Name:___Solution Key____
Winter 2008, 160A Midterm2
Professor Farshid Mojaver
I- Heckscher-Ohlin Theory and More
[8 pts] 1-Answer the following questions using HO model and the Figure below that shows a
country's before and after trade equilibria
A) What are the pretrade quantities of shoes and computers produced by this nation?
Ans) 225 shoes; 200 computers
B) What are the post-trade quantities of shoes and computers produced by this nation?
Ans) 150 shoes; 300 computers
C) What does this country import and how much?
Ans) 350 shoes
D) How can you tell if the country is better off as a result of the trade?
Ans) Higher social indifference cure U2
[11 pts] 2. Consider the following information regarding international trade between US and
Japan.
Japan’s top exports to U.S.:
1. Road vehicles
2. Office machines and computers
3. Electrical and electronic equipment and components
4. Photographic equipment
5. Telecom and audio equipment
Japan’s top imports from U.S.: 1. Office machines and computers
2. Electrical machinery and components
3. Cereals
4. Road vehicles
5. Aircraft
Which model(s) describe Japan-U.S. trade patterns best? Make comments on every item
and then generalize your argument.
Ans)
It seems that there is a lot of intra industry trade between Japan and US. Three of the five
top Japan-US trades are intra industry: ”road vehicles”, “office machines and computers”
and “electrical machinery and components”. These items are typically high tech and
capital-skilled labor intensive. Such products typically exhibit increasing returns to scale
technology of production. This is consistent with the Monopolistic Competition. [5 pts]
But Japan also imports items such as cereal from US – which is a land intensive product
produced in a land abundant country. This fits better with HO model. [2 pts]
Japan imports Aircraft from US. In addition to capital, skill and access to high technology
Aircraft production requires large scale production before it becomes economical. Only
Boeing and Airbus have such large scale of production due to their respective large
domestic demand. Airbus production is not economical for most other countries including
Japan. That is why they import it. This is consistent with model so increasing returns to
scale, Duopoly, and perhaps external economies of scale. [2 pts]
Japan exports “Photographic equipment” and “Telecom and audio equipment”. These are
high tech and high skilled intensive products. Early on Japan invested in R&D in these
fields and developed a niche in their production. External economies of scale have
perhaps played a part in reduction of average cost of these items in Japan. [2 pts]
[10 pts] 3-State and prove Stolper-Samuelson Theorem using the Lerner Diagram.
The Theorem: An increase in the price of a product will increase the price of the factor
used intensively in the production of that product and a reduction in the price of the other
factor. In other world if the price of Computer (relative to Shoes) goes up then there will
be a rise in capital rentals and a fall in wage rates i.e., if PC/PS↑=> W/R↓.
The proof via the Lerner diagram:
– First a discussion of how Lerner diagram is drawn.
– Second: Suppose PC↑, ∆PS =0 then we will see the shift is the $1 revenue isoquant
for computer. From then from the diagram we see that  R↑ & W↓
Capital input
1/R
1/R’
QC =1/PC
QC =1/P’C
QS =1/PS
1/W 1/W’
Labor input
[21 pts] II- Outsourcing
1) Show that outsourcing can lead to improvement of welfare in all participant countries.
Developme
nt
(PA/PD)
B
A
C
(PA/PD)W
Assembly
Movement from A to C represents higher production of final good of outsourcing
firms in the Home country. This leads to higher GDP which presumably leads to
higher welfare in the home country.
2) Explain the increasing skilled-unskilled wage gap observed in the United States, China
and India using outsourcing model.

A reduction in cost of capital or transportation lowers the cost of trade which
makes it desirable to shift more activities in the value-chain from Home to
Foreign.

a shift of activities from one country to the other can increase the relative demand
for skilled labor in both countries which in turn leads to higher wage gap in both
countries.
3) When comparing them to equivalent U.S. workers, why is it that highly skilled Indian
service workers are more relatively productive than other highly skilled Indian workers?
Ans) Service workers are less reliant on capital and infrastructure than other workers.
Because these factors are in scarce supply in India, this hurts nonservice workers far
more than service industry workers.
