Professional Documents
Culture Documents
36. After the opening of free trade with the Rest of the World, the world price establishes itself at $60.
TheU.S. __________ bicycles.
a. Exports 40,000
b. Exports 60,000
c. Imports 60,000
d. Neither exports nor imports any bicycles
ANSWER: A
37. After the opening of free trade between the U.S. and the Rest of the World:
a. Neither the U.S. nor the Rest of the World gain from trade.
b. Both countries gain from trade, but the U.S. gains more.
c. Both countries gain from trade, but the Rest of the World gains more.
d. One cannot determine who gains more.
ANSWER: C
True/False Questions
38. An increase in demand will lead to a larger increase in price the more elastic is supply.
ANSWER: FALSE
39. A decrease in income will lead to an increase in the quantity demanded of an inferior good.
ANSWER: TRUE
40. A simultaneous increase in supply and decrease in demand will lead to a higher equilibrium price.
ANSWER: FALSE
41. If a 1% increase in price leads to a 5% decrease in quantity demanded, the good is considered to be a normal
good.
ANSWER: FALSE
42. Consumer surplus is the amount of net economic benefit to consumers from being able to purchase in a market.
ANSWER: TRUE
43. Everyone benefits in a country that was closed to world trade when it begins to freely trade with the rest of the
world.
ANSWER: FALSE
44. While international trade will benefit both the importing and exporting country in a two-country world, the gains
from trade in the exporting country will usually be greater than the gains from trade in the importing country.
ANSWER: FALSE
45. The net national gain from trade can be measured by the change in consumer and producer surplus that results
from trade.
ANSWER: TRUE
46. The free-trade price of a good in an importing country is expected to be lower than the price of the good in that
country before trade began.
ANSWER: TRUE
47. When free trade begins, producers in the importing nation gain while producers in the exporting nation lose.
ANSWER: FALSE
48. Free trade is a zero-sum activity. That is, one county always gains and the other always loses from free trade.
ANSWER: FALSE
49. The gains from trade are divided in proportion to the price changes that trade brings to the trading countries.
ANSWER: TRUE
50. If the world price is higher than the no-trade domestic price, then domestic producers gain and domestic
consumers lose as a result of free trade.
ANSWER: TRUE
51. The elasticity of demand measures the responsiveness of consumers to changes in the price of a product.
ANSWER: TRUE
52. Over the past half a century the World Trade Volume increased more than ten times.
ANSWER: TRUE
Essay Questions
53. In a two-country world, the opening of free trade does not make everyone in the two countries better off. What
assumption(s) must be made in order to make the claim that both countries do in fact benefit from the free trade?
POSSIBLE RESPONSE: It is true that free trade does not benefit everyone within a country. However, if we
accept the one-dollar-one-vote metric, and measure the national well-being of a country, we will find that there
are net national gains from trade. That means that the gainers are gaining more than the losers are losing. Among
the gainers are the consumers in the importing country, who enjoy lower prices, and possibly a wider variety of
the product, and the producers in the exporting country, who are expanding their production as they are receiving
a higher price in the international market. Among the losers are the consumers of the export-oriented industry
and the import-competing producers.
54. Assume that there are only two countries in the world, Pacifica and Atlantica. Both countries produce and
consume surfboards. The pre-trade price of surfboards in Atlantica is lower than the pre-trade price of surfboards
in Pacifica. Draw a three-graph diagram to depict the Pacifica, Atlantica, and international markets for surfboards
illustrating the pre-trade price difference. Now assume that free trade opens up between Pacifica and
Atlantica. Depict a plausible world price in the graphs. Using what you have learned about consumer and
producer surplus, describe what happens to consumers and producers in each country as a result of the move to
free trade. What happens to overall economic welfare in the two countries? Be sure to label and refer to the
graphs in your answer.
POSSIBLE RESPONSE:
Pacifica
(demand for imports)
The above graph illustrates a possible international price. The graph to the left represents demand and supply in
Atlantica, the graph in the middle the market in Pacifica, and the graph to the right the World market. The
international price of 60 is between the no-trade prices of 40 and 70. The international price is such a price that
the excess supply in Atlantica matches the excess demand in Pacifica. As a result Atlantica exports 30 units
to Pacifica at a price of 60. Both countries gain from international trade. Atlantica gains area C in the right graph,
and Pacifica gains area P.
55. Carefully explain why nations gain from engaging in international trade. Do nations gain equally from trade? If not,
what determines which country gains more? (In your answer you can assume a two-country world.)
POSSIBLE RESPONSE: Demand and supply differ in the two countries and so prices also differ if there is no
international trade. With the opening of international trade arbitrage opportunities arise: opportunities to make
profit by buying the good cheaper in one country and selling it in another. Due to these opportunities the prices
in the two countries equalize. The gain from trade in the importing country arises because consumers in this
country gain more than producers lose as a result of the reduced price. Conversely, the gain from trade in the
exporting country exists because producers gain more than local consumers lose. In general, nations do not gain
equally from trade. The country which experiences a larger change in its price stands to gain more. More
precisely, the national gain from trade is proportional to the change in the price that occurs due to the shift from
no trade to free trade.
56. What is the logic of producing winter clothing in countries whose residents have very little demand for such
clothing?
POSSIBLE RESPONSE: A country might be interested in the production of winter clothing if this country can
export this good in exchange for other goods that cannot be produced at a low cost domestically in this country. This
might be due to the specificity of the technology in this country; this country might have an abundance of resources
that make the production of winter clothing efficient (low cost), whereas this country might be unable to produce
other goods at such a low cost.
57. China produces shoes at a lower cost than the United States. As a result, most of the shoes purchased in theUnited
States are made in China. Should this be a concern to anyone in the United States? If so, who should be concerned
and why? If not, why not?
POSSIBLE RESPONSE: As a result of the free trade between China and the U.S., the price of shoes in
the U.S. will be equal to the international price. What are the effects of free trade on producers and consumers of
shoes in the United States? As a result of the imports of shoes from China, the price of shoes will be lower
(compared to the situation of no trade). Consumers will gain additional consumer surplus due to the lower price
and the increased purchases of shoes (consumers total surplus is measured by the area below the demand curve
for shoes and above the international price). Facing a lower price (the international price), the domestic
producers of shoes in the United States will react by decreasing their production of shoes. Hence, there is loss of
surplus to producers associated with the opening of trade. Some of the shoe producers might go out of business,
which might create temporary unemployment in this industry which will last until the workers producing shoes
find employment in another sector of the economy. In general, consumers gain more than producers lose, so
there is a net gain for the U.S. of opening to trade.
58. The difference in the prices of a good in two countries creates opportunities for arbitrage: traders buy the good at a
low price in one country and sell it at a higher price in the other. When the difference in the prices vanishes, and the
world price is established in both countries, there is no scope for trade anymore because no trader will be willing to
buy the good in one country and sell it in another. Discuss the validity of this statement.
POSSIBLE RESPONSE: This is not a valid statement. Consider the countries A and B, and assume that without
trade the price of the good is Pa in country A and Pb in country B, where Pa< Pb. With the opening of free trade, the
arbitrage possibilities will eliminate the difference in the prices in the two countries. So, the world price, W, will
establish itself between the two local prices:
Pa<w< pb. There will be excess surplus at the price W in country A, and a shortage in country B. Country A will be
exporting the good to country B. It is the ongoing trade that keeps the price the same in the two countries.</w<>
Chapter 3 Why Everybody Trades: Comparative Advantage
13. If a country exports the good that it can produce at a low opportunity cost and imports those goods that it would
otherwise produce at a high opportunity cost, we say that such trade is based upon:
a. Absolute advantage.
b. Arbitrage.
c. Labor productivity differences.
d. Comparative advantage.
ANSWER: D
Table 3.2
In the United Kingdom In the Rest of the World
Labor hours to make:
1 umbrella 3.00 2.00
1 unit of corn 1.00 0.25
14. Refer to Table 3.2. The United Kingdom has an absolute advantage in the production of __________ and the Rest of
the World has an absolute advantage in the production of __________.
a. Neither good; corn
b. Neither good; both goods
c. Both goods; neither goods
d. Corn; umbrellas
ANSWER: B
15. Refer to Table 3.2. The United Kingdom has a comparative advantage in the production of __________ and the Rest of
the World has a comparative advantage in the production of __________.
a. Neither good; corn
b. Neither good; both goods
c. Umbrellas; corn
d. Corn; umbrellas
ANSWER: C
16. Refer to Table 3.2. The opportunity cost of producing a unit of corn in the United Kingdom is __________ umbrellas
and the opportunity cost of producing a unit of corn in the Rest of the World is __________ umbrellas.
a. 1/8; 1/3
b. 1/3; 1/8
c. 3; 8
d. 8; 3
ANSWER: B
17. Refer to Table 3.2. The opportunity cost of producing an umbrella in the United Kingdom is __________ units of corn
and the opportunity cost of producing an umbrella in the Rest of the World is __________ units of corn.
a. 1/8; 1/3
b. 1/3; 1/8
c. 3; 8
d. 8; 3
ANSWER: C
18. Refer to Table 3.2. Once trade is opened, we can anticipate that the international price of umbrellas will lie between
__________ and __________.
a. 1/3 of a unit of corn; 3 units of corn
b. 8 units of corn; 3 units of corn
c. 1/8 of a unit of corn; 1/3 of a unit of corn
d. 8 units of corn; 1/8 of a unit of corn
ANSWER: B
19. Refer to Table 3.2. Once trade is open, we can anticipate that the international price of corn will lie between
__________ and __________.
a. 1/3 of an umbrella; 3 umbrellas
b. 8 umbrellas; 3 umbrellas
c. 1/8 of an umbrella; 1/3 of an umbrella
d. 8 umbrellas; 1/8 of an umbrella
ANSWER: C
Table 3.3
In the United Kingdom In the Rest of the World
Productivity
Umbrellas per labor hour 6 1
Units of corn per labor hour 4 3
20. Refer to Table 3.3. The United Kingdom has an absolute advantage in the production of __________ and the Rest of
the World has an absolute advantage in the production of __________.
a. Both goods; neither good
b. Neither good; both goods
c. Umbrellas; corn
d. Corn; umbrellas
ANSWER: A
21. Refer to Table 3.3. The United Kingdom has a comparative advantage in the production of __________ and the Rest of
the World has a comparative advantage in the production of __________.
a. Both goods; neither good
b. Neither good; both goods
c. Umbrellas; corn
d. Corn; umbrellas
ANSWER: C
22. Refer to Table 3.3. The opportunity cost of producing a unit of corn in the United Kingdom is __________ umbrellas
and the opportunity cost of producing a unit of corn in the Rest of the World is __________ umbrellas.
a. 2/3; 3
b. 3; 2/3
c. 3/2; 1/3
d. 1/3; 3/2
ANSWER: C
23. Refer to Table 3.3. The opportunity cost of producing an umbrella in the United Kingdom is __________ units of corn
and the opportunity cost of producing an umbrella in the Rest of the World is __________ units of corn.
a. 2/3; 3
b. 3; 2/3
c. 3/2; 1/3
d. 1/3; 3/2
ANSWER: A
24. Refer to Table 3.3. Once trade is opened, we can anticipate that the international price of umbrellas will lie between
__________ and __________.
a. 2/3 of a unit of corn; 3 units of corn
b. 3/2 units of corn; 2/3 of a unit of corn
c. 3/2 of a unit of corn; 1/3 of a unit of corn
d. 3 units of corn; 1/3 of a unit of corn
ANSWER: A
25. Refer to Table 3.3. Once trade is open, we can anticipate that the international price of corn will lie between
__________ and __________.
a. 2/3 of an umbrella; 3 umbrellas
b. 3/2 umbrellas; 2/3 of an umbrella
c. 3/2 umbrellas; 1/3 of an umbrella
d. 3 umbrellas; 3/2 umbrellas
ANSWER: C
Table 3.4
In the United States In France
Labor hours to make:
1 gallon of Wine 4.00 1.00
1 pound of Cheese 1.00 2.00
26. Refer to Table 3.4 and assume the United States and France trade only with each other. The United States has an
absolute advantage in the production of __________ and France has an absolute advantage in the production of
__________.
a. Neither good; wine
b. Cheese; neither good
c. Wine; cheese
d. Cheese; wine
ANSWER: D
27. Refer to Table 3.4. What is the relative price of cheese (the price of cheese in terms of wine) in France if it does not
engage in trade?
a. 2 gallons of wine per pound.
b. 1 gallon of wine per pound.
c. 0.5 gallons of wine per pound.
d. 0.25 gallons of wine per pound.
ANSWER: A
28. Refer to table 3.4. The opportunity cost of cheese in France is __________ and the opportunity cost of cheese in
the United States is __________.
a. 1 gallon of wine; 0.5 gallons of wine
b. 2 gallons of wine; 1 gallon of wine
c. 2 gallons of wine; 0.25 gallons of wine
d. 0.5 gallons of wine; 4 gallons of wine
ANSWER: C
29. Refer to Table 3.4 and assume the United States and France trade only with each other. The United States has a
comparative advantage in the production of __________ and France has a comparative advantage in the production of
__________.
a. Both goods; neither good
b. Cheese; wine
c. Wine; cheese
d. Neither good; both goods
ANSWER: B
30. Refer to Table 3.4. Once trade between the United States and France opens, we can anticipate that the international
price of wine will be between __________ and __________.
a. 1 pound of cheese; 4 pounds of cheese
b. 0.5 pounds of cheese; 4 pounds of cheese
c. 1 pound of cheese; 2 pounds of cheese
d. 0.5 pounds of cheese; 2 pounds of cheese
ANSWER: B
31. Refer to Table 3.4. Once trade between the United States and France opens, we can anticipate that the international
price of cheese will be between __________ and __________.
a. 1 gallon of wine; 0.5 gallons of wine
b. 2 gallons of wine; 4 gallons of wine
c. 2 gallons of wine; 0.25 gallons of wine
d. 1 gallon of wine; 4 gallons of wine
ANSWER: C
32. Which of the following is NOT true about a nations production-possibility curve?
a. The production-possibility curve shows all the amounts of different products that an economy can produce when its
resources are fully employed.
b. Points inside the production-possibility curve are feasible, but may represent unemployment of some of the economys
resources.
c. Points outside the production-possibility curve are not feasible production points given the resources in the economy.
d. The production-possibility curve shows how the country gains from trade.
