Prof. Bryan Caplan

bcaplan@gmu.edu

http://www.gmu.edu/departments/economics/bcaplan

Econ 311

Fall, 1999

1. Crusoe and Friday can both work 10 hours per day producing fish, huts, or both. The table below describes what an hour of their time can produce:
2.  Fish Huts Crusoe 100 .25 Friday 30 .2

A. Who has an absolute advantage in fish? In huts?

Crusoe in both: 100>30, .25>.2.

B. Who has a comparative advantage in fish? In huts?

Crusoe in fish, because 100/.25>30/.2/ Friday in huts, because .25/100<.2/30.

C. Suppose Crusoe and Friday initially refuse to trade. Each spends half of his time producing fish, and the other half producing huts. How much does Crusoe produce in a day? Friday? What is the total quantity of fish and huts produced?

Crusoe produces 500 fish and 1.25 huts per day; Friday produces 150 fish and 1 hut per day. Total production: 650 fish, 2.25 huts.

D. Now suppose Crusoe and Friday trade: Friday produces huts all day long, while Crusoe spends 7 hours/day fishing and the rest building huts. What is their total production now? How is that possible?

Crusoe now produces 700 fish and .75 huts per day; Friday produces 0 fish and 2 huts per day. Total production: 700 fish and 2.75 huts - more in BOTH! This is possible because each specialized in his comparative advantage.

3. Britain and France both have 10 million full-time workers, who produce either cotton or wheat. A full-time worker can produce the following in a year:
4.  Cotton Wheat Britain 2 1 France 1 2

A. Who has an absolute advantage in cotton? In wheat?

Britain has an absolute advantage in cotton, France in wheat.

B. Who has a comparative advantage in cotton? In wheat?

Britain in cotton, because 2/1>1/2. France in wheat, because 1/2<2/1.

C. Suppose Britain and France initially refuse to trade. Half of each countries workers produce each good. How much does Britain produce in a year? France? What is the total quantity of cotton and wheat produced?

[Note - I accidentally wrote "day" on the original hw. If you have my answer divided by 365, that's fine!]

Britain produces 5,000,000 units of cotton, and 2,500,000 units of wheat; France produces 2,500,000 units of cotton, and 5,000,000 of wheat. Total production: 7,500,000 of each.

D. Now suppose Britain and France trade. Use one example to show how total production can increase.

Just suppose Britain produces only cotton and France produces only wheat. Then the British produce 0 units of wheat and 10,000,000 of cotton, while France produces 0 units of cotton and 10,000,000 units of wheat. Total production grows to 10,000,000 each!

5. Suppose people are exchanging American dollars for Italian lira. Draw a S&D diagram showing the effect of each of the following from BOTH the U.S. and Italian viewpoints. Then state which currency appreciates, and which depreciates.
1. An increase in the U.S. money supply.
2. From the U.S. viewpoint: the D for lira increases; from the Italian viewpoint, the S of dollars increases. The lira appreciates, the dollar depreciates.

3. A decrease in the Italian money supply.
4.

From the U.S. viewpoint: the S of lira decreases; from the Italian viewpoint, the D for dollars decreases. The lira appreciates, the dollar depreciates.

5. An increase in the popularity in the U.S. of vacations in Sicily.
6. From the U.S. viewpoint: the D for lira increases; from the Italian viewpoint, the S of dollars increases. The lira appreciates, the dollar depreciates.

7. Rumors that the Italian central bank will adopt more expansionary policies.

From the U.S. viewpoint: the S of lira increases; from the Italian viewpoint, the D for dollars increases. The lira depreciates, the dollar appreciates.

6. Suppose the U.S. price of 1 MB of RAM is \$1, the French price is 3 francs, and the price of 1 franc is .\$60. Carefully describe how you could profit from this situation if there were no transportation costs and no taxes.
7. Suppose I start with \$100. Then I would buy 100 MB of RAM, go to France, sell it for 300 francs, sell the francs for \$180 dollars, and then go home \$80 richer.

8. Using the terminology of "Current Accounts" and "Capital Accounts," explain why:
1. Japan's high savings rates lead to trade deficits with the U.S.
2. Japan's high savings rates mean that Japanese want to consume a smaller fraction of what they produce than Americans. They buy a lot of U.S. assets with what they have left. The opposite holds for Americans: they consume a high fraction of what they produce, and thus spend relatively little on Japanese assets. The U.S. Current Account deficit with Japan thus reflects the fact that Americans are buying more current output from Japan than Japan buys from the U.S. The flip side of this is a Capital Account surplus - the Japanese buy more U.S. assets than Americans buy in Japanese assets.

3. France had a trade deficit with the U.S. after World War II.
4. France was producing relatively little, but people in France were willing to borrow from the U.S. to get through this temporary crisis. Thus, the French were consuming a lot of U.S. output but Americans were consuming little French output (of which there was relatively little), implying a Current Account deficit of the French with the Americans. This was possible because Americans acquired French assets in exchange - the Capital Account surplus balanced the Current Account deficit.

5. Russian had a trade deficit with the U.S. as confidence in the ruble deteriorated.

Russians wanted to get hold of dollars to insulate themselves from the falling value of the ruble. Thus, they wanted to acquire U.S. assets (dollars). To get them, they exported current Russian output without buying much American output. Thus, Americans bought more of Russian output than Russians bought of American output, implying a Current Account deficit for the U.S. with Russia (equivalently, a Current Account surplus for Russia with the U.S.). This was possible because of the Capital Account surplus of the U.S. with Russia (Russians were acquiring more in U.S. assets than Americans were acquiring in Russian assets).

9. Apply one of the fallacies about international trade that Bastiat discusses to one contemporary issue. Be careful to state the specific fallacy Bastiat critiques.
10. Bastiat, in "Equalizing the Conditions of Production," explains that many people believe that international trade is only beneficial if countries compete under "equal conditions." This is a simple fallacy, he explains, because trade is only beneficial if countries are in some way UNEQUAL. There are gains to trade precisely because countries have different abilities and conditions that make each relatively better in some tasks.

This is exactly parallel to the contemporary debate about "globalization," especially the push to apply Western labor market regulations to poorer countries. One of the main reasons for trade between rich and poor countries is precisely that poor countries have abundant, but unskilled labor, which gives them a comparative advantage in certain kinds of manufacturing. Eliminate those differences entirely and the whole point of international trade disappears.

11. Read the attached speech by Franklin Roosevelt, "Government and Modern Capitalism." Pick ONE economic confusion from the text to critique. Then, in less than 1 page, double-spaced:
1. Quote the exact passage you want to critique.
2. "Also, billions of dollars of invested capital have today a greater security of present and future earning power than before. This is because of the establishment of fair, competitive standards and because of relief from unfair competition in wage cutting which of course depressing markets and destroys purchasing power." (p.57)

3. Explain the economic fallacy or confusion implied or stated in the text.
4. One of the implied fallacies is that wage cutting "depresses" markets. Actually, wage cutting is the market's way of eliminating depressions and unemployment. If there is a surplus of labor, wages need to fall to restore full employment.

(Another fallacy here is that purchasing power falls when wages fall. Profits are income for employers, just as wages are income for workers; overall purchasing power doesn't fall merely because wages fall. Moreover, if the quantity of labor employed rises enough, then LABOR income can rise even when wages fall!)

5. Describe the probable consequences of using this fallacy to formulate economic policy.

Simple: Instead of eliminating unemployment, "high-wage" policies perpetuate it. By keeping wages from falling, the government ensures that a surplus of labor will persist.