Principles of Economics - 3e Chapter 34 Globalization and Protectionism

Globalization and Pro FIGURE Flat Screen Competition The market for displays in the United States is huge . The manufacturers of flat screens in the United States must compete against manufacturers from around the world . Credit of by Creative Commons , BY ) CHAPTER OBJECTIVES In this chapter , you will learn about Protectionism An Indirect Subsidy from Consumers to Producers International Trade and Its Effects on Jobs , Wages , and Working Conditions Arguments in Support of Restricting Imports How Trade Policy Is Enacted Globally , Regionally , and Nationally The of Trade Policy Introduction to Globalization and Protectionism BRING IT HOME What the Downside of Protection ?

Governments are motivated to limit and alter market outcomes for political or social ends . While governments can limit the rise in prices of some products , they can not control how much people want to buy or how much firms are willing to sell . The laws of demand and supply still hold . Trade policy is an example where regulations can redirect economic forces , but it can not stop them from manifesting themselves elsewhere . displays , the displays for laptop computers , tablets , and flat screen televisions , are an example of such an enduring principle . In the early , the vast majority of displays used in laptops were imported , primarily from Japan . The small but politically powerful industry a

34 Globalization and Protectionism dumping complaint with the Commerce Department . They argued that Japanese were selling displays at less than fair value , which made it difficult for to compete . This argument for trade protection is referred to as . Other arguments for protection in this complaint included national security . After a preliminary determination by the Commerce Department that the Japanese were dumping , the International Trade Commission imposed a 63 dumping margin ( or tax ) on the import of displays . Was this a successful exercise of trade policy ?

See what you think after reading the chapter . The world has become more connected on multiple levels , especially economically . In 1970 , imports and exports made up 11 of , while now they make up 32 . However , the United States , due to its size , is less internationally connected than most countries . For example , according to the World Bank , 97 of economic activity is connected to trade . This chapter explores trade laws and strategies a country uses to regulate international trade . This topic is not without controversy . As the world has become more globally connected , and workers in countries like the United States , Japan , or the nations of the European Union , perceive a competitive threat from in income countries like Mexico , China , or South Africa , that have lower costs of living and therefore pay lower wages . Firms and workers in countries fear that they will suffer if they must compete against more productive workers and advanced technology in countries . On a different tack , some environmentalists worry that multinational may evade environmental protection laws by moving their production to countries with loose or nonexistent pollution standards , trading a clean environment . Some politicians worry that their country may become overly dependent on key imported products , like oil , which in a time of war could threaten national security . All of these fears governments to reach the same basic policy conclusion to protect national interests , whether businesses , jobs , or security , imports of foreign products should be restricted . This chapter analyzes such arguments . First , however , it is essential to learn a few key concepts and understand how the demand and supply model applies to international trade . Protectionism An Indirect Subsidy from Consumers to Producers LEARNING OBJECTIVES By the end of this section , you will be able to Explain protectionism and its three main forms Analyze protectionism through concepts of demand and supply , noting its effects on equilibrium Calculate the effects of trade barriers When a government policies to reduce or block international trade it is engaging in protectionism . Protectionist policies often seek to shield domestic producers and domestic workers from foreign competition . Protectionism takes three main forms tariffs , import quotas , and . Recall from International Trade that tariffs are taxes that governments impose on imported goods and services . This makes imports more expensive for consumers , discouraging imports . For example , in 2018 , President Trump increased tariffs on goods by , including , monitors , desktop , and many other consumer goods . The intention behind the policy was to shelter manufacturers from competition , helping companies that operate domestically . China responded with tariffs on American goods , launching a trade war . President retained these tariffs and considered additional ones , but as of August 2022 , the administration was considering changes designed to reduce . Another way to control trade is through import quotas , which are numerical limitations on the quantity of products that a country can import . For instance , during the early , the Reagan Administration imposed a quota on the import ofjapanese automobiles . In the , many developed countries , including the United States , found themselves with declining textile industries . Textile production does not require highly skilled Access for free at

Protectionism An Indirect Subsidy from Consumers to Producers 813 workers , so producers were able to set up factories in developing countries . In order to manage this loss ofjobs and income , the developed countries established an international Agreement that essentially divided the market for textile exports between importers and the remaining domestic producers . The agreement , which ran from 1974 to 2004 , the exact quota of textile imports that each developed country would accept from each country . A similar story exists for sugar imports into the United States , which are still governed by quotas . are all the other ways that a nation can draw up rules , regulations , inspections , and paperwork to make it more costly or to import products . A rule requiring certain safety standards can limit imports just as effectively as high tariffs or low import quotas , for instance . There are also nontariff barriers in the form of regulations these rules describe the Made in Country label as the one in which the last substantial change in the product took place . A manufacturer wishing to evade import restrictions may try to change the production process so that the last big change in the product happens in their own country . For example , certain textiles are made in the United States , shipped to other countries , combined with textiles made in those other countries to make then back to the States for a assembly , to escape paying tariffs or to obtain a Made in the USA label . Despite import quotas , tariffs , and , the share of apparel sold in the United States that is imported rose from about half in 1999 to about today . According to the Bureau of Labor Statistics ( estimated the number of jobs in textiles and apparel fell 44 from 2007 to 2014 , and will all by another 25 by 2024 . Even more textile would have been lost without tariffs . domestic jobs that are saved by import quotas come at a cost . Because textile and apparel adds to the costs of imports , consumers end up paying billions more for clothing each year . When the United States eliminates trade barriers in one area , consumers spend the money they save on that elsewhere in the economy . Thus , while eliminating trade barriers in one sector of the economy will result in some job loss in that sector , consumers will spend the resulting savings in other sectors of the economy and hence increase the number ofjobs in those other sectors . Of course , workers in some of the countries of the world who would otherwise have jobs producing textiles , would gain considerably if the United States reduced its barriers to trade in textiles . That said , there are good reasons to be wary about reducing barriers to trade . The 2012 and 2013 in textile factories , which resulted in a loss of life , present complications that our analysis in the chapter will not capture . Realizing the compromises between nations that come about due to trade policy , many countries came together in 1947 to form the General Agreement on Tariffs and Trade ( We cover the in more detail later in the chapter . This agreement has since been superseded by the World Trade Organization ( whose membership includes about 150 nations and most of the world economies . It is the primary international mechanism through which nations negotiate their trade rules about tariffs , quotas , and nontariff barriers . The next section examines the results of such protectionism and develops a simple model to show the impact of trade policy . Demand and Supply Analysis of Protectionism To the , restricting imports may appear to be nothing more than taking sales from foreign producers and giving them to domestic producers . Other factors are at work , however , because do not operate in a vacuum . Instead , sell their products either to consumers or to other ( if they are business suppliers ) who are also affected by the trade barriers . A demand and supply analysis of protectionism shows that it is notjust a matter of domestic gains and foreign losses , but a policy that imposes substantial domestic costs as well . Consider two countries , Brazil and the United States , who produce sugar . Each country has a domestic supply and demand for sugar , as Table details and Figure illustrates . In Brazil , without trade , the

34 Globalization and Protectionism equilibrium price of sugar is 12 cents per pound and the equilibrium output is 30 tons . When there is no trade in the United States , the equilibrium price of sugar is 24 cents per pound and the equilibrium quantity is 80 tons . We label these equilibrium points as point in each part of the . a a 25 Price with no trade . th I Price with free . la , 14 pa la 15 A free trade 12 i pro 10 Price with no 10 a trade . 05 05 a 202528303540 50 so 72 Quantity ( tons of sugar ) Quantity ( tons of sugar ) a ) Brazil ( The United States FIGURE The Sugar Trade between Brazil and the United States Before trade , the equilibrium price of sugar in Brazil is 12 cents a pound and it is 24 cents per pound in the United States . When trade is allowed , businesses will buy cheap sugar in Brazil and sell it in the United States . This will result in higher prices in Brazil and lower prices in the United States . Ignoring transaction costs , prices should converge to 16 cents per pound , with Brazil exporting 15 tons of sugar and the United States importing 15 tons of sugar . If trade is only partly open between the countries , it will lead to an outcome between the and possibilities . Price Brazil Quantity Brazil Quantity Quantity Quantity Supplied ( tons ) Demanded ( tons ) Supplied ( tons ) Demanded ( tons ) 20 35 60 100 cents 12 30 30 66 93 cents 14 35 28 69 90 cents 16 40 25 72 87 cents 20 45 21 76 83 cents 24 50 18 80 80 cents 28 55 15 82 78 cents TABLE The Sugar Trade between Brazil and the United States Access for free at

Protectionism An Indirect Subsidy from Consumers to Producers 815 If international trade between Brazil and the United States now becomes possible , will spot an opportunity buy sugar cheaply in Brazil , and sell it at a higher price in the United States . As sugar is shipped from Brazil to the United States , the quantity of sugar produced in Brazil will be greater than Brazilian consumption ( with the extra production exported ) and the amount produced in the United States will be less than the amount of US . consumption ( with the extra consumption imported ) Exports to the United States will reduce the sugar supply in Brazil , raising its price . Imports into the United States will increase the sugar supply , lowering its price . When the sugar price is the same in both countries , there is no incentive to trade further . As Figure 342 shows , the equilibrium with trade occurs at a price of 16 cents per pound . At that price , the sugar farmers supply a quantity of 40 tons , while the consumers buy only 25 tons . The extra 15 tons of sugar production , shown by the horizontal gap between the demand curve and the supply curve in Brazil , is exported to the United States . In the United States , at a price of 16 cents , the farmers produce a quantity of 72 tons and consumers demand a quantity of 87 tons . The excess demand of 15 tons by American consumers , shown by the horizontal gap between demand and domestic supply at the price of 16 cents , is supplied by imported sugar . Free trade typically results in income distribution effects , but the key is to recognize the overall gains from trade , as Figure shows . Building on the concepts that we outlined in Demand and Supply and Demand Supply and Efficiency in terms of consumer and producer surplus , Figure i ( a ) shows that producers in Brazil gain by selling more sugar at a higher price , while Figure ( shows consumers in the United States from the lower price and greater availability of sugar . Consumers in Brazil are worse off ( compare their consumer surplus with the consumer surplus ) and US . producers of sugar are worse off . There are gains from increase in social surplus in each country . That is , both the United States and Brazil are better off than they would be without trade . The following Clear It Up feature explains how trade policy can countries . Domestic . price with free made Price with Gains of trade , i ?

i . I Domestic I demand i . i I i I I Quantity ( tons of sugar ) Quantity ( tons of sugar ) a ) Brazil ( The United States FIGURE Free Trade of Sugar Free trade results in gains from trade . Total surplus increases in both countries , as the two areas show . However , there are clear income distribution effects . Producers gain in the exporting country , while consumers lose and in the importing country , consumers gain and producers lose . LINK IT Visit this website to read more about the global sugar trade .

34 Globalization and Protectionism CLEAR IT UP Why are there countries ?

Why are the poor countries of the world poor ?

There are a number of reasons , but one of them will surprise you the trade policies of the countries . Following is a stark review of social priorities which the international aid organization , International has widely publicized . countries of the the United States , countries of the European Union , and their domestic farmers collectively by about 200 billion per year . Why does this matter ?

It matters because the support of farmers in countries is devastating to the livelihoods of farmers in countries . Even when their climate and land are to products like cotton , rice , sugar , or milk , farmers in countries it difficult to compete . Farm subsidies in the countries cause farmers in those countries to increase the amount they produce . This increase in supply drives down world prices of farm products the costs of production . As Michael of the Washington it he effects in the regions of West Africa are dramatic . keep ing millions of Africans on the edge of malnutrition . In some of the poorest countries on Earth , cotton farmers are some of the poorest people , earning about a dollar a day . Who from the current system of subsidies ?

About American cotton producers , an average annual income of more than As if subsidies were not enough , often , the countries block agricultural exports from countries . In some cases , the situation gets even worse when the governments of countries , having bought and paid for an excess supply of farm products , give away those products in poor countries and drive local farmers out of altogether . For example , of excess milk from the European Union to Jamaica have caused great hardship for Jamaican dairy farmers . Shipments of excess rice from the United States to Haiti drove thousands of rice farmers in Haiti out of business . The opportunity costs of protectionism are not paid just by domestic consumers , bu also by foreign for many agricultural products , those foreign producers are the world poor . Now , lets look at what happens with protectionism . sugar farmers are likely to argue that , if only they could be protected from sugar imported from Brazil , the United States would have higher domestic sugar production , more jobs in the sugar industry , and American sugar farmers would receive a higher price . If the United States government sets a tariff on imported sugar , or sets an import quota at zero , the result will be that the quantity of sugar traded between countries could be reduced to zero , and the prices in each country will return to the levels before trade was allowed . Blocking only some trade is also possible . Suppose that the United States passed a sugar import quota of seven tons . The United States will import no more than seven tons of sugar , which means that Brazil can export no more than seven tons of sugar to the United States . As a result , the price of sugar in the United States will be 20 cents , which is the price where the quantity demanded is seven tons greater than the domestic quantity supplied . Conversely , can export only seven tons of sugar , then the price of sugar in Brazil will be 14 cents per pound , which is the price where the domestic quantity supplied in Brazil is seven tons greater than domestic demand . In general , when a country sets a low or medium tariff or import quota , the equilibrium price and quantity will be somewhere between those that prevail with no trade and those with completely free trade . The following Work It Out explores the impact of these trade barriers . Access for free at

Protectionism An Indirect Subsidy from Consumers to Producers Effects of Trade Barriers Let look carefully at the effects of tariffs or quotas . If the government imposes a tariff or quota sufficient to eliminate trade with Brazil , two things occur consumers pay a higher price and therefore buy a smaller quantity of sugar . producers obtain a higher price and they sell a larger quantity of sugar . We can measure the effects of a tariff on producers and consumers in the United States using two concepts that we developed in Demand Supply and Efficiency consumer surplus and producer surplus . Domestic supply Domestic supply imports FIGURE Sugar Supply and Demand When there is free trade , the equilibrium is at point A . When there is no trade , the equilibrium is at ep . Look at Figure , which shows a hypothetical version of the demand and supply of sugar in the United ates . ep . Note that when there is free trade the sugar market is in equilibrium at point A where Domestic Quantity Demanded ( Quantity Supplied ( Domestic Os Imports from Brazil ) at a price of . ep . Note , also , that imports are equal to the distance between points and . Graphically , it is the area under a demand curve but above the price . In this case , the consumer surplus ep . Recall that consumer surplus is the value that consumers get beyond what they paid for when they buy a in the United States is the area of the triangle formed by the points , A , and . ep . Recall , also , that producer surplus is another name for is the income producers get above the cost of production , which is shown by the supply curve here . In this case , the producer surplus with trade is the area of the triangle formed by the points , and ep . Suppose that the barriers to trade are imposed , imports are excluded , and the price rises to . Look what happens to producer surplus and consumer surplus . At the higher price , the domestic quantity supplied increases from Os to at point Because producers are selling more quantity at a higher price , the producer surplus increases to the area of the triangle , and Step . Compare the areas of the two triangles and you will see the increase in the producer surplus . Step . Examine the consumer surplus . Consumers are now paying a higher price to get a lower quantity ( instead of ) Their consumer surplus shrinks to the area of the triangle , and . Step . Determine the net effect . The producer surplus increases by the area , The loss of consumer surplus , however , is larger . It is the area , A , ade . In other words , consumers lose more 817

34 Globalization and Protectionism than producers gain as a result of the trade barriers and the United States has a lower social surplus . Who Benefits and Who Pays ?

Using the demand and supply model , consider the impact of protectionism on producers and consumers in each of the two countries . For protected producers like sugar farmers , restricting imports is clearly positive . Without a need to face imported products , these producers are able to sell more , at a higher price . For consumers in the country with the protected good , in this case sugar consumers , restricting imports is clearly negative . They end up buying a lower quantity of the good and paying a higher price for what they do buy , compared to the equilibrium price and quantity with trade . The following Clear It Up feature considers why a country might outsource jobs even for a domestic product . CLEAR IT UP Why are Life Savers , an American product , not made in America ?