ANSWER: D
33. Which of the following is NOT true about a constant cost production possibilities curve?
a. A constant cost production possibilities curve is drawn as a straight line.
b. Along a constant cost production possibilities curve opportunity cost is constant.
c. The opening up of free trade causes a constant cost production possibilities curve to shift to the right.
d. Constant cost production possibilities curves can lead to complete specialization when free trade opens.
ANSWER: C
Figure 3.1
34. Refer to Figure 3.1. The opportunity cost of one unit of corn production in Canada is __________ liters of maple syrup
and in the Rest of the World is __________ liters of maple syrup.
a. 9/7; 2
b. 7/9; 2
c. 9/7; 1/2
d. 7/9; 1/2
ANSWER: C
35. Refer to Figure 3.1. The opportunity cost of one liter of maple syrup production in Canada is __________ units of corn
and in the Rest of the World is __________ units of corn.
a. 9/7; 2
b. 7/9; 2
c. 9/7; 1/2
d. 7/9; 1/2
ANSWER: B
36. Refer to Figure 3.1. After the opening of free trade between Canada and the Rest of the World at the world price of 1
corn per unit of maple syrup, Canada will produce __________ units of corn and __________ liters of maple syrup.
The Rest of the World will produce __________ units of corn and __________ liters of maple syrup.
a. 35; 45; 35; 32.5
b. 70; 90; 100; 50
c. 0; 90; 100; 0
d. 70; 0; 0; 50
ANSWER: C
37. Refer to Figure 3.1. Which of the following terms of trade is a plausible terms of trade for the two-country, two-good
model depicted in the figure?
a. 3/2 units of corn trades for 1 liter of maple syrup.
b. 1 unit of corn trades for 1/4 liter of maple syrup.
c. 3 units of corn trades for 1 liter of maple syrup.
d. 10 liters of maple syrup trades for 2 units of corn.
ANSWER: A
38. Products produced by high-wage workers in developed countries can compete with those produced by low-wage
workers in less-developed countries because:
a. High-wage workers tend to be less productive than low-wage workers.
b. High-wage workers tend to be more productive than low-wage workers.
c. High-wage workers tend to put more time into the production of their goods.
d. Products produced by high-wage workers in developed countries can not compete with those produced by low-wage
workers in less-developed countries.
ANSWER: B
39. A bottle of wine can be produced in France with 2 labor hours, and in the United States with 4 labor hours. A pound of
beef can be produced in France with 1 labor hour, and in the United States with labor hour.
a. France has a comparative advantage in the production of beef.
b. France has an absolute advantage in the production of beef.
c. The United States has an absolute, but not a comparative advantage in the production of beef.
d. The United States has both a comparative and an absolute advantage in the production of beef.
ANSWER: D
Use the following information to answer the questions 40 and 41. Vintland and Moonited Republic produce wine
and cheese. The opportunity cost for the production of a bottle of wine in Vintland is 2 pounds of cheese, and in
theMoonited Republic is 2.5 pounds of cheese.
40. Based on the above information it can be concluded that:
a. Trade between the two countries based on comparative advantage is not possible.
b. Vintland has a comparative advantage in the production of wine and Moonited has a comparative advantage in the
production of cheese.
c. Vintland has a comparative advantage in the production of cheese and Moonited has a comparative advantage in the
production of wine.
d. Vintland has an absolute disadvantage in the production of both goods.
ANSWER: B
41. Based on the above information, the international equilibrium price ratio can be:
a. 2/5 bottles of wine for a pound of cheese.
b. 3/5 bottles of wine for a pound of cheese.
c. 4/5 bottle of wine for a pound of cheese.
d. 1 bottle of wine for a pound of cheese.
ANSWER: A
42. In the two-country-two-good model, if a country has a comparative advantage in the production of a certain good, that
means that this country:
a. Also has an absolute advantage in the production of this good.
b. Will start importing this good.
c. Can produce this good at a lower opportunity cost.
d. Can produce this good at the same opportunity cost.
ANSWER: C
43. In the two-country, two-good model, if a country has an absolute advantage in the production of a certain good, that
means that:
a. It is not possible that this country will start importing this good from the other country.
b. This country also has a comparative advantage in the production of this good.
c. Trade based on comparative advantage will not be possible.
d. This country has a higher labor productivity in the production of this good.
ANSWER: D
True/False Questions
44. David Ricardo is the author of the Wealth of Nations.
ANSWER: FALSE
45. Adam Smiths theory of absolute advantage relied on the labor theory of value.
ANSWER: TRUE
46. Mercantilists believe that when one country benefited from international trade it was at the expense of another country
or countries.
ANSWER: TRUE
47. If Country X has a higher level of labor productivity than the rest of the world in the production of a good, then
Country X has a comparative advantage in the production of the good.
ANSWER: FALSE
48. In order for trade to occur, both countries must be made better off as a result of trade.
ANSWER: FALSE
49. If a country does not have an absolute advantage in the production of a least one good, then trade will not take place.
ANSWER: FALSE
50. In Country X, the opportunity cost of producing an additional unit of Good A is the amount of Good B given up.
ANSWER: TRUE
51. In the Wealth of Nations, Adam Smith presented his theory of comparative advantage.
ANSWER: FALSE
52. If Country A is more productive than Country B in the production of both Good X and Good Y, then economists expect
that Country A will produce everything and export both Good X and Good Y to Country B.
ANSWER: FALSE
53. In the two-country, two-good model, both countries can gain from trade as long as their relative advantages and
disadvantages in producing different goods are different.
ANSWER: TRUE
54. According to the theory of comparative advantage, countries will export those goods for which they have a lower
opportunity cost and import those goods for which they have a higher opportunity cost than the rest of the world.
ANSWER: TRUE
55. The act of buying at a low price in one place and selling at a high price in another place is called relative pricing.
ANSWER: FALSE
56. Arbitrage is the act of buying at one place and selling at another place in order to profit from the price differences that
exist between the two places.
ANSWER: TRUE
57. In the two-country, two-good model, international trade will cause the two national prices that existed in autarky to
move towards a new worldwide equilibrium price.
ANSWER: TRUE
58. A nations production-possibility curve shows the amounts of different products that an economy can produce if all of
its resources are fully employed.
ANSWER: TRUE
59. Straight-line production-possibility curves reflect that the opportunity cost of producing additional units of each good is
constant.
ANSWER: TRUE
60. The production-possibility curve shows various bundles of consumption quantities that lead to the same level of well
being.
ANSWER: FALSE
61. Free trade with constant-cost production-possibility curves usually leads to partial production specialization.
ANSWER: FALSE
62. In the two-country, two-good model, the relative price that will exist in the international markets for a good following
the emergence of free trade will necessarily lie in the range bracketed by the autarky relative prices for the good in the
two countries.
ANSWER: TRUE
63. According to the theory of comparative advantage, trade will not occur if one country is less efficient in the production
of all products.
ANSWER: FALSE
64. A country has a comparative advantage in the production of a good if it can produce more of the good than another
country.
ANSWER: FALSE
65. In Ricardos model, if labor productivity is constant, the production possibilities curve will look like a straight line.
ANSWER: TRUE
66. Ricardos theory of comparative advantage tells us that, if opportunity costs differ and labor productivities are constant,
free trade will lead at least one country to a complete production specialization.
ANSWER: TRUE
67. The opportunity cost measures the amount of labor necessary for the production of one unit of a good.
ANSWER: FALSE
Essay Questions
68. Explain how a country can have an absolute advantage in the production of both goods in the two-country, two-good
model and one country can have the comparative advantage in the production of one good and the other country will
have a comparative advantage in the production of the other good.
POSSIBLE RESPONSE: Let us begin with Adam Smiths theory of absolute advantage. Imagine that two countries, A
and B, use only labor to produce wheat and cloth. We say that one country, say A, has an absolute advantage in the
production of one of the goods, say wheat, if this country can produce more units of wheat per labor hour. If Country A
can also produce more units of cloth per labor hour than Country B, then Country A will also have an absolute
advantage in the production of cloth. So what kind of advantage can Country B then have? It seems that this country is
less efficient in the production of both goods. To answer this question, we look at the opportunity cost of production.
Now we present David Ricardos theory of comparative advantage. We ask the question, how many units of wheat
must Country B forego in order to produce one more unit of cloth? If Country B must forego fewer units of wheat in
order to produce one more unit of cloth compared to Country A, we say that Country B has a lower opportunity cost in
the production of cloth. That implies that Country B has a comparative advantage in the production of cloth; production
of cloth requires a lower sacrifice of production of wheat in Country B.
69. Using graphs, illustrate a two-country, two-good model in which one country has an absolute advantage in the
production of both goods, but a comparative advantage in the production of only one good.
POSSIBLE RESPONSE:
Assume Countries A and B have the same endowment of labor, and let labor be the sole factor of production. Country
B has an absolute advantage in the production of wheat as with the same resources Country B can produce 60 units.
Country A can produce only 40 units. Country B has also an absolute advantage in the production of Cloth (80>40).
The opportunity cost in Country A for the production of one unit of wheat is 40/40=1C/W. The opportunity cost in
Country B is 80/60=(4/3) C/W. Country A has a lower opportunity cost in the production of wheat, hence Country A
has a comparative advantage in the production of wheat.
70. Suppose labor productivity in France is such that one hour of labor is required to produce one gallon of wine while two
hours of labor are required to produce one pound of cheese. Assuming the availability of 1 million labor hours, draw a
constant cost production possibilities curve for France with cheese on the vertical axis and wine on the horizontal axis.
If France has a comparative advantage in the production of wine, show where, with free trade, France will produce on
its production possibilities curve. If the free trade price of wine is two pounds of cheese per gallon, draw a trade line
and use it to illustrate how France can gain from trade.
POSSIBLE RESPONSE:
Wine
(millions gallons)
If France produces only cheese, with 1 million labor hours France will be able to produce half a million pounds of
cheese. If France produces only wine, France will be able produce 1 million gallons of wine. The production
possibilities curve for France is a straight line as is shown in the graph. The opportunity cost of one gallon of wine
in France is half a pound cheese. The international price of a gallon of wine is two pounds of cheese, which is higher
than the opportunity cost of wine production in France. That means it will be beneficial for France to produce only wine
and trade it for cheese instead of producing cheese itself. With free trade France can consume any combination of
quantities of wine and cheese lying on the trade line shown in the graph. France gains from trade because these
combinations are clearly outside of Frances production possibilities curve, so that is they are unattainable without
trade.
71. Explain how products produced by high-wage workers in the United States can compete in countries whose workers
earn much lower wages.
POSSIBLE RESPONSE:
To answer this question let us focus on the basis for trade between the United States and the other countries: the
comparative advantage of the United States in the production of some products and the comparative advantage of the
other countries in the production of another set of products. To determine whether theUnited States has a comparative
advantage in a particular product we need to compare the worker productivity and wages in the United States to the
productivity and wages in the other countries.
Although worker wages in the United States are higher, the United States will have a comparative advantage if
the U.S. workers are sufficiently productive. If the productivity advantage is large enough, the cost of manufacturing
the product in the U.S. will be lower despite the high wages. The U.S. will be able to successfully export this product
and import the products for which it does not have a comparative advantage.
72. According to Ricardos theory, countries will specialize in the production of the good in which they have a comparative
advantage, and the specialization will be complete if free-trade relative prices differ from no-trade relative prices. Yet,
the real world fails to show total specialization. Explain the reasons for this discrepancy.
POSSIBLE RESPONSE: Ricardos theory is based on the assumption of constant labor productivity for each good.
This assumption means that the labor input necessary for the production of each additional unit of the good does not
depend on how much is produced. Because of this assumption, the opportunity costthe amount of the other product
foregone in order to produce one more unit of the goodis constant. A country will produce only the good with a
lower opportunity cost, and will find it beneficial to trade it for the other at a relative price higher than this opportunity
cost. The specialization will be full. In reality, goods are produced with several other factors besides labor, and the
productivity of these production factors is not constant. As a result, in reality the production possibilities curve will be
bowed out, and complete specialization will not be an optimal choice for the country, even if free-trade prices differ
from no-trade prices.
Chapter 4: Trade: Factor Availability and Factor Proportions are Key
6. Refer to Figure 4.1. In autarky Canada will produce at point __________ and consume at point __________.
a. S1; C1
b. S0; C0
c. S1; C0
d. S0; C1
ANSWER: B
7. Refer to Figure 4.1. After the opening up of international trade, Canada will produce at point __________ and
consume at point __________.
a. S1; C1
b. S0; C0
c. S1; C0
d. S0; C1
ANSWER: A
8. Refer to Figure 4.1. Canada has a comparative advantage in which good?
a. Wheat.
b. Cloth.
c. Both wheat and cloth.
d. Neither wheat nor cloth.
