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Name:___Solution Key____ SSI 2006, 160A Midterm Professor Farshid Mojaver I. General Questions on International Trade Theory (40pts) 1) [6 pts] How can international trade improve consumer and producer efficiency? International trade allows countries to increase production because of better allocation of resources. Better allocation of resources is the source of producer efficiency in IT. In addition, international trade allows consumers to have a more stratifying collection of consumer goods and services. This is the source of consumer efficiency. Thus with IT consumers are better off not only because they can consume more (because of higher production resulting from higher production efficiency) but also because they can have a better collection of goods (higher consumer efficiency). 2) [4 pts] How can a developed country compete against some low foreign wage industries? Wage rates reflect overall productivity levels. Higher wages in DCs imply higher productivity in those countries. However the productivity advantages over low wage countries are not the same in every sector. In some sectors it is larger than wage differentials and in some smaller. If the DC specializes on the sectors in which its productivity advantages are larger than its wage disadvantages then it can easily compete with low wage countries. 3) [12 pts] False, True, Or Uncertain, Explain Why (in plain English) [3 points each] a) Voluntary exchange is beneficial to everyone in both individual and national levels. False. b) The HO theory can successfully explain patterns of trade between all countries and in all goods. False. HO predictions are most useful for analyzing North-South trade and trade in resource intensive products. But that constitutes only a small fraction of all international trade. c) A domestic firm may lose out in international competition even if it is the lowest cost producer in the world True d) “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.” False 4) [6 pts] Consider the following information regarding international trade between India and US. Of the two models that you have learned in class so far (Ricardian and H-O) which model (if any) describe India-U.S. trade patterns best? India’s top exports to U.S.: 1. Non-metalic minerals/gems 2. Clothing 3. Textiles 4. Jewelry 5. Metal manufactures India’s top imports from U.S.: 1. Aircraft 2. Office machines and computers 3. Industrial machinery 4. Power generation equipment and engines 5. Scientific equipment India’s top 5 exports to US are all labor intensive products. This fits well with HO model since India can be characterized as a labor abundant country and US as a labor scare country. However the Ricardian model could also be invoked to explain the observed trade pattern too. It could be that relative to other sectors India is more productive in these sectors compared to US (its productivity disadvantages are lower in these sectors) and hence it enjoys a labor cost advantage. India’s top 5 imports from US are all capital and skilled labor intensive. This fits well the HO model. However these imports could also be characterized as high tech products. Then once again the Ricardian model could be used to explain US comparative advantage in those sectors. 5) [12 pts] Gravity and Boarder a) Write the equation for the Gravity model and briefly explain what it says. Tij = A x Yi x Yj /Dij Where Tij is the value of trade between country i and country j, A is a constant Yi and Yj are the GDP of country i and j and Dij is the distance between the country i and country j The gravity model predicts that volume of trade between two countries increase in with the size of their GDP and falls with the distance between their markets. b) How well are the predictions of the Gravity model? Does it predict well for all countries? Gravity equation performs extremely well empirically for the industrialized countries (and not well at all for non-OECD countries) c) The cross-provincial trade in Canada was some 22 times larger that cross-border trade in 1988. What can explain this? Crossing borders involves formalities that take time and perhaps monetary costs like tariffs. These implicit and explicit costs reduce trade. The existence of borders may also indicate the existence of different languages or different currencies, either of which may impede trade more. II-The Ricardian Model of Trade [24 points, parts 3 pts each] The United States has 200 units of labor, while there are 1600 units of labor in India. When they produce, they have the following unit labor requirements. ULR (hr/unit of output) Clothing Machines U.S. 2 1 India 10 20 1) Which country has absolute advantage in the production of clothing and why? What about machines? U.S has absolute advantage in both machines and clothing because her labor productivity in both sectors are larger than those of India. 