In 1912 , Clarence Crane invented Life Savers , the hard candy with the hole in the middle , in Cleveland , Ohio . Starting in the late and for 35 years afterward , a plant in Holland , Michigan produced 46 billion Life Savers a year , in 200 million rolls . However , in 2002 , the Kraft Company announced that it would close the Michigan plant move Life Saver production across the border to Montreal , Canada . One reason is that Canadian workers are paid slightly less , especially in healthcare and insurance costs that are not linked to employment there . Another main reason is that the United States government keeps the sugar price high for he of sugar farmers , with a combination of a government price floor program and strict quotas on imported sugar . In recent years , the price of sugar has been about double the price of sugar produced by the res of the world . Life Saver production uses over 100 tons of sugar each day , because the candies are 95 sugar . A number of other candy companies have also reduced production and expanded foreign production . using industries have eliminated over jobs over the last 20 years , more than seven times the total em in sugar production . While the candy industry is especially affected by the cost of sugar , the costs are spread more broadly . consumers pay roughly billion per year in higher food prices because of elevated sugar costs . Meanwhile , sugar producers in countries are driven out of business . Because of the sugar subsidies to domestic producers and the quotas on imports , they can not sell their output , or at all , in the Uni ed States market . The fact that protectionism pushes up prices for consumers in the country enacting such protectionism is not always acknowledged openly , but it is not disputed . After all , if protectionism did not domestic producers , there would not be much point in enacting such policies in the place . Protectionism is simply a method of requiring consumers to subsidize producers . The subsidy is indirect , since consumers pay for it through higher prices , rather than a direct government subsidy paid with money collected from taxpayers . However , protectionism works like a subsidy , nonetheless . The American satirist Ambrose tariff this way in his 1911 book , The ' Dictionary . Tariff , A scale of taxes on imports , designed to protect the domestic producer against the greed of his The effect of protectionism on producers and consumers in the foreign country is complex . When a government uses an import quota to impose partial protectionism , Brazilian sugar producers receive a lower price for the sugar they sell in a higher price for the sugar they are allowed to export to the United States . Notice that some of the burden , paid by domestic consumers , ends up in the hands of foreign producers in this case . Brazilian sugar consumers seem to from protectionism , because it reduces the price of sugar that they pay ( compared to the situation ) On the other hand , at least some of these Brazilian sugar consumers also work as sugar farmers , so protectionism reduces their incomes Access for free at

International Trade and Its Effects on Jobs , Wages , and Working Conditions 819 . Moreover , if trade between the countries vanishes , Brazilian consumers would miss out on better prices for imported do not appear in our example of sugar protectionism . The effects of protectionism on foreign countries notwithstanding , protectionism requires domestic consumers of a product ( consumers may include either households or other ) to pay higher prices to domestic producers of that product . In addition , when a country enacts protectionism , it loses the economic gains it would have been able to achieve through a combination of comparative advantage , specialized learning , and economies of scale , concepts that we discuss in International Trade . International Trade and Its Effects on Jobs , Wages , and Working Conditions LEARNING OBJECTIVES By the end of this section , you will be able to Discuss how international trade the job market Analyze the opportunity cost of protectionism Explain how international trade impacts wages , labor standards , and working conditions In theory at least , imports might injure workers in several different ways , lower wages , or poor working conditions . Let consider these in turn . Fewer Jobs ?

In the early , the United States was negotiating the North American Free Trade Agreement ( with Mexico , an agreement that reduced tariffs , import quotas , and to trade between the United States , Mexico , and Canada . Ross , a 1992 candidate for president , claimed , in prominent campaign arguments , that if the United States expanded trade with Mexico , there would be a giant sucking sound as employers relocated to Mexico to take advantage of lower wages . After all , average wages in Mexico were , at that time , about of those in the United States . passed Congress , President Bill Clinton signed it into law , and it took effect in 1995 . For the next six years , the United States economy had some of the most growth and low unemployment in its history . Those who feared that open trade with Mexico would lead to a dramatic decrease in jobs were proven wrong . his result was no surprise to economists . After all , the trend toward globalization has been going on for decades , notjust since . reduced the number of available jobs , then the United States should have been seeing a steady loss ofjobs for decades . While the United States economy does experience rises and falls in unemployment rates , the number ofjobs is not falling over extended periods of time . The number of . jobs rose from 71 million in 1970 to 150 million in 2021 . certainly saves jobs in the industry being protected but , for two reasons , it costs jobs in other unprotected industries . First , if consumers are paying higher prices to the protected industry , they inevitably have less money to spend on goods from other industries , and are lost in those other industries . Second , if a firm sells the protected product to other , so that other must now pay a price for a key input , then those firms will lose sales to foreign producers who do not need to pay the price . Lost sales translate into lost jobs . The hidden opportunity cost of using protectionism to save jobs in one industry is jobs sacrificed in other industries . This is why the United States International Trade Commission , in its study of barriers to trade , predicts that reducing trade barriers would not lead to an overall oss ofjobs . Protectionism jobs from industries without import protections to industries that are from imports , but it does not create . Moreover , the costs of through protectionism can be very high . A number of different studies have attempted to estimate the cost to consumers in higher prices saved through protectionism . Table shows a sample of results , compiled by economists at the Federal Reserve Bank . Saving ajob through As of July , was replaced with the United ( free trade agreement . It is broadly similar to the original .

34 Globalization and Protectionism protectionism typically costs much more than the actual worker salary . For example , a study published in 2002 compiled evidence that using protectionism to save an average job in the textile and apparel industry would cost saved . In other words , those workers could have been paid per year to be unemployed and the cost would only be half ofwhat it is to keep them working in the textile and apparel industry . This result is not unique to textiles and apparel . Industry Protected with Import Tariffs or Quotas Annual Cost per Job Saved Sugar Polyethylene resins Dairy products Frozen concentrated orange juice Ball bearings Machine tools Women handbags Glassware Apparel and textiles Rubber footwear Women nonathletic footwear TABLE Cost to Consumers of Saving a Job through Protectionism ( Source Federal Reserve Bank of Dallas ) Why does it cost so much to through protectionism ?

The basic reason is that not all of the extra money that consumers pay because of tariffs or quotas goes to save jobs . For example , if the government imposes tariffs on steel imports so that steel buyers pay a higher price , steel companies earn greater , buy more equipment , pay bigger bonuses to managers , give pay raises to existing also avoid some additional workers . Only part of the higher price of protected steel goes toward . Also , when an industry is protected , the economy as a whole loses the of playing to its comparative other words , producing what it is best at . Therefore , part of the higher price that consumers pay for protected goods is lost economic , which we can measure as another deadweight loss , like what we discussed in Labor and Financial Markets . There a bumper sticker that speaks to the threat some US . workers feel from imported products Buy . Jobs . If an economist were driving the car , the sticker might declare Block Jobs for Some Americans , Lose Jobs for Other Americans , and Also Pay High Prices . Trade and Wages Even if trade does not reduce the number ofjobs , it could affect wages . Here , it is important to separate issues about the average level from issues about whether the wages of certain workers may be helped or hurt by trade . Because trade raises the amount that an economy can produce by letting and workers play to their comparative advantage , trade will also cause the average level of wages in an economy to rise . Workers who Access for free at

International Trade and Its Effects on Jobs , Wages , and Working Conditions 821 can produce more will be more desirable to employers , which will shift the demand for their labor out to the right , and increase wages in the labor market . By contrast , barriers to trade will reduce the average level of wages in an economy . However , even if trade increases the overall wage level , it will still some workers and hurt others . Workers in industries that are confronted by competition from imported products may that demand for their labor decreases and shifts back to the left , so that their wages decline with a rise in international trade . Conversely , workers in industries that from selling in global markets may that demand for their labor shifts out to the right , so that trade raises their wages . LINK IT UP View this website ( to read an article on the issues surrounding fair trade coffee . One concern is that while globalization may be , workers in the United States , it may also impose costs on , workers . After all , workers presumably from increased sales of sophisticated products like computers , machinery , and pharmaceuticals in which the United States has a comparative advantage . Meanwhile , workers must now compete against extremely workers worldwide for making simpler products like toys and clothing . As a result , the wages of workers are likely to fall . There are , however , a number of reasons to believe that while globalization has helped some industries and hurt others , it has not focused its negative impact on the wages of Americans . First , about half of trade is trade . That means the trades similar goods with other economies like Canada , Japan , Germany , and the United Kingdom . For instance , in 2014 the exported over million cars , from all the major automakers , and also imported several million cars from other countries . Most workers in these industries have skills and many of them do quite well in the world of globalization . Some evidence suggested that trade between similar countries had a small impact on domestic workers but later evidence indicates that it all depends on how the labor market is . In other words , the key is how workers are in in different industries . The effect of trade on workers depends considerably on the structure of labor markets and indirect effects felt in other parts of the economy . For example , in the United States and the United Kingdom , because labor market are low , the impact of trade on low income workers is small . Second , many workers hold service jobs that imports from countries can not replace . For example , we can not import lawn care services or moving and hauling services or hotel maids from countries long distances away like China or . Competition from imported products is not the primary determinant of their wages . Finally , while the focus of the discussion here is on wages , it is worth pointing out that workers suffer due to protectionism in all the those in which they do not work . For example , food and clothing are protected industries . These workers therefore pay higher prices for these basic necessities and as such their dollar stretches over fewer goods . The and costs of increased trade in terms of its effect on wages are not distributed evenly across the economy . However , the growth of international trade has helped to raise the productivity of workers as a thus helped to raise the average level of wages . Labor Standards and Working Conditions Workers in many countries around the world labor under conditions that would be illegal for a worker in the United States . Workers in countries like China , Thailand , Brazil , South Africa , and Poland are often paid less than the United States minimum wage . For example , in the United States , the national

34 Globalization and Protectionism minimum wage is per hour . A typical wage in many countries might be more like per day , or often much less . Moreover , working conditions in countries may be extremely unpleasant , or even unsafe . In the worst cases , production may involve the child labor or even workers who are mistreated , abused , or entrapped in theirjobs . These concerns over foreign labor standards do not affect most of trade , which is and carried out with other countries that have labor standards similar to the United States , but it is , nonetheless , morally and economically important . In thinking about labor standards in other countries , it is important to draw some distinctions between what is truly unacceptable and what is painful to think about . Most people , economists included , have little with the idea that production by in factories , by people who are abused or mistreated , or by slave labor is morally unacceptable . They would support aggressive efforts to eliminate such shutting out imported products made with such labor . Many cases , however , are less . An opinion article in the New York Times several years ago described the case of Ahmed , a boy from Pakistan . He earned per day working in a carpet factory . He dropped out of school in second grade . Should the United States and other countries refuse to purchase rugs made by Ahmed and his ?

If the carpet factories were to close , the likely alternative job for Ahmed is farm work , and as Ahmed says of his This makes much more money and is more Other workers may have even less attractive alternative jobs , perhaps scavenging garbage or prostitution . The real problem for Ahmed and many others in countries is not that globalization has made their lives worse , but rather that they have so few good life alternatives . The United States went through similar situations during the nineteenth and early twentieth centuries . In closing , there is some irony when the United States government or citizens take issue with labor standards in countries , because the United States is not a world leader in government laws to protect employees . According to a recent study by the Organization for Economic Cooperation and Development ( the is the only one countries that does not provide mandated paid leave for new parents , and among the 40 countries that do mandate paid leave , the minimum duration is about two months . Many European workers receive six weeks or more of paid vacation per year . In the United States , vacations are often one to three weeks per year . countries accused the United States unfair labor standards to make products cheaply , and announced that they would shut out all imports until the United States adopted paid parental leave , added more national holidays , and doubled vacation time , Americans would be outraged . Yet when start talking about restricting imports from poor countries because of low wage levels and poor working conditions , they are making a very similar argument . This is not to say that labor conditions in countries are not an important issue . They are . However , linking labor conditions in countries to trade the emphasis from the real question to ask What are acceptable and enforceable minimum labor standards and protections to have the world over ?

Arguments in Support of Restricting Imports LEARNING OBJECTIVES By the end of this section , you will be able to Explain and analyze various arguments that are in support of restricting imports , including the infant industry argument , the argument , the environmental protection argument , the unsafe consumer products argument , and the national interest argument Explain dumping and race to the bottom Evaluate the of countries perceptions on the benefits of growing trade As we previously noted , protectionism requires domestic consumers ofa product to pay higher prices to domestic producers of that product . Countries that institute protectionist policies lose the economic gains achieved through a combination of comparative advantage , specialized learning , and economies of scale . With these overall costs in mind , let us now consider , one by one , a number of arguments that support restricting imports . Access for free at

Arguments in Support of Restricting Imports 823 The Infant Industry Argument Imagine wants to start its own computer industry , but it has no computer that can produce at a low enough price and high enough quality to compete in world markets . However , politicians , business leaders , and workers hope that if the local industry had a chance to get established , before it needed to face international competition , then a domestic company or group of companies could develop the skills , management , technology , and economies of scale that it needs to become a successful domestic industry . Thus , the infant industry argument for protectionism is to block imports for a limited time , to give the infant industry time to mature , before it starts competing on equal terms in the global economy . Revisit Around the World for more information on the infant industry argument . The infant industry argument is theoretically possible , even sensible give an industry a indirect subsidy through protection , and then reap the economic of having a vibrant , healthy industry . Implementation , however , is tricky . In many countries , infant industries have gone from babyhood to senility and obsolescence without ever having reached the maturity stage . Meanwhile , the protectionism that was supposed to be often took a very long time to be repealed . As one example , Brazil treated its computer industry as an infant industry from the late until about 1990 . In an attempt to establish its computer industry in the global economy , Brazil largely barred imports of computer products for several decades . This policy guaranteed increased sales for Brazilian computers . However , by the , due to lack of international competition , Brazil had a backward and industry , typically lagging behind world standards for price and performance by three to long time in this industry . After more than a decade , during which Brazilian consumers and industries that would have from computers paid the costs and Brazil computer industry never competed effectively on world markets , Brazil phased out its infant industry policy for the computer industry . Protectionism for infant industries always imposes costs on domestic users of the product , and typically has provided little in the form of stronger , competitive industries . However , several countries in East Asia offer an exception . Japan , Korea , Thailand , and other countries in this region have sometimes provided a package of indirect and direct subsidies targeted at certain industries , including protection from foreign competition and government loans at interest rates below the market equilibrium . In Japan and Korea , for example , subsidies helped get their domestic steel and auto industries up and running . Why did the infant industry policy of protectionism and other subsidies work fairly well in East Asia ?

An early 1990 World Bank study offered three guidelines to countries thinking about infant industry protection . Do not hand out protectionism and other subsidies to all industries , but focus on a few industries where your country has a realistic chance to be a producer . Be very hesitant about using protectionism in areas like computers , where many other industries rely on having the best products available , because it is not useful to help one industry by imposing high costs on many other industries . clear guidelines for when the infant industry policy will end . In Korea in the and , a common practice was to link protectionism and subsidies to export sales in global markets . If export sales rose , then the infant industry had succeeded and the government could phase out protectionism . If export sales did not rise , then the infant industry policy had failed and the government could phase out protectionism . Either way , the protectionism would be temporary . Following these rules is easier said than done . Politics often intrudes , both in choosing which industries will receive the of treatment as infants and when to phase out import restrictions and other subsidies . Also , if the country government wishes to impose costs on its citizens so that it can provide subsidies to a few key industries , it has many tools for doing such as direct government payments , loans , targeted tax reductions , and government support of research and development of new technologies . In other words , protectionism is not the only or even the best way to support key industries .

34 Globalization and Protectionism LINK IT UP Visit this website to view a presentation by questioning how integrated the world really is . The Argument Dumping refers to selling goods below their cost of production . laws block imports that are sold below the cost by imposing tariffs that increase the price of these imports to reflect their cost of production . Since dumping is not allowed under World Trade Organization ( rules , nations that believe they are on the receiving end of dumped goods can a complaint with the . According to the , between 1995 and 2020 , it oversaw 137 disputes . Note that dumping cases are . During , case increase . During economic booms , case go down . Individual countries have also frequently started their own investigations . The government has dozens of orders in place from past investigations . In 2022 , for example , some imports that were under orders included olives from Spain , steel from South Korea , coated paper from Indonesia , light commercial vehicles from Germany and Italy , from Vietnam , and cellulose pulp from Canada . Why Might Dumping Occur ?

