SM14ce_Micro_Chap017.doc

Chapter 17 - International Trade Chapter 17 - International Trade McConnell Brue Flynn Barbiero 14ce DISCUSSION QUESTIONS 1. Distinguish among land-, labour-, and capital-intensive goods, citing an example of each without resorting to the textbook examples. ? How do distinctive products, unrelated to resource intensity, relate to international trade? LO17.1 Answer: Land-intensive commodities require a relatively large amount of land to produce. Land-intensive commodities include agricultural products such as corn and wheat. Labour-intensive commodities require a relatively large amount of labour to produce. Labour-intensive commodities require much skilled labour in production, such as transistor radios and clothing. Capital-intensive products are produced with a large amount of capital equipment and include manufactured items such as aircraft and automobiles. These distinctions are important because if a nation has an abundant supply of particular type of resources, it can produce items that are intensive in these resources with a comparative cost advantage. On the other hand, if it has a relative scarcity of certain resources, such as land, then it will be relatively expensive to produce land-intensive products such as corn and wheat. The difference in relative resource abundance among nations leads to a difference in comparative costs of production, which is the basis for international trade and specialization. Distinctive products, those associated with a particular country (perhaps because of a reputation for quality) can provide an export niche for a country. Even though the country may have no cost advantage in producing the good, the “label” on the good is enough to attract buyers willing to pay more than for potentially comparable substitutes. 2. Explain: “Canada can make certain toys with greater productive efficiency than can China. Yet we import those toys from China.” Relate your answer to the ideas of Adam Smith and David Ricardo. LO17.1 Answer: A country is said to have an absolute advantage over other producers of a product if it is the most efficient producer of that product (by which we mean that it can produce more output of that product from any given amount of resource inputs than can any other producer.) A country is said to have a comparative advantage over other producers of a product if it can produce the product at a lower opportunity cost (by which we mean that it must forego less output of alternative products when allocating productive resources to producing the product in question). In the case of toys Canada may have an absolute advantage in producing toys relative to China (can produce toys at a lower cost), but will still import the toys from China because China has a comparative advantage in producing toys (lower opportunity cost). In other words the U.S. can produce toys at a lower cost per unit, but China has to sacrifice less other goods to make the toys. Thus, China should make the toys and Canada should import the toys and produce other goods. In 1776, Adam Smith used the concept of absolute advantage to argue for international specialization and trade. His point was that nations would be better off if they each specialized in the production of those products in which they had an absolute advantage and were therefore the most efficient producers. In the early 1800s David Ricardo extended, and modified, Smith’s idea by demonstrating that it is advantageous for a country to specialize and trade even if it is more productive in all economic activities than some trading partner. A nation does not need Smith’s absolute advantage—total superiority in producing some good—to benefit from specialization and trade. It needs only a comparative advantage. In summary, it is the relative cost of producing the good not the absolute cost that drives trade. 3. Suppose Big Country can produce 80 units of X by using all its resources to produce X or 60 units of Y by devoting all its resources to Y. Comparable figures for Small Nation are 60 units of X and 60 units of Y. Assuming constant costs, in which product should each nation specialize? Explain why. What are the limits of the terms of trade between these two countries? How would rising costs (rather than constant costs) impact the extent of specialization and trade between these two countries? LO17.1 Answer: To answer this question we find the opportunity cost of the two goods. The opportunity cost of good Y (in terms of good X) in Big Country is 3/4 (=60/80) units of Y for each unit of X. That is, Big Country needs to give up 3/4 units of Y to produce 1 more unit of X. Note, this is the slope to Big Country's Production Possibilities Curve with Y on the vertical axis. The opportunity cost of good Y (in terms of good X) in Small Nation is 1 (=60/60) unit of Y for each unit of X. That is, Small Nation needs to give up 1 units of Y to produce 1 more unit of X. Note, this is the slope to Small Nation's Production Possibilities Curve with Y on the vertical axis. Given these opportunity costs Big Country should produce good X (only needs to give up 3/4 units of Y for 1 X) and Small Nation should produce good Y (needs to give up 1 unit of x for 1 unit Y). That is, Big Country has a comparative advantage in producing good X because they have to give up less Y to produce X per unit. The limits of the terms of trade depend on the opportunity costs. For example, Big Country will never pay more than 4/3 a unit of good X for unit of good Y. Big country, can always produce a unit of Y itself by giving up 4/3 a unit of good X. Small Nation will never accept less 1 unit of good X for a unit of good Y because they can always produce a unit of X for good Y. The terms of trade will be between 1 unit of good X for a unit of good Y and 