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## Chapter 2

True/False

1. False: consumers of the exported good lose as its price increases.

2. True.

3. False: producers of the domestic import-competing good see lower prices for their goods.

4. True.

5. True: but both are rare at times!

Multiple Choice

1. A

2. A

3. C

4. A

5. C

Problems

1. a. The equilibrium price of bread in Leinster is 0.6 telephones per loaf; in Saxony the price is 0.2 telephones per loaf.

b. Yes. Since Saxony’s bread price is lower than Leinster’s, there will be an incentive for Leinster bread consumers to buy Saxon bread. Saxon bread producers have an incentive to sell in Leinster, where the price is higher.

c. Figure 2.1c

d. 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): it is 0.25 telephones per loaf. Notice that this is the price at which import demand from Leinster equals export supply from Saxony.

e. At the trade price of 0.25 telephones per loaf, excess demand for bread in Leinster equals 80 million loaves—exactly the amount of excess supply in Saxony at the trade price.

f. Looking at Figure 2.1, consumer gain in Leinster = a + b + c, where producer loss in Leinster = a; consumer loss in Saxony = d; and producer gain in Saxony = d + e.

g. Bread consumers in Leinster and bread producers in Saxony will be happy about the opening of free trade. However, Leinster bread producers will not be happy (they are undercut by cheaper imported Saxon bread), nor will Saxon bread consumers, who used to pay a lower price before the people in Leinster were able to buy the bread.

h. The net gain to Leinster is the area labeled “L”; this is equal in magnitude to the net gain b + c from the domestic graph. The net gain to Saxony is the shaded area labeled “S”; this is equal in magnitude to the net gain e from the domestic graph.

i. The country with the less elastic trade curve (usually the result of less elastic domestic supply and demand curves) will gain the most from trade. In our case, this is Leinster. It was able to “drive” the price it pays for bread far below its previous domestic bread price. As a percentage of the free trade price, Leinster’s price for bread changed 140 percent, whereas in Saxony the price changed only 20 percent.

j . The losses from closing trade would just be the net gain the countries had obtained from free trade: “L” in Leinster, “S” in Saxony.

1. With more elastic domestic supply and demand curves, Leinster’s import demand curve will also become more elastic. Using Figure 2.1c as a guide, you can see that, as a consequence of an increase in elasticity, the international price of bread will rise, and be closer to Leinster’s pre-trade price. The quantity of bread traded will rise; Leinster’s net gains from trade will fall, but Saxony’s gains will rise.

3. They would lose 5 percent per board foot on the 48 billion board feet they continue to sell at home, plus sell four billion less board feet in total, summing to a total loss of \$2.5 billion.

Figure 2.3

Producer surplus loss = a + b + c : price decline on remaining sales

+d : reduction in total sales

= \$2.4 billion

+0.1 billion

\$2.5 billion

4. a. Bean consumers will lose and bean producers will gain as the relative price of beans rises; jeans consumers will gain and jeans producers will lose as the relative price of jeans drops.

b. The net national gain from trade can be measured as the difference in the size of the consumer and producer surpluses as a result of the opening of trade.

Chapter 3

True/False

1. True: that was David Ricardo’s point.

2. True: with constant costs, the opportunity cost of a good is the same, regardless of tastes.

3. True.

4. False: Arbitrage means everyone will pay the same price.

5. False: As long as a comparative advantage exists, trade will benefit even “unproductive” countries.

Multiple Choice

1. D

2. B

3. A

4. A

5. B

Problems

1. a. Leinster has an absolute advantage in both goods since it takes less labor to make bread and less labor to make telephones than in Saxony.

b. Leinster has a comparative advantage in telephones; in Leinster, the price of one telephone is 5/3 of a bread loaf, while in Saxony the price of one telephone is 5 loaves of bread. At the same time Saxony has a comparative advantage in bread: in Saxony, the price of one loaf is 1/5 telephone, while in Leinster the price of one loaf of bread is 3/5 telephone.

