UNIVERSITY OF SOUTHERN INDIANA
DEPARTMENT OF ECONOMICS AND FINANCE
INTERNATIONAL TRADE - ECON 341
FALL 2009 - EXAM 1
True, False, Uncertain - EXPLAIN. Respond to each of the following statements. All points are awarded on the
basis of your explanation. If you use graphs or equations in your answer, be sure to label and define your terms.
(12.5 points each)
1) Comparative advantage means that an economic agent, e.g., a country, has the lowest cost in terms of resources
of producing a good.
False, comparative advantage is determined by relative opportunity costs not resource costs. The student for
complete credit should explain opportunity costs and recognize that resource costs deal with absolute advantage,
not comparative. An example of one country having the absolute disadvantage in two goods will have the
comparative advantage in one would be icing on the cake.
2) The price-specie-flow concept argues that mercantilism trade policies are not effective.
Uncertain, it depends upon time frame. Mercantilist policies may be effective in the short-run if there is significant
unemployment. But in the longer run at full employment, mercantilist polices are negated by the price-specie-flow
mechanism. For full credit, the student should explain/describe mercantilist policies, price-specie-flow, and the
quantity theory of money.
3) The monetized version of the 2 good/2 country Ricardian model demonstrates that a country=s exports are
determined by labor requirements.
Uncertain, labor requirements are the central determinants of trade flows, but they are not the only ones. In the
monetized version of the model we introduced wage rates and exchange rates. Explaining wage rate and exchange
rate limits would garner full credit.
4) Use the table of labor requirements to address the series of statements.
Wheat
Clothing
United States
3 hrs./unit wheat
9 hrs./unit clothing
United Kingdom
4 hrs./unit wheat
4hrs./unit clothing
a. The US has the absolute advantage for clothing and the UK for wheat.
False, the US has the absolute advantage in wheat in that it takes less labor to produce a unit of wheat that in the
UK. UK has the absolute advantage in clothing for the same reason.
b. If the US and UK exchange according to the countries comparative advantage at a terms of trade of 1 unit of
clothing for 2 units of wheat, then both the US and UK gain the equivalent of 3 labor hours per each 2 units of wheat
per 1 unit of clothing traded.
Opportunity Costs
Wheat
Clothing
United States
1/3 clothing/unit wheat
3 wheat/unit clothing
United Kingdom
1 clothing/unit wheat
1 wheat/unit clothing
False. Given the opportunity costs in the table, the US has a comparative advantage in the production of Wheat
and the UK in clothing. At a terms of trade of 1clothing/2wheat, each trade of 2 wheats per clothing leads to the
US expending 6 hours in wheat production and gaining the equivalent of 9 hours in the import of a unit of cloth. It
gains three hours. For the UK is expends 4 hours in the production of the unit of cloth and gains the equivalent of
8 hours in the importation of two units of wheat, for a net gain of 4 hours.
c. Suppose UK has 500 hours of labor available. If it divides this labor into 300 hrs to clothing and 200 hrs to
wheat, then without trade they produce and consume 75 units of clothing and 50 units of wheat.
True, with 500 hours divided into 300 hours to cloth production and 200 hours to wheat production the UK can
produce 300 hours/4hours/cloth = 75 units of cloth and 200 hours/4hours/wheat=50 units of wheat.
d. If the UK can trade all that it wants at the relative price of 0.8W/C then they will produce only wheat.
True, if the terms of trade are 0.8 units of wheat/unit of cloth, the UK would benefit from producing wheat and no
cloth. For each unit of wheat traded the UK would obtain 1.25 units of cloth. It would find it profitable to produce
only wheat and export wheat for its cloth.
e. Consistent with the 2W/C terms of trade and complete specialization, if the UK engages in trade according to
comparative advantage, whereby 80W are exchanged for 40C (note: the direction of trade is not specified), the UK
will consume 80W and 85C.
This is also true. It the terms of trade are 2 units of wheat/unit of cloth the UK will export cloth, leading it to
completely specialize in cloth production. It can produce 500hours/4hours/unit cloth =125 units of cloth. If it
exports 40 units of cloth for 80 units of wheat, it will have 125-40=85 units of cloth and the 80 units of wheat.
