A Workbook in International Trade

SECTION I: TRADE THEORY
1. The Principle of Comparative Advantage
A. EXERCISES
Exercise 1:
What are the limits of the absolute advantage model in international
trade?
Exercise 2:
How does the Ricardian Model improve the understanding of
international trade?
Exercise 3:
State and discuss the assumptions underlying the Ricardian Model.
Which of these assumptions could be easily relaxed?
Exercise 4:
In the Ricardian model, can both countries sell the goods in which they
specialize at post trade relative prices that are equal to pre-trade relative
prices? Explain.
Exercise 5:
To what are the slopes of the production possibilities frontiers equal?
What changes occur if the axes of the production possibilities diagrams
are inverted?
Exercise 6:
Is it possible to interpret the relative costs as opportunity costs? Why is it
better to read the theory of comparative advantage in terms of opportunity
costs instead of labour theory of value?
A Workbook in International Trade
Exercise 7:
Comment upon: „Each country has a comparative advantage for some
good”.
Exercise 8:
Comment upon: „Theories in international trade use the assumptions that
the resources are fully allocated both before and after trade and that the
technology does not change. If the same resources are used both before
and after trade, then the world output cannot increase. Therefore there is
no scope for gains from international trade at world level.”
Exercise 9:
If theories of international trade prove that free trade raises welfare at
world level, why then most states use import protection?
Exercise 10:
Comment upon: "An introductory economics course should drive home
to students the point that international trade is not about competition, it is
about mutually beneficial exchange (…) What a country gains from trade
is the ability to import things it wants. Exports are not an objective in and
of themselves: the need to export is a burden that a country must bear
because its import suppliers are crass enough to demand payment."1
1
Krugman, P. – “What Do Undergrads Need to Know about Trade?”, AEA Papers and
Proceedings, May 1993, p. 23-26.
Trade Theory
B. PROBLEMS
Problem 12:
In countries A and B the labour requirements (expressed as number of
workers) for the production of goods X and Y are given in the table
below:
A B
X 5 3
Y 2 6
In which good should each country specialise according to the theory of

absolute advantage?
How much would each country gain after specialisation, supposing that
each has 120 workers?
Problem 2:
Suppose that the labour requirements (expressed as number of workers)
for goods X and Y produced by country A and country B respectively are
given in the table below:
A B
X 5 6
Y 2 12
Using the absolute advantage model, identify the possibilities of

specialisation that each country has.
Does the answer change if the Ricardian model is used instead?
Problem 3:
With reference to problem 2, calculate the relative costs for goods X and
Y in the two countries.
2
Adapted after Winters, A. – International economics (Fourth Edition), Routledge,
London, 1992, p. 16.
Problem 4:
On the basis of the relative costs calculated above, show the
specialisation each country will choose after giving up autarchy as well as
the trade flows that will emerge.
Problem 5:
If the relative price of good X in terms of good Y is 0.2 can you specify
the relative price of good Y in terms of good X?
Problem 6:
If the relative prices of the two goods are the same in both countries, how
will the two countries specialise? (To have a numerical example, please
use the data from problem 2 turning the labour requirement of good X in
country A into 1).
Problem 7:
With respect to problem 2, determine the lower and upper limits for post-
trade relative price of good X in terms of Y, having in mind that the post-
trade relative price should be an incentive for each country to specialise.
Is it necessary to reiterate the same logic in order to determine the post-
trade relative price of good Y in terms of X? Explain the answer you
give.
Problem 8:
Suppose that in country A the relative price of good X in terms of good Y
is 0.2 and country A has a comparative advantage for product X
compared to country B. What can you state as to the relative price of
good Y in terms of good X in country B?
Problem 9:
With reference to problem 2 and assuming that each country has 120
workers, determine and graph the production possibilities frontiers in
countries A and B. We will use the simplifying assumption that there are
no economies of scale in the two countries.
Trade Theory
Problem 10:
With respect to the results obtained for problem 9, determine and graph
the world production possibilities frontier.
Identify the point on this graph corresponding to a complete
specialisation of the two countries. For this point, show the quantities
produces of each good at the world scale.
In case that complete specialisation is achieved in both countries, is it
possible to determine the post-trade relative prices for good X and Y?
Explain.
Problem 11:
Mark with T (true) or F (false) the statements below and explain the
answers you choose:
a. If a country has absolute advantage for good X, it also has
comparative advantage for good X;
b. If a country has comparative advantage for good X, it also has
absolute advantage for good X.
Problem 12:
Suppose each of the two countries A and B produces two goods: X and
Y. Labour is assumed to be the only factor of production. The labour
requirements (expressed as number of workers) for each country and each
good are given in the table below:
A B
X 5 10
Y 10 40
The following assumptions are also made:

