Unit 18 Answers to exercises principles of economics PDF

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UNIT 1 8EXERCISE 18 PRICE GAPS THAT DID AND DIDN’T FALLFigure 18 shows the price gap of different commodities between theUS and UK over time. Can you think of a reason why price gaps for meatand animal fats such as butter did not start to fall until 1895? Proposean explanation for the smaller price ...

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EXERCISE ANSWERS UNIT 18

UNIT 18 EXERCISE 18.1 PRICE GAPS THAT DID AND DIDN’T FALL Figure 18.5 shows the price gap of different commodities between the US and UK over time. Can you think of a reason why price gaps for meat and animal fats such as butter did not start to fall until 1895? Propose an explanation for the smaller price gaps and the more rapid fall for copper as compared with iron ore. What might account for the increase in the price gap for sugar? Eileen Tipoe UNIVERSITY OF OXFORD AND UNIVERSITY COLLEGE LONDON

Answer Meat and animal fats: One potential explanation is that the technology to transport perishable goods over long distances did not exist, or was extremely costly until later on in the period (invention of refrigerated transport). Before the development of mechanical refrigeration, trade in meat products relied upon ice, which was expensive, inefficient, and worked only for short distances. • •

Iron bars and copper: A plausible hypothesis is that since copper is much lighter than iron bars, transport costs were less important. Sugar: This may be due to factors such as the industrial structure of the sugar industries, barriers to the entry of new firms, and the pricing policies of firms with market power across different jurisdictions.

EXERCISE 18.2 LEARNING MORE ABOUT TARIFFS Download the World Bank data set, ‘Trends in average MFN applied tariff rates in developing and industrial countries, 1981–2010’ (http://tinyco.re/2008507). This data was used to produce Figure 18.7. 1. Choose one country from each income category (code 1 to 4) and plot the evolution of tariffs in these four countries. Use your plots to describe how tariffs in your chosen countries have changed over time. 2. Evidence from other studies suggests that on average, tariffs tend to be higher in lower-income countries than in high-income countries, but that most countries have reduced tariffs substantially in recent decades. Do your plots support this claim? Suggest an explanation for some of the observed differences between your chosen countries (if any). (As a starting point you may want to consider your chosen countries’ membership of global trade agreements such as GATT/WTO (http://tinyco.re/2336439) or the EU (http://tinyco.re/2809410), and also whether the country has followed the structural adjustment programs of the IMF) (http://tinyco.re/2776457).

Answer 1. The countries chosen as an example are: Japan (4), Saudi Arabia (3), Sri Lanka (2), and Kenya (1). For all the countries, tariff rates have decreased between

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EXERCISE ANSWERS UNIT 18

1980s and late 1990s. The most dramatic reduction was in Kenya (code 1) and the least in Saudi Arabia (code 3). 2. Tariff rates have definitely decreased in all countries over time, but throughout the time period considered, Sri Lanka and Kenya (both low-income countries) have higher tariff rates than Saudi Arabia and Japan. This plot therefore supports the empirical evidence mentioned in the question. All chosen countries are part of the WTO: Japan, Sri Lanka, and Kenya joined in 1995, and Saudi Arabia joined in 2005. Membership in the WTO could explain the downward spike in tariffs starting the year these countries joined.

