Chapter 2 : solution

These questions are based on the Gravity Model of Trade, which

states:
T_{ij} = A \times \frac{Y_i \times Y_j}{D_{ij}}
where:
• T_{ij} = trade between countries i and j
• Y_i, Y_j = GDPs of the two countries
• D_{ij} = distance between them
• A = constant
1. Why do some countries trade less than the gravity model predicts?
The gravity model predicts that large and nearby countries should
trade heavily. However, some countries trade less than expected
because of barriers other than distance.
Exampls
India and Pakistan
• Geographically very close.
• Large populations and significant markets.
• Gravity model predicts high trade.
• Actual trade is low because of political tensions, wars, and
trade restrictions.
United States and Cuba
• Close geographically.
• Trade remained very low for decades because of economic
sanctions and political conflict.
Reasons for the anomaly
1. Political conflicts and diplomatic tensions.
2. Trade barriers (tariffs, quotas, sanctions).
3. Different legal and economic systems.
4. Poor transportation and infrastructure.
5. Cultural and language differences.
Conclusion: Distance and GDP are not the only determinants of trade;
political and institutional factors can greatly reduce trade.
2. Why do Ireland and Belgium trade heavily with the United States
despite being EU members?
According to the gravity model, Ireland and Belgium should trade
more with nearby EU countries than with the distant United States.
Explanation
The gravity model also considers economic size (GDP).
• The United States has one of the largest GDPs in the world.
• Many American multinational corporations operate in
Ireland and Belgium.
• Strong historical, linguistic, and investment ties exist,
especially between Ireland and the U.S.
Ireland
• Large presence of U.S. firms such as technology and
pharmaceutical companies.
• English language reduces transaction costs.
• Many exports and imports are linked to U.S. multinational
production networks.
Belgium
• Acts as a major European distribution hub.
• Strong investment and business links with U.S. companies.
Conclusion
Although distance reduces trade, the huge size of the U.S. economy
and strong business connections more than compensate, leading to
greater trade than the simple distance factor would predict.
3. If every country’s GDP doubled, would world trade quadruple?
No.
The gravity model says trade between any two countries is
proportional to the product of their GDPs.
Suppose:
T = A \times \frac{Y_iY_j}{D}
If each GDP doubles:
T’ = A \times \frac{(2Y_i)(2Y_j)}{D}
T’ = 4T
Thus, trade between each pair of countries quadruples.
However:
• World GDP also doubles.
• The gravity model is a partial relationship and does not
imply unlimited growth in trade.
• In theory, under the model, total world trade would be
four times larger, but in reality production capacity, consumption
patterns, and other constraints would prevent a perfect quadrupling.
Answer: According to the gravity model alone, world trade would
quadruple. In reality, it would likely increase by less than four times.
4. Why has intra–East Asian trade grown so rapidly?
The gravity model predicts stronger trade when economies become
larger.
What happened?
Countries such as:
• China
• South Korea
• Japan
• Vietnam
experienced rapid economic growth.
Gravity-model explanation
1. GDPs increased
• Larger economies produce and consume more.
• Trade among them rises.
2. Countries are geographically close
• Short distances reduce transportation costs.
• Nearby countries trade more intensively.
3. Regional production networks developed
• Parts and components move across borders before final
assembly.
• This increases trade within the region.
Conclusion
As East Asian economies became larger while remaining
geographically close, the gravity model predicts both:
• a larger share of world trade, and
• a larger share of trade with each other.
This is exactly what occurred.
5. Why did Britain’s imports shift from distant countries to nearby
European countries?
A century ago, trade mainly consisted of:
• Raw materials
• Agricultural products
• Minerals
These goods could bear high transportation costs because they were
imported from regions with strong natural-resource advantages, such
as:
• Canada
• Argentina
• India
Today
World trade is dominated by:
•Manufactured goods
Intermediate inputs
Components used in production
These goods often require:
• Fast delivery
 • Frequent shipments
• Close supplier relationships
Gravity-model explanation
Distance matters more for such trade because firms benefit from
being near suppliers and customers.
As a result, Britain increasingly imports from nearby European
countries such as:
• Germany
• France
• Netherlands
Conclusion
The shift reflects the changing composition of trade—from raw
materials sourced globally to manufactured and intermediate goods
traded mainly among nearby economies. This is fully consistent with
the gravity model’s prediction that distance reduces trade.
Short Exam Answers
1. Countries may trade less than predicted because of
political conflicts, trade barriers, sanctions, cultural differences, and
weak infrastructure (e.g., India–Pakistan, U.S.–Cuba).
2. Ireland and Belgium trade heavily with the U.S. because
the U.S. has a very large GDP and strong multinational business links,
offsetting the disadvantage of distance.
3. According to the gravity model, if every country’s GDP
doubled, trade between every pair of countries would quadruple;
therefore world trade would also quadruple in theory.
 4. East Asian economies grew rapidly and are geographically
close. Higher GDPs and short distances increased intra-regional trade
as predicted by the gravity model.
5. Britain now imports more from Europe because modern
trade consists mainly of manufactured and intermediate goods that
benefit from proximity, unlike the raw-material trade of a century
ago.