4/3 a unit of X for a unit of good Y. 4. What is an export demand curve? What is an import supply curve? How do such curves relate to the determination of the equilibrium world price of a tradable good? LO17.2 Answer: The export demand curve for a particular country is the difference between quantity supplied and quantity demanded in the domestic market for a price above the domestic equilibrium price (the price that would occur in the market if trade were not possible. The import demand schedule works in the other direction, it is the difference between quantity supplied and quantity demanded in the domestic market for a price below the domestic equilibrium price (the price that would occur in the market if trade were not possible). Here the negative values (quantity supplied minus quantity demanded) are translated into positive values (absolute value) graphically. The intersection of the world supply and demand schedules determines the equilibrium world price for a tradable good. 5. Why is a quota more detrimental to an economy than a tariff that results in the same level of imports as the quota? What is the net outcome of either tariffs or quota for the world economy? LO17.3 Answer: The reason why a quota is more detrimental to an economy than a tariff that results in the same level of imports (as the quota) is that the government loses revenue. Under the tariff the government collects tax revenue and under a quota this tax revenue is lost. Tariffs and quotas impose costs on domestic consumers but provide gains to domestic producers and, in the case of tariffs, revenue to the Federal government. The consumer costs of trade restrictions are calculated by determining the effect the restrictions have on consumer prices. Protection raises the price of a product in three ways: (1) The price of the imported product goes up; (2) the higher price of imports causes some consumers to shift their purchases to higher-priced domestically produced goods; (3) the prices of domestically produced goods rise because import competition has declined. Study after study finds that the costs to consumers substantially exceed the gains to producers and government. A sizable net cost or efficiency loss to society arises from trade protection. Conclusion: The gains that trade barriers create for protected industries and their workers come at the expense of much greater losses for the entire economy. The result is economic inefficiency, reduced consumption, and lowers standards of living. Extending this to the world economy is straightforward. If all domestic economies lose because of trade barriers the world loses (efficiency) as well. 6. “The potentially valid arguments for tariff protection—military self-sufficiency, infant industry protection, and diversification for stability—are also the most easily abused.” Why are these arguments susceptible to abuse? LO17.3 Answer: Each of these valid arguments is often misapplied. Dumping cases by foreign firms in Canada are difficult to prove and rare. Often domestic producers will claim their foreign competitors are dumping when the lower prices simply reflect a comparative advantage in foreign production. If this is true the use of antidumping duties reduces the benefits of trade. The protection of new “infant” domestic industries to allow them to develop efficient production techniques is questionable in an advanced economy such as Canada. There is a tendency for trade barriers to remain in place even after the industry becomes established. The argument relating to military self-sufficiency is questionable when applied to sectors other than those directly related to defense. Almost all industries can claim to play a role in a wartime economy. As a rule, direct government subsidies are a more equitable means of protecting military security than trade protection, since taxpayers as a whole, rather than just consumers of protected industries will shoulder the burden. Direct subsidies also make the costs of these programs obvious rather than hiding them in the form of higher import prices. 7. Evaluate the effectiveness of artificial trade barriers, such as tariffs and import quotas, as a way to achieve and maintain full employment throughout the Canadian economy. How might such policies reduce unemployment in one Canadian industry but increase it in another Canadian industry? LO17.3 Answer: Artificial trade barriers may protect jobs in Canada that need to compete with the foreign sector. This would tend to move the Canadian economy towards full-employment. However, it is likely that foreign countries would impose, or implement, non-tariff barriers on Canadian goods. This response would reduce Canadian exports and cost Canadian jobs in the exporting sector of the economy. This would tend to move the Canadian economy away from full-employment. In effect, the artificial trade barriers will likely reduce unemployment in one industry (import sector) and increase unemployment in another industry (export sector). 8. In 2013, manufacturing workers in Canada earned an average wage of $23.19 per hour. That same year, manufacturing workers in Mexico earned an average wage of $6.36 per hour. (a) How can Canadian manufacturers possibly compete? (b) Why isn’t all manufacturing done in Mexico and other low-wage countries? LO17.3 Answer: Canada can compete if the workers are more productive. That is, if the productivity level for workers in Canada is higher. If this is the case, then some manufacturing will take place in Canada (with productivity adjusted wages equalized). The other reason that all manufacturing doesn’t take place in the low wage countries may be due to trade barriers. 