Macro Chapter 2 Homework

What is splitting up the value chain?

Complex goods like cars and computers have many different parts. Splitting up the value chain means that firms specialize in producing particular parts rather than producing all of them.

Are differences in geography behind the differences in absolute advantages?

Differences in geography can be a source of absolute advantages, but it is not the only source. For example, the amount of effort required to mine silver depends to a great extent on where rich deposits of silver are located, which depends on geography. But highly productive automobile factories can exist almost anywhere because productivity in car production depends on things other than geography.

Why might intra-industry trade seem surprising from the point of view of comparative advantage?

It might seem surprising if one thinks that all cars or computers are the same. For example, the United States both exports and imports cars. That might seem to imply that there is no specialization. But if one looks closer, one sees that: 1. The cars imported and exported are not identical, and 2. Parts for both exported and imported cars are often produced by extremely specialized firms.

What factors does Paul Krugman identify that supported the expansion of international trade in the 1800s?

Krugman argues that improved transportation led to a large increase in trade. Railroads and steamships lowered transportation costs significantly. With poor transportation, many trades do not occur because potential gains from trade are eaten up by transportation costs. When these costs are reduced, the trades become worthwhile

How can there be any economic gains for a country from both importing and exporting the same good, like cars?

There are a number of possible advantages of intra-industry trade. Both nations can take advantage of extreme specialization and learning in certain kinds of cars with certain traits, like gas-efficient cars, luxury cars, sport-utility vehicles, higher- and lower-quality cars, and so on. Moreover, nations can take advantage of economies of scale, so that large companies will compete against each other across international borders, providing the benefits of competition and variety to customers. This same argument applies to trade between U.S. states, where people often buy products made by people of other states, even though a similar product is made within the boundaries of their own state. All states and all countries can benefit from this kind of competition and trade.

What is absolute advantage? What is comparative advantage?

A country has an absolute advantage in producing a good if it uses fewer resources to produce that good than other countries. A country has a comparative advantage in producing a good if it has a lower opportunity cost of producing that good than other countries.

If the removal of trade barriers is so beneficial to international economic growth, why would a nation continue to restrict trade on some imported or exported products?

A nation might restrict trade on imported products to protect an industry that is important for national security. For example, nation X and nation Y may be geopolitical rivals, each with ambitions of increased political and economic strength. Even if nation Y has a comparative advantage in the production of missile defense systems, it is unlikely that nation Y would seek to export those goods to nation X. It is also the case that, for some nations, the production of a particular good is a key component of national identity. In Japan, the production of rice is culturally very important. It may be difficult for Japan to import rice from a nation like Vietnam, even if Vietnam has a comparative advantage in rice production. But the most common reason is that domestic special interests often influence politicians to protect them from foreign competition, even though it would be good for domestic consumers.

You just overheard your friend say the following: "Poor countries like Malawi have no absolute advantages. They have poor soil, low investments in formal education and hence low-skill workers, no capital, and no natural resources to speak of. Because they have no advantage, they cannot benefit from trade." How would you respond?

Beneficial trade can occur as long as opportunity costs differ. In other words, beneficial trade depends on comparative advantage, not absolute advantage.

In Brazil, a unit of labor can produce 100 pounds of beef or 10 autos. In the United States a unit of labor can produce 40 pounds of beef or 30 autos. Which country has the absolute advantage in beef? Which country has the absolute advantage in producing autos? What is the opportunity cost of producing one pound of beef in Brazil? What is the opportunity cost of producing one pound of beef in the United States?

Brazil has the absolute advantage in producing beef and the United States has the absolute advantage in autos. The opportunity cost of producing one pound of beef in Brazil is 1/10 of an auto; in the United States it is 3/4 of an auto.

True or False: The source of comparative advantage must be natural elements like climate and mineral deposits. Explain.

False. Anything that leads to different levels of productivity between two economies can be a source of comparative advantage. For example, the education level of workers, the knowledge base of engineers and scientists, specialized learning, economies of scale, and other factors can all determine comparative advantage

In France it takes one worker to produce one sweater, and one worker to produce one bottle of wine. In Tunisia it takes two workers to produce one sweater, and three workers to produce one bottle of wine. Who has the absolute advantage in the production of sweaters? Who has the absolute advantage in the production of wine? How can you tell?

France has an absolute advantage in the production of both sweaters and wine. You can tell because it takes France less labor to produce a unit of the good.

Complex goods like automobiles and iPhones have many different parts. Why might it make sense for different parts to be made in different countries?

