PS 124A Midterm, Fall 2013

PS 124A Midterm, Fall 2013 Choose the best answer and fill in the appropriate bubble. Each question is worth 4 points. 1. The dominant economic power in the first Age of Globalization was a. Rome b. Spain c. France d. Britain e. The United States 2. Pareto optimal means a. neither player has an incentive to change strategies unilaterally. b. no single actor can be made better off without at the same time making another actor worse off c. it is possible for at least one actor to improve its position without any other actor being made worse off d. it is possible for at least one actor to improve its position by changing strategies unilaterally e. each actor has the maximum possible payoff in the game 3. Tit- for- tat is an example of a. Third party enforcement b. Reciprocity strategy c. Prisoner s dilemma d. Pareto improvement e. Enforcement problem 4. Which of the following strengthens a group s ability to solve the collective action problem? a. Large group of members b. Small group of members c. Members have a viable exit option d. A and C e. B and C 5. In theory, countries with a majoritarian electoral system, compared to countries with proportional representation (PR) electoral systems, are predicted to a. Have higher tariffs, because political parties will appeal to large groups such as labor b. Have lower tariffs, because political parties will appeal to large groups such as consumers c. Have higher tariffs, because interest groups such as sugar growers or textile workers will capture legislators and press for protection d. Have lower tariffs, because interest groups such as automobile manufacturers or corn farmers will capture legislators and press for access to foreign markets e. Have higher tariffs, because political parties will appeal to large groups such as farmers 6. The logic of the collective action problem helps us understand why a. Consumers rather than producers dominate trade politics b. Trade politics tend to favor liberalization

c. Governments tend to liberalize trade unilaterally d. Governments rarely liberalize trade unilaterally e. Public radio is so successful in fundraising drives 7. China is labor abundant relative to the US and the US is capital abundant relative to China. Assume that labor is mobile between industries but capital is not. According to Ricardo- Viner, when China began to trade more intensively with the United States, this would likely lead to: a. Lower real wages for labor in the US. b. Lower real wages for workers in the US who spend a large share of their budget on imported goods c. Lower real wages for workers in the US who spend a large share of their budget on exported goods (i.e., goods made in the US for export) d. Higher real wages for workers in the US who spend a large share of their budget on exported goods (i.e., goods made in the US for export) e. Higher real wages in the US for workers in the export- oriented industry 8. Which of the following are true, according to Oatley? a. The society- based approach assumes that protectionism reduces social welfare and that national policy reflects the balance of power between competing interest groups b. The society- based approach assumes that under certain conditions trade protection can raise social welfare and that national policy reflects the balance of power between competing interest groups c. The society- based approach assumes that protectionism reduces social welfare and that national policy reflects the goals of national policy makers d. The state- based approach assumes that protectionism reduces social welfare and that national policy reflects the goals of national policy makers e. The state- based approach assumes that under certain conditions trade protection can raise social welfare and that national policy reflects the balance of power between competing interest groups 9. Which of the following occurred as a result of ISI policies (according to Oatley)? a. Many developing countries in Africa, Asia, and Latin America had high rates of industrialization and economic growth in the 1960s and 1970s b. By the late 1970s, unprofitable state- owned enterprises were creating significant deficits in government budgets in developing countries c. A rise in imports and fall in exports led to increased trade deficits. d. B and C e. A, B and C 10. According to Rodrik, the lessons from East Asian countries including China include: a. Globalization and diversification are not necessary for long- term dramatic economic growth b. Intensively implemented neoliberal reform is the surest opportunity for dramatic economic reform c. Selectively applying tariffs, import quotas, and price controls can be compatible with or even facilitate long- term economic growth d. Successful long- term economic growth is generally promoted when markets and private incentives play a large role in the economy e. C and D

