1NA400 B/International economics Problems compendium

Transcription

1 Dr. Petre Badulescu 1 LINNEUS UNIVERSITY Department of Economics and Statistics Dr. Petre Badulescu utumn 212 1N4 B/International economics Problems compendium Observe! Critical comments and eventual mistakes in the text are gratefully welcomed. The Compendium contains a relatively grate number of exercises. Solutions and answers for every problem are provided at the end of the compendium. The student shall solve these problems all by oneself and check up on the own answers with the provided solutions at the end of the compendium. Notice that the provided answers are merely clues. It is always required an explanation and justification for a right answer. Furthermore graphic and mathematical descriptions shall be explained in the running text. Content Page 1. International trade theory under perfect competition 2 2. Modern international trade theory: scale economies and imperfections International trade policy 15 Solutions 23

2 Dr. Petre Badulescu 2 1. International trade theory under perfect competition 1. Consider the graphs of the domestic markets for clothing in Sweden and Germany. Price of clothing (kilograms of paper per article of clothing) P a P P Sweden World market Germany S SE d e b c D SE S GE D GE Q Q Q a. Is there a reason for trade in clothing between Sweden and Germany? Why? b. Derive the appropriate export (Sx) and import (Dm) curves, assuming that the world consists of only these two countries. Motivate. c. What will happen if trade becomes possible, assuming that the cost of transportation is negligible? What is the equilibrium trade price of clothing in Sweden? In Germany? d. On the domestic market graphs, indicate the changes in consumer and producer welfare which result from trade opening in each country. e. Which groups in the two countries will be happy with free international trade in clothing between the two countries? Which groups will wish free trade would be banned? f. Examine the consequences of a technology improvement which increases the productivity in the clothing industry in Sweden. Explain!

3 Dr. Petre Badulescu 3 2. Suppose that a small, tropical country produces mangoes for domestic consumption and possibly for export. The domestic demand and supply curves for mangoes in this country are given by the following expressions: Domestic demand: P = 5 M. Domestic supply: P = 25 + M. P denotes the relative price of mangoes and M denotes the quantity of mangoes (in metric tons). a. What are the autarky price and quantity exchanged? Motivate. b. Suppose that the world price of mangoes is 45. Will this small country export mangoes? If so, how many tons? Explain. 3. Home and Foreign produce and consume cars and TVs. Labor is the only input into the production of both products. The marginal productivities of labor in each sector and the total labor (workers) in each country are given in the following table: Car TV Labor, L Home Foreign a. What is the no-trade relative price of cars in each country? Explain. b. In which product does Foreign have a comparative advantage, and why? Explain. c. Graph the production possibilities frontier (PPF) for each country in separate diagrams. Motivate briefly. d. Suppose that in the absence of trade, Home consumes nine cars and two televisions, while Foreign consumes two cars and nine televisions. Show in your diagrams the notrade equilibrium for each country and provide the equilibrium conditions. e. Suppose now that the world relative price of cars is P C /P TV = 1. In what good would each country specialize, according to the Ricardo model? Briefly explain why?

4 Dr. Petre Badulescu 4 f. Show in your diagrams the international trade equilibrium for each country. Label the exports and imports for each country at the new world price line. How does the amount of Home exports compare with Foreign imports? Does each country gain from trade? Briefly explain why or why not. 4. nswer the questions below using the information given by the following table. Home Foreign bsolute advantage country country Number of bicycles (B) 4 2? produced per hour Number of snowboards (S) 6 8? produced per hour Comparative advantage?? a. Complete the table in the same manner as in Table 2-2 on page 39 (in the textbook). b. Which country has an absolute advantage in the production of bicycles? c. Which country has an absolute advantage in the production of snowboards? d. What is the opportunity cost of bicycles in terms of snowboards at Home? What is the opportunity cost of bicycles in terms of snowboards in Foreign? Explain why. e. Which product will Home export and which product will Foreign export? Briefly explain why. 5. ssume that Home and Foreign produce two goods, televisions and cars, and use the following information to answer the questions. In the no-trade equilibrium Home country Foreign country Wage TV = 12 Wage C =? Wage * TV =? Wage * C = 6 MP LTV = 2 MP LC =? MP * LTV =? MP * LC = 1 P TV =? P C = 4 P * TV = 3 P * C =?

5 Dr. Petre Badulescu 5 a. What is the marginal product of labor for televisions and cars in the Home country? What is the no-trade relative price of televisions at Home? b. What is the marginal product of labor for televisions and cars in Foreign? What is the no-trade relative price of televisions at Home? c. Suppose the world relative price of televisions in the trade equilibrium is P TV /P C = 1. Which good will each country export? Briefly explain why. d. In the trade equilibrium, what is the real wage at Home in terms of cars and in terms of televisions? How do these values compare with the real wage in terms of either good in the no-trade equilibrium? Briefly explain why. e. In the trade equilibrium, what is the real wage in Foreign in terms of televisions and in terms of cars? How do these values compare with the real wage in terms of either good in the no-trade equilibrium? Briefly explain why. f. In the trade equilibrium, do Foreign workers earn more or less than those at Home, measured in terms of their ability to purchase goods? Explain why. 6. Suppose that the technology for creating manufacturing goods is Q M K LM, where Q M is manufacturing output, K is the country s endowment of capital, the factor specific to manufacturing, and L M is the amount of the mobile factor, labor, used in manufacturing industry. a. How much does Q M rise if both inputs K, L ) are doubled? ( M b. Now suppose that K is fixed at 1. How much does Q M rise if L M is doubled? c. Is the cost of lost manufacturing output associated with reducing manufacturing employment by one employee larger or smaller when the initial level of employment is 1 or 1? Motivate.