Why would foreign export a product at less than its cost presumably means taking a loss ?

This question has two possible answers , one innocent and one more sinister . The innocent explanation is that demand and supply set market prices , not the cost of production . Perhaps demand for a product shifts back to the left or supply shifts out to the right , which drives the market price to low below the cost of production . When a local store has a sale , for example , it may sell goods at below the cost . If international companies that there is excess supply of steel or computer chips or machine tools that is driving the market price down below their cost of may be the market in action . The sinister explanation is that dumping is part ofa strategy . Foreign sell goods at prices below the cost of production for a short period of time , and when they have driven out the domestic competition , they then raise prices . Economists sometimes call this scenario predatory pricing , which we discuss in the Monopoly chapter . Should Cases Be Limited ?

cases pose two questions . How much sense do they make in economic theory ?

How much sense do they make as practical policy ?

In terms of economic theory , the case for laws is weak . In a market governed by demand and supply , the government does not guarantee that will be able to make a . After all , low prices are for producers , but consumers . Moreover , although there are plenty of cases in which foreign producers have driven out domestic , there are zero documented cases in which the foreign producers up prices . Instead , foreign producers typically continue competing hard against each other and providing low prices to consumers . In short , it is to evidence of predatory pricing by foreign exporting to the United States . Even if one could make a case that the government should sometimes enact rules in the short term , and then allow free trade to resume shortly thereafter , there is a growing concern that investigations often involve more politics than careful analysis . The Commerce Department is charged with calculating the appropriate cost of production , which can be as much an art as a science . For example , if a company built a new factory two years ago , should it count part of the factory cost in this Access for free at

Arguments in Support of Restricting Imports 825 years cost of production ?

When a company is in a country where the government controls prices , like China for example , how can one measure the true cost of production ?

When a domestic industry complains loudly enough , government regulators seem very likely to that unfair dumping has occurred . A common pattern has arisen where a domestic industry an complaint , the governments meet and negotiate a reduction in imports , and then the domestic producers drop the suit . In such cases , dumping cases often appear to be little more than a cover story for imposing tariffs or import quotas . In the 19805 , the United States , Canada , the European Union , Australia , and New Zealand implemented almost all the cases . By the , countries like Argentina , Brazil , South Korea , South Africa , Mexico , and India were the majority of the cases before the . As the number of cases has increased , and as countries such as the United States and the European Union feel targeted by the actions of others , the may well propose some additional guidelines to limit the reach of laws . The Environmental Protection Argument The potential for global trade to affect the environment has become controversial . A president of the Sierra Club , an environmental lobbying organization , once wrote The consequences of globalization for the environment are not good . Globalization , if we are lucky , will raise average incomes enough to pay for cleaning up some of the mess that we have made . But before we get there , globalization could also destroy enough of the planet basic biological and physical systems that prospects for life be radically compromised . If free trade meant the destruction of life itself , then even economists would convert to protectionism ! While economic activity of all pose environmental dangers , it seems quite possible that , with the appropriate safeguards in place , we can minimize the environmental impacts of trade . In some cases , trade may even bring environmental . In general , countries such as the United States , Canada , Japan , the United Kingdom , and the nations of the European Union have relatively strict environmental standards . In contrast , and income countries like Brazil , India , and China have lower environmental standards . The general View of the governments of such countries is that environmental protection is a luxury as soon as their people have enough to eat , decent healthcare , and longer life , then they will spend more money on items such as sewage treatment plants , scrubbers to reduce air pollution from factory smokestacks , and national parks to protect wildlife . This gap in environmental standards between and countries raises two worrisome possibilities in a world of increasing global trade the race to the bottom scenario and the question of how quickly environmental standards will improve in countries . The Race to the Bottom Scenario The race to the bottom scenario of global environmental degradation runs like this . multinational companies shift their production from countries with strong environmental standards to countries with weak standards , thus reducing their costs and increasing their . Faced with such behavior , countries reduce their environmental standards to attract multinational , which , after all , provide jobs and economic clout . As a result , global production becomes concentrated in countries where can pollute the most and environmental laws everywhere race to the Although the scenario sounds plausible , it does not appear to describe reality . In fact , the incentive for to shift production to poor countries to take advantage of their weaker environmental rules does not seem especially powerful . When decide where to locate a new factory , they look at many different factors the costs of labor and capital whether the location is close to a reliable suppliers of the inputs that they need whether the location is close to customers the quality of transportation ,

34 Globalization and Protectionism communications , and electrical power networks the level of taxes and the competence and honesty of the local government . The cost of environmental regulations is a factor , too , but typically environmental costs are no more than to of the costs that a large industrial plant faces . The other factors that determine location are much more important to these companies than trying to skimp on environmental protection costs . When an international company does choose to build a plant in a country with lax environmental laws , it typically builds a plant similar to those that it operates in countries with stricter environmental standards . Part of the reason for this decision is that designing an industrial plant is a complex and costly task , and so if a plant works well in a country , companies prefer to use the same design everywhere . Also , companies realize that if they create an environmental disaster in a country , it is likely to cost them a substantial amount of money in paying for damages , lost trust , and reduced building plants everywhere they minimize such risks . As a result of these factors , plants in countries often have a better record of compliance with environmental laws than do plants . Pressuring Countries for Higher Environmental Standards In some cases , the issue is not so much whether globalization will pressure countries to reduce their environmental standards , but instead whether the threat of blocking international trade can pressure these countries into adopting stronger standards . For example , restrictions on ivory imports in countries , along with stronger government efforts to catch elephant poachers , have been credited with helping to reduce the illegal poaching of elephants in certain African countries . However , it would be highly undemocratic for 16 citizens of countries to attempt to dictate to the citizens of countries what domestic policies and priorities they must adopt , or how they should balance environmental goals against other priorities for their citizens . Furthermore , if income countries want stronger standards in countries , they have many options other than the threat of protectionism . For example , countries could pay for equipment in countries , or could help to pay for national parks . countries could help pay for and carry out the and economic studies that would help environmentalists in countries to make a more persuasive case for tie economic of protecting the environment . After all , environmental protection is vital to two industries of key importance in many and tourism . Environmental advocates can set up standards for labeling products , like this tuna caught in a net that kept dolphins sa or this product made only with wood not taken from rainforests , so that consumer pressure can reinforce environmentalist values . The United Nations also reinforces these values , by sponsoring treaties to address issues such as climate change and global warming , the preservation of biodiversity , the spread of , and the environmental health of the seabed . Countries that share a national border or are within a region often sign environmental agreements about air and water rights , too . The is also becoming more aware of environmental issues and more careful about ensuring that increases in trade do not environmental damage . Finally , note that these concerns about the race to the bottom or pressuring countries for more strict environmental standards do not apply very well to the roughly half of all trade that occurs with other countries . Many European countries have stricter environmental standards in certain industries than the United States . The Unsafe Consumer Products Argument One argument for shutting out certain imported products is that they are unsafe for consumers . Consumer rights groups have sometimes warned that the World Trade Organization would require nations to reduce their health and safety standards for imported products . However , the explains its current agreement on the subject in this way It allows countries to set their own standards . It also says regulations must be based on science . And they should not arbitrarily or discriminate between countries where identical or Access for free at

Arguments in Support of Restricting Imports 827 similar conditions Thus , for example , under rules it is perfectly legitimate for the United States to pass laws requiring that all food products or cars sold in the United States meet certain safety standards approved by the United States government , whether or not other countries choose to pass similar standards . However , such standards must have some basis . It is improper to impose one set of health and safety standards for domestically produced goods but a different set of standards for imports , or one set of standards for imports from Europe and a different set of standards for imports from Latin America . In 2007 , recalled nearly two million toys imported from China due to concerns about high levels of lead in the paint , as well as some loose parts . It is unclear if other toys were subject to similar standards . In 2013 , Japan blocked imports of wheat because of concerns that genetically modified ( wheat might be included in the shipments . The science on the impact of on health is still developing . The National Interest Argument Some argue that a nation should not depend too heavily on other countries for supplies of certain key products , such as oil , or for special materials or technologies that might have national security applications . On closer consideration , this argument for protectionism proves rather weak . As an example , in the United States , oil provides about 36 of all the energy and 21 of the oil used in the United States economy is imported . Several times in the last few decades , when disruptions in the Middle East have shifted the supply curve of oil back to the left and sharply raised the price , the effects have been felt across the United States economy . This is not , however , a very convincing argument for restricting oil imports . If the United States needs to be protected from a possible cutoff of foreign oil , then a more reasonable strategy would be to import 100 of the petroleum supply now , and save domestic oil resources for when or if the foreign supply is cut off . It might also be useful to import extra oil and put it into a stockpile for use in an emergency , as the United States government did by starting a Strategic Petroleum Reserve in 1977 . Moreover , it may be necessary to discourage people from using oil , and to start a program to seek out alternatives to oil . A straightforward way to do this would be to raise taxes on oil . Additionally , it makes no sense to argue that because oil is highly important to the United States economy , then the United States should shut out oil imports and use up its domestic supplies more quickly . domestic oil production is increasing . Shale oil is adding to domestic supply using fracking extraction techniques . Whether or not to limit certain kinds of imports of key technologies or materials that might be important to national security and weapons systems is a slightly different issue . builders are not that they can continue to obtain a key product in wartime , they might decide to avoid designing weapons that use this key product , or they can go ahead and design the weapons and stockpile enough of the key components or materials to last through an armed . There is a Defense National Stockpile Center that has built up reserves of many materials , from aluminum oxides , antimony , and bauxite to tungsten , vegetable tannin extracts , and zinc ( although many of these stockpiles have been reduced and sold in recent years ) Think every country is ?

How about the ?

The following Clear It Up might surprise you . CLEAR IT UP How does the United States really feel about expanding trade ?

How do people around the world feel about expanding trade between nations ?

In summer 2007 , the Pew Foundation surveyed people in 47 countries . One of the questions asked about opinions on growing trade ties between countries . Table shows the percentages who answered either very good or somewhat good for some of countries surveyed . For those who think of the United States as the world leading supporter of expanding trade , the survey results may be perplexing . When adding up the shares of those who say that growing trade ties between countries is very good or somewhat good , Americans had the least favorable attitude toward increasing globalization , while the Chinese

34 Globalization and Protectionism and South Africans ranked highest . In fact , 47 countries surveyed , the United States ranked by far the lowest on this measure , followed by Egypt , Italy , and Argentina . Country Very Good Somewhat Good Total China 38 53 91 South Africa 42 43 87 South Korea 24 62 86 Germany 30 55 85 Canada 29 53 82 United Kingdom 28 50 78 Mexico 22 55 77 Brazil 13 59 72 Japan 17 55 72 United States 14 45 59 TABLE The Status of Growing Trade Ties between Countries ( Source ) One reason why economists often treat the national interest argument skeptically is that lobbyists and politicians can tout almost any product as vital to national security . In 1954 , the United States became worried that it was importing half of the wool required for military uniforms , so it declared wool and mohair to be strategic materials and began to give subsidies to wool and mohair farmers . Although the government removed wool from the official list of strategic materials in 1960 , the subsidies for mohair continued for almost 40 years until the government repealed them in 1993 , and then reinstated them in 2002 . All too often , the national interest argument has become an excuse for handing out the indirect subsidy to certain industries or companies . After all , politicians , not nonpartisan analysts make decisions about what constitutes a key strategic material . How Governments Enact Trade Policy Globally , Regionally , and Nationally LEARNING OBJECTIVES By the end of this section , you will be able to Explain the origin and role of the World Trade Organization ( and General Agreement on Tariffs and Trade ( Discuss the and provide examples of regional trading agreements Analyze trade policy at the national level Evaluate trends in barriers to trade These public policy arguments about how nations should react to globalization and trade are fought out at several levels at the global level through the World Trade Organization and through regional trade agreements between pairs or groups of countries . Access for free at

How Governments Enact Trade Policy Globally , Regionally , and Nationally 829 The World Trade Organization The World Trade Organization ( was officially born in 1995 , but its history is much longer . In the years after the Great Depression and World War II , there was a worldwide push to build institutions that would tie the nations of the world together . The United Nations officially came into existence in 1945 . The World Bank , which assists the poorest people in the world , and the International Monetary Fund , which addresses issues raised by international transactions , were both created in 1946 . The third planned organization was to be an International Trade Organization , which would manage international trade . The United Nations was unable to agree to this . Instead , 27 nations signed the General Agreement on Tariffs and Trade ( in Geneva , Switzerland on October 30 , 1947 to provide a forum in which nations could come together to negotiate reductions in tariffs and other barriers to trade . In 1995 , the transformed into the . The process was to negotiate an agreement to reduce barriers to trade , sign that agreement , pause for a while , and then start negotiating the next agreement . Table 344 shows rounds of talks in the , and now the . Notice that the early rounds of talks took a relatively short time , included a small number of countries , and focused almost entirely on reducing tariffs . Since the , however , rounds of trade talks have taken years , included a large number of countries , and have included an range of issues . Place or Number of Year Name of Main Subjects Countries Round Involved 947 Geneva Tari 23 949 Tari 13 951 Tari 38 956 Geneva Tari 26 Dillon round Tari 26 Tari , measures 62 round Tokyo round Tari , nontariff barriers 102 986 94 Tari , nontariff barriers , services , intellectual property , dispute 123 round sett , textiles , agriculture , creation of round Agriculture , services , intellectual property , competition , 147 investment , environment , dispute settlement TABLE The Negotiating Rounds of and the World Trade Organization The sluggish pace of negotiations led to an that really stood for Gentleman Agreement to Talk and Talk . The slow pace of international trade talks , however , is understandable , even sensible . Having dozens of nations agree to any treaty is a lengthy process . often set up separate trading rules for certain industries , like agriculture , and separate trading rules for certain countries , like the countries . There were rules , exceptions to rules , opportunities to opt out of rules , and precise wording to be fought over in every case . Like the before it , the is not a world government , with power to impose its decisions on others . The total staff of the Secretariat in 2021 is 625 people and its annual budget ( as of 2020 ) is 197 million , which makes it smaller in size than many large universities .

