Page 1/10 Section 3.1 Preparing for exams Short answer questions (10 marks each) 1. (Note, error: the questions reads comparative advantage by but should read comparative advantage in. Basic answer: Definition of comparative advantage and illustration either graphically or in a table. Specialisation, investment and labour capital are the main ways in which a country might enhance and improve its comparative advantage. definition of comparative advantage o a country has a lower opportunity cost than a trade partner in the production of a good o assumptions of comparative advantage and PPFs o use of PPFs to illustrate o divergent PPFs and cost ratios show possible terms of trade investment o increased investment via government grants, tax breaks and incentives foreign investment possible reference to capital output ratio specialisation o increased specialisation move the economy along a learning curve o scale benefits possible labour capital o education, training, experience will all increase productivity o wider implications of development in enhancing comparative advantage Diagram(-s): PPF, cost ratio diagram. Note: Common mistake is to confuse comparative with absolute advantage. 2. Basic answer: Definition of current account in terms of visible and invisible trade plus transfers. Definition/outline of barriers to trade. Keeping price, quantity and revenue/spending clearly separate, examples can be drawn showing how decreasing the ratio of export revenue to import spending will improve the current account. definition and illustration of current account o visible trade balance o invisible trade balance o net transfers definition and examples of trade barriers o tariffs o non-tariff barriers, e.g. quotas, subsidies, anti-dumping etc o hidden or covert trade barriers, e.g. spurious health and safety regulations devaluation of currency (not directly a trade barrier, but should merit marks) illustration of tariffs/quotas in the standard trade diagram clear examples of how increased price of imports decrease in quantity of imports decrease in import spending and thus improvement in current account
Page 2/10 differentiating clearly between price/quantity/revenue of exports same for imports HL: possible exceptions o Marshall-Lerner condition o J-curve effect o a bit peripheral but a bit relevant dangers of trade barriers risk of reciprocal barriers by trade partners, which to a certain extent negate export gains of original protectionist country devaluation by trade partners Diagram(-s): Trade diagrams showing tariffs/quotas, J-curve. Note: Students who simply refer to increase in exports.. without bothering to differentiate between export price/quantity/revenue should not be awarded full marks. 3. Basic answer: In defining free trade one soon arrives at the conclusion that while yes, visible (tariff) barriers have fallen considerably and trade has increased, there are a good many other types of barriers to trade which have replaced the more traditional ones. Trade is in fact still in many respects subject to barriers. definition of free trade i.e. that foreign providers are not in any way disadvantages over domestic providers of goods (beyond perhaps physical distance and transport costs) outline of barriers of more traditional type, i.e. tariffs, quotas, VERs etc. reference to WTO rules banning several types example of MFA quota system ending in 2005 discussion of increases in trade during past 20 or so years however, many other forms of de facto barriers have replaced the visible trade barriers o subsidies to domestic producers (look up Airbus vs Boeing!) o spurious barriers examples of health and safety regulations o anti-dumping tariffs o government favouritism o environmental standards o labour standards o administrative barriers o the monumental increase in REAs/FTAs which creates an advantage for members over non-members (and is exempt from MFN clause) Diagram(-s): Trade diagrams showing tariffs/quotas. Note: Well-versed students will come up with any number of viable examples not on the list above award according to relevance and merit. 4. Basic answer: A trade barrier is broadly defined as any market intervention whereby the ratio of price of exports to price of imports goes down. Thus, a subsidy will lower the domestic price of goods ceteris paribus and unfairly advantage domestic producers over foreign. definition of a trade barrier definition and illustration of a subsidy o use of S/D diagram; S shifts right
Page 3/10 o adding in Pworld, i.e. trade diagram, showing how quantity of imports decreases o possibility of export subsidies how developing countries are severely disadvantaged here since a) they often cannot meet these subsidies, and b) their own markets can be dumped upon by foreign subsidised producers Diagram(-s): Trade diagram illustrating the change in imports. Possibly a trade diagram showing export subsidies (not part of syllabus, see page 508) Note: A straightforward question which needs to be addressed using a clear and well-commented diagram. 5. Basic answer: Define trade barriers as decreasing the ratio of price of exports to price of imports and illustrate how barriers to trade serve to limit developing countries exports to developed countries and even how developed countries can destroy domestic markets in developing countries definition of barriers to trade examples of barriers to trade o tariffs o non-tariff barriers; quotas, regulations, health/safety barriers etc o subsidies examples of developed country trade barriers specifically affecting developing countries o domestic subsidies in developed countries disadvantage producers in developing countries o tariffs and quotas for a number of goods still exist o illustration of tariffs/quotas in trade diagram o comments to the effect that effective tariff levels are in fact much higher than visible tariffs o comments to the effect that tariffs are often higher in developed countries on goods with higher value-added (processed goods) than on low value-added (unprocessed) goods o examples such as raw (green) coffee and processed coffee o subsidies in developed nations can create excess supply which can be dumped on developing countries perhaps destroying domestic markets increasing number of REAs/FTAs serve as barriers to trade for non-members and it is notable that the strongest REAs/FTAs are in the developed world the highest trade barriers often exist for the very goods in which developing countries have a comparative advantage o textiles o agricultural goods o specific examples; sugar market in EU Diagram(-s): Trade diagram showing subsidies/tariffs. Note: Full marks can be given for any one example done in depth.
