Answers to End-of-Chapter Questions

1.

Howcanglobalizationandinternationaleconomicintegrationbemeasured?
Answer:

2.

Thechapteroffersthreewaystomeasureglobalizationandeconomicintegration:(1)trade
flows;(2)factormovements;and(3)convergenceofprices(goods,factors,andassets).
InwhatsenseistheU.S.economymoreintegratedwiththeworldtodaythanitwasacenturyago?
Inwhatwaysisitlessintegrated?
Answer:

TheWTOsTradeProfilefortheUnitedStatesgivesanaveragetradetoGDPratioof
28.3for20092011.ThatimpliesthattheUnitedStatesratioisabout150percentgreater
todaythanitwasin1913((28.311.2)/11.21.53).
Atthesametime,thecompositionofgoodstradedhaschangedfromagriculturaloutput
tomanufacturedgoods.Thisisconsistentwiththeobservationthatworldtradehasbeen
growingfasterthanworldoutput,atleastsince1950.Muchofthegrowthintradesince
then,however,simplybroughtusbacktowherewewerebeforeWorldWarII.
Intermsoflaborflows,theUnitedStatesisprobablylessintegratedwiththeworld
economythanitwasin1890or1900.Duringthattimewehadanopendoorimmigration
policy(forallbutChinesecitizens),andalargershareofourpopulationwasforeignborn
(14.5in1890versuslessthan8percentin1990and12percenttoday).
Capitalflowsaremoredifficulttogeneralizesincetheycanbemeasuredseveralways.
Whiletheabsolutevolumeofcapitalflowshasincreaseddramatically,asashareofworld
GDPitisprobablynomorethanitwasattheturnofthetwentiethcentury,anditmay
evenbeless.Thelevelofinvestmentinnearlyallcountriesisstillhighlycorrelatedwith
domesticsavingsrates.Whatisdifferent,however,istheeasewithwhichcapitalcan
crossinternationalboundaries(lowertransactioncosts)andthemuchgreatervarietyof
assetsthataretraded.Theneedtoprotectagainstexchangerateriskisakeycomponent
oftodaysinternationalfinancialmarketsandisaprimarydifferencefromthefixed
exchangeratestandardofthepast.Theincidenceoffinancialcriseshasnotincreasedand,
asametricofintegration,itimpliesnoincreaseincapitalmarketintegration.
Thegrowthofregionaltradeagreementsisalsoanindicatorofincreasedintegration.
AgrowingroleforinternationalinstitutionssuchastheIMForWorldBankmay
alsoindicateanincreaseininternationalintegration.

3.

WhatdoesthetradetoGDPratiomeasure?Doesalowvalueindicatethatacountryisclosedto
tradewiththeoutsideworld?
Answer:

ThetradetoGDPratioisameasureoftherelativeimportanceoftradetoanational
economy.ItismeasuredbytheratioofexportsplusimportstoGDP.
Arelativelysmallratiodoesnotnecessarilymeanthataneconomyisintentionallyclosed
totheoutsideworld.LargecountriesliketheUnitedStateshavelargedomesticmarkets
thatenablefirmstospecializeandproduceinvolumeinordertoattainanoptimalscale.
Specializationandhighvolumeinmanufacturingisoftenassociatedwithincreased
productivity,sofirmsinlargemarketscanachievethehighestpossiblelevelof
productivitywithouthavingtoselltoforeignmarkets.Firmslocatedinsmallercountries
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2GerberInternationalEconomics,SixthEdition

havetotradetheiroutputacrossinternationalboundariesiftheywanttohavethesame
technologyandthesamelevelofproductivity.Consequently,largecountriestendtohave
lowertradetoGDPratiosregardlessoftheirtradepolicies.
4.

DescribethepatternoverthelastcenturyshownbythetradetoGDPratioforleadingindustrial
economies.
Answer:

5.

Tradeandcapitalflowsweredescribedandmeasuredinrelativeratherthanabsoluteterms.Explain
thedifference.Whichtermseemsmorevalidrelativeorabsolute?Why?
Answer:

6.

Absolutevaluesarethedollaramountsoftradeandcapitalflows.Relativevaluesarethe
ratioofdollarvaluestoGDP.Relativevaluesareabetterindicatoroftheimportanceof
tradeandcapitalflowssincetheyareproportionaltothesizeofnationaleconomies.
LargeeconomiesliketheUnitedStatesmayhavelargeexportandimportvalues,butthe
importanceoftradetothenationaleconomyisnotnearlyasgreatasitisforother
economies.TheUnitedStatesisalargeexporterandimporter,butthenationaleconomy
issolargethattradeismuchlessimportantfortheUnitedStatesthanitisformany
smallercountriessuchasCanada,Belgium,orTheNetherlands.

Inrelativeterms,internationalcapitalflowsmaynotbemuchgreatertodaythantheywere
ahundredyearsago,althoughtheyarecertainlygreaterthantheywerefiftyyearsago.Qualitatively,
however,capitalflowsaredifferenttoday.Explain.
Answer:

7.

Theratiofellbetween1913and1950,butthenbegantoriserelativelyrapidly.Themain
causesofthepatternshowninFigure1.1arethetwoworldwarsandtheGreat
Depressionofthe1930s,andchangesintradepolicyaccompanyingthatperiod.By2000,
theratiosweremostlyhigherthantheywerebeforeWorldWarI.Anotherpatternthe
chapternotesisthattheratioissmallerforthelargepopulationcountriesofJapanandthe
UnitedStates,andhigherforTheNetherlands,withitssmallpopulation.

Majorqualitativedifferencebetweenlatenineteenthandlatetwentiethcenturycapital
flowsincludethefactthattherearemanymoretypesoffinancialinstrumentsavailable
nowcomparedtoacenturyago.Theseinstrumentscanbefinelytailoredtotheincome
andriskpreferencesofinvestors.Secondly,alargeshareofthetotalflowofcapital
acrossbordersisrelatedtotheneedtoprotectagainstfluctuationsinthevalueof
currencies.Thisuseofinternationalcapitalmarketswasnotasnecessarywhennations
operatedwithinfixedexchangeratesystems.Third,thetransactioncostsofparticipatingin
internationalcapitalmarketsaremuchlowertodaythanitwasacenturyago.

Whatarethenewissuesininternationaltradeandinvestment?Inwhatsensedotheyexposenational
economiestooutsideinfluences?
Answer:

Thenewissuesinvolvepolicydifferencesbetweennationsthatuntilrecentlywere
consideredtheexclusiveresponsibilityoflocalornationalgovernments.Examples
includelaborstandards,environmentalstandards,competitionorantitrustpolicies,and
industrialsupportpolicies.
Negotiationsbetweennationspotentiallygiveforeigninterestsavoiceinsettingdomestic
policy.Thescopeandthedepthofthenegotiationsdeterminehowgreatavoice
foreignerswillhave.Itisoftenthecase,however,thatnegotiationseitheroccurorare

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Chapter1TheUnitedStatesinaGlobalEconomy3

proposedbecausesomeaspectofdomesticpolicyisperceivedbyforeignersasabarrier
totrade,andtheyseektoalterthedomesticpolicythatcreatedit.

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4GerberInternationalEconomics,SixthEdition

8.

Describethethreekindsofevidenceeconomistsusetosupporttheassertionthateconomiesopento
theworldgrowfasterthaneconomiesthatareclosed.
Answer:

Theseare:(1)casualempiricalevidenceofhistoricalexperience;(2)economiclogicand
deductivereasoning;and(3)evidenceofstatisticalcomparisonsofcountries.
(1) Thehistoricalevidenceexaminestheexperiencesofcountriesthattriedtoisolate
themselvesfromtherestoftheworld.First,notonlydidtradeprotectionexacerbate
theDepressionofthe1930s,butitalsoledtothemiseryandtragedyofWorldWarII.
Second,anexaminationofcountriessuchasformerEastandWestGermany,North
andSouthKorea,andothercountrieswiththesamehistorical,economic,andethnic
backgroundthatweredividedbywar,indicatethatthosewhoclosedtheireconomies
fromtherestoftheworldsufferedintermsofprosperityandenvironmental
degradation.EastAsiaexperiencedaneconomictakeoffwhenitdecidedtointegrate
withtherestoftheworld,whileLatinAmerica,whichhadthesameeconomic
backgroundasEastAsiabutchosetoremainpartiallyclosed,experiencedmediocre
growth.
(2) Thelogicofeconomictheoryalsosuggestsastrongcausalrelationbetweentradeand
fastereconomicgrowth.Thefollowingisasummaryofthislinkage:
FollowingAdamSmith,DavidRicardoprovedthatcomparativeadvantageleadsto
tradeandthisinturnleadstothereallocationofresourcesandtheimprovementof
thestandardoflivingofanynation,largeorsmall.Moderntradetheoryalsomakes
thecaseforexportsandopentradeasthecausesforeconomicexpansion.Exports
andopentradefostercompetition,innovation,andlearningbydoingandbring
internationalbestpracticestotheattentionofdomesticproducers,spurringgreater
efficiencyandexportexpansion.Thishelpsdomesticproducerstorealizeeconomies
ofscalewhentheyattempttoproducefortheworldmarketratherthanfortheirown
limitedbaseofdomesticconsumers.Largermarketscreateincentivesforfirmsto
engageinresearchanddevelopment,andallowcountriestoimportimportant
productioninputsandforeigncapitalbyminimizingforeignexchangeconstraints.
Theyfacilitatethetransferoftechnologyandmanagerialskills.Itfollowsthatopen
tradeandexportsincreasethedemandforthecountrysoutputandtherefore
contributestronglytopositiveeconomicgrowth.
(3) Eventhoughthestatisticalevidenceisnotquiteconclusive(mainlyduetomeasuring
tradepolicy),theevidenceofstatisticalcomparisonofcountries(crosssectionaltime
series)indicatesthatcountriesbenefitfromopentrade.

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Chapter1TheUnitedStatesinaGlobalEconomy5

Ch2

Answers to End-of-Chapter Questions

1.