2) In absence of trade, what is the opportunity cost of clothing (in terms of machines) in the India and the U.S.? OC of Clothing (in terms of machines) U.S aLC/aLM 2/1 = 2 India bLC/bLM 10/20 = 0.5 3) For which product does India have comparative advantage? India has Comparative Advantage in Clothing production because her opportunity cost of clothing is lower than that in United States 4) What is the relative price of clothing in each country before trade? Autarky PC/PM in U.S = 2 Autarky PC/PM in India = 0.5 5) Draw a graph showing production possibility frontier of U.S. and India. Have Clothing production of the horizontal axis and machines on the Vertical axis. QM QM Unites States LM /aLC = 200/1= 200 India bLC/bLM = 0.5 aLC/aLM = 2 80 QC 100 LI /bLC = 1600/10= 160 QC 6) If world price of shirts to Machines were 1 what would be the world production of Machines and Clothing? Which country would produce each? India produces 160/20 = 80 units of Clothing and exports its excess supply. U.S. produces 200/1 = 200 and exports its excess supply. 7) Use a hypothetical indifference curve in a graph showing gains from trade for each country (when international PC/PM =1). QM QM Unites States India 200 Cons’n after trade Cons’n before trade 80 PC/PM = 1 PC/PM= 1 100 QC 8) Calculate relative wages for United States to India after trade WUS/WInd = WUS/WInd = (bLC/aLM) PM/PC = 10/1 = 10 160 QC III- Hecksche-Ohlin Theory, Increasing Wage Gap and Outsourcing Use the Feenstra model to explain the following questions: [11 points] 1) [6 pts]Explain the effects of US outsourcing to China on US and China’s welfare Suppose there are three factors inputs (unskilled labor, skilled labor, and capital) used to produce two intermediate goods y1 and y2; where y1 is an unskilled-labor intensive (such as activities done in a factory) and y2 is a skilled-labor-intensive non-production input (such as R&D, marketing and after-sale services). The two intermediate goods (y1 and y2) are bundled together to produce a final food yn (labor or capital is not used in bundling). All three products can be internationally traded. Suppose U.S. is skilled-labor abundant. Then according to H-O model = => we expect that U.S. to – export y2 (skilled-labor-intensive intermediate input) and – import y1 (unskilled labor-intensive intermediate input). And just as of H-O model we expect welfare of both countries to improve as a result of this trade (more of the two intermediate goods and the final good will be produced because of better international allocation of resources). 2) [5 pts] Explain the effects of US outsourcing to China on the unskilled- skilled wage gap in the two countries International trade will result in a price reduction of the unskilled-intensive intermediate product y1 in U.S. The effect of this is like that of Stolper-Samuelson, that is: Py1↓ (unskilled labor-intensive) = =>↓wU/wS In China we have the opposite that is Py2↓ (skilled labor-intensive) = =>↑wU/wS III-Factor Movement and Income Distribution [25 pts, Impact 8, SR 12 and LR 5 points] What are the effects of illegal labor immigration on US economy? In answering this question consider two sectors in the economy: Agriculture and Manufacturing. Assume that the illegal immigrants are initially employed in the Agriculture but in the Medium run they can move to the Manufacturing. Use the proper models you have seen in the class and make the proper assumption to analyze the effect of such immigration on US outputs, and real factor prices. Carry your analysis in three scenario: (i) Immediate or Impact, (ii) Short-Medium Run and (iii) Long-Run effect. (i) Impact analysis In the very short run all factors of production are sector specific QM = Q(KM,LM) and QA = Q(KA,LA) With an increase in the type of labor that can be employed in the Agricultural sector employment in that sector goes up. This leads to an increase in production in Agriculture. Increase in the employment of labor in agriculture bid wage rates down in that sector. So far there is no change in Manufacturing, either in employment, production, wages or rents. In the very short run labor can not move between the two sectors. An increase in employment in Agriculture implies an increase in MPT which leads to an increase in Land rentals. Since goods prices have not changes all the factor price changes in this model are real. WA=WM W’A PAMPLA QM PAMPL’A PMMPLM L1 QA ∆L (ii) Short-to Medium Run analysis In the medium run capital employed in each sector can be considered sector specific and labor mobile between the two sectors W”A=W”M PAMPLA QM PAMPL’A L1 PMMPLM L2 ∆L QA Wages in both sectors are lower compared to the situation before immigration. Increase in employment in the manufacturing leads to an increase manufacturing production and an in MPK. With goods prices fixed the latter implies an increase in rents on capital. The rents on land is also higher compared to the situation before trade. Return on K SK R’K RK MPK(L’M)xPM MPK(LM)xPM K (iii) In the Long Run According to the Rybczynski Theorem in a small open economy an increase labor endowment leads to an increase the production of labor intensive product and a reduction in the capital intensive. But factor prices remain the same (because of fixed international goods prices).