Page 4/10 6. Basic answer: There is wide scope here, where any good answer will address the fact that international competitiveness is a matter of relative price and quality of domestic goods compared to other countries goods. a country s focus on comparative (or even absolute) advantage in the production of goods increased specialisation in conjunction with the above exchange rates with possible reference to terms of trade international business cycle will have an influence on the demand for key factor inputs such as steel innovation, R&D etc domestic subsidies can lower costs for export firms inflation rates (i.e. relative inflation rates compared to other exporters) productivity and efficiency in the economy for example supply-side policies might lower domestic prices and make the economy more competitive low interest rates and increased capital could increase productivity as could FDI enhancing human capital via education and training lower costs due to economies of scale Diagram(-s): Divergent PPFs for two countries and how increased specialisation and focus on products in which the home economy has a comparative/absolute advantage; standard trade diagram (see page 486) can illustrate how a country might shift domestic supply to the right and create an exportable surplus; the LRAC curve (HL) together with the world supply can illustrate how increased capital can lower AC and enable benefits of scale; investment schedule together with AS-AD diagram can illustrate the competitive effects of supply-side policies. Note: There is, as mentioned above, wide scope for good answers. Marks should be awarded on the basis of how well the student shows a concrete link between, for example, increased investment in human capital and the competitive gains internationally. 7. Basic answer: Use the standard trade diagram Sdomestic, Ddomestic, Sworld and then shift Sworld upwards to show a tariff. The trapezium (see page 487) shows the loss of domestic consumer surplus, and the two triangles (B and D, figure 4.2.2, page 487) show green loss and net loss of consumer surplus respectively. Together, this is the allocative loss of a tariff. definition of resource misallocation clear trade diagram showing domestic supply /demand and world supply adding a tariff shift world supply upwards the trapezium shows the loss of consumer surplus and (in reading order) o A) gain in domestic supplier surplus ( captured from consumers) o B) green loss to society o C) tax revenue to govt o D) net loss of consumer surplus triangles B) and D) together show the allocative loss, i.e. the deadweight loss to society for explanation to the effect that less efficient producers end up taking over a proportion of output, which is clearly societally suboptimal Diagram(-s): Standard trade diagram.
Page 5/10 Note: Yes, consumer and supplier surplus is outside the syllabus but it would be very difficult to outline allocative failure in this context without the use of these concepts. Extended response questions 1. a) Basic answer: Dumping is when a producing country dumps goods on foreign markets at a price lower than either the price on the home market or below the cost (HL: marginal cost) of production. Common examples are subsidised industries in developed countries which then dump excess supply on developing countries. definition of dumping o goods are sold on a foreign market at a price below the home country price o goods are sold at below cost of production o HL: goods are sold at below MC examples of dumping o developed countries dumping agricultural goods on developing countries o use of examples of goods, often in agriculture o examples, say EU and North Africa o accusations from US that both EU and Chinese firms are selling goods at below cost in US market debate on dumping o whether subsidies pervert the actual costs of production, enabling producers to sell at what looks like an above-cost price but in fact is not o tax relief and other benefits can be used to lower costs for firms, enabling them to sell at unfairly competitive prices abroad Diagram(-s): Note: Better answers will include a sound definition and clear real world examples. b) Basic answer: Define anti-dumping tariff as a tax levied on imports to bring the price of these imports up and reflect the true cost of production. Anti-dumping tariffs have become common for three main reasons: 1) they are allowed according to WTO rules; 2) it is almost impossible in many cases for an offending nation to prove that the real costs are lower than the foreign sales price; and 3) the main anti-dumper is the US where any fines levied on offending foreign firms go to the US firms which have lodged a complaint. The issue of how low cost countries might defend themselves against dumping accusations is, well, difficult, to say the least. The most efficient way would probably be to have a very open book system, where all costs/subsidies are made available to foreign market courts yet the process of counter-claims by offending companies is both timeconsuming and expensive. definition of anti-dumping tariff o tariff is added to goods to reflect true cost of production o almost impossible to establish and thus in many cases in all likelihood unfair reasons for them becoming common o the WTO has granted such tariffs an exception o very difficult to prove one way or another o the proceeds of anti-dumping tariffs in the US go to injured party, i.e. domestic US firm which lodged the original dumping complaint
