SELECTED ANSWERS:

QUESTIONS ON INTERNATIONAL TRADE, SPECULATION, AND ARBITRAGE

2. Draw three graphs side by side to show equilibrium in the world market for corn, U.S. exports of corn, and foreign imports of corn.

See this graph.  At the equilibrium world price, foreign imports equal U.S. exports.
 

3. Who would gain and who would lose if foreign governments were to prohibit imports of film from the United States?

U.S. film producers and foreign consumers lose. U.S. consumers and foreign producers win. The price of film would be lower in the U.S. and higher in the foreign countries.
 

4. Explain why an increase in the foreign supply of film reduces output of film in the United States?

An increase in the foreign supply of film lowers the world equilibrium price. This fall in price reduces the quantity supplied in the United States.
 

5. What is arbitrage? What is an arbitrage opportunity?

Arbitrage is the process of buying something at a place where its price is low, and selling it where its price is higher.  An arbitrage opportunity is a situation in which someone finds out about a price differential that exceeds the cost of arbitrage.
 

6. Explain why equilibrium allows no arbitrage opportunities.

Equilibrium is a situation that has no tendency to change unless market conditions change.  Whenever an arbitrage opportunity arises, people have an incentive to buy and resell more of the good -- so an arbitrage opportunity provides an incentive for a change, and cannot be an equilibrium.  In equilibrium, people have already made use of all available arbitrage opportunities, so there are no more remaining price differentials that exceed the costs of arbitrage.
 

7.  Explain why the equilibrium price differential is zero.

Arbitrage tends to eliminate price differentials.  Arbitrage opportunities disappear as people take advantage of them.  In equilibrium, there are no arbitrage opportunities because when people have arbitrage opportunities, they can profit from additional arbitrage.  This additional arbitrage reduces the price differential -- it raises the price in the place arbitragers buy, and lowers the price in the place arbitragers sell -- until the equilibrium price differential is zero (when arbitrage is costless).
 

8. Who gains and who loses from arbitrage?

Arbitrage raises the price of a good in one location and reduces it somewhere else. Sellers gain and buyers lose in the location where the price rises. Sellers lose and buyers gain in the location where the price falls.
 

9. What is speculation?

Speculation is the process of buying something at a time when its price is low and storing it to sell later when its price might be higher (or storing it to use later).
 

11.  How is today's equilibrium price related to the expected future price?  Explain why.

With costless speculation, a good's expected future price cannot exceed its current price. That's because if people expect the price to be higher in the future than today, they buy and store the good, planning to sell it at a higher price in the future. This activity raises the price today and lowers the expected future price.  As long as the expected future price remains higher than the current price, the scale of speculation increases, further raising the current price and further lowering the expected future price, until they are equal.
 

12. What happens to the current price of a storable good if its expected future demand rises?

An increase in expected future demand, raises the expected future price. This creates an incentive for speculators to store more of the good for future resale, which raises the current price.
 

13. What are the costs of arbitrage and speculation?

See pages 167-169.

14. Use a graph like Figure 7 (page 168) to show how a fall in the cost of arbitrage affects (a) the price at each location, (b) output at each location, and (c) consumption at each location.

Suppose the arbitrage costs fall from $2 per unit, as in Figure 7, to zero.  Then the new equilibrium looks like Figure 4.  Regardless of whether the cost falls all the way to zero, the price falls in the location that previously had the high price (like Boston in Figure 7), and rises in the place (like Minneapolis in Figure 7) that previously had the low price.  In the previously high-price place (like Boston), production falls and consumption rises.   In the previously low-price place (like Minneapolis), production rises and consumption falls.

15. What is a futures price? What is a spot price?

Futures prices are prices of goods for delivery at future dates.  Spot prices are the prices of goods for current delivery (delivery now).
 

16. How is the equilibrium futures price of lumber related to the spot price that people expect for a future date.

The equilibrium futures price equals the expected future spot price.
 

17. Explain why stock prices follow a random walk.

Stock prices follow a random walk because, in equilibrium, the expected future price of a stock approximately equals its current price.  If the current price of a stock were below its expected future price, people would buy more of that stock (to try to profit), driving up the price now.  The oppposite would happen if the current price of a stock were above its expected future price: people would sell the stock (and some would sell it short, borrowing it to sell).   In other words, the future price might be higher or lower than the current price, but on average it will be the current price.
        In fact, stock prices actually follow a random walk with drift -- stock prices have an upward trend.  That trend reflects the cost of speculation in the stock market -- the opportunity cost of having your money in the stock market rather than in another investment, such as a savings account at a bank where your money would earn interest.  The upward trend, or drift, in stock prices pays investors for this opportunity cost.  Stock prices then follow a random walk around this upward trend.
 