6 Dr. Petre Badulescu 6 7. Suppose that there are two products: griculture () and Manufacturing (M) in an economy. griculture is produced with Land and Labor and Manufacturing is produced with Capital and Labour. Labour is mobile between industries. The next two questions refer to the production possibilities frontier (PPF) in Figure 1 below. Figure 1: PPF 1 2 M a. Is the opportunity cost of M higher at point 1 or point 2 in Figure 1? Motivate. b. Provide an intuitive explanation for why the PPF is bowed out in Figure 1. c. If the price of a manufactured product is P M = $1/unit and the marginal product of labour in manufacturing is 2 units per worker, what must the wage paid to a unit of labour be? Briefly explain. d. If P M > P, in which industry is the marginal product of labour higher? e. ssume that you own a manufacturing firm. If P M = $1/unit, the wage is $25, and the marginal product of labour is 4 units per worker, are you hiring too many, too few, or the right amount of labour. Explain. f. Suppose the price of manufactured products in terms of agricultural products falls. What would you expect to happen to the marginal product of labour in agriculture? Explain.

7 Dr. Petre Badulescu 7 8. In the gains from trade diagram (Figure 3-3, page 63 in the textbook), suppose that instead of having a rise in the relative price of manufactures, there is a fall in that relative price. a. Starting at the no-trade point (Figure 3-3), show what would happen to production and consumption. Motivate. b. Which product is exported and which is imported? Why? c. Explain why the overall gains from trade are still positive. 9. Use the information given here to answer the following questions. Manufacturing (M) griculture () Sales revenue: P M Q M 15 P Q 15 Payments to labour: W L M 1 W L 5 Payments to capital: R M K 5 K 1 R M Holding the price of manufacturing constant, suppose the increase in the price of agriculture is 1% and the increase in the wage is 5%. a. Determine the impact of the increase in the price of agriculture on the rental on land and the rental of capital. Motivate. b. Explain what has happened to the real rental on land and the real rental on capital. c. If the price of manufacturing were to fall by 1%, would landowners or capital owners be better off? Explain. How would the decrease in the price of manufacturing affect labour? Explain.

8 Dr. Petre Badulescu 8 1. Home and Foreign produce autos from capital and labor and bananas from land and labour. Labour is mobile between the two industries. The no-trade equilibrium in the two countries is illustrated in the diagrams below. Bananas Home Bananas Foreign utos utos a. Explain how the price of autos relative to bananas is determined in the absence of trade. b. In the diagrams above show candidate equilibrium if the two countries are trading with each other. Indicate how production and consumption have changed in the two countries. c. How has the real rental to capital changed in Home? Explain. How has the real rental to capital changed in Foreign? Explain. d. What happens to the demand for land in Home? Motivate. e. If the winners could without cost compensate the losers, would the countries engage in free trade? Motivate.

9 Dr. Petre Badulescu This problem uses the Heckscher-Ohlin model to predict the direction of trade. Consider the production of hand-made rugs and assembly line robots in Canada and India. ssume the only two factors of production are labour and capital. a. Which country would you expect to be relatively labour-abundant, and which capitalabundant? Why? b. Which industry would you expect to be relatively labour-intensive, and which is capital-intensive? Why? c. Given your answers to a) and b), draw production possibilities frontiers (PPF) for each country. ssuming that consumer preferences are the same in both countries, add indifference curves and relative price lines (without trade) to your PPF graphs. What do the slopes of the price lines tell you about the direction of trade? Motivate. d. llowing for trade between countries, redraw the graphs (with post-trade equilibrium) and include a trade triangle for each country. Identify and label the vertical and horizontal sides of the triangles as either imports or exports. Which factors gain and which factors lose when trade arises between these two countries? Explain carefully. 12. Suppose that there are drastic technological improvements in shoe production at Home such that shoe factories can operate almost completely with computer-aided machines. Consider the following data for the Home country: Computers (C) Shoes (S) Sales revenue: P C Q C 1 P S Q S 1 Payments to labour: W L C 5 W L S 5 Payments to capital: R K C 5 R K S 95 Percentage increase in the price = P P % P P 5% C / C S / S a. Which industry is capital-intensive? Is this a reasonable question, given that some industries are capital-intensive in some countries and labour-intensive in others?

10 Dr. Petre Badulescu 1 b. Given the percentage changes in output prices in the data provided, calculate the percentage change in the rental on capital. How does the magnitude of this change compare with that of labour? c. Which factor gains in real terms, and which factor loses? re these results consistent with the Stolper-Samuelson theorem? Explain. 13. The following are data on U.S. export and imports in 27 at the two-digit Harmonized Schedule (HS) level. Which products do you think support the Heckscher-Ohlin theorem? Which products are inconsistent? Briefly explain. (See problem 9, page 122 in the textbook!) Export Import HS Code Product ($ billions) ($ billions) 22 Beverages Pharmaceutical products Cotton pparel Footwear Iron and steel Copper Electric machinery Vehicles ircraft Furniture Toys Source: International Trade dministration, U.S. Department of Commerce. 14. Consider a country that produces two products: airplanes and shirts. The country is trading to the rest of the world at fixed product prices. irplane producers are using 5 units of capital and 3 units of labour to produce one unit of airplanes and shirt producers are using 2 units of capital and 2 units of labour to produce one shirt. Both factors are mobile between industries. a. Which product is capital-intensive? Motivate. b. Suppose there is a sudden emigration (outflow of labour). What happens to the level of employment in the airplane industry in the long run? Show using the box diagram provided below. Motivate.