Page 6/10 problems for low cost countries o burden of proof somehow seems to lie on producers o low cost countries are exactly that wages and other factors are often far lower than in developed countries, which leads to allegations of unfair low-cost wages by firms in developed world countries possible solutions for low cost countries o open book policy to show real costs and eventual tax benefits and/or subsidies (the problem being that such figures are often sensitive and would not be disclosed for competitive reasons) o low cost countries could band together and establish an office/organisation where firms subjected to anti-dumping tariffs could ask for legal assistance o have the WTO or other international body act as arbiter (judge) in controversies o other possibilities other issues Diagram(-s): Trade diagram to show effect of anti-dumping tariff. Note: The possible solutions are a tricky issue. Allow for wide discussion here, as long as it is relevant. 2. a) Basic answer: Define free trade and then briefly comment on a list of possible advantages, clarifying how/why such an advantage might rise. firms o specialisation and increased use of comparative advantage o possibility of benefits of scale o spread and knowledge of technology production gains o spread of skills and labour capital o access to new/wider markets consumers o increased choice, i.e. variety o lower prices o overall consumer welfare (consumer surplus outside of syllabus) in lower prices and increased consumption o increase in standard of living society in general o political issues; cooperation, peace-dividend o improved global resource allocation o growth via exports other points; possible improvement in environment due to better resource allocation, possibilities of growth in developing countries Diagram(-s): PPFs showing comparative/absolute advantage and increased consumption possibilities (CPF). AS-AD showing growth due to exports. Note: Good answers will cover a few points in illustrative depth, or shallower but more issues. b) Basic answer: Define barriers to trade and exemplify why countries might be tempted to use them. Common examples would be employment argument, safety/health reasons, environmental issues, labour and working standards, tax revenue, hinder dumping, regional support reasons, domestic strategic arguments, and developing infant industries.
Page 7/10 employment o save jobs in domestic industries o protect domestic industries from unfair competition, e.g. low-cost labour goods safety/health reasons o safeguard domestic society against harmful products o examples; FDA in the US or any national agency charged with consumer protection environment o regulations against goods using valuable and limited resources, e.g. hardwoods from diminishing rainforests, ivory from elephants etc o ban on goods which do not meet certain production standards, e.g. goods using CFCs in production o regulations on minimum standards of emissions in production labour/work standards o argument of fairness/solidarity in buying goods from sweatshop firms (often MNCs) in developing countries tax revenue o tariffs will generate government revenues o particularly in countries with scanty domestic tax bases, e.g. developing countries anti-dumping o countries should be allowed to protect domestic producers from unfairly subsidised goods and/or goods sold at below cost (or domestic price) abroad regional policies o subsidies can be used to preserve traditions, way of life and support certain regions and products o cultural considerations in line with the above strategic arguments o nations have a duty to citizens to have a degree of broad production capacity in case of war/blockade/conflict infant industry argument o developing nations need to have protection for a period of time in order to develop domestic industries which initially cannot compete with far more efficient international firms (which might enjoy benefits of scale) Diagram(-s): Trade diagrams to show how imports are limited (tariffs and/or subsidies) and how tax revenue is created. The LRAC curve (HL) may be used to illustrate the infant industry argument and moving along towards scale benefits (page 676). Note: Any four examples done in depth should be able to earn top marks. 3. a) Basic answer: This should not be limited to a list of trade barriers, but include a brief iteration on how imports are limited. examples of barriers to trade o tariffs o non-tariff barriers; quotas, regulations, health/safety barriers, buy domestic policies in local and national government, strategic argument etc o subsidies other ways in which to limit imports o ban (extreme, but US-Cuba is an example) o devaluation of domestic currency
Page 8/10 o non-convertibility of domestic currency showing how these barriers and policies can limit imports o domestic subsidies give domestic producers a cost advantage over foreign producers (use trade diagram) o tariffs and quotas limit imports (use trade diagram) o effect of non-tariff barriers in limiting imports o how a devalued currency adjusts the external value of the currency creating an incentive to buy domestically instead (expenditure-switching) increasing number of REAs/FTAs serve as barriers to trade for non-members and it is notable that the strongest REAs/FTAs are in the developed world Diagram(-s): Trade diagram to show effects of tariffs, quotas, subsidies in limiting imports. Note: There is a long list of possible ways to limit imports. Leeway should be granted, but examples should be relevant and realistic. Good examples merit marks of course. b) Basic answer: This is a huge question, and any two pro et con examples should be able to get maximum marks. The main issues lie in whether the barriers to trade are in fact more costly to society than not implementing them. Each given example of import limitation could be granted a brief pro et con in spite of any argumentative stance taken by the