Answer 2 of the following 3 questions. Each question is worth 30 points, 10 points per sub- question. 1. Hogwarts & Muggles In the community of Hogwarts, there are 10 Wizards. In a month, one Wizard can make 10 brooms, or 30 cloaks. In the city of Muggleville, there are 100 Muggles. In a month, one Muggle can make 2 brooms, or 1 cloak. A. Draw the monthly production possibility frontier (PPF) for Hogwarts and for Muggleville if there is no trade between the two. Include how much each community could produce if it specialized in brooms or cloaks. What is the opportunity cost of brooms in terms of cloaks for each community? What is the opportunity cost of cloaks in terms of brooms for each community? Show your work. ANSWER: Wizards can make up to 100 brooms or 300 cloaks. Opportunity cost of 1 broom is 3 cloaks, opportunity cost of 1 cloak is 1/3 broom (in the time a wizard can make 1 broom he could make 3 cloaks). Muggles can make 200 brooms or 100 cloaks. Opportunity cost of 1 broom is ½ cloak, opportunity cost of 1 cloaks is 2 brooms (in the time one muggle could make 1 cloak he could make 2 brooms). For each country: +1 for correctly labeled axes, +1 for each correct intercept, +2 for correct opportunity cost(s) Hogwarts Muggles Cloaks 400 300 200 100 0 0 10 20 30 40 50 60 70 80 90 100 Cloaks 150 100 50 0 0 20 40 60 80 100 120 140 160 180 200 Brooms Brooms B. Assume that the Mayor of Muggleville is trying to decide if he wants Muggleville to trade with Hogwarts. As a benevolent leader, he wants to make the choice that will make his community best off, in the aggregate. Would you advise that he choose to trade, or not to trade? Use the production possibility frontier to show your logic, and assume that brooms would trade for cloaks at the international price of one cloak per broom. Explain your logic, show your work. ANSWER: He should trade. He could increase the production possibility frontier substantially. Muggles have an absolute disadvantage at making brooms and cloaks, but they have a comparative advantage in making brooms (opportunity cost is ½ cloak, vs. 3 cloaks in Hogwarts). If they make brooms and trade for cloaks, they could have up to 200 cloaks, vs.

100 cloaks without trade. Or for any other mix of cloaks and brooms, they could have more with trade than without trade. +5 for saying he should trade, +5 for correct PPF with trade. Muggles with & without trade Cloaks 300 200 100 0 0 40 80 120 160 200 Brooms Without trade With trade C. Now assume that at the moment the Mayor is making his decision to trade or not, 40 of the Muggles are broom- makers and 60 are cloak- makers. The Wizards in Hogwarts can immediately switch between making brooms and cloaks, but it would take a full year for broom- making Muggles to learn to make cloaks, and a full year for cloak- making Muggles to learn to make brooms. The Mayor will be up for re- election in the next few months, and he wants to win. Should he choose to trade with Hogwarts, or not to trade? Explain your logic. Include in your discussion collective action costs and the role of the political system. If you need to make assumptions for your analysis, be clear about your assumptions. ANSWER: During the time that Muggles are adjusting to trade, the broom makers in Muggleville would be much better off with trade than without trade. They can make their 40 brooms, and trade for up 40 cloaks. Without trade, they would only be able to trade for 20 cloaks (1 cloak costs 2 brooms in Muggleville without trade). For any mix of brooms and cloaks, broom- makers could have more with trade than without trade. Therefore, broom- makers will support trade. But cloak- makers will oppose trade they are not yet able to switch to making brooms, and they will earn less for their cloaks (1 broom instead of 2 brooms). The policy preferences for the two groups is clear with regard to earnings. As for costs the only thing the cloak- makers can buy is brooms, and the cost of brooms goes up with trade, so they are worse off with respect to costs also. Less clear is who the mayor will listen to. If we assume that the election is democratic, and that collective action problems are not an issue, then the cloak- makers should be able to vote the mayor out if he chooses to trade, and they can replace him with a fellow cloak- maker, who can choose to end trade (or perhaps to tax broom- makers in exchange for free trade). If we assume that the election is less democratic (for example, if the election can be bought), then the broom- makers might be able to win. They can spend money earned from trade to buy the election. Or, if we assume that collective action costs are high for some reason, then the

broom- makers, who are a smaller group, might have an advantage in mobilizing votes for the mayor. +5 for identifying that the broom makers win from trade and will support trade, and that cloak makers lose from trade and will oppose trade, with some minimal amount of explanation. Take away 1 point if there is no explanation of the logic of why cloakmakers would oppose trade. +5 for having a clear argument about whether the mayor should support or oppose trade, based on his electoral outlook. For full credit, must be clear about assumptions regarding collective action problem costs, and about electoral rules (for example, majority rules, or wealthy voters can buy influence, or whatever). Partial credit if there is some good reasoning but not the whole thing. 2. Niger and Nigeria Niger and Nigeria are neighboring countries in Africa. Assume that they can only trade with each other, and the only products they can produce for trade are beef (which requires a lot of land and some labor) and transistor radios (which require a lot of capital and some labor). Assume Nigeria has a population of 200 million people, 50 million hectares of land suitable for raising cattle, and an average income level of $1500 per person. Assume Niger has a population of 20 million people, 20 million hectares of land suitable for raising cattle, and an average income level of $500 per person. A. Do you think Niger and Nigeria are likely to trade with each other or not? If they do trade, which countries do you think will export which products? Use the Heckscher- Ohlin model for your analysis. Explain your logic. ANSWER: Niger has one hectare of land per person vs. Nigeria has ¼ hectare of land per person. Niger has $500 per person vs. Nigeria has $1500 per person. Niger therefore is land abundant relative to Nigeria, and Nigeria is capital abundant relative to Niger. The H- O model says that countries will export products that intensively use their relatively abundant factors. Niger should therefore export land- intensive goods (i.e., beef) and Nigeria should export capital- intensive goods (i.e., transistor radios). +3 for saying they would trade. +4 for getting direction of exports correct. +3 for explaining Hechscher- Ohlin logic (be generous/lenient). B. Based on the logic of structuralism and/or infant industry protection, which of these two countries do you think would be more likely to benefit from protectionist policies? What protectionist policies specifically might be beneficial? What are the dangers of those policies? Explain your logic.