Chapter 8 : Solution
1.
Firms cannot set Price = Marginal Cost with internal economies of
scale because they must also cover large fixed costs. If P = MC, they
would make losses.
2.
Using the chapter’s model:
•Total market = 1 + 1.5 + 2 + 1 = 5.5 million cars
•Number of firms increases.
•Output per firm increases.
•Price fa
(Exact numerical answer depends on the formulas and parameters
given on pages 208–212.)
3.
(a
Equilibrium number of firms:
n=\sqrt{\frac{S}{F \times b}}
• U.S.: 10 firms
 • Europe: 13 firms
(b)
Equilibrium prices:
P=c+\frac{1}{bn}
• U.S.: $40,000
• Europe: $35,385
(c)
After free trade:
• Combined market = 833 million consumers
• Number of firms ≈ 18 firms
• New price ≈ $31,111
(d)
Prices fall because the larger market allows firms to produce more
and exploit economies of scale. Consumers benefit from:
• Lower prices
• More variety
• Greater competition
4
(a)
Yes. More productive and larger firms are more likely to adopt the
technology because they can spread the extra fixed cost over more
output.
(b)
Exporting firms are more likely to adopt the technology because they
sell more output and gain more from lower marginal costs.
5.
(a)
More firms in a market mean stronger competition and lower export
prices, increasing the likelihood of dumping accusations.
(b)
A firm from a small country exporting to a large country is more likely
to be accused of dumping because competition is stronger in the
larger market.
6.
(a)
Yes, FDI (if ownership stake gives significant control).
(b)
No, portfolio/foreign exchange transaction.
(c)
No, domestic acquisition, not foreign investment.
(d)
Yes, FDI.
7.
(a)
Vodafone in Romania:
• Horizontal FDI
• U.K. outflow
 • Romania inflow
(b)
General Electric buying Alstom assets:
• Horizontal FDI
• U.S. inflow and outflow
(c)
Exxon in Belgium:
• Vertical FDI
• U.S. outflow
• Belgium inflow
(d)
Petro China in Australia:
• Vertical FDI
• China outflow
• Australia inflow
8.
A firm may produce in multiple facilities to:
• Reduce transport costs
• Serve local markets faster
• Avoid tariffs
• Reduce supply-chain risks
9.
Apparel and footwear firms outsource because production is labor-
intensive and easy to contract out. Capital-intensive industries often
integrate suppliers because production requires specialized assets,
technology, and coordination.
10.
A greater share of intra-firm trade occurs in capital-intensive
industries because firms are more likely to own and control their
foreign suppliers. Apparel and footwear industries have less intra-firm
trade because production is usually outsourced.