11 Dr. Petre Badulescu 11 O Capital O S Labor c. Can you derive an equation that relates the country s output to its endowments? d. Show how emigration of labour alters the shape of the production possibility frontier in the long run. Indicate the level of production of both products before and after the outflow of labour. Use the axes provided below. Motivate. irplane output Shirt output

12 Dr. Petre Badulescu There are two countries, Home and Foreign. The two countries are identical except that Home has a labour force of L and Foreign has a labour force of L *. The figure below is a supply and demand for the world labour market. Wage, W W Foreign wage W B W * * Home wage L L L * L * World amount of labour Starting at points and *, consider a situation in which some Foreign workers migrate to Home but not enough to reach the equilibrium with full migration (point B). s a result of the migration, the Home wage decreases from W to W > W, and the Foreign wage increases from W * to W ** < W. a. re there gains that accrue to the Home country? If so, redraw the graph and identify the magnitude of the gains for each country. If not, say why not. b. re there gains that accrue to the Foreign country? If so, again show the magnitude of these gains in the diagram and also show the world gains. Motivate. c. Suppose now that L = 1 and L * = 2. Given this allocation of labour across Home and Foreign, the value of marginal product of labour in Home is 3 (= W) and in Foreign 2 (= W * ). If labour were to be free to move, the wage in both countries would be 25 = W and L = 15. i.) If immigration were free between countries, how much would the value of output change in Home? ii.) What is Home s national gain in allowing immigration? iii.) Who benefits from immigration in Home and how much. Briefly explain.

13 Dr. Petre Badulescu Modern international trade theory: scale economies and imperfections 1. Explain how increasing returns to scale in production can be a basis for trade. 2. firm faces a fixed cost of 1 and a marginal cost of 2 per unit of output. If the firm is planning to sell 1 units, what is the lowest price that the firm can charge that will allow it to break even? Motivate. 3. In the following diagram, D/N is industry demand divided by the number of differentiated products when each product has the same price and d is the demand curve facing each individual producer of a differentiated product in an existing national market. Price D/N d Quantity a. Draw in the diagram the effect on d and D/N of an increase in N, the number of competing varieties within the existing market. b. Explain why you drew the demand curves as you did. 4. Starting from the long-run equilibrium in the monopolistic competition model, consider what happens when industry demand D increases. For instance, suppose that this is the market for cars, and lower gasoline prices generate higher demand D. a. Draw d diagram for the Home market and show the shift in the D/N T curve and the new short-run equilibrium. b. From the new short-run equilibrium, is there exit or entry of firms, and why?

14 Dr. Petre Badulescu 14 c. Describe where the new long-run equilibrium occurs, and explain what has happened to the number of firms and the prices they charge. 5. The Gravity equation relationship derived from the monopolistic competition model does not hold in the Heckscher-Ohlin (H-O) model. Explain how the logic of the gravity equation breaks down in the H-O model. 6. The United States, France and Italy are among the world s larger producers. To answer the following questions, assume that their markets are monopolistically competitive, and use the gravity equation with B = 93 and n = GDP in 29 ($ billions) Distance from the United States (miles) France 2,635 5,544 Italy 2,9 6,229 United States 14,27 a. Using the gravity equation compare the expected level of trade between the United States and France and between the United States and Italy. b. The distance between Paris and Rome is 694 miles. Would you expect more French trade with Italy or with the United States? Explain what variable (i.e., country size or distance) drives your result. 7. Different soil conditions generate variation in the character of grapes and the wine that is made from them. Is it possible that intra-industry trade can be high in certain industries even in the absence of imperfect competition? Briefly explain.

15 Dr. Petre Badulescu International trade policy 1. This question tests your knowledge of the WTO s rules. a. How would you know if a foreign firm was dumping its product in your domestic market? b. ssume that several countries decided to reduce tariffs exclusively on each other s products but maintain their tariffs on other countries products. Would this argument violate the WTO s most favoured nation principle? Why or why not? c. Why is most favoured nation status called normal trade relations in the United States? 2. Suppose that the domestic demand (D) and supply (S) for peanuts in the small country Home are given by D: Q = 4 1P and S: Q = 5 + 4P. a. Derive the country s import demand curve for peanuts. Draw the graphs for the domestic and import markets. Briefly explain. b. What are the levels of domestic production, consumption, and imports if the world price is 1? Motivate. c. Suppose that the country were to impose a tariff of 5. What happens to the quantity and price of peanuts produced domestically? What happens to the quantity of imports? Explain, calculate and illustrate these changes on your graphs. d. What is the value of tariff revenue raised by this tariff? What is the overall gain or loss in welfare due to the tariff introduction? Estimate and motivate.

