International Trade Policy ECON 4633 Prof. Javier Reyes. Test #1

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1 International Trade Policy ECON 4633 Prof. Javier Reyes Test #1 Instructions Out of the following 10 questions you must answer only 8. You are free to choose questions from different sections. Section 1. The Ricardian Model a* LC / a* LF RD2 a LC / a LF RD1 (Q C +Q* C ) / (Q F +Q* F ) (*) denotes the Foreign country. Home and Foreign produce computers (C) and food (F) using labor as the only input for production. The unit labor requirements at Home, as usual, are denoted by a LC = labor units required to produce one computer and a LF = labor units required to produce one unit of food. For foreign these labor requirements are denoted by (*) For the following questions, consider the Relative Supply - Relative Demand diagram shown in the figure above. 1.- Which country has a comparative advantage in the production of Computers. (1 pt.) Why? (4 pts.)

2 Home has a comparative advantage in the production of computers because Home s opportunity cost of computers in terms of food, a LC /a LF, is less than the opportunity cost of computers in terms of food observed in Foreign, a* LC /a* LF. 2.- If the World Relative Demand curve is represented by D2. What can you conclude about the production of Computers and Food at Home and at Foreign? (1pt.) Why? (4 pts.) (Hint: is there complete specialization in both countries?) When the world relative demand is represented by RD2 the equilibrium relative price of computers and food (P C /P F ) is equal to Foreign s opportunity cost of computers in terms of food. Therefore Foreign produces a combination of food and computers. At the same time, the equilibrium relative price of computers and food (P C /P F ) is higher than Home s opportunity cost of computers in terms of food. Therefore Home specializes in the production of computers and doesn t produce any food. 3.- If the World Relative Demand curve is represented by D1. What can you conclude about the production of Computers and Food at Home and at Foreign? (1pt.) Why? (4 pts.) When the world relative demand is represented by RD1 the equilibrium relative price of computers and food (P C /P F ) is higher than Home s opportunity cost of computers in terms of food and lower than Foreign s opportunity cost of computers in terms of food. Therefore Home specializes in computers and Foreign specializes in food. There is complete specialization in both countries. 4.- If the World Relative Demand curve is represented by D1. Once these countries start trading with each other, what are the effects on wages (nominal and real) at Home? (1 pt.) Why? (4 pts.) Home specializes in computers so we need to analyze the wage in this industry. After trade, with respect to the autarky price level, the relative price of computers and food (P C /P F ) increases. Wage in the computer industry is determined by W = P C *(1/a LC ) W/P C = 1/a LC

3 We can see that the marginal product of labor in the computer industry (1/a LC ) does not change; therefore the real wage in terms of computers does not change. What happens is that as the price of computers rises at home the nominal wage increases by the same proportion. When we look at the real wage in terms of food we can see that: W/P F = (P C /P F )*(1/a LC ) From here it is possible to see that real wage in terms of food increases, this is because the relative price of computers and food (P C /P F ) increases while the marginal product of labor in the computer industry remains constant. Section 2. Specific Factors Model Australia has relatively more land per worker, and Belgium has relatively more capital per worker. These countries produce computers and food. They use capital and labor for the production of computers and land and labor for the production of food. Use the specific factors model framework to answer the following questions: 5.- Draw the Relative Demand - Supply (Q F /Q C ) diagram. In this diagram show the relative supply curves for both countries, Australia and Belgium. (5 pts.) P F /P C RS Belgium RS World (P F /P C ) Belgium RS Australia (P F /P C ) World (P F /P C ) Australia Q F /Q C

4 6.- Once trade opens up between these two countries. What will be the pattern of trade? (1 pt.) (Hint: which country exports food and imports computers) Why? (4 pts.) For Australia, the equilibrium relative price of food and computers (P F /P C ) after trade is higher than the relative price level observed in autarky. This means that consumption of food decreases, supply of food increases, consumption of computers increases, and supply of computers decreases. Therefore, Australia exports food and imports computers. For Belgium the opposite is true, so Belgium exports computers and imports food. 7.- In Australia, who wins and who loses from trade? (1 pt.) (Hint: check the returns for labor, land, and capital) Why? ( 4 pts.) This is a difficult one. What you have to do is look at the graph of labor allocation and think of an increase in the price of food, since (P F /P C ) is increasing. This will let you visualize the following: Nominal wages increase but they increase by less than the increase in P F, therefore the real wage in terms of food decreases. At the same time the nominal wage increases and the price of computers stays constant (or falls), therefore the real wage in terms of computers increases. So the effect on labor is unknown, we would need to know more about the preferences of individuals in order to make a definite statement. Since the real wage in terms of computers rises, the return to capital (payments to capital owners) falls, making owners of capital worse off. On the other hand the real wage in terms of food decreases, therefore the return to land (payment to land owners) increases, making the owners of land better off. Section 3. H O Model Assume that there are two countries that use land and labor to produce computers (labor intensive) and food (land intensive) and are planning to start trading between them. Country Foreign (F) is labor (L) abundant and country Home (H) is land abundant. Specifically, Labor in F = 130 Labor in H = 50 Land in F = 90 Land in H = 60

5 Assume also that at their autarky relative price ratios the land to labor ratio in the production of computers for F is ¼, the land to labor ration in the production of food for F is ¾. For H the land to labor ratio in the production of computers is ½, and the land to labor ratio in the production of food is What would be the equilibrium allocations for labor and land for each industry in country F, when there is no trade? (5 pts.) After some algebra you can see that: T C * = 3.75, T F * = 86.25, L C * = 15, and L F * = 115. After trade is allowed between the two countries, assuming factor price equalization, the new world relative price ratio determines that the land to labor ratio for each country in the production of computers is 1/3 and the land to labor ratio in the production of food is 3/ When these economies trade with each other, what would be the predictions for the production and trade patterns according to the H-O model? (Hint: which country would produce more computers relative to food after trade) (1 pt.) Why? (4 pts.) With trade home will increase its production food relative to cloth production and Foreign will do the opposite. Home will export food since this is the land intensive good and Home is the land abundant country. Foreign will export computers since this is the labor intensive good and Foreign is the labor abundant country Once trade is allowed, who gains and who loses in each country and why? (Hint: analyze the income distribution for workers and owners of land). (5 pts.)

6 For Home the land to labor ratios for both industries fall with trade, then the MPL C and MPL F decrease while the MPT C and MPT F increase. Given the changes in the marginal products of labor and land, real wage in terms of both goods falls and real rent in terms of both goods increases. This means that the owners of labor (workers) are worse off, while the owners of land are better off. For Foreign the results are exactly the opposite since the land to labor ratios increase in both industries.

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