9. How might protective tariffs reduce both the imports and the exports of the nation that levies tariffs? In what way do foreign firms that “dump” their products onto the Canadian market in effect provide bargains to Canadian consumers? How might the import competition lead to quality improvements and cost reductions by Canadian firms? LO17.3 Answer: If a country imposes import tariffs other countries may follow with their own import tariffs. These foreign import tariffs will reduce the exports of the nation that originally imposed the import tariffs. If foreign firms dump their products on the Canadian market they are in effect selling them for below cost. This provided the consumers in Canada a bargain because they can purchase the goods at below cost price. The fact that foreign firms will be losing 'money' by dumping makes it difficult to sustain this practice for long periods of time. If domestic firms need to compete with imports this may lead to quality improvements in domestic goods to differentiate themselves from the imports and may result in cost reductions in Canada as firms try to compete on the cost side of the ledger (allows the firm to lower price). The LAST WORD What was the central point that Bastiat was trying to make in his imaginary petition of the candle makers? Answer: Bastiat’s objective was to discredit the arguments in favor of protectionism by carrying the arguments to logical but absurd conclusions. Bastiat was demonstrating that there are numerous forces that create competitive challenges for firms and industries, but that doesn’t necessarily justify the imposition of protectionist measures. REVIEW QUESTIONS 1. In Country A, a worker can make 5 bicycles per hour. In Country B, a worker can make 7 bicycles per hour. Which country has an absolute advantage in making bicycles? LO17.1 a. Country A. b. Country B. Answer: b. Country B. Feedback: Country B has an absolute advantage in making bicycles because Country B is more efficient in the sense of being able to convert the same amount of input into a larger amount of output. Please note that the definition of absolute advantage focuses on the efficiency with which countries can turn input into output. It says nothing at all about the opportunity costs of producing a particular type of output or how much of other products must to be foregone in order to produce a unit of that particular type of output.  The concept of comparative advantage deals with those opportunity-cost issues. 2. In Country A, the production of 1 bicycle requires using resources that could otherwise be used to produce 11 lamps. In Country B, the production of 1 bicycle requires using resources that could otherwise be used to produce 15 lamps. Which country has a comparative advantage in making bicycles? LO17.1 a. Country A. b. Country B. Answer: a. Country A. Feedback: Country A has a comparative advantage in making bicycles because Country A has a lower opportunity cost of producing bicycles when we measure opportunity cost in terms of the amount of alternative products that must be foregone in order to produce 1 bicycle.    To produce 1 bicycle, Country A only has to give up the production of 11 lamps.  By contrast, Country B has to give up the production of 15 lamps.  Thus, if we had to decide which country should be producing bicycles, we would go with Country A because it can produce bicycles at a lower opportunity cost in terms of lamps foregone. 3. True or False: If Country B has an absolute advantage over Country A in producing bicycles, it will also have a comparative advantage over Country A in producing bicycles. LO17.1 Answer: False. Feedback: This statement is false because the possession of an absolute advantage does not necessarily imply that a country will also have a comparative advantage. A country can have an absolute advantage but not a comparative advantage because the definitions of absolute advantage and comparative advantage focus on different things. Absolute advantage focuses on costs as measured by the amount of inputs required to make a single unit of given product.  Thus, the country that can produce a single bicycle using the least amount of labor input is the country that has the absolute advantage in producing bicycles. By contrast, comparative advantage focuses on costs as measured by the amounts of other products that a country has to forego in order to free up the resources necessary to make single unit of a given product.  Thus, even if a country is really efficient at making bicycles in the sense of being able to make a single bicycle using only a very small amount of labor, it may still be really inefficient at making bicycles in the sense of having to give up a lot of other goods and services in order to free up the labor needed to make a single bicycle.  That is, it may have an absolute advantage but not a comparative advantage. 4. Suppose that the opportunity-cost ratio for pears and apples is 4P ? 1A in British Columbia but 1P ? 2A in Ontario. Which province has the comparative advantage in producing apples? LO17.1 a. British Columbia. b. Ontario. c. Neither. Answer: b. Ontario. Feedback: Ontario has the comparative advantage in producing apples.   This is true because Ontario has to give up less pears in order to produce a tonne of apples. The easiest way to see this is to begin by dividing both sides of Ontario’s opportunity-cost ratio by 2.  That will give you ½P ? 1A.  That version of Ontario’s opportunity-cost ratio makes it clear that for every tonne of apples that Ontario produces, it must forego ½ tonne of pears. By contrast, British Columbia’s opportunity-cost ratio of 4P ? 1A indicates that for every tonne of apples that British Columbia produces, it must forego 4 tonnes of pears. As a result, Ontario has a comparative advantage in producing apples because it can produce them at a lower opportunity cost as measured by the amount of pears that must be foregone in order to free up enough resources to produce one tonne of apples. 