HW5 Solution Key
UCDavis, 160a, Fall 2011
Prof. Farshid Mojaver
Foreign Ofshoring of Goods and Services
1. Consider an outsourcing model in which Home’s skilled labor has a higher relative wage than
Foreign’s skilled labor and in which the costs of capital and trade are uniform across production
activities.
a. Will Home’s outsourced production activities be high or low on the value chain for a given
product? That is, will Home outsource activities that are skilled-labor intensive or unskilledlabor-intensive? Explain.
b. Suppose that Home 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?
c. Draw relative labor supply and demand diagrams for Home and Foreign showing the effect of
this change. What happens to the relative wage in each country?
Answer:
a. The high relative wage of Home skilled labor makes skilled-labor intensive activities more
expensive at Home relative to Foreign. Equivalently, the low relative wage of unskilled labor
makes unskilled-labor-intensive activities less expensive at Home relative to Foreign. As a result,
Home will undertake production activities lower on the value chain while outsourcing higher
value activities to Foreign.
b. A uniform increase in the tariff level causes fewer activities to be outsourced. The slicing of
the value chain reflects this increased cost as a rightward shift; Home expands the set of activities
that it does at Home to include incrementally higher value activities, whereas the set of high value
outsourced activities shrinks.
c. An expansion in the set of production activities done at Home (to include higher value ones)
increases the average skill intensity of Home production. This increases the relative demand for
skilled labor at Home. Similarly, because Foreign ceases to do its least skill-intensive activities,
the average
2. Consider a U.S. firm’s production of automobiles, including R&D and component production.
a. Starting from a no-trade equilibrium in a PPF diagram, illustrate the gains from
outsourcing if the United States has comparative advantage in component production.
b. Now suppose that advances in engineering abroad decrease the relative price of research
and development. Illustrate this change on your diagram and state the implications for
production in the United States.
c. Does the U.S. firm gain from advances in research and development abroad? Explain
why or why not.
Answer:
a. See the following figure, where the outsourcing equilibrium is B and
b. See the following figure, where the new equilibrium is B’ and C’.
c. Because the United States imports R&D and exports components, a decrease in the
relative price of R&D abroad represents an improvement in the U.S. terms of trade; as a
result, U.S. output increases to Y2 so there are gains for the United States.
3. The diagram below shows what happened to the relative wage and relative demand for skilled
labor in the U.S. manufacturing sector during the 1990s.These points are plotted using the data
from Figures 7-6 and 7-7.
a. What must have happened to the demand and supply curves to explain this change in
relative wage and relative employment?
b. Why do you think the demand and supply curves shifted this way? (Hint: Think about
where the workers who leave manufacturing might be going.)
Answer:
a. The relative non-production wage increased significantly in U.S. manufacturing between 1990
and 2001 but the relative employment of non-production labor did not change much. This pattern
is consistent with an outward shift in relative demand and an inward shift in relative supply for
non-production workers. As such, relative demand for skilled labor has increased (shifted right)
and the relative supply of skilled labor has decreased (shifted left). See the figure below.
b. The increase in relative demand is a continuation of what we already saw in the 1980s, due to
skilled-biased technologic change and outsourcing. The reduction in relative supply is new,
however. One explanation for this is that skilled workers were pulled out of manufacturing and
into services (because many skill-intensive service sectors have been expanding).
4. Why is it relatively easier for an undeveloped country to export service activities through
outsourcing than to participate in the global economy by producing manufacturing components?
Answer: Because outsourcing of manufactures involves the trade of intermediate inputs across
several borders, there is an extra cost associated with transporting the goods. Therefore, a country
must have good infrastructures such as developed roadways to participate in the global economy.
In India, for example, communications technology developed rapidly whereas transportation
developed more slowly, which allowed the South Asian country to partake in service outsourcing.
5. It is widely noted that although China is the favored destination for manufacturing outsourcing,
it is far behind India in the business of outsourced services. What are some differences between
these two countries that may account for this causal observation?
Answer: Although wages are also low in India, due to its weak transportation infrastructure it is
unable to successfully compete against China in manufacturing outsourcing. However, it has an
advantage over China in service outsourcing because the country has developed an advanced
communication infrastructure. Moreover, as a former British colony, India has a proficiency in
the English language. The workforce in India is well educated and highly skilled in information
technology. In addition, Tarun Khanna, a professor at the Harvard Business School, notes that
India has a thriving entrepreneurial effort unhampered by government bureaucracy, unlike China
(The McKinsey Quarterly, 2004). These include a low level of government intervention in the
Indian capital markets and no regulations in industries such as software.
Economies of Scale and Imperfect Competition
1. Explain how increasing returns to scale in production can be a basis for trade.
Answer: With increasing returns to scale, countries benefit from trade due to the potential to
reduce their average costs by expanding their outputs through selling in a larger market.
