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ANSWERS TO END-OF-CHAPTER QUESTIONS
5-1 Describe the four major economic flows that link the U.S. with other nations. Provide a specific
example to illustrate each flow. Explain the relationship between the top and bottom flows in
Figure 5-1.
The four major economic flows are: the flows of goods and services (trade flows); the flows of
capital equipment and labor (resource flows); the flows of information and technology; and the
financial flows (money).
The financial flows provide the money necessary to pay for exports and imports.
5-2 How important is international trade to the U.S. economy? In terms of volume, does the United
States trade more with industrially advanced economies or with developing economies? What
country is the United States most important trading partner, quantitatively?
Exports and imports constituted 11 percent and 16 percent of GDP respectively in 2005. These
proportions have more than doubled since 1975. The United States trades more with industrially
advanced economies although the U.S. trade with Mexico is substantial. The U.S.s most
important trading partner quantitatively is Canada, buying 24 percent of our exports and
providing 17 percent of our imports in 2005.
5-3 What factors account for the rapid growth of world trade since the Second World War? Who are
the major players in international trade today? Besides J apan, what other Asian nations play
significant roles in international trade?
The rapid growth in world trade has been facilitated by a reduction in trade barriers, by increasing
prosperity of nations around the world, and by improved communication and transportation that
have made trade easier among the worlds major industrial powers.
The major players in international trade are the United States, J apan and Germany along with
Canada and the members of the European Union. China is an emerging power along with the
newly industrializing economies of Hong Kong, Singapore, South Korea and Taiwan who have
increased their share of global trade from about 3 percent of the total to 10 percent since 1972.
5-4 (Key Question) The following are production possibilities tables for China and the United States.
Assume that before specialization and trade the optimal product-mix for China is alternative B
and for the United States alternative U.
Product Chinas production possibilities

Apparel (in 1000s)
Chemicals (in tons)

A
30
0
B
24
6
C
18
12
D
12
18
E
6
24
F
0
30
Product U.S. production possibilities

Apparel (in 1000s)
Chemicals (in tons)
R
10
0
S
8
4
T
6
8
U
4
12
V
2
16
W
0
20

a. Are comparative cost conditions such that the two areas should specialize? If so, what
product should each produce?
b. What is the total gain in apparel and chemical output that results from this specialization?
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c. What are the limits of the terms of trade? Suppose actual terms of trade are 1 unit of apparel
for 1-1/2 units of chemicals and that 4 units of apparel are exchanged for 6 units of
chemicals. What are the gains from specialization and trade for each area?
d. Explain why this illustration allows you to conclude that specialization according to
comparative advantage results in more efficient use of world resources?
(a) Yes, because the opportunity cost of apparel is less (1A =1C) in China than in the United
States (1A =2C). China should produce apparel and the United States should produce
chemicals.
(b) If they specialize, the United States can produce 20 tons of chemicals and China can produce
30,000 units of apparel. Before specialization China produced alternative B and the United
States alternative U for a total of 28,000 units of apparel (24,000 +4,000) and 18 tons of
chemicals (6 tons +12 tons). The gain is 2,000 units of apparel and 2 tons of chemicals.
(c) The limits of the terms of trade are determined by the comparative cost conditions in each
country before trade: 1A =1C in South Korea and 1A =2C in the United States. The terms
of trade must be somewhere between these two ratios for trade to occur.
If the terms of trade are 1A =1-1/2C, China would end up with 26,000 units of apparel (=
30,000 - 4,000) and 6 tons of chemicals. The United States would have 4,000 units of apparel
and 14 tons of chemicals (=20 - 6). China has gained 2,000 units of apparel. The United
States has gained 2 tons of chemicals.
(d) Through the specialization and trade illustrated in this example, the world is obtaining more
output from its fixed resources.
5-5 Suppose that the comparative-cost ratios of two productsbaby formula and tuna fishare as
follows in the hypothetical nations of Canswicki and Tunata.
