Tutorial 5 Flashcards
Suppose that Australia and Mexico are the only two countries in the world. In Australia a worker can produce 12 tonnes of wheat or 1 barrel of oil a day. In Mexico, a worker can produce 2 tonnes of wheat or 2 barrels of oil a day.
a) What will be the price ratio between the two commodities (i.e. the price of oil in terms of wheat) in each country if there is no trade?
a) If there is no trade 1 barrel of oil is worth 12 tonnes of wheat in Australia 1 barrel of oil is worth 1 tonne of wheat in Mexico i.e. oil is relatively more valuable (in terms of wheat) in Australia than in Mexico. Wheat is relatively less valuable in Australia than in Mexico
Suppose that Australia and Mexico are the only two countries in the world. In Australia a worker can produce 12 tonnes of wheat or 1 barrel of oil a day. In Mexico, a worker can produce 2 tonnes of wheat or 2 barrels of oil a day. b) If free trade is allowed and there are no transportation costs, what commodity would Australia import? What about Mexico?
b) Under free trade with no transportation costs, Australia will import oil (which it values more highly than Mexico), and Mexico will import wheat (for similar reasons).
Suppose that Australia and Mexico are the only two countries in the world. In Australia a worker can produce 12 tonnes of wheat or 1 barrel of oil a day. In Mexico, a worker can produce 2 tonnes of wheat or 2 barrels of oil a day. c) In what range will the price ratio have to fall under free trade? Why?
c) The price ratio under free trade must be acceptable to both sides, so it must fall within the range of 1 - 12 tonnes of wheat per barrel of oil. If the ratio is too high – for example, if oil is traded at more than 12 tonnes of wheat per barrel – Australia will not be interested in importing oil. If the ratio is too low – for example, if oil is traded at less than 1 tonne of wheat per barrel – then Mexico will not be interested in exporting oil.
Suppose that Australia and Mexico are the only two countries in the world. In Australia a worker can produce 12 tonnes of wheat or 1 barrel of oil a day. In Mexico, a worker can produce 2 tonnes of wheat or 2 barrels of oil a day. d) [E] Picking one possible post-trade price ratio, show clearly how it is possible for both countries to benefit from free trade.
d) [E] Selecting (for example) an intermediate price ratio of 1 barrel of oil = 6 tonnes of wheat, we can see that Australia will benefit from trade because it will be able to obtain oil at a lower cost than before trade: before trade Australia had to give up 12 tonnes of wheat to obtain a barrel of oil; now Australia would only have to give up 6 tonnes of wheat. Similarly, Mexico will benefit from being able to obtain wheat at a lower cost (1 tonne of wheat = 1/6 barrels of oil) than before trade (1 tonne of wheat = 1 barrel of oil). To see the point more clearly, consider for example the case of a worker in Australia. Instead of working for one day to produce a barrel of oil, this worker can now produce 12 tonnes of wheat, swap 6 of these 12 tonnes for a barrel of oil, and end up with both a barrel of oil and 6 tonnes of wheat. As for a worker in Mexico, instead of working for one-half day to produce 1 tonne of wheat and another one-half day to produce a barrel of oil, (s)he can now work for one whole day to produce 2 barrels of oil, swap one of these 2 barrels for 6 tonnes of wheat, and end up with 6 tonnes of wheat (more than before) as well as one barrel of oil.
- A large mulberry tree in your neighbour’s yard provides you with welcome shade but gives her only a lot of inedible and messy mulberries. She wants to cut the tree down. a) Does she have the legal right to do so?
a) In most societies, the neigbour would normally have the legal right to cut the tree down, as it is on her land.
- A large mulberry tree in your neighbour’s yard provides you with welcome shade but gives her only a lot of inedible and messy mulberries. She wants to cut the tree down. b) You say to her: “I know you hate those messy mulberries, but not nearly as much as I would hate losing the shade.” Can you prove your statement? If you can’t prove that you value continued shade more than she values a clean yard, can you induce her to place a higher value on her benefits from leaving the tree than on her benefits from cutting it down? (Hint: How do you induce the sewer cleaner to decide he would rather clear your sewer line on a Sunday afternoon than watch his favorite football team?)
b) Some possible ways to prove that I truly value the shade provided by the tree and to induce my neigbour to raise her estimation of the tree’s worth is to offer: ii) to clean her yard for her, or iii) to do other favours (run errands) for her, or iiii) to pay her some financial compensation.
- A large mulberry tree in your neighbour’s yard provides you with welcome shade but gives her only a lot of inedible and messy mulberries. She wants to cut the tree down. c) An alternative route for you is to challenge her legal right to cut down the tree. You might try to have the tree declared a historic landmark, or go to court to demand that she file an environmental impact statement before being allowed to remove the tree. What is the danger to you in this tactic? (Hint: If you think you may be prevented in the future from exercising a right you now possess, will you wait to see what becomes of your right or will you exercise it while you still clearly have it?)
If the neigbour suspects that a legal challenge will soon be mounted, she may wish to pre-empt the legal battle by cutting the tree down as early as possible. And if court cases like this become common, people may be reluctant to let trees mature on their properties, so that tree-lovers as a group may lose out in the long run.
