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Name:___Solution Key____
Professor Farshid Mojaver
SSI 2004, 160A Midterm
1-The Ricardian Model of Trade [30 points, parts 8 &10 4 pts, 9 6 pts, the rest 2 pts each ]
1) Malaysia has 200 units of labor, while there are 400 units of labor in Indonesia. When they
produce, the countries have the following unit labor requirements.
Shirts
Cameras
Malaysia
20
10
Indonesia
20
40
1-1) Which country has absolute advantage in shirt production and why? What about camera
production?
Malaysia has absolute advantage in Camera because her labor productivity in
that sector is higher than that of Indonesia. No country has absolute advantage
in the production of shirts.
1-2) In absence of trade, what is the opportunity cost of Shirts (in terms of Cameras) in
Indonesia and Malaysia?
Malaysia
Indonesia
OC of Shirts (in terms of Cameras) aLS/aLC
bLS/bLC
20/10 = 2
20/40 = 0.5
1-3) For which product does Indonesia have comparative advantage?
Indonesia has Comparative Advantage in Shirt production because her
opportunity cost of Shirt is lower than that in Malaysia
1-4) Draw a graph showing production possibility frontier of Malaysia and Indonesia. Have
Shirt production of the horizontal axis and Camera on the Vertical axis.
QC
QC
Malaysia
LM /aLC =
200/10= 20
Indonesia
aLS/aLC = 2
bLS/bLC = 0.5
10
10
QS
LI /bLS = 400/20= 20
1-5) What is the relative price of Shirts in each country before trade?
Autarky PS/PC in Malaysia = 2
Autarky PS/PC in Indonesia = 0.5
QS
1-6) If world price of shirts to cameras were 1 what would be the world production of
Camera and Shirts? Which country would produce each?
Indonesia produces 400/20 = 20 units of shirts and exports its excess supply.
Malaysia produces 200/10 = 20 and exports its excess supply.
1-7) Use a hypothetical indifference curve in a graph showing gains from trade for each
country (when international PS/PC =1).
QC
QC
Malaysia
20
Indonesia
PC/PS= 1
Cons’n
after trade
10
Cons’n
before trade
PC/PS= 1
10
QS
20
QS
1-8) Calculate relative wages for Malaysia to Indonesia after trade WM/WI =
WM/WI = (bLS/aLC) PC/PS = 20/10 = 2
1-9) Label the graph below carefully (fill for the question marks)
PS/PC
aLC↓→ (aLS/aLC )↑
aLS/aLC = 2
Malaysia
1
bLS/bLC = 0.5
Relative
Supply
Relative
Demand
Indonesia
aLC↓→(LI /bLS)/(LM /aLC) ↓
(LI /bLS)/(LM /aLC) = (400/20)/(200/10) = 1
1-10) What is the effect of a technological improvement in Camera production in Malaysia?
Illustrate your answer in the graph above. See above graph
1-11) What constitutes the basis of trade in the Ricardian Model? (in other words who exports what)
Technological difference represented by differential labor productivities.
2-Hecksche-Ohlin Theory of Trade [30 pts, parts 3,7,10 &11 3 pts, 12 4 pts and the rest 2 pts]
2-1) What constitutes the basis of trade in the HO theory of trade?
Factor endowment
2-2) What is the prediction of HO theory regarding trade patterns?
Each country will export the good that uses its factor abundant intensively
2-3) What are the assumptions of the HO model on the technology production (mention 3)?
1- Constant returns to scale technology in both sectors
2- Different factor intensity (i.e., one is L-intensive and the other K-intensive)
3- Identical technology in all countries
2-4) Based on HO theory what would be the impact of free trade on the existing international
wage gaps?
HO predicts that equalization of product prices would lead to the equalization of
factor prices. So wage gaps are expected to shrink with free trade.
2-5) Has this prediction come true to any degree? Why international wage rates are still so
different?
The gap has narrowed but as long as there are technological differences factor
productivities and hence factor prices will not be the same.
2-6) Is the following statement True or False?
HO predicts that with free trade production techniques (capital-labor ratio) in any given
industry will be identical in all countries irrespective of factor endowment. Please comment
on your answer.
True. Factor content depends of factor prices. Once Factor prices are equalized
amongst all countries they will all have the same factor contents since
technology of production is the same in all countries.
2-7) Suppose that a small open economy like South Korea that is considered a capital-scarce
country, experiences a massive influx of foreign capital. Based on HO model what is your
prediction of (i) production (ii) trade patterns, and (iii) factor prices in South Korea?
(i)
(ii)
(iii)
Production of labor capital intensive goods are expected to increase and
that of labor intensive good to decrease (based on Rybczynski theorem)
With such import biased growth, both exports of labor intensive goods
and imports of capital intensive goods decrease.
There would be no change in factor prices
2-8) What does "Leontieff Paradox" refer to?
That contrary to the prediction HO theory, U.S. imports are indeed capital
intensive; the capital/labor content of U.S. imports is larger than its exports
2-9) What is the main source of problem in HO model?