If one firm made all the parts required for an automobile, the degree of specialization would be much smaller than if many different firms made the parts. When a particular firm specializes in a particular part, it is more likely to learn unique skills that raise its productivity. In addition, it will be more likely to have significant economies of scale.

Why might increased trade with other countries reduce average costs of production?

Markets in some countries might be too small to take advantage of all economies of scale. Exporting some of the production expands the market and so allows firms to take advantage of all the economies of scale. In addition, trade with other countries allows for an even greater degree of specialization as firms split up the value chain.

Does intra-industry trade contradict the theory of comparative advantage?

No. It actually reinforces the theory because it allows for additional specialization.

Why does the United States not have an absolute advantage in coffee?

Other countries have much more favorable climates for growing coffee.

Are the gains from international trade more likely to be relatively more important to large or small countries?

Small countries. Without trade, large countries with large internal markets will have room for more specialization and can have greater economies of scale.

Under what conditions does comparative advantage lead to gains from trade?

The gains will emerge if each country specializes in the good for which it has a comparative advantage and trades for other goods. The terms of trade must be such that they provide an improvement over domestic opportunity costs. For example, suppose the U.S. can produce two more tables if it produces one less cabinet. If trade allows us to produce a cabinet and trade it for more than two tables, we will be better off.

In the previous question, is there an "ask" where Venezuelans may say "no thank you" to trading with Canada?

Yes. If Canada asks for more than 2,000 barrels of oil for its 1,000 lumber, Venezuela would be better off not trading.

Can a nation's comparative advantage change over time? What factors would make it change?

Yes. In industries that do not depend on climate or natural deposits of minerals and the like, changes in technology or knowledge about how to produce can alter opportunity costs and hence comparative advantages.

Look at Table 2.8: Total Production at Point A before Trade. Is there a range of trades for which there will be no gains?

Yes. Without trade, the United States can produce 1,000 more shoes by giving up 4,000 refrigerators. So any trade that gives the U.S. 1,000 shoes that costs more than 4,000 refrigerators will make it worse off. Without trade, Mexico can produce 1,000 more refrigerators by giving up 800 shoes. So any trade that gives Mexico 1,000 refrigerators that costs more than 800 shoes will make it worse off.

In Germany it takes three workers to make one television and four workers to make one video camera. In Poland it takes six workers to make one television and 12 workers to make one video camera. a. Who has the absolute advantage in the production of televisions? Who has the absolute advantage in the production of video cameras? How can you tell? b. Calculate the opportunity cost of producing one additional television set in Germany and in Poland. (Your calculation may involve fractions, which is fine.) Which country has a comparative advantage in the production of televisions? c. Calculate the opportunity cost of producing one video camera in Germany and in Poland. Which country has a comparative advantage in the production of video cameras? d. In this example, is absolute advantage the same as comparative advantage, or not? e. In what product should Germany specialize? In what product should Poland specialize?

(a) In Germany, it takes fewer workers to make either a television or a video camera. Germany has an absolute advantage in the production of both goods. (b) Producing an additional television in Germany requires three workers. Shifting those three German workers will reduce video camera production by 3/4 of a camera. Producing an additional television set in Poland requires six workers, and shifting those workers from the video cameras reduces the output of video cameras by 6/12 of a camera, or 1/2. Thus, the opportunity cost of producing televisions is lower in Poland, so Poland has the comparative advantage in the production of televisions. Note: Do not let the fractions like 3/4 of a camera or 1/2 of a video camera bother you. If either country were to expand television production by a significant amount, that is, lots more than one unit, then we will be talking about whole cameras and not fractional ones. You can also spot this conclusion by noticing that Poland's absolute disadvantage is relatively lower in televisions, because Poland needs twice as many workers to produce a television but three times as many to produce a video camera, so the product with the relatively lower absolute disadvantage is Poland's comparative advantage. (c) Producing a video camera in Germany requires four workers, and shifting those four workers away from television production has an opportunity cost of 4/3 television sets. Producing a video camera in Poland requires 12 workers, and shifting those 12 workers away from television production has an opportunity cost of two television sets. Thus, the opportunity cost of producing video cameras is lower in Germany, and video cameras will be Germany's comparative advantage. (d) In this example, absolute advantage differs from comparative advantage. Germany has the absolute advantage in the production of both goods, but Poland has a comparative advantage in the production of televisions. (e) Germany should specialize, at least to some extent, in the production of video cameras, export video cameras, and import televisions. Conversely, Poland should specialize, at least to some extent, in the production of televisions, export televisions, and import video cameras.

