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Name:___Solution Key____ Winter 2008, 160A Midterm1 Professor Farshid Mojaver I. General Questions on International Trade Theory [24 points, 4 pts each] 1) Adam Smith argues that social interest is served best when individuals pursue their selfinterest “By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it” a) What is meant by self-interest and social interest here? Income/GDP b) Under what conditions this might hold? 1- have competitive markets 2- self interest is followed within rules of the game 3- have good rules 2) How can international trade improve 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. 3) How do you resolve this seemingly paradoxical result that the most productive domestic firm may lose out to some of the least productive firms in a low wage country. A local firm might be the most productive firm in a certain industry (say a US firm in apparel industry) but the industry is not amongst the more productive industries in the country. That is the productivity advantages of other firms are even higher than the firm in question (compared to other countries). If the firm is located in a country that average productivity is high wages are also high so the productivity advantage of the firm might not be strong enough to outweigh its wage disadvantage. 4) How could the navigation act protect Britain domestic industry? Giving monopoly of import to British ships leads to expansion of the shipping industry which in turn strengthens British naval power. This was instrumental for furthering British interest around the globe including opening and monopolizing new markets for British products. 5) In a purely exchange economy with only two people and two goods show that trade is mutually advantages to all partied. How is the result generalized to international trade between two countries? This mutual-gain conclusion can be generalized to international trade between two countries, as long as countries are treated as a single unit (one nation like one person) and both countries are engage in voluntarily trade. This result stems from countries having different endowments and people having balanced and similar preferences. 6) In a purely exchange economy show that then there are more than two people involved trade is not necessarily advantages to everyone. How is this generalized to international trade? Trade is not advantages to everyone. Import competing industries lose out (are worse off compared to autarky) and export industries gain in trade. This conclusion can also be generalized to the context of international trade. II-The Ricardian Model of Trade [32 points, 4 points each ] 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. ULR Malaysia Indonesia Shirts 20 20 Cameras _ 10 40 labor force 200 400 1) Which country has absolute advantage in shirt production and why? What about camera production? Malaysia has absolute advantage in Camera because it can produce Cameras with fewer resources (labor) compared to Indonesia. No country has absolute advantage in the production of shirts. 2) Which country has comparative advantage in Shirts and why? OC of Shirts (in terms of Cameras) is 2 cameras in Malaysia and 0.5 cameras in Indonesia. Indonesia has comparative advantage Shirt because opportunity cost of shirt production is lower in that country. 3) What is relative price of Shirts in Malaysia before trade? What about Indonesia? Relative price of Shirts before trade is equal to the opportunity cost of shirt production. Autarky PS/PC in Malaysia = 2 and Autarky PS/PC in Indonesia = 0.5 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 aLS/aLC = 2 10 10 QS Indonesia bLS/bLC = 0.5 LI /bLS = 400/20= 20 QS 5) 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. 6) 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 7) Calculate relative wages for Malaysia to Indonesia after trade WM/WI WM/WI = (bLS/aLC) PC/PS = MPLMal, C /MPLInd, S (PC/PS) = (20/10)*1 = 2 8) What will happen to the Malaysia-Indonesia wage gap if productivity of export sector in Malaysia goes up? What happens to the wage gap when the productivity of import sector in Malaysia goes up? As MPLMal,C so does WM/WI . As MPLMal, S no change happens in WM/WI. III. Questions in the Specific Factors Model Consider a small open economy that produces Manufacturing and Food using labor, capital. Labor is mobile, but capital is sector specific in the short run. KM denotes capital employed in the manufacturing sector and KF capital in the food sector. 1. [9 points] Show the effect of an exogenous increase in the price Food (say because of an increase in the world demand for food) on wages (both nominal and real), allocation of labor, levels of production and rents on specific factors KM and KF (both nominal and real). 2) [6 points] Suppose that under free trade Home would be exporting Food. Of the three factors of production (L, KM and KF) which one would benefit from trade and which one would lose out in the short run. If Home exports Food that means relative price of food rises with trade. That would increase return to the specific factor employed in the Food sector, RF and decrease that in the Manufacturing sector RM. Owners of the factors specific to export sector would be gain from trade and owners of factors specific to import sector would lose out. IV. Factor Movement 1) [14 points] Show the effect of an increase in labor endowment on wages and rents in the long run. (Hint: use an Edgeworth box and employ Small Open Economy assumption to keep goods prices fixed) As shown in the above figure, an increase in labor endowment (we suppose a reasonable magnitude of increase) has no effect on the labor-capital ratio in either sector (computer and shoe). Under standard assumptions, this implies that there is no change in the marginal products of any factor in any sector. In addition, since home country is a small open economy, prices are fixed. Thus neither wages nor rents respond to an increase in total labor force in the long run. 2) [15 points] Using appropriate models and graphs show the validity of the following claims a) there is a tendency for labor to migrate from the rest of the world to US b) migration improves US GDP but it can lower the GDP of the ROW c) migration is beneficial for the migrants and workers in the foreign country but it hurts workers in the host country d) owners of land/capital in the host country (U.S.) are better off as a result of labor migration e) the world as a whole is better as a result of migration Wage Wage B W A W’ C W* MPL MPL* O L L’ O* Migration of labor from Foreign to Home • There are two factors of production: Land (T) and Labor (L), two countries and one good. Both countries have the same technology but different overall land-labor ratios. Home is the land-abundant country and Foreign is the labor-abundant country. Foreign workers would like to move to Home until the marginal product of labor is the same in the two countries. Increase Home labor force & thus the real wage falls in Home. Decrease the Foreign labor force & increase the real wage in Foreign. The redistribution of the world’s labor force = >Increases the world’s output as a whole Leaves some groups worse off. Leads to a convergence of real wage rates Assuming that the immigrant labor becomes the citizen of Home country home national welfare in higher by ABLL’ while that of foreign country is lower by ACLL’ and the net international gain is ABC,