18. Would the U.S. interest rate rise or fall if the government were to prohibit borrowing from people in foreign countries? Explain why.

International trade

(See this graph to see why.)  International trade in loans is like international trade in other goods: exporting loans means lending to other countries; importing loans means borrowing from other countries.  Because the U.S. borrows from people in other countries (in real life), prohibiting international trade in loans would raise the interest rate in the U.S.
 

19. Would the United States borrow more or less from people in other countries if people in the United States saved more? Explain why.

If people in the U.S. saved more, the supply of loans in the U.S. would rise.  The United States would borrow less from people in other countries if people in the United States save more money. The world interest rate would fall leading to less lending by other countries. Since they lend less we borrow less.
 

20. Refer to the accompanying table to answer the following questions:
 
United States
Other Countries
World
  
Price
Quantity Demanded
Quantity Supplied
Quantity Demanded
Quantity Supplied
Quantity Demanded
Quantity Supplied
12
2
13
5
25
    
11
4
12
6
22
    
10
6
11
7
19
    
9
10
10
8
17
    
8
11
9
9
15
    
7
12
8
10
14
    
6
14
6
11
13
    
5
16
0
12
12
    
4
18
0
13
9
    
3
20
0
14
0
    
2
22
0
15
0
    

a. Fill in the rest of the table. What is the world market demand for radios? What is the world market supply?
b. Find the world equilibrium price and quantity.
c. Draw graphs of the U.S. demand and supply, the rest of world's demand and supply, and the world market demand and supply.
d. Does the United States export or import radios in this example? How much does it export or import? What is the money value of these exports or imports? Does the rest of the world export or import radios? How much do other countries import?

a.
 
United States
Other Countries
World
  
Price
Quantity Demanded
Quantity Supplied
Quantity Demanded
Quantity Supplied
Quantity Demanded
Quantity Supplied
12
2
13
5
25
    7  38
11
4
12
6
22
  10  34
10
6
11
7
19
  13  30
9
10
10
8
17
  18  27
8
11
9
9
15
  20  24
7
12
8
10
14
  22  22
6
14
6
11
13
  25  19
5
16
0
12
12
  28  12
4
18
0
13
9
  31  9
3
20
0
14
0
  34  0
2
22
0
15
0
  37  0

b. The equilibrium price is $7. The equilibrium quantity is 22.
c. (Answer omitted -- you should be able to do this, using the numbers in the table above!)
d. The United States imports 4 million radios at a money value of $28 million. The rest of the world exports 4 million radios.
 

21. Refer to the table from Problem 20 and answer the following questions:
a. Suppose that the U.S. demand for radios increases by 4 units at every price. (Add 4 to all numbers in the U.S. Quantity Demanded column, so the United States demands 6 if the price is $12, 8 if is the price $11, 10 if the price is $10, 14 if the price is $9, and so on.) Find the new world equilibrium price and quantity. How much does the United States produce now? How much does it consume? How much does it export or import? How much does the rest of the world produce, consume and export or import?
a.
 
United States
Other Countries
World
  
Price
Quantity Demanded
Quantity Supplied
Quantity Demanded
Quantity Supplied
Quantity Demanded
Quantity Supplied
12
6
13
5
25
  11  38
11
8
12
6
22
  14  34
10
10
11
7
19
  17  30
9
14
10
8
17
  22  27
8
15
9
9
15
  24  24
7
16
8
10
14
  26  22
6
18
6
11
13
  29  19
5
20
0
12
12
  32  12
4
22
0
13
9
  35  9
3
24
0
14
0
  38  0
2
26
0
15
0
  41  0
The new world equilibrium price is $8 and the equilibrium quantity is 24.  The United States consumes 15 million radios, produces 9 million, and imports 6 million. The rest of the world consumes 9 million, produces 15 million, and exports 6 million.

b. Suppose that the foreign demand for radios increases by 4 units at every price. Find the new world equilibrium price and quantity. How much does the United States produce, consume, and export or import? How much does the rest of the world produce, consume, and export or import?
a.
 