16 Dr. Petre Badulescu Consider a large country applying a tariff t to imports of a product like that represented in the following figure. Price (a) Importer s domestic market Price (b) World market S X * P WORLD B * D M S 1 D 1 Q Q W Quantity a. How does the export supply curve in panel (b) compare with that in the small-country case? Explain why these are different. b. How does the import tariff t affect the free trade equilibrium? What is the net impact on the large country welfare? Does this tariff raise or lower Foreign welfare? Explain and illustrate the welfare impact in your graphs. c. Explain how the tariff affects the price paid by consumers in the importing country and the price received by producers in the exporting country. Use graphs to illustrate how the prices are affected if (i) the export supply curve is very elastic (flat) or (ii) the export supply curve is inelastic (steep). 4. a. The optimal tariff formula states that the tariff that raises national welfare the most is inversely related to the elasticity of the export supply curve. Provide an intuitive explanation for why this is so. b. If the foreign export supply is less than perfectly elastic, what is the formula for the optimal tariff Home should apply to increase welfare?

17 Dr. Petre Badulescu 17 c. What happens to Home welfare if it applies a tariff higher than the optimal tariff? Motivate. 5. Refer to the graphs in Problem 3. Suppose that instead of a tariff, Home applies an import quota limiting the amount Foreign can export to 14 units. a. Determine the net effect of the import quota on the Home economy if the quota licenses are allocated to local producers. b. Calculate the net effect of the import quota on the Home welfare if the quota rents are earned by Foreign exporters. 6. The figure below shows the no-trade equilibrium for an industry in Home under perfect competition at point B (with the price P C ) and under monopoly at point (with the price P M ). In this problem, we compare the welfare of Home consumers in these two situations. Euro/ Q P M P C B Marginal cost, MC Marginal revenue, MR Home demand, D Q M Q C Quantity, Q a. Explain the no-trade equilibrium under monopoly and under perfect competition. Under perfect competition, outline the area of total Home surplus (the sum of consumer surplus and producer surplus). b. Under monopoly, with the price P M, outline the area of total Home surplus. Motivate and show in your figure.

18 Dr. Petre Badulescu 18 c. Compare your answer to parts a) and b), and outline what the difference between these two areas is. What is this difference called and why? Explain. 7. Suppose now that Home, from Problem 6, engages in international trade. We treat Home as a small country, facing the world price of P W. a. Explain the free-trade equilibrium under perfect competition and under monopoly. Use a graph like the one in Problem 6 to show the Home free-trade equilibria. b. What is the welfare impact at Home from international free trade, (i) under perfect competition and (ii) under monopoly? Outline the area of gains or losses under (i) and (ii) in your figure. Explain. c. Given Home monopoly producer surplus in autarky equilibrium, and based on your answer to part b. (ii), outline the area of gains from free trade under Home monopoly. d. Compare your answer to parts b. (i) and c). That is, which area of gains from free trade is higher and why? Explain. 8. Consider an industry in which Home (a small country) has a monopoly with an upward sloping marginal cost curve MC. The price on world markets is P W. Home is originally engaged in international free trade and it imposes a (no prohibitive) tariff of size t. a. Use the following diagram to show the effects of this tariff on production, producer surplus, consumption, consumer surplus, and government revenue. Motivate. Euro/ Q MC P W MR D X * Quantity, Q

19 Dr. Petre Badulescu 19 b. Now suppose instead that the government imposes a quota that yielded the same level of imports as the tariff t. Which policy (the quota or the tariff) has a larger effect on consumer surplus? Explain. c. Would the quota rent created by this quota be bigger than, smaller than, or exactly the same as the revenue generated by the tariff? Explain. 9. Consider the case of a Foreign monopoly with no Home production. For simplicity, we assume that marginal cost are constant, MC *. Starting from free trade equilibrium, consider a $1 tariff applied by the Home government. a. If the demand curve is linear, what is the shape of the marginal revenue curve? Briefly explain the free-trade equilibrium. b. Therefore, how much does the tariff-inclusive Home price increase because of the tariff, and how much does the net-of-tariff price received by the Foreign firm fall? c. Discuss the welfare effects of implementing the tariff. Use a graph to illustrate under what conditions, if any, there are increases in Home welfare. 1. Suppose that in response to a threatened antidumping duty of t, the Foreign monopoly raises its price by the amount, t. a. Illustrate the losses for the Home country. b. How do these losses compare with the losses from a safeguard tariff of the amount t, applied by the Home country against the Foreign monopolist? c. In view of your answers to (a) and (b), why are antidumping cases filed so often? 11. Why is it necessary to use a market failure to justify the use of infant industry protection? 12. What is a positive externality? Explain the argument of knowledge spillovers as a potential reason for infant industry protection.

20 Dr. Petre Badulescu If infant industry protection is justified, is it better for the Home country to use a tariff or a quota, and why? 14. Consider a large country with export subsidies in place for agriculture. Suppose the country changes its policy and decides to cut its subsidies in half. a. re there gains or losses to the large country, or is it ambiguous? What is the impact on domestic prices for agriculture and on the world price? b. Suppose a small food-importing country abroad responds to the lowered subsidies by lowering its tariffs on agriculture by the same amount. re there gains or losses to the small country, or is it ambiguous? Explain. c. Suppose a large food-importing country abroad reciprocates by lowering its tariffs on agricultural goods by the same amount. re there gains or losses to this large country, or is it ambiguous? Explain. 15. Suppose Home is a small exporter of wheat. t the world price of $1 per ton, Home growers export 2 tons. Now suppose the Home government decides to support its domestic producer with an export subsidy of $4 per ton. Use the following figure to answer these questions.. Home Price 14 D S Quantity a. What is the quantity exported under free trade and with the export subsidy?