5. Suppose that the opportunity-cost ratio for fish and lumber is 1F ? 1L in Canada but 2F ? 1L in Iceland. Then should specialize in producing fish while should specialize in producing lumber. LO17.1 a. Canada; Iceland. b. Iceland; Canada. Answer:  b. Iceland; Canada. Feedback: The correct answer is that Iceland should specialize in producing fish while Canada should specialize in producing lumber. This is true because Iceland has a comparative advantage in producing fish while Canada has a comparative advantage in producing lumber.  Those comparative advantages imply that if each country specializes in the production of the product for which it has a comparative advantage, total output between the two countries can rise.  It is for that reason—increasing the total amount of output that can be produced—that the two countries should specialize and trade. To see that Iceland has a comparative advantage in producing fish, divide both sides of its opportunity-cost ratio by 2.  Doing so yields, 1F ? ½L.  That version of Iceland’s opportunity cost ratio demonstrates that in order to produce one ton of fish, Iceland has to give up only ½ ton of lumber. By contrast, Canada’s opportunity cost ratio of 1F ? 1L indicates that in order to produce one ton of fish, Canada must give up one ton of lumber. Thus, Iceland has the comparative advantage in producing fish because it can produce fish at a lower opportunity cost in terms of lumber foregone. A similar analysis demonstrates that Canada has the comparative advantage in producing lumber because it has the lower opportunity cost in terms of fish foregone. You can see this by comparing Canada’s opportunity-cost ratio of 1F ? 1L with Iceland’s opportunity cost ratio of 2F ? 1L.  Canada only has to give up one ton of fish to produce a ton of lumber whereas Iceland has to give up 2 tons of fish to produce a ton of lumber. 6. Suppose that the opportunity-cost ratio for watches and cheese is 1C ?1W in Switzerland but 1C ?4W in Japan. At which of the following international exchange ratios (terms of trade) will Switzerland and Japan be willing to specialize and engage in trade with each other. LO17.1 Select one or more answers from the choices shown. a. 1C = 3W. b. 1C = 1/2 W. c. 1C = 5W. d. ½ C = 1W. e. 2C = 1W. Answers: a. 1C ? 3W and d. ½C ? 1W Feedback: These are the only two correct answers because they are the only two international exchange ratios (terms of trade) that will be advantageous to both countries. One way to see this is to note that only international exchange ratios that lie between the domestic opportunity-cost ratios of the two countries will be acceptable to both.  That is, only international exchange ratios between Switzerland’s opportunity cost ratio of 1C ? 1W and Japan’s opportunity cost ratio of 1C ? 4W will be beneficial to both countries and therefore acceptable as international exchange ratios at which both countries would be willing to trade. For a deeper understanding of why that is true, recall that specialization and trade will only happen if each country feels that the international exchange ratio is better than what the country could do if it shut its borders and did not engage in international trade. To see how this works, consider the first possible answer, in which the international exchange ratio is 1C ? 3W.  Switzerland will find that ratio attractive because it will allow greater consumption than its domestic opportunity-cost ratio.  To see why, note that its domestic opportunity-cost ratio of 1C ? 1W implies that for every watch that Switzerland wants, it will have to give up a unit of cheese if it limits itself to domestic production and does not engage in international trade.  But if Switzerland instead opts for international trade, it will be able to get three watches for each unit of cheese that it produces and then trades for watches at the international exchange ratio of 1C ? 3W. Because getting three watches for each unit of cheese is better than getting only one watch for each unit of cheese, Switzerland will want to trade at the international exchange ratio of 1C ? 3W. For similar reasons, Japan will also find this international trade ratio attractive.  To see why, note that if Japan did not trade, its domestic opportunity-cost ratio of 1C ? 4W implies that it would have to give up four watches for each unit of cheese that it wants. By contrast, if it took advantage of the international exchange ratio of 1C ? 3W, it would be able to get one unit of cheese through trade by producing and then trading away only three watches.  Clearly it is better to have to give up only three watches to get a unit of cheese than to have to give up four watches to get a unit of cheese.  And so Japan will also want to trade at the international exchange ratio of 1C ? 3W rather than ban trade and produce domestically. Finally, note that international trade will not take place if the international exchange ratio lies outside of the range that lies between each country’s own domestic opportunity cost ratio.  International trade will not take place in such cases because any such international exchange ratios will be acceptable to only one—but not both—of the countries.  As a result, one of them won’t be willing to trade. 7. We see quite a bit of international trade in the real world. And trade is driven by specialization. So why don’t we see full specialization—for instance, all cars in the world being made in South Korea, or all the mobile phones in the world being made in China? Choose the best answer from among the following choices. LO17.1 a. High tariffs. b. Extensive import quotas. c. Increasing opportunity costs. d. Increasing returns. Answer: c. Increasing opportunity costs. Feedback: The correct answer is that we don’t see full specialization because of increasing opportunity costs. International trade is indeed driven by specialization, but the benefits of specialization can dissipate as a country specializes more and more in the production of one good. What happens is that diminishing returns set in so that the country will face increasingly high opportunity costs for producing the good in question.  