United States
Other Countries
World
  
Price
Quantity Demanded
Quantity Supplied
Quantity Demanded
Quantity Supplied
Quantity Demanded
Quantity Supplied
12
2
13
9
25
  11  38
11
4
12
10
22
  14  34
10
6
11
11
19
  17  30
9
10
10
12
17
  22  27
8
11
9
13
15
  24  24
7
12
8
14
14
  26  22
6
14
6
15
13
  29  19
5
16
0
16
12
  32  12
4
18
0
17
9
  35  9
3
20
0
18
0
  38  0
2
22
0
19
0
  41  0
 b. The new world equilibrium price is $8 and the equilibrium quantity is 24. The United States consumes 11 million radios, produces 9 million, and imports 2 million.  The rest of the world consumes 13 million radios, produces 15 million, and exports 2 million.

c. Suppose that the U.S. supply of radios increases by 6 units at every price. Find the new world equilibrium price and quantity. How much does the United State produce, consume, and export or import? How much does the rest of the world produce, consume, and export or import?
 
 
United States
Other Countries
World
  
Price
Quantity Demanded
Quantity Supplied
Quantity Demanded
Quantity Supplied
Quantity Demanded
Quantity Supplied
12
2
19
5
25
    7  44
11
4
18
6
22
  10  40
10
6
17
7
19
  13  36
9
10
16
8
17
  18  33
8
11
15
9
15
  20  30
7
12
14
10
14
  22  28
6
14
12
11
13
  25  25
5
16
6
12
12
  28  18
4
18
6
13
9
  31  15
3
20
6
14
0
  34  6
2
22
6
15
0
  37  6
The new world equilibrium price is $6 and the equilibrium quantity is 25.  The United States consumes 14 million radios, produces 12 million, and imports 2 million. The rest of the world consumes 11 million, produces 13 million, and exports 2 million.

d. Suppose that the foreign supply of radios increases by 6 units at every price. Find the new world equilibrium price and quantity. How much does the united States produce, consume, and export or import. How much does the rest of the world produce, consume and export or import.
 
United States
Other Countries
World
  
Price
Quantity Demanded
Quantity Supplied
Quantity Demanded
Quantity Supplied
Quantity Demanded
Quantity Supplied
12
2
13
5
31
    7  44
11
4
12
6
28
  10  40
10
6
11
7
25
  13  36
9
10
10
8
23
  18  33
8
11
9
9
21
  20  30
7
12
8
10
20
  22  28
6
14
6
11
19
  25  25
5
16
0
12
18
  28  18
4
18
0
13
15
  31  15
3
20
0
14
6
  34  6
2
22
0
15
6
  37  6
 d. The new world equilibrium price is $6 and the equilibrium quantity is 25.  The United States consumes 14 million radios, produces 6 million, and imports 8 million. The rest of the world consumes 11 million, produces 19 million, and exports 8 million.
 

22.  Start with the equilibrium in Figure 1 (page 155). Use graphs similar to Figures 2 and 3 (pages 158-9) to show what happens to output, consumption, and exports or imports of film by the United States and other countries when:
a. U.S. demand for film increases.
b. U.S. supply of film increases.

a.  In the graph below, the increase in U.S. demand raises the equilibrium price from $5 to $6, increases the quantity consumed in the U.S. from 3 to 5 million units and increases the quantity produced in the U.S. from 9 to 10 million, increasing U.S. imports from 4 to 5 million units.   Foreign supply and demand do not change, but the higher world price raises the foreign quantity supplied (foreign output) from 4 to 4.2 million units, and reduces the foreign quantity demanded (foreign consumption) from 10 to 9.2 million units, reducing foreign imports from 6 to 5 million.   So the increase in U.S. demand raises U.S. consumption and production in both countries, raises the price, and lowers foreign consumption.  It raises U.S. imports and foreign exports.

A graph similar to 2 in the text, except U.S demand, rather than foreign demand, rises.
 

b.  An increase in U.S. supply from S1 to S2 raises U.S. output, reducing the world price.  At that lower price, quantities demanded in both countries increase and the quantity supplied in foreign countries decreases.  So U.S. output rises, foreign output falls, and consumption increases in both countries.  The rise in foreign consumption and fall in foreign output means that foreign countries import more, so the U.S. exports more.

23.  Begin with the equilibrium in Figure 1.  Show in a diagram what would happen to prices, production, and consumption of film in each country if the U.S. government were to prohibit international trade in film.

Without international trade, supply and demand in each country separately would determine that country's equilibrium price and quantity.  The graphs would look like panels (a) and (b) of Figure 1 (page 155 of the text) with the equilibria at points A and B.