ANSWER: A
9. Refer to Figure 4.1. After the opening up of international trade, Canada will export __________ units of wheat and
import __________ units of cloth.
a. 0; 0
b. 20; 80
c. 20; 5
d. 60; 15
ANSWER: B
10. Refer to Figure 4.1. After the opening up of international trade, Canada will import __________ units of wheat and
export __________ units of cloth.
a. 0; 0
b. 25; 25
c. 30; 65
d. 65; 65
ANSWER: A
11. Refer to Figure 4.1. Before the opening up of international trade, 1 unit of wheat will trade for __________ units of
cloth. After the opening up of international trade 1 unit of wheat will trade for __________ units of cloth.
a. 1; 0.25
b. 4; 1.
c. 1; 4.
d. 0; 2.5.
ANSWER: C
12. Refer to Figure 4.2. Before trade opens, the Rest of the World produces __________ yards of cloth and __________
units of wheat; while consuming __________ yards of cloth and __________ units of wheat.
a. 10; 8; 8; 10
b. 4; 16; 8; 10
c. 8; 10; 12; 8
d. 8; 10; 8; 10
ANSWER: D
13. Refer to Figure 4.2. After trade, Canada produces __________ yards of cloth and __________ units of wheat and
consumes __________ yards of cloth and __________ units of wheat.
a. 20; 3; 12; 11
b. 12; 11; 12; 11
c. 20; 3; 20; 3
d. 16; 6; 12; 11
ANSWER: A
14. Refer to Figure 4.2. In autarky, the Rest of the World produces and consumes __________ yards of cloth and
__________ units of wheat. In autarky Canada produces and consumes __________ yards of cloth and __________
units of wheat.
a. 8; 10; 20; 3
b. 8; 10; 16; 6
c. 4; 16; 20; 3
d. 12; 8; 12; 11
ANSWER: B
Figure 4.2
15. Refer to Figure 4.2. Before trade, the total amount of cloth produced in the world was __________ yards and the
total amount of wheat produced in the world was __________.
a. 24; 19
b. 24; 16
c. 19; 24
d. 16; 24
ANSWER: B
16. Refer to Figure 4.2. As a result of specialization and trade, cloth production in the world is increased by __________ yards and wheat
production is increased by __________ units.
a. 0; 3
b. 0; 0
c. 24; 19
d. 3; 0
ANSWER: A
17. Which of the following can explain why product prices in two countries will differ in a world with no trade?
I. Production conditions in the two countries are different and therefore the production-possibility curves
in the two countries are different.
II. Consumption conditions are different in the two countries and therefore the community indifference
curves in the two countries are different.
III. Trade would not be possible because the international price ratio would be the same in the two
countries.
a. I and III
b. II
c. I and II
d. I and II and III
ANSWER: C
18. A country whose ratio of capital to other factors of production is greater than the rest of the worlds ratio of capital
to other factors of production is:
a. Relatively capital-intensive.
b. Relatively capital-abundant.
c. Running a trade deficit.
d. Operating at a point inside its production possibilities curve.
ANSWER: B
19. The United States is relatively capital-abundant because:
a. Capital costs more in the United States than in the rest of the world.
b. The United States has more capital than the rest of the world.
c. The United States produces more high-tech goods than the rest of the world.
d. The ratio of capital to other factors of production is greater in the United States than the rest of the
worlds ratio of capital to other factors of production.
ANSWER: D
20. Which of the following theories predicts that a country will export those goods that use the countrys abundant
factor(s) intensively in production and import those goods that use the countrys scarce factor(s) intensively in
production?
a. Absolute advantage.
b. Comparative advantage.
c. Heckscher-Ohlin theory.
d. The production differentiation model.
ANSWER: C
21. If Country A is labor-abundant and capital-scarce, Country B is labor-scarce and capital-abundant, Good X is
produced in a labor-intensive process, and Good Y is produced in a capital-intensive process, we would expect that:
a. Country A would export Good X.
b. Country B would import Good Y.
c. Country A would import Good X.
d. Country B would import both Good X and Good Y.
ANSWER: A
22. China has 20% of the worlds population but only 10% of the worlds farmable land. The Heckscher-Ohlin theory of
trade would predict which of the following for China following the opening of trade?
a. China will export land-intensive goods like wheat and import labor-intensive goods like clothing.
b. China will shift resources into the production of agricultural goods and away from manufactured goods.
c. China will shift resources out of the production of agricultural goods and into the production of labor-
intensive goods.
d. China will export capital-intensive goods like automobiles and import labor-intensive goods like clothing.
ANSWER: C
23. A product is relatively __________ if labor costs are a greater proportion of the products value than they are the
value of other products.
a. Capital-abundant
b. Labor-abundant
c. Capital-intensive
d. Labor-intensive
ANSWER: D
24. If Country A has a relatively higher ratio of labor to the other factors of production than does Country B, then:
a. Country A is labor-abundant.
b. Country A is labor-scarce.
c. Country A is labor-intensive.
d. Country B is labor-intensive.
ANSWER: A
25. Given the following relationship:
(U.K. land supply) < (Rest of the worlds land supply)
(U.K. labor supply) > (Rest of the worlds labor supply)
One can conclude that:
a. The U.K is labor abundant.
b. The U.K. is labor intensive.
c. The Rest of the World is labor abundant.
d. The Rest of the World is land intensive.
ANSWER: A
26. Which of the following economists proposed an international trade model that explains international trade
patterns using factor proportions?
a. Adam Smith
b. David Ricardo
c. Eli Heckscher and Bertil Ohlin
d. Joseph Stiglitz
ANSWER: C
27. Assume a two-country, two-good, two-factor of production world with the countries being the United States and
the Rest of the World, the two goods being steel and wheat, and the two factors of production being capital and
land. If the United States was capital-abundant and steel production was capital-intensive, the Heckscher-Ohlin
model would predict that the United States would export __________ and import __________.
a. Steel; wheat
b. Wheat; steel
c. Steel; steel
d. Wheat; wheat
ANSWER: A
28. Assume a two-country, two-good, two-factor of production world with the countries being the United States and
the Rest of the World, the two goods being steel and wheat, and the two factors of production being capital and
land. If the United States was capital-abundant and steel production was capital-intensive, the Heckscher-Ohlin
model would predict that the Rest of the World would export __________ and import __________.
a. Steel; wheat
b. Wheat; steel
c. Steel; steel
d. Wheat; wheat
ANSWER: B
Use the following information to answer questions 29 thru 35.
Assume a two-country, two-good, two-factor of production world where the following relationships hold:
(K/L)US > (K/L)ROW
(K/L)automobiles > (K/L)shoes
Where (K/L)US is the capital-labor ratio in the United States, (K/L)ROW is the capital-labor ratio in the Rest of the World,
(K/L)automobilesis the capital-labor ratio in the production of automobiles, and (K/L)shoes is the capital-labor ratio in the
production of shoes. Assume further that technology and tastes are the same in the United States and the Rest of the
World.
29. The relationships shown above indicate that the United States is:
a. A capital-intensive country.
b. Scarce in land.
c. A labor-abundant country.
d. A capital-abundant country.
ANSWER: D
30. The relationships shown above indicate that the production of shoes is:
a. Capital-intensive.
b. Labor-intensive.
c. Labor-abundant.
d. Capital-abundant.
ANSWER: B
31. The relationships shown above indicate that in the United States the price of automobiles relative to shoes is:
a. Higher than in the Rest of the World.
b. Lower than in the Rest of the World.
c. The same as in the Rest of the World.
d. It is impossible to compare the prices with the information provided.
ANSWER: B
32. The relationships shown above indicate that the United States has a comparative advantage in the production of
__________ while the Rest of the World has a comparative advantage in the production of __________.
a. Both goods; neither good
b. Shoes; automobiles
c. Automobiles; shoes
d. Neither good; both goods
ANSWER: C
33. According to the Heckscher-Ohlin model, the opening of trade between the United States and the Rest of the
World should cause theUnited States to export __________ and import __________.
a. Both goods; neither good
b. Shoes; automobiles
c. Automobiles; shoes
d. Neither good; both goods
ANSWER: C
34. According to the Heckscher-Ohlin model, the opening of trade between the United States and the Rest of the
World should cause the Rest of the World to export __________ and import __________.
a. Both goods; neither good
b. Shoes; automobiles
c. Automobiles; shoes
d. Neither good; both goods
ANSWER: B
35. Trade between the United States and the Rest of the World would lead to:
a. An improvement in economic well-being in the United States but deterioration in economic well-being in
the Rest of the World.
b. No change in economic well-being in the United States but an improvement in economic well-being in the
Rest of the World.
c. An improvement in economic well-being in both the United States and in the Rest of the World.
d. Deterioration in economic well-being in the United States but an improvement in economic well-being in
the Rest of the World.
ANSWER: C
Use the information below to answer questions 36 thru 38.
The following cost data is for the mythical land of Painduvin where they produce nothing but bread and wine using
only land and labor as inputs.
1 unit of Bread 1 unit of Cheese
Labor Input 5 dollars 20 dollars
Land Input 4 dollars 10 dollars
36. In Painduvin, bread is __________ and cheese is __________.
a. Labor-intensive; land-intensive
b. Land-intensive; labor-intensive
c. Labor-abundant; land-abundant
d. Land-abundant; labor-abundant
ANSWER: B
37. If Painduvin were land-abundant, the opening up of free trade would cause the price of bread relative to cheese to:
a. Rise.
b. Fall.
c. Stay the same.
d. Unable to answer with the information provided.
ANSWER: A
38. If Painduvin were land-abundant, the opening up of free trade would cause the production of bread to __________
and the production of cheese to __________.
a. Rise; rise
b. Rise; fall
c. Fall; fall
d. Fall; rise
ANSWER: B
Use the following information to answer questions 39 and 40.
Puglia has 15 thousand acres of land and 45 thousand laborers, whereas the Rest of the World has 100 thousand acres
of land 200 thousand laborers. These countries produce the labor intensive good A, and the land intensive good B.
39. Based on the above information, Pugelovia is relatively:
a. Labor-abundant.
b. Labor-intensive.
c. Land-abundant.
d. Land-intensive.
ANSWER: A
40. Based on the above information, Pugelovia will:
a. Not trade with the Rest of the World.
b. Export good B, and import good A.
c. Export good A, and import good B.
d. Import both good A and good B.
ANSWER: C
International Price = 1
C/W
41. Figure 4.2 illustrates the production possibilities curve of Pugelovia. This country can produce only wine and
cheese, and trade these products with the rest of the world. Pugelovias production possibilities curve indicates
that this country has __________ marginal costs of production.
a. Constant
b. Increasing
c. Decreasing
d. Progressive
ANSWER: B
42. Refer to Figure 4.2. Pugelovia imports:
a. 20 units of wine.
b. 20 units of cheese.
c. 50 units of wine.
d. 80 units of cheese.
ANSWER: B
43. Refer to Figure 4.2. Pugelovia exports:
a. 50 units of wine.
b. 50 units of cheese.
c. 30 units of wine.
d. 80 units of cheese.
ANSWER: B
True/False Questions
44. Increasing-cost production-possibility curves are bowed out from the origin.
ANSWER: TRUE
45. Increasing-cost production-possibility curves lead to partial specialization.
ANSWER: TRUE
46. In the two-country, two-good model, the opening of trade will necessarily lead to complete specialization in the
production of one good by one country and complete specialization in the production of the other good by the
other country.
ANSWER: FALSE
47. Increasing marginal costs of production arise as a result of the fact that different inputs to production are used in
different proportions in the production of different goods.
ANSWER: TRUE
48. As a country moves up along its bowed-out production possibility curve, the opportunity cost of producing more
of the good on the y-axis decreases.
ANSWER: FALSE
49. The production-possibility curve does not provide enough information to determine the amount of each good
produced by the economy.
ANSWER: TRUE
50. The comparison of the production-possibility curves of the two countries in the two-country, two-good model with
constant-cost production-possibility curves is sufficient to determine the specialization point, but insufficient to
determine the specialization point with increasing-cost production-possibility curves.
ANSWER: TRUE
51. Indifference curves show the various bundles of consumption quantities that lead to the same level of well-being.
ANSWER: TRUE
52. Heckscher-Ohlin theory relies upon the factor proportions used in the production of different goods and
differences in the endowments of different factors in different countries to explain international trade patterns.
ANSWER: TRUE
53. If the proportion of labor to capital in a country is greater than the proportion of labor to capital in the rest of the
world, we can conclude that the country is labor abundant and will have a comparative advantage in the
production of goods that use capital intensively.
ANSWER: FALSE
54. If Country A is relatively abundant in labor and Country B is relatively abundant in capital, Heckscher-Ohlins theory
predicts that Country A will export relatively labor-intensive goods and Country B will export relatively capital-
intensive goods.
ANSWER: TRUE
55. If Country A is relatively land-abundant and Country B is relatively labor-abundant, Heckscher-Ohlin theory predicts
that Country A will export textiles (a relatively labor-intensive good) and Country B will export corn (a relatively
land-intensive good).
ANSWER: FALSE
56. The Heckscher-Ohlin theory of trade differs from the Ricardian model by assuming that there are only two goods.
ANSWER: FALSE
57. In contrast to the Ricardian model, the Heckscher-Ohlin model assumes that production has increasing marginal
costs.
ANSWER: TRUE
58. The community indifference curves illustrate the technological capabilities of a country.
ANSWER: FALSE
59. The production possibilities curve illustrates the consumption preferences of a countrys population, and explains
why all people prefer to be employed rather than unemployed.
ANSWER: FALSE
60. According to the Heckscher-Ohlin model, countries will engage in trade only if they have different production
technologies.
ANSWER: FALSE
Essay Questions
61. Explain the differences between the two-country two-good model with constant costs of production and the model
with increasing costs of production. Adequately describe the production possibilities curves for each country in
each case. Describe production, consumption, and the degree of specialization in each country under both cost
situations.