34 Globalization and Protectionism Regional Trading Agreements There are different types of economic integration across the globe , ranging from free trade agreements , in which participants allow each others imports without tariffs or quotas , to common markets , in which participants have a common external trade policy as well as free trade within the group , to full economic unions , in which , in addition to a common market , monetary and policies are coordinated . Many nations belong both to the World Trade Organization and to regional trading agreements . The best known of these regional trading agreements is the European Union . In the years after World War II , leaders of several European nations reasoned that if they could tie their economies together more closely , they might be more likely to avoid another devastating war . Their efforts began with a free trade association , evolved into a common market , and then transformed into what is now a full economic union , known as the European Union . The EU , as it is often called , has a number of goals . For example , in the early it introduced a common currency for Europe , the euro , and phased out most of the former national forms of money like the German mark and the French franc , though a few have retained their own currency . Another key element of the union is to eliminate barriers to the mobility of goods , labor , and capital across Europe . In 2016 , Britain voted to leave the European move that was completed in January 2020 . For the United States , perhaps the regional trading agreement is the North American Free Trade Agreement ( The United States also participates in some regional trading agreements , like the Caribbean Basin Initiative , which offers reduced tariffs for imports from these countries , and a free trade agreement with Israel . The world has seen a of regional trading agreements in recent years . About 100 such agreements are now in place . Table lists a few of the more prominent ones . Some arejust agreements to continue talking . Others set goals for reducing tariffs , import quotas , and . One economist described the current trade treaties as a spaghetti bowl , which is what a map with lines connecting all the countries with trade treaties looks like . There is concern among economists who favor free trade that some of these regional agreements may promise free trade , but actually act as a way for the countries within the regional agreement to try to limit trade from anywhere else . In some cases , the regional trade agreements may even with the broader agreements of the World Trade Organization . Trade , Participating Countries Agreements A ' Australia , Canada , Chile , People Republic of China , Hong Kong , China , Indonesia , Japan , Republic of Korea , Malaysia , Mexico , New Zealand , New Guinea , Peru , oo era ion ( Philippines , Russia , Singapore , Chinese Taipei , Thailand , United States , Vietnam Austria , Belgium , Cyprus , Czech Republic , Denmark , Finland , France , Germany , Greece , Hungary , Ireland , Italy , Netherlands , Poland , Portugal , Spain , Sweden , United Kingdom European Union ( EU ) TABLE Some Regional Trade Agreements Following the 2016 referendum vote to leave the European Union , the UK government triggered the withdrawal process on March 29 , 2017 , setting the date for the UK to leave by April 2019 . In January 2020 , the withdrawal was complete and the United Kingdom is now no longer part of the EU trading bloc . Also , as of 2020 , has been replaced by the United ( tree trade agreement . As of July , was replaced with the United ( free trade agreement . It is broadly similar to the original . Access for free at

How Governments Enact Trade Policy Globally , Regionally , and Nationally Trade Participating Countries Agreements North America Free Trade Agreement ( Canada , Mexico , United States Latin American Integration Association ( Argentina , Bolivia , Brazil , Chile , Columbia , Ecuador , Mexico , Paraguay , Peru , Venezuela , Panama Association of , Indonesia , Malaysia , Philippines , Singapore , Thailand , Southeast Asian . Vietnam Nations ( Southern African Development Community ( Congo , Madagascar , Mozambique , South Africa , Zimbabwe TABLE Some Regional Trade Agreements Following the 2016 referendum vote to leave the European Union , the UK government triggered the withdrawal process on March 29 , 2017 , setting the date for the UK to leave by April 2019 . In January 2020 , the withdrawal was complete and the United Kingdom is now no longer part of the EU trading bloc . Also , as of 2020 , has been replaced by the United ( free trade agreement . Trade Policy at the National Level Yet another dimension of trade policy , along with international and regional trade agreements , happens at the national level . The United States , for example , imposes import quotas on sugar , because ofa fear that such imports would drive down the price of sugar and thus injure domestic sugar producers . One of of the United States Department of Commerce is to determine if there is import dumping from other countries . The United States International Trade government whether the dumping has substantially injured domestic industries , and if so , the president can impose tariffs that are intended to offset the unfairly low price . In the arena of trade policy , the battle often seems to be between national laws that increase protectionism and international agreements that try to reduce protectionism , like the . Why would a country pass laws or negotiate agreements to shut out certain foreign products , like sugar or textiles , while simultaneously negotiating to reduce trade barriers in general ?

One plausible answer is that international trade agreements offer a method for countries to restrain their own special interests . A member of Congress can say to an industry lobbying for tariffs or quotas on imports Sure would like to help you , but that pesky agreement just wo let LINK IT UP If consumers are the biggest losers from trade , why do they not back ?

The quick answer is because it is easier to organize a small group of people around a narrow interest ( producers ) Versus a large group that has diffuse interests ( consumers ) This is a question about trade policy theory . Visit this website zo and read the article by Jonathan . 831

34 Globalization and Protectionism Trends in Barriers to Trade In newspaper headlines , trade policy appears mostly as disputes and acrimony . Countries are almost constantly threatening to challenge other nations unfair trading practices . Cases are brought to the dispute settlement procedures of the , the European Union , and other regional trading agreements . Politicians in national legislatures , goaded on by lobbyists , often threaten to pass bills that will establish a fair playing field or prevent unfair trade most such bills seek to accomplish these goals by placing more restrictions on trade . Protesters in the streets may object to trade rules or to the entire practice of international trade . Through all the controversy , the general trend in the last 60 years is clearly toward lower barriers to trade . The average level of tariffs on imported products charged by industrialized countries was 40 in 1946 . By 1990 , after decades of negotiations , it was down to less than . One of the reasons that negotiations shifted from focusing on tariff reduction in the early rounds to a broader agenda was that tariffs had been reduced so dramatically there was not much more to do in that area . tariffs have followed this general pattern After rising sharply during the Great Depression , tariffs dropped off to less than by the end of the century . Although measures of import quotas and are less exact than those for tariffs , they generally appear to be at lower levels than they had been previously , too . Thus , the last has seen both a dramatic reduction in barriers to trade , such as tariffs , import quotas , and nontariff barriers , and also a number of technological developments that have made international trade easier , like advances in transportation , communication , and information management . The result has been the powerful surge of international trade . These trends were altered by two important events in 2016 the UK vote to leave the EU and the election of President Trump in the United States , whose administration pursued a policy of raising trade barriers . In 2018 , tariffs on a broad range of imports from China were raised by around 25 . As of 2022 , the UK has been out of the EU for two years , and it remains unclear if President administration will adjust or remove President Trump trade barriers . The of Trade Policy LEARNING OBJECTIVES By the end of this section , you will be able to Asses the complexity of international trade Discuss why a economy is so affected by international trade Explain disruptive market change Economists readily acknowledge that international trade is not all sunshine , roses , and happy endings . Over time , the average person gains from international trade , both as a worker who has greater productivity and higher wages because of the of specialization and comparative advantage , and as a consumer who can from shopping all over the world for a greater variety of quality products at attractive prices . The average person , however , is hypothetical , not a mix of those who have done very well , those who have done all right , and those who have done poorly . It is a legitimate concern of public policy to focus not just on the average or on the success stories , but also on those who have not been so fortunate . Workers in other countries , the environment , and prospects for new industries and materials that might be of key importance to the national economy are also all legitimate issues . The common belief among economists is that it is better to embrace the gains from trade , and then deal with the costs and with other policy tools , than it is to cut off trade to avoid the costs and . To gain a better intuitive understanding for this argument , consider a hypothetical American company called . invents a new technology that allows the to increase the output and quality of its goods with a smaller number of workers at a lower cost . As a result of this technology , other Access for free at

The of Trade Policy 833 in this industry will lose money and will also have to lay some of the competing will even go bankrupt . Should the United States government protect the existing and their employees by making it illegal for to use its new technology ?

Most people who live in economies would oppose trying to block better products that lower the cost of services . Certainly , there is a case for society providing temporary support and assistance for those who themselves without work . Many would argue for government support of programs that encourage retraining and acquiring additional skills . Government might also support research and development efforts , so that other may ways of outdoing . Blocking the new technology altogether , however , seems like a mistake . After all , few people would advocate giving up electricity because it caused so much disruption to the kerosene and candle business . Few would suggest holding back on improvements in medical technology because they might cause companies selling leeches and snake oil to lose money . In short , most people view disruptions due to technological change as a necessary cost that is worth bearing . Now , imagine that new technology is as simple as this the company imports what it sells from another country . In other words , think of foreign trade as a type of innovative technology . The objective situation is now exactly the same as before . Because of new in this case is importing goods from another in this industry will lose money and lay off workers . Just as it would have been inappropriate and ultimately foolish to respond to the disruptions of new technology by trying to shut it down , it would be inappropriate and ultimately foolish to respond to the disruptions of international trade by trying to restrict trade . Some workers and will suffer because of international trade . In a living , breathing economy , some workers and will always be experiencing disruptions , for a wide variety of reasons . Corporate management can be better or worse . Workers for a certain can be more or less productive . Tough domestic competitors can create just as much disruption as tough foreign competitors . Sometimes a new product is a hit with consumers sometimes it is a . Sometimes a company is blessed by a run of good luck or stricken with a run ofbad luck . For some , international trade will offer great opportunities for expanding productivity for other , trade will impose stress and pain . The disruption caused by international trade is not fundamentally different from all the other disruptions caused by the other workings ofa market economy . In other words , the economic analysis of free trade does not rely on a belief that foreign trade is not disruptive or does not pose indeed , the story of begins with a particular disruptive market new causes real . In thinking about the disruptions of foreign trade , or any of the other possible costs and of foreign trade discussed in this chapter , the best public policy solutions typically do not involve protectionism , but instead involve ways for public policy to address the particular issues resulting from these disruptions , costs , and , while still allowing the of international trade to occur . BRING IT HOME What the Downside of Protection ?

The domestic display industry employed many workers before the imposed the dumping margin tax . displays make up a portion of the cost of producing laptop much as 50 . Therefore , the antidumping tax would substantially increase the cost , and thus the price , of laptops . As a result of the decision , Apple moved its domestic manufacturing plant for Macintosh computers to Ireland ( where it had an existing plant ) shut down its manufacturing plant for laptops . And IBM cancelled plans to open a laptop manufacturing plant in North Carolina , instead deciding to expand production at its plant in Japan . In this case , rather than desired effect of protecting interests and giving domestic manufacturing an advantage over items manufactured elsewhere , it had the unintended effect of driving the

34 Globalization and manufacturing completely out of the country . Many people lost theirjobs and most display production now occurs in countries other than the United States . Access for free at 34 Key Terms 835 Key Terms laws laws that block imports sold below the cost and impose tariffs that would increase the price of these imports to reflect their cost of production common market economic agreement between countries to allow free trade in goods , services , labor , and capital between members while having a common external trade policy disruptive market change innovative new product or production technology which disrupts the status quo in a market , leading the innovators to earn more income and and the other to lose income and , unless they can come up with their own innovations dumping selling internationally traded goods below their cost of production economic union economic agreement between countries to allow free trade between members , a common external trade policy , and coordinated monetary and policies free trade agreement economic agreement between countries to allow free trade between members General Agreement on Tariffs and Trade ( forum in which nations could come together to negotiate reductions in tariffs and other barriers to trade the precursor to the World Trade Organization import quotas numerical limits on the quantity of products that a country can import national interest argument the argument that there are compelling national interests against depending on key imports from other nations ways a nation can draw up rules , regulations , inspections , and paperwork to make it more costly or to import products protectionism government policies to reduce or block imports race to the bottom when production locates in countries with the lowest environmental ( or other ) standards , putting pressure on all countries to reduce their environmental standards World Trade Organization ( organization that seeks to negotiate reductions in barriers to trade and to adjudicate complaints about violations of international trade policy successor to the General Agreement on Tariffs and Trade ( Key Concepts and Summary Protectionism An Indirect Subsidy from Consumers to Producers There are three tools for restricting the flow of trade tariffs , import quotas , and . When a country places limitations on imports from abroad , regardless of whether it uses tariffs , quotas , or nontariff barriers , it is said to be practicing protectionism . Protectionism will raise the price of the protected good in the domestic market , which causes domestic consumers to pay more , but domestic producers to earn more . International Trade and Its Effects on Jobs , Wages , and Working Conditions As international trade increases , it contributes to a shift away from industries where that economy does not have a comparative advantage and toward industries where it does have a comparative advantage . The degree to which trade affects labor markets has much to do with the structure of the labor market in that country and the adjustment process in other industries . Global trade should raise the average level by increasing productivity . However , this increase in average wages may include both gains to workers in certain jobs and industries and losses to others . In thinking about labor practices in countries , it is useful to draw a line between what is unpleasant to think about and what is morally objectionable . For example , low wages and long working hours in poor countries are unpleasant to think about , but for people in parts of the world , it may well be the best option open to them . Practices like child labor and forced labor are morally objectionable and many countries refuse to import products made using these practices . Arguments in of Restricting Imports There are a number of arguments that support restricting imports . These arguments are based around

836 34 Questions industry and competition , environmental concerns , and issues of safety and security . The infant industry argument for protectionism is that small domestic industries need to be temporarily nurtured and protected from foreign competition for a time so that they can grow into strong competitors . In some cases , notably in East Asia , this approach has worked . Often , however , the infant industries never grow up . On the other hand , arguments against dumping ( which is setting prices below the cost of production to drive competitors out of the market ) often simply seem to be a convenient excuse for imposing protectionism . countries typically have lower environmental standards than countries because they are more worried about immediate basics such as food , education , and healthcare . However , except for a small number of extreme cases , shutting off trade seems unlikely to be an effective method of pursuing a cleaner environment . Finally , there are arguments involving safety and security . Under the rules of the World Trade Organization , countries are allowed to set whatever standards for product safety they wish , but the standards must be the same for domestic products as for imported products and there must be a basis for the standard . The national interest argument for protectionism holds that it is unwise to import certain key products because if the nation becomes dependent on key imported supplies , it could be vulnerable to a cutoff . However , it is often wiser to stockpile resources and to use foreign supplies when available , rather than preemptively restricting foreign supplies so as not to become dependent on them . How Governments Enact Trade Policy Globally , Regionally , and Nationally Governments determine trade policy at many different levels administrative agencies within government , laws passed by the legislature , regional negotiations between a small group of nations ( sometimes just two ) and global negotiations through the World Trade Organization . During the second half of the twentieth century , trade barriers have , in general , declined quite substantially in the United States economy and in the global economy . One reason why countries sign international trade agreements to commit themselves to free trade is to give themselves protection against their own special interests . When an industry lobbies for protection from foreign producers , politicians can point out that , because of the trade treaty , their hands are tied . The of Trade Policy International trade certainly has income distribution effects . This is hardly surprising . All domestic or international competitive market forces are disruptive . They cause companies and industries to rise and fall . Government has a role to play in cushioning workers against the disruptions of the market . However , just as it would be unwise in the long term to clamp down on new technology and other causes of disruption in domestic markets , it would be unwise to clamp down on foreign trade . In both cases , the disruption brings with it economic . Questions . Explain how a tariff reduction causes an increase in the equilibrium quantity of imports and a decrease in the equilibrium price . Hint Consider the Work It Out Effects of Trade Barriers . Explain how a subsidy on agricultural goods like sugar adversely affects the income of foreign producers of imported sugar . Explain how trade barriers save jobs in protected industries , but only by costing jobs in other industries . Explain how trade barriers raise wages in protected industries by reducing average wages . How does international trade affect working conditions of countries ?

Do the jobs for workers in countries that involve making products for export to countries typically pay these workers more or less than their alternative ?

How do trade barriers affect the average income level in an economy ?

Access for free at 34 Review Questions 837 . How does the cost of saving jobs in protected industries compare to the workers wages and salaries ?

Explain how predatory pricing could be a motivation for dumping . 10 . Why do countries like Brazil , Egypt , or Vietnam have lower environmental standards than countries like the Germany , Japan , or the United States ?

11 . Explain the logic behind the race to the bottom argument and the likely reason it has not occurred . 12 . What are the conditions under which a country may use the unsafe products argument to block imports ?

13 . Why is the national security argument not convincing ?

14 . Assume a perfectly competitive market and the exporting country is small . Using a demand and supply diagram , show the impact of increasing standards on a exporter of toys . Show the tariff impact . Is the effect on toy prices the same or different ?

Why is a standards policy preferred to tariffs ?

15 . What is the difference between a free trade association , a common market , and an economic union ?

16 . Why would countries promote protectionist laws , while also negotiate for freer trade internationally ?

17 . What might account for the dramatic increase in international trade over the past 50 years ?

18 . How does competition , whether domestic or foreign , harm businesses ?

19 . What are the gains from competition ?

Review Questions Who does protectionism protect ?

From what does it protect them ?

21 . Name and three policy tools for enacting protectionism . 22 . How does protectionism affect the price of the protected good in the domestic market ?

23 . Does international trade , taken as a whole , increase the total number ofjobs , decrease the total number of jobs , or leave the total number ofjobs about the same ?

24 . Is international trade likely to have roughly the same effect on the number ofjobs in each individual industry ?

25 . How is international trade , taken as a whole , likely to affect the average level of wages ?

26 . Is international trade likely to have about the same effect on everyone wages ?

27 . Wiat are main reasons for protecting infant industries ?

Why is it to stop protecting them ?

28 . Wiat is dumping ?

Why does prohibiting it often work better in theory than in practice ?

29 . Wiat is the race to the bottom scenario ?

30 . Do the rules of international trade require that all nations impose the same consumer safety standards ?

31 . Wiat is the national interest argument for protectionism with regard to certain products ?

32 . Name several of the international treaties where countries negotiate with each other over trade policy . 33 . Wiat is the general trend of trade barriers over recent decades higher , lower , or about the same ?

34 . If opening up to free trade would benefit a nation , then why do nations notjust eliminate their trade barriers , and not bother with international trade negotiations ?

35 . gains and who loses from trade ?

36 . is trade a good thing if some people lose ?

838 34 Critical Thinking Questions 37 . What are some ways that governments can help people who lose from trade ?

