HW1 Solution Key

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HW1 Solution Key

UCDavis, 160a, SSII 2010 Prof. Farshid Mojaver

Some Trade Terminology

  1. What does autarky mean? No trade

  2. What is a “laissez faire” policy with respect to trade?

Hands off – no restrictive trade policy – free trade

  1. Is export promotion considered to be a “laissez faire” policy? If not then what is it?

No! Export promotion is intended to protect export industries. This is done through various regulations and government interventions.

  1. In the trade spectrum show autarky, free trade, export promotion, and a move toward protectionism/trade liberalization.

No trade

  1. What is protectionism? What is being protected and against what?

Protectionism protects domestic industries against foreign competition via various regulations and government interventions in the market.

  1. What is trade liberalization? What is being liberalized?

A movement in the direction of free trade occurs when regulations on trade are removed. Since the elimination of trade policies will generally increase the amount of international trade, it is referred to as trade liberalization.
Pure Exchange Model

Consider two farmers, one with an endowment of 5 pounds of peaches, the other with an endowment of five pounds of cherries. Suppose these two farmers meet daily and make a mutually agreeable exchange of 2 pounds of peaches for 3 pounds of cherries.

  1. Write down an expression for the terms of trade. Explain how the terms of trade relates to the dollar prices of the two goods.

TOT = 3 lb cherries /2lb peaches = ($/lb peaches)/($/lb cherries) =Ppeaches/Pcherries=3/2

(At this point it is immaterial to write ToT as Ppeaches/Pcherries or Pcherries/Ppeaches)

  1. Consider the following shocks (or changes). Explain how each of these shocks may influence the terms of trade between the farmers. Assume that each farmer's sole interest is to maximize her own utility.

1. The cherry farmer arrives at the market with 5 extra pounds of cherries.

TOT↑ (here defined as lb peaches/ lb cherries) because of the increase in supply of cherries

2. The peach farmer has just finished reading a book titled "How to Influence

TOT↑ because the peach seller can increase demand for his peach

3. Damp weather causes mold to grow on 40% of the peaches.
TOT↑ because supply of peaches goes down
4. News reports indicate that cherry consumption can reduce the risk of cancer.
TOT decreases because the demand for cherries GOES UP

Adam Smith and gains from trade

Answer the following questions pertaining to the excerpts from Adam Smith’s Wealth of Nations (posted on the class web page).

  1. How does Adam Smith measure the contribution of any individual to national wealth?

By his/her income

  1. Adam Smith argues that social interest is promoted best when individuals pursue their self-interest. What is meant by “social interest” and how is it measured?

It seems that Adam Smith views social interest as the level of consumption or power to consume in the society (and of course security). Social consumption capacity is measured by GDP. Thus social interest is reduced to GDP.

  1. How can pursuit of self interest lead to maximization of social interest?

If social interest is measured by GDP and each person years his/her contribution to production, then in a perfectly competitive market, pursuit of self interest (maximization of personal income) under certain conditions leads to the maximization of social interest.

  1. Under what conditions pursuit of self interest can lead to the maximization of GDP?

a- have competitive markets

b- self interest is followed within rules of the game

c- have good rules

  1. What is the main problem with measuring social interest with GDP?

GDP does not ell us anything about the distribution of income in the society. A society can be very wealthy (high income per capita) and yet a great many members of its citizens live in poverty. GDP does not measure external costs such as pollutions and the depletion of natural resources.

  1. What is the source of gain from trade according to Adam Smith?

More can be produced with specialization but this is possible only if people trade. Without trade people/countries have to produce all they need.

  1. How does Adam Smith generalize the results he draws from domestic trade between individuals to gains from trade between nations?

Countries just like individuals can gain from specialization and trade. If each person /nation specializes in the production of what it has some advantage then it earns more income with which it can purchase other goods.

  1. Does everyone gain from voluntary trade (discuss in absolute and relative terms)?

Generally speaking trade increases national income of every country but that does not mean that within the country everyone is better off with the trade. Some people may lose because of international trade. International trade may worsen the relative position of country I terms of GDP. That is the gains from trade may be distributed unevenly as a result some countries may feel unhappy about it even though in absolute terms trade had made them better off.

  1. What enables an individual/a nation to produce something at a lower cost?

Specialization & having a natural of acquired advantage

  1. What are the sources of national advantages in trade?

Natural advantages-climate, natural resources, ect.

Acquired advantages – increase in productivity because of specialization, division of labor, repletion of tasks and gaining more skill

  1. If Great Britain can make good wine and lots of it if needed why should she import it?

Since foreigners are 30 times more productive in wine production GB has to spend 30 times more than foreigners to produce the same wine. That is GB can import the needed wine with 1/30th of the resources employed domestically.

  1. What are the two justifications for some level of protection of domestic industry according to Adam Smith?

- Protection of defense related industry

- When domestic industry in taxed

  1. What was the major function of the act of navigation in GB?

It restricted the kind of good that can be imported to GB and required that all the imports to GB must be done with British ships.

  1. How the act protected GB domestic industry?

The act made imports to GB more expensive by restricting imports to British ships. The act boosted the ship industry in GB.

  1. According to Adam Smith does it matter what or with whom you trade?

Adam Smith praised measures that restricted trade with Holland. GB was not in war with Holland at that time but the two countries were trading rivals. Adam Smith was aware that such restrictions might reduce GB national income in the short run but it saw an strategic gain in the pursuing it.

  1. Why Adam Smith supports the act of Navigation despite his own argument that the act reduces trade and the opulence of GB?

Because “defense” is “much more important that opulence”.

  1. How can the defense industry benefit from this policy?

Giving monopoly of import to British ships expands shipping industry in GB which in turn strengthens British naval power which was instrumental in furthering British interest around the globe.

  1. In addition to the defense argument made by Adam Smith do you see any other reason for the act of navigation? Did the act actually lead to greater opulence in addition to better defense?

The act of navigation stifled Dutch trade and industry. By limiting market access of its main trade rival GB secured larger market for its industry and better terms of trade. This was a strategic move on the part of GB.

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