INTB 334 Yoto V. Yotov Drexel University Solution Problem Set #1 This problem set is designed to help you master the concepts and tools covered in class so far and to prepare you better for the coming Midterm. The format of the test will be identical to the format of this problem set. The only difference is that I have added one more quantitative question here (optional!) to cover the specific factors model. I. Multiple Choice Questions (40 points) 1. Given the following information: Marginal Product of Labor Cloth Widgets Home 1/10 1/20 Foreign 1/60 1/30 (a) Neither country has a comparative advantage. (b) Home has a comparative advantage in cloth. (c) Foreign has a comparative advantage in cloth. (d) Home has a comparative advantage in widgets. (e) Home has a comparative advantage in both products. 2. A nation engaging in trade according to the Ricardian model will find its consumption bundle (a) inside its production possibilities frontier. (b) on its production possibilities frontier. (c) on or outside its production possibilities frontier. (d) inside its trade-partner s production possibilities frontier. (e) on its trade-partner s production possibilities frontier. Answer: C 3. If the world terms of trade for a country are somewhere between the domestic cost ratio of H and that of F, then (a) country H but not country F will gain from trade. (b) country H and country F will both gain from trade. (c) neither country H nor F will gain from trade. (d) only the country whose government subsidizes its exports will gain.
4. If a production possibilities frontier is bowed out (concave to the origin), then production occurs under conditions of (a) constant opportunity costs. (b) increasing opportunity costs. (c) decreasing opportunity costs. (d) infinite opportunity costs. 5. If one country s wage level is very high relative to the other s: (a) neither country has a comparative advantage. (b) only the low wage country has a comparative advantage. (c) only the high wage country has a comparative advantage. (d) each country could have comparative advantage in some good. Answer: D 6. Consider a Ricardian setting. If the United States s PPF was flatter to the widget axis, whereas Germany s was flatter to the butter axis, we know that (a) the United States has no comparative advantage (b) Germany has a comparative advantage in butter. (c) the U.S. has a comparative advantage in butter. (d) Not enough information is given. 7. In the Ricardian 2X2 model, if two countries under autarky engage in trade then (a) The real wage will not be affected since this is a financial variable. (b) The real wage will decrease when a country attains full specialization (c) The real wage will increase in one country only if it decreases in the other (d) The real wage will rise in both countries. Answer: D 8. If two countries in Autarky (not engaged in international trade) begin trading with in a manner consistent with the Ricardian model of comparative advantage, then (a) The amount of labor required to produce one unit of imports will decrease in both countries. (b) The amount of labor required to produce one unit of both products will decrease in both countries. (c) The amount of labor required to produce one unit of imports will decrease only in the relatively labor abundant country (d) The amount of labor required to produce one unit of imports will decrease only in the relatively capital abundant country. Answer: A
9. Countries trade with each other because they are or because of. (a) different, costs (b) similar, scale economies (c) different, scale economies (d) similar, costs Answer: C 10. In general which of the following tend to promote the probability of trade volumes between two countries (a) Linguistic and/or cultural affinity (b) Historical ties (c) Sizes of economies (d) Mutual membership in preferential trade agreements (e) All of the above Answer: E II Provide definition of the following term (4 points): Terms of Trade: The ratio of the exports price over the price of imports for a country. The larger the terms of trade, the better for the country. III True or False (6 points) 1 F A country has a comparative advantage for producing a good when it has a lower cost of producing this good than the other country. 2 F The country with the best technology for producing a good always has a comparative advantage in producing this good. IV. Quantitative/Graphing Problem (30 points) Apply the Ricardian model to the following scenario: Two countries, Home (H) and Foreign (F) produce two goods, clothing (C) and wheat (W) using labor as the only factor of production. Marginal productivity of labor is constant in each country and is defined by the following schedule: 1 unit of labor can produce 1 unit of clothing and 1/2 units of wheat at home, while 1 unit of labor can produce 1 units of clothing and 1/3 units of wheat. Finally, each country has 1000 workers.
