Name:___Solution Key____
Winter 2008, 160A Midterm1
Professor Farshid Mojaver
I. General Questions on International Trade Theory (32 points, 4 pts each)
1) Adam Smith argues that social interest is served best when individuals pursue their selfinterest “By pursuing his own interest he frequently promotes that of the society more
effectually than when he really intends to promote it”
a) What is meant by self-interest and social interest here?
Income/GDP
b) Under what conditions this might hold?
1- have competitive markets
2- self interest is followed within rules of the game
3- have good rules
2) How can international trade improve producer efficiency?
International trade allows countries to increase production because of better allocation of
resources. Better allocation of resources is the source of producer efficiency in IT.
3) 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.
4) 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.
A local firm might be the most productive firm in a certain industry (say a US firm in apparel
industry) but the industry is not amongst the more productive industries in the country. That is the
productivity advantages of other firms are even higher than the firm in question (compared to
other countries). If the firm is located in a country that average productivity is high wages are also
high so the productivity advantage of the firm might not be strong enough to outweigh its wage
disadvantage.
5) How could the navigation act protect Britain domestic industry?
Giving monopoly of import to British ships leads to expansion of the shipping industry
which in turn strengthens British naval power. This was instrumental for furthering
British interest around the globe including opening and monopolizing new markets for
British products.
6) Proximity: How can proximity explain part of international trade?
Countries that are close to each other, particularly if they share a common boarder are
observed to trade more heavily with each other. One reason for this is lower
transportation cost. Cultural similarities help human interactions and trade between two
countries. This is more likely to be the case with countries that share common boarders.
7) In a purely exchange economy with only two people and two goods show that trade is mutually
advantages to all partied.
8) In a purely exchange economy show that with more than two people show that international
trade is not necessarily advantages to everyone.
II-The Ricardian Model of Trade [32 points, 4 points each ]
Malaysia has 200 units of labor, while there are 400 units of labor in Indonesia. When they
produce, the countries have the following unit labor requirements.
Malaysia
Indonesia
ULR
Shirts
Cameras _
20
10
20
40
labor force
200
400
1) 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.
2) Which country has comparative advantage in Shirts and why?
Malaysia
Indonesia
OC of Shirts (in terms of Cameras) 20/10 = 2
20/40 =0.5
Indonesia has comparative advantage Shirt because opportunity cost of shirt production is
lower in that country.
3) What is relative price of Shirts in Malaysia before trade? What about Indonesia?
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
4) 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
Indonesia
aLS/aLC = 2
10
QS
10
bLS/bLC = 0.5
LI /bLS = 400/20= 20
QS
5) 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.
6) 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
7) Calculate relative wages for Malaysia to Indonesia after trade WM/WI
WM/WI = (bLS/aLC) PC/PS = 20/10 = 2
20
QS
8) What will happen to the Malaysia-Indonesia wage gap if productivity of export sector in
Malaysia goes up? What happens to the wage gap when the productivity of import sector in
Malaysia goes up?
The wage gap increases in the first instance and it remains the same in the second one.
Questions in the Specific Factors Model
1) Consider a small open economy that produces Manufacturing and Food using labor ,
land and capital. Labor is mobile, land T is specific to food production and capital K is
specific to Manufacturing.
a) In the table below show the effect of an increase in each of the factor endowments
(Labor, Capital K and Land T) on nominal wages W, Rents on capital RK , and rents on
land RT . What are the effects on real returns? No explanation is required.
The effects on nominal returns:
Rise in L
Rise in K
Rise in T
W
fall
rise
rise
RK
rise
fall
fall
RT
rise
fall
fall
Since prices are constant, real returns change in the same direction as nominal returns.
b) Suppose that under free trade Home would be exporting Food. Of the three factors of
production which one would benefit from trade and which one would lose out.
If Home exports Food that means relative price of food rises with trade. That would
increase return to Land RT and a reduction in return to capital RK. In this case, capital
owners are interested in pushing for autarky. Land owners, obviously, are interested in
free trade.
c) In 1986, the price of oil on world markets dropped sharply. Since the United States is
an oil-importing country, this was widely regarded as good for the U.S. economy. Yet in
Texas and Louisiana in 1986 was a year of economic decline. Why? What will your
prediction be about the current state of economy of these states taking into account the
new price developments in the world? (Hint: Texas and Louisiana are both major oil
producing states in the US)
Since oil related industries in these states are competing with imports a decrease in the
price of imported oil, reduces the incomes of factors specific to the oil and gas industries
leading to an overall economic decline in these states.
The prediction about the current situation should be just the opposite, since currently the
world oil prices are very high and would cause an increase in the incomes of the factors
specific to the oil industry. And since oil-related industries are dominant in the two states
we would expect their overall economic performance to be very good.
IV-Factor Movement [15 points]
Make an argument showing that
a) there is a tendency for labor to migrate from the rest of the world to US
b) migration improves US GDP but it can lower the GDP of the ROW
c) migration is beneficial for the migrants and workers in the foreign country but it
hurts workers in the host country
d) owners of land/capital in the host country (U.S.) are better off as a result of labor
migration
e) the world as a whole is better as a result of migration
a)
Wage
Wage
B
W
A
W’
C
W*
MPL
MPL*
O
L
L’
O*
Migration of labor from
Foreign to Home


•
There are two factors of production: Land (T) and Labor (L), two countries and one good.
Both countries have the same technology but different overall land-labor ratios. Home is
the land-abundant country and Foreign is the labor-abundant country.
Foreign workers would like to move to Home until the marginal product of labor is the
same in the two countries. Increase Home labor force & thus the real wage falls in Home.
Decrease the Foreign labor force & increase the real wage in Foreign.
The redistribution of the world’s labor force = >Increases the world’s output as a whole
 Leaves some groups worse off. Leads to a convergence of real wage rates

Assuming that the immigrant labor becomes the citizen of Home country
home national welfare in higher by ABLL’ while that of foreign country is
lower by ACLL’ and the net international gain is ABC,