21 Dr. Petre Badulescu 21 b. Calculate the effect of the export subsidy on consumer surplus, producer surplus, and government revenue. c. Calculate the overall net effect of the export subsidy on Home welfare. 16. Refer to problem 15. Rather than a small exporter of wheat, suppose that Home is a large country. Continue to assume that the free-trade world price is $1 per ton and that the Home government provides the domestic producer with an export subsidy in the amount of $4 per ton. Because of the export subsidy, the local price increases to $12 while the foreign market price declines to $8 per ton. Use the following figure to answer the following questions. Home Price D S Quantity a. Relative to the small-country case, why does the new domestic price increase by less than the amount of the subsidy? b. Calculate the effect of the export subsidy on consumer surplus, producer surplus, and government revenue. c. Calculate the overall net effect of the export subsidy on Home welfare. Is the large country better or worse off compared with the small country with the export subsidy? Explain.

22 Dr. Petre Badulescu Refer to problem 15. Suppose Home is a small exporter of wheat. t the world price of $1 per ton, Home growers export 2 tons. But rather than an export subsidy, suppose the Home government provides its domestic producers with a production subsidy of $4 per ton. Use the following figure to answer these questions. Home Price 14 D S Quantity a. What is the quantity exported with the production subsidy? Motivate. b. Calculate the effect of the production subsidy on consumer surplus, producer surplus, and government revenue. c. Calculate the overall net effect of the production subsidy on Home welfare. Is the cost of production subsidy more or less than the cost of the export subsidy for the small country? Explain.

23 Dr. Petre Badulescu 23 Solutions 1. International trade theory under perfect competition 1. a. Yes. The autarky pre-trade equilibrium price of clothing is 2 kilograms of paper in Germany and 3 kilograms of paper in Sweden, according to the countries diagrams. Since German s relative price of clothing (P GE = 2) is less than Sweden s (P SE = 3) in autarky, there will be an incentive for Sweden s clothing consumers to buy German clothing. German clothing producers have an incentive to sell in Sweden where the price is relatively higher than on the home market. b. See Chapter 2 in the textbook and Lecture 1! P Sweden P World market P Germany Price of clothing (kilograms of paper per article of clothing) a b c S SE D SE SE GE S x D m d e S GE D GE Import Q Q värld Q Export Q c. When trade has been opened up between Sweden and Germany, then a unique international price is formed via the free forces behind the world market s supply (Sx) and demand (Dm). The price will gradually rise in the export country, because the demand on the country s export product increases, and in a similar way falls the price of clothing in the import country (demanded quantity increases when the product price falls via the world market). The process continues until just one relative price is formed on the world market, where the export supply is identically equal with the import demand at one and the same price the international trade equilibrium price, and there is international trade equilibrium on the world market for clothing. The equilibrium trade price must be the same in both countries (that s why it is the price at which they trade with each other, see above): it is 2.3 kilogram of paper per article of clothing. Notice that this is the price where export supply from Germany equals import demand from Sweden. t P world = 2.3 is Export Import = Q world. See the graphs!

24 Dr. Petre Badulescu 24 d. Consumer s welfare gain in Sweden = area (a + b + c) and producer s loss = area a. Consumer s welfare loss in Germany = area d and producer s gain = area (d + e). See the graphs above! The net welfare gain to Sweden is shown by the blue painted area labelled SE in the central graph for the world market. This gain is equal in magnitude to the net welfare gain the area (b + c) from the domestic graph. The net welfare gain to Germany is the green painted area labelled GE in the central graph above. This gain is equal in magnitude to the net welfare gain the area e from the domestic graph. e. Clothing consumers in Sweden and clothing producers in Germany will be happy about the opening of free international trade. However, Swedish clothing producers will not be happy (they are undercut by cheaper imported German clothing) nor will German clothing consumers, who used to pay a lower price before the people in Sweden were able to buy the clothing. f. Starting point: International trade equilibrium on the world market for clothing where export supply (Sx) equals import demand (Dm) and the international trade equilibrium price, say Pw = P. t Pw export (X) is equal to import (M). The technological improvement raises the productivity which, in turn, reduces the marginal cost (MC), and Sweden increases its supply of clothing to say S 1 the surplus in demand (at P ) drops Dm falls to say D 1 m P falls to say P 1 : the new international trade equilibrium when Sx = D 1 m. The result at P 1, compared to the starting point, is as follows. We label supplied quantity Q S and demanded quantity Q D. Sweden: Q S and Q D both go up, surplus in demand M to M 1. Germany: Q S, Q D, surplus in supply X to X a. To find the autarky pre-trade prices and quantities, the demand and supply equations must be solved simultaneously, i.e., we use the conditions for the market equilibrium. To find M, set the right hand sides equal to each other. So doing, yields M = Using this result, insert it into either equation to find P = 37.5.

25 Dr. Petre Badulescu 25 b. If the world price is 45, this country would be an exporter of mangoes, because 37.5 < 45. To find out how many it would export, construct an export supply equation, that is, an excess supply equation. lgebraically, this is done by subtracting demand from supply (both expressed in terms of M): Export supply Sx = Domestic supply Domestic demand = P 25 (5 P). Sx = P. If the world price equals 45, then this country will export 15. Observe that you could also obtain this result by substituting 45 for P in domestic supply and demand equations to find the quantity supplied and demanded at the price and calculating the surplus available for export. 3. a. The no-trade relative price of cars at Home is P C /P TV = 2/3, which means that to produce one more car costs 2/3 TV. t Foreign it is P * C/P * TV = 3/2. b. Foreign has a comparative advantage in producing televisions because it has a lower opportunity cost than Home in the production of televisions. c. Home s equation of the production possibilities frontier (PPF) is: TV = 8 (2/3) Cars t Home can be maximal produced 12 cars when all resources (labour) are used in the car industry or 8 TVs when all labour is used for the production of televisions. The absolute value of the slope of the PPF gives the opportunity cost of cars in terms of televisions, and equals the relative price of cars, i.e. P C /P TV = (MP LTV /MP LC ) = 2/3. Foreign s equation of the production possibilities frontier is: Cars = 12 (3/2) TV In Foreign can be maximal produced 8 cars when all resources (labour) are used in the car industry or 12 TVs when all labour is used for the production of televisions. The absolute value of the slope of the PPF gives the opportunity cost of cars in terms of televisions, and equals the relative price of cars, i.e. P * C/P * TV = (MP * LTV/MP * LC) = 3/2. Draw the diagrams here! See below 3.d!