As costs rise, so will the price that it has to charge to foreigners for additional units of the good.    At some point, the price will rise so high that foreigners will no longer want to buy any more because it will be cheaper for them to produce additional units domestically or purchase them yet another country whose production has not yet been affected by diminishing returns and increasing costs.   As a result, what we see in the real world is incomplete specialization, with several countries often dominating an industry but no single country achieving full specialization and 100% control of global production.    As an example, consider cars, which are exported to other countries from South Korea, the United States, Japan, Germany, France, Sweden, and so on.   Each of these countries has specialized some of its industrial capacity into the production of cars, but diminishing returns implies that none of them has been able to capture 100% of the world car market.   8. Which of the following are benefits of international trade? LO17.1 Choose one or more answers from the choices shown. a. A more efficient allocation of resources. b. A higher level of material well-being. c. Gains from specialization. d. Promoting competition. e. Deterring monopoly. f. Reducing the threat of war. Answer: All of the choices are correct. Feedback: All of the answers are correct because each one is indeed a benefit of international trade. 9. True or False: If a country is open to international trade, the domestic price for a homogeneous good can differ from the international price for the same good. LO17.2 Answer:  False. Feedback: If a country is open to international trade, the domestic price for a homogeneous good will always be equal to the international price. That is because anyone in the country who wants to buy or sell will be participating in the international market and paying the international price that equates the quantities demanded and supplied globally. By contrast, if a country is closed to international trade, the domestic price can differ substantially from the international price because the domestic price will be affected only by domestic demand and domestic supply. 10. Suppose that the current international price of wheat is $6 per bushel and that the Canada is currently exporting 30 million bushels per year. If Canada suddenly became a closed economy with respect to wheat, would the domestic price of wheat in Canada end up higher or lower than $6? LO17.2 a. Higher. b. Lower. c. The same. Answer: b. Lower. Feedback: If Canada suddenly became a closed economy, the domestic price of wheat would end up being lower than the current international price of wheat. That is because from the perspective of Canadian farmers, closing the Canadian economy to international trade in wheat would mean drastically lowering the overall demand for their product.  That is, the total demand for Canadian wheat would fall sharply because Canadian wheat farmers would now be cut off from all of the foreigner consumers who had previously been consuming all of the wheat that the Canada had been exporting.  That reduction of the total demand for Canadian wheat would result in a lower equilibrium domestic price of wheat if Canada were to become a closed economy with respect to wheat. 11. Suppose that if Iceland and Japan were both closed economies, the domestic price of fish would be $100 per ton in Iceland and $90 per ton in Japan. If the two countries decided to open up to international trade with each other, which of the following could be the equilibrium international price of fish once they begin trading? LO17.2 a. $75. b. $85. c. $95. d. $105. Answer: c. $95. Feedback: The correct answer is that $95 could be the equilibrium international price of fish if Iceland and Japan began trading fish with each other. That is true because an equilibrium in international trade can only exist if the international price can adjust so that one country becomes the exporter, the other country becomes the importer, and the quantity exported and supplied by the exporting country exactly equals the quantity imported and demanded by the other country.  The $95 price is the only price that could possibly make that happen because it's the only price at which one of the countries will want to export and the other will want to import. In particular, Iceland will want to import at the $95 price because that price for fish is less than its domestic price of $100.  At the same time, Japan will want to export at the $95 price because that price is more than the $90 domestic price at which fish can be sold. Thus, it is possible that $95 could be the equilibrium international price because one country will want to export while the other will want to import. By contrast, none of the other prices could possibly work because for each of them, you wouldn’t end up with one country wanting to import and one country wanting to export.   12. Draw a domestic supply-and-demand diagram for a product in which Canada does not have a comparative advantage. What impact do foreign imports have on domestic price and quantity? On your diagram show a protective tariff that eliminates approximately one-half of the assumed imports. What are the price-quantity effects of this tariff on (a) domestic consumers, (b) domestic producers, and (c) foreign exporters? How would the effects of a quota that creates the same amount of imports differ? LO17.3 Answer: Canada does not have a comparative advantage in this product so the world price Pworld is below the Canadian domestic price of Pdomestic.  