Suppose in France it takes one worker to produce one sweater, and one worker to produce one bottle of wine. In Tunisia it takes two workers to produce one sweater, and three workers to produce one bottle of wine. Compute the opportunity costs of producing sweaters and wine in both France and Tunisia. Who has the lower opportunity cost of producing sweaters and who has the lower opportunity cost of producing wine?

In France, the tradeoff between sweaters and wine is one-to-one. If it decides to produce one more sweater, it will have to move one worker away from producing wine, which will reduce wine production by one; if it decides to produce one more bottle of wine, it will have to move one worker away from producing sweaters, which will reduce sweater production by one. In Tunisia the calculation is a little more complicated. If it decides to produce one more sweater, it must move two workers away from producing wine, which will reduce wine production by two-thirds of a bottle; if it decides to produce one more bottle of wine, it will have to move three workers away from producing sweaters, which will reduce sweater production by one and a half sweaters. Country Opportunity Cost of One Sweater (in terms of wine) Opportunity Cost of One Bottle of Wine (in terms of sweaters) France 1 1 Tunisia 2/3 3/2 So Tunisia has a lower opportunity cost (and hence comparative advantage) in producing sweaters, and France has a lower opportunity cost (and hence comparative advantage) in producing wine.

What are the two main sources of economic gains from intra-industry trade?

Intra-industry trade allows firms to specialize in different segments of markets (e.g. fuel-efficient cars, luxury cars) and even in producing specific parts of a larger item like cars. Learning takes place as people specialize in particular pieces of the value chain. In addition, specialization allows for economies of scale.

What is intra-industry trade?

Intra-industry trade refers to trade within the same industry from one country to another. For example, the United States both exports and imports cars.

In World Trade Organization meetings, what do you think low-income countries lobby for?

Low-income countries lobby for access to the world's markets, especially in agriculture. They also lobby for an end to the agricultural subsidies that rich countries give their farmers. Such subsidies put poor countries at a competitive disadvantage.

Do consumers benefit from intra-industry trade?

Yes. Consumers benefit from lower costs and greater variety.

You just got a job in Washington, D.C. You move into an apartment with some acquaintances. All your roommates, however, are slackers and do not clean up after themselves. You, on the other hand, can clean faster than each of them. You determine that you are 70% faster at dishes and 10% faster with vacuuming. All of these tasks have to be done daily. Which jobs should you assign to your roommates to get the most free time overall? Assume you have the same number of hours to devote to cleaning. Now, since you are faster, you seem to get done quicker than your roommate. What sorts of problems may this create? Can you imagine a trade-related analogy to this problem?

The point of this question is that having an absolute advantage in everything does not preclude gains from trade. It is analogous to the "Comparative Advantage Goes Camping" example in the textbook. In this case, you would need to determine which roommates have a comparative advantage in which task. That you are faster at everything may make your roommates resent that they have to help out.

If trade increases world GDP by 1% per year, what is the global impact of this increase over 10 years? How does this increase compare to the annual GDP of a country like Sri Lanka? Discuss. Hint: To answer this question, here are steps you may want to consider. Go to the World Development Indicators (online) published by the World Bank. Find the current level of World GDP in constant international dollars. Also, find the GDP of Sri Lanka in constant international dollars. Once you have these two numbers, compute the amount the additional increase in global incomes due to trade and compare that number to Sri Lanka's GDP.

The textbook notes that world GDP is about $30 trillion. A one-percent increase amounts to $300 billion. Even ignoring the effects of compounding, this amounts to $3 trillion over 10 years. In 2014, Sri Lanka's GDP was $78.82 billion. So the gains from trade could be quite substantial.

Why might a low-income country put up barriers to trade, such as tariffs on imports?

There could be a variety of reasons. Tariffs on imports protect domestic producers from competition even as they raise prices for consumers. Usually this is done for political reasons because the producers are typically more politically powerful than the consumers (who may not even know why prices are so high). It could also be done to avoid social unrest if there are a lot of small producers who would be driven out of business if the local market were opened up to foreign competition.

How does comparative advantage lead to gains from trade?

When countries (and individuals) specialize in their comparative advantage, productivity is higher and so total production is higher. The gains come from the higher production.

Is it possible to have a comparative advantage in the production of a good but not to have an absolute advantage? Explain.

Yes. Absolute advantage depends on who uses fewer resources to produce the good. Comparative advantage depends on who has a lower opportunity cost of producing the good. Even a country with an absolute advantage in everything is very unlikely to have a comparative advantage in everything.