26 Dr. Petre Badulescu 26 d. dd the indifference curve for each country to the diagrams in problem 3.c. Label the indifference curve (U ), and the no-trade equilibrium production and consumption for each country. Home no-trade consumption point is : (cars, TVs) = (9, 2). Foreign notrade consumption * : (cars, TVs) = (2, 9). Se the diagrams! The equilibrium conditions the tangency point between the PPF and the U : consumers willingness to pay for a car in terms of televisions, i.e. the opportunity cost of an extra car [measured by the absolute value of the slope of the indifference curve at the tangency point to the PPF) must equal the opportunity cost of producing that car (the absolute value of the slope of the PPF at the tangency point to the U ). TV (units) Home TV * (units) 12 U * Foreign 8 Slope = 2/3 9 * PPF U Slope = 3/2 2 e. The world relative price of cars is P C /P TV = 1. The classical theory of international trade (Ricardo) will predict that each country specializes fully (because of a constant opportunity cost of cars-strait line PPF) in the production of the product in which it has a comparative advantage, and export it to the other country, and import the other product from the other country. Home would specialize in cars, export cars, and import televisions, whereas the foreign country would specialize in television, export televisions, and import cars. The reason is because Home has a comparative advantage in the production of cars and Foreign in the production of televisions Cars (Units) 2 PPF * 8 Cars * (Units)

27 Dr. Petre Badulescu 27 f. Graph the new world price line (the slope is 1) for each country in your diagrams, add a new indifference curve (U 1 ) for each country in the international trade equilibrium! TV (units) Home TV * (units) 12 U * B * U * 1 Foreign 8 Slope = 1 U 1 Export 9 8 * C * Slope = 1 4 PPF U C Import Export B 12 Cars (Units) 2 Import 4 PPF * 8 Cars * (Units) The amount of Home exports of cars is equal to the amount of Foreign car imports at the world relative price of cars = 1 in the trade equilibrium. In addition, Home imports of televisions equal Foreign exports of televisions. The two trade triangles are congruent. This means balanced trade, i.e. the exports pay entirely for imports! re there any gains from trade? Yes. Both Home and Foreign benefit from the free trade relative to their no-trade consumption (production) because they are able to consume at higher indifference curves. See the equilibrium consumption points (C and C * ) in the diagrams above!

28 Dr. Petre Badulescu a. See the table. Number of bicycles (B) produced per hour Number of snowboards (S) produced per hour Comparative advantage Home Foreign bsolute advantage country country 4 2 Home/Foreign ratio MP MP LS LB 6 8 Home/Foreign ratio 3 2 MP MP * LS * LB 4 2 3/4 b. Home has an absolute advantage in the production of bicycles because it is able to produce bicycles with fewer resources (more per hour) than Foreign. Equivalently, labour requirement to produce one more bicycle in Home is a LS = 1/MP LS = 1/4 it takes 1/4 hours to produce an extra bicycle, whereas in Foreign it takes 1/2 hours. 1/4 < 1/2 c. Foreign has an absolute advantage in the production of snowboards because it is able to produce snowboards with fewer resources (more per hour) than Home. Equivalently, labour requirement to produce one more snowboard in Home is a LB = 1/MP LB = 1/6 it takes 1/6 hours to produce an extra snowboard, whereas in Foreign it takes 1/8 hours. 1/8 < 1/6 d. The opportunity cost of B in terms of S is given by the absolute value of the slope of the PPF. The opportunity cost of one bicycle is 3/2 snowboards at Home. The opportunity cost of one bicycle is 8/2 snowboards in Foreign. e. Foreign has a lower opportunity cost in producing snowboards than Home. Therefore, Foreign has a comparative advantage in the production of snowboards. Given Foreign s comparative advantage, Home has a comparative advantage in the production of bicycles. Thus, Home will export bicycles and Foreign will export snowboards.

29 Dr. Petre Badulescu a. MP LC = 3, MP LTV = 2, and P TV /P C = MP LC / MP LTV = 3/2. b. MP * LC = 1, MP * LTV = 2, and P * TV/P * C = MP * LC/ MP * LTV= 1/2 c. Home will export cars and Foreign will export televisions because Home has a comparative advantage in cars production whereas Foreign has a comparative advantage in televisions. d. Workers at Home are paid in terms of cars because Home exports cars. Home is better off with trade because its real wage in terms of televisions has increased. MP Home wages with trade ( PC / PTV ) MPLC LC 3 units of car or (1) 3 3 units of TV Home wages without trade MP LC ( PC / PTV ) MPLC 3 units of car or (2 / 3) 3 2 units of TV e. Foreign workers are paid in terms of televisions because Foreign exports televisions. Foreign gains in terms of cars with trade. Foreign wages with trade ( P * TV / P * C ) MP * LTV (1) 2 or 2 units of cars MP * LTV 2 units of TV Foreign wages without trade ( P * TV / P * C ) MP * TV (1/ 2) or 2 1units of car MP * LTV 2 units of TV f. Foreign workers earn less than workers at Home in terms of cars because Home has an absolute advantage in the production of cars. Home workers also earn more than Foreign workers in terms of televisions.

