International Trade Theory

Econ. 442/2-A
Prof. E. Siggel

Fall

2016

Mid-term exam: Solution

General instructions: (1) Please write concisely and legibly.
(2) Use the space available on the question sheets only. Back sides may be used for scribbling.
(3) No materials allowed, except calculators.
I
Definitions (5 points each)
(1)
Standard trade model
The standard trade model is the general neoclassical two-sector
model of general equilibrium, which assumes two products and two
countries, but leaves it unspecified what is the source of comparative
advantage. It predicts, that a country specializing in the product of
comparative advantage will obtain gains from trade in terms of
economy-wide welfare benefits.
(2)
Leontief paradox
While the American economy was considered to be relatively capital
rich, its exports were shown by Leontief to be relatively labourintensive and its import-competing industries relatively capitalintensive, which is opposite to what the Heckscher-Ohlin trade model
predicts.
II
True/False questions (5 points each)
In each of the following statements explain what is right and shat is wrong and why.
(1)
The specific factors model applied to foreign direct investment shows that a capital flow from
the Foreign to the Host country leads to benefits for all parties involved, workers and capital owners
in both countries.
T: the capital flow benefits workers in the Host country and capital owners
in the Foreign country.
F: it is untrue that workers in the Foreign country and capital owners in the
Host country gain because workers in Foreign will lose jobs and capitalists
in Host will lose return to capital.

(2)
In the intra-industry trade model attributed to Krugman the combination of economies of
scale and product differentiation leads to two-way trade. Accordingly, monopolistic competition
implies declining average costs and economies of scale are the cause of product prices declining with
the number of firms in the market.
T: In the Krugman model the combination of scale economies and
product differentiation lead to intra-industry trade when free trade is
established.
F: The second part is faulty: monopolistic competition leads to price
decline with increasing number of producers and economies of scale
caused by fixed costs lead to average costs rising with the number of
producers.
III Problems (10 points each)

(1)
The Ricardian trade model with five goods
Let two countries, Home and Foreign, produce the products A, B, C, D and E with the following
amounts of labour per unit of output; let labour be the only relevant factor of production:

(a)

Home
Foreign
A
4
5
B
6
8
C
10
10
D
12
10
E
15
12
Who has an absolute advantage in producing A, B, C, D and E?

Home has an absolute advantage in producing A and B, while Foreign has an absolute
advantage in producing D and E, and in C neither country has absolute advantage.

(b)
What is Home's relative productivity (RP) in each of these lines of production?
for product A: RP = 1.25
for product B: RP = 1.33
for product C:
0.8

RP = 1 for product D: 0.83

and products E: RP =

(c)
If Home's equilibrium wage rate is $7 and Foreign's rate is $6, what goods will be produced
and exported by Home and by Foreign if free trade prevails between the two countries? Explain why,
i.e. state the criterion of comparative advantage for both countries.
Home produces A and B because RPA and RPB > w/w* = 7/6=1.17
Foreign produces C and D and E because PR C , RPD and RPE > w*/w =
6/7=0.86
(d)
Compute Homes and Foreigns prices (=costs):
Pa=28
Pb= 42
Pc= 70
Pd= 84 Pe= 105
Pa*= 30
Pb*=48 Pc*= 60
Pd*= 60 Pe*= 72
(e)
Now suppose that Home's wage rate is raised to $10. What will happen to production in, and
trade between, the two countries? In which products is Home still competitive?
Home would lose competitiveness in products A and B because the
prices (costs) would rise to Pa = 40 and Pb = 60. It would want to
import all five products and therefore suffer external deficit and
decline of employment.
(f)
What happens to comparative advantage under the conditions described under (e)?
Comparative advantage remains unaffected by the wage increase.
(g)
What is bound to happen to Home's wage rate in the longer run?
It will have to go back to its former equilibrium level.

(2)
The Heckscher-Ohlin model
Let the two countries, Home and Foreign, produce machines (M) and food (F) using only two
factors of production, capital and labour. Assume that machine production is capital-intensive and
food production is labour-intensive, and that Home is capital-rich, relative to Foreign.
(a)
Draw the diagrams of the PPF (M on the vertical and F on the horizontal axis) and of the
contract curve (machines in left-hand corner of the box, capital on the vertical axis of the box) for the
Home country only, by making the assumption about its capital richness clearly visible. Show the
contract curve in the box diagram and explain the slope of the curvature of both curves: i.e.
decreasing or increasing slope and why.

OF

45o

P
C

K
A

OM
L

The slopes of the PPF and of the contract curve are decreasing. For
the PPF this reflects increasing costs and for the contract curve
because expansion of M-goods will make both industries less Kintensive.
(b)
Now show the consumption and production point under autarchy (A) in both diagrams,
assuming that consumers prefer equal quantities of both goods. Then introduce the trade line in the
PPF diagram, assuming that the price ratio PF/PM equals 1. In which product does the Home country
have comparative advantage and why? Explain briefly.
Home has comparative advantage in M-goods because the relative
price of M-goods (Pm/Pf) is lower in autarchy than the international
price ratio (Pm/Pf)w.
c)
Identify the new production point (P) in both diagrams and describe the nature of the
specialization that occurs in Home.
Home specializes in M-goods: it will produce more M and less F.
d)
Does the specialization (move from A to P) imply that the production process in machines
becomes more or less capital-intensive? Why? Is this also true for food production?
The specialization in M-goods makes the K/L ratio decline in both
sectors, because the expanding M-sector is capital-intensive, which
creates a shortage of capital and abundance of labour.
e)
What is the consequence of this change in factor intensity for the relative wage (w/r) and
why?
In both sectors the relative wage must decline, due to the declining
capital intensity.

f)
Which theorem predicts this outcome, and what does it say?
The Stolper-Samuelson theorem states that an increase of the
relative price of a product will benefit the factor used intensively in
its production.