CHAPTER 15COMPARATIVE ADVANTAGE AND PROTECTIONISM

I. CHAPTER OVERVIEW

In this chapter, Samuelson and Nordhaus present the basic economic model of trade. The fundamental point isthat foreign trade can improve welfare (i.e., the standard of living) of most nations, even if they already are themost productive in producing everything. Part of David Ricardo’s great contribution to the study ofinternational trade was to show that inefficiency in all lines of production would make a country poor, but itwould not cause its trading opportunities to totally evaporate. Relatively efficient and inefficient countries canstill trade to mutual advantage, provided there are some differences in their relative costs of production. Thefirst part of the chapter explains Ricardo’s innovative view of trade.

Once the case for free trade is made, Samuelson and Nordhaus turn the coin over to look at its oppositeside—protectionism. If free trade is so beneficial, why do we see so many barriers to free trade in the realworld? To answer this question, it is essential to see how trade barriers work. Only then can their effects bedelineated and their merits evaluated. The second section of Chapter 15 tends to this task. With the effects ofprotectionism firmly in hand, the various arguments for and against protection are then critically reviewed.

II. LEARNING OBJECTIVES

After you have read Chapter 15 in your text and completed the exercises in this Study Guide chapter, youshould be able to:

1. Discuss some of the recent trends in foreign trade and understand the economic factors that lie behindinternational trade patterns.2. Distinguish between absolute advantage and comparative advantage.3. Explain, using a simple two-commodity model, how a country can increase its real income byspecializing (for the purpose of export) in the commodity in which it has a comparative advantage andimporting the commodity in which it has a comparative disadvantage.4. Understand that the Ricardo model is easily extended to include multinational trading arrangements.5. Use supply-and-demand analysis to outline the economic effects of protection. Show that openingtrade in a good drives its domestic price toward equality with its world price. Show that a tariff can beexpected to generate welfare losses.6. Outline the economic as well as the noneconomic arguments for trade restriction and evaluate theirvalidity.7. List a few nontariff barriers to trade that have been employed by the United States in the past few yearsand explain how they work.

III. REVIEW OF KEY CONCEPTS

Match the following terms from column A with their definitions in column B.A B

__ Principle of 1 Occurs when a firm from Country B sells its product in Country A at a pricecomparative beneath its average cost, or at a price lower than the existing domestic price inadvantage Country B.

__ Absolute 2. Illustrates pre- and post-trade production and consumption, and tradeadvantage alternatives for a country.

__ Comparative 3. Program or policy which protects the domestic economy at the expense ofadvantage other countries.

__ Terms of trade 4. Tariff that maximizes a country’s domestic real income by shifting the terms oftrade in its favor.

__ Consumption- 5. Each country will specialize possibility curve in the production and export ofadvantage those goods that it can produce at relatively low cost and import those which it

produces at relatively high cost.__ Multilateral 6. Tariff which is used to protect a new domestic industry from powerful fully

trade developed international competitors.__ Tariff 7. Exists when a country can produce a commodity at lower relative cost.__ Quota 8. Exists when a country can produce a commodity with greater absolute efficiency

or lower resource cost.__ Mercantilism 9. The exchange of goods and services among a multitude of nations.__ Dumping 10. A ratio of export prices to import prices which defines the upper and lower price

boundaries for goods traded between countries.

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__ Optimal tariff 11. Pre-Ricardian economic philosophy that espoused the benefits of trade surplusesand the acquisition of gold.

__ Infant industry 12. A tax on imported goods and services.tariff

__ “Beggar thy 13. A limit on the quantity of imports.neighbor” policy

IV. SUMMARY AND CHAPTER OUTLINE

This section summarizes the key concepts from the chapter.

A. The Nature of International Trade1. The fundamental point of this chapter is that foreign trade can improve the welfare (i.e., the standard ofliving) of most nations, even if they are the most productive in producing everything.2. There are several differences between international trade and domestic trade. When a country moves intothe international arena, it:

a. enjoys a much richer menu of products to choose from.b. must deal with the laws and regulations of another sovereign nation.c. must trade its currency in foreign exchange markets.

3. While there are numerous reasons why nations may find it beneficial to engage in international trade, thereare three main economic considerations:

a. diversity in conditions of production.b. economies of scale and decreasing average costs.c. differences in tastes.

