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ECON 4290 Midterm:

Course Code
ECON 4290
Xavier DeVassay
Study Guide

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Chapter 2
Commodity Trade
This chapter presents two models which stress international trade as the interaction
between consumers: the standard two-good model and the varieties model. We can think
of these models either as primitive worlds where no production takes place and nature
determines consumers' endowments, or else as descriptions of a time period so short that
firms cannot alter their production plans.
In the standard two-good model, countries trade, and consumers are thus better off, only
if autarky relative prices differ. Consumers' preferences and their endowments combine to
determine autarky prices. Generally, these prices will differ across countries if either or
both of the following hold: (i) preferences differ, and (ii) endowments differ.
In the varieties model, consumers like variety. If countries' endowments differ in the
varieties they contain, trade may occur even with identical relative prices. Trade makes
consumers better off by giving them a wider choice of varieties.
In autarky, a country's consumers trade with each other. While opening up to free
international trade benefits some of these consumers and harms others, it is not a zero-sum
game: As Section 2.4 shows, the winners gain enough that they could compensate the
losers and still be better off than they were before international trade. This is the
fundamental reason economists favor international trade. Of course, if no compensation
takes place, the case for free trade is weaker, as it then implies sacrificing some
individuals' welfare for others'. This problem is not unique to trade policy. Most public
policy changes imply winners and losers, and, in the absence of compensation, may be
hard to justify. For example, changes in monetary policy or government spending and
taxation affect individuals differently. The demand that losers be compensated is often
voiced much more loudly for changes in trade policy than it is for other public policy
changes. Changes in monetary policy, for example, may affect more people but rarely
ignite the sort of angry protests that occurred at the 1999 World Trade Organization
meetings in Seattle.
Although the chapter assumes that trade is balanced, that is, the value of exports equals
the value of imports, the insight that trade reflects differences in endowments and/or
preferences can be extended to trade over time. Thus a country wants to have a surplus
on the balance of trade, i.e. it wants the value of its exports to exceed the value of its
imports, if it desires to consume less today than it produces today in return for raising its
consumption in some future period.

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1. Which of the following statements is false?
(a) All budget lines are price lines.
(b) All price lines are budget lines.
2. Suppose the world market relative price of American-made IBM personal
computers, which are exported to the Netherlands, falls. The terms of trade of the
United States have
(a) improved.
(b) deteriorated (worsened).
(c) Both of the above.
(d) Neither of the above.
3. Sweden and Norway trade extensively with each other. If Sweden's terms of trade
with Norway improve, then Norway's terms of trade with Sweden must
(a) improve.
(b) deteriorate (worsen).
(c) Both of the above.
(d) Neither of the above.
4. Define
(a) a balance of trade surplus.
(b) a balance of trade deficit.
(c) balanced trade.
5. Define "an increase in real income."
6. True or false:
"The worst a country can do by opening up to trade is to remain at the autarky
level of utility."

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7. Consider two island nations that have agreed to use the French franc as their
common currency. Suppose that a bottle of red wine costs two francs on
Martinique and six francs on Corsica while a beret costs ten francs on Martinique
and twenty francs on Corsica.
(a) Will there be any trade?
(b) Find the set of possible world (relative) prices of berets.
(c) What will be the pattern of trade if the trade route is opened between
Corsica and Martinique?
8. In the following diagram an economy's endowment point is E and its initial
consumption point is F when the world terms of trade (the relative prices on the
world market) are given by line 1.
Suppose a change in world prices causes the budget line to change to line 2 and
that consumption is now at point F'.
(a) Has the relative price of food increased?
(b) Have this nation's terms of trade improved?
9. True or false: "A terms of trade improvement raises a country's real income."
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