Whatisaninstitution?Giveexamplesofbothformalandinformalinstitutions.Explainhowthey
differfromorganizations.
Answer:

Aninstitutionisasetofrulesofbehavior.Itsetslimitsorconstraintsonsocial,political,
andeconomicinteraction.Therulescanbeformallyrecognizedinacodeoflaws,club
rules,oranorganizationsstandardsofbehavior.Therulesofaninstitutionmayalso
beinformalasinthecaseoftablemannersorsocialcustoms.Examplesofformal
institutionsincludecivilcodes,commercialcodes,anduniversitystandardsofbehavior
(e.g.,regardingplagiarismorsexualharassment).Examplesofinformalinstitutions
includegiftexchangesonbirthdays,eatingsaladwiththesmallfork,andgivingupyour
seattoanelderlypersononacrowdedbus.
InstitutionsdifferfromorganizationsinthesamewaythatthegovernmentoftheUnited
StatesdiffersfromtheConstitution.Thelatteristhesetofrulesthatgovernstheformer.
Organizationsareassociationsofindividualsorgroups,institutionsaretherulesthat
determinethelimitsandimperativesoftheirbehavior.

2.

Whataretheargumentsinfavorofinternationalorganizations?Whataretheargumentsagainst
them?Whichdoyouthinkarestronger?
Answer:

Argumentsinfavor:Internationalorganizationsareessentialforthecontainmentof
nationalorregionalcrisesandtheavoidanceoftheirpropagationinternationally.By
providingasetofrules(institutions)whicharecertainandknown(transparent),they
reduceuncertaintyandincreasestability.Inmanyinstances,theyovercomeproblemsof
freeridingintheinternationaleconomyinordertoinsuretheprovisionof(international)
publicgoodssuchaslenderoflastresortfinancingforresolvingaliquiditycrisis,oropen
marketsinarecession.
Argumentsagainst:Thetextdescribestheproblemswithinstitutionsintermsofissues
ofsovereignty(mayforceadoptionofdomesticpoliciesagainstnationswillorinterests),
transparency(decisionmakingatinstitutionsmaybedominatedbyotherspursuing
theirowninterests),ideology(advicemaybebadorbiased),andimplementationand
adjustmentcosts(asymmetriesinnegotiationpowerandinabilitytoabsorbcosts
imposed).Overall,criticsquestionwhetherinstitutionsgenerateeconomicinequality
andcompoundriskstovulnerablegroups.
Theissueofwhichargumentsarestrongerisambiguous.Eithercanbeviewedasmore
cogent.Thekeyisthatstudentsunderstandbothargumentsandthattheydevelopaset
ofreasonstosupporttheirviews.

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6GerberInternationalEconomics,SixthEdition

3.

Givetheargumentsforandagainstfreetradeagreements.Howmightthesigningofafreetrade
agreementbetweentheUnitedStates,CentralAmerica,andtheDominicanRepublichaveharmed
Bangladesh?
Answer:

ProponentsofRTAsviewthemasbuildingblocksforfreer,moreopen,worldtrade.
Theyareabletoperformthisfunctionbecauseitiseasierforafewcountriestoreach
agreementondifficulttrademattersthanitisforalargenumberofcountriestoreachthe
sameagreements.Furthermore,thedomesticeffectsofareductionoftradebarriersare
lessdramaticsincefewercountriesareinvolved.Importflowsandjoblossesand
displacementsaresmallerandmoreeasilymanaged.Inaddition,RTAmemberscan
experimentwithnewagreements,suchaslaborandenvironmentalstandardsthataretoo
contentiousinalargersetofnegotiations.Opponentsquestiontheseassumptionsand
arguethatRTAsundermineprogresstowardmultilateralagreements,suchastheDoha
RoundoftheWTO.TheyarguethatRTAspolarizecountriesbecausetheyare
discriminatoryagainstnonmembersandbecausetheydisadvantagesmallercountriesthat
enterintoagreementswithlargeones,sincethesmallcountrieslacktheabilityto
negotiateeffectivelyandtheyareoftenunabletotakeadvantageofthemarketopeningof
thelargercountryduetotheirlimitedinfrastructureandotherresources.
BangladeshmaybehurtbyafreetradeagreementbetweentheUnitedStatesand
CentralAmericaduetothetradediversionthatmightresult.IfBangladeshisthe
lowestcostproducerofapparel,forexample,thenaloweringofU.S.tariffsagainst
CentralAmericacouldresultinproductionfortheU.S.marketshiftingfrom
BangladeshtoCentralAmerica.

4.

Whatarepublicgoodsandhowdotheydifferfromprivateones?Giveexamplesofeach.
Answer:

5.

Publicgoodsarenondiminishableandnonexcludable.Privategoodsgenerallyshare
neitherofthesecharacteristics.Privategoodsincludemostthingsthatareboughtandsold
inprivatemarkets(restaurantmeals,clothing,houses,cars,etc.)whilepublicgoodsare
oftenprovidedcollectively.Publicgoodsincludenationaldefense,publicairways,civil
andcommercialcodes,andsoforth.

Whatarethemaintasksorfunctionsof(1)theInternationalMonetaryFund,(2)theWorldBank,
(3)theGeneralAgreementonTariffsandTrade,and(4)theWorldTradeOrganization?
Answers: (1) TheIMFsroleistoactasalenderoflastresortinthecaseofadebtcrisisorforeign
exchangecrisis.Itprovidestechnicalexpertiseandadviceandassistsnational
governmentswithnecessarybutdifficultreorganizationsoftheirnationaleconomies.
(2) TheWorldBanksmission,ingeneralterms,istoassisttheeconomicdevelopment
ofnationsthroughtheprovisionofloans,technicalexpertise,andadvice.
(3) GATTisaseriesofmultilateraltradenegotiationsandresultingtreatieswhichbinds
thetariffsandtradepoliciesofnationsandlimitstheirabilitytoarbitrarilychange
them.Itsmissionistokeepmarketsforgoodsopenandtoensurethatnationsfollow
asetofrulesgoverningfairtrade.

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Chapter1TheUnitedStatesinaGlobalEconomy7

(4) TheWTOisanumbrellaorganizationcreatedbytheUruguayroundofGATT.Its
roleissimilartoGATTs,butithasexpandeditsfunctiontoincludeagreementson
services,agriculture,andtextilesandapparel,allofwhichwereomittedfromthe
previousroundsofGATT.Inaddition,itprovidesrulesfortheresolutionoftrade
disputesbetweennationsandactsasaforumforthediscussionandimplementation
offurtherreductionsintradebarriers.
6.

WhennationssigntheGATTagreement,theybindtheirtariffsattheircurrentlevel,orlower.Tariff
bindingmeansthattheyagreenottoraisethemexceptunderunusualcircumstances.Explainhow
tariffbindingintheGATTpreventsfreeridingduringaglobalslowdown.
Answer:

Duringaglobalslowdown,nationsmaybetemptedtoraisebarrierstoimports.Thehope
isthatreducedimportswillprovidegreaterincentivefordomesticproductionandadd
jobsinimportcompetingindustries.Thispartofthestrategyusuallyworksbutatthecost
ofthelossofjobsinexportindustries.Exportindustriesarehurtifothernationsretaliate
andimposesimilarbarrierstoimports.
Theproblemisthateverycountrywantstolettheothersbetheonestokeeptheirmarkets
open.Thefreeriderproblemoccursbecausenationsthatimposeimportbarriersarefree
ridingonthepoliciesofnationsthatdonotsimilarlyimposebarriers.Tariffbinding
eliminatesthispossibility.

7.

KindlebergersstudyoftheGreatDepressionofthe1930sledhimtobelievethatmarketeconomies
aresometimesunstableandthatnationscangetlockedintoprolongeddownturns.Othereconomists
arenotconvinced.SupposethatyoudisagreewithKindlebergerandthatyoubelievethatmarket
basedeconomiesareinherentlystable.Howwouldyouviewtheneedforinternationalinstitutionsto
addresstheprovisionofeachofthepublicgoodsinTable2.5?
Answer:

Iftheinternationaleconomyisinherentlystable,thentheneedforinternational
institutionsdecreases.Mostofthecaseswherethereisafailuretoprovidethepublic
goodsinTable2.3areaconsequenceofthefailuregovernmentstoimplementsound
economicpolicies.
Governmentsmaytrytoclosemarketsduringarecessionbutenlightenedgovernments
recognizethisasselfdefeatingsinceothernationswillretaliate.Governmentclosureof
marketsisagovernmentalfailure,notamarketfailure.
Privatecapitalmarketswillchannelfundstodevelopingcountriesifthesecountrieshave
therightpolicies.Again,theproblemofcapitalshortagesindevelopingcountriesmaybe
asmuchafailureofthedevelopingcountryseconomicpoliciesasitisafailureof
markets.
Privatemarketswillseekoutpaymentmethodsthatareacceptabletoalltheparties
involved.
Financialcrisescausedbyashortageofliquidityareanindicatorofdeeperproblems.At
times,itisnecessarytoletbadfirmsfail.Thesetypesofcriseswillburnthemselvesout
andleavelittlelastingimpactontheinternationaleconomy.

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8GerberInternationalEconomics,SixthEdition

8.

Whatarethefivemaintypesofregionaltradeagreementsandwhataretheirprimarycharacteristics?
Answer:

Thefivemaintypesofregionaltradeagreementsare:(1)apartialtradeagreement;
(2)afreetradearea;(3)acustomsunion;(4)acommonmarket;and(5)aneconomic
union.
(1) Apartialtradeagreementfreesuptradebetweentwoormorecountriesinafew
goods.AnexampleistheU.S.CanadaAutoPactwhichcreatedfreetradeincarsand
carpartsinthe1960s.ItlaterformedthebasisfortheU.S.Canadafreetrade
agreement.
(2) Afreetradeareaallowsgoodsandservicestocrossinternationalborderswithout
payingatariffandwithoutlimitationsimposedbyquotas.Manyitems,suchaslabor
andenvironmentalissues,areusuallyleftoutoftheagreement.Example:NAFTA.
(3) Acustomsunionisafreetradeareaplusacommonsetoftariffstowardnonmembers.
Inthissituation,membershavefreetradewitheachotherandagreetolevy
thesametariffonimportsfromnonmembers.Examples:MERCOSUR,andfromthe
mid1970stoearly1990s,theEuropeanUnion.
(4) Acommonmarketisacustomsunionplusanagreementtoallowthefreemobility
ofinputssuchaslaborandcapital.Example:theEuropeanUnioninthe1990s.
(5) Aneconomicunionisacommonmarketwithsubstantialcoordinationof
macroeconomicpolicies,includingacommoncurrency,andharmonizationof
standardsandregulations.Example:the12EuropeanUnionmembersthatparticipate
intheeuro.
Sincemostformalagreementscombineincompleteelements,thisclassificationismore
clearcutthanthemessierreality.

9.