B. Comparative Advantage Among Nations1. If the United States had no domestic sources of tin, then it would surely have to import the tin it needed.What is not so obvious is why the United States, or any other country for that matter, should import acommodity which it could and does produce. The basic message of this chapter is that a nation should importsome goods which it is capable of producing at home if it wants to use its resources to the best advantage.Each country should move toward specializing in the production of those commodities it is best equipped tomake, given its own resources and those available to other countries. It should export part of what it hasproduced, receiving in exchange other goods (imports) which it is less equipped to make.2. Before trying to understand why certain frequently held notions about international trade are incorrect, youmust first grasp the basic notion of comparative advantage; it alone explains why, in terms of real income, itpays each nation to move toward specializing in the production of a specific good or goods, to export thosegoods, and to use the proceeds of that export trade to finance the import of other goods. A country has anabsolute advantage in the production of any good X if it can produce X at a smaller cost than a potentialtrading partner. It has a comparative advantage in the production of X if it can produce X relatively lessexpensively than it can produce some other tradable commodity.3. The potential gains from trade are derived from comparative advantage. A country can collect these gainsby concentrating its production efforts on goods in which it has a comparative advantage, exporting some or allof its output in exchange for goods in which it has a comparative disadvantage. A country with absoluteadvantages in the production of all goods can therefore still improve its welfare through trade if it concentrateson the production of goods in which its absolute advantage is largest.4. The Ricardo model, which first described comparative advantage and the potential gains from trade, is aclassical, full-employment model. Adjustment in the product mix designed to take full advantage of thepotential can, however, be marked painfully by the short- to medium-term unemployment of displaced factorsof production. Even when long-run equilibrium has been achieved with full employment, moreover, somepeople may be worse off than before. The idea is only that aggregate welfare has been improved.5. The mercantilist philosophy was that a nation ought to apply the same principles of prudence appropriatefor a family. It is prudent for a family to try to save part of its income. The nation, mercantilists said, is justthe family on a larger scale. Furthermore, they equated saving, at the national level, with the accumulation ofgold.

The argument is not totally fallacious. Any nation will find it desirable to have reserves of gold (orforeign exchange) to cope with changing events which may produce balance-of-payments deficits. Even at thefamily level, though, the argument for “prudence” is wrong if interpreted as meaning that all families musthoard their money. Savings that are not allowed to flow into investment spending lead only to depression andto a decrease in savings.

C. Protectionism

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1. Three principal reasons, often working together, explain the rationale behind most of the actual or proposedrestraints of foreign trade:

a. A country fears unemployment and regards import competition as a potential source of thatunemployment.b. A country is short of foreign exchange reserves and sees increased tariffs as a potential source of newrevenue.c. The groups within a country who would benefit most directly from protection bring political pressureto bear for its imposition.

2. In a period of heavy unemployment, it is hard to preach comparative advantage and free trade to legislatorsand business people. They will argue that a reduction in imports would raise domestic employment at theexpense of lower aggregate demand and correspondingly higher unemployment abroad, and so they mightadvocate an increase in protective tariffs. Such an attempt to “export unemployment” could, of course, benegated when other countries retaliate with similar tariff increases.3. It would be wrong to insist that import restrictions can never reduce unemployment. The proper objectionis that fiscal and monetary policies can be far more effective. Moreover, these policies avoid the dubious ethicsof trying to foist off domestic unemployment onto other nations, and they do not incur the danger ofretaliation.4. Given reasonable assurance that unemployment can be handled by methods other than protection, manypeople in developed countries find it fairly easy to accept the free-trade principle; but people living in lessdeveloped countries tend to be more hesitant. They look at the world’s most prosperous nations and hope thattheir own country might someday enjoy equally high standards of production and income. They wonder ifsome restriction on imports may be needed in order to widen production and employment opportunities and tofoster their nation’s industrial growth.5. Simple supply-and-demand analysis can be employed to show that protection strategies increase domesticprices and generate welfare losses by (a) promoting inefficient domestic production and (b) reducingconsumption.6. Unless the protection is prohibitive, it can generate revenue for the government. (Tariff collections orimport license auctions can be equivalent in this regard.)7. Noneconomic arguments for protection are sometimes made: national interest and/or security, culturaland/or regional integrity, and so on. Domestic subsidies can be more effective in these instances.8. Other economic arguments are false: protecting domestic employment, special-interest protection, andmercantilistic pursuit of favorable terms of trade. Alternative domestic policies can be more effective in theseinstances.9. Dynamic arguments for protection are more attractive, but they can be risky. Optimal tariff barriers andinfant-industry protection run the risk of retaliation, for example.

V. HELPFUL HINTS

1 Absolute advantage means lower resource cost, or more efficient use of resources. Comparative advantagemeans lower relative cost, that is, relative to what has to be given up.

Consider the following example. There are two countries: Annastasia and Bobbyland, or A and B. Priorto trade, they each produce two goods: robots (R) and xylophones (X). Table 15-1 shows the labor cost(assuming labor is the only factor of production) of producing a unit of each good.

TABLE 15-1 Labor Hours Needed to Produce One Unit A B

R 1 hour 10 hoursX 3 hours 20 hours

Annastasia has an absolute advantage in the production of both goods. It can produce them with fewerresources. To evaluate comparative advantage, we need to measure the relative cost of producing eachcommodity within each country.