Imports will reduce the domestic price, increasing consumption from nontrade, and decreasing domestic production.  See the graph.  A tariff (a) harms domestic consumers by increasing price and decreasing consumption; (b) aids domestic producers through the increase in price and the expansion of domestic production; (c) harms foreign exporters by decreasing exports. (Assuming that the country imposing the tariff is a small part of the world market. If not, price could also be affected.) 13. Canadian apparel makers complain to Parliament about competition from China. Parliament decides to impose either a tariff or a quota on apparel imports from China. Which policy would Chinese apparel manufacturers prefer? LO17.3 a. Tariff. b. Quota. Answer: b. Quota. Feedback: Chinese apparel manufacturers would prefer a quota because it would generate higher per-unit prices for the goods they sell in the United States.   With either a tariff or a quota, China will see its total volume of sales to the United States decline.  But the question then becomes: Which policy would offer China the greater amount of benefits to help compensate for the decline in sales? A tariff won’t help the Chinese at all because the money from the tariff will be collected by the Canadian government.  But a quota can actually increase China’s per-unit selling price because the reduction in supply caused by the quota will raise the equilibrium price of apparel in Canada.  As a result, while the quota will mean that China will be selling fewer units of clothing in Canada, it will also mean that each of the units of clothing that it does continue to sell will be sold at a higher per-unit price.   Thus, China will prefer a quota over a tariff because it will at least be getting more per unit despite selling fewer units.  (Whether or not the increase in per-unit price can make up for the decline in the number of units sold will depend on the elasticities of the demand and supply curves.) PROBLEMS 1. Assume that the comparative-cost ratios of two products—baby formula and tuna fish—are as follows in the nations of Canswicki and Tunata: Canswicki: 1 can baby formula = 2 cans tuna fish Tunata: 1 can baby formula = 4 cans tuna fish In what product should each nation specialize? Which of the following terms of trade would be acceptable to both nations: (a) 1 can baby formula = 2 1/2 cans tuna fish; (b) 1 can baby formula = 1 can tuna fish; (c) 1 can baby formula = 5 cans tuna fish? LO17.1 Answer: Canswicki should produce baby food, and Tunata should produce tuna; (a) acceptable; (b) not acceptable; (c) not acceptable. Feedback: Consider the following example. Assume that the comparative-cost ratios of two products—baby formula and tuna fish—are as follows in the nations of Canswicki and Tunata: Canswicki: 1 can baby formula =2 cans tuna fish Tunata: 1 can baby formula =4 cans tuna fish In what product should each nation specialize? The opportunity cost of producing 1 can of baby formula in Canswicki is 2 cans of tuna fish. The opportunity cost of producing 1 can of baby formula in Tunata is 4 cans of tuna fish. Since the opportunity cost of producing baby formula is lower in Canswicki, this implies Canswicki should produce baby formula. This also implies that Tunata should specialize in producing Tuna. We can also look at the opportunity cost of producing cans of tuna fish (in terms of foregone cans of baby formula). The opportunity cost of producing 1 can of tuna fish in Canswicki is 1/2 a can of baby formula. The opportunity cost of producing 1 can of tuna fish in Tunata is 1/4 a can of baby formula. Since the opportunity cost of producing tuna fish is lower in Tunata, this implies Tunata should produce tuna fish. This also implies that Canswicki should specialize in producing baby formula. Which of the following terms of trade would be acceptable to both nations: (a) 1 can baby formula = 2 1/2 cans tuna fish? These terms of trade are acceptable. The best Canswicki can do without trade is produce 2 cans of tuna fish for each can of baby formula. If they trade 1 can of baby formula for 2.5 cans of tuna fish they will be better off. Tunata will also trade because they only need to give up 2.5 cans of tuna fish for each can of baby formula. If Tunata produced baby formula themselves they would need to give up 4 cans of tuna fish for each can of baby formula. (b) 1 can baby formula = 1 can tuna fish? These terms of trade would not be acceptable. Canswicki would not be willing to trade 1 can of baby formula for 1 can of tuna fish. They can do better themselves by producing 2 cans of tuna fish for each can of baby formula. (c) 1 can baby formula = 5 cans tuna fish? These terms of trade would not be acceptable. Tunata would not be willing to trade (give up) 5 cans of tuna fish for 1 can of baby formula. They could do better themselves by producing a can of baby food and giving up 4 cans of tuna fish. 2. The following are hypothetical production possibilities tables for New Zealand and Spain. Plot the production possibilities data for each of the two countries separately. Referring to your graphs, answer the following: LO17.1 a. What is each country’s cost ratio of producing plums and apples? b. Which nation should specialize in which product? c. Show the trading possibilities lines for each nation if the actual terms of trade are 1 plum for 2 apples. (Plot these lines on your graph.) d. Suppose the optimum product mixes before specialization and trade were alternative B in New Zealand and alternative S in Spain. What would be the gains