CriticsoftheglobalinstitutionshaveavarietyofcomplaintsabouttheWTO,theIMF,andtheWorld
Bank.Explainthemaincategoriesofcomplaints.
Answer:

Thetextdescribestheproblemswithinstitutionsintermsofissuesofsovereignty(may
forceadoptionofdomesticpoliciesagainstnationswillorinterests),transparency
(decisionmakingatinstitutionsmaybedominatedbyotherspursuingtheirown
interests),ideology(advicemaybebadorbiased),andimplementationandadjustment
costs(asymmetriesinnegotiationpowerandinabilitytoabsorbcostsimposed).They
especiallyquestionthedominanceoftheUnitedStatesandindustrializednationsin
determiningthepoliciesinstitutionssetforclientcountries,sincethosepoliciesmaybe
wrongorbiasedorimposeparticularharmtosomegroupsintheclientnations
populations.Overall,criticsquestionwhetherinstitutionsgenerateeconomicinequality
andcompoundriskstovulnerablegroups.

Ch3

Answers to End-of-Chapter Questions

1.

UsetheinformationinthetableonlaborproductivitiesinFranceandGermanytoanswerquestionsa
throughf.
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Chapter1TheUnitedStatesinaGlobalEconomy9

Cheese
Cars
a.
b.
c.
d.
e.
f.

OutputperHourWorked
France
Germany
2kilograms
1kilogram
0.25
0.5

Whichcountryhasanabsoluteadvantageincheese?Incars?
WhatistherelativepriceofcheeseinFranceifitdoesnottrade?InGermany?
WhatisopportunitycostofcheeseinFrance?InGermany?
Whichcountryhasacomparativeadvantageincheese?Incars?Explainyouranswer.
Whataretheupperandlowerboundsforthetradepriceofcheese?
DrawahypotheticalPPCforFranceandlabelitsslope.SupposethatFrancefollowsits
comparativeadvantageindecidingwheretoproduceonitsPPC.Labelitsproductionpoint.
Ifthetradepriceofcarsis5kilogramsofcheesepercar,drawatradeline(CPC)showinghow
Francecangainfromtrade.

Answers:
a. FrancehastheabsoluteadvantageincheeseandGermanyincars.ThisfollowsbecauseFrances
productivityishigherincheeseandGermanysishigherincars.
b. TheautarkicrelativepriceofcheeseinFranceisoneeighthcarperkilogram;inGermanyitis
onehalfcar.

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10GerberInternationalEconomics,SixthEdition

c. Opportunitycostsareequaltorelativeprices.
d. Francehasacomparativeadvantageincheesebecauseitsopportunitycostislower(oneeighth
carversusonehalfcarinGermany).Bythesamereasoning,Germanyhasacomparative
advantageincars.
e. Thetradepriceofcheesewillsettlebetweenoneeighthandonehalfcarperkilo.
f.

2.

SupposethetableinProblem1looksasfollows.Usetheinformationtoanswerquestionsathroughf.
OutputperHourWorked
Cheese
Cars

France

Germany

1kilogram

2kilograms

0.25car

2cars

Answers:
a. Germanyhasanabsoluteadvantageinbothcheeseandcars.
b. 1cheese0.25carinFrance;1cheese1carinGermany
c. sameasPart(b).
d. Francehasacomparativeadvantageincheesebecauseitsopportunitycostintermsof
carsislower(0.25carvs.1car);Germanyhasacomparativeadvantageincarproduction
(1cheesevs.4cheese).

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Chapter1TheUnitedStatesinaGlobalEconomy11

e.
f.

3.

Thetradepriceofcheesewillsettlebetween0.25carand1car.

Explainhowanationcangainfromtradeeventhoughnoteveryoneismadebetteroff.Isthisa
contradiction?
Answer:

4.

Economicnationalistsindevelopedcountriesworrythatinternationaltradeisdestroyingthenational
economy.Acommoncomplaintisthattradeagreementsopentheeconomytoincreasedtradewith
countrieswhereworkersarepaidafractionofwhattheyearnathome.Explainthefaultylogicofthis
argument.
Answer:

5.

Thisisnotacontradiction.Thegainsfromtradeimplythatthewinnerscouldcompensate
theloserscompletelyandstillhavegainsleftover.Somepeoplemaylosejobs(inthe
exampleinthetext,astheUnitedStatesmovedtowardspecializationinsteel,American
workerswereshiftedoutofthebreadindustryandintothesteelindustry),butothers
benefitfromthehigherdemandfortheirproduct(workersinthesteelindustry).Aslong
asthewinnersgainsaregreaterthantheloserslosses,wecanconcludethatthenation
wins.

Theerrorinlogicisthefailuretotakeintoaccountthedifferencesinproductivity.The
lowwageworkersinlessdevelopedcountriesingeneralarepaidlessbecausethey
producelessoutputduringeachhouroflabor.Furthermore,thedevelopednationsand
thelessdevelopednationsarenotincompetitionforeconomicgrowth.Growthinone
countrybenefitstheotherthroughanincreaseinthedemandforitsproducts.Economic
nationaliststendtoviewtradeasazerosumgameinwhichonesidelosesandthe
otherwins.

Manypeoplebelievethatthegoalofinternationaltradeshouldbetocreatejobs.Consequently,when
theyseeworkerslaidoffduetoafirmsinabilitytocompeteagainstcheaperandbetterimports,they
assumethattrademustbebadfortheeconomy.Isthisassumptioncorrect?Why,orwhynot?
Answer:

Thegoaloftradeistoimproveanationsallocationofitsresourcessotheyaredirected
totheirmostvaluableuse.Tradeisnotaboutcreatingjobs,butisaboutraisingthe
standardoflivingthroughamoreefficientallocationofresources.Trademaycause
workerstobecomelaidoffiftheyareininefficientindustriesthatdonotproduceaccording
tothenationalcomparativeadvantage.Whilethismaybehardonthepeoplewholose
theirjobs,italsofreesuplaborandcapitalsoitcanbedirectedtobetteruses.

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12GerberInternationalEconomics,SixthEdition

6.

SupposethatGermanydecidestobecomeselfsufficientinbananasandeventoexportthem.In
ordertoaccomplishthis,largetaxincentivesaregrantedtocompaniesthatwillinvestinbanana
production.Soon,theGermanindustryiscompetitiveandabletosellbananasatthelowestprice
anywhere.DoesGermanyhaveacomparativeadvantage?Why,orwhynot?Whatarethe
consequencesfortheoveralleconomy?
Answer:

Governmentsubsidiescanlowerthecostofproductionbuttheywillnotchangethe
productivityofbananaproduction.Thelaborandcapitalthatispulledintobanana
productionarepulledoutoftheproductionofsomeothergood.Thereisnothinginthe
taxincentivesthatchangestherelativepriceoropportunitycostofbananas.Hence
Germanydoesnothaveacomparativeadvantageeventhoughthetaxincentivesallow
firmstoselltheiroutputatcompetitiveprices.Theconsequencefortheeconomyisthat
laborandcapitalareusedupinarelativelyinefficientendeavorandarelessavailable
foruseintheproductionofgoodswhereGermanydoeshaveacomparativeadvantage.
Henceoveralleconomicwelfarefalls,eventhoughthebananaproducersaredoingwell.
Resourcesthatareusedforthetaxincentivesaredivertedfromsomeotherprogram,
creatinganadditionalopportunitycost.

Answers to End-of-Chapter Questions

Chap 4

1. Accordingtothefollowingtable,whichcountryisrelativelymorelaborabundant?Explainyour
answer.Whichisrelativelymorecapitalabundant?
UnitedStates

Canada

Capital

40machines

10machines

Labor

200workers

60workers

Answer:

Thecapitallaborratiosare1/5and1/6fortheUnitedStatesandCanada.Since1/5is
greaterthan1/6,theUnitedStatesiscapitalabundant.Bythesamereasoning,the
laborcapitalratioishigherinCanada,soitislaborabundant.

2. SupposethattheUnitedStatesandCanadahavethefactorendowmentsgiveninthetablein
Question1.Supposefurtherthattheproductionrequirementsforaunitofsteelis2machines
and8workers,andtherequirementforaunitofbreadis1machineand8workers.
a. Whichgood,breadorsteel,isrelativelycapitalintensive?Laborintensive?Explainyouranswer.
b. Whichcountrywouldexportbread?Why?
Answers:
a. Thecapitallaborratiotomakesteelis1/4;tomakebreaditis1/8.Hencesteelismorecapital
intensiveandbreadismorelaborintensive.
b. SincetheUnitedStatesiscapitalabundantandsteeliscapitalintensive,accordingtothe
HeckscherOhlintrademodel,theUnitedStateswillexportsteelandCanadawillexportbread.

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3. Supposethatbeforetradetakesplace,theUnitedStatesisatapointonitsPPCwhereitproduces
20loavesofbreadand20unitsofsteel.Oncetradebecomespossible,thepriceofaunitofsteelis2
unitsofbread.Inresponse,theUnitedStatesmovesalongitsPPCtoanewpointwhereitis
producing30unitsofsteeland10loavesofbread.Isthecountrybetteroff?Howdoyouknow?
Answer:

TheUnitedStatesisdefinitelybetteroffbecauseitcanconsumeagreaterquantityof
bothgoods.Ifittradedfivesteelfor10breaditwouldhave20breadand25steel.Thisis
thesameamountofbreadasbeforetrade,andfivemoreunitsofsteel.Itcankeepthe
extrafivesteel,ortradesomeorallofthemforadditionalbread.Ineithercase,the
consumptionbundleisgreaterthanitwasbeforetrade.

4. GiventheinformationinQuestions1and2,explainwhathappenstothereturnstocapitalandlabor
ineachcountryaftertradebegins.
Answer:

Thechangesinthereturnstocapitalaredifferentbycountry.IntheUnitedStates,the
demandforcapitalincreasesbecausemoresteelwillbeproduced;conversely,the
demandforlaborfallsbecauseofthedropinbreadproduction.Ownersofcapitalbenefit
fromtheincreaseindemandfortheirinputs,whileownersoflaborsufferadeclinein
theirreturns(wages).InCanada,theeffectsarereversed.

