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Answers to End-of-Chapter Questions1. How can globalization and international economic integration be measured?

Answer: The chapter offers three ways to measure globalization and economic integration: (1) trade flows; (2) factor movements; and (3) convergence of prices (goods, factors, and assets).

2. In what sense is the U.S. economy more integrated with the world today than it was a century ago? In what ways is it less integrated?

Answer: The WTO’s Trade Profile for the United States gives an average tradetoGDP ratio of 28.3 for 20092011. That implies that the United States’ ratio is about 150 percent greatertoday than it was in 1913 ((28.3 11.2)/11.2 1.53).

At the same time, the composition of goods traded has changed from agricultural output to manufactured goods. This is consistent with the observation that world trade has been growing faster than world output, at least since 1950. Much of the growth in trade since then, however, simply brought us back to where we were before World War II.

In terms of labor flows, the United States is probably less integrated with the world economy than it was in 1890 or 1900. During that time we had an open door immigration policy (for all but Chinese citizens), and a larger share of our population was foreign born(14.5 in 1890 versus less than 8 percent in 1990 and 12 percent today).

Capital flows are more difficult to generalize since they can be measured several ways. While the absolute volume of capital flows has increased dramatically, as a share of worldGDP it is probably no more than it was at the turn of the twentieth century, and it may even be less. The level of investment in nearly all countries is still highly correlated with domestic savings rates. What is different, however, is the ease with which capital can cross international boundaries (lower transaction costs) and the much greater variety of assets that are traded. The need to protect against exchange rate risk is a key component of today’s international financial markets and is a primary difference from the fixed exchange rate standard of the past. The incidence of financial crises has not increased and, as a metric of integration, it implies no increase in capital market integration.

The growth of regional trade agreements is also an indicator of increased integration. A growing role for international institutions such as the IMF or World Bank may also indicate an increase in international integration.

3. What does the tradetoGDP ratio measure? Does a low value indicate that a country is closed to trade with the outside world?

Answer: The tradetoGDP ratio is a measure of the relative importance of trade to a national economy. It is measured by the ratio of exports plus imports to GDP.

A relatively small ratio does not necessarily mean that an economy is intentionally closed to the outside world. Large countries like the United States have large domestic markets that enable firms to specialize and produce in volume in order to attain an optimal scale. Specialization and high volume in manufacturing is often associated with increased productivity, so firms in large markets can achieve the highest possible level of productivity without having to sell to foreign markets. Firms located in smaller countries

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2 Gerber • International Economics, Sixth Edition

have to trade their output across international boundaries if they want to have the same technology and the same level of productivity. Consequently, large countries tend to havelower tradetoGDP ratios regardless of their trade policies.

4. Describe the pattern over the last century shown by the tradetoGDP ratio for leading industrial economies.

Answer: The ratio fell between 1913 and 1950, but then began to rise relatively rapidly. The main causes of the pattern shown in Figure 1.1 are the two world wars and the Great Depression of the 1930s, and changes in trade policy accompanying that period. By 2000,the ratios were mostly higher than they were before World War I. Another pattern the chapter notes is that the ratio is smaller for the large population countries of Japan and theUnited States, and higher for The Netherlands, with its small population.

5. Trade and capital flows were described and measured in relative rather than absolute terms. Explain the difference. Which term seems more valid—relative or absolute? Why?

Answer: Absolute values are the dollar amounts of trade and capital flows. Relative values are the ratio of dollar values to GDP. Relative values are a better indicator of the importance of trade and capital flows since they are proportional to the size of national economies. Large economies like the United States may have large export and import values, but the importance of trade to the national economy is not nearly as great as it is for other economies. The United States is a large exporter and importer, but the national economy is so large that trade is much less important for the United States than it is for many smaller countries such as Canada, Belgium, or The Netherlands.

6. In relative terms, international capital flows may not be much greater today than they werea hundred years ago, although they are certainly greater than they were fifty years ago. Qualitatively, however, capital flows are different today. Explain.

Answer: Major qualitative difference between late nineteenth and late twentieth century capital flows include the fact that there are many more types of financial instruments available now compared to a century ago. These instruments can be finely tailored to the income and risk preferences of investors. Secondly, a large share of the total flow of capital across borders is related to the need to protect against fluctuations in the value of currencies. This use of international capital markets was not as necessary when nations operated within fixed exchange rate systems. Third, the transaction costs of participating in international capital markets are much lower today than it was a century ago.

7. What are the new issues in international trade and investment? In what sense do they expose national economies to outside influences?

Answer: The new issues involve policy differences between nations that until recently were considered the exclusive responsibility of local or national governments. Examples include labor standards, environmental standards, competition or antitrust policies, and industrial support policies.

Negotiations between nations potentially give foreign interests a voice in setting domesticpolicy. The scope and the depth of the negotiations determine how great a voice foreigners will have. It is often the case, however, that negotiations either occur or are


Chapter 1 The United States in a Global Economy 3

proposed because some aspect of domestic policy is perceived by foreigners as a barrier to trade, and they seek to alter the domestic policy that created it.



8. Describe the three kinds of evidence economists use to support the assertion that economies open to the world grow faster than economies that are closed.

Answer: These are: (1) casual empirical evidence of historical experience; (2) economic logic and deductive reasoning; and (3) evidence of statistical comparisons of countries.

(1) The historical evidence examines the experiences of countries that tried to isolate themselves from the rest of the world. First, not only did trade protection exacerbate the Depression of the 1930s, but it also led to the misery and tragedy of World War II. Second, an examination of countries such as former East and West Germany, North and South Korea, and other countries with the same historical, economic, and ethnic background that were divided by war, indicate that those who closed their economies from the rest of the world suffered in terms of prosperity and environmental degradation. East Asia experienced an economic takeoff when it decided to integrate with the rest of the world, while Latin America, which had the same economic background as East Asia but chose to remain partially closed, experienced mediocre growth.

(2) The logic of economic theory also suggests a strong causal relation between trade andfaster economic growth. The following is a summary of this linkage:

Following Adam Smith, David Ricardo proved that comparative advantage leads to trade and this in turn leads to the reallocation of resources and the improvement of the standard of living of any nation, large or small. Modern trade theory also makes the case for exports and open trade as the causes for economic expansion. Exports and open trade foster competition, innovation, and learning by doing and bring international best practices to the attention of domestic producers, spurring greater efficiency and export expansion. This helps domestic producers to realize economies of scale when they attempt to produce for the world market rather than for their own limited base of domestic consumers. Larger markets create incentives for firms to engage in research and development, and allow countries to import important production inputs and foreign capital by minimizing foreign exchange constraints. They facilitate the transfer of technology and managerial skills. It follows that open trade and exports increase the demand for the country’s output and therefore contribute strongly to positive economic growth.

(3) Even though the statistical evidence is not quite conclusive (mainly due to measuring trade policy), the evidence of statistical comparison of countries (crosssectional timeseries) indicates that countries benefit from open trade.



Ch2

Answers to End-of-Chapter Questions1. What is an institution? Give examples of both formal and informal institutions. Explain how they

differ from organizations.

Answer: An institution is a set of rules of behavior. It sets limits or constraints on social, political, and economic interaction. The rules can be formally recognized in a code of laws, club rules, or an organization’s standards of behavior. The rules of an institution may also be informal as in the case of table manners or social customs. Examples of formal institutions include civil codes, commercial codes, and university standards of behavior (e.g., regarding plagiarism or sexual harassment). Examples of informal institutions include gift exchanges on birthdays, eating salad with the small fork, and giving up your seat to an elderly person on a crowded bus.