In Thailand, one worker can produce one ton of rubber or one telephone. In Indonesia, it takes two workers to produce one ton of rubber and it takes eight workers to produce a telephone. a. Who has the absolute advantage in the production of rubber? in telephones? How can you tell? b. Calculate the opportunity cost of producing 100 additional telephones in Thailand and in Indonesia. Which country has a comparative advantage in the production of telephones? c. Calculate the opportunity cost of producing 100 additional tons of rubber in Thailand and in Indonesia. Which country has a comparative advantage in producing rubber? d. In which product should each country specialize? e. If Thailand sends 100 telephones to Indonesia in exchange for 200 tons of rubber, what will be the gains from trade for each country?

a. Absolute advantage depends on who uses fewer resources to produce the good. Thailand has an absolute advantage in both goods. In Thailand it takes only one worker to produce a ton of rubber, compared to two in Indonesia. Likewise, in Thailand it takes only one worker to produce a telephone, compared to eight in Indonesia. b. To produce 100 additional telephones, Thailand would need to move 100 additional workers into the telephone industry. That means that there would be 100 fewer workers producing rubber, so the production of rubber would fall by 100 tons. In other words, in Thailand, the opportunity cost of 100 additional telephones is 100 tons of rubber. To produce 100 additional telephones, Indonesia would need to move 800 additional workers into the telephone industry. That means that there would be 800 fewer workers producing rubber, so rubber production would fall by 400 tons. In other words, in Indonesia, the opportunity cost of 100 additional telephones is 400 tons of rubber. Thailand has a comparative advantage in telephones because it has the lower opportunity cost. c. To produce 100 additional tons of rubber, Thailand would need to move 100 additional workers into the rubber industry. That means that there would be 100 fewer workers producing telephones, so the production of telephones would fall by 100. In other words, in Thailand, the opportunity cost of 100 additional tons of rubber is 100 telephones. To produce 100 additional tons of rubber, Indonesia would need to move 200 additional workers into the rubber industry. That means that there would be 200 fewer workers producing telephones, so the production of telephones would fall by 25. In other words, in Indonesia, the opportunity cost of 100 additional tons of rubber is 25 telephones. Indonesia has a comparative advantage in rubber because it has the lower opportunity cost. d. Each country should specialize in the good for which it has a comparative advantage. In this case, Thailand should specialize in telephones and Indonesia should specialize in rubber. e. If Thailand did NOT trade, it would have to give up 200 telephones to get 200 tons of rubber. With trade, Thailand can get the 200 tons of rubber for only 100 telephones, so its gain is 100 telephones (200 minus 100). One can also think of it this way: With NO trade, if Thailand gives up the production of 100 telephones, it can get 100 tons of rubber. With trade, if Thailand gives up 100 telephones, it can get 200 tons of rubber, so it gains 100 tons of rubber. If Malaysia did NOT trade, it would have to give up 400 tons of rubber to get 100 telephones. With trade, Indonesia can get 100 telephones for only 200 tons of rubber. So it gains 200 tons of rubber (400 minus 200). One can also think of it this way: With NO trade, if Indonesia gives up the production of 200 tons of rubber, it can get 25 telephones. With trade, if Indonesia gives up 200 tons of rubber, it can get 100 telephones, so it gains 75 telephones.

Table 2.14 shows how the average costs of production for semiconductors (the "chips" in computer memories) change as the quantity of semiconductors built at that factory increases. a. Based on these data, sketch a curve with quantity produced on the horizontal axis and average cost of production on the vertical axis. How does the curve illustrate economies of scale? b. If the equilibrium quantity of semiconductors demanded is 90,000, can this economy take full advantage of economies of scale? What about if quantity demanded is 70,000 semiconductors? 50,000 semiconductors? 30,000 semiconductors? c. Explain how international trade could make it possible for even a small economy to take full advantage of economies of scale, while also benefiting from competition and the variety offered by several producers. Table 2.14: Quantity of Semiconductors Average Total Cost 10,000 $8 each 20,000 $5 each 30,000 $3 each 40,000 $2 each 100,000 $2 each

a. Plotting the points on a diagram and then drawing a line through them. The curve illustrates economies of scale by showing that as the scale increases, that is, as production at this particular factory goes up, the average cost of production declines. The economies of scale exist up to an output of 40,000 semiconductors; at higher outputs, the average cost of production does not decline any further. b. At any quantity demanded above 40,000, this economy can take full advantage of economies of scale; that is, it can produce at the lowest cost per unit. Indeed, if the quantity demanded was quite high, like 500,000, then there could be a number of different factories all taking full advantage of economies of scale and competing with each other. If the quantity demanded falls below 40,000, then without foreign trade, the economy cannot take full advantage of economies of scale. c. The simplest answer to this question is that the small country could have a large enough factory to take full advantage of economies of scale, but then export most of the output. For semiconductors, countries like Taiwan and Korea have recently met this description. Moreover, this country could also import semiconductors from other countries which also have large factories, thus getting the benefits of competition and variety. A slightly more complex answer is that the country can get these benefits of economies of scale without producing semiconductors simply by buying semiconductors made at low cost around the world. An economy, especially a smaller country, may well end up specializing and producing a few items on a large scale, but then trading those items for other items produced on a large scale, and thus gaining the benefits of economies of scale by trade, as well as by direct production.