- Labour is perfectly mobile between the domestic sectors but is
completely immobile internationally;
- There is free trade;
- There are no transportation costs;
- There are no economies of scale (unit labour requirements are
constant with changes of output);
- There is perfect competition;
- Consumer preferences are identical in both countries, being thus

possible to determine an aggregate world demand curve.
Considering the information above:
a. Indicate in what commodity countries A and B have an absolute
advantage;
b. Indicate in what commodity countries A and B have a comparative
advantage (after having determined the comparative costs);
c. Show the pattern of specialization as well as the trade flows that will
emerge;
d. Suppose country A has 500 workers while country B has 400
workers, determine and graph the pretrade production possibilities
frontiers;
e. Assuming full specialisation, determine the limits of the post trade
relative prices for the two goods and calculate the post trade output
for each good;
f. Supposing the relative post trade price of good X is 0.4, determine
the relative post trade price of good Y and the gains from trade.
Problem 13:
There are two countries (A and B), two goods (X and Y) and only one
factor of production (labour). With one unit of labour the following
quantities of goods can be produced in each country:
A B
X 2 4
Y 5 8
Indicate in what commodity countries A and B have a comparative

advantage.
Trade Theory
Problem 14:
The prices of commodities X and Y (in lei and euros respectively) are
given in the table below:
Romania (ROL) EU
(EUR)
X 500,000 15
Y 1,000,000 45
For which commodity (or commodities) does Romania have absolute

and/or comparative advantage over the European Union, knowing that the
exchange rate between the two currencies is EUR 1 = ROL 30,000?
What changes occur with regard to absolute and comparative advantages
if the exchange rate becomes 1 euro = ROL 40,000? Comment upon these
changes.
Problem 15:
Suppose two countries (A and B) and five commodities (P1, P2, P3, P4 and
P5). The labour inputs (expressed in hours of labour) for each commodity
in each country are given in the table below:
A B
P1 1 10
P2 2 8
P3 5 5
P4 6 4
P5 9 3
For which commodity (commodities) does country A have absolute

and/or comparative advantage? What trade pattern will emerge after
specialisation?
Problem 16:
There are two countries (A and B) and five commodities (P1, P2, P3, P4
and P5). The labour inputs (expressed in hours of labour) for each
commodity in each country are given in the table below:
A B
P1 1 10
P2 2 8
P3 5 5
P4 6 8
P5 8 10
For which commodity (commodities) does country A have absolute

and/or comparative advantage? What other information is needed in order
to determine the trade pattern that emerges after specialisation?
Problem 17:
There are two goods (X and Y) produced in each of the five countries (A,
B, C, D and E). The labour requirements (expressed in labour hours) for
each good in each country are given in the table below:
A B C D E
X 2 3 4 5 6
Y 8 9 10 10 10
Which are the trade specialisation options for the two countries? Which
are the factors that determine the choice of one of them?
Trade Theory
C. ANSWERS
Answer to Problem 1: country A has absolute advantage in good Y, and

country B has absolute advantage in good X. Before trade, country A can
produce 12 units of good X and 30 units of good Y, while country B can
produce 20 units of product X and 10 units of product Y. The world
autarchic output totals 32 units of X and 40 units of Y. If international
trade and specialization occur country A will produce 60 units of Y while
country B will produce 40 units of X. Thus, trade is beneficial for each
country as, using the same resources, each country can consume larger
quantities of goods. Also, at world level, the total consumption rises
compared to the autarchic situation following a better use of resources.
Answer to Problem 2: according to the absolute advantage model,

country A should specialize in the production of both goods, while
country B should specialize in none, which is impossible to put into
practice. The Ricardian model solves out this dilemma, and offers a
solution for mutually advantageous specialization, as follows in problems
3 and 4.
Answer to Problem 3: the relative cost of X is 2.5 in country A and 0.5

in country B; the relative cost of Y is 0.4 in country A and 2 in country B.
Answer to Problem 4: country A will specialize and export good Y and

will import good X; country B will specialize and export good X and will
import good Y.
Answer to Problem 5: the relative cost of good Y is 5.
Answer to Problem 6: according to the Ricardian model, the two

countries have no incentive to specialize and trade.
Answer to Problem 7: the relative post-trade price of good X should be

no less than 0.5 and no more than 2.5; in order to determine the limits of
the relative post-trade price of good Y it is not necessary to reiterate the
same logic. The relative price of good X multiplied by the relative price
of good Y is always equal to 1.
Answer to Problem 8: the relative price of good Y in country B (before

trade) is less than 5.
Answer to Problem 9: the production possibilities frontier in country A

