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30057 International Economics (Part II International trade)

May 2015
Additional sample questions
Q1. Consider two countries, Germany and Vietnam, producing two goods, machinery and rice, using
labor as a production factor. Suppose that Germany is relatively more efficient than Vietnam in the
production of machinery. What are the effects of trade liberalization on welfare in both countries?
Draw a graph to illustrate gains from trade in both countries.
Germany is relatively more efficient than Vietnam in the production of machinery, or the opportunity

cost of machinery is lower in Germany: <

or the relative autarky price of M is lower in Germany.

In free trade, according to the standard equilibrium in the Ricardian model, countries are perfectly
specialized in the comparative advantage goods and the relative price converges: Germany will export
M and Vietnam will export rice.
In equilibrium,

<

(the relative price of M in the free trade equilibrium).

Gains from trade in Germany. In autarky consumption possibilities are constrained by production
possibilities: the budget constraint and the PPF coincide.
In free trade, Germany is perfectly specialized, therefore it produces M only (horizontal intercept, point
P). However, now the budget constraint becomes steeper, as the relative price at which goods can be
exchanged in consumption is greater.
Thus, consumers reach a higher indifference curve welfare increases. With free trade, in fact,
consumption possibilities expand. All the bundles between the PPF and the new budget constrained
were not affordable in autarky, while in free trade they can be chosen.

Gains from trade in Vietnam. In autarky consumption possibilities are constrained by production
possibilities: the budget constraint and the PPF coincide.
In free trade, Vietnam is perfectly specialized; therefore it produces R only (vertical intercept).
However, now the budget constraint becomes flatter, as the relative price at which goods can be

exchanged in consumption is greater. In fact <

Thus, consumers reach a higher indifference curve welfare increases. With free trade, in fact,
consumption possibilities expand. All the bundles between the PPF and the new budget constrained
were not affordable in autarky, while in free trade they can be chosen.
We have assumed a standard free trade equilibrium with perfect specialization. In this model, it is also
possible to reach an equilibrium in which one country is perfectly specialized while the other one

produces both goods. A country is not perfectly specialized when the relative international price is
exactly equal to the relative price in autarky. In this case, this country is not gaining from trade. The
budget constraint will be precisely the PPF as in autarky.
Q2. Countries A and B have two factors of production, capital and labor, with which they produce
two goods, X and Y, using the same technology. X is capital-intensive; A is capital-abundant. The two
goods are freely exchanged between the two countries. Analyze the effects on the terms of trade and
on the two countries welfare of an increase in As capital stock.
According to the Heckscher-Ohlin model, as country A is capital-abundant, in free trade it will export
the capital intensive good X Effects of export-biased growth.
Suppose that A is a small country (no impact on international prices).
An increase in capital expands production possibilities and the effect is stronger in the capital intensive
industry: the PPF shifts out and the shift is biased toward X.

If the country is small, the relative price of good X will not be affected.
As there is a one-to-one relationship between goods and factor prices, then the relative price of capital
(r/w) is unchanged.
As the relative demand for capital depends on its relative price, capital intensity is unchanged in both
industries.
As factors are fully employed in equilibrium and as capital intensity must be constant, the new units of
capital should be employed in the capital intensive industry. To maintain K/L constant in that industries,
some workers must be freed by the Y industry Production of X increases and production of Y
decreases.
In the graph of the PPF, the new production point is on the new PPF, where the value line, with a
constant slope, is tangent. Country A is more specialized in X than before.
Consumers now can consume on a higher value line utility increases, welfare increases.
On the other hand, country B is not affected by As growth, as A is small.
Large country. What happens when the country is large?
As the increase in capital induces an increase of the units of the capital intensive good X produced and
a decrease of Y, the relative supply of X in country A increases.
But in this case A is large If As RS increases, then world RS increases. This leads to a reduction in the
relative price of good X. As good X is the exported good, As terms of trade deteriorate.

In these case, we have to effects on As economy:


- As the country grows, production and consumption possibilities expand increasing welfare.
- As terms of trade worsen, welfare decreases.
The net impact on welfare is uncertain. However, according to the empirical evidence the positive effect
prevails.
As As terms of trade deteriorate, Bs terms of trade improve. B is better off.
Q3. Explain rigorously the effects of international trade on income inequality predicted by the
Heckscher-Ohlin model. Can we confirm empirically these predictions? Discuss alternative
explanations for the increase in wage inequality in developed and developing countries.
Consider two countries, Home and Foreign, producing two goods, X and Y, using two factors of
production, skilled-workers (S) and unskilled-workers (L).
Suppose that Home is relatively abundant of skilled workers and X is relatively skill intensive.
According to the Heckscher-Ohlin theorem, in free trade a country will export the good that uses
relatively intensively in production the relatively abundant factor. Thus, Home will export X and Foreign

will export Y. In free trade, the relative price of good X converges: thus < < .

