Adam Smith and gains from trade (8 pts)



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Adam Smith and gains from trade (8 pts)


Answer the following questions pertaining to the excerpts from Adam Smith’s Wealth of Nations

  1. Why Adam Smith supports the act of Navigation despite his own argument that the act reduces trade and the opulence of Great Britain (at least in the short run)?

Because “defense” is “much more important that opulence”.


  1. In addition to the defense argument made by Adam Smith do you see any other reason for the act of navigation? Did the act actually lead to greater opulence in addition to better defense?

The act of navigation stifled Dutch trade and industry. By limiting market access of its main trade rival GB secured larger market for its industry and better terms of trade. This was a strategic move on the part of GB.
Economic Consultant in Poorestan (25 points

Poorestan is a poor country with income per capita and poor natural resources. At the present Poorestan lives in isolation and does not trade with any country. Policy makers in Poorestan are debating whether they should open up to international trade but they are several concerns and questions and they turn to you for advice.



    1. Make an argument in support of international trade. Why trade is “good’ for Poorestan.

    2. Policy makers in Poorsetan are concerned that they have nothing to export, that technologically they are far behind any other country in every sector. What would you address this concern.

    3. Policy makers in Poorestan want to know if they open up trade what would be their exports. Make some educated guesses as the types of goods that Poorestan could export.

    4. Policy makers in Poorestan want to know who gains and who loses from trade if they open up to international trade. Please make sure you address the questions both in the (i) short run and (ii) long run. (10 pts)



4) [5 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.


1-The Ricardian Model of Trade [24 points, 4 pts each ]

a) Answer the following questions given the information in the following table.
Unit Labor Requirements

Malaysia Indonesia

Shirts 20 20

Cameras 10 40
b) Which country has absolute advantage in shirt production and why? What about camera production?
Malaysia has absolute advantage in Camera because her labor productivity in that sector is higher than that of Indonesia. No country has absolute advantage in the production of shirts.

c) In absence of trade, what is the opportunity cost of Shirts (in terms of Cameras) in Indonesia and Malaysia?

Malaysia Indonesia

OC of Shirts (in terms of Cameras) aLS/aLC bLS/bLC

20/10 = 2 20/40 = 0.5


d) For which product does Indonesia have comparative advantage?
Indonesia has Comparative Advantage in Shirt production because her opportunity cost of Shirt is lower than that in Malaysia
e) What is the relative domestic price of Shirts in each country before trade?

Autarky PS/PC in Malaysia = 2



Autarky PS/PC in Indonesia = 0.5
f) Suppose there are 200 units of labor in Malaysia and 400 in Indonesia. Draw a graph showing production possibility frontier of Malaysia and Indonesia. Have Shirt production of the horizontal axis and Camera on the Vertical axis.

f) If world price of shirts to cameras were 1 what would be the world production of Camera and Shirts? Which country would produce each?
Indonesia produces 400/20 = 20 units of shirts and exports its excess supply. Malaysia produces 200/10 = 20 and exports its excess supply.

g) Use a hypothetical indifference curve in a graph showing gains from trade for each country (when international PS/PC =1).


h) What constitutes the basis of trade in the Ricardian Model? (in other words who exports what)

Technological difference represented by differential labor productivities. Use the following to



2) Consider the following information about production in the United States and China


  1. Which country has absolute advantage in apparel and why?



  1. Which country has comparative advantage in apparel and why?



  1. What will US export to China and why?


3) Assume that Germany and China can produce beer and cloth. If the MPLc/MPLb for Germany is 2/5 and MPLc/MPLb for China is 1, then

Germany has a comparative advantage in:

China has a comparative advantage in:
B) beer and cloth, respectively.

Hecksher-Ohlin and Sector-Specific Models

1) According to the information provided in the table,

Production and Prices in Two Industries



a) the wage rate in the agriculture sector is: A) $50
b) the wage rate in the manufacturing sector is: D) $30.
c) then what do we can expect to happen in the economy:

Labor will migrate from the manufacturing to the agriculture sector.


d) if the price of the agriculture good decreases to $5, then:

B) The wage rate in the agriculture sector will be $25.