Critical Thinking Questions 38 . 39 . 40 . 41 . 42 . 43 . 44 . 45 . 46 . 47 . 48 . 49 . 50 . 51 . 52 . Show graphically that for any tariff , there is an equivalent quota that would give the same result . What would be the difference , then , between the two types of trade barriers ?

Hint It is not something you can see from the graph . From the Work It Out Effects of Trade Barriers , you can see that a tariff raises the price of imports . What is interesting is that the price rises by less than the amount of the tariff . Who pays the rest of the tariff amount ?

Can you show this graphically ?

If trade barriers hurt the average worker in an economy ( due to lower wages ) why does government create trade barriers ?

Why do you think labor standards and working conditions are lower in the countries of the world than in countries like the United States ?

How would direct subsidies to key industries be preferable to tariffs or quotas ?

How can governments identify good candidates for infant industry protection ?

Can you suggest some key characteristics of good candidates ?

Why are industries like computers not good candidates for infant industry protection ?

theory argues that it is economically rationale ( and ) to sell additional output as long as the price covers the variable costs of production . How is this relevant to the determination of whether dumping has occurred ?

How do you think Americans would feel if other countries began to urge the United States to increase environmental standards ?

Is it legitimate to impose higher safety standards on imported goods that exist in the foreign country where the goods were produced ?

Why might the unsafe consumer products argument be a more effective strategy ( from the perspective of the importing country ) than using tariffs or quotas to restrict imports ?

Why might a tax on domestic consumption of resources critical for national security be a more approach than barriers to imports ?

Why do you think that the rounds and , more recently , negotiations have become longer and more to resolve ?

An economic union requires giving up some political autonomy to succeed . What are some examples of political power countries must give up to be members of an economic union ?

What are some examples of innovative products that have disrupted their industries for the better ?

In principle , the of international trade to a country exceed the costs , no matter whether the country is importing or exporting . In practice , it is not always possible to compensate the losers in a country , for example , workers who lose theirjobs due to foreign imports . In your opinion , does that mean that trade should be inhibited to prevent the losses ?

Access for free at 53 . 54 . 34 Problems 839 Economists sometimes say that protectionism is the choice for dealing with any particular problem . What they mean is that there is often a policy choice that is more direct or effective for dealing with the choice that would still allow the of trade to occur . Explain why protectionism is a choice for helping workers as a group helping industries stay strong protecting the environment ( advancing national defense Trade has income distribution effects . For example , suppose that because of a reduction in trade barriers , trade between Germany and the Czech Republic increases . Germany sells house paint to the Czech Republic . The Czech Republic sells alarm clocks to Germany . Would you expect this pattern of trade to increase or decrease jobs and wages in the paint industry in Germany ?

The alarm clock industry in Germany ?

The paint industry in Czech Republic ?

The alarm clock industry in Czech Republic ?

What has to happen for there to be no increase in total unemployment in both countries ?

Problems 55 . 56 . Assume two countries , Thailand ( and Japan ( have one good cameras . The demand ( and supply ( for cameras in Thailand and Japan is described by the following functions is the price measured in a common currency used in both countries , such as the Thai Baht . Compute the equilibrium price ( and quantities ( in each country without trade . Now assume that free trade occurs . The price goes to Baht . Who exports and imports cameras and in what quantities ?

You have just been put in charge of trade policy for . Coffee is a recent crop that is growing well and the export market is developing . As such , coffee is an infant industry . coffee producers come to you and ask for from cheap Tanzanian coffee . What sorts will you enact ?

Explain .

840 34 Problems ' The country of exports steel to the Land of Submarines . Information for the quantity demanded ( and quantity supplied ( in each country , in a world without trade , are given in Table and Table 3447 Price ( 60 230 180 70 200 200 80 170 220 90 150 240 100 140 250 TABLE Price ( 60 430 310 70 420 330 80 410 360 90 400 400 100 390 440 TABLE Land of Submarines a . What would be the equilibrium price and quantity in each country in a world without trade ?

How can you tell ?

What would be the equilibrium price and quantity in each country if trade is allowed to occur ?

How can you tell ?

Sketch two supply and demand diagrams , one for each country , in the situation before trade . On those diagrams , show the equilibrium price and the levels of exports and imports in the world after trade . If the Land of Submarines imposes an import quota of 30 , explain in general terms whether it will or injure consumers and producers in each country . Does your general answer change if the Land of Submarines imposes an import quota of 70 ?

Access for free at A The Use of Mathematics in Principles of Economics 841 APPENDIX A The Use of Mathematics in Principles of Economics ( This appendix should be consulted after reading Welcome to Economics ! Economics is not math . There is no important concept in this course that can not be explained without mathematics . That said , math is a tool that can be used to illustrate economic concepts . Remember the saying a picture is worth a thousand words ?

Instead of a picture , think ofa graph . It is the same thing . Economists use models as the primary tool to derive insights about economic issues and problems . Math is one way of working with ( or manipulating ) economic models . There are other ways of representing models , such as text or narrative . But why would you use your to bang a nail , ifyou had a hammer ?

Math has certain advantages over text . It disciplines your thinking by making you specify exactly what you mean . You can get away with fuzzy thinking in your head , but you can not when you reduce a model to algebraic equations . At the same time , math also has disadvantages . Mathematical models are necessarily based on simplifying assumptions , so they are not likely to be perfectly realistic . Mathematical models also lack the nuances which can be found in narrative models . The point is that math is one tool , but it is not the only tool or even always the best tool economists can use . So what math will you need for this book ?

The answer is little more than high school algebra and graphs . You will need to know What a function is How to interpret the equation of a line ( slope and intercept ) How to manipulate a line ( changing the slope or the intercept ) How to compute and interpret a growth rate ( percentage change ) How to read and manipulate a graph In this text , we will use the easiest math possible , and we will introduce it in this appendix . So if you some math in the book that you can not follow , come back to this appendix to review . Like most things , math has diminishing returns . A little math ability goes a long way the more advanced math you bring in , the less additional knowledge that will get you . That said , if you are going to major in economics , you should consider learning a little calculus . It will be worth your while in terms of helping you learn advanced economics more quickly . Algebraic Models Often economic models ( or parts of models ) are expressed in terms of mathematical functions . What is a function ?

A function describes a relationship . Sometimes the relationship is a . For example ( using words ) your professor is Adam Smith . This could be expressed as Professor Adam Smith . Or Friends Bob Shawn Margaret . Often in economics , functions describe cause and effect . The variable on the side is what is being explained ( the effect ) On the side is what is doing the explaining ( the causes ) For example , suppose your GPA was determined as follows GPA This equation states that your GPA depends on three things your combined SAT score , your class attendance , and the number of hours you spend studying . It also says that study time is twice as important ( as either score ( or ( If this relationship is true , how could you raise your GPA ?

By not skipping class and studying more . Note that you can not do anything about your SAT score , since if you are in college , you have ( presumably ) already taken the SATs . Of course , economic models express relationships using economic variables , like Budget

842 A The Use of Mathematics in Principles of Economics , assuming that the only things you buy are economics books and music . Most of the relationships we use in this course are expressed as linear equations of the form Expressing Equations Graphically Graphs are useful for two purposes . The is to express equations visually , and the second is to display statistics or data . This section will discuss expressing equations visually . To a mathematician or an economist , a variable is the name given to a quantity that may assume a range of values . In the equation of a line presented above , and are the variables , with on the horizontal axis and on the vertical axis , and and representing factors that determine the shape of the line . To see how this equation works , consider a numerical example In this equation for a line , the term has been set equal to and the term has been set equal to . Table shows the values of and for this given equation . Figure shows this equation , and these values , in a graph . To construct the table , just plug in a series of different values for , and then calculate what value of results . In the , these points are plotted and a line is drawn through them . 12 15 18 21 24 IU ' In I Values for the Slope Intercept Equation Access for free at

A The Use of Mathematics in Principles of Economics 843 30 25 20 10 FIGURE Slope and the Algebra of Straight Lines This line graph has on the horizontal axis and on the vertical axis . The is , the point where the line intersects the . The slope of the line is that is , there is a rise of on the vertical axis for every increase of on the horizontal axis . The slope is the same all along a straight line . This example illustrates how the and In terms in an equation for a straight line determine the shape of the line . The term is called the . The reason for this name is that , then the term will reveal where the line intercepts , or crosses , the . In this example , the line hits the vertical axis at . The In term in the equation for the line is the slope . Remember that slope is as rise over run more , the slope of a line from one point to another is the change in the vertical axis divided by the change in the horizontal axis . In this example , each time the increases by one ( the run ) the term rises by three . Thus , the slope of this line is three . Specifying a and a is , specifying and In in the equation for a identify a line . Although it is rare for data points to arrange themselves as an exact straight line , it often turns out that a straight line can offer a reasonable approximation of actual data . Interpreting the Slope The concept of slope is very useful in economics , because it measures the relationship between two variables . A positive slope means that two variables are positively related that is , when increases , so does , or when decreases , decreases also . Graphically , a positive slope means that as a line on the line graph moves from left to right , the line rises . The relationship , shown in Figure later in this Appendix , has a positive slope . We will learn in other chapters that price and quantity supplied have a positive relationship that is , will supply more when the price is higher . A negative slope means that two variables are negatively related that is , when increases , decreases , or when decreases , increases . Graphically , a negative slope means that , as the line on the line graph moves from left to right , the line falls . The density relationship , shown in Figure later in this appendix , has a negative slope . We will learn that price and quantity demanded have a negative relationship that is , consumers will purchase less when the price is higher . A slope of zero means that there is no relationship between and Graphically , the line is that is , zero rise over the run . Figure of the unemployment rate , shown later in this appendix , illustrates a common pattern of many line graphs some segments where the slope is positive , other segments where the slope is negative , and still other segments where the slope is close to zero . The slope of a straight line between two points can be calculated in numerical terms . To calculate slope , begin by designating one point as the starting point and the other point as the end point and then calculating the rise over run between these two points . As an example , consider the slope of the air density graph between the

844 A The Use of Mathematics in Principles of Economics points representing an altitude meters and an altitude of meters Rise Change in variable on vertical axis ( end point minus original point ) Run Change in variable on horizontal axis ( end point minus original point ) Thus , the slope of a straight line between these two points would be that from the altitude meters up to meters , the density of the air decreases by approximately meter for each of the next meters . Suppose the slope of a line were to increase . Graphically , that means it would get steeper . Suppose the slope of a line were to decrease . Then it would get . These conditions are true whether or not the slope was positive or negative to begin with . A higher positive slope means a steeper upward tilt to the line , while a smaller positive slope means a upward tilt to the line . A negative slope that is larger in absolute value ( that is , more negative ) means a steeper downward tilt to the line . A slope of zero is a horizontal line . A vertical line has an infinite slope . Suppose a line has a larger intercept . Graphically , that means it would shift out ( or up ) from the old origin , parallel to the old line . line has a smaller intercept , it would shift in ( or down ) parallel to the old line . Solving Models with Algebra Economists often use models to answer a question , like What will the unemployment rate be if the economy grows at per year ?

Answering questions requires solving the system of equations that represent the model . Suppose the demand for personal pizzas is given by the following equation 16 where is the amount of personal pizzas consumers want to buy ( quantity demanded ) and is the price . Suppose the supply pizzas is where is the amount of pizza producers will supply ( quantity supplied ) Finally , suppose that the personal pizza market operates where supply equals demand , or We now have a system of three equations and three unknowns ( and ) which we can solve with algebra Since , we can set the demand and supply equation equal to each other 16 Subtracting from both sides and adding to both sides yields In other words , the price personal pizza will be . How much will consumers buy ?

Access for free at A The Use of Mathematics in Principles of Economics 845 Taking the price of , and plugging it into the demand equation , we get ( So if the is each , consumers will purchase 12 . How much will producers supply ?

Taking the price of , and plugging it into the supply equation , we get ( 10 12 So if the is each , producers will supply 12 personal pizzas . This means we did our math correctly , since . Solving Models with Graphs If algebra is not your forte , you can get the same answer by using graphs . Take the equations for and and graph them on the same set of axes as shown in Figure . Since is on the vertical axis , it is easiest ifyou solve each equation for The demand curve is then and the supply curve is . Note that the vertical intercepts are and , and the slopes are for demand and for supply . lfyou draw the graphs carefully , you will see that where they cross ( the price is and the quantity is 12 , just like the algebra predicted . Demand Supply Price Quantity FIGURE Supply and Demand Graph The equations for and 05 are displayed graphically by the sloped lines . We will use graphs more frequently in this book than algebra , but now you know the math behind the graphs . Growth Rates Growth rates are frequently encountered in real world economics . A growth rate is simply the percentage change in some quantity . It could be your income . It could be a business sales . It could be a nation . The formula for computing a growth rate is straightforward Change in quantity Quantity Suppose pays 10 per hour . Your boss , however , is so impressed with your work that he gives you a per hour raise . The percentage change ( or growth rate ) in your pay is 10 or 20 . Percentage change To compute the growth rate for data over an extended period of time , for example , the average annual growth in over a decade or more , the denominator is commonly a little differently . In the previous example , we the quantity as the initial the quantity when we started . This is for a time calculation , but when we compute the growth over and over , it makes more sense to the quantity as the average quantity over the period in question , which is as the quantity halfway between the initial

846 A The Use of Mathematics in Principles of Economics quantity and the next quantity . This is harder to explain in words than to show with an example . Suppose a nation was trillion in 2005 and trillion in 2006 . The growth rate between 2005 and 2006 would be the change in ( trillion trillion ) divided by the average between 2005 and 2006 ( trillion trillion ) In other words trillion trillion ( trillion trillion ) growth Note that ifwe used the method , the calculation would be ( trillion trillion ) trillion growth , which is approximately the same as the second , more complicated method . Ifyou need a rough approximation , use the method . If you need accuracy , use the second method . A few things to remember A positive growth rate means the quantity is growing . A smaller growth rate means the quantity is growing more slowly . A larger growth rate means the quantity is growing more quickly . A negative growth rate means the quantity is decreasing . The same change over times yields a smaller growth rate . If you got a raise each year , in the year the growth rate would be 10 20 , as shown above . But in the second year , the growth rate would be 12 or growth . In the third year , the same raise would correspond to a 14 . The moral of the story is this To keep the growth rate the same , the change must increase each period . Displaying Data Graphically and Interpreting the Graph Graphs are also used to display data or evidence . Graphs are a method of presenting numerical patterns . They condense detailed numerical information into a visual form in which relationships and numerical patterns can be seen more easily . For example , which countries have larger or smaller populations ?