student. Alternatively, a good answer might pick to argue for/against different policies in total. The key is to render solid economic arguments in support of the line of argument taken. limiting imports is generally negative o less choice for consumers o higher prices o decrease in consumption and lower living standards o less consumer welfare (consumer surplus lost use trade diagram) o domestic firms grow lazy/uncompetitive behind protectionist walls o forward-linkage effects can increase domestic price of goods and decrease the international competitiveness of domestic firms o limits possibilities of trade and thus utilising comparative advantage, benefits of scale etc o misallocation (use trade diagram to show deadweight loss) o environmental costs of producing goods better left to more efficient producers there are viable points for an economy to limit imports o infant industry argument protect fledgling industries, allow them to get up to scale o limit harmful goods o strategic argument o possible government revenue from tariffs o protection of domestic labour market against unfair competition o anti-dumping argument o improve current account in balance of payments assessing the costs and benefits of the points above, i.e. is there a net societal gain in saving 10,000 jobs in the steel industry when this is offset against higher domestic steel prices for steel-using industries i.e. what is the real cost of each job? other issues o the increase in free trade has improved relations between countries ( peace dividend ); possibility of reciprocal trade barriers and trade war; declining relations of nations in trade dispute; there is ample evidence that trade is not a zero sum game and that jobs are in fact not saved in the LR
Page 9/10 o developing countries must be allowed to protect themselves from highly efficient international firms just like the present developed nations did once; increasing trade liberalisation can lead to global entities which empower themselves at the expense of small domestic firms and even governments Diagram(-s): PPFs/ CPFs showing increased consumption possibilities (CPF). Trade diagram showing effects of tariffs etc. Note: Good real world examples and there are many should be amply rewarded. 4. a) Basic answer: A basic definition of each is a good start; terms of trade can be defined as the average price of a country s basket of export goods in relation to the average price of a country s basket of import goods. (HL: use index of terms of trade, i.e. IndexØP X/IndexØP M x 100). The balance of trade is the total amount of export revenue minus import spending. definition of terms of trade o the amount of a given amount of export goods necessary to buy a given amount of import goods o barter or commodity terms of trade, i.e. quantity of Volvos per quantity of Toyotas o index of terms of trade (HL); index of the average price of exports over an index of the average price of imports time one hundred (IndexØP X/IndexØP M x 100) o explanation that a change in the price of either the domestic and/or imported good will change the terms of trade definition of trade balance o price of exports times quantity of exports equals export revenue o price of imports times quantity of imports equals imports spending o export revenue minus import spending equals the (visible) trade balance o explanation that a change in either price or quantity (ceteris paribus) of exports or imports will change revenue/spending, and thus the trade balance trade balance in context, i.e. the current account and the balance of payments Diagram(-s): Note: A seemingly straightforward question, but an alarming number of students falter in defining basic concepts. b) Basic answer: Definition and outline of possible barriers to trade, for example tariffs, quotas, subsidies etc. They should, however, be picked in accordance with the ability to change the ratio between export and import prices as this is the central theme. The answer should clearly identify how an increase in the price of imports 1) would change the terms of trade (ceteris paribus) and thus 2) possibly improve the trade balance depending on whether import expenditure in fact decreases or not (HL: refer to Marshall-Lerner condition). definition of trade barriers o and how these would serve to raise the price of imports o thus decreasing imports o illustration using trade diagram to show increase in price, decrease in imports o stating that an increase in the price of imports has the effect of worsening the terms of trade
Page 10/10 reference to expenditure-switching example of effects on trade balance o price of imports rises o how this could lead to lower imports (HL should include either Marshall-Lerner condition or J-curve effect) o that imports are a negative component in the trade balance o thus the trade balance should improve when imports fall definition of the exchange rate price of domestic currency in terms of a trade partner s currency use of the exchange rate to affect the terms of trade and trade balance o a devaluation/depreciation of the currency (ceteris paribus) will decrease the terms of trade o a lower exchange rate will raise the price of imports o and lower the price of exports o leading (possibly HL should include Marshall-Lerner condition and/or J-curve) to an increase in exports and export revenue o and a decrease in imports and import spending o thus, the terms of trade have fallen and the trade balance has improved Diagram(-s): Trade diagram to illustrate the effects of trade barriers. Possibly J-curve. Note: All too often students are hazy on the issue of whether an improvement in the terms of trade can actually be bad i.e. worsen the current account.