Institutions differ from organizations in the same way that the government of the United States differs from the Constitution. The latter is the set of rules that governs the former. Organizations are associations of individuals or groups, institutions are the rules that determine the limits and imperatives of their behavior.

2. What are the arguments in favor of international organizations? What are the arguments against them? Which do you think are stronger?

Answer: Arguments in favor: International organizations are essential for the containment of national or regional crises and the avoidance of their propagation internationally. By providing a set of rules (institutions) which are certain and known (transparent), they reduce uncertainty and increase stability. In many instances, they overcome problems of free riding in the international economy in order to insure the provision of (international) public goods such as lender of last resort financing for resolving a liquidity crisis, or openmarkets in a recession.

Arguments against: The text describes the problems with institutions in terms of issuesof sovereignty (may force adoption of domestic policies against nation’s will or interests),transparency (decision making at institutions may be dominated by others pursuingtheir own interests), ideology (advice may be bad or biased), and implementation and adjustment costs (asymmetries in negotiation power and in ability to absorb costs imposed). Overall, critics question whether institutions generate economic inequalityand compound risks to vulnerable groups.

The issue of which arguments are stronger is ambiguous. Either can be viewed as more cogent. The key is that students understand both arguments and that they develop a setof reasons to support their views.



3. Give the arguments for and against free trade agreements. How might the signing of a free trade agreement between the United States, Central America, and the Dominican Republic have harmed Bangladesh?

Answer: Proponents of RTAs view them as building blocks for freer, more open, world trade. They are able to perform this function because it is easier for a few countries to reach agreement on difficult trade matters than it is for a large number of countries to reach the same agreements. Furthermore, the domestic effects of a reduction of trade barriers are less dramatic since fewer countries are involved. Import flows and job losses and displacements are smaller and more easily managed. In addition, RTA members can experiment with new agreements, such as labor and environmental standards that are too contentious in a larger set of negotiations. Opponents question these assumptions and argue that RTAs undermine progress toward multilateral agreements, such as the Doha Round of the WTO. They argue that RTAs polarize countries because they are discriminatory against nonmembers and because they disadvantage smaller countries that enter into agreements with large ones, since the small countries lack the ability to negotiate effectively and they are often unable to take advantage of the market opening ofthe larger country due to their limited infrastructure and other resources.

Bangladesh may be hurt by a free trade agreement between the United States and Central America due to the trade diversion that might result. If Bangladesh is the lowest cost producer of apparel, for example, then a lowering of U.S. tariffs against Central America could result in production for the U.S. market shifting from Bangladesh to Central America.

4. What are public goods and how do they differ from private ones? Give examples of each.

Answer: Public goods are nondiminishable and nonexcludable. Private goods generally share neither of these characteristics. Private goods include most things that are bought and soldin private markets (restaurant meals, clothing, houses, cars, etc.) while public goods are often provided collectively. Public goods include national defense, public airways, civil and commercial codes, and so forth.

5. What are the main tasks or functions of (1) the International Monetary Fund, (2) the World Bank, (3) the General Agreement on Tariffs and Trade, and (4) the World Trade Organization?

Answers: (1) The IMF’s role is to act as a lender of last resort in the case of a debt crisis or foreign exchange crisis. It provides technical expertise and advice and assists national governments with necessary but difficult reorganizations of their national economies.

(2) The World Bank’s mission, in general terms, is to assist the economic development of nations through the provision of loans, technical expertise, and advice.

(3) GATT is a series of multilateral trade negotiations and resulting treaties which binds the tariffs and trade policies of nations and limits their ability to arbitrarily change them. Its mission is to keep markets for goods open and to ensure that nations follow a set of rules governing fair trade.



(4) The WTO is an umbrella organization created by the Uruguay round of GATT. Its role is similar to GATT’s, but it has expanded its function to include agreements on services, agriculture, and textiles and apparel, all of which were omitted from the previous rounds of GATT. In addition, it provides rules for the resolution of trade disputes between nations and acts as a forum for the discussion and implementation of further reductions in trade barriers.

6. When nations sign the GATT agreement, they bind their tariffs at their current level, or lower. Tariff binding means that they agree not to raise them except under unusual circumstances. Explain how tariff binding in the GATT prevents free riding during a global slowdown.

Answer: During a global slowdown, nations may be tempted to raise barriers to imports. The hope is that reduced imports will provide greater incentive for domestic production and add jobs in importcompeting industries. This part of the strategy usually works but at the costof the loss of jobs in export industries. Export industries are hurt if other nations retaliate and impose similar barriers to imports.

The problem is that every country wants to let the others be the ones to keep their marketsopen. The freerider problem occurs because nations that impose import barriers are free riding on the policies of nations that do not similarly impose barriers. Tariff binding eliminates this possibility.

7. Kindleberger’s study of the Great Depression of the 1930s led him to believe that market economies are sometimes unstable and that nations can get locked into prolonged downturns. Other economists are not convinced. Suppose that you disagree with Kindleberger and that you believe that market based economies are inherently stable. How would you view the need for international institutions to address the provision of each of the public goods in Table 2.5?

Answer: If the international economy is inherently stable, then the need for international institutions decreases. Most of the cases where there is a failure to provide the public goods in Table 2.3 are a consequence of the failure governments to implement sound economic policies.

Governments may try to close markets during a recession but enlightened governments recognize this as selfdefeating since other nations will retaliate. Government closure of markets is a governmental failure, not a market failure.

Private capital markets will channel funds to developing countries if these countries have the right policies. Again, the problem of capital shortages in developing countries may be as much a failure of the developing country’s economic policies as it is a failure of markets.

Private markets will seek out payment methods that are acceptable to all the parties involved.

Financial crises caused by a shortage of liquidity are an indicator of deeper problems. At times, it is necessary to let bad firms fail. These types of crises will burn themselves out and leave little lasting impact on the international economy.



8. What are the five main types of regional trade agreements and what are their primary characteristics?

Answer: The five main types of regional trade agreements are: (1) a partial trade agreement; (2) a free trade area; (3) a customs union; (4) a common market; and (5) an economic union.

(1) A partial trade agreement frees up trade between two or more countries in a few goods. An example is the U.S.Canada Auto Pact which created free trade in cars andcar parts in the 1960s. It later formed the basis for the U.S.Canada free trade agreement.

(2) A free trade area allows goods and services to cross international borders without paying a tariff and without limitations imposed by quotas. Many items, such as labor and environmental issues, are usually left out of the agreement. Example: NAFTA.

(3) A customs union is a free trade area plus a common set of tariffs toward nonmembers.In this situation, members have free trade with each other and agree to levy the same tariff on imports from nonmembers. Examples: MERCOSUR, and from themid1970s to early 1990s, the European Union.

(4) A common market is a customs union plus an agreement to allow the free mobility of inputs such as labor and capital. Example: the European Union in the 1990s.

(5) An economic union is a common market with substantial coordination of macroeconomic policies, including a common currency, and harmonization of standards and regulations. Example: the 12 European Union members that participatein the euro.

Since most formal agreements combine incomplete elements, this classification is more clearcut than the messier reality.

9. Critics of the global institutions have a variety of complaints about the WTO, the IMF, and the WorldBank. Explain the main categories of complaints.