A careful reader could examine a long list of numbers representing the populations of many countries , but with over 200 nations in the world , searching through such a list would take concentration and time . Putting these same numbers on a graph can quickly reveal population patterns . Economists use graphs both for a compact and readable presentation of groups of numbers and for building an intuitive grasp of relationships and connections . Three types of graphs are used in this book line graphs , pie graphs , and bar graphs . Each is discussed below . We also provide warnings about how graphs can be manipulated to alter viewers perceptions of the relationships in the data . Line Graphs The graphs we have discussed so far are called line graphs , because they show a relationship between two variables one measured on the horizontal axis and the other measured on the vertical axis . Sometimes it is useful to show more than one set of data on the same axes . The data in Table is displayed in Figure which shows the relationship between two variables length and median weight for American baby boys and girls during the three years of life . The median means that half of all babies weigh more than this and half weigh less . The line graph measures length in inches on the horizontal axis and weight in pounds on the vertical axis . For example , point A on the shows that a boy who is 28 inches long will have a median weight of about 19 pounds . One line on the graph shows the relationship for boys and the other line shows the relationship for girls . This kind of graph is widely used by healthcare providers to check whether a child physical development is roughly on track . Access for free at

A The Use of Mathematics in Principles of Economics 847 I Elm . I I ' in A , 19 . in ' Li 15 22 26 25 Til ! 34 73 A Length ( FIGURE The Relationship for American Boys and Girls The line graph shows the relationship between height and weight for boys and girls from birth to years . Point A , for example , shows that a boy of 28 inches in height ( measured on the horizontal axis ) is typically 19 pounds in weight ( measured on the vertical axis ) These data apply only to children in the first three years of life . Buys from Birth to 36 Months Girls from Birth to 36 Months Length ( inches ) Weight ( pounds ) Length ( inches ) Weight ( pounds ) TABLE Length to Weight Relationship for American Boys and Girls Not all relationships in economics are linear . Sometimes they are curves . Figure presents another example ofa line graph , representing the data from Table . In this case , the line graph shows how thin the air becomes when you climb a mountain . The horizontal axis of the shows altitude , measured in meters above sea level . The Vertical axis measures the density of the air at each altitude . Air density is measured by the weight of the air in a cubic meter of space ( that is , a box measuring one meter in height , width , and depth )

848 A The Use of Mathematics in Principles of Economics As the graph shows , air pressure is heaviest at ground level and becomes lighter as you climb . Figure shows that a cubic meter of air at an altitude of 500 meters weighs approximately one kilogram ( about pounds ) However , as the altitude increases , air density decreases . A cubic meter of air at the top of Mount Everest , at about meters , would weigh only 0023 kilograms . The thin air at high altitudes explains why many mountain climbers need to use oxygen tanks as they reach the top of a mountain . Air Density ( Mount Everest ( I I I I I I I I I I Altitude ( in ) FIGURE All Density Relationship This line graph shows the relationship between altitude , measured in meters above sea level , and air density , measured in kilograms of air per cubic meter . As altitude rises , air density declines . The point at the top of Mount Everest has an altitude of approximately meters above sea level ( the horizontal axis ) and air density of kilograms per cubic meter ( the vertical axis ) Altitude ( meters ) Air Density ( meters ) 500 TABLE Altitude to Air Density Relationship Access for free at

A The Use of Mathematics in Principles of Economics 849 Altitude ( meters ) Air Density ( meters ) TABLE Altitude to Air Density Relationship The relationship and the density relationships in these two represent averages . Ifyou were to collect actual data on air pressure at different altitudes , the same altitude in different geographic locations will have slightly different air density , depending on factors like how far you are from the equator , local weather conditions , and the humidity in the air . Similarly , in measuring the height and weight of children for the previous line graph , children ofa particular height would have a range of different weights , some above average and some below . In the real world , this sort of variation in data is common . The task of a researcher is to organize that data in a way that helps to understand typical patterns . The study of statistics , especially when combined with computer statistics and spreadsheet programs , is a great help in organizing this kind of data , plotting line graphs , and looking for typical underlying relationships . For most economics and social science majors , a statistics course will be required at some point . One common line graph is called a time series , in which the horizontal axis shows time and the vertical axis displays another variable . Thus , a time series graph shows how a variable changes over time . Figure shows the unemployment rate in the United States since 1975 , where unemployment is as the percentage of adults who want jobs and are looking for a job , but can not find one . The points for the unemployment rate in each year are plotted on the graph , and a line then connects the points , showing how the unemployment rate has moved up and down since 1975 . The line graph makes it easy to see , for example , that the highest unemployment rate during this time period was slightly less than 10 in the early and 2010 , while the unemployment rate declined from the early to the end of the , before rising and then falling back in the early , and then rising sharply during the recession from .

850 A The Use of Mathematics in Principles of Economics CI . I . I ' tum HUI uh . Year FIGURE Unemployment Rate , This graph provides a quick visual summary of unemployment data . With a graph like this , it is easy to spot the times of high unemployment and of low unemployment . Pie Graphs A pie graph ( sometimes called a pie chart ) is used to show how an overall total is divided into parts . A circle represents a group as a whole . The slices of this circular pie show the relative sizes of . Figure shows how the population was divided among children , working age adults , and the elderly in 1970 , 2000 , and what is projected for 2030 . The information is conveyed with numbers in Table , and then in three pie charts . The column of Table shows the total population for each of the three years . Columns categorize the total in terms of age birth to 18 years , from 19 to 64 years , and 65 years and above . In columns , the number shows the actual number ofpeople in each age category , while the number in parentheses shows the percentage of the total population comprised by that age group . Year Total Population 19 and Under years Over 65 1970 million ( 2000 million ( 2030 million ( TABLE Age Distribution , 1970 , 2000 , and 2030 ( projected ) Access for free at

A The Use of Mathematics in Principles of Economics 851 201 Million Million ( 93 ) Million Million ( 285 ) Million 162 Million ( 52 ) a ) Age distribution in 1970 ( age distribution in 2000 70 Million ( 20 ) I 19 and under 1882 Million ( 535 ) I Over 65 ( age distribution in 2030 FIGURE Pie Graphs of the Age Distribution ( numbers in millions ) The three pie graphs illustrate the division of total population into three age groups for the three different years . In a pie graph , each slice of the pie represents a share of the total , or a percentage . For example , 50 would be half of the pie and 20 would be of the pie . The three pie graphs in Figure show that the share of the US . population 65 and over is growing . The pie graphs allow you to get a feel for the relative size of the different age groups from 1970 to 2000 to 2030 , without requiring you to slog through the numbers and percentages in the table . Some common examples of how pie graphs are used include dividing the population into groups by age , income level , ethnicity , religion , occupation dividing different into categories by size , industry , number of employees and dividing up government spending or taxes into its main categories . Bar Graphs A bar graph uses the height bars to compare quantities . Table lists the 12 most populous countries in the world . Figure provides this same data in a bar graph . The height of the bars corresponds to the population of each country . Although you may know that China and India are the most populous countries in the world , seeing how the bars on the graph tower over the other countries helps illustrate the magnitude of the difference between the sizes of national populations .

852 A The Use of Mathematics in Principles of Economics 1400 1200 1000 800 600 400 200 I I I I I I I I I I ' 6069 ?

Population ( 69 ' ab ?

99 00 FIGURE Leading Countries of the World by Population , 2015 ( in millions ) The graph shows the 12 countries of the world with the largest populations . The height of the bars in the bar graph shows the size of the population for each country . Country Population China India United States 321 Indonesia 255 Brazil 204 Pakistan 190 184 158 Russia 146 Japan 127 Mexico 121 Philippines 101 TABLE Leading 12 Countries of the World by Population Bar graphs can be subdivided in a way that reveals information similar to that we can get from pie charts . Figure offers three bar graphs based on the information from Figure about the age distribution in 1970 , 2000 , and 2030 . Figure ( a ) shows three bars for each year , representing the total number of persons in each age bracket for each year . Figure ( shows just one bar for each year , but the different age groups are now shaded inside the bar . In Figure ( still based on the same data , the vertical axis measures percentages rather than the number of persons . In this case , all three bar graphs are the same height , representing 100 of the population , with each bar divided according to the percentage of population in each age group . It is sometimes easier for a reader to run their eyes across several bar graphs , comparing the Access for free at

A The Use of Mathematics in Principles of Economics 853 shaded areas , rather than trying to compare several pie graphs . I 400 200 130 , 160 300 140 53 120 . 250 ' 100 200 30 150 . so . 40 100 20 50 1970 ' 2000 ' 2030 ' Time Pe ) Time Period ( year ) a ) Bars for separate age groups ( Bars show total population divided into age groups 100 A 19 and under I years 80 Over 65 ' 1970 2000 2030 Time Period ( year ) Bars show total population divided into percentages FIGURE AB Population with Bar Graphs Population data can be represented in different ways . a ) Shows three bars for each year , representing the total number of persons in each age bracket for each year . Shows just one bar for each year , but the different age groups are now shaded inside the bar . Sets the vertical axis as a measure of percentages rather than the number of persons . All three bar graphs are the same height and each bar is divided according to the percentage of population in each age group . Figure and Figure show how the bars can represent countries or years , and how the vertical axis can represent a numerical or a percentage value . Bar graphs can also compare size , quantity , rates , distances , and other quantitative categories . Comparing Line Graphs with Pie Charts and Bar Graphs Now that you are familiar with pie graphs , bar graphs , and line graphs , how do you know which graph to use for your data ?

Pie graphs are often better than line graphs at showing how an overall group is divided . However , if a pie graph has too many slices , it can become to interpret . Bar graphs are especially useful when comparing quantities . For example , if you are studying the populations of different countries , as in Figure , bar graphs can show the relationships between the population sizes of multiple countries . Not only can it show these relationships , but it can also show breakdowns of different groups within the population .

854 A The Use of Mathematics in Principles of A line graph is often the most effective format for illustrating a relationship between two variables that are both changing . For example , time series graphs can show patterns as time changes , like the unemployment rate over time . Line graphs are widely used in economics to present continuous data about prices , wages , quantities bought and sold , the size of the economy . How Graphs Can Be Misleading Graphs not only reveal patterns they can also alter how patterns are perceived . To see some of the ways this can be done , consider the line graphs of Figure , Figure , and Figure All . These graphs all illustrate the unemployment from different perspectives . iii 010 a . DO ) Qu ) 030500 00700700700100 Year ( a ) Unemployment rate . wide and short 11 I II ON ?

QO ) 010 ) 03050 ) Year ( Unemployment rate , narrow and tall Access for free at A The Use of Mathematics in Principles of Economics 855 30 28 26 24 22 20 18 Unemployment Rate ( to . on 75 I 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 ( Unemployment rate . with wider range 01 numbers on axis 10 Unemployment Rate ) to ) i i 13 ! VOl ( Unemployment rate . with smaller range of numbers on vertical axis Unemployment Rate ( CO 1960 1985 1970 1975 1980 1985 1990 1995 2000 2005 2010 Year ( Unemployment rate , averages FIGURE Presenting Unemployment Rates in Different Ways , All of Them Accurate Simply changing the width and height of the area in which data is displayed can alter the perception of the data .

856 A The Use of Mathematics in Principles of Economics Unemployment Rate ( 05 011111111111111111111111111 ( 999 ( Unemployment rate , monthly data 12 11 10 10 cu 35 32 ) Year ( Unemployment rates . since 1975 only FIGURE Presenting Unemployment Rates in Different Ways , All of Them Accurate Simply changing the width and height of the area in which data is displayed can alter the perception of the data . Suppose you wanted a graph which gives the impression that the rise in unemployment in 2009 was not all that large , or all that extraordinary by historical standards . You might choose to present your data as in Figure ( a ) Figure ( a ) includes much of the same data presented earlier in Figure , but stretches the horizontal axis out longer relative to the vertical axis . By spreading the graph wide and , the visual appearance is that the rise in unemployment is not so large , and is similar to some past rises in unemployment . Now imagine you wanted to emphasize how unemployment spiked substantially higher in 2009 . In this case , using the same data , you can stretch the vertical axis out relative to the horizontal axis , as in Figure ( which makes all rises and falls in unemployment appear larger . A similar effect can be accomplished without changing the length of the axes , but by changing the scale on the vertical axis . In Figure ( the scale on the vertical axis runs from to 30 , while in Figure ( the vertical axis runs from to 10 . Compared to Figure , where the vertical scale runs from to 12 , Figure ( makes the in unemployment look smaller , while Figure ( makes it look larger . Another way to alter the perception of the graph is to reduce the amount by changing the number plotted on the graph . Figure ( shows the unemployment rate according to averages . By averaging out some of the changes , the line appears smoother and with fewer highs and lows . In reality , the unemployment rate is reported monthly , and Figure ( shows the monthly since 1960 , which more than the average . Figure ( is also a vivid illustration of how graphs can Access for free at

A The Use of Mathematics in Principles of Economics 857 compress lots of data . The graph includes monthly data since 1960 , which over almost 50 years , works out to nearly 600 data points . Reading that list of 600 data points in numerical form would be hypnotic . You can , however , get a good intuitive sense of these 600 data points very quickly from the graph . A trick in manipulating the perception of graphical information is that , by choosing the starting and ending points carefully , you can the perception the variable is rising or falling . The original data show a general pattern with unemployment low in the , but spiking up in the , early , early , early , and late . Figure ( however , shows a graph that goes back only to 1975 , which gives an impression that unemployment was gradually falling over time until the 2009 recession pushed it back up to its original is a plausible interpretation if one starts at the high point around 1975 . These kinds of shall wejust call them presentation choices are not limited to line graphs . In a pie chart with many small slices and one large slice , someone must decide what categories should be used to produce these slices in the first place , thus making some slices appear bigger than others . If you are making a bar graph , you can make the vertical axis either taller or shorter , which will tend to make variations in the height of the bars appear more or less . Being able to read graphs is an essential skill , both in economics and in life . A graph is just one perspective or point , shaped by choices such as those discussed in this section . Do not always believe the first quick impression from a graph . View with caution . Key Concepts and Summary Math is a tool for understanding economics and economic relationships can be expressed mathematically using algebra or graphs . The algebraic equation for a line is , where is the variable on the horizontal axis and is the variable on the vertical axis , the term is the and the term is the slope . The slope of a line is the same at any point on the line and it indicates the relationship ( positive , negative , or zero ) between two economic variables . Economic models can be solved algebraically or graphically . Graphs allow you to illustrate data visually . They can illustrate patterns , comparisons , trends , and apportionment by condensing the numerical data and providing an intuitive sense of relationships in the data . A line graph shows the relationship between two variables one is shown on the horizontal axis and one on the vertical axis . A pie graph shows how something is allotted , such as a sum of money or a group of people . The size of each slice of the pie is drawn to represent the corresponding percentage of the whole . A bar graph uses the height of bars to show a relationship , where each bar represents a certain entity , like a country or a group of people . The bars on a bar graph can also be divided into segments to show . Any graph is a single visual perspective on a subject . The impression it leaves will be based on many choices , such as what data or time frame is included , how data or groups are divided up , the relative size of vertical and horizontal axes , whether the scale used on a vertical starts at zero . Thus , any graph should be regarded somewhat skeptically , remembering that the underlying relationship can be open to different interpretations . Review Questions Exercise Name three kinds of graphs and state when is most appropriate to use each type of graph . Exercise What is slope on a line graph ?

Exercise What do the slices ofa pie chart represent ?

Exercise 858 A The Use of Mathematics in Principles of Economics Why is a bar chart the best way to illustrate comparisons ?

Exercise How does the appearance of positive slope differ from negative slope and from zero slope ?

Access for free at Indifference Curves 859 APPENDIX Indifference Curves Economists use a vocabulary of maximizing utility to describe people preferences . In Consumer Choices , the level of utility that a person receives is described in numerical terms . This appendix presents an alternative approach to describing personal preferences , called indifference curves , which avoids any need for using numbers to measure utility . By setting aside the assumption of putting a numerical valuation on assumption that many students and economists uncomfortably indifference curve framework helps to clarify the logic of the underlying model . What Is an Indifference Curve ?

