Name:___Solution Key____
Practice Midterm 1
Professor Farshid Mojaver
I. General Questions on International Trade Theory [20 points, 4 pts each]
1) Why worldwide production increases as a result of international trade?
International trade allows improvement in the allocation of resources worldwide which in
turn leads to higher worldwide production and consumption.
2) How do you resolve this seemingly paradoxical result that the most productive domestic
firm may lose out to some of the least productive firms in a low wage country?
The local firm might be the most productive one in the world but if the productivity advantage of
firms in other industries are even higher then cost disadvantages (because of higher general wages
in home country) can put the firm in an international disadvantage losing out to a low-tech firm in
a low wage country.
3) Consider a purely exchange economy in which two Farmers (say Smith and Jones) are
endowed with certain amount of apples and oranges.
a) What is the reason for trade here? Does everyone (Smith and Jones) gains from trade here?
b) Once we generalize the model to two countries can you conclude that everyone gains from
trade?
a) Here the reason for trade is balanced preferences.
b) Not everyone gains from trade. International Trade makes import competing industries
worse off and export industries better off
4) How can a developed country compete against low foreign wage countries?
Wage rates reflect overall productivity levels. Higher wages in Developed Countries imply
higher productivity. However for different industries the productivity advantages over low
wage countries may vary drastically. For those industries in which the productivity
advantages are larger than cost disadvantages, the DC has comparative advantage and can be
competitive in international market. .
5) Why is the PPF a straight line in the Ricardian model and bowed out in Hecksher-Ohlin
model?
In the Ricardian model PPF is a straight line because there is only one homogeneous factor of
production; labor. That makes the marginal productivity of labor constant in both sectors which in
turn makes PPF curve a straight line (constant opportunity cost). 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.
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
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) Now suppose that trade opens up and the world relative price of shirt is 1. Suppose that
labor is immobile between sectors in the short run. Assuming that the wage rates are
completely flexible what would be the production of Shirts and Cameras in Malaysia in the
short run?
QC
B
A
With higher Camera prices produces
in Malaysia would like to expand
Camera production but they are
unable to do that because of
immobility of labor in the short run..
Lower Shirt prices set pressure on
Shirt production. They tend to fire
workers but workers would accept
lower wages and as a result cost of
Shirt in Malaysia country goes down
to its international prices.
C
IAut
IFT
P=1
QS
h) Now suppose labor is totally mobile between sectors. Use a hypothetical indifference
curve in a graph showing gains from trade for each country (when international PS/PC =1).
Which country would produce each?
QC
QC
Malaysia
Indonesia
20
PS/PC= 1
Cons’n
after trade
10
Cons’n
before trade
PS/PC= 1
10
QS
20
QS
2) [10 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.
III-Heckscher-Ohlin Model
1) [24 pts] Questions on HO theory
a) What constitutes the basis of trade in the HO theory of trade?
Differences in 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 is resolved when two things happen: first we consider the fact that there are
more than one factor of production and we measure factor abundance of a country by
comparing its world share of factor with its world share of GDP and second we drop the
assumption of equal technology, that is we allow for difference in technology (by adjusting
factor share by its effectiveness).
2) [10 pts] State and prove Stolper-Samuelson Theorem
3) [10 pts] Does HO model explain the rise of wage gap (High-skilled-Low-skilled) in US?
4) [20 pts] Consider a HO like model with two goods (R&D and Parts), two countries (Home and
Foreign) and two factors of production (High and Low skilled labor). R&D is High-skilled
intensive and Parts Low-skilled intensive. Home is High-skilled abundant. Answer the following
questions: Once trade opens up
1) who exports what and why?
2) what happens to wages rates (WH and WL) in Home country? In Foreign? What happens to the
wage gaps (WH /WL) in Home and Foreign?
Now suppose home imposes tariffs on its imports from Foreign.
3) What happens to production mix in Home?
4) What happens to wages rates (WH and WL) in Home and Foreign?
III. Questions in the Specific Factors Model
[20 points] Consider a small open economy that produces Manufacturing and Food using
labor and capital. Labor is mobile, but capital is sector specific in the short run. KM
denotes capital employed in the manufacturing sector and KF capital in the food sector.
Show the effect of an exogenous increase in the price Food (say because of an increase in
the world demand for food) on
a. Wage rates (both nominal and real),
b. allocation of labor (LM and LF),
c. levels of production and (QM and QF),
d. rents on specific factors KM and KF (both nominal and real).