POSSIBLE RESPONSE: If the cost of production of each good is constant, the opportunity cost of production of one
good (in terms of production foregone of the other good) is also constant. In an economy with constant cost of
production, the production possibilities curve (ppc) is a straight line. In such a situation it is beneficial for a country
to fully specialize in the production of one good, and export this good in exchange for imports of the other good.
The good that will be produced is the good with an opportunity cost that is lower than the relative international
price of this good (the price of the good expressed in units of the other good). Conversely, the good with an
opportunity cost higher than the international price will be imported. The result is complete specialization.
This reasoning is behind Ricardos idea of comparative advantage and complete specialization. Ricardo assumed
that all goods are produced with one factor of production labor, and in order to double the production of a
product, a producer just needs to double the amount of the input factor the labor hours. Realistically, however,
production requires a variety of factor inputs: land, skilled labor, unskilled labor, capital, etc., and different
products use factor inputs in different proportions. The basic variation of these inputs leads to an increasing cost of
production. That means the production possibilities curve is bowed out. In other words, the opportunity cost of
production of one good is not constant but rather increasing with the increased production of this good. When a
country is opened to trade only a partial specialization will be observed.
62. Explain why constant costs of production result in complete specialization and why increasing costs of production
result in partial specialization.
POSSIBLE RESPONSE: Constant cost of production implies constant opportunity cost, which is the amount of the
other good that must be foregone to increase the production of a certain good with one unit. If a good has a higher
opportunity cost compared to the relative international price of this good, then it is beneficial for a country to
produce the other good and export it in exchange for imports of this good. Because the opportunity cost does not
change with the increased production of the other good, it will be beneficial for the country to completely
specialize in the good with opportunity cost lower than the international price, and import the other good.
With increasing cost of production, the opportunity cost of a good is increasing with the increased production.
Optimally, the country will produce the two goods in such a proportion, that the opportunity cost is equal to the
international price ratio. With increasing opportunity cost this implies a partial specialization.
63. Is the following statement true or false and why? In the two-good, two-country model with increasing costs, the
degree of specialization is determined only by considering societys preferences as illustrated with indifference
curves. However, in the same model, it is possible to determine the post-trade consumption point in each country
without indifference curves.
POSSIBLE RESPONSE: The community indifference curves reflect the preferences of the countrys consumers for
consumption of both goods. With or without trade, the production decision of a country will depend on the
technology and the available factors of production (production possibilities curve), on the one hand, and the
preferences of the consumers toward the consumption of the two goods (indifference curves) on the other hand.
Without a free trade the consumption point coincides with the production. When international trade is allowed,
the consumption point does not coincide with the production point anymore, but reflects both production and
trade. It is not possible to determine post-trade consumption in each country without indifference curves as we
will not know which consumption point is preferred by the consumers in the country.
64. Assume a two-country, two-good, two-factor of production world with the countries being the United States and
the Rest of the World, the two goods being steel and wheat, and the two factors of production being capital and
land. Further assume that the United States is capital-abundant and steel production is capital-intensive. Suppose
that in autarky the United States operates at a point on its production possibilities curve where it produces 20 units
of wheat and 20 units of steel. Once international trade opens, the international price of one unit of steel is two
units of wheat. In response to the opening of trade the United States moves along its production possibilities curve
to a new point where it produces 30 units of steel and 10 units of wheat. Is the United States better-off following
the opening of trade? Provide a logical proof of your answer.
POSSIBLE RESPONSE: The opening of trade allows the United States to (partially) specialize in the production of
steel because steel is capital intensive and the United States is capital abundant. We need to compare the well-
being of the United States in the case of autarky to the case of free trade. In autarky the United States would
consume 20 units of steel and 20 units of wheat.
When free trade is allowed, the United States can extend the production of steel to 30 units, that is, by 10 units.
The foregone wheat is also 10 units; the production of wheat goes down from 20 to 10 units. But the United
States can exchange steel for wheat in the proportion 1 unit of steel for 2 units of wheat. If the United States would
sell the 10 more units of steel produced for 20 units of wheat, the United States would end up in a situation in
which it consumes 30 units of wheat and 20 units of steel. This is better than the autarky situation of only 20 units
of wheat and 20 units of steel. The country is thus better off in the case of free trade.
65. As a result of the North American Free Trade Agreement (NAFTA), trade restrictions between Canada, the United
States, and Mexicowere eased and cross-border trade increased. What predictions would the Heckscher-Ohlin
model make concerning the changes in labor-intensive industries such as textiles in both Mexico and the United
States and in capital-intensive-industries such as steel production in both Mexico and the United States as a result
of NAFTA?
POSSIBLE RESPONSE: The Heckscher-Ohlin model predicts that free trade will allow countries to specialize in the
production of goods that intensively use their relatively abundant factors of production. Applied to NAFTA, the
Heckscher-Ohlin model implies thatMexico will extend its production in industries such as textiles as they require
the intensive use of labor. The United States, on the other hand, will expand its production of steel, which is a
capital-intensive industry.
66. Explain how tastes or preferences can reverse the predictions made by the Heckscher-Ohlin trade model so that,
for example, labor-abundant countries import labor-intensive goods.
POSSIBLE RESPONSE: The production decision of a country depends not only on the available factors of production,
but also on the technology of the country, and the preferences of the consumers within the country. The
preferences of consumers of this country as well as other countries define the international demand for a product.
Conversely, factor availability, and technology define the international supply of a product. If consumers within a
country value labor-intensive goods so much that the marginal satisfaction of this product is higher than the
opportunity cost of production, then it possible that this country consumes more than their own production of
labor-intensive goods, which means the country is importing these goods from other countries.
67. Using the concepts of community indifference curves and production possibilities frontier, explain how the
international price of a good is determined in the Heckscher-Ohlin two goods model. What is the unit of
measurement for the price of a good in this model?
POSSIBLE RESPONSE: The production possibilities curve (ppc) illustrates the maximal quantities of two goods that a
country can produce with full employment of its resources. What combination of quantities along the ppc
producers will eventually decide to produce depends on the relative price of the good (the price is expressed in
units of the other good). A community indifference curve indicates all combinations of quantities of the two goods,
which provide the same satisfaction to the community. The ppc can be used to derive the marginal cost of a
product (expressed in units of the other product to be given up), which defines the supply of this product. The
system of indifference curves can be used to derive the demand of the product. The international price of a good in
the Hecksher-Olin model is determined in such a way, that the excess supply in one of the countries is matched by
the shortage (excess demand) in the other country. The first country exports the good in exchange for importing
the other good.
68. Explain why the Heckscher-Olin model predicts only partial specialization in the production of two goods, while
Ricardos comparative advantage model predicts full specialization.
POSSIBLE RESPONSE: Ricardo considered only labor as a production resource and believed that production has
constant costs. That is, to double production, the producer just needs to employ twice as much labor. The
opportunity cost in Ricardos model is constant, which implies that the production possibilities curve is a straight
line. Assume that a country faces a relative international price of a product that is, lets say, lower than the
opportunity cost of production of that product. That means, it is cheaper to buy that product at international
market in exchange for the other product rather than use their own labor for producing it. Their own labor will be
more efficiently employed in the production of the other product. Because the marginal cost is the same no matter
how much of both products is produced, the country specializes fully in the production of the product that has a
lower opportunity cost compared to the international price, and exchanges it for the other at the international
market.
This is the major difference to the Heckscher-Ohlin model. In this model, opportunity cost is increasing, so there
will be a certain quantity combination of the two goods along the production possibilities curve, for which
opportunity cost matches the relative (international) price. This is the optimal combination of production
quantities for the country.
Chapter 5 Who Gains and Who Loses from Trade?
57. What is intra-industry trade? Is intra-industry trade consistent with the predictions of the
Heckscher-Ohlin theory? Clearly explain why it is or is not consistent with Heckscher-Ohlin.
POSSIBLE RESPONSE: Intra industry trade is a trade in which a country both exports and imports
the same or a very similar product. Intra-industry trade is not generally consistent with the
Heckscher-Ohlin theory. The Heckscher-Ohlin theory predicts that countries will export goods that
extensively use their abundant resources and will import goods that extensively use their scarce
resource. The Heckscher-Ohlin theory is suited to explain trade between developing and
industrialized countries because they differ in their endowments of production resources. The
Heckscher-Ohlin theory fails to explain why we observe so much trade among industrialized
countries: 70% of the exports of industrialized countries go to other industrialized countries.
58. Explain the concept of scale economies. Explain the difference between internal and external scale
economies. What are the consequences of opening trade in those industries with substantial
external scale economies?
POSSIBLE RESPONSE: Scale economies are realized when the increase in output outpaces the
increase in the expenditures on all inputs in the production process. As an example, if we double
all input factors, with scale economies the output will more than double. As a consequence, the
average cost of production (cost per unit) will decline as output increases. Internal scale economies
are observed when the expansion of the size of the firm is the basis for the decline in its products
average cost. In contrast, external scale economies arise if the average cost of production declines
with an increase in the size of the entire industry within a specific geographic area.
The presence of substantial external scale economies in an industry typically leads to the clustering
of the production in specific geographical areas. Examples are the concentration of the banking
and finance industries in London and New York City, the production of stylish clothing, shoes and
accessories in Italy, watches in Switzerland, etc. External scale economies generally depend on the
size of the entire industry in the location. Which are the locations that will prosper is difficult to
predict and depends on factors such as domestic market size, history, government intervention,
etc.
Chapter 8 Analysis of a Tariff
Price
8. Referring to Figure 8.1, the impact of a tariff on shoes on the amount of domestic producer
surplus is a __________ measured by area __________.
a. Gain; a
b. Loss; a
c. Gain; (a+b)
d. Loss; (a+b)
ANSWER: A
9. Referring to Figure 8.1, the impact of a tariff on shoes on the amount of domestic consumer
surplus is a __________ measured by area __________.
a. Gain; d
b. Loss; d
c. loss; (a+b+c+d)
d. Loss; (b+d)
ANSWER: C
10. Referring to Figure 8.1, the revenue collected by the U.S. government as a result of the tariff on
shoes is shown by area __________.
a. a
b. a + b
c. c
d. b + c + d
ANSWER: C
11. Referring to Figure 8.1, the imposition of a tariff on shoes caused economic welfare in the U.S. to
__________ by an amount measured by area __________.
a. Fall; c
b. Fall; (b+d)
c. Fall; (b+c+d)
d. Rise; (a+c)
ANSWER: B
12. Referring to Figure 8.1, what area measures the production effect of the tariff on shoes?
a. a
b. b
c. c
d. d
ANSWER: B
13. Referring to Figure 8.1, what area measures the consumption effect of the tariff on shoes?
a. a
b. b
c. c
d. d
ANSWER: D
Figure 8.2: The U.S. Market for Computers
Price
$2,400
$2,000
14. Referring to Figure 8.2, under free-trade the U.S. imported __________ computers, but after
imposing a tariff the U.S. imported __________ computers.
a. 100,000; 70,000
b. 70,000; 100,000
c. 200,000; 190,000
d. 90,000; 100,000
ANSWER: A
15. Referring to Figure 8.2, the imposition of a tariff on computers caused producer surplus to
__________ by __________.
a. Rise; 20,000 computers
b. Rise; $44,000
c. Rise; $44 million
d. Fall; $48 million
ANSWER: C
16. Referring to Figure 8.2, the imposition of a tariff on computers caused consumer surplus to __________ by
__________.
a. Fall; 10,000 computers
b. Fall; $40,000
c. Rise; $76 million
d. Fall; $78 million
ANSWER: D
17. Referring to Figure 8.2, how much revenue will the U.S. government collect as a result of the tariff
on computers?
a. $400,000
b. $40 million
c. $28 million
d. $76 million
ANSWER: C
18. Referring to Figure 8.2, the imposition of a tariff on computers caused economic welfare in
theU.S. to __________ by __________.
a. Fall; 30,000 computers
b. Fall; $6 million
c. Rise; $34 million
d. Fall; $34 million
ANSWER: B
19. Referring to Figure 8.2, what is the production effect of the tariff on computers?
a. $48 million.
b. $4 million.
c. $28 million.
d. $44 million.
ANSWER: B
20. Referring to Figure 8.2, what is the consumption effect of the tariff on computers?
a. $2 million.
b. $4 million.
c. $76 million.
d. $78 million.
ANSWER: A
Use the following information to answer questions 21 thru 27.
A small country is considering imposing a $5 per bottle tariff on imported wine. Economists have
estimated the following figures based on this tariff amount:
World price of wine (free trade): $20
Domestic production (free trade): 500,000
Domestic production (after tariff): 600,000
Domestic consumption (free trade): 750,000
Domestic consumption (after tariff): 650,000
21. With no tariff on imported wine, the countrys imports __________ bottles of wine, but after
imposing the tariff the country will import __________ bottles of wine.
a. 100,000; 100,000
b. 250,000; 50,000
c. 150,000; 50,000
d. 750,000; 650,000
ANSWER: B
22. The imposition of the tariff on wine will cause domestic producer surplus to __________ by
__________:
a. Rise; 100,000 bottles
b. Rise; $500,000
c. Fall; $2.5 million
d. Rise; $2.75 million
ANSWER: D
23. The imposition of the tariff on wine will cause domestic consumer surplus to __________ by
__________:
a. Fall; 100,000 bottles
b. Fall; $250,000
c. Fall; $3.5 million
d. Rise; $3.5 million
ANSWER: C
24. The imposition of the tariff on wine will cause government tariff revenue to rise by how much?
a. $250,000
b. $1.25 million
c. $3.5 million
d. $500,000
ANSWER: A
25. The imposition of the tariff on wine will cause the countrys economic well-being to __________ by
__________.
a. Fall; $0.5 million
b. Rise; $0.75 million
c. Fall; 100,000 bottles of wine
d. Fall; $0.75 million
ANSWER: A
26. What would be the production effect of the tariff on wine?
a. $250,000
b. $500,000
c. $2.5 million
d. $2.75 million
ANSWER: A
27. What would be the consumption effect of the tariff on wine?
a. $250,000
b. $500,000
c. $3.5 million
d. $2.75 million
ANSWER: A
28. Which of the following is a change in the ratio of international prices of a large country's exports
to the international price of the large country's imports resulting from the imposition of a tariff in
the country?
a. One-dollar, one-vote.
b. Production effect.
c. Consumption effect.
d. Terms-of-trade effect.