People can not really put a numerical value on their level of satisfaction . However , they can , and do , identify what choices would give them more , or less , or the same amount of satisfaction . An indifference curve shows combinations of goods that provide an equal level of utility or satisfaction . For example , Figure presents three indifference curves that represent Lilly preferences for the that she faces in her two main relaxation activities eating doughnuts and reading paperback books . Each indifference curve ( Um , and Uh ) represents one level of utility . First we will explore the meaning of one particular indifference curve and then we will look at the indifference curves as a group . 120 100 80 ' 60 Uh ( 40 ( Um 20 I I I I I I 12 Books FIGURE Indifference Curves Lilly would receive equal utility from all points on a given indifference curve . Any points on the highest indifference curve Uh , like , provide greater utility than any points like A , and on the middle indifference curve Um . Similarly , any points on the middle indifference curve Um provide greater utility than any points on the lowest indifference curve Ul . The Shape of an Indifference Curve

860 Indifference Curves The indifference curve Um has four points labeled on it A , and Since an indifference curve represents a set of choices that have the same level of utility , Lilly must receive an equal amount , judged according to her personal preferences , from two books and 120 doughnuts ( point A ) from three books and 84 doughnuts ( point ) from 11 books and 40 doughnuts ( point ) or from 12 books and 35 doughnuts ( point ) She would also receive the same utility from any of the unlabeled intermediate points along this indifference curve . Indifference curves have a roughly similar shape in two ways ) they are downward sloping from left to right ) they are convex with respect to the origin . In other words , they are steeper on the left and on the right . The downward slope of the indifference curve means that Lilly must trade off less of one good to get more of the other , while holding utility constant . For example , points A and sit on the same indifference curve Um , which means that they provide Lilly with the same level of utility . Thus , the marginal utility that Lilly would gain from , say , increasing her consumption of books from two to three must be equal to the marginal utility that she would lose if her consumption was cut from 120 to that her overall utility remains unchanged between points A and . Indeed , the slope along an indifference curve as the marginal rate of substitution , which is the rate at which a person is willing to trade one good for another so that utility will remain the same . Inc curves like Um are steeper on the left and on the right . The reason behind this shape involves diminishing marginal notion that as a person consumes more ofa good , the marginal ity from each additional unit becomes lower . Compare two different choices between points that all provide Lil an equal amount of utility along the indifference curve Um the choice between A and , and between and In both choices , Lilly consumes one more book , but between A and her consumption of doughnuts fal by 36 ( from 120 to 84 ) and between and it falls by only ( from 40 to 35 ) The reason for this difference is that points A and are different starting points , and thus have different implications for marginal ity . At point A , Lilly has few books and many doughnuts . Thus , her marginal utility from an extra book will be relatively high while the marginal utility of additional doughnuts is relatively on the margin , it will take a relatively large number to offset the utility from the marginal book . At point , however , Lil has many books and few doughnuts . From this starting point , her marginal utility gained from extra books will be relatively low , while the marginal utility lost from additional doughnuts would be relatively on the margin , it will take a relatively smaller number of doughnuts to offset the change of one marginal book . In short , the slope of the indifference curve changes because the marginal rate of su is , the quantity of one good that would be traded for the other good to keep utility changes , as a result of diminishing marginal utility goods . The Field of Indifference Curves Each indifference curve represents the choices that provide a single level of utility . Every level of utility will have its own indifference curve . Thus , Lilly preferences will include an number of indifference curves lying nestled together on the though only three of the indifference curves , representing three levels , appear on . In other words , an number of indifference curves are not drawn on this you should remember that they exist . Higher indifference curves represent a greater level of utility than lower ones . In Figure , indifference curve Ul can be thought of as a low level of utility , while Um is a medium level of utility and Uh is a high level of utility . All of the choices on indifference curve Uh are preferred to all of the choices on indifference curve Um , which in turn are preferred to all of the choices on Ul . To understand why higher indifference curves are preferred to lower ones , compare point on indifference curve Um to point on indifference curve Uh . Point has greater consumption of both books ( to three ) and doughnuts ( 100 to 84 ) so point is clearly preferable to point . Given the of an indifference all the points on the curve have the same level on indifference curve Uh is preferred to point on indifference curve Um , then it must be true that all points on indifference curve Uh Access for free at

Indifference Curves 861 have a higher level of utility than all points on Um . More generally , for any point on a lower indifference curve , like Ul , you can identify a point on a higher indifference curve like Um or Uh that has a higher consumption of both goods . Since one point on the higher indifference curve is preferred to one point on the lower curve , and since all the points on a given indifference curve have the same level , it must be true that all points on higher indifference curves have greater utility than all points on lower indifference curves . These arguments about the shapes of indifference curves and about higher or lower levels of utility do not require any numerical estimates of utility , either by the individual or by anyone else . They are only based on the assumptions that when people have less of one good they need more of another good to make up for it , if they are keeping the same level of utility , and that as people have more of a good , the marginal utility they receive from additional units of that good will diminish . Given these gentle assumptions , a of indifference curves can be mapped out to describe the preferences of any individual . The Individuality of Indifference Curves Each person determines their own preferences and utility . Thus , while indifference curves have the same general slope down , and the slope is steeper on the left and on the shape of indifference curves can be different for every person . Figure , for example , applies only to preferences . Indifference curves for other people would probably travel through different points . with Indifference Curves People seek the highest level of utility , which means that they wish to be on the highest possible indifference curve . However , people are limited by their budget constraints , which show what are actually possible . Maximizing Utility at the Highest Indifference Curve Return to the situation of Lilly choice between paperback books and doughnuts . Say that books cost , doughnuts are 50 cents each , and that Lilly has 60 to spend . This information provides the basis for the budget line shown in Figure . Along with the budget line are shown the three indifference curves from Figure . What is Lilly choice ?

Several possibilities are in the diagram . 120 100 80 60 40 20 Books FIGURE Indifference Curves and a Budget Constraint Lilly preferences are shown by the indifference curves . Lilly budget constraint , given the prices of books and doughnuts and her income , is shown by the straight line .

862 Indifference Curves Lilly optimal choice will be point , where the budget line is tangent to the indifference curve Um . Lilly would have more utility at a point like on the higher indifference curve Uh , but the budget line does not touch the higher indifference curve Uh at any point , so she can not afford this choice . A choice like is affordable to Lilly , but it lies on indifference curve Ul and thus provides less utility than choice , which is on indifference curve Um . The choice of with books and 100 doughnuts is highly desirable , since it is on the highest indifference curve Uh of those shown in the diagram . However , it is not affordable given Lilly budget constraint . The choice of with three books and 70 doughnuts on indifference curve Ul is a wasteful choice , since it is inside Lilly budget set , and as a , Lilly will always prefer a choice on the budget constraint itself . Choices and are both on the opportunity set . However , choice of six books and 48 doughnuts is on lower indifference curve Ul than choice of three books and 84 doughnuts , which is on the indifference curve Um . If Lilly were to start at choice , and then thought about whether the marginal utility she was deriving from doughnuts and books , she would decide that some additional doughnuts and fewer books would make her would cause her to move toward her preferred choice . Given the combination of personal preferences , as by her indifference curves , and Lilly opportunity set , which is determined by prices and income , will be her choice . The highest achievable indifference curve touches the opportunity set at a single point of tangency . Since an number of indifference curves exist , even ifonly a few of them are drawn on any given diagram , there will always exist one indifference curve that touches the budget line at a single point of tangency . All higher indifference curves , like Uh , will be completely above the budget line and , although the choices on that indifference curve would provide higher utility , they are not affordable given the budget set . All lower indifference curves , like Ul , will cross the budget line in two separate places . When one indifference curve crosses the budget line in two places , however , there will be another , higher , attainable indifference curve sitting above it that touches the budget line at only one point of tangency . Changes in Income A rise in income causes the budget constraint to shift to the right . In graphical terms , the new budget constraint will now be tangent to a higher indifference curve , representing a higher level of utility . A reduction in income will cause the budget constraint to shift to the left , which will cause it to be tangent to a lower indifference curve , representing a reduced level of utility . If income rises by , for example , 50 , exactly how much will a person alter consumption of books and doughnuts ?

Will consumption of both goods rise by 50 , or will the quantity of one good rise substantially , while the quantity of the other good rises only a little , or even declines ?

Since personal preferences and the shape of indifference curves are different for each individual , the response to changes in income will be different , too . For example , consider the preferences of Manuel and Natasha in Figure ( a ) and Figure 133 ( They each start with an identical income of 40 , which they spend on yogurts that cost and rental movies that cost . Thus , they face identical budget constraints . However , based on Manuel preferences , as revealed by his indifference curves , his choice on the original budget set occurs where his opportunity set is tangent to the highest possible indifference curve at , with three movies and 28 yogurts , while Natasha choice on the original budget set at will be seven movies and 12 yogurts . Access for free at

Indifference Curves 863 50 so New budget constraint 40 40 20 20 Original budget Original budget constraint constraint 10 15 10 15 Rental Movies Rental Movies ( a ) reaction to more income ( Natasha reaction to more income FIGURE Manuel and Natasha Indifference Curves Manuel and Natasha originally face the same budget constraints that is , same prices and same income . However , the indifference curves that illustrate their preferences are not the same . a ) Manuel original choice at involves more yogurt and more movies , and he reacts to the higher income by mainly increasing consumption of movies at . Conversely , Natasha original choice ( involves relatively more movies , but she reacts to the higher income by choosing relatively more yogurts . Even when budget constraints are the same , personal preferences lead to different original choices and to different reactions in response to a change in income . Now , say that income rises to 60 for both Manuel and Natasha , so their budget constraints shift to the right . As shown in Figure ( a ) Manuel new utility maximizing choice at will be seven movies and 32 is , Manuel will choose to spend most of the extra income on movies . Natasha new utility maximizing choice at will be eight movies and 28 is , she will choose to spend most of the extra income on yogurt . In this way , the indifference curve approach allows for a range of possible responses . However , goods are normal goods , then the typical response to a higher level of income will be to purchase more of exactly how much more is a matter preference . If one of the goods is an inferior good , the response to a higher level of income will be to purchase less of it . Responses to Price Changes Substitution and Income Effects A higher price for a good will cause the budget constraint to shift to the left , so that it is tangent to a lower indifference curve representing a reduced level . Conversely , a lower price for a good will cause the opportunity set to shift to the right , so that it is tangent to a higher indifference curve representing an increased level of utility . Exactly how much a change in price will lead to the quantity demanded good will depend on personal preferences . Anyone who faces a change in price will experience two interlinked motivations a substitution effect and an income effect . The substitution effect is that when a good becomes more expensive , people seek out substitutes . If oranges become more expensive , scale back on oranges and eat more apples , grapefruit , or raisins . Conversely , when a good becomes cheaper , people substitute toward consuming more . If oranges get cheaper , people up machines and ease off on other fruits and foods . The income effect refers to how a change in the price of a good alters the effective buying power of one income . If the price ofa good that you have been buying falls , then in effect your buying power has are able to purchase more goods . Conversely , if the price of a good that you have been buying rises , then the buying power of a given

864 Indifference Curves amount of income is diminished . One common source of confusion is that the income effect does not refer to a change in actual income . Instead , it refers to the situation in which the price ofa good changes , and thus the quantities of goods that can be purchased with a amount of income change . It might be more accurate to call the income effect a buying power effect , but the income effect terminology has been used for decades , and it is not going to change during this economics course . Whenever a price changes , consumers feel the pull of both substitution and income effects at the same time . Using indifference curves , you can illustrate the substitution and income effects on a graph . In Figure , Ogden faces a choice between two goods haircuts or personal pizzas . Haircuts cost 20 , personal pizzas cost , and he has 120 to spend . Haircuts 10 20 Pizza FIGURE Substitution and Income Effects The original choice is A , the point of tangency between the original budget constraint and indifference curve . The new choice is , the point of tangency between the new budget constraint and the lower indifference curve . Point is the tangency between the dashed line , where the slope shows the new higher price of haircuts , and the original indifference curve . The substitution effect is the shift from A to , which means getting fewer haircuts and more pizza . The income effect is the shift from to that is , the reduction in buying power that causes a shift from the higher indifference curve to the lower indifference curve , with relative prices remaining unchanged . The income effect results in less consumed of both goods . Both substitution and income effects cause fewer haircuts to be consumed . For pizza , in this case , the substitution effect and income effect cancel out , leading to the same amount of pizza consumed . The price of haircuts rises to 30 . Ogden starts at choice A on the higher opportunity set and the higher indifference curve . After the price of haircuts increases , he chooses on the lower opportunity set and the lower indifference curve . Point with two haircuts and 10 personal pizzas is immediately below point A with three haircuts and 10 personal pizzas , showing that Ogden reacted to a higher price of haircuts by cutting back only on haircuts , while leaving his consumption of pizza unchanged . The dashed line in the diagram , and point , are used to separate the substitution effect and the income effect . To understand their function , start by thinking about the substitution effect with this question How would Ogden change his consumption if the relative prices of the two goods changed , but this change in relative prices did not affect his utility ?

The slope of the budget constraint is determined by the relative price of the two goods thus , the slope of the original budget line is determined by the original relative prices , while the slope of the new budget line is determined by the new relative prices . With this thought in mind , the dashed line is a graphical tool inserted in a way It is inserted so that it is parallel with the new budget constraint , so it the new relative prices , but it is tangent to the original indifference curve , so it the original level of utility or buying power . Thus , the movement from the original choice ( A ) to point is a substitution effect it shows the choice that Access for free at

Indifference Curves 865 Ogden would make if relative prices shifted ( as shown by the different slope between the original budget set and the dashed line ) but power did not shift ( as shown by being tangent to the original indifference curve ) The substitution effect will encourage people to shift away from the good which has become relatively more Ogden case , the haircuts on the vertical toward the good which has become relatively less this case , the pizza on the vertical axis . The two arrows labeled with for substitution effect , one on each axis , show the direction of this movement . The income effect is the movement from point to , which shows how Ogden reacts to a reduction in his buying power from the higher indifference curve to the lower indifference curve , but holding constant the relative prices ( because the dashed line has the same slope as the new budget constraint ) In this case , where the price of one good increases , buying power is reduced , so the income effect means that consumption goods should fall ( if they are both normal goods , which it is reasonable to assume unless there is reason to believe otherwise ) The two arrows labeled with i for income effect , one on each axis , show the direction of this income effect movement . Now , put the substitution and income effects together . When the price increased , Ogden consumed less of it , for two reasons shown in the exhibit the substitution effect of the higher price led him to consume less and the income effect of the higher price also led him to consume less . However , when the price of pizza increased , Ogden consumed the same quantity of haircuts . The substitution effect of a higher price for pizza meant that haircuts became relatively less expensive ( compared to pizza ) and this factor , taken alone , would have encouraged Ogden to consume more haircuts . However , the income effect of a higher price for pizza meant that he wished to consume less of both goods , this factor , taken alone , would have encouraged Ogden to consume fewer haircuts . As shown in Figure , in this particular example the substitution effect and income effect on Ogden consumption of haircuts are of he ends up consuming the same quantity of haircuts after the price increase for pizza as before . The size of these income and substitution effects will dif er from person to person , depending on individual preferences . For example , if Ogden substitution effect away from pizza and toward haircuts is especially strong , and outweighs the income effect , then a higher price for pizza might lead to increased consumption of haircuts . This case would be drawn on the graph so that the point of tangency between the new budget constraint and the relevant indifference curve occurred point and to the right . Conversely , if the substitution effect away from pizza and toward haircuts is not as strong , and the income effect on is relatively stronger , then Ogden will be more likely to react to the higher price of pizza by consuming less of both goods . In this case , his optimal choice after the price change wi above and to the left of choice on the new budget constraint . Although the substitution and income effects are often as a sequence of events , it should be remembered that they are twin components of a single change in price . Although you can analyze them separately , the two effects are always proceeding hand in hand , happening at the same time . Indifference Curves with and Choices The concept of an indifference curve applies to in any household choice , including the choice or the choice between present and future consumption . In the choice , each indifference curve shows the combinations of leisure and income that provide a certain level of utility . In an choice , each indifference curve shows the combinations of present and future consumption that provide a certain level of utility . The general shapes of the indifference sloping , steeper on the left and on the remain the same . A Example Petunia is working at ajob that pays 12 per hour but she gets a raise to 20 per hour . After family responsibilities and sleep , she has 80 hours per week available for work or leisure . As shown in Figure , the highest level of utility for Petunia , on her original budget constraint , is at choice A , where it is tangent to the

866 Indifference Curves lower indifference curve ( Ul ) Point A has 30 hours of leisure and thus 50 hours per week of work , with income of 600 per week ( that is , 50 hours ofwork at 12 per hour ) Petunia then gets a raise to 20 per hour , which shifts her budget constraint to the right . Her new choice occurs where the new budget constraint is tangent to the higher indifference curve Uh . At , Petunia has 40 hours of leisure per week and works 40 hours , with income of 800 per week ( that is , 40 hours of work at 20 per hour ) 40 . 8800 ) Income ( Uh Original budget constraint 20 30 40 60 80 Hours of Leisure FIGURE Effects of a Change in Petunia Wage Petunia starts at choice A , the tangency between her original budget constraint and the lower indifference curve . The wage increase shifts her budget constraint to the right , so that she can now choose on indifference curve Uh . The substitution effect is the movement from A to In this case , the substitution effect would lead Pe to choose less leisure , which is relatively more expensive , and more income , which is relatively cheaper to earn . The income effect is the movement from to . The income effect in this example leads to greater consumption of both goods . Overall , in this example , income rises because of both substitution and income effects . However , declines because of the substitution effect but increases because of the income , in Petunia case , to an overall increase in the quantity of leisure consumed . Substitution and income effects provide a vocabulary for discussing how Petunia reacts to a higher hourly wage . The dashed line serves as the tool or separating the two effects on the graph . The substitution effect tells how Petunia would have changed her hours of work if her wage had risen , so that income was relatively cheaper to earn and leisure was relatively more expensive , but if she had remained at the same level of utility . The slope of the constraint in a diagram is determined by the wage rate . Thus , the dashed line is carefully inserted with the slope of the new opportunity set , the tradeoff of the new wage rate , but tangent to the original indifference curve , showing the same level of utility or buying The shi from original choice A to point , which is the point of tangency between the original indifference curve and the dashed line , shows that because of the higher wage , Petunia will want to consume less leisure and more income . The arrows on the horizontal and vertical axes of Figure show the substitution effect on leisure and on income . The income effect is that the higher wage , by shifting the budget constraint to the right , makes it possible for Petunia to reach a higher level of utility . The income effect is the movement from point to point that is , it shows how Petunia behavior would change in response to a higher level of utility or buying power , with the wage rate remaining the same ( as shown by the dashed line being parallel to the new budget constraint ) The income effect , encouraging Petunia to consume both more leisure and more income , is drawn with arrows on the horizontal and vertical axis of Figure . Putting these effects together , Petunia responds to the higher wage by moving from choice A to choice . This movement involves choosing more income , both because the substitution effect of higher wages has made Access for free at

