Problem Set 2_Answers

Problem Set 2_Answers - UNIVERSITY OF SOUTHERN CALIFORNIA...

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Unformatted text preview: UNIVERSITY OF SOUTHERN CALIFORNIA Marshall School of Business FBE 462 – International Trade & Commercial Policy Answers to Problem Set #2 1. If production of firm involves a fixed cost, then a. there exists internal economies of scale. b. there exists external economies of scale. c. there exists constant returns to scale. d. there exists decreasing returns to scale. 2. With increasing returns to scale and transaction costs, a. a firm will likely locate its production in a smaller market. b. a firm will likely locate its production in a bigger market. c. a firm will be indifferent in locating its production between the smaller or bigger markets. d. a country with a higher demand for a good will likely be an importer of this good. 1. A. The numbers presented indicate the productivity of labor (output per labor year) in each product for each country. They can be used as direct indicators of absolute advantage— for each product, which country’s labor is more productive? Pretzelvania has the absolute advantage in both products. B. There are a number of (mathematically equivalent) ways to examine comparative advantage, which involves relative comparisons between products and countries. (In the rest of the answers, we drop “thousands” from all numbers.) If we use the labor-productivity numbers as presented, then we can examine the countryto-country ratio of productivities for the two products. Pretzelvania’s advantage (relative to Toblerenia) in chocolate is 6/4 = 1.5, while its relative advantage in beer is 15/8 = 1.875. Thus Pretzelvania has a comparative advantage in beer (its relative advantage in beer is larger). Another way to look at this is to use relative cost or price numbers to determine comparative advantage (this is closer to our concept of trade based on arbitrage). The indicator of cost is labor years per unit of output, so we need to use the inverses of the numbers given in the problem. Here we usually look at the product-to-product ratio of price (or cost) for each country (with no trade), and then compare the two countries. The relative price (or cost) of chocolate in Pretzelvania is (1/6)/(1/15) = 2.5 (with no trade, chocolate is 2.5 times as expensive as is beer in Pretzelvania). The relative price (or cost) of chocolate in Toblerenia is (1/4)/1/8) = 2 (with no trade). With no trade, Toblerenia has the comparative advantage in chocolate, because chocolate is relatively inexpensive in Toblerenia. Looked at the other, with no trade the relative price of beer is 1/2.5 = 0.4 in FBE 462 Problem Set #2 Answers Pretzelvania, and it is 1/2 = 0.5 in Toblerenia, so Pretzelvania has the comparative advantage in beer. In a free-trade equilibrium, each country will export the product in which it has the comparative advantage. Pretzelvania will export beer to Toblerenia, and Pretzelvania will import chocolate from Toblerenia. C. The limits to the free-trade equilibrium price ratio are given by the fact that one country must be willing to export one product, and the other country must be willing to export the other product. The relative price of chocolate will be no lower than the no-trade price ratio in Toblerenia (2), and it will be no higher than the no-trade price ratio in Pretzelvania (2.5). D. We must re-do the comparison from part B. If we use labor productivities, then Pretzelvania’s relative advantage in beer declines to 15/12 = 1.25. Comparative advantage reverses—Pretzelvania’s relative advantage is now larger in chocolate (1.5). If we use relative costs and prices, the relative price of chocolate in Toblerenia with no trade is now (1/4)/(1/12) = 3. With no trade chocolate is now relatively expensive in Toblerenia, so Pretzelvania now has the comparative advantage in chocolate. After this change, the trade pattern will reverse—Pretzelvania will now export chocolate and import beer. 2. A. Production remains at A, and the country can trade with the rest of the world at a relative price of robes that is lower than the no trade price ratio—along the price line PWo. The country's consumption shifts to point F, and the country reaches community indifference curve CIC2. The country gains from trade—its consumption point is “outside” of its production capabilities and it reaches a higher community indifference curve. 2 FBE 462 Problem Set #2 Answers B. The substitution effect for consumers is the pure reaction to the relative price change. The relative price of robes falls, so buy more robes; the relative price of cheese rises, so buy less cheese. The income effect for consumers is the pure response to changes in purchasing power (real income, or well-being, shown by the cic achieved). Real income or well-being increases (a higher cic), so buy more robes and buy more cheese (if both are normal goods). The actual change in consumption quantities is the combination of the substitution effect and the income effect. For robes, both effects are positive, so that an increase in consumption quantity is possible, but a decrease is not possible. For cheese, in general, both an increase and decrease in consumption quantity would be possible—it depends on whether the positive income effect or the negative substitution effect is larger. However, in this specific case, the graph is clear. Because the new consumption point F must be to the “southeast” of the initial consumption A, the quantity consumed of cheese must decrease—the substitution effect is larger for cheese. C. If the country adjusts its production point to the tangency with the ppc at point R, it can trade along the new dashed price-income line, and then consume at point H and reach an even higher indifference curve CIC3. 