Answer: The text describes the problems with institutions in terms of issues of sovereignty (may force adoption of domestic policies against nation’s will or interests), transparency (decision making at institutions may be dominated by others pursuing their own interests), ideology (advice may be bad or biased), and implementation and adjustment costs (asymmetries in negotiation power and in ability to absorb costs imposed). They especially question the dominance of the United States and industrialized nations in determining the policies institutions set for client countries, since those policies may be wrong or biased or impose particular harm to some groups in the client nations’ populations. Overall, critics question whether institutions generate economic inequality and compound risks to vulnerable groups.

Ch3

Answers to End-of-Chapter Questions1. Use the information in the table on labor productivities in France and Germany to answer questions a

through f.



Output per Hour WorkedFrance Germany

Cheese 2 kilograms 1 kilogramCars 0.25 0.5

a. Which country has an absolute advantage in cheese? In cars?b. What is the relative price of cheese in France if it does not trade? In Germany?c. What is opportunity cost of cheese in France? In Germany?d. Which country has a comparative advantage in cheese? In cars? Explain your answer.e. What are the upper and lower bounds for the trade price of cheese?f . Draw a hypothetical PPC for France and label its slope. Suppose that France follows its

comparative advantage in deciding where to produce on its PPC. Label its production point.If the trade price of cars is 5 kilograms of cheese per car, draw a trade line (CPC) showing how France can gain from trade.

Answers:a. France has the absolute advantage in cheese and Germany in cars. This follows because France’s

productivity is higher in cheese and Germany’s is higher in cars.b. The autarkic relative price of cheese in France is oneeighth car per kilogram; in Germany it is

onehalf car.



c. Opportunity costs are equal to relative prices.d. France has a comparative advantage in cheese because its opportunity cost is lower (oneeighth

car versus onehalf car in Germany). By the same reasoning, Germany has a comparative advantage in cars.

e. The trade price of cheese will settle between oneeighth and onehalf car per kilo.f.

2. Suppose the table in Problem 1 looks as follows. Use the information to answer questions a through f.

Output per Hour Worked

France Germany

Cheese 1 kilogram 2 kilograms

Cars 0.25 car 2 cars

Answers:a. Germany has an absolute advantage in both cheese and cars.b. 1 cheese 0.25 car in France; 1 cheese 1 car in Germanyc. same as Part (b).d. France has a comparative advantage in cheese because its opportunity cost in terms of

cars is lower (0.25 car vs. 1 car); Germany has a comparative advantage in car production (1 cheese vs. 4 cheese).



e. The trade price of cheese will settle between 0.25 car and 1 car.f.

3. Explain how a nation can gain from trade even though not everyone is made better off. Is this a contradiction?

Answer: This is not a contradiction. The gains from trade imply that the winners could compensatethe losers completely and still have gains left over. Some people may lose jobs (in the example in the text, as the United States moved toward specialization in steel, American workers were shifted out of the bread industry and into the steel industry), but others benefit from the higher demand for their product (workers in the steel industry). As long as the winner’s gains are greater than the loser’s losses, we can conclude that the nation wins.

4. Economic nationalists in developed countries worry that international trade is destroying the national economy. A common complaint is that trade agreements open the economy to increased trade with countries where workers are paid a fraction of what they earn at home. Explain the faulty logic of thisargument.

Answer: The error in logic is the failure to take into account the differences in productivity. The lowwage workers in less developed countries in general are paid less because they produce less output during each hour of labor. Furthermore, the developed nations and the lessdeveloped nations are not in competition for economic growth. Growth in one country benefits the other through an increase in the demand for its products. Economic nationalists tend to view trade as a zerosum game in which one side loses and the other wins.

5. Many people believe that the goal of international trade should be to create jobs. Consequently, when they see workers laid off due to a firm’s inability to compete against cheaper and better imports, they assume that trade must be bad for the economy. Is this assumption correct? Why, or why not?

Answer: The goal of trade is to improve a nation’s allocation of its resources so they are directed to their most valuable use. Trade is not about creating jobs, but is about raising the standard of living through a more efficient allocation of resources. Trade may cause workers to become laid off if they are in inefficient industries that do not produce accordingto the national comparative advantage. While this may be hard on the people who lose their jobs, it also frees up labor and capital so it can be directed to better uses.



6. Suppose that Germany decides to become selfsufficient in bananas and even to export them. Inorder to accomplish this, large tax incentives are granted to companies that will invest in banana production. Soon, the German industry is competitive and able to sell bananas at the lowest price anywhere. Does Germany have a comparative advantage? Why, or why not? What are the consequences for the overall economy?

Answer: Government subsidies can lower the cost of production but they will not change the productivity of banana production. The labor and capital that is pulled into banana production are pulled out of the production of some other good. There is nothing in the tax incentives that changes the relative price or opportunity cost of bananas. Hence Germany does not have a comparative advantage even though the tax incentives allow firms to sell their output at competitive prices. The consequence for the economy is that labor and capital are used up in a relatively inefficient endeavor and are less available for use in the production of goods where Germany does have a comparative advantage. Hence overall economic welfare falls, even though the banana producers are doing well. Resources that are used for the tax incentives are diverted from some other program, creating an additional opportunity cost.

Answers to End-of-Chapter Questions1. According to the following table, which country is relatively more laborabundant? Explain your

answer. Which is relatively more capitalabundant?

United States Canada

Capital 40 machines 10 machines

Labor 200 workers 60 workers

Answer: The capitallabor ratios are 1/5 and 1/6 for the United States and Canada. Since 1/5 is greater than 1/6, the United States is capital abundant. By the same reasoning, the laborcapital ratio is higher in Canada, so it is labor abundant.

2. Suppose that the United States and Canada have the factor endowments given in the table in Question 1. Suppose further that the production requirements for a unit of steel is 2 machines and 8 workers, and the requirement for a unit of bread is 1 machine and 8 workers.a. Which good, bread or steel, is relatively capitalintensive? Laborintensive? Explain your answer.b. Which country would export bread? Why?

Answers:a. The capitallabor ratio to make steel is 1/4; to make bread it is 1/8. Hence steel is more capital

intensive and bread is more labor intensive.b. Since the United States is capital abundant and steel is capital intensive, according to the

HeckscherOhlin trade model, the United States will export steel and Canada will export bread.



3. Suppose that before trade takes place, the United States is at a point on its PPC where it produces 20 loaves of bread and 20 units of steel. Once trade becomes possible, the price of a unit of steel is 2 units of bread. In response, the United States moves along its PPC to a new point where it is producing 30 units of steel and 10 loaves of bread. Is the country better off? How do you know?

Answer: The United States is definitely better off because it can consume a greater quantity of both goods. If it traded five steel for 10 bread it would have 20 bread and 25 steel. This is the same amount of bread as before trade, and five more units of steel. It can keep the extra five steel, or trade some or all of them for additional bread. In either case, the consumption bundle is greater than it was before trade.

4. Given the information in Questions 1 and 2, explain what happens to the returns to capital and labor in each country after trade begins.

Answer: The changes in the returns to capital are different by country. In the United States, the demand for capital increases because more steel will be produced; conversely, the demand for labor falls because of the drop in bread production. Owners of capital benefit from the increase in demand for their inputs, while owners of labor suffer a decline in their returns (wages). In Canada, the effects are reversed.