ANSWER: D
29. Which of the following refers to the percentage by which a nation's trade barriers raise an
industry's value added per unit of output?
a. One-dollar, one-vote.
b. Optimal tariff.
c. Effective tariff.
d. Terms-of-trade effect.
ANSWER: C
30. Given the following information about domestic lamp production, what is the effective rate of
protection afforded to the domestic lamp industry by a 20% tariff on lamps?
With free trade:
Unit value (price) of a lamp = $175.00
Unit cost of lamp inputs = $100.00
With 20% tariff on lamps:
Unit value (price) of a lamp = $210.00
Unit cost of lamp inputs = $100.00
a. 20%
b. 46%
c. 110%
d. 102%
ANSWER: B
31. At free-trade prices, a tennis racquet sells for $100 and contains $40 worth of aluminum inputs and
$30 worth of plastic. In Country A, the nominal tariff rates are 40% on tennis racquets, 20% on
aluminum, and 10% on plastic. Given these rates, what is the effective rate of protection on racquets
in Country A?
a. 40%
b. 63%
c. 10%
d. 96%
ANSWER: D
32. Which of the following statements is accurate?
I. Tariffs are likely to decrease world economic well-being.
II. A tariff helps producers and hurts consumers in the country imposing the tariff.
III. A tariff always decreases economic domestic well-being if imposed in a small country and
may increase, decrease, or leave unchanged the economic well-being if imposed in a large
country.
a. I and II
b. I and III
c. II and III
d. I, II, and III
ANSWER: D
33. If a country with monopsony power imposes a tariff on imported farm equipment, the world price
of farm equipment will:
a. Fall.
b. Rise.
c. Be unaffected.
d. Become equal to the domestic price of farm equipment.
ANSWER: A
34. An optimal tariff is __________ the more __________ the foreign export supply.
a. Higher; elastic
b. Lower; rigid
c. Higher; inelastic
d. , ;&nbs, p; Lower; inelastic
ANSWER: C
35. A nation can gain from imposing a tariff if:
a. The tariff is a prohibitive tariff.
b. The tariff is an ad valorem tariff.
c. The tariff causes the world price to fall to such a degree that the amount of the tariff paid
by foreign exporters exceeds the losses caused by the production and consumption effects.
d. The tariff causes the tariff revenue collected by the domestic government to exceed the
losses caused by the production and consumption effects.
ANSWER: C
36. At free-trade prices, a bicycle sells for $100 and contains $90 worth of inputs. Country X has a
nominal tariff rate of 15% on bicycles, and 10% on the inputs. Given these rates, what is the effective
rate of protection of bicycles in Country X?
a. 10%
b. 60%
c. 5%
d. 15%
ANSWER: B
Use the following information to answer questions 37 thru 39.
With free trade, a big country produces 1 million bikes per year and imports another 2 million bikes per
year at the (world) price of $60 per bike. Assume that the country imposes a specific tariff of $5 per bike.
As a result, the world price of a bike decreases to $58; the import of bicycles drops down to 1.6 million
bikes; and the domestic production increases to 1.1 million bikes.
37. After the country imposes the tariff, domestic consumers are paying a price of __________ for a
bike.
a. $60
b. $70
c. $63
d. $65
ANSWER: C
38. As a result of the tariff, the government collects an amount of __________ million dollars in tax
revenue.
a. 2
b. 4
c. 6
d. 8
ANSWER: D
39. As a result of the imposed tariff:
a. The country gains national well-being because the tariff encourages production.
b. The country loses national well-being because the tariff hurts consumers.
c. The country loses national well-being because tariffs always lead to a welfare loss.
d. The country gains national well-being because the amount of the tariff revenue paid by the
exporting country more than offsets the consumption and the production effect.
ANSWER: D
40. The nationally optimal tariff is the tariff for which:
a. The production effect is equal to the consumption effect.
b. The government collects the highest revenue.
c. The highest difference between the government tariff revenue and the sum of consumption
and production effect is attained.
d. The highest difference between the part of the tariff revenue paid by the exporting country
and the welfare loss associated with the consumption and production effects is attained.
ANSWER: D
41. Which of the following has overseen the global rules of government policy toward international
trade since 1995?
a. World Trade Organization.
b. General Agreement on Tariffs and Trade.
c. International Monetary Fund.
d. World Bank.
ANSWER: A
True/False Questions
42. When a tariff is imposed, it is expected that domestic producers will raise their price to the same
level as the price of the imported product after the tariff is imposed.
ANSWER: TRUE
43. A tariff always lowers the well-being of each nation, including the nation imposing the tariff.
ANSWER: FALSE
44. A tariff imposed by a small country hurts the tariff imposing country but brings gains to the rest
of the world.
ANSWER: FALSE
45. The consumption effect shows the welfare loss to the economy resulting from consumers shifting
from imports to more expensive domestic production.
ANSWER: FALSE
46. The one-dollar, one-vote metric says that every dollar of gain is more important than every dollar
of loss, regardless of who the gainers or losers are.
ANSWER: FALSE
47. A nationally optimal tariff causes no production or consumption effects.
ANSWER: FALSE
48. The United Nations oversees global rules of government policy toward international trade.
ANSWER: FALSE
49. It is possible for a large country to be better off, worse off, or no better off/no worse off as a result
of a tariff being imposed.
ANSWER: TRUE
50. For a small country, the consumption effect plus the production effect represent the loss in
economic welfare that results from the imposition of the tariff.
ANSWER: TRUE
51. Monopsony power is a change in the ratio of international prices of a large country's exports to
the international price of the large country's imports resulting from the imposition of a tariff by
the country.
ANSWER: FALSE
52. A nationally optimal tariff is a tariff that creates the largest net gain for the country imposing it.
ANSWER: TRUE
53. Within a country, a tariff causes a redistribution of well being between domestic producers and
the government only.
ANSWER: FALSE
54. A small country always stands to lose by imposing a tariff because the tariff will not have an
impact on its terms of trade.
ANSWER: TRUE
55. The effective rate of protection of a product measures how a countrys entire set of trade barriers
affects the value added per unit of output of this product.
ANSWER: TRUE
56. An ad valorem tariff is formulated as a money amount per unit of import that is due when the
good reaches the importing country.
ANSWER: FALSE
57. The production effect measures the welfare gain of domestic producers which can sell their
product at a higher price as a result of the imposed tariff.
ANSWER: FALSE
Essay Questions
58. Suppose that the world price of automobiles is $20,000 and domestic producers of automobiles use
$10,000 worth of imported inputs and no domestic inputs. What is the effective rate of protection in
the domestic automobile industry if there is a 25% tariff on imported automobiles and a 50% tariff
on imported inputs?
POSSIBLE RESPONSE: The effective rate of protection for an industry is measured as the
percentage change in the unit value added which results from all protective measures on inputs and
the final good. With free trade, the value added for an automobile is $20,000-$10,000=$10,000. With a
25% tariff on imported automobiles, the new price for an automobile rises to $25,000. Accounting for
the tariff on imported inputs, the new value of the inputs is $15,000. The new value added for an
automobile is $25,000-$15,000=$10,000. The effective rate of protection is then ($10,000-
$10,000)/$10,000=0%.
59. Compare and contrast the effects of a tariff on prices and national well-being imposed in a small
country with the effects of a tariff imposed in a large country. Be sure to include carefully drawn
graphs.
POSSIBLE RESPONSE:
Tariff by a small country
Tariff by a large country
A tariff imposed by a small country will not have an impact on the world price of the good. That
is, the domestic price will rise by the amount of the tariff. A small country cannot gain by
imposing a tariff. The welfare loss resulting from the tariff is measured by the sum of the
production effect (area b) and the consumption effect (area d). As a result of the tariff, consumers
lose the area (a+b+c+d), producers gain area (a), and the government collects the area (c) in tariff
revenues.
A tariff imposed by a large country will have an effect on the world price. As shown in the second
graph, the world price will decrease once the tariff is imposed. The resulting effects on consumers
and producers will essentially be the same as the above described effects. The difference
(compared to the case of a small country) is the area (e) which measures the portion of the
government tariff revenues that are effectively paid by foreigners. The burden of this part of the
government tariff revenues is carried by the foreign producers who now export to the country at a
lower price. Whether a large country eventually gains or loses from the tariff depends on whether
the gained area (e) is larger or smaller than the welfare loss associated with the area (b+d).
60. You are given the following information about copper in the United States:
Situation Situation
With Tariff Without Tariff
World Price $0.40 per lb. $0.50 per lb.
Tariff (specific) $0.20 per lb. 0
U.S. Domestic Price $0.60 per lb. $0.50 per lb.
U.S. Consumption 210 million lb. 250 million lb.
U.S. Production 140 million lb. 100 million lb.
a. Calculate the loss to U.S. consumers of copper from imposing the tariff.
b. Calculate the gain to U.S. producers of copper from imposing the tariff.
c. Calculate the gain in tariff revenue to the U.S. government from imposing the tariff.
d. Calculate the net gain or loss to the U.S. economy as a whole from imposing the tariff.
POSSIBLE RESPONSE:
a. As a result of the tariff the domestic price rises by $0.10 (from $0.50 to $0.60) per pound.
Consumers consume 250-210=40 million pounds less. The consumption effect is x $0.10 x 40
million = $2 million. Consumers lose additionally $0.10 x 210 million = $21 million due to the
higher price they pay for their consumption after the tariff is imposed. They lose a total of $23
million.
b. U.S. producers charge $0.10 more per pound and expand their production by 40 million pounds.
Their gain of producer surplus from expanding the production quantity is x $0.10 x 40 million=
$2 million. Their gain from selling the production quantity they used to sell before the tariff now
at a $0.10 higher price is 100 million x $0.10=$10 million. Their gain totals $12 million.
c. The tariff revenue to the U.S. government equals the product of the imported quantity and the
tariff per unit. After imposing the tariff the U.S. imports 210-140=70 million pounds.
The U.S.revenue is $0.20 x 70 million= $14 million.
d. The net gain of the U.S. as a whole is $14 million in government revenue minus $23 million in
consumer loss, plus $12 million in producer gain, which equals $3 million.
61. A country can actually improve its well being if it is in a position to implement an optimal tariff.
Explain what an optimal tariff is, what conditions must be in place in order to implement an
optimal tariff, and how such a tariff will increase national welfare. Assuming your country could
implement an optimal tariff, would you suggest it do so? Why or why not?
POSSIBLE RESPONSE: An optimal tariff is a tariff which maximizes the welfare of a country as
measured by the gain in tariff revenue that is essentially paid by foreigners to the government
minus the loss associated with the consumption and production effects arising from the tariff. A
country can gain by a tariff only if it is large enough to have an impact on the international price
of the product. By imposing a tariff the country can improve its terms of trade, and may
experience a net gain. One needs to exert caution when advising government officials on the
implementation of a tariff. Such a decision should incorporate the eventuality that importing
countries retaliate by imposing trade restrictions on your countrys exports.
62. The higher the tariff, the more domestic production is increased. Thus, a prohibitive tariff is socially
optimal. Comment on this statement drawing on all you have learned in the course up to now.
POSSIBLE RESPONSE: The statement is based on the (false) premise that more domestic
production is better than less. Also, the statement fails to account for the well-being of other agents
in the economy who are not producers: the consumers who are interested in a lower price of the
good, and the government, which is collecting revenue. Let us focus first on the decision of
producers. It is true that the higher the tariff the higher the quantity supplied by domestic
producers. However, for the society as a whole this production might be too costly. It involves
valuable resources that can have a better use in other industries. The loss associated with such an
inefficient production is the production effect.
A prohibitive tariff will definitely be to the disadvantage of consumers because the consumers will
not be able to consume imports at all. The consumption effect is the loss for consumers who buy
less of the product. For the government, a prohibitive tariff generates no government revenues as
there will be no imports of the good.
63. When a small country imposes a tariff, the domestic price of the good increases. This causes a
production and a consumption effect. Explain carefully these two effects, and discuss whether
they increase or decrease the countrys well-being.
POSSIBLE RESPONSE: Small countries cannot affect the international prices of goods when they
impose tariffs or other trade barriers. If a small country imposes a tariff, the domestic price of the
product increases by the size of the tariff. This will have an effect on the decisions of domestic
producers and consumers.
Producers will start to produce more because they can now sell the product domestically at a
higher price. Although producers stand to gain, this gain is at the expense of consumers who are
paying a higher price. From the viewpoint of the society as a whole, this increase of production is a
loss. The increased production costs more resources to make at home than to import from abroad.
This loss is called the production effect.
Consumers will start to consume less of the product due to its higher price although they value the
product more than its international price (without the tariff). This is the source of the
consumption effect, which is again a loss for the country.
Chapter 9 Nontariff Barriers to Imports
Price
$90
$80
8. Referring to Figure 9.1, what is the amount allowed in the quota on MP3 players?
a. 2 million MP3 players.
b. 5 million MP3 players.
c. 12 million MP3 players.
d. 17 million MP3 players.