3. A. False. The Ricardian approach is a theory of comparative advantage. The correct comparison is between relative labor productivities, not absolute levels. Thus, a country with absolute productivity advantages in all products will only export those products for which its relative productivity advantage is large. 3 FBE 462 Problem Set #2 Answers B. False. (There are several mathematically equivalent ways to answer this.) According to the Ricardian approach, a country will trade according to comparative advantage—to maximize its relative advantage or to minimize its relative disadvantage. The numbers as given are indicators of labor productivity. (Choiland has an absolute productivity advantage in both products.) Choiland’s relative productivity advantage in bowls is 80/50, and in chairs it is 16/8. Choiland’s maximum relative advantage is in chairs, so Choiland will export chairs (and import bowls). We can also invert the numbers given in the statement to obtain indicators of product cost and price (labor years per unit of output of each product). We can use these price indicators to find the opportunity for arbitrage if we start with no trade. For labor years per unit produced: Puglia Choiland Chairs 1/8 1/16 Bowls 1/50 1/80 With no trade, the relative price of bowls (PB/PC) in Puglia is 0.16 (= (1/50)/(1/8)), and in Choiland it is 0.20 (= (1/80)/(1/16)). Bowls are relatively expensive in Choiland with no trade, so with free trade Choiland will import bowls (and export chairs). C. False. The Heckscher-Ohlin theory is a theory of comparative advantage. The correct comparison is between relative amounts of different factor endowments, not amounts of a single factor. A country will export relatively land-intensive agricultural products if it has relatively more land than other countries, where the comparison is its share of the world’s land compared to its share of other factors like the world’s total skilled labor, unskilled labor, and so forth. For instance, if this country with the most land has an even larger share of the world’s population and labor, Heckscher-Ohlin theory predicts that the country will export labor-intensive products and import agricultural products. D. True (or, at least, there is tendency in this direction, assuming that trade follows the Heckscher-Ohlin theory). With no trade the rental return to land would be high in the land-scarce country and low in the land-abundant country. With a shift to free trade, production of the land-intensive product increases in the land-abundant country, so the rental return rises in this country because of strong demand for land. With a shift to free trade, production of the land-intensive product decreases in the land-scarce country, so the rental return decreases in that country because of weak demand for (or excess supply of) land. Thus, free trade brings about (a tendency toward) equalization of returns to land in these countries. E. Partly true, partly false. It depends on which types of products are exported by the country, and which types of products are imported. If trade follows the Heckscher-Ohlin theory, then it depends on which factors are relatively abundant and relatively scarce in the country. If trade follows the H-O theory, then the statement is true if the country is abundant in land and capital, and scarce in labor. In this case, when the country opens to free trade, it expands production of land-intensive and capital-intensive products, which expands (national) demand for land and capital, so the (real) returns to land and capital increase, and owners of land and capital are better off. Also, opening to free trade 4 FBE 462 Problem Set #2 Answers shrinks production of labor-intensive products, which reduces (national) demand for labor (or results in excess supply of labor), so the (real) wage for labor decreases, and workers are worse off. But, if trade follows the H-O theory, and if the country is abundant in labor and scarce in land and capital, then the statement is false. The reasoning is the same as above, with the roles of labor and land and capital reversed. 4. A. The Heckscher-Ohlin theory states that a country will export those products that use relatively intensively the country's relatively abundant factors of production, and import those products that use relatively intensively the country's relatively scarce factors of production. It is significant as a modern theory of the basis for comparative advantage, and it has implications for international differences in factor prices (factor price equalization) and for domestic income distribution. B. Intraindustry trade is the simultaneous export and import by a country of the same or similar products -- products categorized into the same industry category. This two-way trade in similar products is significant as a part of international trade patterns not easily explained by Heckscher-Ohlin (or other) theories of comparative cost advantages. Rather, it shows the importance of product differentiation, with an additional source of gains from this kind of trade arising from the greater variety of products available to consumers. 5 ...
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