[20 pts] III- Increasing Returns to Scale
Consider the long-run trade equilibrium in the monopolistic competition model as
illustrated below. Consider a situation where the foreign and domestic demand for a
particular good increase. For instance, suppose that this is the market for cars and lower
gasoline prices generates higher demand.
a) Redraw the Figure below and show what happens when this change in demand occurs,
specifically, show which curve(s) shift.
b) If the old equilibrium is at point C, describe where the new long run equilibrium
occurs, and what happens to the number of firms and the price they charge.
D0/Nc
C’
C
dc’
dc
mrc
AC
MC
mrc’
Short run effect where number of firms is fixed at Nc: Demand goes up and so does
the scale of production. The existing firms make above normal profits as the number of
firms are fixed in the short run.
D0/Nc
Nd >Nc
D1/Nd
C
D
dc
mrd
dd
AC
MC
Long Run effect: Higher profit attracts new firms to the market. As new firms enter the
market demand curve facing each firm shifts down. Consequently the price and the scale
of production fall compared to their short term levels. But now there are more varieties in
the market and demand curve is flatter.
Multiple Choice Questions [30 points]
1. Why is the PPF bowed out in the Hecksher-Ohlin model?
A) because capital is specific to computer production
B) because labor is specific to shoe production
C) because capital is better suited to computer production than shoe production
D) because labor is specific to shoe production, capital is specific to computer
production, and capital is better suited to computer production than shoe production
2 Leontief found that the HO model did not work for the United States because:
A) the United States was importing labor-intensive commodities.
B) the U.S. capital/labor ratio for imported goods was larger than that for the exported
goods.
C) the U.S. capital/labor ratio for imported goods was smaller than that for the
exported goods.
D) there was a trade imbalance in the United States.
3 The Leontief paradox found that:
A) exports should always be capital intensive.
B) imports should always be labor intensive.
C) the U.S. exports were labor intensive.
D) the U.S. exports were capital intensive.
4 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.
5 Suppose that Home has 20% of the world's capital, 10% of the world's skilled labor, and
30% of the world's unskilled labor and produces 20% of the world's GDP. This
information suggests that Home is:
A) capital abundant.
B) skilled labor abundant.
C) less-skilled-labor abundant.
D) not abundant in capital, skilled labor, or unskilled labor.
6 If we measure scarcity or abundance correctly, we should use the concept of “effective
factor endowment.” This means:
A) the actual factor endowment multiplied by the average productivity of workers
compared with its share of world GDP.
B) trying to find out how much labor and capital are really involved in producing
goods competing with imports and exports.
C) measuring more effectively a nation's actual factor endowment.
D) the actual factor endowment of labor multiplied by the productivity of capital,
because effectively the productivity of one depends on the quantity of the other.
7. The GATT/WTO allows nations to impose tariffs in response to unfair trade practices
such as:
A) dumping.
B) transportation costs.
C) environmental degradation.
D) dumping and environmental degradation.
8. Which of the following is an exception to the most favored nation principle?
A) trade in petroleum
B) trade with Japan
C) tariff concessions negotiated within a free-trade area or a customs union
D) trade in services
9. The safeguard provision or escape clause allows a country to:
A) import products below cost from foreign countries.
B) export products by selling below cost to foreign countries.
C) avoid tariffs in foreign countries temporarily.
D) Temporarily increase tariffs on certain imported goods.
10. A country that becomes a member of the World Trade Organization agrees to “bind” its
tariffs. “Binding” means that the country agrees not to increase existing tariffs and that
it will not introduce new tariffs. However, the GATT allows three exceptions to
“binding.” Which of the following is not an exception to binding?
A) antidumping duties against dumped imports
B) countervailing duties against subsidized imports
C) safeguard or escape clause tariffs
D) tariff reductions negotiated in free-trade areas
Answers
1) C
2) B
3) C
4) A
5) C
6) A
7) A
8) C
9) D
10) D
Use the following to answer questions 11-15:
Figure: Home Market I
11. The Home market shown in the figure has imposed a _____ tariff. : 6
12. Under free trade, the Home country will import: 16
13. After the imposition of the tariff, the producer surplus in the Home country:
increases by $72.
14. The government revenue due to the tariff is: $48
15. What is the deadweight loss because of the tariff? $24