is:
PPA ( x) = 60 − 2.5 ⋅ x ;
the production possibilities frontier in country B is:
PPB ( x) = 20 − 0.5 ⋅ x .
Answer to Problem 10: the world production possibilities frontier can be

described by the following function:
80 − 0.5 ⋅ x , x ∈ [0,40 )
PPW (x) = 60 , x = 40
160 − 2.5 ⋅ x , x ∈ (40,64]
The full specialization point is (40,60), meaning that the world output of
good X is 40 and the world output of good Y is 60. The relative world
price of good X and the relative world price of good Y cannot be
determined in this point. More information is needed with regard to
consumer preferences.
Answer to Problem 11: both statements are false.
Answer to Problem 12: a. country A has absolute advantage in both

goods; b. country A has comparative advantage for good Y and country B
has comparative advantage for good X; c. country A will specialize in
and export good Y and will import good X, while country B will
specialize in and export good X and will import good Y; d. the autarchic
production possibilities frontiers are:
- For country A:
PPA ( x) = 50 − 0.5 ⋅ x ,
Trade Theory
- For country B:
PPB ( x) = 10 − 0.25 ⋅ x
The post-trade world production possibilities frontier is:
60 − 0.25 ⋅ x , x ∈ [0,40 )
PPW (x) = 50 , x = 40
70 − 0.5 ⋅ x , x ∈ (40,140]
e. the relative post trade price of good X will be no less than 0.25 and no
more than 0.5, while the relative price of good Y will be no less than 2
and no more than 4. Assuming full specialization, the world output of
good X is 40 and the world output of good Y is 50.
f. the relative post trade price of good Y will be 2.5.
The gains from trade derive from the favourable change in the
consumption curves. Thus, in country A and B, respectively, the
consumption will be described by the following equations:
C A ( x) = −0.4 ⋅ x + 50
C B ( x) = −0.4 ⋅ x + 16
Answer to Problem 13: country A has comparative advantage in Y and

country B has comparative advantage in X.
Answer to Problem 14: when the exchange rate is EUR 1 = ROL

30,000, Romania has absolute advantage in X and the EU has absolute
advantage in Y. A new exchange rate, EUR 1 = ROL 40,000, will lead
Romania to have absolute advantage for both goods. The comparative
advantage does not depend on the exchange rate. Thus, Romania will
always have comparative advantage in Y and EU in X.
Answer to Problem 15: country A has comparative and absolute

advantage in goods P1 and P2, and country B has comparative and
absolute advantage in goods P4 and P5. Neither country is interested in
trading good P3.
Answer to Problem 16: country A will tend to specialize in the goods

from the upper part of the table, while country B will tend to specialize in
the goods from the lower part of the table. The exact pattern of
specialization cannot be described unless the consumers’ preferences are
known. For instance, country A can specialize in good P1, and country B
in the rest of the goods. Also, country A can specialize in P1, P2 and P3,
and country B in P4 and P5. All the other possibilities can be taken into
account, having in mind the above-mentioned note and the fact that each
country should have at least a good to specialize in (P1 for country A, and
P5 for country B).
Answer to Problem 17: the answer to problem 17 is very similar to that