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5. Supposethattherearethreefactors:capital,labor,andland.Breadrequiresinputsoflandandlabor,
andsteelrequirescapitalandlabor.
a. Whichfactorsarevariable,andwhicharespecific?
b. SupposeCanadasendowmentsoflandandcapitalare10capitaland100land,andthe
UnitedStatesare50capitaland100land.Whichgooddoeseachcountryexport?
c. Howdoestradeaffectthereturnstoland,labor,andcapitalintheUnitedStatesandinCanada?
Answers:
a. Laboristhevariablefactorandcapitalandlandarespecific.
b. CanadaislandabundantrelativetotheUnitedStates(100/10isgreaterthan100/50),so
Canadascomparativeadvantageisintheexportofbread,thegoodwiththespecificinputof
land.TheUnitedStatescomparativeadvantageissteel.
c. IntheUnitedStates,ownersoflandarehurtbytrade,ownersofcapitalbenefit,andtheeffects
onlaborareindeterminate.Thelattereffectdependsonlaborspreferenceforbreadandsteel.In
theUnitedStates,breadpricesfall,butsteelpricesrise.InCanada,ownersoflandbenefitfrom
trade,ownersofcapitalarehurt,andtheeffectsonlaborareindeterminate.Thelattereffect
dependsonlaborspreferenceforbreadandsteel.InCanada,breadpricesrise,butsteelprices
fall.
6. Describethechangesinproductionrequirementsandthelocationofproductionthattakeplaceover
thethreephasesoftheproductcycle.
Answer:

Inthefirstphase,allproductionisinhighincomecountries.Theinputrequirements
includerelativelylargeamountsofscientificandengineeringskills,marketingexpertise,
andaccesstoriskcapital.Experimentationwithnewproductsdependsonaccesstohigh
incomeconsumers,andcompetitivepressuresrequireaquickfeedbackfromconsumers
toproducers.Thenewproductstendtobehighlyvariableintheirdesignandperformance
characteristics,andexperimentationisimportantinfindingtherightcombinationof
prices,options,andquality.
Inthesecondphase,somestandardizationistakingplace,alongwithsomesalesofthe
productindevelopingcountries.Theearlyperiodofintenseexperimentationisoverand
firmsarebeginningtosettleonthelowestcostproductiontechnologies.Productionis
migratingoverseas,wherelaborcostsarelower.
Inthefinalphase,experimentationwithdesignandmanufacturingtechnologiesisover,
theproductiscompletelystandardized,andtheinputrequirementsaremoreheavily
biasedtowardsunskilledorsemiskilledlabor.Muchoftheproductioncanbe
accomplishedinassemblyoperations,whichcanbelocatedinlowwagecountries.
Bythethirdphase,mostoftheproductionhasleftthehighincomecountriesexcept
inthecaseswhereproductdifferentiationcancontinue.

7. Doesintrafirmtradecontradictthetheoryofcomparativeadvantage?Whyorwhynot?
Answer:

No,ingeneralitdoesnot,butitmayinsomecases.Mostintrafirmtradecanbe
understoodasafirmthatcutsupitsproductionprocessintoseveraldistinctstages,
andthenrelocatessomeorallofthestagestodifferentcountrieswherethefactor
endowmentsareconsistentwiththeproductionrequirementsofeachstage.Labor
intensiveproductionstageswillberelocatedtolaborabundantcountries,andsoforth.

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Chapter1TheUnitedStatesinaGlobalEconomy15

Inthiscase,firmsaretakingadvantageofthecomparativeadvantageofdifferentnations
inordertoproducetheirgoodsatthelowestoverallcost.
Insomecases,however,theremaybeothermotivesforlocatingaproductionstagein
anothercountry.Thesemotivesincludethedesiretoavoidtradebarriersbyproducingall
orpartofagoodinsidethecountrywheresalesareanticipated,thedesiretoescape
taxation,theattempttodetermarketentrybyarivalfirm,andasinsuranceagainst
unforeseenevents(e.g.,politicalinstability).
8. GeneralMotorsisaU.S.basedmultinational,butitisalsooneofthelargestcarmanufacturersin
EuropeandSouthAmerica.HowmightDunningsOLItheoryexplainthetradeoffsGMfacedasit
decidedwhethertoexporttothosetwomarketsortoproduceinthem?
Answer:

Transportationcostsaresignificantintheautosector,meaningthatproducingcloseto
thefinalmarketcanhavecostadvantages.TheEuropeanmarketmayhavedesign
preferencesthataredifferentfromtheU.S.market(i.e.,drivingontherightsideofthe
road,fueleconomygivenhighergasprices,higherspeedlimits,andtheneedforpoweron
highways).Thiswouldgiveadvantagestoaproductionlocationwithmoredirect
accesstothefinalmarket.Otherautomanufacturersthatcouldhandleproductionare
GMsdirectcompetition,makingGMunlikelytochooselicensingandasharingofits
manufacturing,design,andtechnology.

9. Manydomesticallyownedapparelmanufacturersbuytheirgarmentsoverseas,sewtheirlabelsinto
them,andthensellthemabroadorbackintothehomemarket.Whataresomeoftheconsiderations
thataclothingmanufacturermightgothroughtochoosethisstrategyinsteadofproducingathome
andexporting?
Answer:

Thesefirmsperceivetheirassettobetheirbrand.Thismayinvolvesomeelementsof
design(orderingspecificoutputfromforeignsuppliers)butalsocouldinvolvequality.It
canbebasedstrictlyonmarketingandadvertising,creatinganimagefromsomethingthat
isintheendrelativelycheapandeasytocreate.Allowingforeignfirmstheabilityto
brandtheclothesthroughlicensingmakesthemlosecontrolofthisasset.Sewinglabels
inallowssomeelementofqualitycontrolwhilereducingproductioncosts.Garment
assemblyisrelativelylaborintenseandlowskill,makingitmorelikelytooccurinless
developed,laborabundantcountries.Design,marketing,andaccesstohighspending
consumersaremorelikelytobeassetsoffirmsindevelopedcountries.Owningan
assemblyoperationdirectlyisnotnecessaryforthemtopreservethisassetaslongasthey
haveultimatecontroloverwhattheyputtheirnameonandhowthatproductis
distributedandmarketed.

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16GerberInternationalEconomics,SixthEdition

10. SupposeSpainweretoopenitsdoorstoalargenumberofunskilledAfricansseekingtoimmigrate.
Ingeneral,whateffectswouldyouexpecttoseeinSpainstradepatternsanditscomparative
advantage?
Answer:

Intheory,laborbecomesmoreabundantandSpainscomparativeadvantagecouldshift
tomoreunskilled,laborintenseproduction.Inpractice,thislaborinflowmaybeusedto
produceservicesthatarenottraded.Theymayfreeupcitizenstoworkinthealready
existingexportsectorandhavelittleeffectoncomparativeadvantage.

Answers to End-of-Chapter Questions

1.

Chap 5

Whatisintraindustrytradeandhowdoesitdifferfrominterindustrytrade?Arethegainsfromtrade
similar?
Answer:

Intraindustryisinternationaltradeofproductsmadewithinthesameorsimilarindustries,
forexample,carforcar,beerforbeer,etc.Differentiatedproducts,whichare
characteristicsofmonopolisticcompetitionandoftenoligopoly,leadtotradebetween
nationswithcommoditiesinthesameindustry.Homogeneousgoods,therefore,would
notmakeanysenseforintraindustrytrade.
Interindustrytradeisinternationaltradeoftwoormoredifferentproducts,forexample,
carforbread.Interindustrytradecanbeexplainedbycomparativeadvantage.Oneofthe
distinguishingcharacteristicsofintraindustrytradeisthepresenceofinternaleconomies
ofscalewithfallingaveragecostsoverarelativelylargerangeofoutput.
Thepresenceofinternaleconomiesofscaleiswhyfirmswanttoenterexportmarkets.
Exportsenablefirmstorealizeloweraveragecostsandbecompetitivebothinternallyand
externally.Thisisoneofthegainsfromintraindustrytrade,andthisgaincontrastswith
comparativeadvantagebasedtradebecausedomesticconsumersoftheexportedproduct
alsogain.Consumersgainsincecompetitionforcesfirmstopassontheirlowercoststo
them.Intraindustrytradewouldalsoexpandthenumberoffirms,therebyenhancing
competitionandthevarietyofgoodsavailableforconsumers.

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Chapter1TheUnitedStatesinaGlobalEconomy17

Itmaybeusefultointroducethetradeclassificationsystemsforstudentsandinstructors
thatwantmoredetail.TheNAICS(NorthAmerica)andSITC(morecommon)systems
areavailabletoviewontheCensuswebsite:
NAICS:http://www.census.gov/foreigntrade/reference/codes/naics/naicsmst.txt
SITC:http://www.census.gov/foreigntrade/reference/codes/sitc/sitcmstr.txt
Aquicklookattheactualcodeshelpsstudentsintuitivelyunderstandthatthemore
detailedaproductclassification,thelessintraindustrytradethereis(e.g.,office
equipmentversuspencilsharpeners).Acompleteguidetoallclassificationsystemsis
availableat:http://www.census.gov/foreigntrade/guide/sec2.html#classification.

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18GerberInternationalEconomics,SixthEdition

2.

ComparingU.S.tradewithGermanyandBrazil,istradewithGermanymorelikelytobebasedon
comparativeadvantageoreconomiesofscale?Why?
Answer:

3.

TradewithGermanyismorelikelytobebasedoneconomiesofscalesinceitconsistsof
theexportandimportofsimilarproductsandoccursmostlyincountriesthathavesimilar
productivity,technology,andfactorendowments.TradewithBrazilislikelytobebased
oncomparativeadvantagesinceBrazilsproductivity,technology,andfactorendowments
arenotsimilartotheUnitedStates.