ANSWER: Structuralists such as Prebisch and Singer argue that countries who export commodities tend to have declining terms of trade prices of commodities tend to fall and prices of manufactured goods tend to rise. Therefore, a country such as Niger exporting beef and importing radios might be better off using protectionist policies to encourage local production of radios. Similarly, the infant industry protection argument argues that countries who cannot produce manufactured goods at a competitive price in the short run might be able to obtain economies of scale or economies of experience and become competitive if they are given the chance, and this chance might be obtained if there are protectionist policies. Niger is therefore more likely to benefit from protectionist policies than Nigeria. One policy that might be beneficial is tariffs on radios. This would raise price of radios from Nigeria, which would enable Niger radio makers to compete. However, in the meantime, this would cause a deadweight loss for Niger, because the extra cost to consumers would exceed the extra revenues for radio makers. Also, if Niger radio makers are never competitive with Nigerian radio makers, they might lobby the government to keep those tariffs in place forever. Another policy that might be beneficial is subsidies for the radio industry This would help Niger radio makers overcome their competitive disadvantage. However, this would be a drain on government revenues, which would lead to higher taxes (or default). If the subsidies are paid for with export taxes on beef, this would result in less beef being produced, which would hurt GDP. Also the radio makers might lobby to keep those subsidies forever. Those are probably the most obvious policies. Another might be overvalued exchange rates to buy the materials necessary to make radios. That would likely lead to a trade deficit and lower income for beef growers. Another might be reduced interest rates for borrowers planning to start a radio factory, that would reduce willingness to save, which would reduce the ability to finance future investment. Another might be import quotas, to reduce how many radios come in from Nigeria. This would harm consumers in the short run, because it would also increase domestic prices, and might also lead to corruption as government officials sell import licenses to their supporters or cronies. +2 for identifying that Niger is more likely to benefit (or +3 if they said Nigeria would import radios in Part A, and now say Nigeria would benefit from protection). +3 for correctly explaining the logic of either structuralism or infant industry protection. (Give 2/3 if just say that structuralism says that the state needs to intervene for manufacturing to happen) +3 for a good ISI policy, including the logic of how it would help. +2 for correctly explaining the danger of the ISI policy, including the logic. C. Which segments of society in each country would be in favor of protectionist policies, and which would be in favor of free trade? Explain your logic. From the factor model the land owners in Niger would benefit from free trade, and the factory owners in Nigeria would benefit from free trade, because they would be able to charge

higher returns for the use of the factors they own. All consumers would benefit from free trade because prices would be lower, on average. Labor in Nigeria would also benefit from free trade, according to Rogowski s table (and because transistor radios require more labor than beef) but award full credit even if labor is not mentioned. From the specific factors model the radio making industry in Nigeria would benefit from trade and the beef industry would benefit in Niger, because the sector that intensively uses the comparatively abundant factor benefits from trade. The radio making industry in Niger would benefit from protection and the beef industry in Nigeria would benefit from protection. From Ricardo- Viner: neither of these goods are very labor intensive, so it s not super clear which country s labor would win or lose from trade (probably Nigeria s workers would benefit and Niger s would lose). Workers, if they are mobile, would generally benefit from trade due to lower prices (which increases their real income) unless they mostly consume the product that their country exports and not the product being imported. Government officials and their cronies might also benefit from protectionist policies in either country, because they can sell import licenses or otherwise benefit from intervention. +6 for correctly identifying winners AND losers in BOTH countries using any of the logics above. (subtract 3 points if they don t do one of the countries, and/or subtract 1 point if they don t do both winners and losers for one of the countries) +3 for correctly explaining the logic of the model they are using to identify winners/losers +1 for identifying government officials as a potential beneficiary from protectionist policies D. EXTRA CREDIT (5 points): Assume that each country s preferred policy is to protect its own import- competing sector and to gain access to the other country s import- competing sector. Draw each country s ideal point in a two- dimensional policy space and the status quo policy (in which each country has a tariff rate based on his preferred policy). Using circular indifference curves, identify the space that would enable a Pareto improvement through trade negotiation. ANSWER: The figure should look something like this, but with Niger and Nigeria markets on the axes. Or Niger s axis could be tariffs on radios, and Nigeria s axis could be tariffs on beef.