a. Which country has absolute advantage in the production of clothing? How about wheat? Explain. Neither Home nor Foreign has absolute advantage in production of clothing. Labor is equally productive in clothing in each country. Home has absolute advantage in production of wheat because labor is more productive at home when it comes to wheat. b. Which country has comparative advantage in clothing? How about wheat? Comparative advantage is determined by relative costs. Based on the information on marginal productivity, we can calculate the opportunity costs for each good in terms of the other at Home and at Foreign. The relative (opportunity) cost schedules are presented in the following table: C W H 1/2W 2C F 1/3W 3C The table indicates that Home has comparative advantage in production of Wheat (2<3) and Foreign has comparative advantage in production of Clothing (1/2>1/3). c. According to the principle of comparative advantage, which country should specialize and export what good? F will specialize in production of and export C and home should specialize in production of and export W. d. In order for Home to gain from trade the world price of Clothing in terms of Wheat should be lower than 1/2. e. At what price of clothing in terms of wheat the benefits of foreign from trade will be largest? What will the benefit for home be at this price? Foreign will have largest benefits from trade when the relative price of clothing in terms of wheat is 1/2. At this price Home will not benefit from trade, as this the price at which they can trade in autarky. f. Draw the PPF for home in Autarky by putting clothing on the X-axis. Make sure that you label your each axis and that you mark down the appropriate numbers for the maximum amounts of wheat and clothing. What is the slope of the PPF? Then, use an indifference curve, U1, to mark the autarky equilibrium if you know that in autarky home will produce and consume 600 units of clothing and 200 units of wheat.
W 500 PPF 200 E 600 1000 The slope of the PPF is -1/2 (or -2, if you have W on the X-axis). C g. Now assume that home and foreign start trading at zero cost at relative price of wheat in terms of clothing equal to 5/2? Is this price feasible? If so, use graphical analysis, to show that Home can gain from trade. Denote the new trade equilibrium T. W 500 PPF 200 E T U2 U1 600 1000 1250 C Yes, the price is feasible, as home will be willing to trade (sell wheat) if the relative price of wheat is greater than 2C, which they can get in autarky, and F will also be
willing to buy, as long as they pay less than 3C per wheat, which is their autarky price. At a world price of wheat in terms of clothing equal to 5/2, it is possible for Home to consume more of each good, which can be seen on the graph by the higher Indifference curve U2, any point of which brings the Home economy higher satisfaction (utility) than the utility at point E, which was the Autarky equilibrium. Thus, Home will gain from trade. V. Essay Questions (20 points). A. Many countries in Sub-Saharan Africa have very low labor productivities in many sectors, in manufacturing and agriculture. They often despair of even trying to attempt to build their industries unless it is done in an autarkic context, behind protectionist walls because they do not believe they can compete with more productive industries abroad. Discuss this issue in the context of the Ricardian model of comparative advantage. What this argument says is that countries cannot gain from trade if they do not have absolute advantage in something. It is comparative advantage, rather than absolute advantage, which determines the pattern and gains from trade. The Ricardian model of comparative advantage argues that every country must have a comparative advantage in some product (assuming there are more products than countries). Refer to the misconception productivity and competitiveness about comparative advantage from your notes. B. In 1975, wage levels in South Korea were roughly 5% of those in the United States. It is obvious that if the United States had allowed Korean goods to be freely imported into the United States at that time, this would have caused devastation to the standard of living in the United States, because no producer in this country could possibly compete with such low wages. Discuss this assertion in the context of the Ricardian model of comparative advantage. According to the Ricardian model, international comparisons of absolute wages are irrelevant. Wages reflect productivity (absolute advantage), and we saw that even if one country is more productive in everything, it will still be beneficial for the country to engage in trade according to the principle of comparative advantage. In terms of this example, this means that after trade, United States would be able to provide its population with a higher standard of living than would be possible without trade. This is the intuition behind the Pauper Labor Argument from your notes.