HW1 Solution Key
UCDavis, 160a, SSII 2008
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
3- 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
2- 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.
3- 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.
a. 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) = Pcherries/Ppeaches=3/2
(At this point it is immaterial to write ToT as Ppeaches/Pcherries or Pcherries/Ppeaches)
b.
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
People."
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↓ because demand for cherries goes down
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
2- 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 by Adam
Smith?
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.
3- How does pursuit of self interest can lead to maximization of social interest?
Contribution of each individual to GDP is equal to his/her income. Adam Smith
argues that when individuals maximize their income by pursuing their self interest
then social interest (GDP) is also maximized.
4- 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
5- What is the main problem with measuring social interest with GDP?
If we accept the level of consumption as an economic measure of national interest,
the main problem with GDP is a measure of social interest is that this 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.
6- How does Adam Smith generalize the conclusion he gets from his example of
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.
7- 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.
8- What enables an individual/a nation to produce something at a lower cost?
Specialization & having a natural of acquired advantage
9- 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
10- While Great Britain can make good wine 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.
11- 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
12- 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.
13- 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.
14- According to Adam Smith does it matter what or with home 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.
15- 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”.
16- 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.
17- 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.