Whatarethedifferencesbetweenexternalandinternaleconomiesofscalewithrespectto(i)thesize
offirms,(ii)marketstructure,and(iii)gainsfromtrade?
Answers:
i. Anexternaleconomyofscaleexistswhenthefallintheaveragecostsoftheindustrylowersthe
averagecostsofthetypicalfirm.Withexternaleconomies,thesizeorscaleeffectsarelocated
intheindustry,andNOTTHEFIRM.Thus,eventhoughthesizeofeachfirmintheindustry
doesnotincrease,theindustryexpandsduetodecliningcosts.Therearejustmorefirmsinthe
expandingindustry.Thiscouldbeduetotheentryofmorefirmsasexistingfirmsrealize
economicprofits,oritcouldbeduetothesplittingofexistingfirmsintodifferentfirmswith
increasinglynarrowspecialization.Thuswithexternaleconomiesofscale,thefirmsareexpected
tobesmallinsize.Withinternaleconomiesofscale,thecausefortheexpansionof
afirmssizeisitsowndecliningaveragecosts.Thatis,thesizeorscaleeffectsarelocatedin
thefirm,andNOTINTHEINDUSTRY.Averagecostsofthefirmdeclineasoutputexpands.
Thisusuallyleadstolargerfirmsbecausesizeconfersacompetitiveadvantageintheformof
loweraveragecosts.
ii. Asmentionedabove,withexternaleconomiesofscalethescaleeffectsarelocatedwithinthe
industry,andnotwithinthefirm.Thepotentialforexternaleconomiesofscalegainsleadsfirms
toconcentrateinspecificregions.Themarketstructureinthiscaseisagglomerations.Onthe
otherhand,decliningaveragecostswithininternaleconomiesofscaleinviteoutsiderstoenter
theindustry.Withinternaleconomiesofscale,thereisalsothepotentialforproductstobe
similarbutdifferentiated.Thisindustrystructure,calledmonopolisticcompetition,existswhena
largenumberoffirmscompetewitheachothertoproduceavarietyofgoods.Monopolistically
competitivestructuresmayalsobetheresultofmodestgainsfrominternaleconomiesofscale.
Ontheotherhand,thescaleeconomiescouldbesubstantialwithinternaleconomiesofscale.If
so,somefirmshaveroomtogrowsincetheywouldbeabletoexploitthissituationforfurther
expansion,marketcontrol,andevendomination.Therefore,internaleconomiesofscalemaylead
toanoligopolymarketstructure.Ontheextreme,asinglefirmmayservetheentire(world)
market.Thiskindofmarketstructureiscalledamonopoly.Thissuggeststhepossibilityofmore
thanonelongrunindustryequilibriumcondition(multipleequilibria).

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Chapter1TheUnitedStatesinaGlobalEconomy19

iii. Intraindustrytradeisabyproductofinternaleconomiesofscale.Asexplainedinthetext,the
benefitsinclude:(a)lowerpricespassedontoconsumersbymonopolisticallycompetitivefirms
enjoyingeconomiesofscale;(b)lowerpricespassedontoconsumerswheninternationaltrade
leadstoanincreaseinfirms;(c)increasesinconsumerchoiceduetointernationaltrade,etc.
Unfortunately,thegainsfromtradearelesscertain(evenharmful)withexternaleconomiesof
scale,whichhypotheticallycouldlockinproductioninlessefficientcountriesandpreventthe
developmentofproductioninamoreefficientcountry.Thisispartlyduetohistoricalaccidents
ratherthanefficiencyadvantagesintradepatterns.
4.

Whatarethethreekeyincentivesforfirmsinaparticularindustrytoclustertogetheringeographical
region?
Answer:

5.

Howmighttradehurtacountryifitimportsgoodsthatareproducedunderconditionsofexternal
economiesofscale?
Answer:

6.

Theseare:(1)largepoolofskilledlabor,whichreducesthesearchcostsandencourages
highdegreesoflaborspecialization,(2)specializedsuppliersofinputs,whichhelpsfirms
holddowntheircostsbyreducingtheirtransportationandinformationalcosts,and
(3)knowledgespilloversduetoinformationexchangethroughformalandinformal
networksofpeople.

Trademaystiflethedevelopmentofnewindustriesthatcouldbemoreefficientthanthe
existingones,reducingglobalefficiency.Thiscouldbeduetoahistoricalaccidentofan
initialheadstart,ortradeotherwisegivesascaleadvantagetoalreadyexistingfirmsin
onecountry.Theinitialheadstartcreatesefficiencyadvantagesfortheexistingfirms.
Thishappensforanumberofreasons,suchas(a)betterdevelopedlinkagebetweenthe
alreadyexistingproducersandtheirsuppliers,and(b)lowerpricesofferedbythefirms
enjoyingexternaleconomiesofscale.

WhentheUnitedStatessignedafreetradeagreementwithCanada(1989),nooneinthe
UnitedStatesthoughttwice.WhentheagreementwithMexicowassigned(1994),therewas
significantopposition.Usetheconceptsofinterindustryandintraindustrytradetoexplainthe
differencesinoppositiontothetwotradeagreements.
Answer:

Canadianproductivity,technology,andfactorendowmentsaremoreorlesscomparable
withthoseoftheUnitedStates.Consequently,tradebetweentheUnitedStatesand
Canadaisintraindustryratherthaninterindustrytrade.AsshowninQuestion3,thereare
quiteafewbenefitsfromintraindustrytrade.Ontheotherhand,tradewithMexicois
likelytobebasedoncomparativeadvantage(interindustrytrade)sinceMexicos
productivity,technology,andfactorendowmentsarenotsimilartothoseoftheUnited
States.Consequently,therewerepossibilitiesforCanadaandMexicotoloseinthe
productionofgoodsandservicesforindustriesinwhichthattheydidnthavecomparative
advantage.SinceunskilledlaborisrelativelyscarceintheUnitedStates,jobsthatdidnot
requirehighskilledlabor,abundantcapital,andsophisticatedtechnologywouldhave
gonetoMexico.ThiswasoneofthefundamentalreasonswhypeopleintheUnitedStates
wereagainstNAFTA.Ontopofthis,politiciansincorrectlyportrayedNAFTA,despitethe
factthattradecancreateaswellasdestroyjobs.Further,theUnitedStatesbenefitedfrom
theproductionofgoodsandservicesthatrequiredskilledlabor,abundantcapital,and
sophisticatedtechnology.SomeMexicanssawthisasunfair,andrebelled.

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20GerberInternationalEconomics,SixthEdition

7.

Whatarethetheoreticaljustificationsfortargetingthedevelopmentofspecificindustries?
Answer:

Theprimaryjustificationistocounteractamarketfailure.Althoughmarketfailurescome
inallshapesandsizes,allimplythatmarketsdonotresultintheoptimalallocationof
resourceseitherproducingtoomuchortoolittle.Industrialpoliciesaremostly
concernedwithcaseswheretoolittle(ornone)ofagoodisproduced.Marketfailures
alsoimplythatthesocialreturnsofanactivityarenotthesameastheprivatereturns.
Whenmarketsproducetoolittle,socialreturnsaregreaterthanprivatereturnsandthe
socialoptimuminvolveshigherlevelsofoutput.
Theoretically,thereasonsfortoolittleproductionmaybeduetothefollowing:(1)when
skillsand/ortechnologiesspilloverintotheeconomybeyondthefirmsthatcreatethem.
Thisoccurswheninformationleaksoutofthefirstentrantfirmsaboutproduction,
technological,andmarketingfeasibilities.Whenthisoccurs,thesocialreturnsarehigher
thanprivatereturns.(2)whencapitalmarketimperfectionsresultininadequate
investmentcapital.Accordingtothisargument,newfirmsmayfacedifficultiesin
attractingsufficientnewstartupcapital.Theyalsofaceinadequatefinancingopportunities
forresearchanddevelopment.Targetingspecificindustries,therefore,isimportant.
Asecondjustificationforindustrialpoliciesisstrategictradepolicy,whereitis
theoreticallypossibletocaptureabovenormalprofitsearnedbyaforeignfirm.Inorder
forstrategictradetoberelevant,theindustrymusthaveverystrongeconomiesofscale
andfirmsmusthavemarketpower.

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Chapter1TheUnitedStatesinaGlobalEconomy21

8.

Whataresomeofthecommonproblemsinimplementingindustrialpolicies?
Answer:

9.

Theyare:(1)thedifficultyofobtaininginformationnecessarytomeasuretheextentof
marketfailure,andchoosingwhichindustrytotarget;(2)knowingtheoptimumamount
ofresources(costs)toprovidethetargetedindustry;(3)encouragingrentseeking
behavior(whichmayrequirethehiringoflobbyists,economists,etc.)byfirmsinother
industries.Thisactivityusesupresourceswithoutaddingtototaloutput.(4)containing
theexternalbenefitsofR&Dspendingwithinnationalboundaries.IfthebenefitsofR&D
spendingarenotkeptwithinnationalboundaries,thebenefitsarepartlycapturedby
foreignfirms.

Figure5.3inthetextillustratesthecaseofanindustrythatgeneratesexternalsocialbenefitswithits
production.Drawasupplyanddemandgraphforanindustrythatcreatesexternalcostswithits
production.Compareandcontrastthemarketdeterminedpriceandoutputlevelwiththesocially
optimalpriceandoutputlevels.
Answer:

Inanegativeexternalitythesocialreturnsarelessthanprivatereturns,soafree
marketproducesmorethantheoptimalamount(Q2insteadofQ1inFigure5.1).This
isbecauseproducersfailtotakeintoaccounttheexternalcostswhencalculatingtheir
costsofproduction(andiftheydo,theywillproducelessthantheoptimalamount).
Asaresult,themarginalprivatecostislessthanthemarginalsocialcost.Consequently,
SprivinFigure5.1shouldbelabeledasSsocandthetwowayarrowlineconnectingthetwo
supplycurvesmustbelabeledasExternalCosts.ProducerschargeP2insteadofP1.

Answers to End-of-Chapter Questions

1.

chap6

Graphthesupplyanddemandofagoodthatisbothproduceddomesticallyandimported.Assume
thatthecountryisnotlargeenoughtoaffecttheworldprice.Illustratetheeffectsofatariffon
imports.Discussthefollowing:

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22GerberInternationalEconomics,SixthEdition

a.
b.
c.
d.
e.

Incomedistributioneffects
Resourceallocationeffects
Domesticproductionandconsumptioneffects
Governmentrevenueeffects
Priceofthegoodeffects

Answers:
SeeFigure6.3inthetext.
a. Theincomedistributioneffectsarealossinconsumersurplus,someofwhichisdestroyed,but
otherpartsofwhicharetransferredtoproducersandthegovernment.
b. Theresourceallocationeffectsincludeaproductioninefficiencyfromtheexpansionofrelatively
highercostdomesticproduction.Theconsumptionsidealsoexperiencesareductioninefficiency
duetosqueezingconsumers,whovaluethegoodmorethanitcoststobuyit,outofthemarket.
c. Domesticproductionrises,consumptionfalls.
d. Governmentrevenuerisesbytheamountofthetarifftimesthenumberofunitsimported.
e. Thepricerisesbytheamountofthetariff.
2.

Supposetheworldpriceforagoodis40andthedomesticdemandandsupplycurvesaregivenby
thefollowingequations:
Demand:P802Q
Supply:P53Q
a.
b.
c.
d.

