International Trade and Investment
Problem Set 1
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 1
Overview
Topics
Ricardian Trade
Heckscher-Ohlin Trade
Approach
Interaction in groups (please re-arrange your seating on my signal)
Discussion and Q&A in plenum
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 2
Outline
Question 1: Ricardo
Question 2: Heckscher-Ohlin
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 3
Question 1: Ricardo
The following unit labour requirements describe a two country economy (Ricardo’s original
example):
Table: Unit Labour Requirements
England
Portugal
Wine
4
10
Cloth
2
20
Assume that consumers in both countries want to consume both goods.
1. Why should England trade with Portugal if it is much more productive in both industries? Under
free trade, what is the pattern of trade and why?
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 4
Solution
1 Why should England trade with Portugal if it is much more productive in both industries? Under
free trade, what is the pattern of trade and why?
What matters for trade is not absolute, but comparative advantage, i.e. opportunity costs
England has high opportunity costs for producing wine (4/2 = 2) relative to Portugal
(10/20 = 0.5), so that it is more efficient for England to focus on cloth and exchange it for wine
on the world market
England will export cloth and import wine, while Portugal imports cloth and exports wine
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 5
Ricardo cont’d
2 What is the range of possible
free trade prices of wine
relative to cloth? What would
you need to know in order to
pin down the relative prices?
Hint: use the relative supply
curve to illustrate your
argument.
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 6
Ricardo cont’d
2 What is the range of possible
free trade prices of wine
relative to cloth? What would
you need to know in order to
pin down the relative prices?
Hint: use the relative supply
curve to illustrate your
argument.
Relative prices are in the
interval [0.5, 2]
PC
PW
P
aCL
P
aWL
=2
E
aCL
E
aWL
=
RS World
1
2
For equilibrium prices, need
demand and both endowments
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 6
0
QCE +QCP
E +Q P
QW
W
Ricardo cont’d
3 Let total labour in England be
100, and 10 in Portugal. Draw
a diagram with the world
relative supply curve and label
all relative quantities and
prices. Add two world relative
demand curves; one where
England gains from
international trade and one
where it does not. What
explains this difference from an
intuitive point of view?
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 7
Ricardo cont’d
3 Let total labour in England be
100, and 10 in Portugal. Draw
a diagram with the world
relative supply curve and label
all relative quantities and
prices. Add two world relative
demand curves; one where
England gains from
international trade and one
where it does not. What
explains this difference from an
intuitive point of view?
PC
PW
P
aCL
P
aWL
1
E
aCL
E
aWL
RS World
=2
PC
PW
=
2ú
1
2
RD Õ
0
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 7
1
QCE +QCP
E +Q P
QW
W
2ú
= 50
RD
QCE +QCP
E +Q P
QW
W
Ricardo cont’d
3 Let total labour in England be 100, and 10 in Portugal. Draw a diagram with the world relative
supply curve and label all relative quantities and prices. Add two world relative demand curves;
one where England gains from international trade and one where it does not. What explains this
difference from an intuitive point of view?
Given RD, opening up to trade implies that the relative price of cloth rises and both countries fully
specialise
England can exchange cloth for more wine on the world market than it could under autarky (by
re-allocating labour from cloth to wine production) æ gains from international trade
Consumers’ preferences more heavily skewed towards wine (RD Õ ) æ total wine production by
Portugal is no longer sufficient to satisfy demand
relative price of wine rises until even English vineyards find it just about profitable to make wine
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 8
Ricardo cont’d
4 Let the population in England double. Discuss the resulting effects (without a graph).
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 9
Ricardo cont’d
4 Let the population in England double. Discuss the resulting effects (without a graph).
Amount of relative cloth supply doubles, too
With RD æ fall in the relative price of cloth, potentially down to 0.5
Extreme case: total relative world demand for cloth at the relative price of 0.5 fully satisfied by
England alone
English vineyards find that they can start producing wine
Portugal benefits from an increase in England’s workforce, since its terms-of-trade have improved
For English workers, the terms-of-trade effect is in fact negative and their wages fall