2) Suppose that the Home country in the two-sector (manufacturing and agriculture) specific-factors model has a comparative advantage in manufacturing output. When trade occurs
a. What will happen to the return (rental) on land? It will fall.
b. What will happen to the return (rental) on capital? It will rise
c. What will happen to the marginal product of capital used in manufacturing production when trade occurs? It will rise.
Use the following to answer questions 31-36:
Figure: A Country's Before and After Trade Equilibria

31. What is the equilibrium post-trade point of production? C
32. What are the post-trade quantities of shoes and computers produced by this nation?

150 shoes; 300 computers
33. What happened to the relative price of shoes in this nation after trade?

Shoes became relatively cheaper in terms of computers.
34. The trade triangle shows the exports that were exchanged for imports. What are the three points of the “trade triangle”? A, B, D
35. How many shoes will this nation import and export? 350 & 125
37. Consider two products, automobiles and shoes. If shoes are labor intensive and automobiles are capital intensive, what can we expect in free-trade conditions?

The relative price of shoes in the shoe-exporting country will increase.
38. Why is the PPF bowed out in the Hecksher-Ohlin model?

because capital is better suited to computer production than shoe production
39. The Leontief paradox found that: the U.S. exports were labor intensive.

40. The Leontief paradox questioned the validity of: the Heckscher-Ohlin model.




41.

Suppose that all countries eliminate their barriers to trade. The Heckscher-Ohlin model predicts that:

A)

Wages should become more equal throughout the world.

B)

Wages should become more unequal throughout the world.

C)

The volume of international trade should fall.

D)

There should be increased migration of labor among countries.


iv. What is the final verdict on the Leontief paradox and 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.
4. Suppose two countries, Canada and Mexico, produce two goods, timber and televisions.

Assume that land is specific to timber, capital is specific to televisions, and labor is free to move between the two industries. When Canada and Mexico engage in free trade, the relative price of televisions falls in Canada and the relative price of timber falls in Mexico.



a. In a graph, show how the wage changes in Canada because of a fall in the price of televisions, holding constant the price of timber. Can we predict that change in the real wage?
Answer: As shown by the following figure, real wage falls but by less than the percentage decrease in the price of televisions.



b. What is the impact of opening trade on the rentals on capital and land in Canada?

Can we predict that change in the real rentals on capital and land?


Answer: Because capital is specific to the television sector, the drop in the relative price of television will lead to a fall in the rental on capital. With Canada exporting timber, rental on land will rise because land is specific to the timber industry.
c. What is the impact of opening trade on the rentals on capital and land in Mexico? Can we predict that change in the real rentals on capital and land?
Answer: Through the exports of televisions, the relative price of televisions will rise in Mexico, which will lead to an increase in the rental on capital. By contrast, the rental on land will fall.
d. In each country, has the specific factor in the export industry gained or lost, and has the specific factor in the import industry gained or lost?
Answer: In both cases, the specific factor in the export industry (i.e., land in

Canada and capital in Mexico) gained whereas the factor specified to the import industry (i.e., capital in Canada and land in Mexico) loses when the two countries engage in trade.


Problem 6 Using a HO framework discuss the effects of U.S.-China trade on Skilled-Unskilled wage gap in US and China. Do we actually see these predicted effects on skilled-unskilled wage gaps in the two countries? Are you satisfied with this HO explanation of rising skilled-unskilled wage gap in US?

HO would predict that as result of trade between skilled scarce China and skilled abundant US, price of skilled intensive products increase in US (decrease in China) according to SS this should lead to an increase in wages of skilled labor (a reduction of wages of unskilled labor). We expect the opposite to happen in China. That is as result of US-China trade we expect skilled-unskilled wage gaps to increase in US and to decrease in China.