ANSWER: B
9. Referring to Figure 9.1, the quota on MP3 players will cause domestic producers to:
a. Gain $10 million.
b. Lose $10 million.
c. Gain $110 million.
d. Gain $120 million.
ANSWER: C
10. Referring to Figure 9.1, the quota on MP3 players will cause domestic consumers to:
a. Lose $25 million.
b. Gain $25 million.
c. Lose $170 million.
d. Lose $195 million.
ANSWER: D
11. Referring to Figure 9.1, with a competitive auction, how much revenue can the government expect
to receive?
a. $20 million.
b. $50 million.
c. $120 million.
d. $170 million.
ANSWER: B
12. Referring to Figure 9.1, given that a competitive auction is used by the government to allocate
import licenses, the quota on MP3 players will cause a __________ to the nation of __________.
a. Loss; $35 million
b. Loss; $85 million
c. Gain; $35 million
d. Loss; $195 million
ANSWER: A
13. Referring to Figure 9.1, if import licenses are allocated based on a resource-using application
procedure, the loss to the economy will be:
a. $35 million.
b. $50 million.
c. $85 million.
d. $195 million.
ANSWER: C
14. Referring to Figure 9.1, if instead of using a quota to limit imports they were limited by a
voluntary export restraint (VER), the loss to the nation would be:
a. $35 million.
b. $50 million.
c. $85 million.
d. $195 million.
ANSWER: C
15. A small country imports T-shirts. With free trade at a world price of $10, domestic production is
10 million T-shirts and domestic consumption is 42 million T-shirts. The countrys government
now decides to impose a quota to limit T-shirt imports to 20 million per year. With the import
quota in place, the domestic price rises to $12 per T-shirt and domestic production rises to 15
million T-shirts per year. This quota on T-shirts causes domestic producers to:
a. Gain $5 million.
b. Lose $5 million.
c. Gain $25 million.
d. Gain $30 million.
ANSWER: C
16. A small country imports T-shirts. With free trade at a world price of $10, domestic production is
10 million T-shirts and domestic consumption is 42 million T-shirts. The countrys government
now decides to impose a quota to limit T-shirt imports to 20 million per year. With the import
quota in place, the domestic price rises to $12 per T-shirt and domestic production rises to 15
million T-shirts per year. This quota on T-shirts causes domestic consumers to:
a. Gain $7 million.
b. Lose $7 million.
c. Lose $70 million.
d. Lose $77 million.
ANSWER: D
17. A small country imports T-shirts. With free trade at a world price of $10, domestic production is
10 million T-shirts and domestic consumption is 42 million T-shirts. The countrys government
now decides to impose a quota to limit T-shirt imports to 20 million per year. With the import
quota in place, the domestic price rises to $12 per T-shirt and domestic production rises to 15
million T-shirts per year. If the government uses a competitive auction to allocate import licenses,
it will collect approximately how much in revenue?
a. $40 million.
<, ;, P class=MsoNormal style="MARGIN-LEFT: 54pt; TEXT-INDENT: -18pt; tab-stops: list 54.0pt; mso-list: l7 level2
lfo1">b. $70 million.
c. $200 million.
d. $240 million.
ANSWER: A
18. A small country imports T-shirts. With free trade at a world price of $10, domestic production is
10 million T-shirts and domestic consumption is 42 million T-shirts. The countrys government
now decides to impose a quota to limit T-shirt imports to 20 million per year. With the import
quota in place, the domestic price rises to $12 per T-shirt and domestic production rises to 15
million T-shirts per year. This quota on T-shirts causes a __________ to the nation in the amount
of __________.
a. Gain; $40 million
b. Loss; $12 million
c. Gain; $65 million
d. Loss; $5 million
ANSWER: B
19. A small country imports T-shirts. With free trade at a world price of $10, domestic production is
10 million T-shirts and domestic consumption is 42 million T-shirts. The countrys government
now decides to impose a quota to limit T-shirt imports to 20 million per year. With the import
quota in place, the domestic price rises to $12 per T-shirt and domestic production rises to 15
million T-shirts per year. If import licenses are allocated based on fixed favoritism, how much will
be gained by the holders of the import licenses?
a. $40 million.
b. $70 million.
c. $200 million.
d. $240 million.
ANSWER: A
20. A small country imports T-shirts. With free trade at a world price of $10, domestic production is
10 million T-shirts and domestic consumption is 42 million T-shirts. The countrys government, in
an attempt to protect domestic T-shirt producers, pressures foreign exporters to voluntarily
restrict their exports of T-shirts to 20 million T-shirts per year. With the VER in place, the
domestic price rises to $12 per T-shirt and domestic production rises to 15 million T-shirts per
year. How much does the importing nation lose as a result of this VER?
a. $12 million.
b. $20 million.
c. $52 million.
d. $240 million.
ANSWER: C
21. A domestic monopoly would rather be protected with a quota than with a tariff because:
a. The deadweight loss will be smaller with a quota.
b. The monopolist can collect more from selling import licenses than it can from a tariff.
c. A quota is more efficient and thus lowers the cost s of the monopolist.
d. A quota allows the firm to assert its monopoly power.
ANSWER: D
22. An import quota is worse than a tariff under which of the following cases?
I. If the quota licenses are allocated through resource using application procedures.
II. If a dominant domestic firm can use the quota to assert its monopoly pricing
power.
III. If the domestic industry in the importing country is highly competitive.
a. I only
b. II only
c. I and II
d. I and III
ANSWER: C
23. The least efficient method a government can use in allocating import licenses is:
a. Fixed favoritism.
b. A competitive auction.
c. Resource-using application procedures.
d. A free lottery.
ANSWER: C
24. When a large country imposes an import quota:
a. World prices rise.
b. World prices fall.
c. Domestic prices fall.
d. Domestic production falls.
ANSWER: B
Figure 9.2: The. Market for Mopeds in a Large Country
(a) The national market for Mopeds
Price
$800
$750
$715
Price
$800
$750
$715
25. Referring to Figure 9.2, the illustrated quota on imported mopeds will cause domestic moped
producers to gain:
a. $2.5 million.
b. $27.5 million.
c. $42.5 million.
d. $80 million.
ANSWER: B
26. Referring to Figure 9.2, the illustrated quota on imported mopeds will cause domestic moped
consumers to lose:
a. $7.5 million.
b. $21.25 million.
c. $82.5 million.
d. $97.75 million.
ANSWER: C
27. Referring to Figure 9.2, if the government allocated import licenses using a competitive auction,
the government will gain how much in license revenue?
a. $31.5 million.
b. $45 million.
c. $76.5 million.
d. $720 million.
ANSWER: C
28. Referring to Figure 9.2, the illustrated quota on imported mopeds will cause the importing nation
to:
a. Lose $10 million.
b. Lose $29.75 million.
c. Gain $31.5 million.
d. Gain $21.5 million.
ANSWER: D
29. Referring to Figure 9.2, the illustrated quota on imported mopeds will cause the world to lose:
a. $7 million.
b. $10 million.
c. $17 million.
d. $31.5 million.
ANSWER: A
30. A voluntary export restraint (VER):
a. Ensures foreign exporting firms are unable to exercise monopoly power.
b. Usually requires the foreign exporting firms act like a cartel, restricting sales and raising
prices.
c. Raises more revenue for the government than a tariff or quota.
d. Lowers world prices.
ANSWER: B
31. With a voluntary export restraint (VER), the economic rent created by the quantitative limit on
trade is collected by:
a. The government of the importing county.
b. Consumers in the importing country.
c. Producers in the importing country.
d. Exporting firms in the exporting country.
ANSWER: D
32. Suppose a country sets all of its tariffs at 40% which causes a reduction in imports of 20%. If the
total imports affected by the tariffs are 40% of GDP, the net national loss from the tariffs as a
percentage of GDP is:
a. 1.6%.
b. 8%.
c. 16%.
d. 160%.
ANSWER: A
33. Which of the following allows the pre, sident of t, he United States to negotiate to eliminate unfair
trade practices put in place by foreign governments?
a. World Trade Organization.
b. General Agreement on Tariffs and Trade.
c. Section 301.
d. United Nations.
ANSWER: C
34. Which of the following is an effect of the Uruguay Round?
I. The Uruguay Round included provisions for future negotiations to liberalize trade in
services.
II. The Uruguay Round included agreement requiring member countries to protect intellectual
property.
III. The Uruguay Round included the conversion of import quotas in agricultural products to
import tariffs.
a. I
b. I and II
c. II and III
d. I, II, and III
ANSWER: D
35. The cost of protection as a percentage of GDP is often calculated by the following formula:
Price
800
750
(b) The marginal benefits from domestic moped production
Marginal Benefit
$140
$125
16. Refer to Figure 10.1 and assume that a $50 per unit tariff is imposed on imported mopeds. What is
the production effect caused by the tariff?
a. $14 million.
b. $2.5 million.
c. $5 million.
d. $7.5 million.
ANSWER: B
17. Refer to Figure 10.1 and assume that a $50 per unit tariff is imposed on imported mopeds. What is
the consumption effect caused by the tariff?
a. $14 million.
b. $2.5 million.
c. $5 million.
d. $7.5 million.
ANSWER: C
18. Referring to Figure 10.1, if a $50 per unit tariff on imported mopeds were imposed, the marginal
benefit to the nation of the increased production of moped is:
a. $14 million.
b. $2.5 million.
c. $5 million.
d. $7.5 million.
ANSWER: A
19. Referring to Figure 10.1, if a $50 per unit tariff on imported mopeds were imposed, the overall
impact on the nation would be:
a. A gain of $14 million.
b. A loss of $21.5 million.
c. A gain of $6.5 million.
d. A loss of $7.5 million.
ANSWER: C
20. Referring to Figure 10.1, if a $50 per unit subsidy was given to domestic producers of mopeds,
production would increase by:
a. 100,000 units.
b. 500,000 units.
c. 600,000 units.
d. 1.2 million units.
ANSWER: A
21. Referring to Figure 10.1, if a $50 per unit subsidy was given to domestic producers of mopeds,
consumption of mopeds would fall by:
a. 100,000 units.
b. 200,000 units.
c. 600,000 units.
d. Consumption would not change as a result of the subsidy.
ANSWER: D
22. Referring to Figure 10.1, in comparing a $50 per unit tariff on imported mopeds with a $50 per
unit subsidy on domestic production of mopeds, we can conclude that the nation is __________
better-off with a __________.
a. $2.5 million; tariff
b. $2.5 million; subsidy
c. $14 million; subsidy
d. $7.5 million; subsidy
ANSWER: B
23. Which of the following arguments for protection postures that temporary protection is needed for
an industry with initially high costs and lower costs in the long run?
a. The developing government argument.
b. The infant industry argument.
c. The dying industry argument.
d. The national defense argument.
ANSWER: B
24. Subsidies mean that infant industry firms can likely charge:
a. Higher prices while competing with foreign firms.
b. Higher prices than foreign firms are able to receive.
c. A price equal to the world price and still earn a profit.
d. The foreign tariff to other customers of the foreign firm.
ANSWER: C
25. Which of the following distortions makes the infant industry argument for protection valid?
a. Imperfections in developing financial markets might mean that banks and other
institutions are unwilling to provide funding to firms in an infant industry.
b. The benefits from the early business investments do not accrue to the firms making these
early investments.
c. Young firms that produce important military hardware cannot be established without
government support.
d. Both (a) and (b).
ANSWER: D
26. Which of the following statements is true?
I. If young firms are struggling to obtain funding from underdeveloped financial markets, the
most efficient policy solution would be a production subsidy.
II. If young firms are struggling to retain their trained workers, then government should offer
a subsidy to offset the costs of training workers.
III. Infant industry tariffs are less likely to be removed than infant industry subsidies.
a. I only
b. I and II
c. II and III
d. II only
ANSWER: C
27. Which of the following arguments for protection states that import-competing firms that are
struggling to stay in business should be provided protection in order to maintain jobs and continue
domestic production?
a. The developing government argument.
b. The infant industry argument.
c. The dying industry argument.
d. The national defense argument.
ANSWER: C
28. Which of the following statements is true?
I. In a first-best world, import-competing firms that were struggling to stay in business would
be allowed to go out of business and workers would find jobs in other industries.
II. In a second-best world, the most efficient way for government to correct for workers being
displaced when industries die being unable to find jobs in the resulting congested labor
markets is to provide subsidies for those workers to move to areas where there are jobs.
III. In a second-best world, if workers do not have the skills for new jobs after they lose their jobs
in dying import-competing industries, the most efficient government policy would be subsidies
to pay for retraining those displaced workers.
a. I and II
b. I and III
c. II and III
d. I, II, and III
ANSWER: D
29. In the U.S., trade adjustment assistance:
a. Will provide workers who have been displaced from import-competing firms with an
additional 12 to 18 months of unemployment compensation as well as being eligible for
retraining programs and subsidies for job search and moving costs.
b. Is optimal in both a first-best and second-best environment.
c. Provides incentives for workers to search for new jobs outside the import-competing
industry prior to them losing their jobs in the import-competing industry.
d. All of the above.
ANSWER: A
30. Tariffs imposed by a developing country:
a. May benefit the country because they represent an efficient mechanism for collecting
revenue, but are unlikely to benefit the rest of the world.
b. Can benefit both the country and the rest of the world by creating net social gains. Such
tariffs likely represent the most efficient means of government revenue for a country with
limited means of collecting income or sales taxes.
c. Will be as inefficient as tariffs imposed by developed countries.
d. Are likely to represent only a very small fraction of government revenues because the
volume of imports to developing countries is relatively small.