The Stolper-Samuelson theorem states that an increase in the relative price of a good will increase the
real return to the factor used intensively in the production of that good, and will decrease the real
return to the other factor, in terms of both goods. Thus in Home we should observe an increase in the
relative wage of skilled workers, while in Foreign a decrease in the skill premium.
In particular, the model predicts that in Home the relative price of good X increases. Given the one-toone relationship between goods prices and factor prices, the relative wage of skilled workers increases
(increased inequality). Moreover, as the relative price of skilled-workers increase, as we can observe
from the graph of the relative factor demands, skill-intensity in production decreases in both industries.
Note that, given the assumed decreasing marginal returns in the model, when the relative amount of
skilled workers decreases in an industry, the marginal product of skilled workers increases while the
marginal product of unskilled workers decreases. This means that the real wage of skilled workers
increases, while the real wage of unskilled workers decreases.

In Home:

If

Thus, according to the Heckscher-Ohlin model we should observe:


1. An increase in the relative price of skill-intensive goods in Home
2. An increase in wage inequality in Home
3. A decrease in wage inequality in Foreign
4. A decrease in skill-intensity in Home
While we can find evidence of prediction 2., we cant find evidence of predictions 1., 3., and 4. In
particular, we observe an increase in inequality in both countries and we observe an increase in skillintensity.
Alternative explanations: skill-biased technological change and offshoring.
Skill-biased technological change
Most economists believe that an important factor to explain increasing inequality is skill-biased
technological change brought about by computerization and ICT
Computers are
complements to skilled labor
substitutes to unskilled labor
the relative demand for skilled workers increases as the price of computers falls
the skill premium increases
In particular, one can argue that
1. Computerization led to larger cost reductions in skill-intensive industries
2. Computerization led to skill upgrading in all industries
3. Computerization led to an increase in the skill premium in all countries
Offshoring and trade liberalization
Consider a firm that has to decide the localization of the activities performed to produce a good. Consider a
stylized representation of the value chain and rank activities according to their skill-intensity.

Assume that:
Foreign wages for unskilled and skilled workers are less than those at Home
< <
Additionally, we assume the relative wage of unskilled labor is lower in foreign than at home

<

Although labor costs are lower in Foreign, the firm must also take into account extra costs of doing
business there (trade/transport costs) and assume that these extra costs apply uniformly across all the
activities in the value chain.
Based on our previous assumptions, it will make sense for the firms to send the most unskilled-labor
intensive activities abroad and keep the more-skilled labor intensive activities at Home. Activities to the
left of line A are sent abroad because the cost savings from paying lower wages in Foreign are greatest
for the less-skilled labor intensive activities.
Suppose there is a fall in trade costs. This makes offshoring easier. Suppose that the activities between
line A and line B are now offshored to Foreign.

These activities are more skill-intensive that the one already performed in Foreign. Skill-intensity in the
country increases. The relative demand for skilled workers increases the relative wage of skilled
workers increases.
These activities are less skill-intensive than the ones that are performed in Home after the reduction in
trade costs. Skill-intensity of Home production increases: the relative demand for skilled workers
increases the relative wage of skilled workers increases.

Q4. Consider an industry characterized by external economies of scale. Discuss the role of market size
in determining the pattern of trade and specialization of countries in free trade.
Consider an industry characterized by external economies of scale and two countries with identical
technologies. Assume that the two countries differ in terms of their size: demand in country H is larger
than in country F ( > ).
As technologies are identical, the two countries will have the same forward-falling (due to external
economies) supply curve.
The autarky equilibrium in the two countries is at the intersection between the supply curve and the
demand curve. As demand is larger in Home, the quantity produced by the industry is larger, and so,
thanks to economies of scale, the average cost of production is lower. Thus in autarky, Hs price is lower
than Fs one.

This means that if the two countries open up to trade, Home will be specialized in the production of the
good and the country will export the good.