Canswicki: 1 can baby formula =2 cans tuna fish
Tunata: 1 can baby formula =4 cans tuna fish
In what product should each nation specialize? Explain why terms of trade of 1 can baby formula
=2-1/2 cans tuna fish would be acceptable to both nations.
Canswicki should specialize in baby formula and Tunata in tuna fish because the opportunity cost
of producing baby formula in Canswicki is less than in Tunata. (In other words, the opportunity
cost of producing tuna in Canswicki is greater at 1/2 can formula per can of tuna than in Tunata,
where each can of tuna means giving up only 1/4 can of formula.)
Since neither country can do as well as this trade if they produce both products for themselves,
they should benefit from these terms of trade. The best that Canswicki can do on its own without
trade is 2 cans of tuna fish for each can of baby formula given up, so 2-1/2 cans of tuna would be
an improvement. The best that Tunata can do without trade is to give up 4 cans of tuna produced
for each can of baby formula, so 2-1/2 cans would be less of a sacrifice in exchange for a can of
baby formula.
5-6 (Key Question) True or false? U.S. exports create a demand for foreign currencies; foreign
imports of U.S. goods generate supplies of foreign currencies. Explain. Would a decline in U.S.
consumer income or a weakening of U.S. preferences for foreign products cause the dollar to
depreciate or appreciate? Other things equal, what would be the effects of that depreciation or
appreciation on U.S. exports and imports?
The first part of this statement is incorrect. U.S. exports create a domestic supply of foreign
currencies, not a domestic demand for them. The second part of the statement is accurate. The
foreign demand for dollars (from US. exports) generates a supply of foreign currencies to the
United States.
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A decline in U.S. incomes or a weakening of U.S. preferences for foreign goods would reduce
U.S. imports, reducing U.S. demand for foreign currencies. These currencies would depreciate
(the dollar would appreciate). Dollar appreciation means U.S. exports would decline and U.S.
imports would increase.
5-7 If the European euro were to decline in value (depreciate) in the foreign exchange market, would
it be easier or harder for the French to sell their wine in the United States? Suppose you were
planning a trip to Paris. How would the depreciation of the euro change the dollar price of this
trip?
If the European euro declines in value, it means that Americans can receive more euros for each
dollar. Therefore, they do not need as many dollars to pay the euro price of a bottle of French
wine, so the quantity demanded would rise and it should be easier to sell French wine in the U.S.
Likewise, the euro depreciation would make it less costly for Americans to travel in France, since
the dollar would now buy more euros (assuming that prices inside France have not risen to
entirely offset the depreciation of the euro).
5-8 True or False? An increase in the American dollar price of the South Korean won implies that
the South Korean won has depreciated in value. Explain.
This is a false statement. It implies just the opposite. If the price of the South Korean won has
risen, this means it has appreciated in value by definition. It now takes more dollars to buy a
won, which means the dollar has lost purchasing power vis vis the won. It is the dollar that has
depreciated against the won.
5-9 What measures do governments use to promote exports and restrict imports? Who benefits and
who loses from protectionist policies? What is the net outcome for society?
Governments promote exports by providing subsidies to export producers, which effectively lowers their
costs and enables themto sell their products at lower prices on world markets. Subsidies enable export
firms or industries to compete against other nations, but the fact the subsidy was necessary for this
competition means that the most efficient use of resources is not taking place.
Restriction of imports can be accomplished by protective tariffs, by import quotas, and by non-
tariff barriers such as licensing requirements, unreasonable quality standards, and unnecessary
import procedures.
The benefits of protectionist policies are to the industry that has to compete on world markets
either with its exports or against imports. Even this may be a short-run benefit, because industries
that are protected may become so inefficient and outmoded that they are unable to stay afloat
even with the protection in the long run. There may also be some political benefits as those
protected groups have a strong self interest in this protection and are vocal opponents of free trade
for their industries, whereas the benefits of free trade are more diffuse and the benefits to any
single group of voters is less noticeable.