Howmuchisconsumed?
Howmuchisproducedathome?
Whatarethevaluesofconsumerandproducersurplus?
Ifatariffof10percentisimposed,byhowmuchdoconsumptionand
domesticproductionchange?
e. Whatisthechangeinconsumerandproducersurplus?
f. Howmuchrevenuedoesthegovernmentearnfromthetariff?
g. Whatisthenetnationalcostofthetariff?
Answers:
a. Usingthedemandcurvetodetermineconsumption,40802Q,orQ20.
b. Usingthesupplycurvetodetermineproduction,4053Q,orQ11.67.
c. Consumersurplusisgivenby20(8040)1/2400;producersurplus
is11.67(405)1/2204.17.
d. A10percenttariffraisespricesby4,from40to44.Consumptionmovesalong
thedemandcurve:44802Q,orQ18.Productionmovesupthesupply
curve:4453Q,orQ13.

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Chapter1TheUnitedStatesinaGlobalEconomy23

e.

Thenewvalueforconsumersurplusis18(8044)1/2,or324;henceithasfallenby76.
Producersurplusis13(445)1/2253.5;henceithasgrownby49.33.
f. Tariffrevenueis5420.
g. Thenetnationalcostofthetariffisthecombinationoftheefficiencylossandtheconsumption
deadweightloss.Itisequaltothelostconsumersurplusminusthetransfertoproducersandthe
government,or7649.33206.67.
3.

Underwhatconditionsmayatariffactuallymakeacountrybetteroff?
Answer:

4.

Inadditiontotheproductionandconsumptionsidedeadweightlosses,whataresomeoftheother
potentialcostsoftariffs?
Answer:

5.

Otherpotentialcostsoftariffsincludethethreatofretaliationandthepotentiallossof
exportsmarkets,thestiflingoftheincentivetoinnovate,andtheencouragementofrent
seeking.

TheUruguayRoundoftheGATTbeganaprocessofphasingouttheuseofvoluntaryexport
restraints.Whydidtheycomeintowidespreaduseinthe1980s?Forexample,giventhatVERs
areaformofquotas,andthattheycreatequotarentsandalargerreductioninnationalwelfarethan
tariffs,whydidnationsusetheminsteadoftariffs?
Answer:

6.

Itispossibleforalargecountrytoimprovenationalwelfarebylevyingatariff.The
conditionsthatmustholdarethatthecountryislargeenoughtoaffecttheworld
pricewhenitimposesatariff,andothernationsmustnotretaliate.Itispossibleunder
thesecircumstancestodesignatariffthatraisesnationalwelfarebycausingtheprice
ofimportstofall.Aslongasthegainsfromthecheaperimportsaregreaterthanthe
productionandconsumptionsidelosses,thenationalwelfareimproves.

Voluntaryexportrestraintsavoidtheobligationsnationsshareundertherulesofthe
GATTtonotraisetariffs.Theydonotrequirelegislativeactiontoimplement.
Furthermore,VERspermittedpoliticianstoclaimtheysupportedfreetradewhile
atthesametimeofferingprotectiontospecialinterests.

TheGATTstronglyfavorstariffsasaprotectivemeasureoverquotasorothernontariffmeasures.It
encouragesnewmemberstoconvertquotastotheirtariffequivalents.Oneofthemainreasonstariffs
arepreferredisbecausetheyaremoretransparent,particularlybycomparisontonontariffmeasures.
Explaintheideaoftransparency,andhownontariffmeasuresmaybenontransparent.
Answer:

Transparencyreferstotheabilityofeveryonetoeasilydiscoverandunderstandtherules.
Tariffsaretransparentbecausetheyusuallyarenotassociatedwithspecialcircumstances
knownonlytoaselectfew.Nontariffbarrierslikeanoutrightquotamayormaynotbe
transparent.Quotasmayvaryaccordingtothecountrytryingtoexport;theymayalsobe
implementedintheformofimportlicensesthatinvolvelargeamountsofredtapeand
unknownavailability.Nontariffmeasuressuchashealthandsafetycodes,product
standards,ortestingrequirementscanbeevenlesswelldefinedandposeanevengreater
uncertaintyforfirmstryingtoenterthemarket.

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24GerberInternationalEconomics,SixthEdition

7.

SupposethatbicyclesaremadeintheUnitedStatesoutofacombinationofdomesticand
foreignparts.
a. Ifabikesellsfor$500butrequires$300ofimportedparts,whatisthedomesticvalueadded?
b. Ifa20percenttariffisleviedonbikesofthesamequalityandwiththesamefeatures,howdo
thepriceandthedomesticvalueaddedchange?(AssumetheUnitedStatescannotcausethe
worldpricetochange.)
c. Whatistheeffectiverateofprotection?
d. Ifinadditiontothe20percenttariffonthefinalgood,a20percenttariffonimportedpartsis
alsolevied,whatistheeffectiverateofprotectionforU.S.bikemanufacturers?
Answers:
a. Valueaddedis$500$300$200.
b. Thedomesticpricerisesby20percentto$600;thevalueaddedis$600$300$300,
henceithasrisen$100.
c. Theeffectiverateofprotectionis(300200)/2000.550percent.
d. Thecostofinputsrisesfrom$300to$360,sovalueaddedis$600$360$240.
Theeffectiverateofprotectionisnow(240200)/2000.220percent.

Answers to End-of-Chapter Questions

chap 7

1. WhichindustriesaremoreheavilyprotectedintheUnitedStatesandJapan?Arehighincomeor
lowincomenationsmoreaffectedbyAmericanandJapanesetradebarriers?Explain.
Answer:

IntheUnitedStates,themostheavilyprotectedindustriesaretextileandapparel
producersand,toalesserdegree,agriculture.InJapan,protectionisconcentratedon
agricultureandthefoodandbeverageindustry.Protectioninbothcountriesisinolder,
laborintensiveindustrieswherethecountriesnolongerhavecomparativeadvantages.
Theeffectsaregreatestonlowincomecountriessincethesearetheindustrieswherethey
dohaveacomparativeadvantage.ThefailureoftheUnitedStates,Japan,andother
industrialnationstoopentheirmarketstotheagriculturalproductsandapparelfrom
developingcountrieshasdeprivedthosenationsofpotentialexportmarkets.

2. Whatnewareasoftradeandinvestmentreceivedcoverageundertheagreementsignedinthe
UruguayRoundoftheGeneralAgreementonTariffsandTrade?
Answer:

TheUruguayRoundextendedtheGATTandcreatedseveralnewagreements.GATT
nowcoversagriculture,textiles,andapparel,andnewagreementsweresignedforthe
firsttimeintheareasoftradeinservices,treatmentofforeigninvestment,andthe
protectionofintellectualpropertyrights.Inaddition,theagreementcreatedtheumbrella
organizationcalledtheWorldTradeOrganizationthatwilloverseetheGATTandrelated
agreements.TheWTOalsoconductsperiodicreviewsofeachnationstradepolicies,and
hascreatedastreamlineddisputeresolutionprocedure.

3. Giventhattariffsandquotascostconsumersandthattheyaregrosslyinefficientmeansforcreating
orpreservingjobs,whydocitizensallowthesepoliciestoexist?

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Chapter1TheUnitedStatesinaGlobalEconomy25

Answer:

Thecostsoftariffsandquotasarediffusedthroughoutanentirenation,whilethebenefits
areconcentrated.Thiscreatesanasymmetricsetofincentivestoorganizearoundthe
issueoftradepolicy.Beneficiariesofprotectionstandtogainagreatdealand
consequentlyfinditeconomicallyworthwhiletoorganizeinordertoreceiveprotection.
Individualconsumerslosejustalittle,sothereisonlyasmalleconomicincentiveto
organizeagainstprotectionistpolicies.

4. Whatarethemainargumentsusedbynationstojustifyprotectionforparticularindustries?Which
areeconomic,andwhicharenoneconomic?
Answer:

Theargumentsare(1)revenue,(2)thelaborargument,(3)theinfantindustryargument,(4)
thenationalsecurityargument,(5)culturalprotection,and(6)theretaliationargument.
Thefirstthreeargumentsareaboutgovernmentrevenue,jobs,andmanufacturing,sothey
areeconomicarguments.Arguments4and5haveeconomiccomponents,butare
primarilybasedonnoneconomicconsiderations.Theretaliationargumentisperhapsmore
explicitlyeconomicaswell.

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26GerberInternationalEconomics,SixthEdition

5. Evaluatethelaborandinfantindustryargumentsforprotection.
Answer:

Thelaborargumentisbasedonthefalseassumptionthatlowerwagesautomatically
conferacompetitiveadvantagetoanation.Lowerwagesarethemostvisibleindicator
oflowerproductivities.Theproponentsofthepauperlaborargumentfailtocompletely
considerthecausesoflowerwagesandtheirconsequencesfortrade.Theadvantagesof
lowerwagesareoffsetbythelowerproductivitythatinevitablyaccompaniesthem.
Theinfantindustryargumentrequiresthreeconditionsinorderforittobevalid.First,
theremustbeatechnologicalexternalitythatcannotbecapturedbythefirmsthatproduce
it.Second,theprotectionmustbelimitedintime.Third,itmustenablethefirms
receivingittoexperiencefallingcostssothattheinitiallyhighercostsdisappearandthe
lowornegativeratesofreturnareconvertedintonormalreturns.Thelatterconditionis
equivalenttorequiringthepolicytopayforitselfinthelongrun.

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Chapter1TheUnitedStatesinaGlobalEconomy27

6. Aretariffsjustifiedasaretaliatorymeasureagainstothernations?Justifyyouranswer.
Answer:

Thereisnoagreementamongeconomistsonthisissue.Oneschoolsaysthattariffsmake
uslessefficient,sotheyareunwarranted.Ifotherschoosetohurttheirowneconomies,
whyshouldwefollowsuit?Anotherschoolsaystariffsarejustifiediftheycausethe
offendingnationtoopenitsmarkets.Tradeisbeneficialforall,soiftheycanleadto
increasedtrade,theyarewarranted.Thethirdgroupseesthemaswarrantedbecausethey
worryabouttheunfairadvantagetheymaygrantthenationlevyingthetariff,particularly
inhightechindustrieswherescaleeconomiesareimportant.Tariffsshutoutforeign
competitionandgrantthefirmsinthecountryaccesstoalargermarkettheirown
domesticmarketplusforeignmarkets.Thismaybeaneconomicadvantageinsome
industries.