Part 2. Take Home Portion - 25 points each. Answer each question as completely as possible. Assume complete
ignorance on the part of the grader.
1) Answer the following questions given the information in the following table.
Labor requirements
Sausage
Beer
United Kingdom
16 hr/lb
8 hr/gal
Australia
12 hr/lb
8 hr/gal
a. Which country has the comparative advantage in what good?
Opportunity Costs
Sausage
Beer
United Kingdom
2 gal beer/lb sausage
1/2 lb/gal
Australia
3/2 gal /lb
2/3 lb/gal
Since the relative opportunity cost of producing sausage is less for Australia than in UK, 3/2<2 gal/lb, Australia
has the comparative advantage in sausage. The UK has the comparative advantage in the production of beer since
it has the lower opportunity costs of producing beer, 1/2<2/3 lb/gal. Note the opportunity cost of producing
sausage is the amount of beer forgone, i.e., gallons of beer/ pound of sausage and of course, the converse.
b. What are the limits on the terms of trade specified in terms of lbs of sausage/gallon of beer for mutually beneficial
trade to exist between the UK and Australia? Which country gains as the terms of trade become larger but still
within these limits?
The terms of trade specified in the question are lbs of sausage/gallon of beer. The question asks for the TOT for
mutually beneficial trade to exist, that is for each country to specialize in a different good. For this to occur the
TOT as specified must fall between the opportunity costs of producing beer ( lbs of sausage/gallon of beer), or
1/2lb/gal(UK)<TOT<2/3lb/gal(Australia). If the TOT of trade fall outside this range both countries will specialize
in the same good. That is to say if TOT>2/3lb/gal both will specialize in beer, and if TOT<1/2lb/gal both would
specialize in sausage production. With the TOT specified as they are an increase in the amount of sausage per unit
beer, clearly the UK benefits by obtaining more sausage per unit of beer exported. Another way of explaining this
is that as TOT rises, the relative price of beer increases, a country benefits if the price of its export good rises
relative to the goods it imports.
c. What are the wage rate limits in the UK if the wage rate in Australia is A$4/hr and the exchange rate is ,1/A$1?
The concept of wage limits is based on the equation of the country competitive in the export of a good, a1jW1e<
a2jW2. This suggests that country 1 has a lower monetary cost in country 2’s currency of producing good j and
would be competitive in its export, ceteris paribus. Clearly this competitiveness depends upon the wage in country
1. A rise in its wage may lead to country 2 becoming the exporter of good j. Conversely, a2kW2< a1kW1e, suggests
that country 1 is not competitive in the production of good k, and consequently should import it from country 2.
Again, this outcome clearly is dependent upon the wage rate in country 1. Should it fall sufficiently the inequality
could reverse and country 1 could become competitive in the production of good k. We can combine these two
equations into comparisons of relative productivities of producing goods j and k and compare them to the relative
labor costs: a1j/a2j<W2/W1e<a1k/a2k.
[Note that this equation compares the relative labor productivities of producing goods j and k, to the relative labor
costs. As a1/a2 decreases, labor in country 1 becomes relatively more productive than in country 2. That is to say
as a1/a2 decreases that it now requires relatively less labor in country 1 to produce the good than country 2. If
country 1 advantage in its productivity is greater (a1/a2 is smaller) than the relative costs of its labor as compared to
country 2 it will be competitive in exporting the good. Also note that W2/W1e is the cost of labor in country 2 per
unit cost of labor in country 1. Plug is some numbers to see this: W2= A$4/hr, W1=£4/hr, and e=A$1/£, then labor
per hour costs the same across both countries. Now if W2=A$6/hr, W1=£4/hr, and e=A$1/£, then labor per hour
in country 2 are 11/2 times more than compared to country 1.]