5. Suppose that there are three factors: capital, labor, and land. Bread requires inputs of land and labor, and steel requires capital and labor.a. Which factors are variable, and which are specific?b. Suppose Canada’s endowments of land and capital are 10 capital and 100 land, and the

United States’ are 50 capital and 100 land. Which good does each country export?c. How does trade affect the returns to land, labor, and capital in the United States and in Canada?

Answers:a. Labor is the variable factor and capital and land are specific.b. Canada is land abundant relative to the United States (100/10 is greater than 100/50), so

Canada’s comparative advantage is in the export of bread, the good with the specific input of land. The United States’ comparative advantage is steel.

c. In the United States, owners of land are hurt by trade, owners of capital benefit, and the effects on labor are indeterminate. The latter effect depends on labor’s preference for bread and steel. In the United States, bread prices fall, but steel prices rise. In Canada, owners of land benefit from trade, owners of capital are hurt, and the effects on labor are indeterminate. The latter effect depends on labor’s preference for bread and steel. In Canada, bread prices rise, but steel prices fall.

6. Describe the changes in production requirements and the location of production that take place over the three phases of the product cycle.

Answer: In the first phase, all production is in highincome countries. The input requirements include relatively large amounts of scientific and engineering skills, marketing expertise, and access to risk capital. Experimentation with new products depends on access to highincome consumers, and competitive pressures require a quick feedback from consumers to producers. The new products tend to be highly variable in their design and performancecharacteristics, and experimentation is important in finding the right combination of prices, options, and quality.

In the second phase, some standardization is taking place, along with some sales of the product in developing countries. The early period of intense experimentation is over and firms are beginning to settle on the lowestcost production technologies. Production is migrating overseas, where labor costs are lower.

In the final phase, experimentation with design and manufacturing technologies is over, the product is completely standardized, and the input requirements are more heavily biased towards unskilled or semiskilled labor. Much of the production can be accomplished in assembly operations, which can be located in lowwage countries. By the third phase, most of the production has left the highincome countries except in the cases where product differentiation can continue.

7. Does intrafirm trade contradict the theory of comparative advantage? Why or why not?

Answer: No, in general it does not, but it may in some cases. Most intrafirm trade can be understood as a firm that cuts up its production process into several distinct stages, and then relocates some or all of the stages to different countries where the factor endowments are consistent with the production requirements of each stage. Laborintensive production stages will be relocated to laborabundant countries, and so forth.



In this case, firms are taking advantage of the comparative advantage of different nations in order to produce their goods at the lowest overall cost.

In some cases, however, there may be other motives for locating a production stage in another country. These motives include the desire to avoid trade barriers by producing all or part of a good inside the country where sales are anticipated, the desire to escape taxation, the attempt to deter market entry by a rival firm, and as insurance against unforeseen events (e.g., political instability).

8. General Motors is a U.S.based multinational, but it is also one of the largest car manufacturers in Europe and South America. How might Dunning’s OLI theory explain the tradeoffs GM faced as it decided whether to export to those two markets or to produce in them?

Answer: Transportation costs are significant in the auto sector, meaning that producing close to the final market can have cost advantages. The European market may have design preferences that are different from the U.S. market (i.e., driving on the right side of the road, fuel economy given higher gas prices, higher speed limits, and the need for power on highways… ). This would give advantages to a production location with more direct access to the final market. Other auto manufacturers that could handle production are GM’s direct competition, making GM unlikely to choose licensing and a sharing of its manufacturing, design, and technology.

9. Many domestically owned apparel manufacturers buy their garments overseas, sew their labels into them, and then sell them abroad or back into the home market. What are some of the considerations that a clothing manufacturer might go through to choose this strategy instead of producing at home and exporting?

Answer: These firms perceive their asset to be their brand. This may involve some elements of design (ordering specific output from foreign suppliers) but also could involve quality. It can be based strictly on marketing and advertising, creating an image from something thatis in the end relatively cheap and easy to create. Allowing foreign firms the ability to brand the clothes through licensing makes them lose control of this asset. Sewing labels in allows some element of quality control while reducing production costs. Garment assembly is relatively labor intense and low skill, making it more likely to occur in lessdeveloped, laborabundant countries. Design, marketing, and access to highspending consumers are more likely to be assets of firms in developed countries. Owning an assembly operation directly is not necessary for them to preserve this asset as long as theyhave ultimate control over what they put their name on and how that product is distributed and marketed.



10. Suppose Spain were to open its doors to a large number of unskilled Africans seeking to immigrate. In general, what effects would you expect to see in Spain’s trade patterns and its comparative advantage?

Answer: In theory, labor becomes more abundant and Spain’s comparative advantage could shift to more unskilled, laborintense production. In practice, this labor inflow may be used to produce services that are not traded. They may free up citizens to work in the already existing export sector and have little effect on comparative advantage.

Answers to End-of-Chapter Questions1. What is intraindustry trade and how does it differ from interindustry trade? Are the gains from trade

similar?

Answer: Intraindustry is international trade of products made within the same or similar industries,for example, carforcar, beerforbeer, etc. Differentiated products, which are characteristics of monopolistic competition and often oligopoly, lead to trade between nations with commodities in the same industry. Homogeneous goods, therefore, would not make any sense for intraindustry trade.

Interindustry trade is international trade of two or more different products, for example, carforbread. Interindustry trade can be explained by comparative advantage. One of the distinguishing characteristics of intraindustry trade is the presence of internal economies of scale with falling average costs over a relatively large range of output.

The presence of internal economies of scale is why firms want to enter export markets. Exports enable firms to realize lower average costs and be competitive both internally andexternally. This is one of the gains from intraindustry trade, and this gain contrasts with comparativeadvantagebased trade because domestic consumers of the exported product also gain. Consumers gain since competition forces firms to pass on their lower costs to them. Intraindustry trade would also expand the number of firms, thereby enhancing competition and the variety of goods available for consumers.



It may be useful to introduce the trade classification systems for students and instructors that want more detail. The NAICS (North America) and SITC (more common) systems are available to view on the Census website:NAICS: http://www.census.gov/foreigntrade/reference/codes/naics/naicsmst.txt SITC: http://www.census.gov/foreigntrade/reference/codes/sitc/sitcmstr.txtA quick look at the actual codes helps students intuitively understand that the more detailed a product classification, the less intraindustry trade there is (e.g., “office equipment” versus “pencil sharpeners”). A complete guide to all classification systems isavailable at: http://www.census.gov/foreigntrade/guide/sec2.html#classification.


http://www.census.gov/foreign-trade/reference/codes/sitc/sitcmstr.txt


2. Comparing U.S. trade with Germany and Brazil, is trade with Germany more likely to be based on comparative advantage or economies of scale? Why?

Answer: Trade with Germany is more likely to be based on economies of scale since it consists of the export and import of similar products and occurs mostly in countries that have similar productivity, technology, and factor endowments. Trade with Brazil is likely to be based on comparative advantage since Brazil’s productivity, technology, and factor endowmentsare not similar to the United States.

3. What are the differences between external and internal economies of scale with respect to (i) the size of firms, (ii) market structure, and (iii) gains from trade?

