Name:___Solution Key____
SSII 2008, 160A Midterm Professor Farshid Mojaver
I. General Questions on International Trade Theory [3 points each, 15 points total]
1) [3 pts]Why Adam Smith supports the act of Navigation despite his own admission that that the act reduces trade and the opulence of all countries including Grate Britain?
Because “defense” is “much more important that opulence”.”.
3) 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.
4) How can a developed country compete against low foreign wage countries?
- While it is true that in developed economies wage rates are higher but labor requirement is lower due to higher overall productivity in those economies. In the sectors in which the productivity advantage outweighs the wage disadvantage the high wage economy can complete against a low wage economy.
5) Make an argument to show that a domestic firm may lose out in international competition even if it is the most productive producer in the world.
A domestic firm that has the highest productivity in the world may lose out in international trade because there might be firms with even higher productivity in that country that drive the average wages higher (i.e, US might have the most productive apparel industry in the world but even higher productivity in wheat production drives the wages high so that it is not cost effective produce apparel in US).
7) Why in the Ricardian model unlike the HO model international trade leads to complete specialization?
Because by assumption the opportunity cost production is constant (PPF is a straight line) in the Ricardian model whereas in HO the opportunity cost is increasing.
II-The Ricardian Model of Trade [21 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____Labor Endowment
U.S.2 1200
India 5 10 1600
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 its labor productivities are larger than India in both sectors.
2) In absence of trade, what is the opportunity cost of clothing (in terms of machines) in US and what does it measure? What is the opportunity cost of clothing in India?
U.S India
OC of Clothing (in terms of machines) aLC/aLM bLC/bLM
2/1 = 2 5/10 = 0.5
OC of clothing in US is 2 machines that is, US has to give up one machine for each unit of cloth production.
3) What is the comparative advantage of India and why?
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 China = 0.5
5) Draw a graph showing production possibility frontier of U.S. and China. Have Clothing production of the horizontal axis and machines on the Vertical axis.
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 1600/5 = 320 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).
III-Hecksche-Ohlin Theory of Trade[25 pts]
1.[8 points] What is the basis of trade in the HO theory and how is that illustrated?
–The basis of trade in HO theory is differences in factor endowment. HO theory maintains that each country exports the product that uses its abundant factor intensively. For example is if consider two factors of labor and capital assume and two goods of computer (capital intensive) and shoes (labor intensive) and if we assume Home is relatively capital abundant K/L > K*/L* then the theory predicts that Home will export Computer and Foreign will export shoes. L/K < L*/K*
–This is illustrated in the graph bellow.
Post-Trade: Production and Consumption of Home and Foreign Country
At (PC/PS) < (PC/PS)W < P*C/P*S capital abundant Home exports capital intensive computer and Labor abundant Foreign exports Labor intensive shoes.
2. [9 points] Testing HO Model
i. 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.
iii. How does the sign test perform using many countries and many factors of production? Does this resolve the Paradox?
Combining all the countries, the sign test is successful in exactly one-half of the cases(passing for 4.5 factors out of nine). So from this extensive study of the Heckscher-Ohlin model with multiple factors, goods and countries, it is shown to perform quite poorly when confronted with real-world facts and figures.
iv. What is the final verdict on the HO theory?
The test of HO model does not do well unless we drop the assumption of equal technology. Once we allow for difference in technology (by adjusting factor share by its effectiveness) the paradox disappears and nearly two third of effective factors pass the sign test.
3-State and prove Stolper-Samuelson Theorem using the Lerner Diagram [8 pts]
The Theorem: An increase in the price of a product will increase the price of the factor used intensively in the production of that product and a reduction in the price of the other factor. In other world if the price of Computer (relative to Shoes) goes up then there will be a rise in capital rentals and a fall in wage rates i.e., if PC/PS↑=> W/R↓.
The proof via the Lerner diagram:
–First a discussion of how Lerner diagram is drawn.
–Second: Suppose PC↑, ∆PS =0 then we will see the shift is the $1 revenue isoquant for computer. From then from the diagram we see that R↑ & W↓
IV. International trade and Income distribution [9 points]
Discuss the effect of an increase in the price of import goods on factor prices (who gains and who loses).
In the short run the return to the specific factors employed in the import-competing sector increases and that of export sector decreases. The change in the real return to the mobile factor can increase or decrease depending on the mix of workers’ consumption basket.
In the long run return to the factor employed intensively in the production of import competing sector goes up and that of export sector goes down.
V. International Factor Movement [12 points]
1-Discuss the effect of immigration on factor prices and the level if production in each sector.
In the short run immigration leads to a reduction in wages and an increase in the return to all specific factors. Production goes up in all lectors.
In a small open economy labor migration has no effect on factor prices in the long run. Production of labor-intensive products increase and that of capital intensive products decrease in the long run.
2-Show that labor migration increases world output and the GDP of the immigrant receiving country.
- There are two factors of production: Land (T) and Labor (L), two countries and one good. Before Immigration Home is land-abundant country compared to the Foreign country. This implies that labor productivity and thus wages are higher in Home country before Immigration.
- Inspired by higher wages Foreign workers migrate to Home. Consequently production in Home increases and falls in Foreign. But the international net change in production is positive immigrants are more productive in Home compared to Foreign due to higher Land labor ratio. Immigration continues until wage rates are equalized in the two countries.
•The redistribution of the world’s labor force = >Increases the world’s output as a whole
- World income in higher by the area ABC.
- Assuming that the immigrant labor becomes the citizen of Home country home national welfare in higher by ABLL’.
VI- Outsourcing [9 points each,18 pts total]
1)Show that outsourcing can lead to welfare improvement in all participant countries.
Movement from A to C represents higher production of final good of outsourcing firms in the Home country. This leads to higher GDP, which presumably leads to higher welfare in the home country.
2)Explain the increasing skilled-unskilled wage gap observed in the United States, China and India using outsourcing model.
- A reduction in cost of capital or transportation lowers the cost of trade, which makes it desirable to shift more activities in the value-chain from Home to Foreign.
- a shift of activities from one country to the other can increase the relative demand for skilled labor in both countries which in turn leads to higher wage gap in both countries.