ANSWER: B
31. Which of the following arguments for protection derives from the fact that funding of public goods
in some countries is difficult given little or no means to collect income or sales taxes?
a. The developing government argument.
b. The infant industry argument.
c. The dying industry argument.
d. The national defense argument.
ANSWER: A
32. The French highly value domestic production of traditional French cheeses made by high-cost,
traditional production methods. The most efficient policy tool to protect this traditional industry
in a second-best world would be:
a. A production subsidy.
b. An import tariff on cheeses produced outside of France.
c. An import ban on cheeses produced outside of France.
d. Free trade since no protectionist policy would be efficient in a second-best world.
ANSWER: A
33. The United States produces some of the electronic components for use in its fighter planes, but due
to the limited number of companies that produce these items it is forced to import these parts
from Japan as well. There is concern that in the case of a prolonged war, these important imports
may not be available. Fearing that the air force may be unable to fulfill its tasks in the case of a
long war, the United States should:
a. Ban the importation of these electronics parts in order to ensure the vitality of the
domestic means of electronics production.
b. Impose tariffs on the imports of these electronic parts.
c. Subsidize the domestic production of these electronics parts.
d. Tax private consumers of these electronics parts.
ANSWER: C
34. Direct democracy makes tariffs less likely to be voted into law because:
a. The size of the individual losses to each voter would be larger than the individual losses to
each of the winners from any potential protectionist measure.
b. The majority of voters recognizes that tariffs are inefficient and therefore would vote for a
production subsidy instead of an import tariff.
c. Free riders would ensure that everyone got to the polls to vote.
d. The number of people who are hurt by protectionist measures exceeds the number of
people who gain from protectionist measures.
ANSWER: D
35. Tariffs are more likely to be imposed when:
a. Voters in the country are asked to make the determination.
b. The average gain per proponent far exceeds the average cost per opponent and the costs of
lobbying policy makers are high.
c. The number of people who are hurt by protectionist measures exceeds the number of
people who gain from protectionist measures and those who are harmed are highly
organized.
d. Import-competing producers are unorganized.
ANSWER: B
36. According to the specificity rule:
a. Tariffs should be placed only on specific products.
b. Government policy should target as closely as possible the source of the distortion that
separates private and social benefits (or costs).
c. The tariff favors only specific interest groups within a country.
d. Only specific industries are allowed to participate in government lobbying.
ANSWER: B
37. Instead of placing a tariff on the imports of steel, a government has decided to offer steel workers
a trade adjustment assistance which will allow them to prequalify. Such a policy is consistent with:
a. The dying industry argument.
b. The specificity rule.
c. The infant industry argument.
d. The national pride argument.
ANSWER: B
38. Tariff rates are typically higher on final consumption goods than on intermediate goods and raw
materials sold to producing firms. This tendency is known as:
a. The tariff escalation pattern.
b. The free rider problem.
c. The democratic vote problem.
d. The second-best world.
ANSWER: A
39. The tax-or-subsidy approach for solving externality problems was developed by:
a. Arthur Pigou
b. Ronald Coase
c. Eli Heckscher
d. Bertil Ohlin
ANSWER: A
40. Tariffs are more likely to be imposed when:
a. Consumers can act together and eliminate the free-rider problem.
b. Producers are a dispersed group and are unable to define their joint interests.
c. Producers are a well-organized group with substantial resources to use for political
lobbying.
d. The government is corrupt.
ANSWER: C
True/False Questions
41. Free trade is economically efficient in a first-best world.
ANSWER: TRUE
42. In a first-best world, price, marginal benefit, marginal cost, marginal social benefit, and marginal
social cost are all equal at the margin.
ANSWER: TRUE
43. While trade restrictions do provide gains to certain segments in the economy, such restrictions will
always be a net negative for the nation as a whole.
ANSWER: FALSE
44. If Social marginal cost (SMC) > Price (P) = Buyers private marginal benefit (MB) = Sellers
private marginal cost (MC) = Social marginal benefit (SMB) too little is supplied.
ANSWER: FALSE
45. In the absence of any other distortion, a tariff will create a distortion, but a government subsidy
will not create a distortion.
ANSWER: FALSE
46. The specificity rule states that the most efficient way to correct a distortion is to use a government
policy tool that is directed at the source of the distortion.
ANSWER: TRUE
47. If additional domestic production will lead to positive spillover effects, then an import tariff aimed
at increasing domestic production would better adhere to the specificity rule than a government
subsidy aimed at increasing domestic production.
ANSWER: FALSE
48. Government loans are more efficient than production subsidies if a young industry faces financial
markets that are unwilling to provide funding to the industry due to the high risk.
ANSWER: TRUE
49. Import tariffs are efficient second-best policy solutions for many developing countries where
government revenue is difficult to obtain by other means such as an income or sales tax.
ANSWER: TRUE
50. In a representative democracy, it is likely that consumers will be able to keep protectionist
measures from becoming law because consumers have more to lose and they are a larger group
than the potential winners from any protectionist measure.
ANSWER: FALSE
51. The national defense argument justifies the use of import barriers on goods that would be
important in the case of a military emergency.
ANSWER: TRUE
52. Arthur Pigou put forward the idea that positive and negative externalities can be resolved by
creating new private property institutions.
ANSWER: FALSE
53. External effects arise because there is a misalignment between private and social benefits or costs.
ANSWER: TRUE
54. The dying industry argument suggests that industries in decline should not be protected because
they cannot contribute to a countrys prosperity anymore.
ANSWER: FALSE
55. Tariffs and quotas are one-size-fits-all measures that always work as a tool to internalize external
effects.
ANSWER: FALSE
Essay Questions
56. Studies based on 1990 data show that in the United States, consumers paid an average of about
$169,000 per job per year maintained by import protection. Given that these employees earned much
less than $169,000 per year, it would be much cheaper to simply pay these workers not to work and
impose no import restrictions. How can you explain the logic of maintaining such restrictions?
POSSIBLE RESPONSE: The findings of the study are consistent with the idea that the cost of
protection often exceeds the benefit, and overall a country loses from import restrictions. Among the
losers are the final consumers, and among the gainers are the firms and the workers in the protected
industries. Import restrictions are often imposed by politicians under the pressure of lobbying
groups. Producer groups are more effective than consumer groups when it comes to political
lobbying. The producer groups are small and concentrated groups which can better solve the free
rider problem. Consumer groups, in contrast, are large, anonymous, and dispersed groups that are
unable to effectively resolve the free rider problem within the group. Therefore, politicians who
answer to well-organized import-competing producer groups are more likely to use restrictions to
trade although this is not beneficial to the well-being of the country as a whole
57. The United States has recently begun building a new type of flat panel 3-dimensional television
(FP3D). Unfortunately for U.S. producers, Japanese firms have been producing FP3Ds longer
than U.S. firms so they are more efficient and more competitive. Should the United States impose
temporary protection in the form of a tariff on this product to protect the domestic industry until
it is competitive with Japanese producers? Why or why not?
POSSIBLE RESPONSE: This question is about the infant industry argument for protection. The
infant industry argument asserts that a protection is justified temporarily until domestic
producers learn how to produce at low enough cost, and eventually be able to compete without a
tariff. To be able to answer the question the government should compare the future producer
surplus to the cost to consumers while the tariff is in place. The problem for the government is in
assessing whether the U.S. producers will eventually become so efficient that they are able to
compete internationally and realize surpluses.
According to the infant industry argument firms make losses when they begin operation and then
become profitable later on. But isnt this a feature that describes almost every business? Is a
protection at all needed?
The protection would be the right choice under two circumstances. One would be the circumstance
in which there are imperfections in the financial markets and firms do not have access to financial
capital. U.S. firms are unlikely to suffer from this problem as the U.S. has well-developed financial
markets. The second circumstance would be the case in which the early business investments
accrue to the firms making these investments. Again, this is unlikely to happen in the U.S. due to
the well development patent laws. Should this be a concern, there will be a case for a temporary
industry protection.
58. Suppose Russia can produce automobiles relatively cheaply, but they have poor gas mileage and
create a great deal of air pollution. The U.S. government, concerned about the quality of air,
would like to see fewer Russian automobiles and more cleaner-running American automobiles on
the road.
a. What is the nature of the market failure that would justify the U.S. government taking
some action against the importation of Russian automobiles?
POSSIBLE RESPONSE: The market failure in this case is a negative external effect that
arises because of the air pollution. There is misalignment between the marginal private cost
of the individual consumer who purchases a Russian car, and the marginal social cost (the
damage) from air pollution. In the presence of such external cost, U.S. government action is
warranted.
b. Explain why imposing a tariff is a second best policy to employ in this case and what policy
choice would be more efficient.
POSSIBLE RESPONSE: Imposing a tariff has to reduce the number of Russian cars on the
streets down to the efficient number for which the marginal social benefit equals the
marginal cost of a car. As an alternative to a tariff, the government can use a tax or a
subsidy. The tax-or-subsidy approach requires the identifying of distortions in peoples and
firms private incentives and the designing of a policy that corrects for these incentives by
levying taxes or giving subsidies. In the particular example, the government should impose
a tax on air pollution. That means, car drivers who drive Russian cars should pay a tax that
is commensurate to the damage to the society they cause due to the air pollution.
59. What is the dying industry argument for establishing barriers to, imports? What are, its merits
and weaknesses? What measure(s) are more efficient than an import tariff if the intention is to
help workers who would be displaced from a dying industry? Why? What measure(s) are more
efficient than an import tariff if maintaining current production levels is the intention of
government policy?
POSSIBLE RESPONSE: The dying industry argument is based on the assertion that production
resources such as workers, managers, capital and land cannot quickly be reemployed to other
uses. Especially for workers there are significant extra costs associated with their prequalification
should they be forced to switch to jobs in other industries. Because this transition cannot take
place smoothly, there is a case for government intervention in industries which lose their
competitiveness to foreign producers. A temporary trade barrier that keeps these jobs can serve as
a protection of the economy from unemployment. It helps prevent the job market from
congestion, the situation in which many workers do not have the skills that match the available
jobs. There might be circumstances in which government protection indeed causes less damage
than just keeping the resources idle.
Using a tariff on imports is not the most efficient measure for a government. According to the
specificity rule, the government should use policies that target as directly as possible the source of
distortion. If the goal of the government is to help workers, the government should use policies
such as trade adjustment assistance which smooth workers transition to other occupations. The
trade adjustment assistance provides workers with an unemployment compensation that gives
them income during the time they need to acquire the skills to be successful in their new
employment. If the country is just interested in keeping the current production level, the country
can grant subsidies to producers. This measure will bring down the cost of domestic production,
and will prevent the crowding out of domestic products by cheaper imports.
60. Give as many scenarios as you can in which it is good to protect domestic production for a nation
as a whole (not just for workers and firms receiving protection). Explain why your arguments are
valid in a second best world.
POSSIBLE RESPONSE: The case for protection can be made when there is a discrepancy
between social and private benefits or cost from an activity. If this activity is a domestic
production of a good, there is a case for protecting the domestic producers. Protection of domestic
production might be desirable in situations in which domestic production creates positive external
effects such as the following:
The production in one industry creates know-how or management techniques that can be
used in other industries.
Workers in the industry are acquiring skills and attitudes that can be useful in other
industries.
The country and its citizens can take pride from producing the product locally, or the
product is essential to national defense.
Protecting domestic production can also be beneficial in the following circumstances:
It is expected that firms in the industry can lower their costs over time.
Workers face high cost if they are forced to switch to a job in a different industry.
Chapter 11 Pushing Exports
$180
$160
12. Referring to Figure 11.1, with free trade and a world price of $160 per ton, the United States
produced __________ tons of grain, consumed __________ tons of grain, and exported __________
tons of grain.
a. 60; 120; 60
b. 60; 120; 120
c. 120; 60; 60
d. 120; 40; 60
ANSWER: C
13. Referring to Figure 11.1, following the imposition of a $20 per ton export subsidy on U.S. grain
exports, the United States produced __________ tons of grain, consumed __________ tons of grain,
and exported __________ tons of grain.
a. 150; 40; 110
b. 150; 60; 110
c. 60; 40; 150
d. 100; 40; 120
ANSWER: A
14. Referring to Figure 11.1, the production effect of the subsidy is:
a. $200 million.
b. $300 million.
c. $1 billion.
d. $2.2 billion.
ANSWER: B
15. Referring to Figure 11.1, the consumption effect of the subsidy is:
a. $200 million.
b. $300 million.
c. $1 billion.
d. $2.2 billion.
ANSWER: A
16. Referring to Figure 11.1, the cost to the government of the subsidy is:
a. $1 billion.
b. $3 billion.
c. $600 million.
d. $2.2 billion.
ANSWER: D
17. Referring to Figure 11.1, the net loss in national well-being as a result of the subsidy is:
a. &, amp;, nbsp; $200 million.
b. $300 million.
c. $500 million.
d. $2.2 billion.
ANSWER: C
18. Which of the following countries provides government supports to its farmers?
a. The United States.
b. Japan.
c. The European Union.
d. All of the above.
ANSWER: D
19. Assume that Country A imposes an export subsidy and Country B imposes a countervailing duty
(of the same magnitude as the export subsidy). Which of the following statements is true?
I. In terms of overall economic well-being in the domestic economy, Country B would be better
off to allow the export subsidy to be in place and not impose the countervailing duty.
II. In terms of overall economic well-being in the domestic economy, Country B would be better
off with a combination of an export subsidy imposed by Country A and a countervailing duty
than with free trade.
a. I only
b. II only
c. I and II
d. None are true.