With RD Õ æ prices remain unchanged, more production of wine and cloth
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 9
Outline
Question 1: Ricardo
Question 2: Heckscher-Ohlin
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 10
Heckscher-Ohlin
Consider an economy with the following properties
Two perfectly competitive sectors, (M)achines and (T)extiles
Two factors of production, low skill (LL ) and high skill (LH ) labour
– in fully elastic supply L̄L and L̄H
2
1
1
2
Production technologies are YM = (LH ) 3 (LL ) 3 and YT = (LH ) 3 (LL ) 3
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 11
Heckscher-Ohlin cont’d
1. Use the firms’ first order conditions to show that sector M is high skill intensive.
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 12
Heckscher-Ohlin cont’d
1. Use the firms’ first order conditions to show that sector M is high skill intensive.
so that
L H
MPLH
wH
i (Li , Li )
=
wL
MPLLi (LLi , LH
i )
1
2
H ≠ 13
(LLM ) 3
3 (LM )
1
H 23
L ≠ 23
3 (LM ) (LM )
=2
LLM
wH
= L;
H
w
LM
13: Ys
1 LLT
wH
= L
H
2 LT
w
Since firms in both sectors face the same factor prices, we can conclude that
LLM
1 LLT
=
,
H
4 LH
LM
T
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 12
Y(.
43
1
Heckscher-Ohlin cont’d
2 What condition on L̄L and L̄H must be satisfied for our economy to be high skill labour abundant
relative to the world?
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 13
Heckscher-Ohlin cont’d
2 What condition on L̄L and L̄H must be satisfied for our economy to be high skill labour abundant
relative to the world?
L̄H
>
L̄L
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 13
3
L̄H
L̄L
4World
Heckscher-Ohlin cont’d
3 Graph our country’s PPF and
argue why it must always lie
above a straight line
connecting the two intercepts.
Add the world PPF if our
country is high skill abundant.
Hint: Even though our country
is small by assumption, for the
purpose of the graph treat the
world as relatively similarly
sized.
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 14
Heckscher-Ohlin cont’d
3 Graph our country’s PPF and
argue why it must always lie
above a straight line
connecting the two intercepts.
Add the world PPF if our
country is high skill abundant.
Hint: Even though our country
is small by assumption, for the
purpose of the graph treat the
world as relatively similarly
sized.
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 14
Heckscher-Ohlin cont’d
4 Since our country is a small
open economy, the pertinent
price ratio is the one in the rest
of the world. Illustrate our
country’s and the world’s
production points in the
previous graph and explain
what condition needs to be
satisfied in each point. Do they
coincide with the consumption
points? What is the pattern of
trade?
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 15
Heckscher-Ohlin cont’d
4 Since our country is a small
open economy, the pertinent
price ratio is the one in the rest
of the world. Illustrate our
country’s and the world’s
production points in the
previous graph and explain
what condition needs to be
satisfied in each point. Do they
coincide with the consumption
points? What is the pattern of
trade?
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 15
Heckscher-Ohlin cont’d
5 Comparative Statics: Assume
that all workers are fully
flexible across sectors. What is
the effect of an increase of PM
on nominal and real wages and
rents? Use appropriate
diagrams to illustrate your
arguments graphically.
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 16
Heckscher-Ohlin cont’d
5 Comparative Statics: Assume
that all workers are fully
flexible across sectors. What is
the effect of an increase of PM
on nominal and real wages and
rents? Use appropriate
diagrams to illustrate your
arguments graphically.
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 16
Heckscher-Ohlin cont’d
5 Comparative Statics: Assume that all workers are fully flexible across sectors. What is the effect of
an increase of PM on nominal and real wages and rents? Use appropriate diagrams to illustrate
your arguments graphically.
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 17
Heckscher-Ohlin cont’d
5 Comparative Statics: Assume that all workers are fully flexible across sectors. What is the effect of
an increase of PM on nominal and real wages and rents? Use appropriate diagrams to illustrate
your arguments graphically.
ø price of machines æ sectoral re-allocation from textiles (shrinks) to machines (expands)
Relative demand for high skilled labour ø
Nominal and real high skill wages (i.e. in term of both goods) increase, low skill ones fall
More directly with Stolper-Samuelson Theorem:
“If the price of a good increases, then the remuneration of the factor used intensively in that sector
increases in nominal and real terms, while the remuneration of the other factor falls in nominal and
real terms.”
Machine sector high skill labour intensive æ higher nominal and real high skill wages
Textiles sector low skill labour intensive æ lower nominal and real high skill wages
Summer Term | Law and Economics | Chair of Microeconomics | Prof. Frank Pisch PhD | 17