Chapter 8

Trade
Questions
1. Consider the figure given below. The darker line shows how many units of goods A and B a worker
in Taiwan can produce and the lighter line shows the number of units of goods A and B that a worker
in Korea can produce. Does this figure indicate anything about either worker having a comparative or
absolute advantage in either good?

Answer: From the figure, we can see that, compared to a worker in Taiwan, a worker in Korea produces
more of both goods A and B. This means that the Korean worker has an absolute advantage in the
production of both goods. In Korea, the opportunity cost of Good B is 150 / 35 = 4.3; in Taiwan the
opportunity cost of Good B is 100 / 15 = 6.7. Therefore workers in Korea have a comparative advantage
in the production of Good B. A similar calculation shows that the Taiwanese worker has a comparative
advantage in the production of good A.
2. Can a country have comparative advantage in producing all goods and services? Can it have an
absolute advantage in producing all goods and services?
Answer: Comparative advantage is the ability of an individual, firm, or country to produce a certain good
at a lower opportunity cost than other producers. Since the opportunity costs of two goods are reciprocals
of each other, a country cannot have lower opportunity costs in producing all goods and services.
Therefore, it cannot have comparative advantage in producing all goods and services.
3. What is meant by complete specialization? How does it affect the total level of output produced by
both trading partners?
Answer: Complete specialization occurs when each individual, firm, or country produces only what it has
comparative advantage in and relies on trade for the other goods and services it needs.
The total level of output produced by both trading partners increases with complete specialization because
each country can produce what it is most efficient at.
4. What do the points to the left, right, and on a production possibilities curve (PPC) signify? Which of
these points are attainable, and why?

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Answer: When dealing with a PPC, you should consider these rules: points on the PPC are attainable and
efficient, points inside the PPC are attainable and inefficient, points beyond the PPC are unattainable.
‘Being attainable to the PPC’ means that your production combinations are achieved by making full use
of your available resources, technology, or skills.
5. Explain the impact, if any, of each of the following on the PPC.
a. Brazil’s population suffers from water shortages even though the country has about a fifth of the
water reserves of the world.
b. China’s one-child policy was planned to reduce the country’s population and limit the demand for
natural resources.
c. Niger was among the top ten countries in the world with the highest fertility rates in 2016.
Answer:
a. The water shortages mean a reduced availability of natural resources for various reasons, which
shifts the PPC outwards.
b. The Chinese plan reduces the availability of labor in the economy, which means that the PPC will
shift inward. However, if we discuss the limited demand for natural resources, this means that the
stock increases, which shifts the PPC outwards.
c. A rise in population means an outward shift of the PPC curve.
6. How does the relationship between the domestic equilibrium price and the world price of a good
explain whether a country is an importer or an exporter of that good?
Answer: If a good’s world price is lower than a country’s domestic equilibrium price, the country will
import that good. However, a country will export the good if its world price is higher than its domestic
equilibrium price.
7. Outsourcing business processes has become increasingly common with globalization. The immediate
gain it offers a transnational company is a reduction in the use of domestic labor in the production
function, which leads to an increase in the goods’ competitiveness in the world market. What do you
think can be the negative effect of this gain on the trade balance in the domestic economy?
Answer: Transnational companies outsource their production activities to decrease their input costs. The
prices of the goods will fall, increasing the consumer surplus on the market. The reduced use of domestic
labor means unemployed workers. The production abroad means that the goods are imported in the home
country of the transnational company, which becomes unfavorable in the long term because it will run to
a deficit in the trade balance at the cost of maximizing the profit of the transnational company.
8. Would producers and consumers of export goods benefit from international trade? Explain.
Answer: The producers of an exported good gain from international trade because the higher price and
quantity sold increase the producer surplus. However, the consumers of an exported good lose from
international trade because the higher price causes its domestic demand to fall and decrease the consumer
surplus.
9. What are some of the common arguments against free trade?
Answer: There are several arguments against free trade. Some of them are:
i. National security concerns – Countries would rather diversify by investing in steel production
and defense technology and maintaining a variety of agricultural industries so that they do not
need to rely on other countries during a war.