The costs of protectionist policies are more widespread. The costs of protectionist policies arise
because resources are not being used as efficiently as they might be under free trade. This raises
the cost of production and raises prices, and means the total quantity of world output produced
and consumed is not as great as it could be without such barriers. Consumers lose since they
must pay higher prices, but worldwide producers also lose because productivity is not as high as
it could be.
The net outcome to society is negative. Costs outweigh the benefits for the reasons stated above.
5-10 (Key Question) Identify and state the significance of each of the following: (a) WTO; (b) EU; (c)
euro; and (d) NAFTA. What commonality do they share?
(a) The WTO oversees trade agreements reached by member nations and arbitrates trade disputes
among them. (b) The EU is a trading bloc of 25 European countries who have agreed to abolish
tariffs and import quotas on most products and have liberalized the movement of labor and capital
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within the EU. (c) The euro is the common currency that is used by 12 of the original 15 EU
countries. (d) NAFTA is a trade bloc made up of the United Sates, Canada, and Mexico whose
purpose is to reduce tariffs and other trade barriers among the three countries.
All of the above have the goals of increasing international trade and leading to a better allocation
of the worlds resources.
5-11 Explain: Free-trade zones such as the EU and NAFTA lead a double life. They can promote
free trade among members, but pose serious trade obstacles for nonmembers. Do you think the
net effects of these trade blocs are good or bad for world trade? Why? How do the efforts of the
WTO relate to these trade blocs?
Free-trade zones increase the efficient use of resources within the zones by eliminating trade
barriers and allowing for the freer movement of resources across international borders among the
member nations. On the other hand, if trade barriers are retained against imports from nations
outside the zone, this results in a less efficient allocation of resources in the larger global
economy.
The evidence seems to point to the net effect of trade blocs as being good for world trade. They
seem to be a first step in breaking down trade barriers as can be seen from the expansion of the
original European Economic Community to todays 25-member European Union, and the
expansion of the U.S.-Canada free trade agreement to NAFTA. Also, the attraction of the large
consumer markets within each trade zone makes other trade blocs more likely to conclude
agreements between blocs that would further lower trade barriers.
Some might argue that such blocs are bad for world trade because the unity and self-sufficiency
gained inside the trade zone may inhibit further overtures for trade expansion outside the bloc, but
so far this does not seem to have been the case.
The WTO provides a forum for the trade blocs to meet and negotiate further reductions in trade
barriers among the trade blocs.
5-12 Speculate as to why some U.S. firms strongly support trade liberalization while other U.S. firms
favor protectionism. Speculate as to why some U.S. labor unions strongly support trade
liberalization while other U.S. labor unions strongly oppose it.
When trade barriers are eliminated, some U.S. firms will be hurt by the increased competition
from foreign companies. On the other hand, if trade barriers against U.S. products are eliminated,
the U.S. companies producing those products will be able to sell more of their products outside
the U.S. Likewise, the union workers working for the firm that face increased international
competition may lose their jobs, whereas union workers working for companies that are
expanding due to international trade will experience an increase in job opportunities.
5-13 What is the Doha Round and why is it so-named? How does it relate to the WTO? How does it
relate to the Uruguay Round?
The Doha Round, started in late 2001, is the latest round of negotiations for the WTO, and is
named for its city of origin, Doha, Qatar. Like other WTO (and GATT) negotiations, the purpose
is to further reduce tariffs, quotas, and other barriers that distort trade. The Uruguay Round
negotiations preceded the Doha Round, and established the WTO.
5-14 (Last Word) What point is Bastiat trying to make in his imaginary petition of the candlemakers?
Bastiats objective was to discredit the arguments in favor of protectionism by carrying the
arguments to logical but absurd conclusions. Bastiat was demonstrating that there are numerous
forces that create competitive challenges for firms and industries, but that that doesnt necessarily
justify the imposition of protectionist measures.