Q5. Consider two countries characterized by identical technologies, factor endowments and
preferences. Suppose they are producing cars, a differentiated good, in autarky. Discuss in detail the
effects of trade openness.
Assumptions:
- 2 identical countries
- Differentiated goods firms market power
- Internal economies of scale: = +
- Symmetric firms
- Free entry/exit = 0 =
According to the assumptions, we can determine the number of firms and the price charged in equilibrium.
In particular, we can derive a relationship between the average cost of production and the number of firms
(CC curve) and a relationship between the price charged by the individual firm and the number of firm:

1
: =
+

Where F = fixed cost, c = marginal cost, S = market size, n = number of firms, P = price charged by the firm,
b = demand price sensitivity.
To determine the number of firms in equilibrium, we apply the free entry/exit condition: P = AC.
1

+ =
+
=

: =

Graphically:

=
2 =

In this model, we can proxy trade openness with an increase in S.


If market size increases, each firm can expand its production taking advantage of economies of scale,
thus the average cost declines: the CC curve becomes flatter.
The free trade equilibrium is characterized by a lower price and a larger number of firms.
Note that, from the analytical solution, when S increases n increases less than proportionally.
Effects of trade openness:
- P decreases (pro-competitive effect): consumption possibilities expand, therefore consumers are
better off.
- > (variety effect): more varieties available. As consumers love variety, they are better off.

- = As S increases more than n, the quantity produced by the individual firm increases (scale

effect). Firms are larger, thus exploiting more economies of scale more efficient!
- < 2 (defragmentation effect): the number of firms in free trade is lower than the total
number of firms in autarky in the two countries.
Q6. Only a small share of firms exports. Present a model that can explain this stylized fact. In
particular discuss the assumptions and the main results.
Assumptions:
- 2 identical countries
- Internal economies of scale
- Differentiated good
- Heterogeneous firms: = + . Firms are characterized by different levels of productivity
(different marginal costs or production).
- Trade costs. To sell units in the foreign country, domestic firms must pay a tariff the marginal
cost for exported goods is greater and equal to the marginal cost plus the tariff Firms set higher
prices abroad and sell a lower quantity: lower profits
Given the assumptions, we can show why only a subset of firms exports.
Define as profits earned on the domestic market and on the Foreign market
respectively.

Profits decreases in the marginal cost. We can find a cutoff marginal cost such that profits
earned on the domestic market are zero. Thus, firms with > get negative profits in the
domestic market and will exit.
As the marginal cost of the goods sold in market Foreign is greater and equal to plus the tariff t,
given the marginal cost, profits from exports are lower than profits from domestic sales. Profits are
zero for the firm with a marginal cost = .
Only firms with < will find exports profitable exporters.
Firms with a marginal cost that is greater that the export cutoff but lower than the domestic cutoff,
will sell on the domestic market only.

Q7. Why do firms perform different tasks of the production process in different countries? Discuss in
detail the determinants of the fragmentation of the value chain. In particular illustrate costs and
benefits of this strategy.
To answer this question you should discuss the main determinants of vertical fragmentation of
production and main costs and benefits. Here you can find the main issues you have to discuss.
Determinants: differences in factor costs (why do they differ?); resources specific to a particular
location.
Main costs/benefits: reduction in costs of production, trade/transport costs, coordination costs (timing)
Q8. Show graphically and discuss the effects on prices and welfare of an import tariff imposed by a
large country.
Consider a country importing a good at the international price . At this price, domestic producers
supply 0 while domestic consumers demand 0. Imports are given by 0 0 .
If the country introduces a tariff on imports, foreign exporters are willing to sell the good in country
Home only if they can get a price that is equal to the world price plus the amount of the tariff. This
leads to an increase in the domestic price of the good: .
As the country is large, however, this trade policy impacts on the international price of the good too.
Given the reduction in the amount of imports demanded by Home, excess supply arises in the
international market, reducing the international price of the good: .

Thus, the new international price will be lower (


) and the domestic price will be higher and equal to

+ .
At a higher price, domestic producers supply more (1 ), domestic consumption declines (1 ) and
imports shrink.

Consumers surplus declines (-a-b-c-d) as they reduce the amount consumed and pay higher prices.
Producers are better of (+a) as they can produce more (or even less efficient firms can produce) and
they receive a higher price.
The government receives tariff revenues = + c+ e (tariff times imported units).
The net effect is: + e (b+d). A tariff in a large country can have either a positive or a negative effect on
welfare!