Office Use Only
Summer School B
2019
Faculty of Business and Economics
TEST CODE: ECS3121
TITLE OF PAPER: Economics of International Trade and Finance
TEST DURATION: 2 hours writing time
READING TIME: 10 minutes
THIS PAPER IS FOR STUDENTS STUDYING AT:( tick where applicable)
 Berwick
Learning
 Caulfield
 Parkville
 Clayton
 Malaysia
 Gippsland
 Peninsula
 Other (specify)
 Off Campus Learning  Open
 Enhancement Studies  Sth Africa
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Page 1 of 10
Question One
Answer questions I-V based on the following diagram of a country in international trade
equilibrium
Figure 1:
EB represents the country’s PPF (production possibility frontier) in autarky; FB represents the
post-trade CPF (consumption possibility frontier)
I. This country has comparative advantage in good
a. S
b. T
c. Y
d. Z
II. Upon opening up for trade (equilibrium), this country produces at point
a. B
b. C
c. D
d. E
III. In post-trade equilibrium, this country consumes at point
a. B
b. C
c. D
d. E
IV. Exports for this country equal
a. OA units of Z
b. AB units of Z
c. AC units of Y.
d. AD units of Y.
Page 2 of 10
V. Imports for this country equal
a. OA units of Z
b. AB units of Z
c. AC units of Y
d. AD units of Y.
Question Two
Which of the following is not a reason for increasing opportunity costs?
a. for the nation to produce more of a commodity, it must use resources that are
less and less suited in the production of the commodity
b. factors of production are not homogeneous
c. technology differs among nations
d. factors of production are not used in the same fixed proportion in the
production of all commodities
Question Three
Mutually beneficial trade cannot occur if production frontiers are:
a. different but tastes are the same
b. equal but tastes are not
c. the same and tastes are also the same.
d. different and tastes are also different
Question Four:
The equilibrium price and quantity for a commodity traded between two nations occurs where:
a. the slopes of the two offer curves is equal to zero
b. the slopes of the two offer curves are the same.
c. the two offer curves intersect
d. the price ratio of good X for good Y is equals one.
Question Five
The H-O model extends the classical trade model by:
a. explaining the basis for comparative advantage
b. examining the effect of trade on factor prices
c. both (a) and (b)
d. neither (a) nor (b)
Question Six
According to the H-O model, trade reduces international differences in:
a. neither relative nor absolute factor prices
b. absolute but not relative factor prices
c. relative but not absolute factor prices
d. both relative and absolute factor prices
(15 Marks)
Page 3 of 10
Question Seven
We discussed a number of current International economic problems in our first lecture.
Mention four of them and explain how these problems can affect South Africa through
a. Employment
b. Investment
c. Trade
(10 Marks)
Answer
The following were the current problems discussed in class. Candidate should explain
how each of the 4 mentioned problems are affects investments, employment and trade.
Award 1 mark each for correctly mentioning the problems and 2 marks each for
explaining how each problem affects South Africa through employment, investments
and trade. Note that the student may mention factors outside the provided list. Inform
me if you are not sure of a mentioned problem by student
 Trade Protectionism in Industrial Countries
 Excessive Fluctuations and Large Disequilibria in Exchange Rates
 Financial Crises in Emerging Market Economies
 High Structural Unemployment and Slow Growth in Europe and Stagnation
in Japan
 Energy and environmental problems in Africa
 Mediocre growth in the important economies in Africa
 Deep Poverty in Many Developing Countries
 Drought and famine in Africa
 Geopolitical tensions in Asia
 Protectionists leaders (e.g. Pres. Trump)
 Rise of populism and intolerance.
 Brexit and spillovers to Europe and world economy
 Slow commodity prices recovery and effects on African economies.
Question Eight
a. For two nations, describe how the autarky market conditions for a commodity
should tell us the direction of trade flow after they open up for trade.
Illustrate with the relevant diagram. (10 Marks)
Answer
Award 4 marks to well labelled diagram similar to the one below.
Page 4 of 10
Award the rest of the six marks according to the following points
 Autarky equilibrium price of commodity X in Nation 1 (P1) is lower
than that for Nation 2 (P2)
 With free trade, there will be added demand of X in Nation 1 from
Nation 2.
 At a relative price greater than P1, Nation 1’s excess supply of X
(Panel A) gives rise to Nation 1’s international supply curve of X (S
in Panel B).
 At a relative price lower than P3, Nation 2’s excess demand for X
(Panel C) gives rise to Nation 2’s demand for imports of X (D in
Panel B).
 With free trade, international equilibrium price lies between the
autarky prices of commodity X in both countries. In our illustration,
this occurs at price P2 (Panel B.