7.24  A drought in North America reduces output of oats in the United States. Use graphs to help explain why this increases U.S. imports of oats from Argentina.

The graph above shows that the fall in U.S. supply raises the world price, reducing the quantities demanded in each country and raising the quantity supplied in South America.  Because South American output rises and South American consumption falls, South American exports rise and U.S imports rise as shown.

25.  Being with equilibrium in Figure 4 (page 161).  Draw graphs to show what happens to the equilibrium price and equilibrium output and consumption in each place if:
a. Demand for souvenir caps increases there.

(a) An increase in demand there raises the equilibrium price in both locations, increasing quantities supplied in both locations and decreasing quantity demanded here.  The higher output in both locations and lower consumption here makes possible the increase in consumption there.   Here now exports more to there than before the rise in demand.

b. Supply of souvenir caps increases there
b.  Draw a graph similar to the one in part (a), but with an increase in supply there instead of an increase in demand.  The results: the price falls, raising quantities demanded in both locations and reducing the quantity supplied here.  So output rises there, and output falls here.  Consumption rises in both locations and the price falls.   Here now exports less to there than before the rise in supply.
 

26.  Draw diagrams to show the effects of an increase in the expected future demand for a product next year on today's (price of the good, (b) quantity produced, (c) quantity consumed. Also show the amount of the good (d) produced next year and (e) consumed next year, along with (f) the price next year.

An increase in expected future demand from D1  to D2  raises the expected future price.  This creates an incentive for speculators to store more product for future resale. (a) This increased demand raises the price of the good today from $20 to $21 in the graph.  (b) Output today rises from 13 to 14.  (c) Consumption falls today from 7 to 4.  (d) Expected future output rises from 7 to 8.  (e) Expected future consumption rises from 13 to 18. f) The expected future price and the current price both rise (by the same amount, from $20 to $21).
 

27.  Snow in Florida reduces the number of oranges that will be available in the future. Comment on the following statement: "The price of orange juice may rise in the future, but the current price does not change because the weather in Florida does not change the amount of orange juice already in stores."

The graph in the previous problem (26) applies here.  The decrease in the expected future supply of oranges -- and therefore the future supply of orange juice -- raises the current price of orange juice by increasing the amount of orange juice currently put into storage for future sale.
 

28.  When the price of crude oil increases, gasoline prices rise immediately even for gasoline that sellers already had in storage and that was produced from older, cheaper crude oil. Use graphs to explain why.

An increase in the price of crude oil raises the cost of producing future gasoline, which reduces the future supply of gasoline.  This raises the future price and provides an incentive for speculators to buy gasoline now, store it, and resell in the future at the higher price.  This raises the current demand for gasoline, raising its price.  (The speculators could be the companies that sell gasoline -- they can speculate by holding some gasoline off the market now with plans to sell it in the future at a higher price.  This reduces the current supply of gasoline, raising its price. )  So the price rises even for gasoline that was already in storage and had already been produced from older, cheaper crude oil.
 

29.  What can you do to try to profit if the futures price of eggs differs from the spot price of eggs that you  expect next month?

If the futures price is higher than the spot price that you expect next month, then sell egg futures and plan to buy the eggs on the spot market next month (to cover the eggs that you have sold on the futures market).
If the futures price is lower than the spot price that you expect next month, then buy egg futures and plan to sell the eggs on the spot market next month.
 

30.  Comment on this claim made by a well-known financial consulting firm: "Our stock analysis can help you pick the winners and avoid the losers, and our track record over the last year proves it."

(1) Stock prices follow (approximately) a random walk, so it is very unlikely that this consulting firm can help you pick winners and avoid losers.
(2) If the consulting firm is confidant about its knowledge of winners and losers, why don't the people who work that firm as advisors buy the winners and avoid (or short-sell) the losers?  These people could get rich and wouldn't have to work anymore as investment advisors.  If they're so smart, why aren't they rich?
(3) Past track records might only prove that the firm was lucky -- see the discussion and examples of selection bias on page 27 of the textbook.
 
 

Copyright 1999, Alan C. Stockman.  All rights reserved on all text and graphics, except those already in the public domain.  You may copy any or all of this page in electronic or print form for your own use in learning economics.  Others may copy any and all of this page provided that they provide credit, in a clearly visible manner, to any and all readers, in the form: "Taken from Alan C. Stockman's Introduction to Economics Web Site, University of Rochester, and used with permission of Alan C. Stockman."