Indifference Curves 867 income relatively cheaper or easier to earn , and because the income effect of higher wages has made it possible to have more income and more leisure . Her movement from A to also involves choosing more leisure because , according to Petunia preferences , the income effect that encourages choosing more leisure is stronger than the substitution effect that encourages choosing less leisure . Figure represents only Petunia preferences . Other people might make other choices . For example , a person whose substitution and income effects on leisure exactly each other might react to a higher wage with a choice like , exactly above the original choice A , which means taking all of the of the higher wages in the form of income while working the same number of hours . Yet another person , whose substitution effect on leisure outweighed the income effect , might react to a higher wage by making a choice like , where the response to higher wages is to work more hours and earn much more income . To represent these different preferences , you could easily draw the indifference curve Uh to be tangent to the new budget constraint at or , rather than at . An Choice Example Quentin has saved up . He is thinking about spending some or all of it on a vacation in the present , and then will save the rest for another big vacation years from now . Over those years , he expects to earn a total 80 rate of return . Figure 130 shows Quentin budget constraint and his indifference curves between present consumption and future consumption . The highest level of utility that Quentin can achieve at his original budget constraint occurs at point A , where he is consuming , saving for the future , and expecting with the accumulated interest to have for future consumption ( that is , in current savings plus the 80 rate of return ) However , Quentin has just realized that his expected rate of return was high . A more realistic expectation is that over years he can earn a total return of 30 . In effect , his budget constraint has pivoted to the left , so that his original choice is no longer available . Will Quentin react to the lower rate of return by saving more , or less , or the same amount ?

Again , the language of substitution and income effects provides a framework for thinking about the motivations behind various choices . The dashed line , which is a graphical tool to separate the substitution and income effect , is carefully inserted with the same slope as the new opportunity set , so that it the changed rate of return , but it is tangent to the original indifference curve , so that it shows no change in utility or buying power . The substitution effect tells how Quentin would have altered his consumption because the lower rate of return makes future consumption relatively more expensive and present consumption relatively cheaper . The movement from the original choice A to point shows how Quentin substitutes toward more present consumption and less future consumption in response to the lower interest rate , with no change in utility . The substitution arrows on the horizontal and vertical axes of Figure 130 show the direction of the substitution effect motivation . The substitution effect suggests that , because of the lower interest rate , Quentin should consume more in the present and less in the future . Quentin also has an income effect motivation . The lower rate of return shifts the budget constraint to the left , which means that Quentin utility or buying power is reduced . The income effect ( assuming normal goods ) encourages less present and future consumption . The impact of the income effect on reducing present and future consumption in this example is shown with i arrows on the horizontal and vertical axis of Figure .

868 Indifference Curves 5000 ' 35 000 . 35 mo ( A ( 000 , Future Consumption Present Consumption FIGURE Indifference Curve and an Budget Constraint The original choice is A , at the tangency between the original budget constraint and the original indifference curve Uh . The dashed line is drawn parallel to the new budget set , so that its slope reflects the lower rate of return , but is tangent to the original indifference curve . The movement from A to is the substitution effect in this case , future consumption has become relatively more expensive , and present consumption has become relatively cheaper . The income effect is the shift from to that is , the reduction in utility or buying power that causes a move to a lower indifference curve Ul , but with the relative price the same . It means less present and less future consumption . In the move from A to , the substitution effect on present consumption is greater than the income effect , so the overall result is more present consumption . Notice that the lower indifference curve could have been drawn tangent to the lower budget constraint point or point , depending on personal preferences . Taking both effects together , the substitution effect is encouraging Quentin toward more present and less future consumption , because present consumption is relatively cheaper , while the income effect is encouraging him to less present and less future consumption , because the lower interest rate is pushing him to a lower level . For Quentin personal preferences , the substitution effect is stronger so that , overall , he reacts to the lower rate of return with more present consumption and less savings at choice . However , other people might have different preferences . They might react to a lower rate of return by choosing the same level of present consumption and savings at choice , or by choosing less present consumption and more savings at a point like For these other sets of preferences , the income effect of a lower rate of return on present consumption would be relatively stronger , while the substitution effect would be relatively weaker . Sketching Substitution and Income Effects Indifference curves provide an analytical tool for looking at all the choices that provide a single level of utility . They eliminate any need for placing numerical values on utility and help to illuminate the process of making decisions . They also provide the basis for a more detailed investigation of the complementary motivations that arise in response to a change in a price , wage or rate of , the substitution and income effects . Ifyou are finding it a little tricky to sketch diagrams that show substitution and income effects so that the points of tangency all come out correctly , it may be useful to follow this procedure . Step . Begin with a budget constraint showing the choice between two goods , which this example will call candy and movies . Choose a point A which will be the optimal choice , where the indifference curve will be it is often easier not to draw in the indifference yet . See Figure . Access for free at

Indifference Curves 369 Movies Candy FIGURE Step . Now the price of movies changes let say that it rises . That shifts the budget set inward . You know that the higher price will push the down to a lower level of utility , represented by a lower indifference curve . But at this stage , draw only the new budget set . See Figure . A Movies Candy FIGURE Step . The key tool in distinguishing between substitution and income effects is to insert a dashed line , parallel to the new budget line . This line is a graphical tool that allows you to distinguish between the two changes ( the effect on consumption of the two goods of the shift in the level of utility remaining is the substitution effect and ( the effect on consumption of the two goods of shifting from one indifference curve to the relative prices staying is the income effect . The dashed line is inserted in this step . The trick is to have the dashed line travel close to the original choice A , but not directly through point A . See Figure .

870 Indifference Curves Movies Candy FIGURE Step . Now , draw the original indifference curve , so that it is tangent to both point A on the original budget line and to a point on the dashed line . Many students it easiest to select the tangency point where the original indifference curve touches the dashed line , and then to draw the original indifference curve through A and The substitution effect is illustrated by the movement along the original indifference curve as prices change but the level of utility holds constant , from A to As expected , the substitution effect leads to less consumed of the good that is relatively more expensive , as shown by the ( substitution ) arrow on the vertical axis , and more consumed of the good that is relatively less expensive , as shown by the arrow on the horizontal axis . See Figure . Movies Candy FIGURE Step . With the substitution effect in place , now choose point on the new opportunity set . When you choose point , think about whether you wish the substitution or the income effect to have a larger impact on the good ( in this case , candy ) on the horizontal axis . If you choose point to be directly in a vertical line with point A ( as is illustrated here ) then the income effect will be exactly offsetting the substitution effect on the horizontal axis . If you insert point so that it lies a little to right of the original point A , then the Access for free at

Indifference Curves substitution effect will exceed the income effect . If you insert point so that it lies a little to the left of point A , then the income effect will exceed the substitution effect . The income effect is the movement from to , showing how choices shifted as a result of the decline in buying power and the movement between two levels of utility , with relative prices remaining the same . With normal goods , the negative income effect means less consumed good , as shown by the direction of the i ( income effect ) arrows on the vertical and horizontal axes . See Figure . Candy FIGURE In sketching substitution and income effect diagrams , you may wish to practice some of the following variations ( Price falls instead of a rising ( The price change affects the good on either the vertical or the horizontal axis ( Sketch these diagrams so that the substitution effect exceeds the income effect the income effect exceeds the substitution effect and the two effects are equal . One note The helpful dashed line can be drawn tangent to the new indifference curve , and parallel to the original budget line , rather than tangent to the original indifference curve and parallel to the new budget line . Some students this approach more intuitively clear . The answers you get about the direction and relative sizes of the substitution and income effects , however , should be the same . Key Concepts and Summary An indifference curve is drawn on a budget constraint diagram that shows the between two goods . All points along a single indifference curve provide the same level . Higher indifference curves represent higher levels . Indifference curves slope downward because , if utility is to remain the same at all points along the curve , a reduction in the quantity of the good on the vertical axis must be by an increase in the quantity of the good on the horizontal axis ( or vice versa ) Indifference curves are steeper on the far left and on the far right , because of diminishing marginal utility . The choice along a budget constraint will be the point of tangency where the budget constraint touches an indifference curve at a single point . A change in the price of any good has two effects a substitution effect and an income effect . The substitution effect motivation encourages a to buy less of what is relatively more expensive and more of what is relatively cheaper . The income effect motivation encourages a to buy more of both goods rises or less goods if utility falls ( if they are both normal goods ) In a choice , every wage change has a substitution and an income effect . The substitution effect of a wage increase is to choose more income , since it is cheaper to earn , and less leisure , since its opportunity

872 Indifference Curves cost has increased . The income effect of a wage increase is to choose more of leisure and income , since they are both normal goods . The substitution and income effects ofa wage decrease would reverse these directions . In an consumption choice , every interest rate change has a substitution and an income effect . The substitution effect of an interest rate increase is to choose more future consumption , since it is now cheaper to earn future consumption and less present consumption ( more savings ) since the opportunity cost consumption in terms ofwhat is being given up in the future has increased . The income effect of an interest rate increase is to choose more present and future consumption , since they are both normal goods . The substitution and income effects of an interest rate decrease would reverse these directions . Review Questions Exercise What point is preferred along an indifference curve ?

Exercise Why do indifference curves slope down ?

Exercise Why are indifference curves steep on the left and on the right ?

Exercise How many indifference curves does a person have ?

Exercise How can you tell which indifference curves represent higher or lower levels of utility ?

Exercise What is a substitution effect ?

Exercise What is an income effect ?

Exercise Does the income effect involve a change in income ?

Explain . Exercise Does a change in price have both an income effect and a substitution effect ?

Does a change in income have both an income effect and a substitution effect ?

Exercise Would you expect , in some cases , to see only an income effect or only a substitution effect ?

Explain . Exercise Which is larger , the income effect or the substitution effect ?

Access for free at Present Discounted Value APPENDIX Present Discounted Value As explained in Financial Markets , the prices of stocks and bonds depend on future events . The price ofa bond depends on the future payments that the bond is expected to make , including both payments of interest and the repayment of the face value of the bond . The price of a stock depends on the expected future earned by the . The concept ofa present discounted value ( which is as the amount you should be willing to pay in the present for a stream of expected future payments , can be used to calculate appropriate prices for stocks and bonds . To place a present discounted value on a future payment , think about what amount of money you would need to have in the present to equal a certain amount in the future . This calculation will require an interest rate . For example , if the interest rate is 10 , then a payment of 110 a year from now will have a present discounted value of is , you could take 100 in the present and have 110 in the future . We will shows how to apply the idea discounted value to a stock and then we will show how to apply it to a bond . Applying Present Discounted Value to a Stock Consider the case of Babble , a company that offers speaking lessons . For the sake of simplicity , say that the founder of Babble is 63 years old and plans to retire in two years , at which point the company will be disbanded . The company is selling 200 shares of stock and are expected to be 15 million right away , in the present , 20 million one year from now , and 25 million two years from now . All will be paid out as dividends to shareholders as they occur . Given this information , what will an investor pay for a share of stock in this company ?

A investor , thinking about what future payments are worth in the present , will need to choose an interest rate . This interest rate will the rate of return on other available investment opportunities , which is the opportunity cost of investing capital , and also a risk premium ( that is , using a higher interest rate than the rates available elsewhere if this investment appears especially risky ) In this example , say that the investor decides that appropriate interest rate to value these future payments is 15 . Table shows how to calculate the present discounted value of the future . For each time period , when a is going to be received , apply the formula Future value received years in the future ( Interest ) numbers of years Present discounted value Payments from Firm Present Value 15 million in present 15 million 20 million in one year 20 ( million 25 million in two years 25 ( million Total million TABLE Calculating Present Discounted Value of a Stock Next , add up all the present values for the different time periods to get a answer . The present value calculations ask what the amount in the future is worth in the present , given the 15 interest rate . Notice that

874 Present Discounted Value a different calculation needs to be done separately for amounts received at different times . Then , divide the of total by the number of shares , 200 in this case million . The price per share should be about per share . Of course , in the real world expected are a best guess , not a hard piece of data . Deciding which interest rate to apply for discounting to the present can be tricky . One needs to take into account both potential capital gains from the future sale of the stock and also dividends that might be paid . Differences of opinion on these issues are exactly why some investors want to buy a stock that other people want to sell they are more optimistic about its future prospects . Conceptually , however , it all comes down to what you are willing to pay in the present for a stream to be received in the future . Applying Present Discounted Value to a Bond A similar calculation works in the case of bonds . Financial Markets explains that if the interest rate falls after a bond is issued , so that the investor has locked in a higher rate , then that bond will sell for more than its face value . Conversely , if the interest rate rises after a bond is issued , then the investor is locked into a lower rate , and the bond will sell for less than its face value . The present value calculation sharpens this intuition . Think about a simple bond . It was issued for at an interest rate of . Thus , after the year , the bond pays interest of 240 ( which is ) At the end of the second year , the bond pays 240 in interest , plus the in principle . Calculate how much this bond is worth in the present if the discount rate is . Then , recalculate if interest rates rise and the applicable discount rate is 11 . To carry out these calculations , look at the stream being received from the bond in the future and out what they are worth in present discounted value terms . The calculations applying the present value formula are shown in Table . Stream of Payments ( for Present Value ( for the Stream of Payments ( for Present Value ( for the the interest rate ) interest rate ) the 11 interest rate ) 11 interest rate ) 240 payment after one ( 240 payment after one year year payment after ( payment after ( second year second year Total Total TABLE Computing the Present Discounted Value of a Bond The calculation shows that the present value of a bond , issued at , is just . After all , that is how much money the borrower is receiving . The calculation that the present value is the same for the lender . The bond is moving money around in time , from those willing to save in the present to those who want to borrow in the present , but the present value ofwhat is received by the borrower is identical to the present value ofwhat will be repaid to the lender . The second calculation shows what happens if the interest rate rises from to 11 . The actual dollar payments in the column , as determined by the interest rate , do not change . However , the present value of those payments , now discounted at a higher interest rate , is lower . Even though the future dollar payments that the bond is receiving have not changed , a person who tries to sell the bond will that the investments value has fallen . Again , calculations are often more complex , in part because , not only the interest rate prevailing in the market , but also the riskiness of whether the borrower will repay the loan , will change . In any case , the price ofa bond is always the present value of a stream of future expected payments . Access for free at

Present Discounted Value 375 Other Applications Present discounted value is a widely used analytical tool outside the world of . Every time a business thinks about making a physical capital investment , it must compare a set of present costs of making that investment to the present discounted value of future . When government thinks about a proposal to , for example , add safety features to a highway , it must compare costs incurred in the present to received in the future . Some academic disputes over environmental policies , like how much to reduce carbon dioxide emissions because of the risk that they will lead to a warming of global temperatures several decades in the future , turn on how one compares present costs of pollution control with future . Someone who wins the lottery and is scheduled to receive a string of payments over 30 years might be interested in knowing what the present discounted value is of those payments . Whenever a string of costs and stretches from the present into different times in the future , present discounted value becomes an indispensable tool of analysis .