 Thus P2 is equilibrium-relative commodity price with trade where
quantity of imports demanded equal quantity of exports supplied
b. Let country’s A endowment of labour equal 200 and country B’s endowment
of labour equals 200. The number of units of labour required to produce 1
unit of X in country A equals 5, and the number of units of labour required to
produce 1 unit of Y in country A equals 4. The number of units of labour
required to produce 1 unit of X in nation B equals 4, and the number of units
of labour required to produce 1 unit of good Y in B equals 8.
i. Which country has an absolute advantage in which good(s)? Why?
(2 Marks)
Answer
Country
A
B
Labor
Requirement
X
Y
5
4
4
8
Labor
Endowment
200
200
Country A has absolute advantage in Y since it is more efficient in
producing it compared to Country B. Likewise, Country B has
absolute advantage in X since it uses fewer hours to produce it
compared to country A.
Page 5 of 10
ii. If free trade were allowed according to absolute advantage framework,
what degree of productive specialization would occur? Why? How much
of each good will be produced? (4 Marks)
Answer
Under the absolute advantage framework, Country A should
specialize commodity Y and Country B should specialize in
commodity X. (1 Mark)
Both countries completely specializes because the absolute
advantage theory assumes constant opportunity costs. Full
specialization and exchanging should provide the nations with the
best welfare. (1.5 Marks)
Country A fully specializes and produces 50Y for exchange with
Country B whilst Country B produces 50X. (1.5 Marks)
iii. Answer the questions in parts (ii) and (iii) using the principle of
comparative advantage instead of absolute advantage. (6 Marks)
Answer
Opportunity cost of producing commodity X (note that candidate
can use smallest absolute disadvantage method, mark accordingly)
(1 Mark)
Opportunity cost of X in Country A=50/40=1.25
Opportunity cost of X in Country B=25/50=0.5
(2 Marks)
Country B has a lower opportunity cost in production of X. Since we
are dealing with a 2-country -2-commodity framework, country A
assumes opportunity cost in the production of Y. (2 Marks)
Similar to (ii) both countries completely specializes because the
comparative advantage theory assumes constant opportunity costs.
Full specialization and exchanging should provide the nations with
the best welfare. Country A fully specializes and produces 50Y for
exchange with Country B whilst Country B produces 50X. (1 Mark)
iv. How does your answer in (ii) and (iii) differ from those in (iv)? Why?
(3 Marks)
Answer
Award marks according to similar arguments presented below
Both theories arrives at the same conclusion, however absolute
advantage considers productivity based on absolute differences in
efficiencies. Thus, all you need to know is labour input productivity.
Comparative advantage considers relative efficiency or opportunity
costs. Here you need to know relative outputs given labour inputs.
Thus even if one country has an absolute advantage in producing
all goods, comparative advantages still allows the nations to benefit
from trade.
Page 6 of 10
Question Nine
a. Why does trade lead to specialization in production? Explain why
specialization is complete in presence of constant opportunity costs and
incomplete when opportunity costs are increasing. Illustrate with relevant
diagrams. (13 marks)
Answer
Award 3 marks each for a diagram and 7 marks for explanation similar
to the one below.
Trade allows countries to identify their commodity of comparative
advantage (commodities that they can relatively produce efficiently).
Thus with trade, it is rational for nations to specialize in the production
of commodities with lower opportunity costs.
In the case of constant opportunity cost, resources either are perfect
substitutes for each other or used in fixed proportion in production of
both commodities, and all units of the same factor are homogeneous.
The price differences remain unchanged and hence nations can
completely without losing its comparative advantage; thus the use of
straight line PPF as shown below;
In the case of increasing opportunity cost, as countries specializes,
production costs rises since factors are not either homogenous or
perfect substitutes. As specialization continues, relative commodity
prices move towards each other until they become identical in both
nations. Upon price equalization, it does not pay either nation to
continue to expand production of the commodity of its comparative
advantage else they lose their advantages; thus the use of concave PPF
as shown below.
Page 7 of 10
b. Using a set of offer curves explain how equilibrium terms of trade is reestablished (in a two-country/two-commodity world) if one of the countries
decides to charge a relative price higher than the world equilibrium relative
price. (12 Marks)
Answer
Award 5 marks for diagram similar to the one below and 7 marks for
explanation similar to the one given
With this illustration, there exists one relative commodity price that
trade is balanced. This occurs at a price of PX/PY=PB=1 and exchange
of 60X for 60Y. Beyond this price, trade imbalance would result; excess
demand/ supply should bring us back to equilibrium conditions.
The diagram above (or similar offer curves) can be used to illustrate
how equilibrium is restored if one nation prices its export higher than
world equilibrium price. For instance, at a higher price of PF’ =2,
Nation 2 wants to export 40Y but Nation 1 wants to import in excess of
the initial equilibrium volume (this occurs where
price line of
PX/PY=2 (extrapolate this line) meets Nation 1 offer curve). The
excess surplus pushes the price back to equilibrium where Nation 2
exports 60Y and Nation 2 imports this 60 Y.