Answers: i. An external economy of scale exists when the fall in the average costs of the industry lowers the

average costs of the typical firm. With external economies, the size or scale effects are located in the industry, and NOT THE FIRM. Thus, even though the size of each firm in the industry does not increase, the industry expands due to declining costs. There are just more firms in the expanding industry. This could be due to the entry of more firms as existing firms realize economic profits, or it could be due to the splitting of existing firms into different firms with increasingly narrow specialization. Thus with external economies of scale, the firms are expectedto be small in size. With internal economies of scale, the cause for the expansion of a firm’s size is its own declining average costs. That is, the size or scale effects are located in the firm, and NOT IN THE INDUSTRY. Average costs of the firm decline as output expands. This usually leads to larger firms because size confers a competitive advantage in the form of lower average costs.

ii. As mentioned above, with external economies of scale the scale effects are located within the industry, and not within the firm. The potential for external economies of scale gains leads firms to concentrate in specific regions. The market structure in this case is agglomerations. On the other hand, declining average costs within internal economies of scale invite outsiders to enter the industry. With internal economies of scale, there is also the potential for products to be similar but differentiated. This industry structure, called monopolistic competition, exists when a large number of firms compete with each other to produce a variety of goods. Monopolistically competitive structures may also be the result of modest gains from internal economies of scale. On the other hand, the scale economies could be substantial with internal economies of scale. If so, some firms have room to grow since they would be able to exploit this situation for further expansion, market control, and even domination. Therefore, internal economies of scale may leadto an oligopoly market structure. On the extreme, a single firm may serve the entire (world) market. This kind of market structure is called a monopoly. This suggests the possibility of more than one longrun industry equilibrium condition (multiple equilibria).



iii. Intraindustry trade is a byproduct of internal economies of scale. As explained in the text, the benefits include: (a) lower prices passed on to consumers by monopolistically competitive firms enjoying economies of scale; (b) lower prices passed on to consumers when international trade leads to an increase in firms; (c) increases in consumer choice due to international trade, etc. Unfortunately, the gains from trade are less certain (even harmful) with external economies of scale, which hypothetically could lock in production in less efficient countries and prevent the development of production in a more efficient country. This is partly due to historical accidents rather than efficiency advantages in trade patterns.

4. What are the three key incentives for firms in a particular industry to cluster together in geographical region?

Answer: These are: (1) large pool of skilled labor, which reduces the search costs and encourages high degrees of labor specialization, (2) specialized suppliers of inputs, which helps firmshold down their costs by reducing their transportation and informational costs, and(3) knowledge spillovers due to information exchange through formal and informal networks of people.

5. How might trade hurt a country if it imports goods that are produced under conditions of external economies of scale?

Answer: Trade may stifle the development of new industries that could be more efficient than the existing ones, reducing global efficiency. This could be due to a historical accident of an initial head start, or trade otherwise gives a scale advantage to already existing firms in one country. The initial head start creates efficiency advantages for the existing firms. This happens for a number of reasons, such as (a) better developed linkage between the already existing producers and their suppliers, and (b) lower prices offered by the firms enjoying external economies of scale.

6. When the United States signed a free trade agreement with Canada (1989), no one in the United States thought twice. When the agreement with Mexico was signed (1994), there was significant opposition. Use the concepts of interindustry and intraindustry trade to explain the differences in opposition to the two trade agreements.

Answer: Canadian productivity, technology, and factor endowments are more or less comparable with those of the United States. Consequently, trade between the United States and Canada is intraindustry rather than interindustry trade. As shown in Question 3, there are quite a few benefits from intraindustry trade. On the other hand, trade with Mexico is likely to be based on comparative advantage (interindustry trade) since Mexico’s productivity, technology, and factor endowments are not similar to those of the United States. Consequently, there were possibilities for Canada and Mexico to lose in the production of goods and services for industries in which that they didn’t have comparative advantage. Since unskilled labor is relatively scarce in the United States, jobs that did not require highskilled labor, abundant capital, and sophisticated technology would have gone to Mexico. This was one of the fundamental reasons why people in the United States were against NAFTA. On top of this, politicians incorrectly portrayed NAFTA, despite the fact that trade can create as well as destroy jobs. Further, the United States benefited fromthe production of goods and services that required skilled labor, abundant capital, and sophisticated technology. Some Mexicans saw this as unfair, and rebelled.



7. What are the theoretical justifications for targeting the development of specific industries?

Answer: The primary justification is to counteract a market failure. Although market failures comein all shapes and sizes, all imply that markets do not result in the optimal allocation of resources—either producing too much or too little. Industrial policies are mostly concerned with cases where too little (or none) of a good is produced. Market failures also imply that the social returns of an activity are not the same as the private returns. When markets produce too little, social returns are greater than private returns and the social optimum involves higher levels of output.

Theoretically, the reasons for too little production may be due to the following: (1) when skills and/or technologies spill over into the economy beyond the firms that create them. This occurs when information leaks out of the first entrant firms about production, technological, and marketing feasibilities. When this occurs, the social returns are higher than private returns. (2) when capital market imperfections result in inadequate investment capital. According to this argument, new firms may face difficulties in attracting sufficient new startup capital. They also face inadequate financing opportunitiesfor research and development. Targeting specific industries, therefore, is important.

A second justification for industrial policies is strategic trade policy, where it is theoretically possible to capture abovenormal profits earned by a foreign firm. In order for strategic trade to be relevant, the industry must have very strong economies of scale and firms must have market power.



8. What are some of the common problems in implementing industrial policies?

Answer: They are: (1) the difficulty of obtaining information necessary to measure the extent of market failure, and choosing which industry to target; (2) knowing the optimum amount of resources (costs) to provide the targeted industry; (3) encouraging rentseeking behavior (which may require the hiring of lobbyists, economists, etc.) by firms in other industries. This activity uses up resources without adding to total output. (4) containing the external benefits of R&D spending within national boundaries. If the benefits of R&Dspending are not kept within national boundaries, the benefits are partly captured by foreign firms.

9. Figure 5.3 in the text illustrates the case of an industry that generates external social benefits with its production. Draw a supply and demand graph for an industry that creates external costs with its production. Compare and contrast the market determined price and output level with the socially optimal price and output levels.

Answer: In a negative externality the social returns are less than private returns, so a free market produces more than the optimal amount (Q2 instead of Q1 in Figure 5.1). This is because producers fail to take into account the external costs when calculating their costs of production (and if they do, they will produce less than the optimal amount). As a result, the marginal private cost is less than the marginal social cost. Consequently, Spriv in Figure 5.1 should be labeled as Ssoc and the twoway arrow line connecting the two supply curves must be labeled as “External Costs.” Producers charge P2 instead of P1.

Answers to End-of-Chapter Questions1. Graph the supply and demand of a good that is both produced domestically and imported. Assume

that the country is not large enough to affect the world price. Illustrate the effects of a tariff on imports. Discuss the following:



a. Income distribution effectsb. Resource allocation effectsc. Domestic production and consumption effectsd. Government revenue effectse. Price of the good effects

Answers:See Figure 6.3 in the text.a. The income distribution effects are a loss in consumer surplus, some of which is destroyed, but

other parts of which are transferred to producers and the government.b. The resource allocation effects include a production inefficiency from the expansion of relatively

higher cost domestic production. The consumption side also experiences a reduction in efficiencydue to squeezing consumers, who value the good more than it costs to buy it, out of the market.

c. Domestic production rises, consumption falls.d. Government revenue rises by the amount of the tariff times the number of units imported.e. The price rises by the amount of the tariff.

2. Suppose the world price for a good is 40 and the domestic demandandsupply curves are given by the following equations:

Demand: P 80 – 2QSupply: P 5 3Q

a. How much is consumed?b. How much is produced at home?c. What are the values of consumer and producer surplus?d. If a tariff of 10 percent is imposed, by how much do consumption and

domestic production change?e. What is the change in consumer and producer surplus?f. How much revenue does the government earn from the tariff?g. What is the net national cost of the tariff?