to problem 16. The exact pattern of specialization can be determined only
if consumers’ preferences are revealed. The most competitive country for
the good X is A, followed by B, C and so on. The most competitive
country for the good Y is E, followed by D, C and so on. There are
several options for specialization and trade. For instance only A produces
good X and sells it to all the other countries, buying in exchange good Y.
Also, countries A and B can both specialize in the production of X selling
it to the remaining three countries in exchange for Y. And the examples
may continue.
Trade Theory
2. The Specific Factor Model
A. EXERCISES
Exercise 1:
Assess each statement below and identify which factor of production is
specific and which is mobile:
a. Land is used solely for agriculture;
b. Capital is needed to produce both food and office machines;
c. No high-skilled workers are needed in the mining industry.
Exercise 2:
In the Specific Factor Model, the production possibility frontier is a curve
and not a straight line, as in the Ricardian Model. Explain what
assumption(s) lead to this difference.
Exercise 3:
An error has been deliberately introduced in the following statements.
Read the lines below and make the correction:
A country manufactures food and cars. It uses labour and land for the
production of food and it employs labour and capital in the car industry.
The workers in the car industry negotiate a salary raise becoming thus
better off than farmers. Their action leads to an increase in the food
production as compared to cars. Consequently the price of land rises,
while capital becomes cheaper. In the end owners of capital gain and
owners of capital lose.
Exercise 4:
Suppose relative price of food in terms of manufactures rises, what
changes occur in the domestic distribution of income?
Exercise 5:
Suppose a country is a net exporter of manufactures and a net importer of
food. Capital is specific to the manufacturing industry, land is specific to
agriculture and labour is the mobile factor.
Who will lobby for trade restrictions: the capital owners, the land owners,
industry workers or farmers?
Exercise 6:
Why, according to the Specific Factor Model, the slope of the economy’s
allocation of labour line is always equal to –1?
B. PROBLEMS
Problem 1:
There are two goods obtained in a country: food and steel. Food is
produced using labour and land, while steel is produced using labour and
capital. Thus, labour can be used in either sector, while land and capital
are both specific factors that can be used only in the production of one
good.
For a given capital supply, the production function for steel is:
q s = 2 ⋅ x LS , where x LS stands for the labour input for steel.
Also, for a given land supply, the production function for food is:
q F = x LF , where x LF stands for the labour input for food.
Assuming that there are 16 workers in total in the whole country:
a. Graph the production functions for steel and food, respectively;
b. Determine and graph the economy’s allocation of labour;
c. Determine and graph the production possibility frontier;
d. Explain why the production possibilities frontier is a curve (and not a
line, as in the Ricardian model).
Problem 2:
With reference to problem 1, suppose that the proportion of steel and
food prices is PS:PF = 2. The price of food is 400 USD/tonne.
Determine:
a. The price of steel;
b. The quantities produced in both sectors (steel and food);
c. How the labour is allocated between the two sectors;
d. The wage rate in this economy.
Trade Theory
Problem 3:
With reference to problem 2, explain the changes that occur in the
quantities produced in both sectors (steel and food), in the allocation of
labour and in the wage rate, if the price of food rises by 10% and the
price of steel rises by 20%.
Show these changes in the four-quadrant diagram.
C. ANSWERS
Answer to Problem 1: b. the economy’s allocation of labour is described

by the following curve: x LS = − x LF + 16 ; c. the production possibilities
frontier is given by the following curve: q F = 2 ⋅ 16 − q S2
Answer to Problem 2: a. the price of steel is PS = 800 USD/tonne; b. the

quantity of steel is q S = 2 2 tonnes (approximately 2.83 tonnes) and the
quantity of food is q F = 4 2 tonnes (approximately 5.65 tonnes); c.
there are 8 men-months in the food industry and also 8 men-months in the
200
steel industry; d. the wage rate in this economy is USD
2
(approximately USD 141. 42).
Answer to Problem 3: the quantity of food decreases to 5.4 tonnes,

while the quantity of steel rises to 2.95 tonnes; the quantity of labour
decreases in the food industry to 7.3 man-month and it increases in the
steel industry to 8.7 man-month; the new wage rate will be approximately
USD 162.73, showing thus in increase by approximately 15%.
3. The Heckscher – Ohlin Model
A. EXERCISES
Exercise 1:
Is factor abundance an absolute notion or a relative one? How do you
define a labour abundant country?
Exercise 2:
If Home is labour abundant compared to Foreign and labour and capital
are the only factors of production, in which factor is Foreign abundant?
Explain.
Exercise 3:
If, given two goods having different production functions and two
factors, one product is intensive in one factor, can one be sure that the
other good is intensive in the other factor? Explain your answer.
Exercise 4:
Suppose a two-factor economy (with labour and terrain) producing two
goods, food and cloth. Food is terrain intensive, while cloth is labour
intensive. How will the land owners react to an import tariff on cloth?
Exercise 5:
How can factor constraint(s) affect the shape of the production
possibilities curves? Compare the Specific Factor Model to the
Heckscher-Ohlin Model.
Exercise 6:
Why the equalization of factor prices never totally happens in reality?
Exercise 7:
What is the Leontieff paradox? Does it prove that the Heckscher-Ohlin
Model is wrong? Explain.
Trade Theory
Exercise 83:
Comment upon: “The world’s poorest countries cannot find anything to
export. There is no resource that is abundant – certainly not capital nor
land, and in small poor nations not even labour is abundant”.
Exercise 9:
In a situation in which Romania has scarce resources relative to the
European Union in producing cars, discuss the impact of removing trade
barriers in car industry for:
a. Romanian car buyers;
b. Romanian car industry owners;
c. Romanian car industry workers;
d. Romanian oil industry owners.
B. PROBLEMS
Problem 1:
Two goods (cloth and steel) are produced using two factors of production
(labour and capital – L and K, respectively). The production functions for
the two goods are given in the table below:
K (units) L (units)
Steel 20 10
(1 tonne)
Cloth 5 4
(100 metres)
Identify the good that is intensive in labour and the good that is intensive
in capital. Explain how you came to this conclusion.
3
Krugman, P., Obstfeld, M. – International Economics. Policy and Trade (Second
Edition), HarperCollins Publishers, New York, 1991, p. 85
Problem 2:
With reference to problem 1, a country is endowed with 600 units of
labour and with 1000 units of capital. Determine and graph the
production possibilities frontier for this country, on the basis of capital
and labour constraints.
Problem 3:
With reference to problem 2, what changes occur with respect to the
supply of steel and cloth if the domestic labour endowment increases
from 600 units to 700 units? (Rybczynski Effect)
Problem 4:
With respect to problem 1, suppose that the price of cloth is USD 50,
while the price of steel is USD 140.
Determine the wage and rent rates that make possible the simultaneous
production of both goods.
If the price of cloth increases by 8%, how will the wage and rent rates
alter? (Stolper – Samuelson Effect)
Problem 5:
Suppose that Home (domestic economy) has 100 million workers and
300 million acres of land, while Foreign (foreign economy) has 500
million workers and 1000 million acres of land. There are two goods
produced in each economy: food and cloth. Both goods require land and
labour, as follows:
Land (units) Labour (units)