2. There is a basis for trade: Saxons can buy inexpensive telephones from Leinster and sell their bread there for a higher price than at home. Leinsterian telephone manufacturers can sell in Saxony for more than the pre-trade price; consumers in Leinster can buy bread more cheaply from Saxony.

3. a. Figure 3.3a

b. At a price of one telephone per four loaves of bread, Saxony will export bread to Leinster in exchange for telephones.

c. With complete specialization, Leinster produces at point T, and Saxony produces at point B. Each country can then trade their good for the other country’s good, at a price of one telephone for four loaves of bread. The “consumption possibilities curve” is just the ray emanating from the production point with slope 1/4. Notice that the consumption line lies outside each country's production possibilities curve. That’s a good illustration of the benefits that come from trade.

Figure 3.3c

4. a. Figure 3.4a

The pre-trade price is calculated from the slopes of the PPCs, which are constant. In Chile, the price of one yard of cloth is 1.5 bushels of wheat, and the price of one bushel of wheat is 2/3 yard of cloth. In Brazil, the price of one yard of cloth is 2.5 bushels of wheat; the price of one bushel of wheat is 2/5 yard of cloth.

b. Chile is the low-cost cloth producer; Brazil is the low-cost wheat producer. Thus, Chile will export cloth; Brazil will export wheat. But the maximum that Brazil will pay for one yard of cloth is 2.5 bushels of wheat (its own pre-trade price).

c. Figure 3.4c

With this change in the productivity of labor in cloth, Brazil’s PPC rotates upward, and the country’s pre-trade price for a yard of cloth changes from 2.5 bushels of wheat to 1 bushel of wheat. Now, Brazil is the low-cost cloth producer and Chile is the low-cost wheat producer. The trade patterns will be reversed!

5. Suppose that you, as the older sibling, are absolutely better at washing dishes and taking out the garbage. Your younger brother could do these chores too, but he is absolutely worse at them than you. It is likely, however, that his comparative disadvantage lies in washing the dishes. Your parents could have you do a less than complete job on both tasks by splitting your limited time between them and let your brother go ride his skateboard. It would be more efficient (and more equitable) to have you focus on washing the dishes well, and let your brother use his labor resources to take out the garbage.

To be more precise: Let’s say it takes you 15 minutes to do the dishes and five minutes to take out the trash. Your brother, on the other hand, would need 45 minutes to wash the dishes properly, and ten minutes to take out the trash. Clearly you have an absolute advantage in “production” of these services.

 You Your brother Labor to do dishes (minutes) 15 45 Labor to take out trash (minutes) 5 10

Notice your brother has a comparative advantage in taking out the trash. While he would have to “give up” 4 1/2 trash runs to do the dishes, you would only lose out on doing three runs. Alternatively, you could say that the cost to you of taking out the trash is getting one third of the dishes done, whereas the cost to your brother is getting less than one quarter of them done. You are the low cost producer of clean dishes; your brother is the low cost producer of trash disposal.

Chapter 4

True/False

1. False: it is the abundance of land relative to other factors that matters.

2. True: with increasing costs, there will come a point at which the opportunity cost of producing another unit is far greater than anyone would be willing to pay for that extra unit.

3. True.

4. True.

5. True. In H-O, it is because factor intensities differ that differing relative endowments of those factors across countries will lead one country to have a comparative advantage over another in the production of the good that intensively uses its abundant factor.

Multiple Choice

1. A

2. A

3. B

4. D

5. A

Problems

1. a. The ratio of land to labor in Leinster is 8 million acres to 2 million laborers or 4:1. The ratio in Saxony is 2 million acres to 400,000 laborers or 5:1. Therefore, although Saxony has absolutely fewer acres of land than Leinster, Saxony is “land abundant.” Leinster is the “labor abundant” country since it has one laborer for each four acres.

b. Telephones are labor-intensive goods; bread is land-intensive. According to H-O, then, Leinster will export telephones and import bread; Saxony will export bread and import telephones.

