Name:___Solution Key____
SSII 2007, 160A Midterm Professor Farshid Mojaver
I. General Questions on International Trade Theory (17 pts)
1) [5 pts] 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) [3 pts] What was Adam Smith’s justification for making an exception for free trade?
The main justification for making exception to free trade was national security or the “defense” which was viewed to be “much more important than opulence”.
3) [3 pts] 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) [3 pts] 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.
5) [3 pts] 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.
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 China. When they produce, they have the following unit labor requirements.
ULR (hr/unit of output)
Clothing Machines
U.S. 2 1
China 5 10
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 her labor productivity in both sectors are larger than those of China.
2) In absence of trade, what is the opportunity cost of clothing (in terms of machines) in the China and the U.S.?
U.S China
OC of Clothing (in terms of machines) aLC/aLM bLC/bLM
2/1 = 2 5/10 = 0.5
3) For which product does China have comparative advantage?
China 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?
China 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 [32 pts]
1. [10 points] What is the basis of trade in the HO theory and how is that illustrated? Please state the assumptions of the model?
Assumptions
There are two countries (Home and Foreign) with:
– Same tastes & Same technology
– And Different factor endowment
In particular let’s assume L/K < L*/K*
– i.e. Home is Capital Abundant, Foreign is Capital Scars
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. [12 points] Testing HO Model [12 points]
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.
ii. How is the HO theory restated in a world of many factors of production?
Sign of (Country’s % share of factor – % share of world GDP)
= Sign of (Country’s factor content of net exports)
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. [10 points] Using a graph show that an in crease in the relative price of capital intensive computer to labor intensive shoe will reduce Wage-Rent ratio, that is: PC/PS↑è W/R↓.
· Higher computer prices leads to higher Computer production (and lower Shoe production):PC/PS↑è QC/QS ↑ è RD for (L/K)↓ with fixed RS è W/R↓
IV. International trade and Income distribution [9 points]
Discuss the effect of an increase in the price of export goods on factor prices (who gains and who loses)
(i) in the very short run (impact analysis)
As export prices increase so does the return to all factors employed in the export sector.
(ii) in the short run (hint: use the Specific Factors Model)
In the short run the return to the specific factors employed in the export sector increase that of import sector decrease. Real return to the mobile sector can increase or decrease depending of the mix of export-import goods in workers’ consumption basket.
(iii) in the long run (hint: use the Heckscher-Ohlin Model)
in the long run return to the factor employed intensively in the production of export sector goes up and that of import sector goes down.
V. International Factor Movement [6 points]
Discuss the effect of international labor movement on factor prices
(i) in the short run (hint: use the Specific Factors Model)
Expansion of the labor force due to labor migration leads to the reduction of wages and increase in return to all specific factors.
(ii) in the long run (hint: use the Heckscher-Ohlin Model)
in the long run labor migration has no effect on factor prices of a small open economy (SOE)
VI- Outsourcing: [15 points]
Consider an outsourcing model where the Home country has a higher relative wage of skilled labor than the Foreign country and where the costs of capital and trade are uniform across production activities.
(a) Will the Home country’s outsourced production activities be high or low on the value chain for a given product? That is, will the Home country outsource skilled labor-intensive or unskilled labor-intensive production activities? Explain.
Home country will outsource high activities on the value chain, i.e. skilled labor-intensive production activities because opportunity cost of making skilled-intensive -products are higher in Home country (which is turn is the result of higher relative wage of skilled labor).
(b) Suppose that the Home country uniformly increases its tariff level, effectively increasing the cost of importing all goods and services from abroad. How does this affect the “slicing” of the value chain?
This will push the dividing line towards the high ending of the value chain, i.e. the Home country reduces outsourcing of skilled labor-intensive products.
(c) Draw relative labor supply and demand diagrams for the Home and Foreign countries showing the effect of this change. What happens to the relative wage in each country?
As shown in the figure, a rise in the tariff level in the Home country will result in an increase in the relative demand for skilled labor in both countries, which leads to a higher relative wage of skilled labor in both countries.