In Annastasia, the relative cost of producing one robot is 0.33 xylophones. Here is why: WhenAnnastasia decides to produce robots, it costs 1 hour of labor for each one. If that hour of labor had been usedin the manufacture of xylophones, it could have produced one-third of a xylophone instead.

In Bobbyland, the relative cost of R is 0.50X. Relatively speaking, or relative to what each country has togive up, Annastasia has a comparative advantage in the production of R.

In A, the relative cost of producing one X is 3R. In B, the relative cost of producing one X is 2R. So, Bhas a comparative advantage in the production of X. Relatively speaking, B gives up less to produce X.2. In a two-good world, it is definitionally impossible for a country to have a comparative advantage in theproduction of both goods. However, in a many-good world, one country will always have a comparativeadvantage in something.

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3. Prices do not need to be measured in monetary terms—they can be measured in terms of the other good.

VI. MULTIPLE CHOICE QUESTIONS

These questions are organized by topic from the chapter outline. Choose the best answer from the optionsavailable.

A. The Nature of International Trade1. Countries engage in international trade to:

a. take advantage of economies of scale.b. acquire additional resources.c. satisfy the tastes of their citizens.d. all of the above.e. a and b only.

2. One of the big differences between domestic trade and international trade is that:a. the distances, and hence the transportation costs, are greater.b. foreigners are harder to deal with.c. currencies must be exchanged.d. all of the above.e. none of the above.

3. What is the difference between domestic and international trade?a. A country enjoys a much richer menu of products to choose from.b. Trading across frontiers involves different customs, which may have an impact on trade.c. A country must trade its currency in foreign exchange markets.d. All of the above.e. None of the above.

B. Comparative Advantage Among Nations4. In terms of comparative advantage, which of the following is the most correct explanation of why bananasare imported instead of grown commercially in the United States?

a. Bananas cannot be produced in the temperate zones.b. It would take a great deal of effort to produce bananas in the United States.c. Bananas can be produced with less effort in other countries than they can in the United States.d. U.S. resources are better employed in producing other commodities, and tropical-country resources arebetter employed in banana production than in other things.e. The U.S. climate does not lend itself to banana production.

5. Before international trade begins, a country will have an equilibrium ratio of prices (determined by relativeproduction costs in the classical Ricardo model) between any two commodities. If trade involving thesecommodities begins with another country, then this price ratio will ordinarily be altered:

a. only if a change in production costs results within the country.b. in all cases (except when the volume of international trade proves to be too small to affect it).c. only in cases where the volume of international trade is small.d. not at all, since it is an equilibrium relationship.e. only in cases where the volume of international trade is exceedingly large.

Use Table 15-2 to answer questions 3 through 7. The table records the output of labor (assumed to be the onlyinput involved) in the production of wine and cloth in two countries, A and B.

TABLE 15-2 Production per Hour Country A Country B

Yards of cloth 5 15Liters of wine 10 20

6. Comparing the two countries and contemplating trade between them on the basis of production advantages,it would be correct to say that Country A has:

a. an absolute advantage in cloth production.b. an absolute advantage in wine production.c. a comparative advantage in cloth production.d. a comparative advantage in wine production.e. a comparative advantage in neither commodity.

7. Suppose that initially there is no trade between these two countries. In Country A, the currency unit is the

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“donaro;” in Country B. it is the “gelt.” The prices of cloth in A and B in their pretrade situations are,respectively, 20 donaros and 60 gelts. For an equilibrium in which each country continues to produce bothcommodities, the corresponding wine prices would have to be:

a. 5 donaros, 20 gelts.b. 40 donaros, 45 gelts.c. 10 donaros, 45 gelts.d. 10 donaros, 80 gelts.e. 40 donaros, 80 gelts.

8. If trading opportunities were to open (international transport costs assumed to be zero or negligible), thenwe should expect Country B to:

a. import wine.b. export wine.c. import both commodities.d. export both commodities.e. neither export nor import, since its productive situation is such that there is no prospect of profitabletrade with Country A.

9. Before the trading opportunity of question 5 emerged, each country had its own price ratio, reflectingdomestic production costs. If trade develops between Countries A and B, this ratio—specifically, the ratio ofthe price of wine to the price of cloth—should:

a. rise in Country A, fall in Country B.b. fall in Country A, rise in Country B.c. rise in both.d. fall in both.e. not change in either country, except perhaps during a short transitional period before equilibrium isreestablished.

10. Once international trade has been established and a new equilibrium has been reached, then the ratio ofcloth price to wine price (transport costs still assumed to be zero) might reasonably be:

a. 1.2 in both countries.b. 1.6 in both countries.c. 1.3 in A, 2.1 in B.d. 2.1 in A, 1.3 in B.e. 2.3 in both countries.