7. WhatarethefourlegalproceduresthatAmericanfirmshaveattheirdisposalforseekingprotection?
Whataretheconditionsthatwouldgeneratearequestforeachkindofprotection?
Answer:

Thefourproceduresare(1)countervailingduties,(2)antidumpingduties,(3)escape
clauserelief,and(4)Section301retaliation.Countervailingdutiesaregrantedin
responsetoforeignsubsidies;antidumpingdutiesaregrantedwhenaforeignfirmsells
inthedomesticmarketatapricethatisconsideredtoolow(lessthanfairvalue);escape
clausereliefisgrantedasatemporaryprotectionagainstsuddensurgesinimports;and
Section301retaliationisusedtopunishanationforsomeothertypeofpracticethatis
perceivedasconferringanunfairadvantageonitsfirms,orinresponsetoalackof
opennesstoAmericangoods.

Answers to End-of-Chapter Questions

1.

chap 8

Whatarethethreewaysforcountriestohandledifferentstandardsabroad?Dostandardshavetobe
thesameforcountriestobeintegrated?
Answer:

Thethreewaysforcountriestohandledifferentstandardsareharmonization,mutual
recognition,andseparatestandards.Countriesdonothavetohavethesamestandards
tobeeconomicallyintegrated.Infact,requiringthesamestandardsmayposepotential
problems.Harmonizationstandards,forexample,mightleadtotheadoptionofinferior
standardsandmayfailtotakeintoaccountincomedifferences.Byimposingundue
standardrequirements,acountrymayalsofailtoachieveallthatispossibleofitstrading
partners.Itisgenerallybetterfortradingcountriestorecognizeeachothersstandardsor
maintainseparatestandardswhenthelevelofeconomicdevelopmentdiffers.

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28GerberInternationalEconomics,SixthEdition

2.

Whataretheadvantagesanddisadvantagesforcountriesthatadoptthesamestandards?
Answer:

Advantages:Onepossibleadvantageisthegainineconomicefficiencyfromsharingthe
samestandard.Sharedstandardspermitmanufacturerstoproduceasinglestandardrather
thanmultiplestandards,andthismayallowfirmstocaptureeconomiesofscale.Also,
commonstandardshavethepotentialtoincreaseandexpandthecommercialtiesbetween
twoormorecountries.
Disadvantages:
a. Requiringthesamestandardsmaycausealossofefficiencyiftheadoptionofa
commonstandardresultsinalockingofaninferiorstandard.
b. Foratleasttworeasonsitmaybeextremelydifficult,costly,orevenimpossibleto
adoptthesamestandards.First,theremaybethousands(hundredsofthousandsinthe
caseofafullyintegratedcommonmarketliketheEU,forexample)ofgoodsthat
wouldrequireharmonizationand/ortheadoptionofthesamestandards.Thisinturn
wouldrequirethehiringofalargenumberofboardsandcommitteesofexpertsto
bothdeterminethebestcompromisebetweentheexistingindividualnational
standardsanddeveloponenationalstandard.Second,culturalissuesmaybeinvolved
intheharmonizationofstandards.Thismakestheissuepoliticalandeconomicas
wellastechnical.

3.

Whenhighdefinitiontelevision(HDTV)wasfirstconsideredapossibilityintheUnitedStates,the
U.S.governmentheldacompetitiontoselectthetechnicalstandardsthatwouldbeusednationwide.
WhywouldthegovernmentseeanadvantagetosettingonestandardforHDTV,andwhatare
theprosandconsfortheprivatebusinessesthatwereinterestedinproducingHDTVfortheU.S.
market?
Answer:

Thereareefficiencygainswhentwoormorecountriesadoptthesamestandards.For
example,sincesharedstandardspermitmanufacturerstocaptureeconomiesofscale,
wewouldexpectall50U.S.statestoadoptthesamestandards.Further,theadoption
ofcommonstandardsallowsstatesorcountriestoworktogetherandincreasetheir
commercialties.Topreventlockingintooradoptinginferiorstandards,theU.S.
governmentmightalsoholdacompetitiontoselectthetechnicalstandards.
Onthedownside,sharingandadoptingonestandarddoeshaveitscosts.Choosingone
standardhastheunintendedeffectoflesseningthedifferencesbetweennations,therefore
destroyingsomesourcesofcomparativeadvantage.Thecosttosocietywouldbeeven
greaterifthecountryisdealingwithanewlyintroducedproduct(suchasHDTV).Inthe
situationofunknownbeststandards,itmaybewiseforregulatorstoleavetheiroptions
openoradoptacompetitionoffuturestandards.
ConcerningthespecificHDTVexample,privatebusinessesthatproducedthefirst
HDTVshaveanadvantageoverotherssimplybecausetheirproductcouldbeadopted
asthestandard.Whilethiscouldbeveryprofitableforthesefirms,ifaninferiorstandard
islockedin,thiscouldharmtosocietyasawhole.
(Note:ThecaseofHDTVwasnotexplicitlyconsideredinthischapter!)

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Chapter1TheUnitedStatesinaGlobalEconomy29

4.

Whydostandardsvaryacrosscountries?Illustrateyouranswerwithexamplesintheareaoflabor
standards.
Answer:

5.

Standardsingeneral,andlaborstandardsinparticular,varygreatly.Theyrangefrom
basicstandardrightssuchastherighttobefreefromforcedlaborandtherightto
representationinaunion,tomorecontentiousrightssuchasuniversalstandardsfor
minimumwages,limitsonthenumberofhourssomeonecanworkinaday,healthand
safetystandards,etc.Ofcourse,laborstandardsaredifficulttodefinegiventhewide
variationinincomesandlivingstandardsaroundtheworld.Forexample,iflowincome
countries(withrelativelyabundantunskilledlabor)wereforcedtopayaminimumwage
highenoughtosatisfycriticsinhighincomecountries,lowincomecountrieswould
sufferwhenthehighwageratesforceemployerstoclosedowntheirproduction.
Consequently,unemploymentwouldrise.

Whatarelaborstandards,andwhyareargumentsaboutlaborstandardsconfinedprimarilyto
argumentsbetweenhighincomecountriesontheonehand,andlowandmiddleincomecountries
ontheother?
Answer:

Asmentionedinthetext,defininglaborstandardsisdifficultgiventhewidevariationin
incomesandlivingstandardsaroundtheworld.Eventhoughthereisafairamountof
ambiguityattachedtolaborstandards,mostpeoplewouldprobablyagreewiththe
standardsproposedbytheILOandOECD,whichare:(1)prohibitionofforcedlabor;
(2)freedomofassociation;(3)therighttoorganizeandbargaincollectively;(4)anend
toexploitationofchildlabor;and(5)nondiscriminationinemployment.
Argumentsaboutlaborstandardsareconfinedprimarilytoargumentsbetweenhigh
incomeandlowincomecountriesbecausetheconditionsandlivingstandardsin
developingcountriesarestarklydifferentfromthoseinhighincomecountries.Labor
andenvironmentalstandardsandtheenforcementofexistinglawstendtobelowerin
developingcountriesthaninhighincomecountries.Mostcountriestendtoplacehigher
valuesonbetterpayandgreenerenvironmentalpoliciesastheireconomiesdevelop.
Whenlowandhighincomenationsbegintotrade,andthepricesofthegoodsimported
fromdevelopingcountriesarelowerthantheirhighincomecounterparts,peopleinhigh
incomecountrieshavemanyquestions.Theytendtoassociatethelowerpriceswithsuch
thingsasexploitationofchildlabor,unsafeworkingconditions,lesserornopollution
controls,etc.

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30GerberInternationalEconomics,SixthEdition

6.

Discussthereasonswhyusingtradebarrierstoenforcelabororenvironmentalstandardsmaybeless
efficientthanothermeasures.
Answer:

7.

Whataretheargumentsinfavorofusingtradebarrierstoenforcelaborandenvironmentalstandards?
Assesseachargument.
Answer:

8.

First,aswasshowninChapter7,imposingtradebarriersisverycostly.Theycreate
deadweightlossesathomeinconsumptionandproduction.Second,onlylargecountries,
ifanyatall,couldusetradebarrierssuccessfullytostoptheoffendingcountry.Evena
largecountrymaybeunabletousetradebarrierseffectivelyunlessalargenumberof
countriesjointogethertoimposethetradesanctions.Convincingothernationstotake
partinthesanctionshasproveddifficultinthepast.Moreover,imposingtradebarriers
maymakeconditionsworseratherthanbetter,sincesomeproducersmaymovetheir
facilitiesintotheinformalsectoroftheeconomy.Ifsanctionsagainstacountrycreate
incentivesforbusinessestoavoidthescrutinyoflaborinspectors,thenalargershareof
theworkingpopulationcouldfindthemselvesdealingwithworseconditions.Third,there
isalsotheborderlinebetweenprotectionismandconcern.Incountriesthatusetrade
barriersasanenforcementmechanismitisnothardtofindspecialinterestgroupsusing
tradebarriersasameanstojustifytheirrealgoalobtainingprotectionagainstforeign
competition.Giventhatindustrializedcountriesprotectagriculturalandtextile/apparel
products(twoindustriesinwhichdevelopingcountrieshaveacomparativeadvantage),
developingcountriesarehighlyreluctanttogiveintothesanctions.Fourth,sincechild
laborlawsarevagueandvaryaccordingtotheincomelevelofeachcountry,thereisno
internationalagreementforuniversalchildlaborlaws.Lastbutnotleast,theuseoftrade
barriersmayleadtoretaliationandlargertradewars,whichcouldbeverycostlytoall
countriesinvolved.

Laborandenvironmentalactivistsadvocatefortheuseoftradebarriers(tariffs,quotas,or
outrightlimitationofimports)toenforcelaborstandards.Theyarguethatpressuringa
countrycouldalteritslaborstandards.Tradeeconomistsareskepticalabouttheefficacy
oftradebarriersastoolsforoverturningforeignlaborpracticesonseveraltheoreticaland
empiricalgrounds(seealsoQuestion6).Therearenoclearstandardsthatcouldbe
universallyadoptedandenforcedinbothlaborandenvironmentstandards.