+ 1 for putting reasonable axes on the diagram. +1 for putting ideal points in reasonable positions and labeling +1 for putting status quo in reasonable position and labeling +1 for drawing circles with ideal point in middle and intersecting with SQ +1 for correctly identifying area with pareto improvement/joint gains 3. China and US The US can grow more rice than it can eat, and wants to export rice to China. China can make more shoes than it can wear, and wants to export shoes to the US. However, Chinese rice growers are politically powerful, and have convinced the government to impose tariffs on imported rice, and American shoe manufacturers are politically powerful, and have convinced the government to impose tariffs on imported shoes. Each government therefore receives the following payoffs under the following conditions: 10 if the country keeps its own high tariffs and the other country lowers its high tariffs 8 if both countries lower their high tariffs 6 if both countries maintain their high tariffs 4 if the country lowers its own high tariffs and the other country keeps its high tariffs A. Create a 2x2 table showing each government s decision (lower or keep its high tariffs) and the resulting payoffs. Then solve for the Nash Equilibria (there may be one or more

than one). For each Nash Equilibrium, is the outcome Pareto Efficient? Explain why or why not. What is the expected outcome(s)? China Lower high tariff Keep high tariff US Lower high tariff 8 8 4 10 Keep high tariff 10 4 6 6 ANSWER: The NE would be high tariff, high tariff, because each country would be better off with high tariff no matter what the other country does. This outcome is not PE because they would both be better off if they both had lower tariffs. The expected outcome is therefore high tariffs remain. +2 for putting numbers in correct cells +2 for correctly solving for the NE +2 for showing how they solved for NE (underlining/circling numbers is fine, or they can say that neither country will regret their decision, something like that) +2 for saying that NE is not Pareto Efficient (if they did numbers wrong, give credit if there answer is correct given the numbers they used) +2 for explaining Pareto efficient (can just say both would be better off if both chose lower tariff) B. Now assume that a third party enforcer is in the game. The third party enforcer will impose a penalty of 3 on any country that does not lower its tariffs. Draw a new 2x2 table with these new payoffs. Then solve for the Nash Equilibria (there may be one or more than one). For each Nash Equilibrium, is the outcome Pareto Efficient? Explain why or why not. What is the expected outcome(s)? China Lower high tariff Keep high tariff US Lower high tariff 8 8 4 7 Keep high tariff 7 4 3 3 ANSWER: The new NE would be Lower, Lower. This outcome is Pareto Efficient because neither can be made better off. The expected outcome would be trade liberalization. +2 for putting numbers in correct cells +2 for correctly solving for the NE +2 for showing how they solved for NE (underlining/circling numbers is fine, or they can say that neither country will regret their decision, something like that) +2 for saying that NE is Pareto Efficient (if they did numbers wrong, give credit if there answer is correct given the numbers they used) +2 for explaining Pareto efficient (can just say no way to make better off)

C. Is the third party enforcer in this game more similar to Britain in the late 1800s, or to the WTO in the late 1900s? Explain why. ANSWER: The third party enforcer in this game is more similar to the British hegemon in the late 1800s, who used gunships and so on to enforce free trade. The WTO does not impose penalties, it only authorizes member countries to raise retaliatory tariffs. +5 if say Britain +5 for explanation (partial credit if explanation is poor) (give small amount of partial credit, like maybe 3 points, if the answer is very good but says that it is more similar to WTO) D. EXTRA CREDIT (5 points): What would be another way to create a new Nash Equilibrium in the China- US game? What assumptions, and what type of institution, would be necessary for that method to succeed? Explain your logic and provide an example. ANSWER: Another way to create a new Nash Equilibtrium would be through repeated trade, and this could be facilitated with an organization such as the WTO. The WTO encourages repeated trade. For repeated trade to enable cooperation, it is necessary that the players use reciprocal strategies such as tit for tat, and the WTO facilitates that too. In this case, though, mutual protectionism would still be a NE. A game with new payoff isn t necessary, but something like this would be fine, where the +4 is future payoffs: China Lower high tariff Keep high tariff US Lower high tariff 8+4=12 8+4 =12 4 10 Keep high tariff 10 4 6 6 Another possible answer might be that the winners from trade could pay off the losers, like the rice buyers in China could pay the rice growers to accept free trade. But the challenge of that is political. How would the rice buyers be able to organize themselves to make that offer? For full credit, the answer would need to bring up that challenge. The whole reason producers have more influence is because they have lower collective action costs. Another possible answer might be something like changing the political system to empower consumers, maybe switch to PR system or reduce collective action problems. They will need to be very clear about their logic to get credit for an answer like that. The answer I have in mind is the WTO answer. +1 for saying repeated interaction +1 for including value the future

+1 for including reciprocity strategy such as tit for tat +1 for giving WTO as example +1 for explaining the logic and/or making an appropriate diagram