11. Differences in comparative production costs are usually cited as the principal basis for international trade.Another (and different) possible source of international exchange is:

a. differences in climates.b. fixed foreign exchange rates.c. differences in transport costs.d. differences in labor skills.e. economies of mass production.

12. Trade between countries of comparable size but with different standards of living will be:a. profitable to the country with lower living standards at the expense of the one with higher standards.b. profitable to both as long as price ratios differ in the two countries, but of no profit to either once acommon price ratio has been established.c. profitable in some degree to both, even after a common price ratio has been established.d. unprofitable to both because one country would be at an absolute disadvantage in all products.e. profitable to the country with higher living standards at the expense of the one with lower livingstandards.

13. In terms of comparative advantage, the most correct explanation of why coffee is imported into the U.S. isthat:

a. coffee cannot be grown in the U.S.b. coffee requires too much fertilizer to produce.c. coffee is in low demand in the U.S.d. U.S. resources are better employed in producing commodities that are relatively more expensive toproduce in other countries and relatively less expensive to produce in the U.S.e. none of the above is correct.

C. Protectionism14. One argument for tariffs contends that they should be imposed to help a domestic producer to compete

when the level of foreign wages is significantly below the level of domestic wages. This argument:a. is conceded by most economists to be correct, although sometimes exaggerated in order to justifysome level of tariff protection.

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b. is fallacious because there are almost no instances in which there is any real difference between thelevels of foreign and domestic wages.c. ignores the fact that differences in relative costs constitute the principal basis for international trade.d. may be correct with respect to money wages at home and abroad but is not correct with respect to realwages.e. is not correctly described by any of the preceding.

15. Country A imposes a new tariff on Country B’s products. Country B is considering a retaliatory tariff onA’s goods. On economic grounds, B should:

a. reject the idea of a tariff increase.b. make the retaliatory tariff less than A’s tariff.c. make the retaliatory tariff more than A’s tariff.d. impose the retaliatory tariff only if B is in a situation of full employment.e. adjust the price of its currency relative to A’s currency.

16. The policy of the mercantilists with respect to foreign trade held that:a. imports should exceed exports—i.e., the country should “get more than it gives”—in order to increasereal income at home as much as possible.b. exports should exceed imports in order to bring in gold.c. since this trade represented commerce, it should be encouraged to the greatest possible degree—i.e.,there should be free trade.d. exports should be kept in balance with imports and at the lowest possible level of both.e. trade in agricultural products was more important than trade in industrial goods.

17. The principal reason high-wage American labor should not require tariff protection from lower-paid foreignlabor is:

a. no American labor would be thrown out of work even if there were no tariffs.b. the high per-worker-hour productivity of American labor in many industries is an offset to the lowercost of foreign labor.c. American consumers tend to buy American-made goods in preference to foreign-made goods.d. a high-wage American industry can be presumed to have a comparative advantage over foreigncompetitors.e. none of the preceding reasons.

18. The argument by workers in a protected industry in the United States that free trade would worsen theincome position of American labor is:

a. not valid even for workers in that industry after allowance is made for the improvement in real incomeafforded by cheaper imports.b. not valid even for workers in that industry after allowance is made for the employment effect ofincreased exports.c. valid for workers in that industry but probably not valid for American labor as a whole.d. valid for workers in that industry and probably valid for American labor as a whole.e. probably valid for workers in that industry but unquestionably invalid for American labor as a whole.

19. From a purely economic point of view, the best level at which to set a tariff (under static assumptions) is:a. the prohibitive point.b. the amount needed to bring the level of foreign costs up to the level of domestic costs.c. zero.d. a level sufficiently low so that it is not likely to invite retaliation by other countries.e. the level at which revenues from the tariff will be at a maximum.

20. One argument for tariff protection contends that a tariff would improve the terms of trade in dealing withother nations. This argument:

a. is a refinement of the mercantilist argument that a nation’s exports should exceed its imports.b. may be valid if the tariff-imposing country is a relatively large one and the tariff is a relatively smallone.c. is a refined version of the infant-industry argument and hence has no validity.d. may be valid if the tariff-imposing country is unimportant in world trade for the commodity orcommodities involved.e. may be valid if it is applied to all the country’s imports, without or almost without exception.

21. It may be argued that a tariff should be imposed on a commodity if that commodity is considered essentialto material well-being and/or if it is suspected that the foreign suppliers thereof might use their supply controlfor purposes of political blackmail. Most economists hold that:

a. the tariff is justified if the commodity is deemed really essential.b. subsidy would be preferable to a tariff if the commodity is deemed really essential.c. the best remedy for threats of political blackmail is to insist on all-around free trade.d. although the imposition of a tariff might be used as a threat, political moves should be met bypolitical countermoves (even to the threat of war), not by economic moves.

