SSII 2010, 160A Midterm
Professor Farshid Mojaver
Name:_____________
There are 136 points in the exam. Please answer all the questions in the space provided
I-General Questions (in this section answer the questions in plain English. No graphs are needed here.)
1) [4 pts] How can a developed country compete against some low foreign wage industries?

Wage rates reflect overall productivity levels. Higher wages in DCs imply higher
productivity in those countries. However the productivity advantages over low
wage countries are not the same in every sector. In some sectors it is larger than
wage differentials and in some smaller. If the DC specializes on the sectors in
which its productivity advantages are larger than its wage disadvantages then it
can easily compete with low wage countries.
2) [4 pts] Why is the PPF a straight line in the Ricardian model and bowed out in Hecksher-Ohlin model?
PPF is a straight line in the Ricardian model because there is only one homogeneous
factor of production and thus opportunity cost is the same regardless of where the
factor is employed. But in the HO model there are more than one factor of
production and the factor intensities are different therefore the factors are not
equally suitable for production in all sectors.
3) [8 pts] Consider a massive influx of foreign capital to a small open economy like Vietnam. Discuss the impact (a)
sectoral production and (b) factor prices.
An influx of capital leads to an increase in the production of capital intensive products and a reduction in the
production of labor intensive products in Vietnam (Rybcsyizki theorem). In the short run return to all sector
specific factors like capital and land goes down and the return to the mobile factor (labor goes up). But in the long
run there is no change in factor prices (based on HO model)
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4) [20 pts] Economic Consultant in Poorestan
Poorestan is a poor country with income per capita and poor natural resources. At the present Poorestan lives in
isolation and does not trade with any country. Policy makers in Poorestan are debating whether they should open up
to international trade but they are several concerns and questions and they turn to you for advice.
a) Make an argument in support of international trade. Why trade is “good’ for Poorestan.
International trade can let each country export the goods in which it has comparative advantage (lower opportunity
costs), then every country gains. Countries can gain from specialization in production, better allocation of resources,
and higher consumption levels.
b)
Policy makers in Poorsetan wonder if there is anything that they can export because they have no technological
advantage in any sector. How would you address this concern?
Poorsetan can produce and export goods in which it has comparative advantage.
c) Make some educated guess as the type of goods Poorestan can export once it opens up to free trade?
Labor-intensive goods.
d) Who wins and who loses in Poorestan (in the short run and in the long run) when she opens up to international
trade. [8 pts]
Exporting factor owners will experience an increase in their real incomes while importing fact owners will
experience a decrease in their factor incomes. In the long run, The compensation principle states that as
long as the total benefits exceed the total losses in the movement to free trade, then it must be possible to
redistribute income from the winners to the losers such that everyone has at least as much as they had
before trade liberalization occurred.
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II-Question on the Ricardian Model of Trade
1) [20 pts] Answer the following questions given the information in the following table.
Unit Labor Requirements
Malaysia
Indonesia
Shirts
20
20
Cameras
10
40
a) Which country has absolute advantage in shirt production and why? What about camera
production?
Malaysia has absolute advantage in Camera because it can produce Cameras with
fewer resources (labor) compared to Indonesia. No country has absolute
advantage in the production of shirts.
b) In absence of trade, what is the opportunity cost of Shirts (in terms of Cameras) in Indonesia and Malaysia?
Opportunity cost of Shirts (in terms of Cameras) is 2 cameras in Malaysia and 0.5 cameras in
Indonesia. Indonesia has comparative advantage Shirt because opportunity cost of shirt production is
lower in that country
c) For which product does Indonesia have comparative advantage?
Shirts
d) What is the relative domestic price of Shirts in each country before trade?
Relative price of Shirts before trade is equal to the opportunity cost of shirt production.
Autarky PS/PC in Malaysia = 2 and Autarky PS/PC in Indonesia = 0.5
e) Suppose there are 200 units of labor in Malaysia and 400 in Indonesia. Draw a graph
showing production possibility frontier of Malaysia and Indonesia. Have Shirt production of
the horizontal axis and Camera on the Vertical axis.
QC
QC
Malaysia
LM /aLC =
200/10= 20
aLS/aLC = 2
10
10
QS
Indonesia
bLS/bLC = 0.5
LI /bLS = 400/20= 20
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QS
f) If world price of shirts to cameras were 1 what would be the world production of
Camera and Shirts? Which country would produce each?
Indonesia produces 400/20 = 20 units of shirts and exports its excess supply.