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ii. Fear of the effects of globalization on a nation’s culture – Globalization is the shift towards
more open, integrated economies that participate in foreign trade and investment. Some
people, however, want to maintain their culture’s uniqueness and therefore view globalization
as homogenization.
iii. Environmental and resource concerns – Countries with lax environmental policies allow for
relatively more pollution than countries with strong environmental policies. Opponents of
free trade often site these policy differences as creating “pollution havens” in poor countries.
iv. Infant industry arguments – Infant industry arguments rely on the idea that in industries with
economies of scale, or substantial learning by doing, it is important for policymakers to
protect local firms early in their development.
v. Potential negative effects on local wages and jobs – Domestic producers and consumers are
affected in different ways by trade. Therefore, many individuals worry about their own jobs
when trade increases between countries.
10. Explain the concept of protectionism. Define one method of protectionism.
Answer: Protectionism is the idea that free trade can be harmful, and government intervention is
necessary to control trade.
Protectionism is tariffs is a common method. It refers to taxes levied on goods and services transported
across political boundaries.
11. As tariff is imposed on imported goods, who will be better off? Explain your answer.
Answer: With tariffs, consumers pay a price that is higher than the world price of a commodity. Tariffs
raise prices for consumers and reduce total surplus in a country. Although the government earns revenues
from tariffs, it also leads to deadweight losses in the market.
12. The infant industry argument relies on the idea that in industries with economies of scale, it is
important for the government to protect newborn companies in their development. What are the
implications of such an economic policy in the short run and long run?
Answer: In the short run, this policy would help the company to gain experience and adapt its production
to the technologies and innovation levels available on the market. It will not be forced to compete directly
with other companies and could stay on the market until its production becomes stable and the products or
services are known by the consumers.
In the long run, the company could become weak and dependent on the governmental support. It will not
withstand the competition from other companies in the field because it would not be able to develop its
comparative advantage and maintain it in the market.
13. Since the “winners” from free trade can more than compensate the “losers” why does it matter if
wages and employment fall when a country engages in free trade?
Answer: While it is correct that the “winners” from free trade can more than compensate the “losers,”
this rarely actually happens. First, the government might not be able to effectively carry out such
wealth transfers. Second, it is often difficult to pinpoint exactly who the winners are and how much
each gained, and who the losers are and how much each lost. Many people enjoy small benefits from
trade but a few people suffer very heavy losses.
14. Consider the following diagram. The discussion in the text implies that if this country imposes a
tariff, social surplus will fall by the sum of area A and area B. Intuitively, why is A part of the
deadweight loss from this tariff? Intuitively, why is B part of the deadweight loss from this tariff?

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Answer: Area A is the deadweight loss that is created when higher cost suppliers are allowed back
into the market; these domestic suppliers are protected by the import tariff. Area B is the deadweight
loss created as some consumers no longer buy at the higher price; this is analogous to the deadweight
loss triangle generated by a tax.

Problems
1. John and Aria run a bookbinding business together. They each work in shifts of 6 hours a day. John
binds 10 books or 12 scripts a day and Aria binds 8 books or 10 scripts a day.
a. Sketch the production possibilities curves (PPC) for John and Aria.
b. Who has an absolute advantage in binding books? In binding scripts? Explain.
c. What is the opportunity cost of binding books and scripts for John? For Aria?
d. What does John have a comparative advantage in producing? Why?
e. What does Aria have a comparative advantage in producing? Why?