from specialization and trade? Answer: (a) New Zealand: cost of producing 1 apple is 0.25 plums; cost of producing 1 plum is 4 apples; Spain: cost of producing 1 apple is 1 plum; cost of producing 1 plum is 1 apple. (b) New Zealand should produce apples and Spain should produce plums. (c) See graphs: (d) Total Gain Apples = 20 (= 60 - 40); Total Gain Plums = 10 (= 60 -50) Feedback: Consider the following example. The accompanying hypothetical production possibilities tables are for New Zealand and Spain. Each country can produce apples and plums. Plot the production possibilities data for each of the two countries separately. Referring to your graphs, answer the following: a. What is each country’s cost ratio of producing plums and apples? The opportunity cost of producing 1 apple in New Zealand is 0.25 plums. That is, for each apple produced in New Zealand the country must give up 0.25 plums. The opportunity cost of producing 1 apple in Spain is 1 plum. That is, for each apple produced in Spain the country must give up 1 plum. We can also look at the opportunity cost of producing plums. The opportunity cost of producing 1 plum in New Zealand is 4 Apples. That is, for each plum produced in New Zealand the country must give up 4 Apples. The opportunity cost of producing 1 plum in Spain is 1 apple. That is, for each plum produced in Spain the country must give up 1 Apple. b. Which nation should specialize in which product? The opportunity cost of producing apples in New Zealand is lower than Spain's opportunity cost of producing apples. Therefore, New Zealand should produce apples and Spain should produce plums. c. Show the trading possibilities lines for each nation if the actual terms of trade are 1 plum for 2 apples. (Plot these lines on your graph.) The graphs below show the each country's production possibilities schedules with and without trade. Apples are on the vertical axis and plums are on the horizontal axis. New Zealand has a vertical intercept of 60 apples (produce only apples) and a horizontal intercept of 15 plums (produce only plums). The slope of production possibilities schedule equals -4 (negative 4). This slope is the opportunity cost of producing plums. That is, for each plum produced by New Zealand they must give up 4 apples. However, after trade, New Zealand's horizontal intercept will be 30 apples. Since the terms of trade are 1 plum for 2 apples, New Zealand could specialize in apple production and trade 2 apples for each plum (produce 60 apples and receive 30 plums). The slope of the after-trade production possibilities schedule is -2 (negative 2). New Zealand must now only give up 2 apples for each additional plum consumed (trade 2 apples for additional plum). The same logic applies to Spain. Before trade the vertical intercept is 60 apples and the horizontal intercept 60 plums. The slope of the production possibilities schedule is -1, which is the opportunity cost of 1 more plum in terms of apples. After trade Spain's vertical intercept is now 120 apples and the horizontal intercept remains at 60 plums. Spain will produce only plums and can trade now 1 plum for 2 apples (terms of trade). If they trade all 60 plums for apples they will receive 120 apples. The new slope of the production possibilities schedule is -2, which is the opportunity cost of consuming (not trading) 1 more plum. (NOTE: The intercepts above reflect possibilities not actual equilibrium consumption bundles. For example, if Spain produced only plums and traded these for apples, they should be able to consume 120 apples (vertical intercept after trade). The problem is that New Zealand is only producing 60 apples (the most it possibly can). This is not a flaw in the logic of the problem because we are only considering the construction of the production possibilities schedules. The next step would be to allow terms of trade to adjust in response to shortages and surpluses of goods based on country preferences. We do not do this step here.) d. Suppose the optimum product mixes before specialization and trade were alternative B in New Zealand and alternative S in Spain. What would be the gains from specialization and trade? The first step is to determine total production before any trade takes place. New Zealand's optimal product mix before trade is alternative B (given above): Apples = 20 Plums = 10 Spain's optimal product mix before trade is alternative S (given above): Apples = 20 Plums = 40 Combined, the optimal mix before trade is: Before Trade Total Apples = 40 (20 New Zealand plus 20 Spain) Before Trade Total Plums = 50 (10 New Zealand plus 40 Spain) The next step is to determine total production after specialization. Recall New Zealand will specialize in apple production (produce only apples) and Spain will specialize in plum production (produce only plums). After Trade Total Apples = 60 (New Zealand alternative D) After Trade Total Plums = 60 (Spain alternative R) The final step is to determine the total gain for each good, which is the difference between total production before trade and total production after trade. Total Gain Apples = 20 (= 60 - 40) Total Gain Plums = 10 (= 60 -50) 3. The following hypothetical production possibilities tables are for China and Canada. Assume that before specialization and trade the optimal product mix for China is alternative B and for Canada is alternative U. LO 17.1 a. Are comparative-cost conditions such that the two areas should specialize? If so, what product should each produce? b. What is the total gain in apparel and chemical output that would result from such specialization? c. What are the limits of the terms of trade? Suppose that the actual terms of trade are 1 unit of apparel for 1½ units of chemicals and that 4 units of apparel are exchanged for 6 units of chemicals. What