We observe the increase in skilled-unskilled wage gaps in US but we do not see the wage gap reductions we expected to see in China. If anything this has actually increase in China. HO explanation is not quite satisfactory because, first we are see conflicting effects, second US trade with NIC’s constitutes only a small fraction of total U.S spending; this is too small to explain the increased gap.

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)

  1. in the very short run (impact analysis)

As export prices increase so does the return to all factors employed in the export sector.





  1. 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.





  1. 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

  1. 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.




  1. 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]

1- Using an outsourcing model show that both countries can gain from trade in intermediate goods (say components and R&D products). Clearly state your assumptions.


2- Explain the increase in relative wage of skilled to unskilled labor in US and China using an outsourcing model.



16.

Workers displaced due to trade:

A)

have had larger losses in manufacturing compared with services.

B)

have had larger losses among older workers than younger workers.

C)

are likely to find replacement jobs within 3 years (in an economy like US).

D)

have experienced all of these answer choices.




17.

The Trade Adjustment Assistance program is:

A)

an unemployment insurance program regardless of the reason for job loss.

B)

an unemployment insurance program that pays for job loss due to import competition.

C)

a subsidy program for the producers.

D)

a tax on importers of foreign goods.




22.

Which of the following statements about the specific-factors model is true?

A)

When exports of a product rise, the increase in revenue is divided among the factors of production equally.

B)

When imports rise, revenues of firms that compete with imports fall. The decrease in revenue is divided among the factors of production equally.

C)

When exports of a product rise, specific factors gain less and mobile factors gain more; when imports rise, specific factors gain more and mobile factors gain less.

D)

When exports of a product rise, specific factors gain more than mobile factors; when imports rise, specific factors lose more than mobile factors.




23.

In general, the gains to some resources from free trade exceed losses suffered by other resources. This means that, in principle:

A)

The government should be able to tax resources that gain and compensate resources that lose so that all resources are better off with trade.

B)

The government should tax imports in order to reduce the losses suffered by some resources.

C)

The government ought to tax exports in order to collect revenue to compensate resources that lose from free trade.

D)

The government ought to tax returns on land because they always increase with free trade.




24.

Which model best explains U.S. exports of chemicals to China and U.S. imports of Chinese tennis shoes?

A)

specific-factors model

C)

Heckscher-Ohlin model

B)

Ricardian comparative advantage model

D)

comparative advantage model



26.

The Hecksher-Ohlin model of international trade uses _____ and ______ to explain trade patterns.

A)

comparative; absolute advantage

C)

factor availability; factor usability

B)

factor abundance; factor intensity

D)

tariffs; quotas




27.

In a capital-intensive industry, the capital/labor ratio will:

A)

rise as the wage/rental ratio falls.

C)

rise as the country's capital stock rises.

B)

fall as the wage/rental ratio falls.

D)

fall as the country's capital stock falls.




28.

The implication of resources being mobile domestically is:

A)

There is often unemployment.

B)

Capital and land are often not suited for use in other industries.

C)

Labor and capital are paid the same wage and rental price in all domestic industries.

D)

They lose the chance to become guest workers in other nations.




29.

The Heckscher-Ohlin Model assumes that:

A)

Factor endowments are same.

B)

Consumer tastes are the same across countries,

C)

The technologies used to produce the two goods are identical across the countries.

D)

Consumer tastes and technologies are the same across countries.



Answer Key


1.

A

2.

A

3.

B

4.

A

5.

B

6.

D

7.

A

8.

B

9.

B

10.

B

11.

B

12.

A

13.

D

14.

B

15.

B

16.

D

17.

B

18.

A

19.

A

20.

B

21.

B

22.

D

23.

A

24.

D

25.

D

26.

B

27.

B

28.

C

29.

D

30.

B

31.

C

32.

D

33.

B

34.

C

35.

C

36.

B

37.

B

38.

C

39.

C

40.

B

41.

A




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