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e. its domestic production should be nationalized if the commodity is deemed really essential.22. If we reduce the flow of import goods by imposing heavy tariffs, our exports are likely to be affected inwhich of the following ways?

a. They will likely be reduced when other countries retaliate by imposing tariffs against those exports (asis likely), but not otherwise.b. There is little reason to expect that they will be affected at all, since retaliatory tariffs have usuallyproved ineffective.c. They will likely be increased, since other countries will find it necessary to buy more from us tocompensate for the higher cost of the goods they sell us.d. They will likely be increased if the tariff raises the level of employment and national product at home,but not otherwise.e. They are likely to be reduced in all or almost all circumstances.

23. A valid counter to the argument that a tariff results in increased money wages in the protected industry isthat:

a. workers in that industry will in all probability suffer a loss in real wages.b. workers in other industries will suffer a loss in real wages.c. the increase in money wages in the protected industry will cause unemployment.d. tariffs cannot increase money wages in any industry.e. any increase in real wages is likely to lead to inflation.

24. Arguments cited in favor of a protective tariff frequently note that tariffs (a) protect domestic industryagainst foreign competition and (b) bring revenue to the government. In response to these arguments, it may besaid that:

a. the tariff reduces rather than increases the sales of the domestic industry.b. if the industry in question enjoys an absolute advantage in production, it stands in no need of such atariff.c. the emphasis on government revenue may lead to a tariff per unit much higher than the domesticindustry needs for protection.d. an effective tariff will actually bring in no government revenue at all.e. none of these statements is correct.

25. A difference between a tariff on an imported good and a quota on the same good is that:a. a quota can never be made to yield revenue for the government, whereas a tariff can.b. a tariff can never be made to yield revenue for the government, whereas a quota can.c. a quota can be used to shut off all, or virtually all, the inflow of the imported good, whereas a tariffcannot.d. a tariff can be used to shut off all, or virtually all, the inflow of the imported good, whereas a quotacannot.e. a quantity-equivalent quota will generate the same revenue only if import rights are auctioned.

26. A prohibitive tariff:a. was used during the Prohibition.b. effectively chokes off all imports.c. prohibits placing a tariff on certain commodities.d. is less restrictive than a nonprohibitive tariff.e. is none of the above.

VII. PROBLEM SOLVING

The following problems are designed to help you apply the concepts that you learned in the chapter.

A. The Nature of International Trade1. a. As shown in Figure 15-2, the trend in the United States over the past half-century has been to (open /

dose) its economy to foreign trade.b. The usual measure of openness, the ratio of ___ and/or ___ to GDP has, in fact, (risen / fallen) overtime.c. The percentage of U.S. GDP that is related to trade is (higher / lower) than the percent whichcharacterizes most of the economies of Europe.B. Comparative Advantage Among Nations

The following questions build toward an examination of the theory of comparative advantage by looking ateconomic conditions before trade begins. The idea is to start by identifying a country’s before-trade positionand standard of living and then to show how the initiation of foreign trade can increase real income.

The same simplifying assumptions employed in the text are employed here. There are only two regions:“America” and “Europe.” Only two commodities are involved: food (F) and clothing (C). All the costs of

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producing either F or C can be measured in hours of labor. For some reason, however, the yields from an hourof labor, in the making of both F and C, differ across international boundaries.

Figure 15-1

TABLE 15-3 Yield of 1 Labor-Hour Units of F Units of C

In America 20 6In Europe 10 8

TABLE 15-4Minutes of Labor

Required to Produce:1 Unit of F 1 Unit of C

In America 3 10In Europe 6 7.5

2 The quantities of F and of C resulting from 1 hour of labor in America and in Europe are given in Table15-3. These data translate into the input requirements recorded in Table 15-4.

a. Assuming that “1 hour of labor” means the same thing in both countries, the figures indicate thatAmerica is more productive in (F / both F and C / C / neither F nor C).b. Europe is, meanwhile, more productive in (F / both F and C / C / neither F nor C).c. In an 8-hour day, therefore, a worker in America can produce either 8 x 20 = 160 units of F or (l0 / 48/ 64 / 80) units of C.d. In Europe a worker can produce either 64 units of C or (10 / 48 / 64 / 80) units of F.

3. This chapter assumes that all the costs of producing either commodity in either region are labor costs andthat all revenue from sale of the commodity goes to that labor.

a. If the market price of a unit of F in America were $1, then the hourly wage earned by an Americanworker producing F would be ($0.05 / $0.10 / $1.00 / $10.00 / $20.00).b. If, instead, F’s price in America were $0.05 (5 cents), then the corresponding hourly wage for an Fworker would be ($0.05 / $0.10 / $1.00 / $10.00 / $20.00).c. Similarly, if C’s price per unit in America were $2, then the hourly wage of a C worker would be($0.30 / $0.60 / $2.00 / $10.00 / $12.00).d. If the price per unit of F were £1 (1 pound) in Europe, then the hourly wage of an F worker therewould be (£1 / £4 / £6 / £8 / £10).e. If C’s price in Europe were £1, on the other hand, then the corresponding hourly C wage would be (£1/ £4 / £6 / £8 / £10).

