KOÇ UNIVERSITY ECON INTERNATIONAL TRADE

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1 KOÇ UNIVERSITY ECON INTERNATIONAL TRADE Mid-term Exam (100 points; 90 minutes) Answer all 5 questions. In providing answers to the questions in this section algebra or graphs might be helpful. State your reasoning precisely and briefly. 1. (12 pts) Suppose that the United States produces software and textiles using skilled and unskilled labor. Both kinds of labor are freely mobile between industries, and all producers, workers, and consumers take prices as given. It takes 3 units of unskilled labor and 1 unit of skilled labor to make one unit of textiles. It takes 2 units of unskilled labor and 2 units of skilled labor to make one unit of software. The US is a skilled-labor abundant country, and has a policy of free trade. Assume that there are no transport costs. Suppose that initially the world price of textiles is $1.50 per unit, and the world price of software is $1.00 per unit. Now, suppose that the unskilled-labor-rich Chinese economy, previously cut off from the world economy, begins to trade actively with the rest of the world, exporting large amounts of textiles. As a result, while the world price of software remains at $1.00, the world price of textiles falls to $1.00 per unit. Compute US wages for skilled and unskilled workers before and after this change occurs. (Don t worry if one of them turns out to be zero.) Denote the wage of skilled-labor and unskilled-labor as S and U, respectively. Then, the zero-profit condition for the textile sector is 3U+S=$1.50, while the zero profit condition for the software sector is 2U+2S=$1.00, before the price change caused by the shift in supply of textiles in China. Solving these gives U=$0.50, S=$0. After the price change, the zero profit condition for the textile sector becomes 3U+S=$1.00. Thus, solving the same system of equations gives U=$0.25 and S=$ (20 pts) Using a Ricardian model in which Turkey and France have comparative advantages in clothing and wine respectively, work out the effects in both countries on the world relative price of clothing and on outputs and real wages in both countries of the following changes (one at a time). Assume that in the initial equilibrium, both countries are completely specialized. a) The labor supply in Turkey expands. (6pts) Let p=p c /p w be the relative price of clothing, and q=q c /q w the relative quantities supplied and demanded on the world market. Then the world market looks like the solid lines in the following graph: The initial equilibrium price is p 0, assumed to be between the two countries autarky prices p T and p F. When the Turkish labor supply expands, this increases the maximum Turkish output of clothing, shifting the relative supply curve to the right, as shown. This lowers the equilibrium relative price of clothing toward, and in this case to, the Turkish autarky price. Outputs in France are unchanged. Output of clothing in Turkey rises, and output of wine there may also rise above 1

2 zero, as it does in the case shown. The real wage in France rises, since workers there benefit from the reduced price of clothing (assuming of course that they want to wear any of them). The real wage in Turkey falls, since the Turkish wage in units of clothing is unchanged but its value in terms of wine falls. b) The Turkish technology for producing wine improves, but not enough to reverse comparative advantage. (7pts) This means a fall in the Turkish unit labor requirement for producing wine, and thus a fall in the Turkish relative autarky price of wine. Thus the Turkish portion of the world relative supply curve shifts up, but remains below the French autarky price. If the shift is small, nothing at all will happen, since the Turkish will remain specialized in producing clothing and the new technology will not be used. More interesting is the case shown below, where the shift is large enough to push up the world relative price of clothing and cause Turkey to start producing some wine. 2

3 Here, then, the relative price of clothing increases, though not all the way to the French autarky price. Output in France is unchanged, while output of wine in Turkey rises above zero and output of clothing falls. The Turkish workers are again made worse off (to the extent that they use clothing), the same as in part (a). The French workers are better off, also as in part (a). c) The French technology for producing wine improves. Now it is the French portion of the relative supply curve that shifts up, while also shrinking horizontally since the French are now able to produce more wine. In this case, the world relative price of clothing again increases. Output of wine in France expands, while output in Turkey does not change. Price of wine decreases, no change in the price of clothing. No change in the nominal wage rate in Turkey, hence Turkish real wages are higher. As labor becomes more productive in wine production, French real wages in terms of wine will increase. As the price of clothing stays the same, The French real wage will go up.. 3

4 3. (25 pts) Consider the two Ricardian economies whose endowments and technologies are those described below. Each has a fixed endowment of labor its only factor of production and can produce two goods, X and Y, using the indicated constant amounts of labor per unit of output: Endowment of Labor Per-unit labor requirement for producing X Y Country A Country B a) Draw the production possibility frontiers for each of these countries. Calculate their autarky relative price of good X, P x /P y. A: autarky px /py = 30/60 = 0.50 B: autarky px /py= 40/60 = 0.67 b) Which country has an absolute advantage in good X? Which in good Y? Which has a comparative advantage in good X? Which in good Y? Absolute advantage in X: A Absolute advantage in Y: A Comparative advantage in X: A Comparative advantage in Y: B c) What are the autarky wages of workers in country A, in units of good X per unit of labor? In units of good Y per unit of labor? What are the autarky wages of workers in country B, also in units of good X and in units of good Y? Can you tell which country s workers are better off in autarky? In A 60 people produces 60 unit X so 1 worker produces 1X therefore his wage; wa/px (in units of X) = 1.0 By the same reasoning wa/py (in units of Y) = 30/60=0.5 In B wb/px(in units of X) =60/120= 0.5 wb/py (in units of Y) =40/120= 0.33 A s workers are better off in autarky because they can consume more of both goods. d) Suppose now that free trade between these countries leads to a world equilibrium price of P x /P y = 1/1.75=0.57. Calculate the new wages of labor in each country in units of both X and Y. Are these workers better off, worse off, or is it impossible to tell? 4

