Let's Assume There Are Only Two Countries That Produce Two G

Let’s assume there are only 2 countries that produce 2 good

Suppose that the United States (US) and the United Kingdom (UK) each have 2 units of productive resources, with 1 used to produce Wine and the other Cloth. The US can produce 40 units of Wine with 1 unit of resources and 40 units of Cloth with 1 unit of resources. The UK can produce 20 units of Wine with 1 unit of resources and 10 units of Cloth with 1 unit of resources. Using this information, the following questions are addressed:

Who has an absolute advantage in the production of Wine? Cloth?

Absolute advantage refers to the ability of a country to produce more of a good with the same amount of resources. In this case, the US can produce 40 units of Wine per resource unit, while the UK can produce only 20 units. Therefore, the US has an absolute advantage in wine production. Similarly, for cloth, the US can produce 40 units per resource, whereas the UK can produce only 10 units per resource, indicating the US also has an absolute advantage in cloth production.

Who has a comparative advantage in the production of Wine? Cloth?

Comparative advantage is determined by opportunity costs. The opportunity cost of producing one unit of Wine in the US is 1 unit of cloth (since 40 units of each are produced with one resource), while in the UK, it is 0.5 units of Cloth (20 units of wine costs 10 units of cloth). Conversely, for cloth, the US foregoes 1 unit of wine to produce 1 unit of cloth, while the UK foregoes 2 units of wine for 1 unit of cloth. Hence, the UK has a comparative advantage in wine production due to lower opportunity cost, and the US has a comparative advantage in cloth production.

Given specialization, what is production before trade? After trade?

Before trade, each country produces both goods according to their own preferences and resources. After specialization based on comparative advantage, the US will specialize in producing both wine and cloth, maximizing efficiency, while the UK will also specialize accordingly. Assuming both countries produce only the goods in which they have comparative advantage, the US will produce 40 units of wine and 40 units of cloth. The UK will focus on wine or cloth depending on the trade agreement, but for simplicity, suppose the US specializes entirely in their advantageous goods, and the UK in theirs. After trade, the countries exchange goods to enjoy higher consumption levels. For instance, the US might export some of its surplus wine or cloth to the UK in exchange for goods the UK specializes in, leading to a more efficient allocation of resources overall.

What are the gains from trade?

The gains from trade arise because both countries can consume more of both goods than they could alone. By specializing according to comparative advantage, the US can export surplus wine or cloth to the UK in exchange for goods the UK produces efficiently. Both countries benefit from increased consumption possibilities, with a higher total utility derived from trade. The gains are quantifiable through the increase in total consumption beyond the pre-trade levels, demonstrating improved resource allocation and higher overall welfare.

What is the “range” of potential exchange rates between US and UK?

The range of potential exchange rates is bounded by the opportunity costs of production in each country. The lowest exchange rate must be above the opportunity cost of the UK in terms of wine (0.5 units of cloth per unit of wine), and the highest must be below the US's opportunity cost (1 unit of cloth per unit of wine). Specifically, the exchange rate of wine for cloth must lie between 0.5 and 1 units of cloth per unit of wine to incentivize beneficial trade and ensure both countries gain from specialization.

Suppose that in Japan, without a tariff 10,000 cars will be sold per year at an equilibrium price of $20,000. With a $5,000 tariff, supply decreases such that 8,000 cars are produced at $22,500 per car.

Graphically, the supply and demand diagram shows the initial equilibrium at $20,000 with 10,000 cars traded. After imposing the tariff, the supply curve shifts, resulting in a new equilibrium at a higher price of $22,500 and a reduced quantity of 8,000 cars. The supply decrease reflects reduced imports due to the tariff, and the higher price indicates consumers pay more.

Why is the increase in price less than the tariff?

The increase in price (from $20,000 to $22,500) is less than the full amount of the tariff ($5,000) because of the market's demand response and the partial absorption of the tariff by suppliers. Consumers reduce quantity demanded, and producers share the tariff cost, leading to a smaller price increase than the tariff amount.

Who bears the burden of the tariff?

The burden of the tariff is shared between consumers and producers. Consumers face higher prices and reduced consumption, while domestic producers may benefit from higher prices. However, the primary burden falls on consumers, as they pay more for imported cars, and some consumer surplus is lost.

What are government revenues from the tariff?

The government revenue from the tariff equals the tariff amount ($5,000) multiplied by the quantity of imported cars after the tariff (8,000). Thus, government revenue is $5,000 x 8,000 = $40 million.

What is the “dead-weight loss” associated with the tariff?

Dead-weight loss represents the lost gains from trade due to the reduction in quantity exchanged (from 10,000 to 8,000 cars). It includes lost consumer surplus and producer surplus not offset by tariff revenue. Graphically, dead-weight loss appears as the triangle between the supply and demand curves over the reduced quantity, indicating inefficiency introduced by the tariff.

Graphically explain the negative effects of quotas and subsidies. Label and explain results in detail.

Quotas restrict the quantity of imports, leading to higher prices and reduced consumer choice. They protect domestic industries but reduce overall welfare, creating dead-weight loss because the quantity traded decreases and consumers face higher prices. The domestic price rises to a level determined by the quota, and the quota rents are captured by foreign exporters or license holders, leading to rent-seeking behavior.

Subsidies, on the other hand, typically lower the domestic price of imports, encouraging higher consumption. While this benefits consumers, it distorts resource allocation and creates dead-weight loss as government expenditures increase without corresponding efficiency gains. Subventions can lead to overproduction or overconsumption of subsidized goods, resulting in economic inefficiencies and potential international trade disputes.

Overall, both policies affect market equilibrium by artificially shifting supply or demand, resulting in inefficiencies, welfare losses, and potential international tensions.

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