2. In this case, we have to modify our measurement of “labor.” Now, although Leinster has more workers, Saxony’s workers supply more days of labor per person per week.

So, if we were to measure factor abundance as the ratio of person-days to acres, we would get the following:

For Leinster: Labor/Acres = (10 million person-days)/8 million acres = 1.25

For Saxony: Labor/Acres = (2.8 million person-days)/2 million acres = 1.40

So Saxony now looks like the relatively labor-abundant country!

3. Figure 4.3

The PPCs of the two countries can be represented by the one drawn. The country with tastes skewed toward pizza will have a higher pre-trade price for pizza in terms of beer than the country that has tastes skewed toward beer. The two countries should trade: the pizza-loving country will produce more beer and export it in exchange for pizza; the beer-loving country will make more pizza and export it in exchange for beer, such as with points PL and BL. We get the interesting result that trade causes each country to specialize less in production—at some middle point like P*—and trade for the preferred good.

4. It doesn’t really matter what each country’s supply and demand curves (or production possibilities and indifference curves) look like; what drives trade is what autarkic price results from those curves.

For example, the two countries illustrated below have very different demand and supply curves. And yet, they do not have any obvious reason to trade with each other because those very different curves yield exactly the same pre-trade price!

Figure 4.4

5. Heckscher and Ohlin don’t have much to say in this case. Factor endowments will still determine relative factor prices (so that the labor-abundant country will tend to have lower wages than the capital-abundant country), but we can’t predict what the pre-trade prices of the goods will be if labor and capital are equally suited to producing both goods.

Chapter 5

True/False

1. True.

2. False: just the reverse is the case, with owners of scarce factors seeing their incomes fall.

3. True: that’s why Joan Robinson will never receive the prize for her work on imperfect competition–proof that it is an imperfect world!

4. True.

5. True: unskilled labor is used relatively more in the import competing industries in the United States.

Multiple Choice

1. C

2. A

3. B

4. A

5. D

Problems

1. When trade opens up, the price of bread falls in Leinster and rises in Saxony. At the same time, the price of telephones rises in Leinster and falls in Saxony.

a. In the short run, Leinster’s bread workers see their wages fall, while telephone workers see their wages rise. In the long run, all workers see their wages rise as labor moves out of the declining bread industry and into the labor-intensive telephone industry.

b. In the short run, Saxony’s bread workers see their wages rise, while telephone workers see their wages fall. In the long run, all workers see their wages fall as labor is released from the labor intensive telephone industry but is not needed in the same amounts in the land-intensive bread industry.

c. If the factor price equalization theorem holds, the wages of the abundant workers in Leinster should rise to meet the falling wages of the scarce workers in Saxony. Similarly, the scarce land in Leinster will earn less than before, abundant land in Saxony will earn more than before, and they should equal each other if FPE holds.

2. Some possible explanatory factors include: trade barriers that prevent commodity price equalization; differences in labor productivity or skill levels between the countries; and immobility of labor between sectors in each country.

3. a. If a factor is immobile between sectors, its income is a function of whether it is employed in the price rising industry or in the price-falling industry. So capital owners, landowners, and laborers in the computer sector would gain; capital owners, landowners, and laborers in the wheat sector would lose.

b. If a factor is mobile between sectors, its income is a function of whether it is the country’s relatively scarce factor or relatively abundant factor. So capital owners would gain and landowners would lose. Labor would migrate from the losing sector to the gaining sector.

4. a. Bread is more labor intensive than wine: 4/9 of the cost of making bread is labor cost, whereas only 1/3 of the cost of making wine is labor cost. Conversely, wine is capital intensive.

b. If inputs cannot move between sectors, everyone in the wine sector will likely gain and everyone in the bread sector will likely lose.

c. Since bread prices are pushed down, bread consumers will celebrate open trade. But since wine prices rose, wine consumers will commiserate with the bread makers.