30 Dr. Petre Badulescu 3 6. a. If the use of both inputs is doubled, then the volume of output is doubled as well. This is an example of a constant returns to scale technology. b. If the use of only one input is increased, then output will rise but at a decreasing rate. If labour is increased by a factor of 2, then output will increase by a factor of 2. Note that it is the same constant returns to scale technology, but there are diminishing returns if only one factor is increased. c. Suppose that here are 1 units of capital, so that QM 1 LM. reduction of employment by 1 lowers output by Q M 1( LM LM 1). Plugging in the numbers (and using a calculator) to solve it, reducing employment by one unit lowers output more when L M = 1 than when L M = 1. This highlights the implications of diminishing marginal product of labor. 7. a. The opportunity cost of M in terms of is given by the absolute value of the slope of the PPF: This is higher at point 2 than at point 1. Figure 1 shows an example of an increasing opportunity cost PPF. b. When all labour is put into griculture, the marginal product of labour in griculture (MP L ) is very low (little land per labourer) and the marginal product of labour in Manufacturing (MP LM ) is high (lots of unused machines). Hence, as labour is moved out of griculture into Manufacturing, initially there is only a very small drop in production and a very large increase in manufacturing output: The opportunity cost of M in terms of is low. s more labour is moved, the MP L is getting larger and the MP LM is getting smaller. Hence, output of starts falling at a faster rate and output of M expands at a slower rate: The opportunity cost of M in terms of is high. c. profit-maximizing firm will choose a labour force that makes the value of the marginal product of labour (MPR L ) equal to the wage (W). In this example, the MRP L is $2 per worker, so in equilibrium it had better be the case that the wage is $2.

31 Dr. Petre Badulescu 31 d. Because P M MP LM = W = P MP L in equilibrium, MP L > MP LM because P M > P. Since wages equalize across the industries, the industry with the lower price per unit of output must have the higher marginal productivity of labour. e. The value of the marginal product of labour is $4, and workers are being paid only $25. This means that revenues could be expanded by more than costs if another worker is hired. Hence, you are employing too few workers. f. If P M /P falls (e.g., suppose that P M drops while P is fixed), then workers will be induced to move out from manufacturing into agriculture. s more workers enter agriculture, the land/labour ration falls. Hence, the MP L falls. This can be seen directly in the figure below. Wage P MMP L P M MP L P 1 MMP L O M L 1 L O Figure shows the effect of a change in the price of a product on the allocation of the mobile factor (L) The fall in the price of a unit of manufacturing products reduces the value of the marginal productivity of labour in manufacturing from the dotted curve to the solid curve. This reduction in labour demand lowers the nominal wage and so induces the agriculture industry to expand (a movement along the demand curve for labour in agriculture). Because the amount of land is fixed, the land/labour ratio falls and the marginal productivity of labour in agriculture falls as well.

32 Dr. Petre Badulescu a. s seen in the diagram, a fall in the relative price of manufactures is shown by the smaller slope (in absolute value) of the international price line. The country produces at point B, at which the international price line is tangent to its PPF. The higher relative price of agriculture attracts workers into that sector such that the output of agriculture increases and the output of manufactured goods decreases. Now the highest level of utility is achieved where the highest possible indifference curve is tangent to the new price line (at C). The increase in utility signified by the higher indifference curve is a measure of gains from trade. Output of agriculture, Q B U 2 The International price line C U 1 PPF The autarky price line Output of manufacturing, Q M b. The decrease in the relative price of manufactures in the trade equilibrium (compared with autarky) also means that the country is importing manufactured goods and exporting agricultural goods. c. Overall gains from trade are still positive because the country is able to sell agriculture at a higher price and buy manufactured goods at a lower price than it could have in autarky. The fact that the relative price (of manufactured goods) fell with trade indicates that the foreign country s autarky relative price was lower. That is, in this case the country has a comparative advantage in agriculture. In Figure 3-4 (textbook), the case illustrated is one in which the country has a comparative advantage in manufacturing goods and thus their export leads to an increase in their relative price.

33 Dr. Petre Badulescu a. Rental on land can be calculated as follows: RT ( P / P ) P Q ( W / W ) R R T T T W L R R T T (.1) 15 (.5) or 12.5%. Recalling that the price of manufacturing remained constant, we get the rental on capital as R M Q M W K L M R R M M W W W R M LM K R R M M 1 (.5).1 or 5 1%. b. Because the 1% increase in the price of agriculture, the real rental on land rose whereas the real rental on capital fell. Therefore, landowners are better off because the percentage increase in the rental on land is greater than the percentage increase in the price of agriculture, whereas the price of manufacture is constant. Capital owners are worse off in terms of their ability to purchase both manufacture and agriculture because the rental to capital has fallen. R M / R M W / W P / P R T / R T, for an increase in P Real rental on capital falls Change in real wage is ambiguous Real rental on land rises c. ssuming that the decrease in the price of manufactures leads to a fall in wage by 5%, capital owners would be worse off because the rental on capital would decrease (2%) more than the drop in the price of manufacturing (1%). Landowners would be better off as the rental on land rises (1%). The effect on labor is ambiguous because although the percentage of wage decrease is less than the percentage fall in price of manufacturing, labour loses in terms of their ability to purchase agriculture.