It seems that the assumption of identical technology which leads to FPE is
particularly troubling.
2-10) After all is HO a useful theory for predicting trade patterns in any goods or for any
subset of countries?
Yes, HO predictions are useful for analyzing North-South trade and trade in
resource intensive products. But that constitutes only a small fraction of all
international trade.
It is found that once TPE assumption is dropped out of HO model then in ¾ of
cases trade flows are accordance of HO expectations. (not required)
2-11) What is the argument of those who believe that the increased wage gap of skilled and
unskilled labor in U.S is the result of the increased trade between US and Newly
Industrialized Countries?
There are two arguments:
(1) Imports of L-intensive goods and the export of K-intensive goods in U.S have
worked in against labor and in favor of capital.
(2) The import of unskilled labor intensive goods has dampened the price of
those products in US and hence the return to unskilled labor has gone down.
It is also argued that the export of U.S. skilled labor has increased demand
for skilled labor and hence its price has increase.
(One explanation is adequate for full credit)
2-12) Is this a valid argument under HO model? Explain.
For the First argument to be valid we should observe a fall I the labor share of
U.S., GDP but the share has remained quite stable in the last 20 years.
For the second argument to be valid under HO model we should observe a
reverse effect on skilled-unskilled wage gaps in NICs. That is because of larger
exports of labor intensive goods wage rates of unskilled should go down and the
imports of killed intensive goods should lead to a reduction in the wages of
skilled labor. But is any thing such gap has increased in NIC’s.
In addition, trade with NIC’s constitutes only a small fraction of total U.S
spending; this is too small to explain the increased gap. So HO does not explain
the phenomenon.
(One explanation is adequate for full credit)
3- The Standard Model of Trade and Terms of Trade [8 points, 3-1&3-2 4 pts each]
3-1) In the graph below shows that:
(i) The country that exports X, has indeed a comparative advantage in X production at its pre
trade prices,
Opportunity cost of X production at pre-trade prices;
that is the slope of PPF at A is less than international relative price of X.
(ii) Free trade increases a country’s GDP evaluated at international prices. Explain.
Good Y
GDP measured at
world prices at pre
trade production
point
GDP measured at world prices
at post trade production point
A
U0
Int’l PX/PY
B
Good X
GDP (or PxX+PyY), measured at international prices, is the highest at free trade
point of production B compared to any other point, such as A (pre trade).
3-2) Consider a world in which two countries, Home and Foreign, engage in free trade
with one another. Let there be two goods produced, X and Y. Suppose consumers in
Home and Foreign have identical homeothetic tastes, and that production in each country
exhibits constant returns to scale. Using bowed-out production possibility frontiers for
Home and for Foreign, draw a free trade equilibrium consistent with Home exporting
good Y and Foreign exporting good X.
Since Home exports Y its TOT = Py/Px and Foreign TOT = Px/Py
4-Some General Questions [12 points, 3 points each]
False, True, Or Uncertain, Explain Why (in plain English only)
1) Voluntary exchange is beneficial to everyone in both individual and national levels.
Flase
2) Free trade can raise aggregate economic efficiency
True
3) A domestic firm may lose out in international competition even if it is the lowest cost
producer in the world
True
4) “Opening up free trade does hurt people in import-competing industries in the short
run. But in the long run, when people and resources can move between industries,
everybody ends up gaining from free trade.”
Flase
5- A question on Income Distribution [20 points, 2 points each]
In March of 2002 the US imposed tariffs of up to 30% on imported steel. The European
Union threatened the US with punitive trade sanctions. The proposed move would have
affected millions of dollars' worth of US exports ranging from citrus fruits to textiles.
Analyze the effects of this policy in the U.S economy in the following table assuming
that the Steel (S) and the Non-Steel (N) sectors uses Labor and capital in their production.
Steel is capital intensive product. US is a large economy.
Use the following notation:
+
the variable increases in this step
the variable decreases in this state
+ N+ the variable has increased in this step compared to the previous one and the net
effect compared to the initial sate (before policy change) is positive
-N+ the variable has decreased in this step compared to the previous one but the net
effect compared to the initial sate is positive
+ N- the variable has increased in this step compared to the previous one but the net
effect compared to the initial sate is negative
0
the variable does not change
A
the variable change is ambiguous (i.e. it may rise, it may fall)
Impact
Short Run
Long Run
Price of Steel
+
-N+
-N+
Nominal wage in Steel sector WS
+
-NA
-N-
Nominal wage in Non-Steel WNS
0
+N-
-N-
Nominal rent in Steel sector RS
+
+N+
-N+
Nominal rent in Non-Steel sector RNS
0
-N-
+N+
Real wage in Steel WS
+
-N+
-N-
Real wage in Non-Steel WNS
-
-N-
-N-
Real rent in Steel sector RS
+
+N+
-N-
capital-labor ratio in Steel production
0
-N-
-N-