5. This is a case of reversing the Stolper-Samuelson effects of free trade. Now, bread will be the price-rising industry and telephones will be the price-falling industry.

a. Because labor is intensively used in the price-falling industry, real wages will fall by more than 14% (due to the magnification effect).

b. Conversely, real land rents in Leinster will rise by more than 14%.

Chapter 6

True/False

1. True. For example, if the United States exports \$1 billion worth of Coors beer and imports \$1billion worth of Heineken beer, net trade in beer is zero, but intra-industry trade in beer is \$2 billion.

2. False: IIT is more prevalent in imperfectly competitive industries.

3. False: economies of scale reduce average costs.

4. True: Consumers of the export good may benefit both from product differentiation and from cost reductions that result from scale economics in production.

5. False: In intra industry trade, factor incomes are relatively unaffected because, as imports of one variety of product increase, exports of another variety expand as well. So we would expect exports of fine riding boots from England to rise as well made Swiss hiking boot imports to England also rise. So employment and incomes of workers in the British footwear industry are relatively unchanged. But the increased variety of footwear available raises the well-being of those workers in their role as buyers of shoes. This might be an example of product differentiation being founded on peculiarities of each country: the passion for horse racing in England and for mountain climbing in Switzerland.

Multiple Choice

1. B

2 B

3. B

4. B

5. B

Problems

1. a. Recall from Figure 2.1 that Leinster imports 80 million loaves of bread from Saxony; in return it exports 20 million telephones because the “price” of the imported bread is 0.25 telephones per loaf. So, for Leinster:

IIT Share = 1 –

= 1 –

= 1 –

= 1 –

= 0

In other words, there is no intra industry trade between the two countries: there is only a straight barter of Leinster’s telephones for Saxon bread. This is entirely consistent with Heckscher Ohlin; in their model, all trade is based on swapping different goods that are manufactured using different relative factor endowments.

b. Recall the notion of product differentiation and the increased importance of luxuries as incomes rise. It is possible that the Leinster bakers who are still in business (recall that we do not have complete specialization in our hypothetical world) might switch from baking the universal, generic white bread to baking specialty breads and pastries. In that case “bread” (as broadly defined) will be exported from Leinster to Saxony.

2. Under a situation of identical tastes and production possibilities, we could not turn to standard theory for why countries would trade (i.e., differences in pre trade price ratios arising from different tastes).

Instead, countries could gain by trading with each other if the goods they produce and buy are subject to economies of scale. For example, suppose both the U.S. and Germany can produce ships or airplanes under the same conditions of increasing returns to scale in both products. Suppose they both had the same tastes, causing each country to “consume” ships and airplanes. The countries could gain from trade only if one country specialized in ships and the other specialized in airplanes. With all conditions identical, they could even flip a coin to see who specializes in what.

Figure 6.2

100

In Figure 6.2, both countries could gain as they move from the common production point A to point B for the ship specialist and point C for the airplane specialist. The two countries could then consume at point D.

3. We are likely to see the rise of intra-industry trade in liquor between the U.S. and France. Consumers in each country will benefit from a greater variety of alcoholic beverages (both domestic and imported) at lower prices. Think of it: cheaper Jack Daniels! Cheaper Remy Martin!

4. IIT share = 1 – [sum of absolute value of (X – M)]/(sum of X + M)

a. With Japan: IIT = 1–{(75 – 60 + 70 – 150)/ (145 + 120)}

IIT = 0.817

With Sudan: IIT = 1–{(50 – 55 + 70 – 0)/ (115 + 55)}

IIT = 0.559

b. IIT with Japan is higher than IIT with Sudan. This is also likely true in the real world because IIT is largely based on a rising demand for knowledge intensive luxuries. The higher the level of consumer income, the greater the proliferation of near-substitute varieties of goods and services. Higher incomes make it possible to value variety for its own sake. Thus, since the United States and Japan have higher income levels, they are buying each others’ version of similar products (e.g., cars, entertainment equipment, etc.).