Country

Trends in average MFN applied tariff rates Japan

Time period Units

Variable

Sri Lanka

Kenya

1981-2010

Saudi Arabia 1981-2010

1983-2010

1982-2010

Percent

Percent

Percent

Percent

1981

2.50

1982

40.30

1983

41.30

1984

41.70

1985

31.00

1986

39.20

1987

3.70

27.30

39.20

27.30

41.70

1988

7.1

8.00

1989

6.9

12.20

1990 1991

6.3

37.50 28.30

43.70

26.90

34.00

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EXERCISE ANSWERS UNIT 18

1992

6.3

1993

6.3

1994

6.3

1995

12.10

25.00

33.60

24.20

31.90

12.50

26.00

32.10

3.1

12.20

20.00

22.00

1996

2.9

13.00

1997

2.8

12.00

19.60

19.00

1998

2.7

12.20

11.10

19.90

1999

2.6

12.30

10.90

18.00

2000

2.5

12.10

9.30

18.10

2001

2.8

8.90

19.20

2002

2.8

8.90

16.80

2003

2.7

6.50

8.70

15.20

2004

2.7

6.60

9.90

14.80

2005

2.7

4.10

11.30

12.40

2006

2.7

4.10

11.00

12.30

2007

2.8

4.00

10.70

12.30

2008

2.6

4.00

2009

2.5

4.00

2010

2.5

13.50

12.10 10.10

11.90

9.30

12.10

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EXERCISE ANSWERS UNIT 18

EXERCISE 18.3 INTERNATIONAL CAPITAL FLOWS: DOES CAPITAL FLOW FROM RICHER TO POORER COUNTRIES? 1. China has enjoyed a period of rapid development over recent decades. Using data from FRED (http://tinyco.re/3965569), plot China’s current account balance over the period 1998–2012, and describe how it has evolved since the late 1990s (Hint: search for ‘total current account balance for China’). Make sure to highlight whether it is a CA surplus or deficit. 2. On the same graph, plot the current account balance of the US over the same time period, and compare it with China’s current account balance (you can also find the data for the US at FRED by searching for ‘total current account balance for United States’). 3. What does your graph suggest about capital flows between richer and poorer countries? Read the 2007 article ‘The paradox of capital’ (http://tinyco.re/9576333) by Eswar Prasad, Raghuram Rajan and Arvind Subramanian, who are IMF economists. Explain what is meant by ‘capital flowing uphill’ and whether or not it is a paradox. 4. Look at Figure 18.8 and note that international capital flows (as measured by average absolute current account balances as a proportion of GDP) in the first decades of the twenty-first century are similar to those of the late nineteenth century. Using the discussion of capital flows in this section and in the article from question 3, was capital ‘flowing uphill’ during Globalization I or Globalization II? Why, or why not?

Answer 1. The Chinese current account surplus expanded rapidly from the late 1990s until 2007, from around 2-3% of GDP from the late 1990s to 2003 to the peak of 10% in 2007 (see chart below). From 2007 onwards, the balance decreased until it reached the 2% level in 2011 and 2012. 2. The current account balance in the US was negative throughout 1998-2012, suggesting imports exceeded exports (unlike in China). The balance in the US decreased slowly from around -2% in 1998 to -6% in 2006. Since 2009, it was rising slowly to the -2% level (see chart below). Data

Total Current Account Balance for China 1998-2012

Source

Organization for Economic Co-operation and Development (2016). Total Current Account Balance for China© [BPBLTT01CNA188S]. Retrieved from FRED. Federal Reserve Bank of St. Louis.

Link

https://research.stlouisfed.org/fred2/series/BPBLTT01CN A188S

Instructions (if appropriate) Notes (if applicable) Publish/downl oad date X-axis variable

27/01/2016 Years

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EXERCISE ANSWERS UNIT 18

Data Source

Total Current Account Balance for the United States 1998-2012 Organization for Economic Co-operation and Development (2016). Total Current Account Balance for the United States© [BPBLTT01USA188S]. Retrieved from FRED. Federal Reserve Bank of St. Louis.

Source Link https://research.stlouisfed.org/fred2/series/BPBLTT01US A188S Instructions (if appropriate) Notes (if applicable) Publish/downl oad date X-axis variable