34 Dr. Petre Badulescu 34 The rental on capital is found by calculating the following: RM ( PM / PM ) PM QM ( W / W ) R R K M M W L M R R M M (.1) 15 (.5) or 2% lthough the rental on land is R T Q T W L R R T T W W W R T L T R R Putting it together we get T T 5,5.25 or 1 2,5%. R M / R M P M / P M W / W R T / R T, for a decrease in P M Real rental on capital falls Change in the real wage is ambiguous Real rental on land rises 1. a. In the absence of trade, the relative price of autos is the slope (in absolute value) of the line tangent to the PPF and Homes indifference curve. b. See the diagrams below. utarky state is displayed in dotted lines, and trade state is displayed in solid lines. Home has the higher autarky relative price of autos and so it is the exporter of bananas. Home s supply of bananas increase and its supply of autos decreases, whereas the opposite is true in Foreign. Home s consumption of bananas is less than its supply of bananas, and its consumption of autos is greater than its supply of autos. The opposite is true in Foreign.

35 Dr. Petre Badulescu 35 Bananas Home Bananas Foreign S 2 B S 1 B D 1 B D 2 B D 2 B S 2 B S 2 S 1 D 1 D 2 utos D 2 S 2 utos Figure: Trade versus utarky in Home and Foreign c. The rental price of capital falls in Home. s labour is pulled out of auto production, the marginal product of capital, MP K, falls. Because MP R / P K the income of a unit of capital has fallen relative to the price of autos. Now notice that R P K B P P B K Because P /P B goes down when the country trades, and because R K /P falls as well, the nominal earnings of a unit of capital will buy less of both goods! The relative price of autos goes up for Foreign, and so the argument for Home applies here but in reverse. The rental on capital rises in Foreign. R P K. d. The demand for land in Home rises as the country increases its production of bananas. The marginal product of land rises as labour is moved from auto production into banana production. The value of the marginal product of land is the demand curve for land. e. Because global resources are used more efficiently, both countries can consume more than they did when they were not trading. Because the country gains from trade means that winners win more than losers lose, the winners could compensate the losers and everyone could be made better off.

36 Dr. Petre Badulescu a. Given Canada s relatively small population (~3 million compared with more than 1 billion in India) and level of development, it is a safe assumption that (L/K) CND < (L/K) INDI. That is, there is more capital per worker in Canada, making it capitalabundant compared with India. Similarly, India would be labour-abundant. b. Given the amount of capital required to produce robots and the amount of labour required to produce rugs, one would expect that (L/K) ROBOT < (L/K) RUG, making robots capital intensive and rugs labour intensive. c. See the following figures. Canada s no-trade production and consumptions of robots and rugs (at the tangency point ) corresponds to a relative price of robots that is lower than that in India. This is shown by the flatter sloped relative price line in Canada. Draw the diagrams here! Output of rugs, QRUG PPF Canada Slope = P / ROBOT P RUG U Output of rugs, Q * RUG PPF * * India Slope = * P P * ROBOT / RUG U * Output of robots, Q ROBOT Output of robots, Q * ROBOT b. See the following figures. The international free-trade equilibrium for each country is at the tangency points between the international trade price line and the PPF (the international production points, S and S * ), and the indifference curve (the international consumption points, C and C * ). t the free-trade world relative price of robots, the trade triangles for each are BCS (Canada) and OC * S * (India). Note that BS = OC * and CB = OS* for balanced trade Effects of trade on the production factors: In the Heckscher-Ohlin theory, the abundant factor gains from trade since the increase demand (due to trade) for the product that uses its services intensively tends to push up its wage relative to the scarce factor s. On the

37 Dr. Petre Badulescu 37 other hand, the scarce factor loses from trade since consumers are now able to import from the other country the product that uses the scarce factor intensively. This means that local production of that product will drop and demand for its services will decline. Here? In Canada, capital owners (the abundant factor) gain from trade, while labour (the scarce factor) loses from trade. In India, labour (the abundant factor) gain from trade, while capital (the scarce factor) loses from trade. Output of rugs, QRUG PPF Canada Imports B U 1 C Exports World price line, slope = (P ROBOT /P RUG ) W S U Output of rugs, Q * RUG India PPF * S * U * 1 Exports * C * O Imports U * Output of robots, Q ROBOT Output of robots, Q * ROBOT The international free-trade equilibrium relative price of robots, (P ROBOT /P RUG ) W, is given by the absolute value of the slope of the world price line (the red line) the tangent, also called the consumption possibilities frontier. This equilibrium relative price is determined by the international market for robots where the import demand equals the export supply. 12. a. W LC /R KC > W LS /R KS (and thus L C /K C > L S /K S ) implies that shoes are capital intensive. This is certainly possible as shown in the New Balance application. b. For computers: For shoes: R / R {( R / R {( P C / P C ) P Q C W / W ) WL {(%)1 ( W / W )(5)}/ 5 ( W / W ) P / P ) P Q {(5%)1 ( W / W )(5)}/ 95 5/ 95 ( W / W )(5/ 95) Substituting the computer equation into the shoes equation: S S S S C ( ( W / W ) WL S C }/ RK }/ RK S C