5 At this price, which is strictly between the two autarky prices, the countries both completely specialize in the good in which they have comparative advantage, A in X and B in Y. In units of the good that they still produce, wages are the same as in autarky: wa/px (in un its of X) = 1.0 wb/py (in units of Y) = 0.33 In units of the good they don t produce, wages depend on the price ratio wb/px=(wb/py)/(py/px)=0.33*(1.75)=0.5775>0.5(before) wa/py==(wa/px)/(px/py)=1*0.57=0.57>0.5(before) Comparing these to the autarky wages in part (c), A s workers are better o ff because they can buy the same amount of X and more Y ( vs. 0.50), and B s workers are also better off because they can buy the same amount of Y and more X (0.57 vs. 0.5). e) Suppose that these two countries actually both trade with a much larger world, in which the relative prices of goods takes on the various values listed below. For each price, indicate which good each country will export ( X, Y, 0 if neither, and? if it is ambiguous). A B i) P x /P y = 1.0 X X ii P x /P y =0.66 X? iii) P x /P y = 0.5? Y iv) P x /P y = 0. Y Y Since they are trading with a larger world, there is now no need for these two countries to export and import different goods. When the world price of a good is below their autarky price, they will import it and not produce it; when it is above they will produce only it and export it, as the table shows. A special case is px /py= 0.5, which is the same as country A s autarky price. At that price, producers are indifferent between producing X and Y, since they break even on both. If they were trading only with country B, which imports X at that price, A would have to export it. But trading with the larger world, A can produce more, less, or the same as its own consumers demand, and its direction of trade is ambiguous. (Same for B at price ratio=0.66) 5

6 4. (20 pts) Consider a model with two countries, the US and Brazil, who trade in coffee. The US is a net importer of coffee, and Brazil is a net exporter. The demand curve for coffee within the US is given by: Q = 60 - P, and the supply is given by: Q = P. There is no consumer demand for coffee in Brazil. The Brazilian supply curve is given by: Q = P. a) Find the equilibrium world price and the quantity traded under free trade, and graph the equilibrium. DS The home import demand schedule: MD(P) = Q Q = (60-P)-(P)= 60-2P. In equilibrium, XS* = MD, yielding P = 60-2P. So the equilibrium world price of wheat is 20 and the quantity traded is 20. The graph is shown below. b) Suppose that Home imposes a quota that limits its imports of coffee to 18 units. Show how this changes the world price and the domestic price in Home, and graph the new equilibrium. Assume that there is no rent seeking. c) Calculate the production distortion, the consumption distortion, and the terms-of-trade benefit for Home, and show these in a graph. Is Home better off because of the quota? The import quota will shift Home s import demand curve. In addition, it will create a difference between the domestic and world prices in Home but not in Foreign. In equilibrium, QS* = 18 due to the import quota, where P is the world price. Therefore, 18= P. The equilibrium world price of wheat is 18 and the quantity traded is 18. Equating 18=MD(P) gives the new domestic price of 21 in H 5. (23 pts) Home and Foreign both produce cars and food using labor and capital. In each country, labor and capital are both freely mobile across industries. It takes 4 units of labor and 2 units of capital to produce 1 unit of food, and 3 units of labor and 3 units of capital to produce 1 car. Home has 300 units of labor and 200 units of capital, while Foreign has 200 units of labor and 150 units of capital. Each country has the same relative demand curve, given by P F /P C = 1.05 (1/6) Q F /Q C, where P j is the price of good j and Q j is the quantity of good j. a) Which country is labor rich? Labor poor? Which good is labor intensive? Capital intensive? Home is labor rich country and foreign is labor poor country. Food is labor intensive and car is capital intensive good b) How much of each good will each country produce? Qf:Quantity of food Home Foreign 4Qf +3Qc=300 4Qf +3Qc=200 2Qf +3Qc=200 2Qf +3Qc=150 Solving those equations we get Home Foreign Qf=50 Qf=25 Qc=33.33 Qc=33.33 c) For Home, find the relative price of food, the wage, and the rental price of capital in autarky. Draw the budget line for a Home worker and for the owner of 1 unit of Home capital. by P F /P C = 1.05 (1/6) Q F /Q C For home Qf/Qc=50/33.33=1.5 Then from equation Pf/Pc=1.05-(1/6)*1.5=0.80 6

7 From zero profit condition; Pf=4w +2r (1) dividing (1) by Pc we get 0.8=Pf/Pc=4w/Pc+2r/Pc (3) Pc=3w+3r (2) dividing (2) by Pc we get 1=Pc/Pc=3w/Pc+3r/Pc (4) After solving (3) and (4) we found w/pc=1/15= and r/pc=4/15=0.266 Home worker has wage w=0.066*pc, so he can buy 0.066*Pc/Pc=0.066car with his whole income or 0.066*Pc/Pf=0.066*(1/0.8)= food with his whole income. Home Capital owner has rental income r=0.266*pc, so he can buy 0.266*Pc/Pc=0.266car with his whole income or 0.266*Pc/Pf=0.266*(1/0.8)= food with his whole income. 7

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