Name:___Solution Key____
Winter 2008, 160A Midterm1 Professor Farshid Mojaver
I. General Questions on International Trade Theory (32 points, 4 pts each)
1) Adam Smith argues that social interest is served best when individuals pursue their self-interest “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 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.
4) 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.
5) 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.
6)Proximity: How can proximity explain part of international trade?
Countries that are close to each other, particularly if they share a common boarder are observed to trade more heavily with each other. One reason for this is lower transportation cost. Cultural similarities help human interactions and trade between two countries. This is more likely to be the case with countries that share common boarders.
7) In a purely exchange economy with only two people and two goods show that trade is mutually advantages to all partied.
8) In a purely exchange economy show that with more than two people show that international trade is not necessarily advantages to everyone.
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
Shirts Cameras _ labor force
Malaysia 20 10 200
Indonesia 20 40 400
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?
Malaysia Indonesia
OC of Shirts (in terms of Cameras) 20/10 = 2 20/40 =0.5
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/PCin Malaysia = 2 and Autarky PS/PCin 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.
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 graphshowing gains from trade for each country (when international PS/PC =1).
7) Calculate relative wages for Malaysia to Indonesia after trade WM/WI
WM/WI = (bLS/aLC) PC/PS= 20/10 = 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?
The wage gap increases in the first instance and it remains the same in the second one.
Questions in the Specific Factors Model
1) Consider a small open economy that produces Manufacturing and Food using labor , land and capital. Labor is mobile, land T is specific to food production and capital K is specific to Manufacturing.
a)In the table below show the effect of an increase in each of the factor endowments (Labor, Capital K and Land T) on nominal wages W, Rents on capital RK , and rents on landRT . What are the effects on real returns? No explanation is required.
The effects on nominal returns:
W / RK / RTRise in L / fall / rise / rise
Rise in K / rise / fall / fall
Rise in T / rise / fall / fall
Since prices are constant, real returns change in the same direction as nominal returns.
b) Suppose that under free trade Home would be exporting Food. Of the three factors of production which one would benefit from trade and which one would lose out.
If Home exports Food that means relative price of food rises with trade. That would increase return to Land RT and a reduction in return to capital RK. In this case, capital owners are interested in pushing for autarky. Land owners, obviously, are interested in free trade.
c) In 1986, the price of oil on world markets dropped sharply. Since the United States is an oil-importing country, this was widely regarded as good for the U.S. economy. Yet in Texas and Louisiana in 1986 was a year of economic decline. Why? What will your prediction be about the current state of economy of these states taking into account the new price developments in the world? (Hint: Texas and Louisiana are both major oil producing states in the US)
Since oil related industriesin these states are competing with imports a decrease in the price of imported oil, reduces the incomesof factors specific to the oil and gas industries leading to an overall economic decline in these states.
The prediction about the current situation should be just the opposite,since currently the world oil prices are very high and would cause anincrease in the incomes of the factors specific to the oil industry. Andsince oil-related industries are dominant in the two states we wouldexpect their overall economic performance to be very good.
IV-Factor Movement [15 points]
Make an argument showing that
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
a)
- 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,