27/01/2016 Years

Variable

Total current account balance as % of GDP

Country

China

USA

Time period

1998-2012

1998-2012

Units

Percent

Percent

1998

3.09

-2.36

1999

1.95

-3.11

2000

1.71

-4.05

2001

1.31

-3.74

2002

2.44

-4.17

2003

2.62

-4.51

2004

3.57

-5.12

2005

5.87

-5.64

2006

8.55

-5.76

2007

10.11

-4.93

2008

9.31

-4.63

2009

4.87

-2.65

2010

4.01

-3.00

2011

1.86

-2.95

2012

2.35

-2.73

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EXERCISE ANSWERS UNIT 18

3. According to the article, net financial capital flows should in theory be from richer countries, where physical capital per worker is higher and hence returns to capital are lower, to poorer countries, where capital is less abundant and there are more unexploited investment opportunities. However, the opposite is true in reality: many industrial economies are running current account deficits, while emerging market economies are running surpluses. This phenomenon is known as capital ‘flowing uphill’. While these ‘uphill’ flows appear to be a paradox, problems with developing countries such as poor infrastructure, institutions such as the legal system, corruption, and inability to repay foreign debt can lower the risk-adjusted returns to investment, explaining why capital does not flow from these countries in the levels that theory suggests. 4. During Globalization I, capital was flowing ‘downhill’: In the late 19th century, high income countries ran current account surpluses and lent to low income countries, financing the construction of railways and other infrastructure. The pattern in Globalization II contrasts with that of Globalization I when capital flowed downhill: In Question 3, we discussed reasons why capital flowed from poorer to richer countries, and Figure 18.10 shows that US FDI went predominantly to European countries with manufacturing wages higher than that in the US. The situation can be compared. Many manufacturing industries requiring relatively cheap labour in factories shifted production to China. China thus became an exporting giant in the first decade of the 2000s, while the US has transformed to a services-based economy. There is a similarity with the late 19th century, insofar as China is importing capital (like Argentina) in order to finance rapid economic development. There are differences, however. In the late 19th century, the capital was supplied and owned by European investors (financial institutions) and went into railways and other infrastructure owned by Argentinian and US firms. In China, the capital has been supplied by western firms, who retain ownership of the productive capacity created.

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EXERCISE ANSWERS UNIT 18

EXERCISE 18.4 ASSESS SOME COUNTRY PRODUCTION SPECIALIZATION PATTERNS Choose a few goods and services not discussed in this unit (for example, wine, automobiles, professional services such as accounting and auditing, consumer electronics, bicycles, or fashion goods). Use Figure 18.14, along with what you know or can research about your chosen products, to provide an explanation of country specialization patterns.

Answer Wine production provides an example of both sources of specialization. Vineyards have emerged in places that receive adequate water and sunlight, as well as having the appropriate terrain (regions of France, California, New Zealand). Equally, we might think that a high density of vineyards in these areas has helped growers exchange ideas and learn techniques from one another, so agglomeration may also play a part in this specialization.

EXERCISE 18.5 COMPARATIVE ADVANTAGE Suppose that there are only two countries in the world, Germany and Turkey, each with four workers. Within a given time period, each worker in Germany can produce three cars or two televisions, and each worker in Turkey can produce two cars or three televisions. 1. Draw the feasible production frontier for each country, with televisions on the horizontal axis and cars on the vertical axis. In the absence of trade, what is the relative price of cars in each country? 2. Suppose that, in the absence of trade, Germany consumes nine cars and two televisions while Turkey consumes two cars and nine televisions. Mark these consumption points as G and T, respectively. Draw the feasible consumption frontier for each country in the absence of trade. Comment on the relationship between the production and consumption frontiers you have drawn for each country. 3. Now suppose Germany and Turkey start trading. What is the range of possible values for the world relative price of cars? If the world relative price of cars is PC/PTV = 1, in which good will each country specialize? 4. Now use the world relative price given above to draw the feasible consumption frontier of each country in the figures you have drawn. Use these figures to explain whether or not each country gains from trade. 5. What is the marginal rate of transformation between cars and televisions in each country? Explain the relationship between comparative advantage and the marginal rate of transformation between goods.

Answer 1. and 2.