Food (1 tonne) 10 40
Cloth (100 metres) 8 50
Which good will Home tend to export? Discuss your answer.
Problem 6:
With reference to problem 5, graph the production possibilities frontiers
for both Home and Foreign.
Trade Theory
Problem 7:
With reference to problem 5, suppose that prices of goods before trade
are those given in the table below:
Home Foreign
Food price (USD) 180 288
Cloth price (USD) 200 240
Also suppose that after specialisation and trade the prices of goods will
be USD 242 for food and USD 220 for cloth.
How will the wage and rent rates evolve in both economies after
specialisation and trade? Explain this evolution.
Also comment upon the changes in income distribution that occur in both
economies after specialisation and trade.
C. ANSWERS
Answer to Problem 1: steel is capital intensive and cloth is labour

intensive, because steel requires more units of capital per unit of labour
(4) compared to cloth (2.5).
Answer to Problem 2: the production possibilities frontier is given by

the equation below:
−0.25 ⋅ qC + 50 , qC ∈ [0,43.4 )
PP = 39.1325 , q C = 43.4
−0.48 ⋅ qC + 60 , q C ∈ [43.4,200 )
Answer to Problem 3: the new production possibilities frontier will be:
−0.25 ⋅ qC + 50 , q C ∈ [0,133.33)
PP = 16.66 , q C = 133.33
−0.4 ⋅ q C + 70 , qC ∈ [133.33,175)
The quantity of cloth rises to 133.33 units and the quantity of steel
decreases to 16.66 units.
Answer to Problem 4: the wage rent is USD 10 and the rent rate is USD
2; after the cloth price increase, the wage rate will be USD 12.6 and the
rent rate will be USD 0.664.
Answer to Problem 5: Home will tend to export cloth (the labour

intensive good), as it is labour abundant.
Answer to Problem 7: the Home wage rate, before trade, is USD 3.11,
while the rent rate is 5.55; the Foreign wage rate, before trade, is 0.53,
while the rent rate is 26.67; after trade the wage rate becomes 1.467 and
the rent rate becomes 18.332.
Trade Theory
4. The Standard Trade Model
A. EXERCISES
Exercise 1:
What does the slope of isovalue line mean?
Exercise 2:
Why, in autarchy, must production and consumption lie on the same line?
Exercise 3:
What does “terms of trade” mean?
Exercise 4:
When one’s country terms of trade improve, what can you state about that
country’s change in welfare?
Exercise 5:
Why does the production possibility frontier shift out more in one
direction than in the other?
Exercise 6:
What are export-biased and import-biased growths?
Exercise 7:
What happens to a country’s terms of trade when there is a domestic
export-biased growth?
Exercise 8:
Define can immiserizing growth.
Exercise 9:
When can immiserizing growth occur?
Exercise 10:
Why does transfer of income not affect relative supply?
Exercise 11:
Suppose country A has a higher marginal propensity to spend on food
than country B. Country A exports food while country B exports cloth. If
country A grants a loan to country B, how will the donor’s terms of trade
change?
Exercise 12:
Define the Metzler’s paradox.
B. PROBLEMS
Problem 1:
Suppose a country’s production possibilities frontier is defined by the
equation below:
f ( x) = − x 2 − 33 ⋅ x + 720 ,
where f (x) is the quantity produced of good Y, and x stands for the
quantity produced of good X.
How many units of good Y will the country manufacture assuming full
allocation of resources and a 5 units’ production of good X?
What is the price ratio ( PX PY )4 for the above-mentioned quantities
produced? Determine the corresponding isovalue line.
What is the total domestic output when PY is EUR 10?
Problem 2:
With reference to problem 1, suppose the relative price of good X rises
from 43 to 53. What changes will there be in the country considered
above with reference to the quantities produced of good X and Y and,
assuming constant PY, to domestic output?
4
PX is the price of good X and PY is the price of good Y.
Trade Theory
Problem 3:
With reference to problem 1, how much will the production of Y and the
price ratio change, knowing that the production of X rises from 5 to 8?
Problem 4:
With reference to problem 1, suppose an indifference curve defined as
follows:
387
h( x ) = + 484 ,
x
where x ∈ (0, ∞) and h(x) is the quantity consumed of good Y, while x is
the quantity consumed of good X.
Supposing PX PY = 43, determine the quantities consumed of each good.
Is the country in question autarchic or is it opened to international trade?
Comment your answer.
Problem 5:
With reference to problems 2 and 4, for a rise in relative price of X from
43 to 53, determine the new indifference curve and the changes that occur
in the country’s trade flows. Comment upon these changes.
C. ANSWERS
To Problem 1: 530 units of Y; price ratio is 43; isovalue line is

