is more likely to leadto a net positive welfare gain of the nation joining the union (1) the smaller is the relative inefficiency of the union member in relation to the non-union member and (2) the higher is the level of the tariff imposed by the customs union on the non-union member.7.The dynamic benefits resulting from the formation of a customs union are (1) increasedcompetition, (2) economies of scale, (3) stimulus to investment, and (4) better utilization of economic resources. These are likely to be much more significant than the static benefits.8.See Figure 7.2. The formation of the customs union has no effect.。