Answers:a. Using the demand curve to determine consumption, 40 80 – 2Q, or Q 20.b. Using the supply curve to determine production, 40 5 3Q, or Q 11.67.c. Consumer surplus is given by 20 (80 – 40) 1/2 400; producer surplus

is 11.67 (40 – 5) 1/2 204.17.d. A 10 percent tariff raises prices by 4, from 40 to 44. Consumption moves along

the demand curve: 44 80 – 2Q, or Q 18. Production moves up the supply curve: 44 5 3Q, or Q 13.



e. The new value for consumer surplus is 18 (80 – 44) 1/2, or 324; hence it has fallen by 76. Producer surplus is 13 (44 – 5) 1/2 253.5; hence it has grown by 49.33.

f. Tariff revenue is 5 4 20.g. The net national cost of the tariff is the combination of the efficiency loss and the consumption

deadweight loss. It is equal to the lost consumer surplus minus the transfer to producers and the government, or 76 49.33 20 6.67.

3. Under what conditions may a tariff actually make a country better off?

Answer: It is possible for a large country to improve national welfare by levying a tariff. The conditions that must hold are that the country is large enough to affect the world price when it imposes a tariff, and other nations must not retaliate. It is possible under these circumstances to design a tariff that raises national welfare by causing the price of imports to fall. As long as the gains from the cheaper imports are greater than the production and consumption side losses, the national welfare improves.

4. In addition to the production and consumption side deadweight losses, what are some of the other potential costs of tariffs?

Answer: Other potential costs of tariffs include the threat of retaliation and the potential loss of exports markets, the stifling of the incentive to innovate, and the encouragement of rent seeking.

5. The Uruguay Round of the GATT began a process of phasing out the use of voluntary export restraints. Why did they come into widespread use in the 1980s? For example, given that VERs are a form of quotas, and that they create quota rents and a larger reduction in national welfare than tariffs, why did nations use them instead of tariffs?

Answer: Voluntary export restraints avoid the obligations nations share under the rules of the GATT to not raise tariffs. They do not require legislative action to implement. Furthermore, VERs permitted politicians to claim they supported free trade while at the same time offering protection to special interests.

6. The GATT strongly favors tariffs as a protective measure over quotas or other nontariff measures. It encourages new members to convert quotas to their tariff equivalents. One of the main reasons tariffs are preferred is because they are more transparent, particularly by comparison to nontariff measures. Explain the idea of transparency, and how nontariff measures may be nontransparent.

Answer: Transparency refers to the ability of everyone to easily discover and understand the rules. Tariffs are transparent because they usually are not associated with special circumstances known only to a select few. Nontariff barriers like an outright quota may or may not be transparent. Quotas may vary according to the country trying to export; they may also be implemented in the form of import licenses that involve large amounts of red tape and unknown availability. Nontariff measures such as health and safety codes, product standards, or testing requirements can be even less well defined and pose an even greater uncertainty for firms trying to enter the market.



7. Suppose that bicycles are made in the United States out of a combination of domestic andforeign parts.a. If a bike sells for $500 but requires $300 of imported parts, what is the domestic value added?b. If a 20 percent tariff is levied on bikes of the same quality and with the same features, how do

the price and the domestic value added change? (Assume the United States cannot cause the world price to change.)

c. What is the effective rate of protection?d. If in addition to the 20 percent tariff on the final good, a 20 percent tariff on imported parts is

also levied, what is the effective rate of protection for U.S. bike manufacturers?

Answers:a. Value added is $500 – $300 $200.b. The domestic price rises by 20 percent to $600; the value added is $600 – $300 $300,

hence it has risen $100.c. The effective rate of protection is (300 – 200)/200 0.5 50 percent.d. The cost of inputs rises from $300 to $360, so value added is $600 – $360 $240.

The effective rate of protection is now (240 – 200)/200 0.2 20 percent.

Answers to End-of-Chapter Questions1. Which industries are more heavily protected in the United States and Japan? Are highincome or

lowincome nations more affected by American and Japanese trade barriers? Explain.

Answer: In the United States, the most heavily protected industries are textile and apparel producers and, to a lesser degree, agriculture. In Japan, protection is concentrated on agriculture and the food and beverage industry. Protection in both countries is in older, laborintensive industries where the countries no longer have comparative advantages. The effects are greatest on lowincome countries since these are the industries where they do have a comparative advantage. The failure of the United States, Japan, and other industrial nations to open their markets to the agricultural products and apparel from developing countries has deprived those nations of potential export markets.

2. What new areas of trade and investment received coverage under the agreement signed in the Uruguay Round of the General Agreement on Tariffs and Trade?

Answer: The Uruguay Round extended the GATT and created several new agreements. GATT now covers agriculture, textiles, and apparel, and new agreements were signed for the first time in the areas of trade in services, treatment of foreign investment, and the protection of intellectual property rights. In addition, the agreement created the umbrella organization called the World Trade Organization that will oversee the GATT and related agreements. The WTO also conducts periodic reviews of each nation’s trade policies, and has created a streamlined dispute resolution procedure.

3. Given that tariffs and quotas cost consumers and that they are grossly inefficient means for creating or preserving jobs, why do citizens allow these policies to exist?



Answer: The costs of tariffs and quotas are diffused throughout an entire nation, while the benefits are concentrated. This creates an asymmetric set of incentives to organize around the issue of trade policy. Beneficiaries of protection stand to gain a great deal and consequently find it economically worthwhile to organize in order to receive protection. Individual consumers lose just a little, so there is only a small economic incentive to organize against protectionist policies.

4. What are the main arguments used by nations to justify protection for particular industries? Which are economic, and which are noneconomic?

Answer: The arguments are (1) revenue, (2) the labor argument, (3) the infant industry argument, (4)the national security argument, (5) cultural protection, and (6) the retaliation argument. The first three arguments are about government revenue, jobs, and manufacturing, so theyare economic arguments. Arguments 4 and 5 have economic components, but are primarily based on noneconomic considerations. The retaliation argument is perhaps moreexplicitly economic as well.



5. Evaluate the labor and infant industry arguments for protection.

Answer: The labor argument is based on the false assumption that lower wages automatically confer a competitive advantage to a nation. Lower wages are the most visible indicator of lower productivities. The proponents of the pauper labor argument fail to completely consider the causes of lower wages and their consequences for trade. The advantages of lower wages are offset by the lower productivity that inevitably accompanies them.

The infant industry argument requires three conditions in order for it to be valid. First, there must be a technological externality that cannot be captured by the firms that produceit. Second, the protection must be limited in time. Third, it must enable the firms receiving it to experience falling costs so that the initially higher costs disappear and the low or negative rates of return are converted into normal returns. The latter condition is equivalent to requiring the policy to pay for itself in the long run.



6. Are tariffs justified as a retaliatory measure against other nations? Justify your answer.

Answer: There is no agreement among economists on this issue. One school says that tariffs make us less efficient, so they are unwarranted. If others choose to hurt their own economies, why should we follow suit? Another school says tariffs are justified if they cause the offending nation to open its markets. Trade is beneficial for all, so if they can lead to increased trade, they are warranted. The third group sees them as warranted because they worry about the unfair advantage they may grant the nation levying the tariff, particularly in hightech industries where scale economies are important. Tariffs shut out foreign competition and grant the firms in the country access to a larger market—their own domestic market plus foreign markets. This may be an economic advantage in some industries.