2. Why is trade within a country greater than trade between countries?
Answer: Border effects prevent trade between countries from being as large as within countries.
These factors include tariffs, quotas, administrative rules and regulations, and whether the
countries have a common border or language.
3. There are some shops in Japan that sell Japanese goods imported from the United States at a
discount over the prices charged by other Japanese shops. How is this possible?
Answer: The Japanese producers are price discriminating (“dumping”) across United States
and Japanese markets, so that the goods sold in the United States are much cheaper than those
sold in Japan. It may be profitable for other Japanese to purchase these goods in the United
States, incur any tariffs and transportation costs, and resell the goods in Japan. Clearly, the
price differential across markets must be nontrivial for this to be profitable. (i.e. the foreign and
domestic markets are not sufficiently “segmented”)
4. Our derivation of the gravity equation from the monopolistic competition model used the
following logic:
(1) Each country produces many products;
(2) Each country demands all of the products that every other country produces;
(3) Thus, large countries demand more imports from other countries.
The gravity equation relationship does not hold in the Heckscher-Ohlin model. Explain how the
logic of the gravity equation breaks down in the Heckscher-Ohlin model: that is, which of the
above statements is no longer true in the Heckscher-Ohlin model?
Answer: The Heckscher-Ohlin model assumes perfect competition. Therefore, each country
produces many products. However, in the Heckscher-Ohlin model not all products produced in
other countries (in autarky) are imported under trade. Rather, because products are not
differentiated, only those identical products with a lower relative price abroad are imported, and
countries specialize in the good that uses their abundant factor intensively. Hence larger countries
do not necessarily demand more imports from other countries.
5-Starting from the long-run equilibrium without trade in the monopolistic competition
model, as illustrated in Figure 6-5, consider what happens when the Home country begins
trading with two other identical countries. Because the countries are all the same, the
number of consumers in the world is three times larger than in a single country, and the
number of firms in the world is three times larger than in a single country.
a. Compared with the no-trade equilibrium, how much does industry demand D increase?
How much does the number of firms (or product varieties) increase?
Therefore, does the demand curve D/NA still apply after the opening of trade?
Explain why or why not.
Answer: Industry demand increases by three times, and the number of firms also
increases by three times. Compared with the no-trade equilibrium, the demand curve
D/NA does not change because both total quantity demanded and the number of firms
tripled.
b. Does the d1 curve shift or pivot due to the opening of trade? Explain why or why not.
Answer: Because D/NA is unchanged, point A is still on the short-run demand curve
facing each firm (d2 in Figure 6-6). However, the demand curve faced by each firm
becomes more elastic due to the increase in the number of firms: d1 pivots to become
flatter.
c. Compare your answer to (b) with the case in which Home trades with only one other
identical country. Specifically, compare the elasticity of the demand curve d1 in the two
cases.
Answer: In the case with three countries, Home consumers have more varieties to choose
from compared with the two-country case. For that reason, the demand curve facing each
firm is flatter (more elastic) when there are more trading partners.
d. Illustrate the long-run equilibrium with trade and compare it with the long-run
equilibrium when Home trades with only one other identical country.
Answer: The long-run equilibrium with trade occurs where the demand curve facing the
firm is tangent to the average cost curve, to the right of the long-run equilibrium without
trade (due to the exit of firms from the industry). Because the demand curve facing each
firm with trade (d3) is flatter when there are three countries compared with two, it will
end up further down the average cost curve in Figure 6-7. Therefore, firms will produce a
greater quantity, at lower average cost, than the in the two-country case.
6. Starting from the long-run trade equilibrium in the monopolistic competition model, as
illustrated in Figure 6-7, consider what happens when industry demand, D, increases. For
instance, suppose that this is the market for cars and lower gasoline prices generate
higher demand D.
a. Redraw Figure 6-7 for the Home market and show the shift in the D/NT curve and the
new short-run equilibrium.
Answer: The increase in demand shifts the D/NA curve to the right, dragging along the
curves d3 and mr3. Each firm produces Q4 at a price of P4 attempting to earn monopoly
profits at point D, and when all firms do so they move along the new D/NT curve to point
E.
D/NT
P4
Pw
D
E
C
d4
mr4
Q3
Q4
AC
MC
b. From the new short-run equilibrium, is there exit or entry of firms, and why?
Answer: In the short-run with trade, monopoly profits are positive because price exceeds
average cost. As a result, firms enter the industry and NT increases.
c. Describe where the new long-run equilibrium occurs, and explain what has happened
to the number of firms and the prices they charge.
Answer: In the long-run with trade, firm entry shifts D/NT and d4 to the left and makes
d4 more elastic until it is tangent to the average cost curve. At that point, monopoly
profits are zero and firms no longer enter the industry. Relative to the short-run
equilibrium in (b), the number of firms increases and price decreases.