OnecommoncritiqueoftheWTOisthatitoverturnsnationalenvironmentalprotections,andforces
countriestolowertheirstandards.Forexample,whentheUnitedStatestriedtoprotectendangered
seaturtles,theWTOpreventedit.Assessthisclaim.
Answer:

TheUnitedStatessoughttoprotectendangeredseaturtlesthatwereharmedbyshrimp
trawlersthatdonotuseturtleexcluderdevices(TEDs)ontheirnets.In1987,the
UnitedStatesissuedguidelinesrequiringshrimptrawlerstouseTEDsontheirnets.It
thenannouncedin1989thatitwouldbanshrimpimportsbeginningMay1991from
countriesthatwerenotcertified.TheguidelinesappliedonlytotheCaribbeanand
WesternAtlantic.By1996,moreconditionswereplacedandtheguidelineswere
extendedworldwide.India,Malaysia,Pakistan,andThailandprotestedtotheWTO,
arguingthattheyweregivenonlyfourmonthstocomply,whileCaribbeancountrieswere
giventhreeyearsandtechnicalassistance.Inaddition,theycomplainedthattheGATT
rulesforbiddiscriminationagainstimportsbasedontheprocessofproduction.In
May1998,theWTOruledagainsttheUnitedStatescitingthatitignoreditsobligationto
consultandnegotiatebeforetakingaction.
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Chapter1TheUnitedStatesinaGlobalEconomy31

TheUnitedStatesappealedthecaseandthedecisionwaspartiallyreversedbytheWTO
AppealsBodystatingthattheU.S.importbarriersarepotentiallyallowablebutthatthe
failuretonegotiateorconferwiththeaffectedcountriesplaceditinviolationofWTO
rules.Thatis,theWTOreversedoneofthetworulingsthatwerepassedagainstthe
UnitedStates.Ineffect,thisWTOdecisionendedupbeingmultilateralinnaturebecause
itallowedtheUnitedStatestoextenditsprotectionwhileallowingtheSouthAsian
fishingfleetstoremaincommerciallyviable.
Thisepisoderaisesthequestionabouttheconnectionbetweentheenvironmentallawsof
anindividualcountryandtradelaws.EventhoughtheWTOrulesendedupbeing
multilateralandatleastpartiallykepttheinterestsofbothparties,thereisacombination
oftradeandnontradeissueshere.Becauseofdifferencesinincomesandstandardsof
living,laborandenvironmentalstandardshavebecome(andwillcontinuetobecome)
apointofconflictbetweentradingnations.

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32GerberInternationalEconomics,SixthEdition

9.

Whatarethealternativestotrademeasuresforraisinglaborandenvironmentalstandards?Whatare
thestrengthsandweaknessesofeachone?
Answers: Theseare:(1)Labelsforexports:thisisacertificationprocessproducingalabelthatis
attachedtothegoodwhenitisproducedandhasbeenpartiallysuccessfulintelling
consumersthatthegoodisproducedinhumaneandenvironmentallyfriendlyways.Even
thoughthismechanismplaysanimportantroleinalleviatingconflictsbetweentrading
countries,ithasitsownproblems.First,ithasbeenacauseofconflictbetweenlaborand
managementwhenforeigninspectorsareallowedtointrude.Second,manycountries
considerforeignintrusionasaninfringementoftheirsovereignty.Itmaybehardto
convinceconsumerstotrustthelabelinginformationaslabelingbecomesmore
widespread.(2)Requiringhomecountrystandards:Thismeasurerequiresfirmsthatopen
operationsinforeigncountriestoholdtheseoperationstothesamestandardsastheir
domestic,orhome,operations.Inotherwords,afirmcannottrytocutcornersorsave
moneybyallowingitsforeignholdingstooperateaccordingtoforeignsubstandards.
Thereareafewadvantagesofthismeasure:(a)iteliminatesthefearofaracetothe
bottombymakingitimpossibleforhomebasedcompaniestoexploitlowstandards;
(b)itshiftsthecostsofimprovedstandardstofirmsandconsumersinhighincome
countries;(c)itremovesthethreatthatdomesticfirmswillrelocateabroadandensures
thatanyrelocationthattakesplaceisduetoforeigncomparativeadvantage;and(d)it
avoidstheproblemsofhighincomecountriesdictatingwhichstandardsareused.The
requirementofhomecountrystandardsforcesfirmswithcrossnationalboundariesto
conformtowhicheverstandardsarehigher.Oneweaknessofthisapproach,ofcourse,is
thatitonlyaddressestheproblemoffirmsinhighstandardscountriesthatgoabroadto
potentiallylowstandardcountries,andnotviceversa.(3)Increasinginternational
negotiations,possiblyusingtheILOforlaborandcreatingnewagreementsforthe
environment.

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Chapter1TheUnitedStatesinaGlobalEconomy33

Answers to End-of-Chapter Questions

1.

chap9

Usethefollowinginformationtoanswerthequestionsbelow.Assumethatthecapitalaccountis
equalto0.
Netunilateraltransfers

50

Exportsofgoodsandservices

500

NetincreaseintheU.S.governmentsnonreserveforeignassets

30

NetincreaseinforeignownershipofU.S.basednonreserveassets

400

NetincreaseinU.S.privateassetsabroad

250

InvestincomereceivedintheUnitedStates

200

NetincreaseinU.S.ownershipofofficialreserveassets

20

Importsofgoodsandservices

600

NetincreaseinforeignownershipofU.S.basedreserveassets

100

InvestmentincomepaidabroadbytheUnitedStates

300

a. Whatisthecurrentaccountbalance?
b. Doesthecapitalaccountequalthecurrentaccount?
c. Whatisthestatisticaldiscrepancy?
Answers:
a. Thecurrentaccountis500200600300+250250
b. Thecapitalaccountis1004002030250200
c. Thestatisticaldiscrepancyis1(250200)250
2.

LookateachofthecasesbelowfromthepointofviewofthebalanceofpaymentsfortheUnited
States.Determinethesubcategoryofthecurrentaccountorfinancialaccountthateachtransaction
wouldbeclassifiedin,andstatewhetheritwouldenterasacreditordebit.
a. TheU.S.governmentsellsgoldfordollars.
b. AmigrantworkerinCaliforniasends$500hometohisvillageinMexico.
c. AnAmericanmutualfundmanagerusesthedepositsofhisfundinvestorstobuyBrazilian
telecommunicationstocks.
d. AJapanesefirminTennesseebuyscarpartsfromasubsidiaryinMalaysia.
e. AnAmericanchurchdonatesfivetonsofricetotheSudantohelpwithfaminerelief.
f. AnAmericanretiredcouplefliesfromSeattletoTokyoonJapanAirlines.
g. TheMexicangovernmentsellspesostotheUnitedStatesTreasuryandbuysdollars.

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34GerberInternationalEconomics,SixthEdition

Answers:
a. TheUnitedStatesexportsofficialreserveassets;itisacreditinthecapitalaccount.
b. AresidentoftheUnitedStatesunilaterallytransfersmoneytoaforeignlocale;itisadebitinthe
currentaccount.
c. Thereisanimportofforeignassets;itisadebitinthecapitalaccountunderthecategoryofa
netchangeinU.S.privateassetsabroad.
d. AnAmericanbasedproducerimportsgoods;itisadebitinthecurrentaccount.
e. ThereisaunilateraltransferfromtheUnitedStatestoabroadforeigncountry;itisadebitinthe
currentaccount.
f. Americanresidentspurchaseaservicefromaforeignfirm;itisadebitinthecurrentaccount.
g. ThereisanetincreaseinnonreserveforeignassetsheldbytheU.S.government;itisadebitin
thecapitalaccount.
3.

Weightheprosandconsofalargetradedeficit.
Answer:

Tradedeficitsaregenerallyconsideredanegativeforacountry,buttherealityismore
subtle.Onthenegativeside,largedeficitssignalthatacountryisaccumulatingforeign
debtthatcanbedifficulttoserviceiftheexcessimportsarenotusedtoenhancenational
productivity.Furthermore,tradedeficitsrequirecapitalinflows.Ifforeigninvestorslose
confidence,itmaybedifficulttosearchthenecessaryforeignreserves.Thisispartly
whathappenedtoMexicoin1994andThailandandIndonesiain1997.
Onthepositiveside,alargetradedeficitcanalsosignalthatforeignershaveconfidence
inthecurrentsetofeconomicpoliciesandthefutureprospectsoftheeconomy.
Furthermore,andmostimportantly,alargetradedeficitandtheattendantcapitalinflows
allowahigherlevelofinvestmentthanwouldbepossiblesolelyonthebasisofdomestic
savings.

4.

Isthebudgetdeficitofacountrylinkedtoitscurrentaccountbalance?Howso?Explainhowitis
possiblefortheUnitedStatescurrentaccountdeficittogrowwhilethebudgetdeficithas
disappeared.
Answer:

5.

Thebudgetdeficitandthecurrentaccountarelinkedbuttherearetheothervariablesof
domesticprivatesavingsanddomesticinvestmentthatarealsojoinedinthesavings
investmentbalance.Forthisreason,thereisnosuchthingasaonetoonecorrespondence
betweenbudgetandtradebalances.Thebasicrelationshipiscapturedintheequation
(4binthetext):SpgovernmentbudgetIcurrentaccount.Fromthisitcanbeseen
thatasthegovernmentbudgetwenttozeroandthecurrentaccountbecamemore
negative,eithersavingsfell,investmentrose,orsomecombinationofthetwooccurred.

Compareandcontrastportfoliocapitalflowswithdirectinvestmentcapitalflows.
Answer:

Thesetwotypesofcapitalflowsaresimilarinthattheybothprovideanationwiththeuse
offoreignsavings.Thatis,theybothrepresentcapitalflowsthatareanetincreaseinthe
amountofresourcesavailableforinvestment.Ontheotherhand,theyareverydifferent
inthetimedimensionsthattheyrepresentandintheirliquidity.FDIisilliquidand
generallyrepresentsfundswithalongertimehorizonthanportfoliocapital.Portfolio
investmentcanmoveinoroutofanationextremelyquicklyandisthemainfocusof
concernsaboutthedestabilizingeffectsofforeigninvestment.
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Chapter1TheUnitedStatesinaGlobalEconomy35

6.

Whyisacurrentaccountsurplusequivalenttoforeigninvestment?
Answer:

Acurrentaccountsurplusleadstothenetaccumulationofforeignassets,whetherrealor
financial.Ineithercase,thereistheprospectofafuturestreamofrevenuethatwillbe
generatedfromtheassets.
Anotherwaytolookatitistoconsiderthatinordertoexportagreatervaluethan
imports,anationmustnotconsumesomeofitsincome(production).Instead,thegoodsand
servicesaresentabroad.Theeffectisthesameasdomesticinvestment:Consumptionout
ofcurrentperiodproductionispostponeduntilafuturedate,andtheexcessoutputisused
toincreasethecapacityoftheeconomytogenerateafuturestreamofincome
(production).

2014PearsonEducation,Inc.