Name:___Solution Key____
Practice Midterm 1
Professor Farshid Mojaver
I. General Questions on International Trade Theory [25 points, 5 pts each]
1) Why does 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 within the same industry,
the most productive firm in one country may lose out to some of the least productive
firms in other countries with lower wages?
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) How can a developed country compete against low wage foreign 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. .
4) Why is the PPF a straight line in the Ricardian model and bowed out in the 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.
5) Write an expression for comparative advantage in terms of MPL (in sector x and y)
and give an interpretation.
A country has comparative advantage in x if the opportunity cost of x production is lower
in that country MPLy/MPLx < MPLy*/MPLx*. Or equivalently if its relative labor
productivity in x is higher than other country: MPLx/MPLy > MPLx*/MPLy*
II-The Ricardian Model of Trade [28 points, parts 4 pts each]
Answer the following questions given the information in the following table.
ULR (hr/unit of output)
Clothing
Machines_
U.S.
2
1
India
5
10
1) Which country has absolute advantage in the production of clothing and why? What about
machines?
U.S has absolute advantage in both machines and clothing because its labor
productivities are larger than India in both sectors.
2) In absence of trade, what is the opportunity cost of clothing (in terms of machines) in US
and what does it measure? What is the opportunity cost of clothing in India?
U.S
India
OC of Clothing (in terms of machines)
aLC/aLM
bLC/bLM
2/1 = 2
5/10 = 0.5
US has to give up two machines for each unit of clothing production.
3) What is the comparative advantage of India and why?
India has Comparative Advantage in Clothing production because her
opportunity cost of clothing is lower than that in United States
4) What is the relative price of clothing in each country before trade?
Autarky PC/PM in U.S = 2
Autarky PC/PM in China = 0.5
5) Now suppose the United States has 200 units of labor, while there are 1600 units of labor
in India. Draw graphs showing production possibility frontier of U.S. and India. Have
Clothing production of the horizontal axis and machines on the Vertical axis.
QM
QM
Unites States
LM /aLC =
200/1= 200
India
bLC/bLM = 0.5
aLC/aLM = 2
160
100
QC
LCh /bLC = 1600/5= 320
QC
6) Use hypothetical indifference curves to show pre-trade equilibrium in each country. Show
home production and consumption at this point..
QM
QM
Unites States
India
200
160
Consumption
before trade
QC
100
320
QC
7) 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 PC/PM =1).
Which country would produce each?
QM
QM
Unites States
India
200
Consumption
after trade
160
PC/PM = 1
Consumption
before trade
PC/PM= 1
100
QC
320
QC
III-Heckscher-Ohlin Model
1) Leontieff Paradox [8 pts]
a) What does the "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.
b) 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) [9 pts] Consider the following PPF curve. The numbers on the graph indicates the slope of PPF
at each point. Suppose home relative autarky prices are (PX/PY)A =.5 and world relative prices are
(PX/PY)W=2.
a) Show home production mix and GDP-iso curve before trade
b) Show home production mix after trade and the new GDP-iso curve evaluated at
international prices
c) Show that production at the point where the slope of PPF is 5 is inferior (leads to lower
GDP evaluated at international prices) when (PX/PY)W=2.
Y
.01
.5
1
2
5
X
3) [10 pts] Does HO model explain the rise in the wage gap (High-skilled-Low-skilled) in US?
Explain your thinking and support it with some evidence.
IV. 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 of 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).