4. Suppose that the prices of F and C in America are both $1.a. A worker, free to choose an occupation in either industry, would earn more by going to work in theproduction of (F / C). Specifically, earnings per hour would be ($1 / $6 / $8 / $10 / $20) in theproduction of F and ($1 / $6 / $8 / $10 / $20) in the production of C.

Given freedom of labor to enter either occupation (and with no other preference between them), theprices noted above (both $1) (could / could not) characterize an “equilibrium” situation in America. Ifthese prices did prevail—say, because the government tried to enforce them by law—then (only F / only C/ both F and C) would be produced.

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b. If the prices of both F and C were somehow £10 in Europe, then (again assuming no barrier tomovement between occupations) (all the workers would move into production of F / all the workerswould move into production of C / there would be no change in the production mix of F and C).c. The point is that the supply of resources (here, the entire labor force) would shift away fromproduction of the “underpriced” commodity unless the prices of F and C stand in the proper relation to oneanother, i.e., unless they reflect relative marginal costs. If the price of F were $3 in America, then the priceof C would have to be ($1 / $3 / $8 / $10 / $12), if both F and C are to be produced.

If the price of C were $2 in America, then the price of F should be ($0.30 / $0.60 / $1.00 / $1.50 / $2.00).Prices of $2.40 for F and $9 for C (would / would not) support an equilibrium.d. It is relative prices that matter here. In America, the ratio between pF and pC must be (1:1 / 3:10 /5:10 / 10:3) because only that ratio matches the underlying ratio of production costs, measured in labortime needed to produce 1 unit of each commodity.

The absolute level of prices would be governed by such factors as the quantity of money circulating within thecountry.

e. If prices of F and C somehow got stuck at $2.40 and $9, respectively, workers would move away fromthe production of (F / C) and into the production of (F / C).

In Europe, the same requirement holds, except that the relationship must match productive conditions there.f. If the price of F in Europe were £4, then the price of C would have to be (£1 / £2 / £3 / £4 / £5) tosupport an equilibrium in which both commodities were produced. More generally, Europe’s price ratio (Fto C) must be (3:10 / 5:10 / 4:5 / 5:4).

The questions thus far have assumed that there is no international trade between America and Europe. Nowassume that the opportunity for trade between the two regions suddenly materializes. Assume, for simplicity,that the costs of shipping goods from one region to the other are so small that they can be considered zero. Theprices of F and of C in America are, respectively, 60 cents and $2.5. In America (and in Europe), opening trade would disrupt the pretrade domestic “equilibrium.” Forexample, in the United States, trade supplements domestic supplies of C.

a. The price of C should therefore (rise / remain unchanged / fall). This in turn means that the ratio ofthe price of F to the price of C (i.e., pF/pC) should (rise / remain unchanged / fall).b. We know that workers would leave the “underpriced” occupation if America’s price ratio pF/pC wereanything other than 3:10 (or 0.3). In this case, workers would move from the production of (F / C) to theproduction of (F / C) as the price ratio rose, and that would be good.

Why? Because America’s new export trade means that more workers are needed in the production of Americanexports—commodity F.

c. In Europe, which imports what America exports, there would (be a / not be any) correspondingchange in domestic prices. There, the ratio pF/pC would (rise / remain unchanged / fall).

The price of F would fall as imports arrived from America. The price of C would rise, meanwhile, since therewould now be a new and increased demand for European C in America.

d. Workers would leave the production of (C / F), moving instead to production of Europe’sexport—commodity C.

6. The points of these questions can be illustrated graphically. Take the input requirements listed in questionl as given, and suppose that Europe and America are both endowed with 10 hours of labor (not very realistic, tobe sure, but a convenient number around which to build some illustrative geometry). Suppose further that bothregions start, in the absence of any trade, by dividing their labor resources equally between F and C.

a. In panel (a) of Figure 15-2, draw the production possibility frontier for America, and identify theinitial production mix as point A. Draw the corresponding frontier for Europe in panel (b), and identify theinitial production mix as point B.b. The slope of the American frontier, equaling ___ in magnitude, represents the relative domestic priceratio of food to clothing in America. The corresponding slope of the European frontier, equaling in ___magnitude, is similarly the relative domestic price ratio in Europe.c. Start with America, which produces ___ units of F and ___ units of C; Europe begins producing ___units of F and ___ units of C. Total “world” production of C is ___ units; total production of F is ___units.

