Answers to Pause-for-Thought Questions
Chapter 11
.
p418 
Draw up a similar table to Table 11.1, only this time assume that the figures are: LDC 6 wheat or
2 cloth; DC 8 wheat or 20 cloth. What are the opportunity cost ratios now?
The opportunity cost of wheat in terms of cloth is 2/6 in the LDC and 20/8 in the DC (i.e. 7.5 times
higher in the DC).
The opportunity cost of cloth in terms of wheat is 6/2 in the LDC and 8/20 in the DC (i.e. 7.5 times
higher in the LDC).
p427 
(a) Protection to allow the exploitation of monopoly/monopsony power can be seen as a ‘firstbest’ policy for the country concerned. Similarly, the use of tariffs to counteract externalities
directly involved in the trade process (e.g. the environmental costs of an oil tanker disaster)
could be seen to be a first-best policy. Explain why.
In both cases the market distortion lies in the trade process itself. Thus monopoly/monopsony
power in trade (as opposed to monopoly/monopsony power within the domestic economy)
can best be exploited by restricting trade. If, for example, a country has monopoly power in
the export of a certain raw material (but there are many producers within the country
competing with each other to export the raw material), then by the government restricting the
output of the raw material to the point where the marginal revenue from its sale abroad equals
its marginal cost, then the country can maximise the profit from exporting the raw material.
In other words, it can exploit its monopoly power to the full. It could do this by imposing
quotas on production or an export tax.
Similarly, if externalities arise directly from trading, then there is a 'first-best' argument
for restricting trade. For example, if trade has adverse cultural and social effects on the
domestic population through being exposed to products from other countries, then restricting
trade would be the optimum solution. Of course, such externalities would be very difficult to
measure and opinions might diverge considerably over whether and how much society was
adversely affected.
(b) Most of the other arguments for tariffs or other forms of protection that we have considered
can be really be seen as arguments for intervention, with protection being no more than a
second-best form of intervention. Go through each of the arguments and consider what
would be a ‘first-best’ form of intervention.
The infant industry argument. Subsidising the relevant industry.
To reduce reliance on goods with little dynamic potential. Subsidising industries which have
dynamic potential, or providing access to capital for such industries, or providing
infrastructure, such as roads, industrial estates or telecommunications, for such industries.
To prevent 'dumping' or other unfair trade practices. Here tariffs may provide the long-term
first-best solution, since they can directly correct the distortion caused by 'dumped' goods
being sold at below cost. An alternative would be to use anti-monopoly legislation which
effectively outlawed such practices.
To prevent the establishment of a foreign-based monopoly. See previous answer.
To spread the risks of fluctuating markets. Here the first-best solution would be to subsidise
the production of other goods. Alternatively, the provision of infrastructure and training for
other industries would help to diversify the economy.
To reduce the influence of trade on consumer tastes. If the problem arises directly from trade,
then trade restrictions, as explained in (a) could be the first-best solution. If, however, the
Answers to pause-for-thought questions in Essentials of Economics (3rd edition), John Sloman
products could equally well be produced by multinationals within the country, then a tax on
such goods, or even banning them, would be the first-best solution.
To prevent the importation of harmful goods. See previous answer.
To take account of externalities. Unless the externalities arise directly from the trade process
(as explained in (a)), the first-best solution would be to tax products or processes that
produce external costs and subsidise those that produce external benefits.
The exploitation of monopoly power. As explained in (a), trade restrictions are a first-best
solution for the country imposing them. The first-best solution for the world, however, would
be to attempt to reduce that monopoly power by encouraging freer trade and more
competition.
To protect declining industries. The first-best solution would be to subsidise such industries
directly – at least for a short time while they gradually run down. If the problem is simply one
of employment in the areas where those industries are located, then providing training or
other forms of help to those likely to be made redundant, or improved infrastructure to
encourage the development of new industries in those areas, might be the optimal solution.
Non-economic arguments. What is first best in each case depends on what the objectives of
intervention are. The efficient solution in each case is to target intervention as closely as
possible at the problem so as to avoid side-effects from the intervention. Thus, if the
objective is to protect traditional rural ways of life, then trade restrictions or export subsidies
for agricultural products may be a very blunt instrument. It would be better to target support
directly on the communities affected, for example, by providing support for the development
of rural cottage industries.
p434 
Is joining a customs union more likely to lead to trade creation or trade diversion in each of the
following cases? (a) The union has a very high external tariff. (b) Costs differences are very great
between the country and members of the union.
(a) Trade diversion. It may now be cheaper to buy a good from a high-cost producer within the
union rather than from a lower-cost producer outside the union. The reason is that the high tariff
would have to be paid on such imports, making their price higher than the high-cost goods
produced inside the union.
(b) Trade creation. If the country joining the union has significant cost differences from existing
members, then this is likely to create trade from the high to the low cost country.
p443 
Why may the new members of the EU have the most to gain from the single market, but also the
most to lose?
Because their economies are less harmonised with the other member economies, and because there
are more internal barriers, partly as a result of transitional arrangements. There is more chance,
therefore, of both trade creation and trade diversion. Also there is likely to be more change in their
economies. The more change there is, the more will there be gainers and losers (new industries
growing up, and old industries declining, with a resulting loss of jobs).
p454 
Why may small developing countries have more to gain than large ones from a policy of becoming
exporters of manufactured products?
Because many manufacturing industries involve substantial economies of scale. In a small
developing country the domestic market may be too small to allow production at full capacity if
2
Answers to pause-for-thought questions in Essentials of Economics (3rd edition), John Sloman
production is solely for the home market. Thus the economies of scale could only be realised by
exporting the product and thereby taking advantage of a larger market. With a large developing
country the domestic market is likely to be large enough for all economies of scale to be realised
and therefore there is less to be gained from exporting.
Then there is the question of competition. In a small developing country, there may be room
for only one producer, which is facing no competition at home. In a closed economy, such a firm
may be very inefficient. By exporting, however, the producer has to be more efficient to survive
the competition. In a large developing country, there may be several producers within the country,
each providing competition for the others. Again there is less to be gained from the competition
that exporting provides.
3