Chapter 9 : Solution
1. Home Import Demand
Demand:
D = 50 - 10P
Supply:
S = 10 + 10P
Import Demand:
MD = D-S
MD = (50-10P)-(10+10P)
MD = 40-20P
Autarky (no trade):
50-10P = 10+10P
P=2
Answer:
• Import demand: MD = 40 − 20P
• No-trade price: P = 2
2.
(a) Foreign Export Supply
Demand:
D^*=60-10P
Supply:
S^*=20+10P
Export Supply:
XS=S^-D^
XS=(20+10P)-(60-10P)
XS=20P-40
Autarky:
60-10P=20+10P
P=2
Answer:
• Export supply: XS = 20P − 40
• No-trade price: P = 2
(b) Free Trade Equilibrium
Set MD = XS
40-20P=20P-40
P=2
Trade volume:
MD=40-20(2)=0
Answer:
• World price = 2
• Trade volume = 0
3. Tariff = 1.5
(a)
Since trade volume is already zero, tariff has:
• No price effect
• No quantity effect
• No trade effect

(b)
• Producers: No change
• Consumers: No change
 • Government: No revenue
(c)
• Terms-of-trade gain = 0
• Efficiency loss = 0
• Net welfare effect = 0
4. Small Foreign Country

Foreign:

D^*=8-2P
S^*=4+2P
Autarky:
P=1
Free trade price lies close to Home’s price.
With tariff:
• Home price rises by full tariff
• Foreign price unchanged
Key Result: Small countries cannot affect world prices.
5. Effective Rate of Protection (Bicycles)
Finished bicycle:
\$200
Components:
\$100
Value added:
200-100=100
Tariff:
50\%
New bicycle price:
300
New value added:
300-100=200
ERP:
\frac{200-100}{100}\times100
=100\%
Answer: 100%
6. Effective Protection on Candy Canes
Sugar = 65% of cost
Sugar price rises 25%
Cost increase:
0.65 \times 25\%
=16.25\%
Answer: Effective protection = −16.25%
(Negative protection)
7. Export Subsidy = 1.5
Effects:
• Foreign price rises
• Home price falls
Exports increase
Welfare:
Home
• Consumers gain
• Producers lose
• Net welfare gain
Foreign
• Producers gain
• Consumers lose
• Government pays subsidy
 • Net welfare loss
8.
(a)
False. Tariffs raise prices but do not necessarily create
high unemployment.
(b)
True. High tariffs and quotas can trigger retaliatory
trade wars.
(c)
False. Tariffs based on wage differences are inefficient
and reduce consumer welfare.
9. Import Quota
World Price:
P=20
Demand:
D=700-10(20)=500
Supply:
S=200+5(20)=300