Consider the market for fire extinguishers. a) Why might fire extinguishers exhibit positive externalities?
Fire extinguishers exhibit positive externalities, because when people buy them for their own use, they also reduce the risk of fire damage to the property of others, and they do not receive any payments for reducing such risk.
Consider the market for fire extinguishers.
b) Draw a diagram for the market for fire extinguishers, and clearly label the demand curve, the social-value curve, the supply curve, and the social-cost curve.
Use a diagram like the one on the next page to illustrate the positive externality from fire extinguishers. Notice that the social value (MSB) curve is above the demand curve (MPB). The gap between the two curves is the external benefit. By contrast, the social cost (MSC) curve is the same as the supply (MPC) curve
Consider the market for fire extinguishers
c) Indicate the market equilibrium level of output and the socially desirable level of output. Briefly explain why these quantities differ.
The market equilibrium level is denoted Qmarket and the socially desirable level of output is denoted Qoptimum. The quantities differ because in deciding to buy fire extinguishers, private consumers don’t take into account the external benefits being provided to other people.
Consider the market for fire extinguishers
d) Suppose the external benefit is $10 per extinguisher. Describe a government policy that would help to achieve the socially desirable outcome. How would this policy affect the price received by suppliers and the price paid by consumers?
A government policy that would help to achieve the socially desirable outcome would be to provide a subsidy (e.g., payment to consumers) of $10 for every fire extinguisher bought. This would shift the demand curve up, to be the same as the social value curve, and the market equilibrium quantity would increase to the socially desirable quantity. Note that the price paid by consumers (out of their own pockets) would be lower than before the subsidy, and the price received by suppliers would be higher.
You are watching an election debate on television. A candidate says: “We need to stop the flow of foreign cars into our country. If we limit the importation of cars, our domestic car production will rise and Australia will be better off.”
Who in Australia will be better off if car imports are restricted?
If car imports are restricted, Australian car manufacturers and their employees stand to gain (at least in the short-to-medium run) because imported cars will become more expensive, so that domestically produced cars become more attractive to domestic buyers.
You are watching an election debate on television. A candidate says: “We need to stop the flow of foreign cars into our country. If we limit the importation of cars, our domestic car production will rise and Australia will be better off.”
Who in Australia will be worse off if car imports are restricted?
Australian consumers (car buyers) will have to pay higher prices and will have less variety to choose from. Australian producers of other goods and services (e.g. agriculture, mining, education, health, etc.) will have to pay higher input costs that will disadvantage them in competing against overseas producers.
You are watching an election debate on television. A candidate says: “We need to stop the flow of foreign cars into our country. If we limit the importation of cars, our domestic car production will rise and Australia will be better off.”
According to the principle of comparative advantage, is Australia as a whole more likely to be better off or worse off if car imports are restricted?
The theory of comparative advantage suggests that restricting imports is likely to have a negative effect on the living standard and material wellbeing in Australia as a whole.
According to this theory, if each country puts more emphasis on producing goods and services in which it has a comparative advantage, and trades with other countries, the combined world outputs will tend to increase, because goods and services will be produced at lower opportunity costs.
If country C1 (say, Japan) has a comparative advantage in producing good G1 (say, cars in general or a particular kind of cars) then by definition C1 can produce G1 at a lower opportunity cost than other countries (including Australia). The more that C1, rather than other countries, produces G1, the lower will be the opportunity cost of G1 at the global level.
Similarly, if Australia has a comparative advantage in producing good G2 (say, iron ore, beef, or tourism, or another kind of cars) then the more that Australia, rather than other countries, produces G2, the lower will be the opportunity cost of G2 at the global level.
Gains from trade arise from achieving these lower opportunity costs. If the gains are shared appropriately, both parties to the trade can benefit. Restricting trade prevents such benefits from being fully realised.
From another perspective, trade has the potential to allow each party to reach consumption possibilities that are not available before. Restricting trade reduces this potential.
You are watching an election debate on television. A candidate says: “We need to stop the flow of foreign cars into our country. If we limit the importation of cars, our domestic car production will rise and Australia will be better off.”
Why do countries often restrict imports?
Trade is not unanimously supported by people everywhere, and countries do often place some restrictions on trade. Some of the possible reasons for this are as follows.
- The comparative advantage analysis above produces a conditional statement about what can happen, rather than a prediction that something will always happens. In some cases, the gains from trade might not be shared to the satisfaction of both sides. For example, agreement to trade might be reached through coercion, misinformation, or failures by one side’s representatives to adequately protect its interests.
- Trade imposes short-term adjustment costs on domestic producers of goods and services that compete with imports. In principle, the gains made by consumers and producers of other goods and services should be more than enough to adequately compensate producers of import substitutes and their employees. In practice, however, it is often difficult to ensure that no-one is hurt in the short-to-medium run. Further, while the benefits tend to be dispersed thinly among a large number of consumers and producers of other goods, the costs tend to be concentrated heavily among a small number of producers who compete with imports. As a result, there is often vocal opposition to trade liberalization.
- Some countries may wish to protect domestic producers from international competition for non-economic reasons, such as national security, cultural heritage, and so on.