7. What are the four legal procedures that American firms have at their disposal for seeking protection? What are the conditions that would generate a request for each kind of protection?

Answer: The four procedures are (1) countervailing duties, (2) antidumping duties, (3) escape clause relief, and (4) Section 301 retaliation. Countervailing duties are granted in response to foreign subsidies; antidumping duties are granted when a foreign firm sells in the domestic market at a price that is considered too low (less than fair value); escape clause relief is granted as a temporary protection against sudden surges in imports; and Section 301 retaliation is used to punish a nation for some other type of practice that is perceived as conferring an unfair advantage on its firms, or in response to a lack of openness to American goods.

Answers to End-of-Chapter Questions1. What are the three ways for countries to handle different standards abroad? Do standards have to be

the same for countries to be integrated?

Answer: The three ways for countries to handle different standards are harmonization, mutual recognition, and separate standards. Countries do not have to have the same standards to be economically integrated. In fact, requiring the same standards may pose potential problems. Harmonization standards, for example, might lead to the adoption of inferiorstandards and may fail to take into account income differences. By imposing undue standard requirements, a country may also fail to achieve all that is possible of its trading partners. It is generally better for trading countries to recognize each other’s standards or maintain separate standards when the level of economic development differs.



2. What are the advantages and disadvantages for countries that adopt the same standards?

Answer: Advantages: One possible advantage is the gain in economic efficiency from sharing the same standard. Shared standards permit manufacturers to produce a single standard rather than multiple standards, and this may allow firms to capture economies of scale. Also, common standards have the potential to increase and expand the commercial ties betweentwo or more countries.

Disadvantages:a. Requiring the same standards may cause a loss of efficiency if the adoption of a

common standard results in a locking of an inferior standard.b. For at least two reasons it may be extremely difficult, costly, or even impossible to

adopt the same standards. First, there may be thousands (hundreds of thousands in thecase of a fully integrated common market like the EU, for example) of goods that would require harmonization and/or the adoption of the same standards. This in turn would require the hiring of a large number of boards and committees of experts to both determine the best compromise between the existing individual national standards and develop one national standard. Second, cultural issues may be involvedin the harmonization of standards. This makes the issue political and economic as well as technical.

3. When highdefinition television (HDTV) was first considered a possibility in the United States, the U.S. government held a competition to select the technical standards that would be used nationwide. Why would the government see an advantage to setting one standard for HDTV, and what are the pros and cons for the private businesses that were interested in producing HDTV for the U.S. market?

Answer: There are efficiency gains when two or more countries adopt the same standards. For example, since shared standards permit manufacturers to capture economies of scale,we would expect all 50 U.S. states to adopt the same standards. Further, the adoption of common standards allows states or countries to work together and increase their commercial ties. To prevent locking into or adopting inferior standards, the U.S. government might also hold a competition to select the technical standards.

On the downside, sharing and adopting one standard does have its costs. Choosing one standard has the unintended effect of lessening the differences between nations, therefore destroying some sources of comparative advantage. The cost to society would be even greater if the country is dealing with a newly introduced product (such as HDTV). In the situation of unknown “best standards,” it may be wise for regulators to leave their optionsopen or adopt a “competition of future standards.”

Concerning the specific HDTV example, private businesses that produced the first HDTVs have an advantage over others simply because their product could be adopted as the standard. While this could be very profitable for these firms, if an inferior standard is locked in, this could harm to society as a whole.

(Note: The case of HDTV was not explicitly considered in this chapter!)



4. Why do standards vary across countries? Illustrate your answer with examples in the area of labor standards.

Answer: Standards in general, and labor standards in particular, vary greatly. They range from basic standard rights such as the right to be free from forced labor and the right to representation in a union, to more contentious rights such as universal standards for minimum wages, limits on the number of hours someone can work in a day, health and safety standards, etc. Of course, labor standards are difficult to define given the wide variation in incomes and living standards around the world. For example, if lowincome countries (with relatively abundant unskilled labor) were forced to pay a minimum wage high enough to satisfy critics in highincome countries, lowincome countries would suffer when the high wage rates force employers to close down their production. Consequently, unemployment would rise.

5. What are labor standards, and why are arguments about labor standards confined primarily to arguments between highincome countries on the one hand, and low and middleincome countries on the other?

Answer: As mentioned in the text, defining labor standards is difficult given the wide variation in incomes and living standards around the world. Even though there is a fair amount of ambiguity attached to labor standards, most people would probably agree with the standards proposed by the ILO and OECD, which are: (1) prohibition of forced labor;(2) freedom of association; (3) the right to organize and bargain collectively; (4) an end to exploitation of child labor; and (5) nondiscrimination in employment.

Arguments about labor standards are confined primarily to arguments between highincome and lowincome countries because the conditions and living standards in developing countries are starkly different from those in highincome countries. Labor and environmental standards and the enforcement of existing laws tend to be lower in developing countries than in highincome countries. Most countries tend to place higher values on better pay and greener environmental policies as their economies develop. When low and highincome nations begin to trade, and the prices of the goods imported from developing countries are lower than their highincome counterparts , people in highincome countries have many questions. They tend to associate the lower prices with such things as exploitation of child labor, unsafe working conditions, lesser or no pollution controls, etc.



6. Discuss the reasons why using trade barriers to enforce labor or environmental standards may be less efficient than other measures.

Answer: First, as was shown in Chapter 7, imposing trade barriers is very costly. They create deadweight losses at home in consumption and production. Second, only large countries, if any at all, could use trade barriers successfully to stop the offending country. Even a large country may be unable to use trade barriers effectively unless a large number of countries join together to impose the trade sanctions. Convincing other nations to take part in the sanctions has proved difficult in the past. Moreover, imposing trade barriers may make conditions worse rather than better, since some producers may move their facilities into the informal sector of the economy. If sanctions against a country create incentives for businesses to avoid the scrutiny of labor inspectors, then a larger share of the working population could find themselves dealing with worse conditions. Third, there is also the borderline between protectionism and concern. In countries that use trade barriers as an enforcement mechanism it is not hard to find special interest groups using trade barriers as a means to justify their real goal—obtaining protection against foreign competition. Given that industrialized countries protect agricultural and textile/apparel products (two industries in which developing countries have a comparative advantage), developing countries are highly reluctant to give in to the sanctions. Fourth, since child labor laws are vague and vary according to the income level of each country, there is no international agreement for universal child labor laws. Last but not least, the use of trade barriers may lead to retaliation and larger trade wars, which could be very costly to all countries involved.

7. What are the arguments in favor of using trade barriers to enforce labor and environmental standards?Assess each argument.

Answer: Labor and environmental activists advocate for the use of trade barriers (tariffs, quotas, oroutright limitation of imports) to enforce labor standards. They argue that pressuring a country could alter its labor standards. Trade economists are skeptical about the efficacy of trade barriers as tools for overturning foreign labor practices on several theoretical and empirical grounds (see also Question 6). There are no clear standards that could be universally adopted and enforced in both labor and environment standards.

8. One common critique of the WTO is that it overturns national environmental protections, and forces countries to lower their standards. For example, when the United States tried to protect endangered sea turtles, the WTO prevented it. Assess this claim.