Answers:
a. The diagram is shown below:

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b. John has an absolute advantage in both services, because he can bind more books than Aria (10 >
8) and more scripts than Aria (12 > 10).
c. In John’s case, the opportunity cost of books is 10/12 = 0.83 scripts and the opportunity cost of
scripts is 12/10 = 1.2 books. In case of Aria, the opportunity cost of books is 8/10 = 0.8 scripts
and the opportunity cost of scripts is 10/8 = 1.25 books.
d. John has a comparative advantage in producing scripts, because his opportunity cost is lower:
1.25 > 1.2.
e. Aria has a comparative advantage in producing books, because her opportunity cost is lower: 0.8
< 0.83.
2. Suppose you and your classmate, Janet, are only studying two subjects, economics and mathematics,
this semester. The opportunity cost of solving questions for both subjects are as follows.

Economics Mathematics
Opportunity cost Opportunity cost

You 1/3 mathematics question 3 economics questions

Janet 2 mathematics questions 1 economics question

At which subject do you and Janet perform better than each other? For every hour spent on studying
economics, you and Janet can finish six and two economics questions, respectively. How many
mathematics questions can you and Janet finish if you spend an hour on studying mathematics?
Answer: I have a comparative advantage in doing economics questions, and Janet has a comparative
advantage in doing mathematics questions. Therefore, I do better at economics than Janet does, while
Janet does better at mathematics than I do.
If Janet and I spend an hour on studying mathematics, I can finish 6 × 1/3 = 2 mathematics questions, and
Janet can finish 2 × 2 = 4 mathematics questions.
3. Suppose a school has 150 first-year and 100 second-year students to work in its greenhouse for
practical training. A first-year student can clean either 2 pots or 2 planters; a second-year student can
clean either 3 pots or 1 planter.
a. Who has a comparative advantage in cleaning pots? In cleaning planters?
b. Suppose the school selects 60 first-years and 60 second-years to clean the pots. How many
planters will the remaining students clean?
c. Why should you have anticipated the answer to part b.?
d. Now assume that the school selects 40 first-years and 40 second-years to clean the pots. How
many planters will the remaining students clean?
Answer:
a. In case of freshmen, the opportunity cost of cleaning pots is 2/2 = 1 and the opportunity cost of
cleaning planters is 2/2 = 1. In case of sophomores, the opportunity cost of cleaning pots is 3/1 =
3 and the opportunity cost of cleaning planters is 1/3 = 0.33. This means that freshmen have a
comparative advantage in cleaning the pots (1 < 3) and the sophomores have a comparative
advantage in cleaning planters (0.33 < 1).
b. If the school uses 60 freshmen and 60 sophomores to clean the pots, then 90 freshmen and 40
sophomores will be available to clean the planters. In this case, (90 × 2) + (40 × 1) = 220 planters.

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c. You should have anticipated this result because you showed in (a) that the easterners have a
comparative advantage in the production of defense.
d. If the school selects 40 first-years and 40 second-years to clean the pots then 110 first-years and
60 second-years will remain. In this case, the number of planters will be (110  2) + (60  1) =
280 planters.
4. There are 10 workers in Thailand and each can produce either 2 computers or 30 tons of rice. There
are 20 workers in the United States and each can produce either 5 computers or 40 tons of rice.
a. Draw the production possibilities frontier for each country. In each case, identify the intercepts
and the slopes of the production possibilities frontier.
b. What is the opportunity cost of computers in Thailand? What is the opportunity cost of computers
in the United States?
c. Which country has a comparative advantage in the production of computers?
d. In the absence of trade, if Thailand consumes 150 tons of rice, how many computers can it
consume? In the absence of trade, if the United States consumes 50 computers, how many tons of
rice can it consume?
e. Someone now proposes that the United States and Thailand enter into a trade agreement. Under
this agreement, the United States will give Thailand 10 computers and Thailand will give the
United States 120 tons of rice. If Thailand continues to consume 150 tons of rice, how many
computers will it be able to consume under this proposal? If the United States continues to
consume 50 computers, how many tons of rice will it be able to consume under this proposal?
f. Should Thailand accept this proposal? Should the United States accept this proposal?
Answer:
a.

b. In Thailand, the opportunity cost of computers is 15 tons of rice and in the United States, the
opportunity cost of computers is 8 tons of rice.
c. Since the opportunity cost of computers in the United States is lower than the opportunity
cost of computers in Thailand, the United States has a comparative advantage in computers.