7. Suppose now, for the sake of argument, that America chooses to specialize in F in trade with Europe at theEuropean domestic price ratio.

a. In panel (a) draw a budget constraint (a consumption frontier based upon specializing in the productionof F and trading to get C) indicating the possible points of consumption given this strategy. If Americawere to continue to consume the original 30 units of C, then it could increase its consumption of F from100 units to ___ units by selling ___ units of F for 30 units of C. Welfare in America, assuming asmooth transition from a 50-50 labor split to 100 percent concentration in the production of F wouldtherefore necessarily (fall / stay the same / rise).

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Now play the same game from the other side of the Atlantic. Assume that Europe decides to specializecompletely in the production of C and buys as much F as it wants given the American price ratio.

b. Draw the appropriate budget constraint in panel (b).c. If Europe were still interested in consuming 40 units of C, it could increase its consumption of F from50 units to ___ units by selling 40 units of C for ___ units of F. European welfare would, in this secondcase, also (climb / remain the same / fall), again making the same assumption of continued fullemployment during the transition.

Figure 15-2

8. The world production frontier can now be constructed.a. Suppose, first of all, that both countries specialize in F; production of F would equal __ units inAmerica and __ units in Europe, for a total of __ units; total production of C would then equal __ units.b. Plot this combination in panel (c) and label it point D.

Now reverse the specializations of both countries.c. Total production of F would then equal __ units, with the production of C climbing to a maximum of__ units.d. Plot this second point in panel (c) and label it E.

Halfway between these extremes are two intermediate cases of mixed specialization.

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e. If Europe specialized in C and America specialized in F, then __ units of F would be produced alongwith __ units of C.f. Denote this point G and plot it in panel (c), as well.g. If the specializations were reversed, though, __ units of F would be produced in Europe and __ unitsof C would be produced in America.h. This point, plotted and labeled H in panel (c), (would / would not) be on the frontier because theproduction level(s) of (F is / C is / neither F nor C is / both F and C are) lower at H than at G.

The world frontier is now at hand.i. A straight line connecting points D and G would correspond to specialization by (America / Europe)in the production of (F / C) and some intermediate combination of F and C produced in (America /Europe). Similarly, points along a line connecting points G and E would correspond to specialization in(America / Europe) in the production of (F / C) and some intermediate combination in (America /Europe) .

(Note: The frontier you just drew should look like the frontier shown in the text.)j. Finally, plot the pretrade initial production point in panel (c) and label it I; it (is / is not) on thefrontier. The point chosen by free trade outlined above would be (D / E / G / H). It (would / would not)be on the frontier, and it would, for both countries, be superior to the initial, pretrade position.

C. Protectionism9. Consult Figure 15-3. Curve SS represents a domestic supply curve for some good X; if X is a competitiveindustry, then SS represents the horizontal sum of the marginal cost curves of many firms. Curve DDrepresents domestic demand for the same good. It is implicitly assumed that consumers do not care where thegood was made; they simply want to buy the indicated quantities at the indicated prices.

a. The market-clearing price in the absence of trade is $___, and ___ units of X would be demanded andsupplied domestically at that price. If the world price of $5 were allowed to prevail, though, then ___units of X would be demanded, ___ units would be supplied domestically, and ___ units would beimported.

Figure 15-3

Now suppose that the domestic government has been convinced somehow to restrict imports by 50 percent.b. A tariff of $__ per unit imported would do the trick, but it would raise the domestic price to $__. Atthat price, __ units would be demanded, __ units would be supplied domestically, and __ units would beimported. The effect of the tariff, therefore, is to (raise / lower) the price of X, (raise / lower) domesticproduction and employment, and (raise / lower) imports.c. Given the tariff of part b, the government would collect $__ in revenue; this is revenue that would becollected above and beyond the revenue that it collected from its domestic tax base. (Hint: To see the taxon your diagram, construct a box underneath the supply and demand curves. The length is the 7.5 unitsthat are imported, and the height is the $2.50 tariff.)

The higher domestic price would, however, promote (less / more) efficient production at home, and therebyproduce an efficiency (loss / gain) of $__.

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The marginal cost of producing X at home would, quite simply, increase to a level 50 percent higher thanthe marginal cost incurred by the rest of the world. The domestic economy would, in other words, be wastingresources in the production of X that would have been employed more efficiently somewhere else.

d. If the government chose to impose a quota rather than a tariff, then it would award licenses to importup to __ units of X.e. If there were no tariff, but if it cost $2.50 per unit to transport X from the world marketplace into thedomestic economy, then your answers to part b (would / would not) be altered. The revenue in part cidentified as going to the government (would / would not) simply go to the transport company.