Imports:
500-300=200
Quota = 50
Domestic price:
700-10P=(200+5P)+50
450=15P
P=30
Answers
(a) Price rises from 20 to 30
(b) Quota rents:
(30-20)\times50
=500
(c) Consumption distortion:
\frac12(100)(10)
=500
(d) Production distortion:
\frac12(50)(10)
=250
10.
Countries may use nontariff barriers because they:
 • Restrict trade more directly
• Protect sensitive industries
• Bypass tariff agreements
• Control product standards and safety
11.
A tariff on manufactured goods:
• Raises manufacturing wages
• Helps manufacturing workers
• Hurts consumers through higher prices
• Makes income distribution more equal if
manufacturing workers are lower paid initially.
Chapter 10 : Solution
1. Arguments for Free Trade
• Efficiency: Prices reflect real costs.
• Larger market: Access beyond the domestic
market.
• Entrepreneurship: More business
opportunities.
• Better politics: Less lobbying, corruption, and
special-interest influence.
2. Valid or Not?
(a)
❌ Not valid – Low incomes for dairy producers alone do
not justify tariffs.
(b)
❌ Not valid – Higher prices for certified foods are not a
reason for trade protection.
(c)
✅ Potentially valid – Export growth can create benefits
throughout the supply chain.
(d)
✅ Potentially valid – May support an infant-industry or
environmental argument.
(e)
❌ Not valid – Job losses alone do not justify protection.
3.
(a) Tariff = 10
• Welfare gain from extra production:
15 \times 100 = 1500
• Deadweight loss:
\frac{1}{2}(10)(100)=500
Net welfare gain = 1000
(b) Production Subsidy = 10
Social benefit:
1500
Subsidy cost:
1000
Net welfare gain = 500
(c)
Production subsidy is better because it encourages
production without reducing consumption.
(d)
Optimal subsidy = 15 (equal to marginal social benefit).
4.
Tariff = 10
Producer gains are weighted 5 times more heavily.
• Producer gain receives extra weight.
• Government may view tariff positively even if
national welfare falls.
Result: Tariff may appear beneficial politically despite
economic inefficiency.
5. Trade Creation or Diversion
(a) X = 50%, Y = €18,000
Japanese cost after tariff:
18,000(1.5)=27,000
Poland = €20,000
✅ Trade Creation
(b) X = 100%, Y = €18,000
Japanese cost after tariff:
36,000
Poland = €20,000
✅ Trade Creation
(c) X = 100%, Y = €12,000
Japanese cost after tariff:
24,000
Poland = €20,000
❌ Trade Diversion
6. China Aluminum Subsidies
Economics
• Subsidies increase output.
• Lower world prices.
• Benefit consumers but hurt foreign producers.
Political Economy
• Domestic industries lobby for protection.
• Governments respond to pressure from
affected workers and firms.
7. Optimal Tariff Argument
A large country can reduce foreign export prices by
imposing a tariff, improving its terms of trade and
potentially increasing national welfare.
8. Trade Warfare and Prisoner’s Dilemma
• If governments maximize national welfare,
trade war can still occur.
• Each country may choose protection to gain
individually.
• Mutual free trade usually gives the best overall
outcome.
• Protectionism may still be chosen if countries
act independently.
9. Norway’s Policy
• Protects rural employment and small farms.
• Helps domestic producers.
• Raises costs for consumers.
• Acts as a non-tariff trade barrier.
• Economically inefficient but politically popular.
Chapter 11 : Solution
1. Countries that benefited most from trade
• Examples: South Korea, China, Singapore,
Taiwan.
• Common policies:
• Export-oriented growth
• Openness to trade
• Investment in education and infrastructure
• Their success generally supports open trade
more than the infant industry argument.
2. Why economists criticize the infant industry
argument
• Governments may protect the wrong
industries.
 • Protection can continue too long.
• Industries may never become competitive.
Asian controversy
• Some Asian countries used temporary
protection successfully.
• Others succeeded mainly because of export
promotion and competition.
• Therefore, economists disagree on how
important protection really was.
3.
(a)
Infant industry protection is justified if:
• Future production costs become lower than
import costs.
• Long-term benefits exceed short-term losses
during the shakedown period.
(b)
Country B has the stronger argument.
Reason:
• Future domestic cost = $20,000, lower than
import cost $25,000.
 • Country A’s future cost equals import cost, so
protection gives little benefit.
4. Why South Korea, China, and India followed different
paths
• Different government policies.
• Different degrees of openness to trade.
• Different economic reforms and investment
strategies.
South Korea: Export-oriented growth.
China: Market reforms and trade liberalization.
India: More gradual reforms and liberalization.
5. Why import-substituting industrialization (ISI)
declined
• Protected industries became inefficient.
• Lack of international competition.
• High prices for consumers.
• Slow economic growth.
• Export-oriented economies achieved better
results.
Chapter 12 : Solution
1.
Disadvantages of strategic trade policy:
• Difficult to identify winning industries.
• Risk of government failure.
• Retaliation by other countries.
• High cost to taxpayers.
2.
No. Future growth alone does not guarantee
government support will be successful. The industry
should have a clear competitive advantage and positive
spillovers.
3.
Critics argue that:
• Basic research has uncertain commercial
benefits.
• Applied research creates direct competitive
advantages and marketable products.
4.
Key assumptions:
• Few firms (oligopoly).
 • High profits available.
• Government can target the right firm.
• Foreign governments do not retaliate.
5.
No, it is not an export subsidy.
• It is a quality certification.
• Consumers may benefit through better quality
and safer products.
6.
Main criticism:
• WTO may prioritize trade over environmental
protection.
WTO’s position:
• Environmental measures are allowed if they
are not disguised trade barriers.
7.
French cultural policies can be seen as strategic trade
policy because they:
• Support domestic cultural industries.
 • Increase international demand for French
products and services.
8.
Why defenders say carbon tariffs are legal:
• They treat imports similarly to domestic
carbon taxes.
Objections:
• Difficult to measure carbon content.
• Could be used as hidden protectionism.
9.
No, it is not a contradiction.
• Trade models focus on the economy as a
whole.
• Autor et al. show that some local communities
suffer long-term job losses even when the overall
economy gains.