Download 1) a) What is meant by producer efficiency

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SSII 2006, 160A Midterm
Professor Farshid Mojaver
I-The Ricardian Model of Trade [24 points, parts 3 pts 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.
Shirts
Cameras
Malaysia
20
10
Indonesia
20
40
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.
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
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
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
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
Indonesia
bLS/bLC = 0.5
LI /bLS = 400/20= 20
QS
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.
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
8. Calculate relative wages for Malaysia to Indonesia after trade WM/WI =
WM/WI = (bLS/aLC) PC/PS = 20/10 = 2
II. Some General Questions on International Trade Theory (14 pts)
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. [4 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)
III-Hecksche-Ohlin Theory of Trade [35 pts, all 3 pts except Q7 8 pts and Q9 6 pts]
1. What constitutes the basis of trade in the HO theory of trade?
Factor endowment
2. What is the prediction of HO theory regarding trade patterns?
Each country will export the good that uses its factor abundant intensively
3. 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.
4. Has this prediction come true to any degree? If not explain the reason.
The gap has narrowed but as long as there are technological differences factor
productivities and hence factor prices will not be the same.
5. What is the effect of an import tax on factor prices in a capital abundant country in the
long run?
According to the SS theorem this would lead to an increase in Rents and a fall in
Wages.
6. What does "Leontieff Paradox" refer to?
That contrary to the prediction HO theory, capital-labor ratio content of U.S.
imports is larger than that in its exports. U.S. exports labor intensive goods and
imports capital intensive products.
7. [8 pts] How is this Paradox resolved?
First, explain the correct way of testing HO model in how in a world of many factors of
production.
The correct test of H-O model is a comparison of a country’s relative factor
endowment with its relative income (where the comparison is made with the
world total factor endowment and the world total income) on one hand and the
factor content of net export on the other.
Sign of (Country’s % share of factor – % share of world GDP)
= Sign of (Country’s factor content of net exports)
Second, explain how productivity differences are incorporated in testing the model?
Drop the similar tech/ productivity assumption and correct factor endowment for
differences in productivity. Call the corrected factor effective factor. And do the
following test:
Sign of (Country’s % share of effective factor – % share of world GDP)
= Sign of (Country’s factor content of net exports)
This test gives the right signs most of the time and Paradox will disappear.
8. Once all the correction is made how well is the prediction of HO model regarding the
patterns of trade?
Then the model predicts well two thirds of the time.
9. [6 pts] Show that an in crease in the relative price of capital intensive computer to labor
intensive shoe will reduce Wage-Rent ratio, that is: PC/PS↑ W/R↓.

Higher computer prices leads to higher Computer production (and lower Shoe
production):PC/PS↑ QC/QS ↑  RD for (L/K)↓ with fixed RS  W/R↓
W/R
(W/R)
(W/R)’
RD
RD’
L/K
IV-Factor Movement and Income Distribution [17 pts]
1. [8 pts] Suppose that a small open economy like South Korea that is considered a capitalscarce country, experiences a massive influx of foreign capital. Based on HO model what is
your prediction of (i) production and (ii) factor prices in South Korea?
Answer this question in two parts: Short-run and Long-run. In the short run assume that all
FDI goes to the manufacturing sector but in the long run the capital can go to the agriculture
sector as well
In the Short Run:
(i)
Output of manufacturing goes up and that of agriculture goes down due.
(ii)
Wages rates increase, rents on capital falls because of higher capital-labor
ratio, rents on land also falls because of higher Land-labor ratio.
In the Long Run:
(i)
Production of labor capital intensive goods are expected to increase and
that of labor intensive good to decrease (based on Rybczynski theorem)
(ii)
There would be no change in factor prices
2. [9 pts] Show that international labor movement:
a) increases the world’s output as a whole
b) increases the GDP of the host country
c) decreases the wage rates in the host country
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
in this example home national welfare in higher by ACLL’ while that of foreign
country is lower by this much plus ABC,
V- Outsourcing [10 pts]
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 QC and QR; where QC is an unskilled-labor intensive
(such as activities done in a factory) and QR is a skilled-labor-intensive non-production
input (such as R&D, marketing and after-sale services). The two intermediate goods (QC
and QR) are bundled together to produce a final food Y (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 QR (skilled-labor-intensive intermediate input) and
– import QC (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. [4 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:
PC↓ (unskilled labor-intensive) = =>↓wL/wS
In China we have the opposite that is PR↓ (skilled labor-intensive) = =>↑wL/wS