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4 THE WORLD ECONOMY 381 Suppose that U.S. wine producers demand protection from international competition and the government obliges them with a \$10 per case tariff. The demand and supply graph shown below illustrates the effects of the tariff policy. The tariff increases the price of imported wine by \$10 per case to \$40. The horizontal line at \$40 per case starting at 250 million cases shows the effect of the tariff on the world supply curve. U.S. wine producers benefit because they are able to produce 250 million cases of wine at the \$40 price. Imports are cut from 200 million cases to 100 million cases. The amount of wine consumed in the United States falls from 400 million cases to 350 million cases. The tariff will generate revenue equal to 100 million cases multiplied by the \$10 per case tariff, or \$1 billion.

5 382 CHAPTER 19 INTERNATIONAL TRADE When you draw a graph to show the effect of a tariff, first locate the position of the world supply curve, then shift it up by the dollar amount of the tariff to find the new quantity supplied and quantity demanded. The revenue generated by the tariff is equal to the tariff multiplied by the quantity of imports. Graphing Pitfalls A tariff is a tax on an imported good, and a tax on a good raises its price. However, it raises the price of the good from the world price, which is below the domestic equilibrium price, and not from the domestic price itself. So don t make the mistake of trying to show the effect of a tariff by increasing the domestic price by the amount of the tariff as shown in the graph below. A tariff shifts the world supply up from a point below the domestic equilibrium price and quantity, not from the domestic equilibrium. True-False Questions If a statement is false, explain why. 1. If the opportunity costs of producing two goods differ between two countries, then specialization and free trade will benefit both countries. (T/F) 2. If all countries were endowed with the same natural resources, there would be fewer opportunities for specialization and trade. (T/F) 3. When two countries engaged in free trade benefit, this means that everyone in both countries benefits. (T/F) 4. If Italy uses fewer resources to produce wine than California, then Italy has a comparative advantage over California in wine production. (T/F)

11 388 CHAPTER 19 INTERNATIONAL TRADE Discussion Questions 1. List and critique the arguments opposed to free trade. 2. Why are less-developed countries at a disadvantage in the terms of their trade with industrialized countries? 3. What's the difference between a customs union and a free trade area? 4. Describe the pattern of U.S. tariffs from 1870 to the present.

12 THE WORLD ECONOMY 389 Problems 1. The table presented below shows the number of automobiles and computers that the United States and France can produce with the same amount of resources. United States France Automobiles Computers a. Which country has an absolute advantage in computer production? Comparative advantage? Explain. b. If these countries specialize and trade, which country will specialize in automobiles? Computers? Explain. c. If free trade exists between the United States and France, then what are the highest and lowest levels for the price of an automobile (expressed in terms of computers)? Which level favors the United States? France? Why? 2. Suppose that in one hour the United States can produce 180 computer microprocessors or 220 bushels of rice and that Japan in one hour can produce 160 microprocessors or 120 bushels of rice. a. What is the opportunity cost of a microprocessor in the United States? In Japan? Who should specialize in microprocessor production? In rice production? Show your work. b. Suppose that these two countries begin to trade and that the price of one computer microprocessor is equal to one bushel of rice after trade. If the United States and Japan specialize according to their comparative advantages and trade, what are the potential gains from trade for each country?

13 Price (\$/lb.) 390 CHAPTER 19 INTERNATIONAL TRADE c. Identify who wins and who loses in each country as a result of trade. 3. The following questions refer to the demand and supply diagram below showing the market for bananas in the United States U.S. Supply U.S. Demand Quantity (lb.) a. Identify the equilibrium price of bananas and the equilibrium quantity before trade? b. Let s now introduce free trade. Suppose banana producers from Honduras are willing to supply any quantity of bananas at a price of \$.20 per pound. Draw the Honduran supply curve on the U.S. banana market in the diagram above. How many bananas will the U.S. producers supply? How many will the Honduran producers supply to U.S. consumers? How many bananas will U.S. consumers purchase? c. Now suppose the United States imposes a \$.20 per pound tariff on Honduran bananas. What is the new price for bananas in the United States? How many bananas will U.S. producers supply? How many will Honduran producers supply? How many bananas will U.S. consumers purchase? How much revenue will the tariff generate? Illustrate your answers in the graph.