Malaysia produces 200/10 = 20 and exports its excess supply.
g) Use a hypothetical indifference curve in a graph showing gains from trade for each
country (when international PS/PC =1).
QC
QC
Malaysia
20
Indonesia
PC/PS= 1
Cons’n
after trade
10
Cons’n
before trade
PC/PS= 1
10
QS
20
QS
2) [9 pts] Consider the following information about production in the United States and China
a. Which country has absolute advantage in apparel and why?
USA, because each worker can produce more in USA ($100,000) than in China ($10,000).
b. Which country has comparative advantage in apparel and why?
China, because the opportunity cost of apparel in terms of wheat is lower in China (0.5) than in USA (2).
c. What will US export to China and why?
Wheat, because USA has comparative advantage in producing wheat.
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III-Heckscher-Ohlin Model
1) [24 pts] Questions on HO theory
a) What constitutes the basis of trade in the HO theory of trade?
Different factor endowment
b) What is the prediction of HO theory regarding trade patterns?
Each country will export the good that uses its abundant factor intensively.
c) Based on HO theory what would be the impact of free trade on the existing international wage gaps?
The wage gaps will be eliminated, which is the Factor-Price Equalization Theorem. Under HO assumption
international trade leads to equalization of factor prices across countries.
d) Has this prediction come true to any degree? Why international wage rates are still so different?
No, because the productivity is different across countries.
e) What does "Leontieff Paradox" refer to?
That contrary to the prediction HO theory, capital-labor ratio content of U.S. imports is larger
than that in its exports. U.S. exports labor intensive goods and imports capital intensive
products.
f) Did the Paradox ever get resolved? And if so how? What is the final verdict on the
Leontief paradox and the HO theory?
The Paradox gets resolved when we drop the assumption of equal technology. Once we
allow for difference in technology (by adjusting factor share by its effectiveness) the
paradox disappears and nearly two third of effective factors pass the sign test.
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2) [10 pts] State and prove Solper-Samuelson Theorem
Solper-Samuelson 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.
Proof:
Capital input
1/R
1/R’
QC =1/PC
QC =1/P’C
QS =1/PS
–
–
Labor input
1/W 1/W’
Suppose PC↑, ∆PS =0 then from the diagram we see that  R↑ & W↓
If the relative price of a good increases, holding factor supplies constant, then the nominal and real
return (in terms of both goods) to the factor used intensively in the production of that good increases,
while the nominal and real return (in terms of both goods) to the other factor decreases.
IV-[16 pts] Sector-Specific Model
Suppose two countries, Canada and Mexico, produce two goods, timber and televisions.
Assume that land is specific to timber, capital is specific to televisions, and labor is free to move between
the two industries. When Canada and Mexico engage in free trade, the relative price of televisions falls in
Canada and the relative price of timber falls in Mexico.
a. In a graph, show how the wage changes in Canada because of a fall in the price of televisions, holding
constant the price of timber. Can we predict that change in the real wage?
Answer: As shown by the following figure, real wage falls but by less than the percentage decrease in the
price of televisions.
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b. What is the impact of opening trade on the rentals on capital and land in Canada?
Can we predict that change in the real rentals on capital and land?
Answer: Because capital is specific to the television sector, the drop in the relative price of television will
lead to a fall in the rental on capital. With Canada exporting timber, rental on land will rise because land is
specific to the timber industry.
c. What is the impact of opening trade on the rentals on capital and land in Mexico? Can we predict that
change in the real rentals on capital and land?
Answer: Through the exports of televisions, the relative price of televisions will rise in Mexico, which
will lead to an increase in the rental on capital. By contrast, the rental on land will fall.
d. In each country, has the specific factor in the export industry gained or lost, and has the specific factor
in the import industry gained or lost?
Answer: In both cases, the specific factor in the export industry (i.e., land in
Canada and capital in Mexico) gained whereas the factor specified to the import industry (i.e., capital in
Canada and land in Mexico) loses when the two countries engage in trade.
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V-[20 points] Outsourcing (make your points using a mode with carefully stated assumptions and labeled
graphs)
1) Show that all countries can gain from trade in intermediate goods (say Components and R&D products).
2) Show that the observed increase in wage rates of skilled labor relative to that of unskilled labor in US and China
could be related to outsourcing. What is the alternative explanation? Which explanation has empirical support?
The alternative explanation is the skilled biased technological change. The empirical results show that
both can explain the relative wage changes.
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