VV ( x ) = −43 ⋅ x + 745 ; total domestic output is EUR 7,450.
To Problem 2: production of X rises from 5 to 10 units; production of Y

decreases from 530 to 290 units; domestic output rises from EUR 7,450
to EUR 8,200.
To Problem 3: production of Y decreases from 530 to 392 units; the

relative price of X rises from 43 to 49.
To Problem 4: the quantity consumed of good X is 3 units and the

quantity consumed of good Y is 613 units; the country in question is
opened to international trade and it exports 2 units of X and imports 83

units of Y.
To Problem 5: the new indifference curve will be

387
h1 ( x) = + 484.918 ; the curve moves to the right, meaning an
x − 0.918
improvement in welfare; the exports of X will rise from 2 to 6.382 units,
and the imports of Y will rise from 83 to 338.25 units.
Trade Theory
5. The New Trade Theory
A. EXERCISES
Exercise 1:
Define economies of scale.
Exercise 2:
What is the difference between internal economies of scale and external
economies of scale?
Exercise 3:
On what does the gap between the marginal revenue and price depend,
for a monopolistic firm?
Exercise 4:
Why, for a monopolistic firm, does the marginal revenue curve always lie
below the demand curve?
Exercise 5:
Explain mathematically why – when the average costs are a decreasing
function of output – marginal cost is always less than average cost (hint:
use an example, say from problem 3).
Exercise 6:
What is intraindustry trade?
Exercise 7:
When does intraindustry trade occur? Compare it to interindustry trade.
Exercise 8:
Suppose that two countries produce and mutually exchange office
machines. Does this mean that none of them has any comparative
advantage in office machines at all?
Exercise 9:
What conditions must be met in order for international dumping to occur?
Exercise 10:
What is reverse dumping?
Exercise 11:
What is reciprocal dumping?
Exercise 12:
How can external economies of scale in one country hamper domestic
production and trade in another country that could potentially produce the
goods more cheaply? Could “external economies” become an argument
for protection? Is it any different from the “infant industry” argument?
Exercise 13:
What is the learning curve? In which sense is it different from “ordinary”
economies of scale?
B. PROBLEMS
Problem 1:
For a monopolist, the reverse demand curve is:
p D (q ) = −10 ⋅ q + 10,000 .
When the quantity produced is 30 units, determine the gap between the
price and the marginal revenue5.
Problem 2:
Derive a firm’s linear cost function knowing that its fixed costs are USD
50,000, while its marginal costs are always equal to USD 1,000.
Why is the value of marginal costs a constant?
Would it be possible for it to depend on quantity? Explain.
5
Note: the price is given in EUR, and the quantity in units.
Trade Theory
Problem 3:
With respect to problem 2, derive the average cost function.
Problem 4:
With respect to problems 1 and 2, determine the profit maximizing
quantity, as well as the corresponding gap between price and marginal
revenue.
Problem 5:
Suppose good X is produced by a monopolistically competitive industry
in two countries: Home and Foreign.
Home sales ( S H ) are 23,040,000 units, while Foreign sales ( S F ) are
6,553,600 units.
The demand curve facing any producer of good X from both Home and
Foreign is described by the equation below:
⎡1
X = S ⋅⎢ −
1
( ⎤
⋅ P−P ⎥, )
⎣ n 16,646,400 ⎦
Where:
- X stands for the firm’s sales;
- S stands for the total sales of the industry;
- n is the number of firms in the industry;
- P6 is the price charged by the firm itself;
- P is the average price charged by its competitors.
The cost function for this industry is described by the following equation:
C ( X ) = 104,040,000 + 20,000 ⋅ X ,
where C stands for the total firm’s cost and X stands for the total firm’s
sales.
a. Derive the average cost function;
b. Determine the number of firms in each country before trade;
6
Note: the prices are given in EUR.
c. Determine a firm’s average cost and the price in each country before
trade;
d. Assuming trade breaks out between Home and Foreign, calculate the
changes in price, number of firms and average costs that occur in the
industry analyzed;
e. Does trade make consumers in both countries better off? Explain.
f. Is trade beneficial to producers of good X in both countries? Explain.
g. Can you state how the production in the integrated market will be
shared between the two countries? Comment upon your answer.
Problem 6:
A manufacturer can get EUR 100 for each product sold domestically and
EUR 80 for each product sold abroad. Suppose domestic sales rise to
EUR 9,000, while foreign sales go up to EUR 5,600. If the manufacturer
wants to expand his sales on either market by 1 unit, he will have to
reduce the respective prices by EUR 1.
Where will he be interested in selling more: on the domestic market or
abroad? Explain.
What would change if the value of foreign sales were EUR 4,800?
C. ANSWERS
To Problem 1: the gap is EUR 300.
To Problem 2:
C (q) = 1,000 ⋅ q + 50,000
50,000
To Problem 3: AC (q) = 1,000 + , for q > 0
q
To Problem 4: the profit maximizing quantity is 450 units; the gap

