Problem Set 2 Outline of Answers

Transcription

1 Advanced International Trade Prof. A. Waldkirch EC 378 Fall 2006 Problem Set 2 Outline of Answers 1. The table below shows the number of computers and pints of beer that the United States and Ireland can produce with ten hours of labor time under four different hypothetical situations. Case 1 Case 2 Case 3 Case 4 Ireland U.S. Ireland U.S. Ireland U.S. Ireland U.S. Computers Beer a) In each case, identify the good in which the U.S. and Ireland have an absolute advantage or disadvantage, respectively. Whenever productivity is higher, a country has an absolute advantage. Case 1: Ireland has an absolute advantage in both goods; thus, the U.S. has an absolute disadvantage in both goods. Case 2: Ireland has an absolute advantage in computers, the U.S. in beer. Case 3: Ireland has an absolute advantage in both goods; thus, the U.S. has an absolute disadvantage in both goods. Case 4: Ireland has an absolute advantage in computers; neither country has an absolute advantage or disadvantage in beer. b) In each case, identify the good in which the U.S. and Ireland have a comparative advantage or disadvantage, respectively. A comparative advantage arises from lower opportunity cost. Case 1: The opportunity cost of a computer is 7.5 pints of beer in Ireland, 20 pints of beer in the U.S. Hence, Ireland has a comparative advantage in computers, the U.S. in beer. Consequently, they each have a comparative disadvantage in the other good. 1

2 Case 2: Ireland s opportunity cost of a computer is now only 2.5 pints of beer, while U.S. opportunity cost is unchanged. Hence, comparative advantage is as in case 1. Case 3: The opportunity cost of a computer is 5 pints of beer for both the U.S. and Ireland; hence, neither country has a comparative advantage in anything. Case 4: Ireland s opportunity cost of a computer is 5 pints of beer, compared to 20 for the U.S. Hence, comparative advantage is as in cases 1 and 2. c) Indicate in each case whether trade is possible. Why or why not? Trade is possible in cases 1, 2, and 4. In case 3, trade is not possible since Ireland s absolute advantage is the same in both goods. d) For case 1, suppose that the U.S. and Ireland exchange 8 computers for 80 pints of beer. How much does each country gain from this trade? What is the range for In terms of beer, Ireland gains 20 pints (since it could produce 60 pints of beer domestically with the resources needed to make 8 computers) and the U.S. 80 pints since making 8 computers themselves would require the resources from 160 pints of beer. In terms of computers, Ireland gains 8/3, the U.S. 4. As long as 8 computers are exchanged for more than 60 and less than 160 pints of beer, both countries gain from trade. 2. Again, use case 1 only. Assume labor is the only factor of production. a) How much labor is needed to produce one computer and one pint of beer, respectively? Ireland needs 1 hour and 15 minutes to make a computer and 10 minutes for a pint of beer. The U.S. needs five hours for a computer and 15 minutes for a pint of beer. b) What is the price of each good if the wage rate is $10/hour and 20 Euro ( )/hour, respectively? Since prices reflect cost, in Ireland, a computer will sell for 25, a pint of beer sells for In the U.S., a computer will sell for $50, a pint of beer $2.50. c) If the exchange rate between the dollar and the euro is $1 = 1, is there scope for Yes. Beer is cheaper in the U.S., computers are cheaper in Ireland; thus, Ireland will trade computers for beer. 2

3 d) If the exchange rate between the dollar and the euro is $1 = 2, is there scope for At this exchange rate, U.S. beer will cost 5, a computer 100. Both are more than in Ireland and hence only Ireland will export. This implies that there will be a trade imbalance and demand for Euros will rise, resulting in an appreciation of the Euro. e) If the exchange rate between the dollar and the euro is $2 = 1, is there scope for At this exchange rate, U.S. beer will be cheaper than Irish beer and the U.S. will export beer. The price of a U.S. computer is 25, the same as an Irish computer and thus no trade in computers will take place. The trade imbalance will lead to an appreciation of the dollar. f) What is the range of exchange rates that will allow the U.S. and Ireland to both export their comparative advantage good < $1 < Again, use case 1 only. Assume each country possesses 100 hours of labor. a) Plot the production possibilities frontiers for both countries. Clearly mark your axes. beer Ireland beer United States computers 20 computers 3

4 b) What is the relative price of computers (PC/PB) in each country in autarky? This is equal to the opportunity cost, which is the slope of the PPF, if you put computers on the horizontal and beer on the vertical axis. It is 600/80 = 7.5 beer in Ireland and 400/20 = 20 beer in the U.S. c) What is the range of possible trading prices if Ireland and the U.S. can trade freely? 7.5 < (PC/PB) Trade < 20 d) Suppose one computer trades for ten pints of beer. In your diagram, indicate each country s production point under free trade and add a consumption possibilities frontier. What quantity of computers and beer must be traded for there to be gains from trade for both countries? Ireland specializes in computers and produces 80; the U.S. specializes in beer, producing 400. The consumption possibilities frontier is the dashed line, with a slope of 10, reflecting the trading price given. There are gains from trade for any quantity of computers and beer traded, as long as it is different from zero. 4. How would you counter the argument that the United States needs to restrict shrimp imports in order to save American jobs? The United States has a comparative disadvantage in the production of shrimp. Restricting shrimp imports would keep US workers from eventually moving into industries in which the United States has a comparative advantage and in which wages are higher. 5. Workers in some Mexican automobile factories are almost as productive as their U.S. counterparts, yet their wage is less than a third. Is this inconsistent with economic theory? Economic theory asserts that wages reflect productivity on a broad level. For the economy overall, wages will reflect productivity. For individual industries, however, wages and productivity may diverge. 4

5 6. Unit labor costs are a useful measure for checking whether the data support the notion that wages reflect productivity. a) How are unit labor costs defined? Unit labor costs are defined as hourly wage cost divided by productivity per hour (or equivalently, by the total wage bill divided by real output): (w*l)/y. If wages move along with productivity, unit labor costs will be unchanged. b) For the U.S., how have unit labor costs changed over the last 30, 20 and 10 years? The Bureau of Labor Statistics conveniently makes unit labor cost data available, albeit as an index. Still, changes in this index over the last 30, 20, and 10 years give us a good idea how labor costs have changed. The index (1992 = 100) was 87.9 in 2004, 97.4 in 1994, 89.8 in 1984, and 53.5 in Thus, unit labor costs have risen significantly between 1974 and 1984, but have remained about the same since, with a drop in the last ten years. This is consistent with recent wage and productivity data that has indicated that productivity growth has exceeded wage growth in the United States. 7. Appendix problem from Salvatore, p. 56: Set up an example of trade with three commodities and three nations in such a way that each of the three nations exports one of the commodities to, and imports one of the commodities from, each of the other two nations. The numbers in the following table refer to the cost or price of producing goods X, Y, and Z in countries A, B, and C in terms of the same currency. Thus, nation A exports good X to countries B and C; country B exports good Y to countries A and C; and country C exports good Z to countries A and B. Country A B C Good X Good Y Good Z