ANSWER: C
Figure 11.2: The U.S. Market for Steel Imports from Korea
Price
$/ton
$400
$375
20. Referring to Figure 11.2, what is the change in national welfare in the United States as a result of
the $25 export subsidy on steel?
a. An increase of $375 million.
b. An increase of $3.75 billion.
c. An increase of $4.125 billion.
d. An increase of $4.5 billion.
ANSWER: C
21. Referring to Figure 11.2, what is the change in national welfare in Korea as a result of the $25
export subsidy on steel?
a. A loss of $375 million.
b. An increase of $3.75 billion.
c. A loss of $4.125 billion.
d. A loss of $4.5 billion.
ANSWER: D
22. Referring to Figure 11.2, what is the change in the worlds welfare as a result of the $25 export
subsidy on steel?
a. A loss of $375 million.
b. An increase of $3.75 billion.
c. A loss of $4.125 billion.
d. A loss of $4.5 billion.
ANSWER: A
23. Refer to Figure 11.2 as the initial situation. Suppose the United States now imposes a
countervailing duty in the amount of $25 per ton of steel. What is the impact of this countervailing
duty on U.S. national welfare?
a. A loss of $375 million.
b. An increase of $3.375 billion.
c. An increase of $3.75 billion.
d. A loss of $4.125 billion.
ANSWER: A
24. Refer to Figure 11.2 as the initial situation. Suppose the United States now imposes a
countervailing duty in the amount of $25 per ton of steel. What is the impact of this countervailing
duty on Korean national welfare?
a. A loss of $375 million.
b. An increase of $750 million.
c. A loss of $3.75 billion.
d. An increase of $4.5 billion.
ANSWER: B
25. Referring to Figure 11.2, the combined net effect of the subsidy and the countervailing duty on
theUnited States is a gain of __________ and the net effect on Korea is a loss of __________.
a. $375 million; $375 million
b. $375 million; $3.75 billion
c. $3.75 billion; $3.75 billion
d. $375 billion; $375 million
ANSWER: C
26. The impact on world welfare of an export subsidy and a countervailing duty (of the same size as
the subsidy) is:
a. There is no impact, either positive or negative.
b. Negative due to overproduction.
c. Negative due to under-consumption.
d. Negative due to increased tax collections.
ANSWER: A
Figure 11.3: A large-country imposes an export subsidy
Price
27. Referring to Figure 11.3, the cost to the government of the indicated subsidy is shown by area(s):
a. c
b. c + h
c. b + c + d
d. b + c + d + f + g + h + i + j
ANSWER: D
28. Referring to Figure 11.3, the change in consumer well-being as a result of the indicated subsidy is
shown by area(s):
a. a
b. (a + b)
c. (a + b + e + f + g)
d. (a + b + c)
ANSWER: B
29. Referring to Figure 11.3, the change in producer well-being as a result of the indicated subsidy is
shown by area(s):
a. a + b
b. a + b + c + d
c. a + b + c + e + f + g + h
d. a + b + c
ANSWER: D
30. Referring to Figure 11.3, the production effect of the indicated subsidy is shown by area(s):
a. b
b. d
c. d + i + j
d. b + f + g
ANSWER: B
31. Referring to Figure 11.3, the consumption effect of the indicated subsidy is shown by area(s):
a. b
b. d
c. d + i + j
d. b + f + g
ANSWER: A
32. Referring to Figure 11.3, the change in national welfare as a result of the indicated subsidy is
shown by area(s):
a. c
b. (b + d)
c. (b + d + f + g + i +j)
d. (b + d + f + g + h + i + j)
ANSWER: D
33. An export subsidy imposed by a large country can be more damaging to national welfare than an
export subsidy imposed by a small country because:
a. The production effect is larger with the large country.
b. The consumption effect is larger with the large country.
c. The terms of trade worsen for the large country but not for the small country.
d. Export subsidies are more damaging to a small country than a large country.
ANSWER: C
34. An export subsidy can be good for a country if:
a. The subsidy allows the exporting firm(s) to capture more monopoly profits in foreign
markets.
b. The subsidy decreases the export price so the export quantity increases.
c. The subsidy is offset by a countervailing duty.
d. The international market for the export product is highly competitive.
ANSWER: A
35. A problem with the use of strategic trade policy is:
a. The analysis requires more information than is likely to be available.
b. There is the risk of foreign retaliation.
c. Policies cannot be looked at in isolation. A policy that gives a strategic advantage in one
industry may give a strategic disadvantage to another due to the higher costs faced as
resources are drawn to the subsidized industry.
d. All of the above.
ANSWER: D
36. Since 1990 the number of countries who adopted antidumping laws _________ significantly, and
by 2008 there were __________ countries with antidumping laws in effect.
a. decreased, less than 50
b. increased, more than 100
c. decreased, close to 100
d. increased, close to 50
ANSWER: B
37. Which country had no antidumping cases until the early 1990s, but became a top initiator of
antidumping cases for the time period 2002-2006?
a. China.
b. India.
c. United Kingdom.
d. United States.
ANSWER: B
38. Which industry accounts for the largest share of antidumping cases filed in the United States in
the 1990s and 2000s?
a. Textile.
b. Chemicals.
c. Steel.
d. Apparel.
ANSWER: C
39. Consider the example of the rivalry game between Airbus and Boeing presented in Figure 11.7 on
page 254 in your textbook. If governments do not provide subsidies to the firms:
a. It is optimal for Boeing to produce if Airbus does not produce.
b. Both firms might decide not to produce because they fear that the other firm will produce.
c. It is optimal for Airbus not to produce if Boeing does not produce.
d. Both a and b.
ANSWER: D
40. Consider the example of the rivalry game between Airbus and Boeing presented in Figure 11.8 on
page 255 in your textbook. The European Unions decision to subsidize Airbus:
a. Might be good for the European Union because Boeing will decide not to produce.
b. Will be good for the European Union only if the U.S. government decides to subsidize
Boeing.
c. It can never be optimal for the European Government to subsidize Airbus.
d. Both a and b.
ANSWER: A
True/False Questions
41. Firms that are participating in persistent dumping will sell less in the foreign market and charge a
higher price than in the home market.
ANSWER: FALSE
42. Firms that are participating in persistent dumping need to be able to prevent resale between the
foreign and domestic markets.
ANSWER: TRUE
43. If markets are competitive, policies that restrict imports are usually harmful to the importing
country while policies that encourage exports are usually beneficial to the exporting country.
ANSWER: FALSE
44. Antidumping duties increase economic well-being in the United States by protecting import-
competing firms.
ANSWER: FALSE
45. It is generally the case that imposing a countervailing duty in response to a foreign export subsidy
provides less welfare gain for a country than had it not imposed the countervailing duty.
ANSWER: TRUE
46. While the United States makes very few claims of dumping, most of their claims are upheld by the
International Trade Commission.
ANSWER: FALSE
47. More price supports and subsidies are provided to agriculture worldwide than any other sector of
the economy.
ANSWER: TRUE
48. An export subsidy imposed in a large exporting country will cause the country's international
terms of trade to increase.
ANSWER: FALSE
49. A large enough production subsidy can turn an imported product into export product.
ANSWER: TRUE
50. Strategic trade policy is a government policy whereby a subsidy is provided in order to help the
domestic firm win a trade battle in an oligopolistic market.
ANSWER: TRUE
51. A price support on agricultural products is a minimum domestic price set by the government. The
government outlaws transaction below the price support, but usually has no commitment to buy
any amounts that farmers cannot sell at this price.
ANSWER: FALSE
52. Giving export subsidies is good for a country when they switch agricultural products from being
importable to being exported.
ANSWER: FALSE
53. A major reason why agricultural products are heavily subsidized in the European Union is
because farmers have strong political lobbies.
ANSWER: TRUE
54. One of the proposals for reforms in the area of dumping is to replace antidumping policies by
safeguard policies. A safeguard is a temporary import protection which allows local import-
competing producers to adjust.
ANSWER: TRUE
Essay Questions
55. How likely is dumping to be predatory? Discuss.
POSSIBLE RESPONSE: Predatory dumping occurs when a foreign firm temporarily charges a low
price with the intention to drive local firms out of business, and eventually attain monopoly power
and raises prices. Predatory dumping is likely to be rare in modern markets. An exporting company
will engage in predatory dumping only if the profits in the distant future outweigh the current losses
associated with the temporary reduction in price. Yet, the future profits are likely to be quite
uncertain. Even if the firm succeeds to drive current competitors out of business, once prices are
raised, new firms will enter the industry as competitors, and prices will not continue to be high for
very long.
56. Milton Friedman has often written that instead of imposing countervailing duties on subsidized
foreign goods, the United States should write a note of thanks to foreign taxpayers. Do you agree?
Why or why not? Illustrate your answer with a simple diagram.
POSSIBLE RESPONSE: To evaluate Milton Friedmans statement let us look at the diagram below
which illustrates the U.S. market for steel.
210
Price
$/ton
$300
$250
Let us assume that the current world price is $300 per ton. Assume now that Brazil introduces an
export subsidy to its production of steel. As a result the export price drops to $250 per ton. Domestic
consumers in the U.S. gain an additional (consumer) surplus equal to v + w + y + z. Producers lose a
surplus equal to v. So, the benefit to the U.S. equals w + y + z. What happens if the U.S. imposes a
countervailing duty? In this case the world price climbs back to the original level of $300. Domestic
producers gain back area v, and domestic consumers lose back v + w + y + z. The U.S. collects a
dollar amount equal to the area y in countervailing duties. As can be seen, the countervailing duty
diminishes the total welfare of the U.S. by w + z.
Thus we agree with Friedmans statement that imposing a countervailing duty is not beneficial to
theU.S. The U.S. should send a thank-you note to Brazilian taxpayers because the reduction in the
world price is indeed financed by the Brazilian government and the Brazilian taxpayers in particular.
This tax money finances the subsidy granted to Brazilian steel producers.
57. What is the economic definition of dumping? If the importing country suspects dumping, what action
can be taken?
POSSIBLE RESPONSE: Dumping is selling exports at a price below the normal value (or fair
market value). There are two definitions of normal value. The traditional definition of normal value is
the price charged in the home market. Dumping in this case means international price
discrimination. The second definition of normal value is the average cost of production. Under this
second definition dumping is selling goods abroad at a price below average production cost. If a
country can show foreign producers dump into their market and injury results, the country can
impose antidumping measures.
58. Thai farmers grow and sell 100 units of rice at a price of $100 per unit. Of the 100 units, 20 are
exported. If urban consumers succeed in getting the Thai government to ban all exports of rice, the
domestic price of rice would drop to $80 per unit and farmers would grow and sell 80 units. How
much loss would the export ban bring to Thai farmers?
POSSIBLE RESPONSE: This problem is illustrated in the following graph.
w
Price
$100
$80
The initial situation defines a producer surplus measured by the area w + v. The ban on the exports
of rise lowers the price to $80, and the new producer surplus is given by area w. The loss is area v,
which can be calculated as (v + x) x = (100 - 80) x 100 (100 - 80) x (100 - 80)/2 = 2000 200 = 1800.
59. The United States demand and supply for grain are:
QD = 150 0.6P
QS = 40 + 0.5P
where QD and QS are in millions of tons and P is $ per ton. The world price of grain is $200 per ton.
a. In a situation of free trade, how much grain would be produced, consumed, and traded in
theUnited States?
POSSIBLE RESPONSE: At the price of $200, the quantity supplied of grain
by U.S.producers is 60 and the quantity demanded of grain in the U.S. is 30. Thus, 60 million
tons will be produced, 30 million tons will be consumed, and 30 million tons will be exported
(see the graph).
b. As a response to alleged unfair foreign practices, U.S. farmers successfully lobby for a $20
export subsidy per unit of U.S. grain exported. Assume that the United States is a small
country in world grain markets and illustrate the U.S. export subsidy and calculate the
impact on U.S. prices, consumption, production, and exports of grain. Also calculate the
welfare effects on producers, consumers, the cost of the subsidy to the government, and the
overall welfare effect on the U.S.
POSSIBLE RESPONSE: As the United States is assumed to be a small country when it
comes to grain production, there will be no effect on the world price. For U.S. farmers revenue
per unit exported rises to $220, and the exporting firms must receive this amount as the selling
price from domestic buyers as well. Domestic production rises from 60 to 70 million tons,
domestic consumption falls from 30 to 18 million tons, and the country exports increases from
30 million tons to 70-18=52 million tons. Domestic producers gain surplus equal to the
area e+f+g, domestic consumers lose surplus equal to the area e+f and the cost of the
government of paying the export subsidy is area f+g+h. The net loss in national well being
resulting from the export subsidy equals the sum of the areas f and h.
60. Explain why strategic export subsidies could be good for a country. For this purpose use the two
firm rivalry game between Airbus and Boeing presented in your textbook. Discuss the differences
between the game in which no subsidies are given, the game in which only Airbus receives a
subsidy, and the game in which both firms are subsidized.
POSSIBLE RESPONSE: The rivalry game without subsidies has no clear cut result. If one of the
firms decides to produce, it is best for the other firm not to produce. Each firm would like to be
the only producer, but if both produce both will lose. If the firms are unable to coordinate, both
firms could decide not to produce, which is suboptimal for at least one of them.
By giving a subsidy, the European Union could give Airbus incentives to produce independent of
whether Boeing produces or not. Knowing that Airbus will produce, Boeing will find it best not to
produce, and Airbus will serve the entire market. Airbus, the European Union, and the world as a
whole would win, compared to no production by either firm.
If both countries subsidize their producers, both firms will end up producing airplanes. In this
situation the market is too small to accommodate two producers, so each operates at a loss net of
its subsidy. The effects on national and world well-being depend on whether sufficient consumer
surplus is created to overcome the producers losses net of the subsidies. (The subsidies are
transfers that do not directly count as net gains or net losses.)