between price and marginal revenue is USD 4,500.
Trade Theory
To Problem 5:
104,040,000
a. AC ( X ) = + 20,000 , for X > 0 ; b. 1,920 firms Home and
X
1,024 firms Foreign; c. for Home, the average cost is equal to price and it
rises to EUR 28,670; for Foreign, the average cost is equal to price and it
rises to EUR 36,256.25; d. post trade price and post trade average cost are
EUR 27,650; the total post trade number of firms in this industry is 2,176.
To Problem 6: as long as both home and abroad he gets a marginal

revenue of EUR 9 for expanding his sales, he can sell one unit more
either home or abroad. If the value of foreign sales were EUR 4,800, the
foreign marginal revenue would be EUR 19, greater than the domestic
marginal revenue (EUR 9). Therefore, in this case, the manufacturer
would be more interested in expanding his foreign sales.
SECTION II: TRADE POLICY
1. Basic Tariff Analysis
A. EXERCISES
Exercise 1:
What is the difference between a “small” country and a “large” country in
basic tariff analysis?
Exercise 2:
If small countries do not gain from import tariffs, then why do they
restrict international trade?
Exercise 3:
What is the difference between a general equilibrium perspective and a
partial equilibrium perspective?
Exercise 4:
What is a prohibitive tariff?
Exercise 5:
Why is it necessary to determine the effective rate of protection?
Exercise 6:
Define consumer surplus and producer surplus.
Exercise 7:
How much will the domestic price increase when a country imposes a
tariff t?
Trade Policy
Exercise 8:
If the tariff on imported inputs is higher than the tariff on the final
commodity, does it necessarily mean that the domestic producer is
disadvantaged compared to a foreign producer?
Exercise 9:
On what does the effective rate of protection depend and in what sense?
Exercise 10:
For which values of effective rate of protection is the domestic industry
discouraged?
Exercise 11:
Define trade creation. How many kinds of trade creation are there?
Identify and define each of them.
Exercise 12:
Define trade diversion.
Exercise 13:
If after a customs union has been created a member state’s trade flows
increase, is it good or bad? Explain.
B. PROBLEMS
Problem 1:
For a small country analysed in partial equilibrium, the following
information is given:
- The free trade price is PW = ROL 1,000;
- The after tariff price is PT = ROL 1,200;
- The free trade domestic demand is DW = 80 thousand units;
- The after tariff domestic demand is DT = 60 thousand units;
- The free trade domestic supply is SW = 20 thousand units;
- The after tariff domestic supply is ST = 40 thousand units.
What is the level of the import tariff?