Answer: The United States sought to protect endangered sea turtles that were harmed by shrimp trawlers that do not use turtle excluder devices (TEDs) on their nets. In 1987, the United States issued guidelines requiring shrimp trawlers to use TEDs on their nets. It then announced in 1989 that it would ban shrimp imports beginning May 1991 from countries that were not certified. The guidelines applied only to the Caribbean and Western Atlantic. By 1996, more conditions were placed and the guidelines were extended worldwide. India, Malaysia, Pakistan, and Thailand protested to the WTO, arguing that they were given only four months to comply, while Caribbean countries weregiven three years and technical assistance. In addition, they complained that the GATT rules forbid discrimination against imports based on the process of production. In May1998, the WTO ruled against the United States citing that it ignored its obligation to consult and negotiate before taking action.



The United States appealed the case and the decision was partially reversed by the WTO Appeals Body stating that the U.S. import barriers are potentially allowable but that the failure to negotiate or confer with the affected countries placed it in violation of WTO rules. That is, the WTO reversed one of the two rulings that were passed against the United States. In effect, this WTO decision ended up being multilateral in nature because it allowed the United States to extend its protection while allowing the South Asian fishing fleets to remain commercially viable.

This episode raises the question about the connection between the environmental laws of an individual country and trade laws. Even though the WTO rules ended up being multilateral and at least partially kept the interests of both parties, there is a combination of trade and nontrade issues here. Because of differences in incomes and standards of living, labor and environmental standards have become (and will continue to become) a point of conflict between trading nations.



9. What are the alternatives to trade measures for raising labor and environmental standards? What are the strengths and weaknesses of each one?

Answers: These are: (1) Labels for exports: this is a certification process producing a label that is attached to the good when it is produced and has been partially successful in telling consumers that the good is produced in humane and environmentally friendly ways. Even though this mechanism plays an important role in alleviating conflicts between trading countries, it has its own problems. First, it has been a cause of conflict between labor and management when foreign inspectors are allowed to intrude. Second, many countries consider foreign intrusion as an infringement of their sovereignty. It may be hard to convince consumers to trust the labeling information as labeling becomes more widespread. (2) Requiring home country standards: This measure requires firms that openoperations in foreign countries to hold these operations to the same standards as their domestic, or home, operations. In other words, a firm cannot try to cut corners or save money by allowing its foreign holdings to operate according to foreign substandards. There are a few advantages of this measure: (a) it eliminates the fear of a racetothebottom by making it impossible for homebased companies to exploit low standards; (b) it shifts the costs of improved standards to firms and consumers in highincome countries; (c) it removes the threat that domestic firms will relocate abroad and ensures that any relocation that takes place is due to foreign comparative advantage; and (d) it avoids the problems of highincome countries dictating which standards are used. The requirement of homecountry standards forces firms with crossnational boundaries to conform to whichever standards are higher. One weakness of this approach, of course, is that it only addresses the problem of firms in highstandards countries that go abroad to potentially lowstandard countries, and not vice versa. (3) Increasing international negotiations, possibly using the ILO for labor and creating new agreements for the environment.



Answers to End-of-Chapter Questions1. Use the following information to answer the questions below. Assume that the capital account is

equal to 0.

Net unilateral transfers 50

Exports of goods and services 500

Net increase in the U.S. government’s nonreserve foreign assets 30

Net increase in foreign ownership of U.S.based nonreserve assets 400

Net increase in U.S. private assets abroad 250

Invest income received in the United States 200

Net increase in U.S. ownership of official reserve assets 20

Imports of goods and services 600

Net increase in foreign ownership of U.S.based reserve assets 100

Investment income paid abroad by the United States 300

a. What is the current account balance?b. Does the capital account equal the current account?c. What is the statistical discrepancy?

Answers:a. The current account is 500 200 600 300 + 250 250b. The capital account is 100 400 20 30 250 200c. The statistical discrepancy is –1 (–250 200) –250

2. Look at each of the cases below from the point of view of the balance of payments for the United States. Determine the subcategory of the current account or financial account that each transaction would be classified in, and state whether it would enter as a credit or debit.a. The U.S. government sells gold for dollars.b. A migrant worker in California sends $500 home to his village in Mexico.c. An American mutual fund manager uses the deposits of his fund investors to buy Brazilian

telecommunication stocks.d. A Japanese firm in Tennessee buys car parts from a subsidiary in Malaysia.e. An American church donates five tons of rice to the Sudan to help with famine relief.f. An American retired couple flies from Seattle to Tokyo on Japan Airlines.g. The Mexican government sells pesos to the United States Treasury and buys dollars.



Answers:a. The United States “exports” official reserve assets; it is a credit in the capital account.b. A resident of the United States unilaterally transfers money to a foreign locale; it is a debit in the

current account.c. There is an “import” of foreign assets; it is a debit in the capital account under the category of a

net change in U.S. private assets abroad.d. An Americanbased producer imports goods; it is a debit in the current account.e. There is a unilateral transfer from the United States to abroad foreign country; it is a debit in the

current account.f. American residents purchase a service from a foreign firm; it is a debit in the current account.g. There is a net increase in nonreserve foreign assets held by the U.S. government; it is a debit in

the capital account.

3. Weigh the pros and cons of a large trade deficit.

Answer: Trade deficits are generally considered a negative for a country, but the reality is more subtle. On the negative side, large deficits signal that a country is accumulating foreign debt that can be difficult to service if the excess imports are not used to enhance national productivity. Furthermore, trade deficits require capital inflows. If foreign investors lose confidence, it may be difficult to search the necessary foreign reserves. This is partly what happened to Mexico in 1994 and Thailand and Indonesia in 1997.

On the positive side, a large trade deficit can also signal that foreigners have confidence in the current set of economic policies and the future prospects of the economy. Furthermore, and most importantly, a large trade deficit and the attendant capital inflows allow a higher level of investment than would be possible solely on the basis of domestic savings.

4. Is the budget deficit of a country linked to its current account balance? How so? Explain how it is possible for the United States’ current account deficit to grow while the budget deficit has disappeared.

Answer: The budget deficit and the current account are linked but there are the other variables of domestic private savings and domestic investment that are also joined in the savingsinvestment balance. For this reason, there is no such thing as a onetoone correspondencebetween budget and trade balances. The basic relationship is captured in the equation(4b in the text): Sp government budget I current account. From this it can be seen that as the government budget went to zero and the current account became more negative, either savings fell, investment rose, or some combination of the two occurred.

5. Compare and contrast portfolio capital flows with direct investment capital flows.

Answer: These two types of capital flows are similar in that they both provide a nation with the useof foreign savings. That is, they both represent capital flows that are a net increase in the amount of resources available for investment. On the other hand, they are very different in the time dimensions that they represent and in their liquidity. FDI is illiquid and generally represents funds with a longer time horizon than portfolio capital. Portfolio investment can move in or out of a nation extremely quickly and is the main focus of concerns about the destabilizing effects of foreign investment.



6. Why is a current account surplus equivalent to foreign investment?

Answer: A current account surplus leads to the net accumulation of foreign assets, whether real or financial. In either case, there is the prospect of a future stream of revenue that will be generated from the assets.

Another way to look at it is to consider that in order to export a greater value than imports, a nation must not consume some of its income (production). Instead, the goods andservices are sent abroad. The effect is the same as domestic investment: Consumption out of current period production is postponed until a future date, and the excess output is usedto increase the capacity of the economy to generate a future stream of income (production).


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