With all this understood, it should be clear in the a1j/a2j<W2/W1e<a1k/a2k equation that country 1 exports good j and
country 2 exports good k. Now to determine the wage limits as W1 rises, W2/W1e decreases making country 1 less
competitive in the export of good j. When a1j/a2j=W2/W1e, we have the upper limit to country 1’s ability to export
good j. From the numbers given in the problem this limit is given as 8hr/gal in country 1 divided by 8hr/gal in
country 2 = A$4/hr/£x/hr(A$1/£), £x/hr=£4/hr. The lower limit defining the breakeven point between producing
good k or importing it in country 1 is 16 hr/lb in country 1 divided by 12 hr/lb in country 2 = A$4/hr/£x/hr(A$1/£),
£x/hr=£3/hr.
To get full credit the student should be able to derive these results and explain their meaning.
d. What are the exchange rate limits if the wage rate in Australia is A$4/hr and is ,3.5/hr in the UK? Be sure to
define the exchange rate as either ,/A$ or A$/ , .
With the understanding of wage rate limits, exchange rate limits are parallel. The value of the English pound
relative to the Australian dollar can also reverse the inequalities in the a1j/a2j<W2/W1e<a1k/a2k equation. As e rises
W2/W1e falls. In this case, since W1 is measured in pounds the exchange rate must be in terms of A$/£, converting
labor costs in the UK to Australian dollars. As the exchange rate rises, the value of the English pound increases,
until the UK is no longer competitive in the export of good j. Vice versa for decreases in the exchange rate. This
defined the exchange limits. Upper limit when the UK no longer exports good j is found be solving for e in 8hr/gal
in country 1 divided by 8hr/gal in country 2 = A$4/hr/£3.5/hr(e): e = A$4/£3.5 or e=8/7 A$/£. The lower limit is
solved by 16 hr/lb in country 1 divided by 12 hr/lb in country 2 = A$4/hr/£3.5/hr(e): e= 12/16 x A$4/£3.5=
6/7A$/£.
To get full credit the student should be able to derive these results and explain their meaning.
2) Include the following three commodities in the previous table (there are now five goods).
Labor requirements
Fish
Wine
Beef
United Kingdom
6hr/lb
20 hr/gal
18 hr/lb
Australia
8 hr/lb
14 hr/gal
20 hr/lb
a. If the wage rates are A$4/hr and is ,4/hr, and the exchange remains the same as before at ,1/A$1, which country
will export what goods?
First task is to combine the tables and calculate the relative labor productivities between the UK and Australia for
each good.
Labor requirements
Sausage Beer
Fish
Wine
Beef
United Kingdom
16 hr/lb
8 hr/gal
6hr/lb
20 hr/gal
Australia
12 hr/lb
8 hr/gal
8 hr/lb
14 hr/gal
Relative labor inverse
productivities
4/3
1
3/4
10/7
18 hr/lb
20 hr/lb
9/10
Now we need to rank these from lowest to highest.
Fish
Beef
Beer
Sausage
Wine
3/4
9/10
1
4/3
10/7
Now we need to compute the relative labor costs W2/W1e = A$4/£4(A$1/£) = 1. With the labor costs in monetary
terms the same, the UK will export fish and beef, Australia will export sausage and wine. The cost of beer is the
same across both countries and will not be traded.
b. Will the patterns of trade change if the exchange rate changes to ,0.8/A$1 or equivalently A$1/,0.8? If so,
how?
With the exchange rate at ,0.8/A$1, or its equivalent A$1/0.8£, the relative monetary labor costs fall to 0.8. This
changes the patterns of trade with the UK only exporting fish and Australia exporting all the other goods.
c. With the exchange rate at ,1/A$1, how will the patterns of trade change if transportation costs are 1hr for each
good?
Labor requirements
Fish
Beef
Beer
Sausage
Wine
United Kingdom
6+1hr/lb
18+1 hr/lb
8 hr/gal
16hr/lb
20 hr/gal
Australia
8 hr/lb
20 hr/lb
8 hr/gal
12 +1hr/lb
14 +1hr/gal
Relative labor inverse
productivities
7/8
1
16/13
20/15
19/20
Adding in transportation costs requires adding the addition hour to the costs in the exporting country as reflected in
the table. Comparing these results to the relative monetary costs of 1 derived earlier, leads to the conclusion that
the patterns of trade do not change.