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d. In the absence of trade, Thailand produces and consumes 150 tons of rice. To produce 150
tons of rice, 150/30=5 workers are needed because each worker can produce 30 tons of rice.
Thailand is left with 5 workers to produce computers. So 5 x 2=10 computers will be
produced in Thailand. In the absence of trade, the United States produces and consumes 50
computers. To produce 50 computers, 50/5=10 workers are needed because each worker can
produce 5 computers. The United States is left with 10 workers to produce rice. So 10 x
40=400 tons of rice will be produced in the United States.
e. Thailand will have to produce 270 tons of rice (150 for Thailand and 120 for the United
States). So 270 / 30 = 9 workers are needed in rice production. Only one worker will produce
computers. One worker produces 2 computers and Thailand receives 10 computers from the
United States in return for 120 tons of rice. So Thailand can consume 12 computers. The
United States will have to produce 60 computers (50 for US and 10 for Thailand). So 60 / 5 =
12 workers are needed in computer production. The remaining 8 workers will produce
8*40=320 tons of rice. So the United States consumes 440 tons of rice by receiving 120 tons
of rice from Thailand in return for 10 computers.
f. As a result of this trade agreement, (i) Thailand’s rice consumption is unchanged, but its
computer consumption rises, and (ii) United States computer consumption is unchanged, but
its rice consumption rises. Therefore both countries should accept this trade agreement.
5.

6. Consider two individuals, Teresa and Justin, who produce vegetables. Each uses the same number of
workers to produce tomatoes or peppers. Production per lot (in kilograms) is shown in the following
table.
Teresa Justin
Tomatoes 100 80
Peppers 130 120
a. Who has an absolute advantage in the production of peppers? Why?
b. Who has a comparative advantage in producing peppers? Explain.
c. What are the terms of trade ranges for both goods? At what prices would Teresa and Justin have
the same gains from trade?
Answers:
a. Teresa has an absolute advantage in producing both goods, because, with the same number of
workers, she can produce 100 kg of tomatoes/lot and 130 kg of peppers/lot, while Justin can
produce only 80 kg of tomatoes/lot and 120kg of peppers /lot.
b. In Teresa’s case, the opportunity cost of tomatoes is 100/130 = 0.76 peppers and the opportunity
cost of peppers is 130/100 = 1.3 tomatoes. In case of Justin, the opportunity cost of tomatoes is
80/120 = 0.66 peppers and the opportunity cost of peppers is 120/80 = 1.5 tomatoes. Teresa has a
comparative advantage in producing peppers (1.3 < 1.5) and Justin has a comparative advantage
in producing tomatoes (0.66 < 0.76).
c. The terms of trade range are between 0.66 and 0.76 for tomatoes and between 1.3 and 1.5 for
peppers. Teresa and Justin have the same gains from trade if the price for tomatoes is (0.66 +
0.76)/2 = 0.71 peppers and if the price for peppers is (1.3 + 1.5)/2 = 1.4 tomatoes.
7.

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8. Suppose the Indonesian government decides to open its market for rice and rubber. The world price
for rice is higher than its domestic price and the world price for rubber is lower than its domestic
price. The supply and demand curves for rice and rubber are shown below.

a. For each good, will the government support export or import? Who gains from trade, producers
or consumers?

b. In both graphs, shade the areas that represent consumer surplus with and without free trade. For
each good, has the consumer surplus increased or decreased after opening up to free trade?

c. In both graphs, shade the areas that represent producer surplus with and without free trade. For
each good, has the producer surplus increased or decreased relative after opening up to free trade?