15 392 CHAPTER 19 INTERNATIONAL TRADE Multiple-Choice Questions 1. d 6. d 11. b 16. e 21. a 2. d 7. a 12. c 17. a 22. c 3. c 8. c 13. c 18. c 23. b 4. e 9. e 14. a 19. b 24. a 5. e 10. d 15. c 20. d Fill in the Blanks 1. costs of producing; geographic specialization; more total goods produced 2. comparative; specialization 3. manufactured goods; agricultural goods 4. concession; reciprocity Discussion Questions 1. The national security argument holds that goods essential to the national security should be produced domestically. The problem with this argument is that the list of goods deemed essential to national security tends to grow over time as industry lobbyists draw connections between their industries and national security. The diversity of industry argument holds that a wide range of industries should exist in a country to increase economic stability. The problem with this argument is that although it may apply to some highly specialized less-developed countries, it hardly applies to the diversified industrial economies, such as the United States, Canada, and France. The antidumping argument states that foreign competitors sell their goods in markets below their domestic cost of production in order to drive competitors out of the industry. Although dumping is illegal in many countries, including the United States, it is difficult to prove, which makes the legislation difficult to enforce. The infant industry argument support trade protection for industries that are just beginning in a country to afford them time to learn the industry and gain expertise. The problem is how to determine when the period of infancy is over. The cheap labor argument holds that industries cannot compete with other countries producing the same goods with much lower labor costs. However, the higher cost of labor in a country often stems from its labor being more productive. This means the higher-cost labor may actually result in lower production costs. The retaliation argument holds that the restriction of access to a country s markets is justified if it is in retaliation for trade restrictions on the other side. If the threat of retaliation or actual retaliation opens up foreign markets, then it is beneficial. But if retaliation doesn t work, it can make a country worse off by restricting the purchases of goods that were beneficial. 2. Less-developed countries are at a disadvantage because their exports are typically agricultural goods and natural resources. The prices of manufactured goods, produced primarily by industrialized countries, have risen relative to the prices of agricultural goods and natural resources. Therefore, the terms of trade, defined as the ratio of an index of export prices to an index of import prices, have declined for less-developed countries. 3. A customs union, like the European Economic Community, has a policy of free trade for members and a

17 Price (\$/lb.) Price (\$/lb.) 394 CHAPTER 19 INTERNATIONAL TRADE U.S. Demand U.S. Supply Honduran Supply Quantity (lb.) c. The new price for bananas in the United States will be \$.40 the price of Honduran imports plus the \$.20 per pound tariff. Now U.S. suppliers will supply 40 pounds of bananas to U.S. consumers, and Honduran suppliers will export 20 pounds of bananas to satisfy the 60 pounds of bananas that U.S. consumers demand at a price of \$.40 per pound. The graph below shows the situation with the tariff. The Honduran supply is raised by the amount of the tariff to the horizontal line at \$.40 per pound. Tariff revenue is the area corresponding to the 20 pounds of bananas that are imported with a \$.20 per pound tax. Tariff revenue is 20 x \$.20 or \$ U.S. Demand U.S. Supply Honduran Supply plus tariff 0.2 Honduran Supply Quantity (lb.)

19 396 CHAPTER 19 INTERNATIONAL TRADE 4. Although it is true that a new industry in a developing country may have to be protected from foreign competition until it gains expertise and can compete effectively in the international market, as suggested by the infant industries argument, a possible downside to such a policy is that a. the protection may be maintained for longer than necessary b. only quotas are used for such protection, therefore no revenue is generated for the government c. the infant industry may still be subject to dumping by foreign producers d. diversity of industry is not promoted e. national security may be sacrificed 5. The impact of a tariff on the price of the imported good is to a. eventually lower it as the importing country becomes more efficient at domestic production b. raise it by the amount of the tariff c. leave it unchanged because the decrease in imports is exactly offset by an increase in domestic production d. raise it by more than the tariff, since domestic producers will leave the industry e. decrease it by more than the tariff since new firms will enter to protected industry Discussion Questions/Problems 1. The following table shows the number of automobiles and computers that can be produced in the United States and England with the same amount or resources. United States England automobiles computers a. What is the opportunity cost of an automobile in the United States? In England? Which country has a comparative advantage in automobile production? How do you know? b. Now suppose the two countries begin to trade. Suppose the price ratio of automobiles to computer equalizes at one to one. How does each country benefit from trade? 2. How do economists define the terms of trade among nations? Why have the terms of trade deteriorated for many developing countries?

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