are the gains from specialization and trade for each nation? Answer: (a) Yes; China should produce apparel and Canada should produce chemicals. (b) Total Gain apparel = 6000; Total Gain chemicals = 2. (c) Limits of the terms of trade = 1000 units of apparel for 1 ton of chemicals and 1000 units of apparel for 2 tons of chemicals; gain of 2000 units of apparel and 2 tons of chemicals. Feedback: Consider the following example. The following hypothetical production possibilities tables are for China and Canada. Assume that before specialization and trade the optimal product mix for China is alternative B and for Canada is alternative U. a. Are comparative-cost conditions such that the two areas should specialize? If so, what product should each produce? Yes, the two areas should specialize. The opportunity cost of producing 1000 units of apparel is 1 ton of chemicals in China. The opportunity cost of producing 1000 units of apparel is 2 tons of chemicals. Thus, the opportunity cost for apparel is lower in China. This implies China should produce apparel and Canada should produce Chemicals. b. What is the total gain in apparel and chemical output that would result from such specialization? The first step is to determine total production before any trade takes place. China's optimal product mix before trade is alternative B (given above): Apparel = 24,000 Chemicals = 6 Canada' optimal product mix before trade is alternative U (given above): Apparel = 4,000 Chemicals = 12 Combined, the optimal mix before trade is: Before Trade Total Apparel = 28,000 (24,000 China plus 4,000 US) Before Trade Total Chemicals = 18 (6 China plus 12 US) The next step is to determine total production after specialization. Recall China will specialize in apparel production (produce only apparel) and Canada will specialize in Chemical production (produce only chemicals). After Trade Total Apparel = 30,000 (China alternative A) After Trade Total Chemicals = 20 (US alternative W) The final step is to determine the total gain for each good, which is the difference between total production before trade and total production after trade. Total Gain Apparel = 2000 (=30,000-28,000) Total Gain Chemicals = 2 (=20-18) c. What are the limits of the terms of trade? Suppose that the actual terms of trade are 1 unit of apparel for 1½ units of chemicals and that 4 units of apparel are exchanged for 6 units of chemicals. What are the gains from specialization and trade for each nation? To determine the limits of the terms of trade we look at opportunity cost. The opportunity cost of producing 1000 units of apparel is 1 ton of chemicals in China. The opportunity cost of producing 1000 units of apparel is 2 tons of chemicals. The most China will trade (give up) is 1000 units of apparel for 1 ton of chemicals. If Canada required more China could do better producing the chemicals themselves. The most Canada is willing to trade (give up) is 2 tons of chemical for 1000 units of apparel. If China required more, Canada could do better producing the apparel This implies the range, or limits, of the terms of trade. 1000 units of apparel for 1 ton of chemicals 1000 units of apparel for 2 tons of chemicals Now assuming the actual terms are 1000 units of apparel for 1.5 tons of chemicals and that the ACTUAL amount traded (exchange) is 4000 units of apparel for 6 tons of chemicals we can find the new consumption levels for each country. Canada produces all 20 tons chemicals. They trade 6 tons of chemical for 4000 units of apparel. So, after trade Canada consumes 14 tons of chemical and 4000 units of apparel. China produces all 30,000 units of apparel. They trade 4000 units of apparel for 6 tons of chemicals. So, after trade China consumes 6 tons of chemical and 26,000 units of apparel. The gain to China comes in apparel. Before trade they consumed 24,000 units of apparel and after trade they consume 26,000. This is a gain of 2000 units of apparel. The gain to Canada comes in chemicals. Before trade they consumed 12 tons of chemicals and after trade they consume 14 tons of chemicals. This is a gain of 2 tons of chemicals. 4. Refer to Figure 3.6. Assume that the graph depicts the Canadian domestic market for corn. How many bushels of corn, if any, will Canada export or import at a world price of $1, $2, $3, $4, and $5? Use this information to construct the Canadian export supply curve and import demand curve for corn. Suppose that the only other corn-producing nation is France, where the domestic price is $4. Which country will export corn? which county will import it? LO 17.2 Answer: At a price of $1: -15,000; Price $2: -7,000; Price $3: 0; Price $4: 6,000; Price $5: 10,000. At a price of $4 Canada will export corn and France will import corn. Feedback: Consider the following example. Refer to Figure 3.6, page 66. Assume that the graph depicts Canadian domestic market for corn. How many bushels of corn, if any, will Canada export or import at a world price of $1, $2, $3, $4, and $5? Use this information to construct the Canadian export supply curve and import demand curve for corn. Suppose that the only other corn-producing nation is France, where the domestic price is $4. Which country will export corn; which county will import it? To calculate the amount of imports or exports subtract quantity supplied from the quantity demanded at each price: Price $1: quantity supplied - quantity demanded = 1,000 - 16,000 = -15,000 (on the import supply schedule below this value will be positive) Price $2: 4,000 - 11,000 = -7,000 Price $3: 7,000 - 7,000 = 0 Price $4: 10,000 - 4,000 =6,000 Price $5: 12,000 - 2,000 = 10,000 At a price of $4 Canada will export corn and France will import corn. 17-7 Copyright © 2015 McGraw-Hill Education. 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