d. Combine your results for each good and explain if Indonesia would benefit from free trade.
Answers:
a. Because the world price for rice is higher than the domestic price, the government will support
the exports. The Indonesian producers will be better off for selling abroad. Consumers do not
gain, as they have to pay more than they would without trade. In case of rubber, the government
will support the imports because the world price is lower than the domestic price. The consumers
gain as they pay a lower price for rubber than they would otherwise. Producers do not gain from
trade as they have to accept a lower price than the price they would get without trade.
b. The consumer surplus for rice without trade is the area represented by A + B, and with trade is A;
therefore, consumer surplus falls by A + B – A = B. The consumer surplus for rubber without
trade is the area represented by A', and with trade is A' + B' + E' + F'; therefore, consumer surplus
rises with A' + B' + E' + F' – A' = B' + E' + F'.

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c. The producer surplus for rice without trade is the area represented by D, and with trade is B + C +
D; therefore, producer surplus rises with B + C + D – D = B + C. The producer surplus for rubber
without trade is B' + C' and with trade is C'; therefore, the producer surplus falls by B' + C' – C' =
B'.
d. Yes, Indonesia benefits from free trade because total surplus in case of rice has increased by C
and total surplus in case of rubber has increased by the areas E' and F'.

9. Suppose your country imports wheat. The price of wheat rises from P 1 to P2 and your country
continues to import wheat. Present and discuss a diagram to answer the following questions: Did
imports rise or fall? Did consumer surplus rise or did it fall? Did producer surplus rise or did it fall?
Did social surplus rise or did it fall?
Answer: The following diagram shows the market for wheat:

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Imports fall from (Q1D – Q1S) to (Q2D – Q2S). The following table summarizes the effects of the price
increase on consumer surplus, producer surplus and social surplus:
Initial Price P1 New Price P2 Change
Consumer surplus A+B+D+E+F+G A+E –B–D–F–G
Producer Surplus C C+B B
A+B+D+E+F+G+
Social Surplus A+E+C+B –D–F–G
C
Consumer surplus fell by the sum of B, D, F, and G,, producer surplus rose by B, and therefore social
surplus fell by D + F + G.
10. Suppose a decrease in the world demand for desktop computers causes the price of desktop
computers to fall from $600 to $500. Before the fall in demand, Juna, a local computer dealer in
Japan, used to produce 9,000 desktop computers and exported 50 percent of it to other countries every
week. However, after the fall in demand, Juna reduced its production to 8,000 units and exports only
40 percent of its total output.
a. What are the changes in the quantity sold to domestic consumers?
b. What are the changes in the consumer surplus?
c. Sketch a diagram to illustrate the changes for Juna.
Answers:
As shown in the following figure, at the world price of $600, Japan produces 9,000 desktop
computers and exports 9,000 × 50% = 4,500 of them. The domestic consumers buy:
9,000 – 4,500 = 4,500 desktop computers.
When the world price decreases from $600 to $500, Japan produces 8,000 desktop computers and
exports 8,000 × 40% = 3,200 of them. The domestic consumers increase their purchase of desktop
computers to 8,000 – 3,200 = 4,800. The consumer surplus increases by [4,500  100] + [(300 
100)/2] = $465,000.

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11. Suppose domestic demand is QD=16-P and domestic supply is QS=P. The world price is $2 and the
import tariff is $3 per unit. First, make a sketch, then find the following values. Each will be areas in
your sketch.
a. Consumer surplus.
b. Producer surplus.
c. Government revenue.
d. Deadweight loss of the tariff.
Answers:
First, the world price plus the tariff will be $2 + $3 = $5. The quantity supplied domestically will thus be
5 and the quantity demanded domestically will be 16 - 5 = 11 (instead of 2 and 14, respectively. Based on
these numbers the relevant areas are either triangles (area is one half base times height) or rectangles (area
is base times height).
a. (1/2)*(11-0)*($16-$5) = $60.50
b. (1/2)*(5-0)*($5-$0) = $12.50
c. (11-5)*($5-$2) = $18.00
d. Two triangles with area (1/2)*(3)*($3) = $4.50, or $9.00 total.

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