5. The standard H-O model suggests that the opening of trade in computers would reduce the well-being of domestic buyers of computers by raising the price they must pay. But we might also consider the possibility that economies of scale exist: when domestic computer manufacturers face additional demand from Eastern Europe, production will increase. With scale economies, costs will fall as production expands. As a result, domestic computer buyers may actually end up better off due to lower computer prices.

Chapter 7

True/False

1. True.

2. True.

3. True! Ask the people who raised you.

4. False: export based growth tends to raise trade volumes.

5. True insofar as isolation cuts the country off from new technologies that could raise productivity in the country.

Multiple Choice

1. C

2. C

3. A

4. D

5. B

Problems

Figure 7.1

a. Saxony is experiencing export biased growth. We would expect the volume of trade between Saxony and Leinster to increase—the Saxon telephone industry will decline (Rybczynski), and Saxony will import more telephones from Leinster instead.

b. Since Saxony is a small country, we would not expect bread’s trade price to change. Consequently, Saxony can reach a higher level of utility as the new indifference curve suggests.

c. Leinster is experiencing “export biased decline.” We would expect that the volume of trade between Leinster and Saxony would fall. In a reverse of immiserizing growth, the level of economic welfare in “large country” Leinster might actually rise: the terms of trade will move in its favor as the supply of telephones (and likely the demand for bread) fall. Whether or not welfare does rise will depend on the degree to which prices change and on the shape of Leinster’s indifference curves.

This is a good example of how economic analysis can miss the broader picture: although the terms of trade move in favor of Leinster, it is the result of a human catastrophe.

2. a. This export-biased growth may result in a reduction in Canadian well-being (a case of immiserizing growth) if the price of wheat falls far enough and if Canada is highly dependent on international trade in wheat and cloth.

b. The rest of the world will gain as a result of the decrease in the price of wheat.

c. The Rybczynski theorem tells us that the cloth sector will contract as the wheat sector expands. Because the wheat sector absorbs fewer unskilled laborers than the cloth sector releases unskilled wages will fall.

d. Canada should benefit from an increase in the world’s supply of labor. This will tend to reduce the price Canada pays for cloth and increase the price (and quantity) of Canada’s wheat exports.

3. Not only can growth affect trade, but openness to trade can affect growth. Because Leinster has a large telephone industry, it is likely that R&D there is significant. Productivity in Saxony may increase as more technologically sophisticated imported telephones reduce the costs of doing business in that country. At the same time, telephone producers in Saxony will have to innovate and improve their products to compete with the imported units; some of the Leinsterian technology may even be diffused into Saxony. Clearly, this can be good for Saxony.

4. a. According to H O, Kazakhstan will export land­-intensive and unskilled labor-intensive goods. It will import capital intensive and skilled labor-intensive goods.

b. To achieve import biased growth to replace imports with a domestically-produced substitute, Kazakhstan would need to increase its endowments of capital and skilled labor. If Kazakhstan were a large country, this would turn the terms of trade in its favor: the price of imports in particular would fall as the demand for them from Kazakhstan declines. As you might have guessed, however, there are few (if any) goods for which Kazakhstan could have an impact on the price.

5. a. This would be a case of import-biased growth: oil imports should fall.

b. In a strict one-dollar one-vote metric, well-being will rise as the terms of trade move in favor of the U.S.

c. If the expansion of the oil sector is large enough, the Dutch disease could very well plague the U.S.

d. Here, you should think about externalities—both positive and negative—to increased production of oil and decreased production of other goods.

6. Assuming the increased savings on the part of American consumers will be transferred to investors and not just hoarded under our collective national mattress, the rate of capital formation in the economy should increase. This would amount to export biased growth of a large country. In theory, this would raise trade volumes with the rest of the world, while reducing the price of American exports and increasing the price of imported goods. At an (unlikely) extreme, this could result in immiserizing growth if the adverse terms of trade movement offsets any gains in our ability to produce capital intensive goods.

Chapter 8

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