10. a. The mercantilist approach to international trade argued that a nation should try to have (exports /imports) in excess of (exports / import)—hence the phrase “favorable balance of trade.” Any surplus soobtained would be used to acquire (merchandise / gold).b. The mercantilist position was thus strongly disposed toward (protectionism / free trade). It was aconvenient argument for many (producer / consumer) groups seeking protection against foreigncompetition.c. It would be (possible / impossible) for every nation to practice mercantilism successfully, since it is(possible / impossible) for every nation to have a surplus of exports. A general attempt to practice thisphilosophy, by trying to expand exports and restrict imports, would lead to a major (rise / fall) in (exportsalone / imports alone / both exports and imports).

VIII. DISCUSSION QUESTIONS

Answer the following questions, making sure that you can explain the work you did to arrive at the answers.

1. Look back at the very beginning of the chapter and the quote from F. Bastiat. Would David Ricardo agreeor disagree with the Candle Makers?2. Explain, in words, how two countries mutually benefit from trade.3. Precisely who are the winners and who are the losers when countries place tariffs and/or quotas on importedgoods?4. It has been argued that raising tariffs generates more revenue for the government. Do you agree?5. List two noneconomic arguments that have been advanced for protection. Are there any alternates to tariffsand quotas?

IX. ANSWERS TO STUDY GUIDE QUESTIONS

III. Review of Key Concepts5 Principle of comparative advantage8 Absolute advantage7 Comparative advantage

10 Terms of trade2 Consumption-possibility curve9 Multilateral trade

12 Tariff13 Quota11 Mercantilism1 Dumping4 Optimal tariff6 Infant industry tariff3 “Beggar thy neighbor” policy

VI. Multiple Choice Questions1. D 2. C 3. D 4. D 5. B 6. D7. C 8. A 9. A 10. B 11. E 12. C

13. D 14. C 15. A 16. B 17. B 18. C19. C 20. B 21. B 22. E 23. B 24. C25. E 26. B

VII. Problem solvingl. a. open

b. imports, exports, risenc. lower

2. a. F

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b. Cc. 48d. 80

3. a. $20.00 ($1.00 x 20)b. $1.00 ($0.05 x 20)c. $12.00 ($2.00 x 6)d. £10e. £8

4. a. F. $20, $6, could not, only Fb. all the workers would move into production of Fc. $10 ($3.00 x 3.33), $0.60 ($2.00/3.33), would notd. 3:10e. F, Cf. £5, 4:5

5. a. fall, riseb. C, Fc. be a, falld. F

6. a. See dashed lines in Figure 15-1, panels (a) and (b).b. -3.33, -1.25c. 100, 30, 50, 40, 70, 150

7. a. See Figure 15-1, panel (a), 162.5, 37.5 (37.5/30 = 1.25), riseb. See Figure 15-1(top of next page), panel (b).c. 133.33, 133.33 (40 x 3.33), climb

8. a. 200, 100, 300, 0b. See Figure 15-1, panel (c).c. 0,140d. See Figure 15-1, panel (c).e. 200, 80f. See Figure USA, panel ( c) .g. 100, 60h. See Figure 15-1, panel (c), would not, both F and Ci. America, F. Europe, Europe, C, Americaj. See Figure 15-1, panel (c), is not, G. would

9. a. $10, 10, 20, 5, 15b. $2.50, $7.50, 15, 7.5, 7.5, raise, raise, lowerc. $18.75 (2.50 x 7.5), rectangle CEFG in Figure 15-2; less, loss, $3.125 (2.5 x 2.5 x 0.5), triangleABC in Figure 15-2 (bottom on next page)d. 7.5e. would not, would

10. a. exports, imports, goldb. protectionism, producerc. impossible, impossible, fall, both exports and imports

VIII. Discussion Questions1. David Ricardo would vehemently disagree with the Candle Makers. Ricardo’s principle of comparativeadvantage points out that both countries can gain and be made wealthier by trade, even if one nation is muchwealthier than the other.2. When countries trade, each country specializes in the production of the commodity that it can produce at arelatively cheaper rate than the other. So in each country, resources are moved into the industry whereproductivity is highest. As a result, total combined output is greater. Besides, countries would not trade iftrading made them worse off.3. The winners are the domestic industry that gets protected and the government that brings in the tariffrevenue. The losers are everyone else: domestic consumers who pay more, efficient foreign firms that exportless, and efficient domestic industries that now will export less if the foreign government retaliates with a tariffof its own.4. Tariffs do indeed raise money for the government. However, there are efficiency losses and losses inconsumer surplus that must be taken into consideration as well.5. Noneconomic arguments for tariffs include national security, protection of the environment, and thepreservation of culture or tradition. Some of the alternatives to tariffs and quotas are voluntary exportrestrictions and nontariff barriers such as licensing restrictions and bureaucratic red tape.

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Figure 15-2

Figure 15-3