Question Ten
a. Define the terms labour-intensive commodity and capital Intensive
commodity. Suppose in a hypothetical country X, 1 unit of textile can be
produced using 10 units of capital and 10 units of labour, while 1 unit of cellphone requires 8 units of capital and 2 units of labour. Which commodity is
labour intensive and which is capital intensive? Is it possible to predict the
pattern of trade based on the Heckscher-Ohlin (H-O) model? Explain your
answer .(4 Marks)
Answer
In a two-commodity, two factor world, commodity Y is capital
intensive and X is labour intensive if the capital-labor ratio (K/L) used
Page 8 of 10
in the production of Y is greater than K/L used in the production of X.
(1 mark)
K/L of textile=10/10=1; K/L of cell-phone =8/2=4- Cell phone is
capital intensive whilst textile is labour intensive. (1 mark)
It is not possible to predict trade based on the H-O model since we
also require factor abundance of two nations: A nation will export the
commodity whose production requires the intensive use of the nation’s
relatively abundant and cheap factor and import the commodity whose
production requires the intensive use of the nation’s relatively scarce
and expensive factor. (2 marks)
b. Suppose that Congo has abundant labour and scarce capital relative to South
Africa. Assume that coffee is labour intensive relative to automobiles and that
the other HO assumptions of the 2x2x2 framework holds.
i. Show diagrammatically how the PPFs for the two countries differ and
explain how that creates the possibility for the mutual beneficial trade
between them. Illustrate changes in welfare gains as the two economies
moves from autarky to free trade.(10 Marks)
Answer
Diagram should be similar to below. Let X be coffee and Nation 1
represents Congo. Let Y be automobiles and Nation 2 represents
South Africa. The PPF for Congo should be skewed along the
coffee axis, indicating abundance of Coffee in Congo compared to
South Africa. On the other hand, the PPF of South Africa should be
skewed along the automobile axis, indicating abundance of
automobiles in South Africa compared to Congo.
Award a maximum of 4 marks for a well-labelled diagrams and 6
marks for explanation similar to the one below
Since Congo has more labour and coffee is labour intensive, Congo
can specialize in coffee and exchange it for automobiles the
capital-intensive good from South Africa, who has more capital.
In autarky, Congo optimizes consumption and production of
coffee and automobiles at point A and the slope of the tangent
through that point (PA=Pcoffee/Pautomobiles) determines the
Page 9 of 10
relative price (opportunity cost) of coffee at that point. Similarly,
South Africa optimizes consumption of coffee and automobiles at
point A’ and the slope of the tangent PA’ determines the relative
price of coffee in South Africa. Since PA < PA’, relative price of
coffee in Congo is lower than that in South Africa. Thus Congo has
a lower opportunity cost in the production of coffee hence has
comparative advantage in the production of coffee. According to
the HO model, Congo should specialize in coffee and South Africa
in automobiles.
After exchange, both countries experience welfare gains. Autarky
welfare was on indifference curve I, whereas post-trade welfare is
on indifference curve II.
ii. What groups within the two countries would support trade based on the
long-run HO model? Explain. (4 Marks)
Answer
Award marks according to similar argument made
According to the HO model, owners of labour would support trade
as their wages increases with specialization and exchange. On the
other hand, owners of capital would not support trade as free trade
reduces their returns due to the inflow of cheap imports.
For South Africa, the owners of labour would not support free trade
since wages would reduce with trade, whereas the owners of
capital will support free trade since the specialization and
increasing demand increases the return to capital in South Africa.
iii. Do you expect those opposing trade in Congo in the short-run to differ
from those opposing trade in the long-run. Explain (assume labour is
mobile in the short-run and capital is not). (7 Marks)
Answer
Award marks according to similar argument made
In the short run, labour is variable (mobile) and capital is fixed
(immobile). Unlike the HO model, owners of a certain capital (the
capital used to produce coffee) would benefit in the short-run.
Returns to capital for the comparative advantage good (capital for
coffee) increases since increasing demand and specialization in
coffee results in the returns to the capital involved in the production
of coffee. The owners of capital in the production of automobiles
will be worse off. Returns to the capital used in the manufacture of
automobiles in Congo would reduce in the short run with trade.
This is because of cheap imports and increase in labour input costs
as producers of automobiles have to increase wages to keep their
workers from leaving to the coffee industry.
In the short-run, we cannot definitely say if owners of labour gains
or losses in Congo. Although nominal wages increases in Congo
with trade, real wages may decrease or increase depending on what
is consumed. If wages are spent on coffee, then consumers are
worse off since price of coffee rises faster than wages with trade.
However if consumers spend their wages on automobiles, then they
will be better off since the price of automobiles are lower than
autarky due to imports from South Africa.
*** END OF PAPER ***
Page 10 of 10