France and Tunisia both have Mediterranean climates that are excellent for producing/harvesting green beans and tomatoes. In France it takes two hours for each worker to harvest green beans and two hours to harvest a tomato. Tunisian workers need only one hour to harvest the tomatoes but four hours to harvest green beans. Assume there are only two workers, one in each country, and each works 40 hours a week. a. Draw a production possibilities frontier for each country. Hint: Remember the production possibility frontier is the maximum that all workers can produce at a unit of time, which, in this problem, is a week. b. Identify which country has the absolute advantage in green beans and which country has the absolute advantage in tomatoes. c. Identify which country has the comparative advantage in each good. d. If France sends 5 green beans to Tunisia in exchange for 10 tomatoes, how much will each country gain?

b. France has an absolute advantage in green beans because it takes less labor to produce green beans (two hours compared to four hours in Tunisia). Tunisia has an absolute advantage in tomatoes because it takes less labor to produce green beans (one hour compared to two in France). c. France has a comparative advantage in green beans because its opportunity cost for one unit of green beans is one tomato, whereas in Tunisia the opportunity cost is four tomatoes. Tunisia has a comparative advantage in tomatoes because its opportunity cost of a tomato is one-fourth units of green beans, whereas in France the opportunity cost is one unit of green beans. d. If France produced 10 tomatoes, it would have to give up the production of 10 green beans. But if France trades for the 10 tomatoes, in this case it would give up only five green beans. France's gains from trade would be five green beans. (Think of it this way: if France does not trade, it sacrifices 10 green beans to get the 10 tomatoes. But if it trades, it will specialize in what it does better, and will produce the 10 green beans itself. It will spend five of those green beans to get the 10 tomatoes, and will have five green beans left over.) If Tunisia produced the five green beans on its own, it would give up the production of 20 tomatoes. If Tunisia trades for the green beans, it will give up 10 tomatoes to get the five green beans. So Tunisia will gain 10 tomatoes. (Tunisia produces 20 tomatoes, for which it has a comparative advantage, sends 10 of them to France for the green beans it wants, and still has 10 tomatoes left over.) 0 2 4 6 8 10 12 0 5 10 15 20 25 30 35 40 45 Green Beans Tomatoes Tunisia 30. In Thailand, one worker can

Review the numbers for Canada and Venezuela from Table 2.11, which describes how many barrels of oil and tons of lumber the workers can produce. Use these numbers to answer the rest of this question. a. Draw a production possibilities frontier for each country. Assume there are 100 workers in each country. Canadians and Venezuelans desire both oil and lumber. Canadians want at least 2,000 tons of lumber. Mark a point on their production possibilities where they can get at least 3,000 tons. b. Assume that the Canadians specialize completely because they figured out they have a comparative advantage in lumber. They are willing to give up 1,000 tons of lumber. How much oil should they ask for in return for this lumber to be as well off as they were with no trade? How much should they ask for if they want to gain from trading with Venezuela? Note: We can think of this "ask" as the relative price or trade price of lumber. c. Is the Canadian "ask" you identified in (b) also beneficial for Venezuelans? Use the production possibilities frontier graph for Venezuela to show that Venezuelans can gain from trade.

b. Without trade, Canada can produce 500 barrels of oil for every 1,000 tons of lumber it gives up. In order to gain from trade, Canada would ask for more than 500 barrels of oil in exchange for 1,000 tons of lumber. Every barrel of oil it gets above 500 would be its gain from trade. If Canada asks for 1,000 barrels of oil for its 1,000 lumber, it will gain 500 barrels of oil. c. Without trade, Venezuela can obtain 1,000 tons of lumber by giving up 2,000 barrels of oil. If it trades with Canada and can get the 1,000 lumber for only 1,000 barrels of oil, it will gain (save) 1,000 barrels of oil. On its production possibilities frontier, suppose that before trade, Venezuela produced 4,000 barrels of oil and 1,000 tons of lumber. If it trades, it will reach a point beyond its production possibilities frontier; it will have 3,000 barrels of oil and 2,000 tons of lumber.