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EXERCISE ANSWERS UNIT 18

The left panel shows the feasible production frontier for Germany and the right panel shows the feasible production frontier for Turkey. Without international trade, the relative price of cars is 2/3 in Germany and 3/2 in Turkey. Without trade, the feasible consumption frontier for each country coincides with the feasible production frontier for that country. 3. The range of world relative prices for cars compatible with trade is 2/3 to 3/2. At a price of 1, Germany would specialize in cars and Turkey in televisions. 4. With trade at this price, the feasible consumption frontier for both countries is the same (as shown below) and expands beyond their production frontier. Therefore, both countries gain from trade.

5. The marginal rate of transformation between cars and televisions is 2/3 in Germany and 3/2 in Turkey, so we can express comparative advantage in a good as having a lower marginal rate of transformation between that good and other goods.

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EXERCISE ANSWERS UNIT 18

EXERCISE 18.6 POWER AND BARGAINING Going back to our example of Carlos and Greta, assume that Greta has the power to set the relative price. Based on what you have learned in Unit 4 about how people play the ultimatum game, how do you think Carlos would react to a price offer of 2.4 apples per tonne of wheat?

Answer Note first that at this relative price, Carlos still gains from trade. His gains are only eliminated at a relative price of 2.5 apples per tonne of wheat. However, he may view this offer as unfair and reject it (as some participants did in the ultimatum game experiments). Had Greta taken this reaction into account, she may set a price more favourable to Carlos.

EXERCISE 18.7 WINNERS AND LOSERS FROM SPECIALIZATION DUE TO ECONOMIES OF SCALE Suppose there are two countries that are identical in their factor endowments. Both would like to consume both passenger cars and commercial vehicles, industries in which there are economies of scale. In the absence of trade, each country would have both industries. If they could trade, both could benefit by specializing and taking advantage of economies of scale to lower their costs of production. Assume that once trade becomes possible, country A specializes in producing passenger cars and country B specializes in producing commercial vehicles. Because of economies of scale, the cost of passenger cars relative to commercial vehicles is lower in country A than in country B. 1. Explain why we would expect to observe trade in similar products, known as intra-industry trade, when production technology is characterized by economies of scale. 2. Who are the winners and losers in this example? How does your result compare with that of the winners and losers in the example of the US and China, where specialization is based on relative factor endowments?

Answer 1. Trade based on economies of scale can occur between countries with the same factor endowments because each country can produce disproportionately more output by specializing in one type of good, and then trading with other countries. With economies of scale, the feasible production and consumption frontier expand more than proportionately with the amount of inputs, so all countries can consume more of each type of good after trade. Therefore, countries can be better off by producing one good and engaging in intra-industry trade, compared to producing a range of similar goods. 2. There is likely to be much less demarcation between winners and losers in this case. All factors involved in passenger car production lose out in economy B

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EXERCISE ANSWERS UNIT 18

and similarly for those involved in commercial vehicle production in economy A. In contrast to the case with specialization based on factor endowment, it is not labour losing and capital gaining. Moreover, labour and capital initially employed in the car industry can move relatively easily into commercial vehicle production and vice versa. These arguments suggest there are likely to be fewer conflicts of interest between winners and losers when specialization is based on economies of scale than on comparative advantage. The growth of trade after World War II was largely of this kind.

EXERCISE 18.8 THE COLLAPSE OF THE SOVIET UNION In the late 1980s and early 1990s, the Soviet Union collapsed. The Soviet Union comprised Russia and some of the countries that now make up eastern Europe and central Asia. It was a planned economy, run from Moscow by the Communist Party. Following this collapse, countries in the former Soviet Union and elsewhere in the former Soviet bloc—with a total of close to 300 million workers—opened their borders to international trade. 1. Assume that Germany was a capital-intensive country, while the former Soviet bloc states were labour-intensive. Use the analysis in this section to identify likely winners and losers from this shock to global trade in: a. Germany b. the countries of the former Soviet bloc 2. What other information would you need to know about these countries to identify the actual winners and losers?

Answer 1a. The winners in Germany are exporters of capital (employers), because they could have exploited their comparative advantage in new markets. The losers might have been German workers in labour-intensive industries, assuming that relatively cheaper labour-intensive im...