What happens to the quantity traded after the imposition of the import
tariff?
Indicate the changes in the consumers’ and producers’ surpluses. Also,
indicate the change in the government revenue after the introduction of
the import tariff.
Problem 2:
For a small country analysed in partial equilibrium, the following
information is given:
- The free trade price is PW = USD 100;
- The free trade domestic demand is DW = 15 thousand units;
- The free trade domestic supply is SW = 5 thousand units.
A specific import tariff is introduced allowing domestic producers to
satisfy the entire domestic demand. Yet, no exports are made.
After tariff the domestic demand drops by 50%. Suppose the price
elasticity of domestic demand is –2,
a. Determine the level of free trade imports;
b. Determine the level of the specific import tariff;
c. Quantify the welfare effects on domestic consumers and producers as
well as on the national government;
d. How much is the deadweight loss and to what is it due?
Problem 3:
Suppose a small country demand function is PD = - 40,000q + 2,000,000
and a small country supply function is PS = 40,000q + 600,000.
International trade negotiations lead to a decrease of the import tariff
from 20% to 10%. Assuming that the quantity imported before
negotiations is 5 (thousand units), calculate the net welfare effect
produced by the change in tariff.
Problem 4:
With reference to the demand and supply functions in problem 3, suppose
in 2003 the small country raises the import tariff by 10 percentage points.
Assuming that the world price is constant and equal to ROL 1,000,000
and before the tariff raise the quantity of imports was 10 (thousand units),
quantify the net welfare effect produced by the change in tariff.
Trade Policy
Problem 5:
A Romanian producer obtains a final commodity worth ROL 3,000,000.
50% of this value represents imported inputs. The nominal tariff on the
final commodity is 15% while the tariff on imported inputs is 10%.
Find the effective rate of protection (ERP) given to the Romanian
producer. Compare the level of the nominal protection with the level of
the effective protection and comment upon the difference.
Why knowing the nominal rate of protection is not enough, being thus
necessary to derive the effective rate of protection?
Problem 6:
With reference to problem 5, if imported inputs are liberalised, what
happens to the ERP?
Problem 7:
With reference to problem 5, how will the ERP change if the Romanian
producer changes the technology used and reduces the need for imported
inputs to 25% of the final commodity value?
Problem 8:
With reference to problem 5 again, if the tariff on the imported inputs
doubles, what happens to the ERP? Also, comment upon the situation in
which the tariff on imported commodities is higher than 30%.
Problem 9:
A domestic producer obtains a final commodity worth USD 100, using
several kinds of inputs. Thus, the value of the final commodity results
from adding the input values, as follows: V f = Vi1 + Vi 2 + Vi 3 + Vnational ,
where:
- V f is the value of the final commodity;
- Vi1 is the value of the first kind of input; this input is imported and is
USD 20 worth;
- Vi 2 is the value of the second kind of input; this input is also
imported and is USD 10 worth;
- Vi 3 is the value of the third kind of input; this input is bought from
domestic suppliers and is USD 30 worth;
- Vnational is the value added in the nation.
According to the domestic tariff schedule, the following tariffs are
imposed on imports:
- 20% for the final commodity;
- 10% for the first kind of input;
- 10% for the second kind of input;
- 5% for the third kind of input.
Calculate the ERP given to the domestic producer.
Show the changes in ERP if:
a. The domestic producer prefers to import the third kind of input;
b. The domestic producer prefers to import the third kind of input and it
is liberalised;
c. The domestic producer imports only the first kind of input, while the
other inputs are bought from domestic suppliers.
d. All imports are liberalised.
Problem 10:
For producing a final commodity USD 500 worth imported inputs USD
100 worth are required. If the tariff on the final commodity is 20%
determine the limits for the tariff on imported inputs so that the domestic
producer is not disadvantaged compared to a foreign producer.
Problem 11:
Suppose a large country domestic demand function is PD = −0.8 ⋅ q + 26
and a large country domestic supply function is PS = 0.6 ⋅ q + 7 (The
quantity is given in million tonnes).
A specific import tariff of USD 4 will increase the domestic price from
USD 10 (the free-trade price) to USD 12.
a. Explain why the domestic price does not rise to USD 14;
b. Calculate the changes in the consumers’ surplus, producers’ surplus
and in the government revenue;
c. Calculate the net welfare effect and comment upon it being positive
or negative.
Trade Policy
Problem 12:
Suppose three countries (A, B and C) manufacture good “X”, having the
costs set in the table below:
A B C
X 120 90 80
The demand in country A is satisfied by a single supplier country (the one

with the lowest price).
a. Is a non-discriminatory 50% tariff imposed by country A a non-
discriminatory one? Why?
b. Suppose A and B form a customs union, maintaining the 50% tariff
on imports from C. What changes occur in country A’s trade flows?
What trade effect can you identify?
c. Also suppose that a customs union has been created between A and B
and the external tariff gets down to 5%. What trade effect do you
encounter in this case? Explain.
d. Using the costs above, build an example showing the trade diversion
effect.
C. ANSWERS
Answer to Problem 1: the tariff rate is 20%; the imported quantity

decreases from 60 thousand units to 20 thousand units; the consumers
lose ROL 14 million, while the producers and government gain ROL 6
million and ROL 4 million, respectively.
Answer to Problem 2: a. the free trade imports rise to 10 thousand units;

b. the specific import tariff is USD 25; c. the consumers lose USD
312,500, while the producers gain USD 187,500; the domestic
government does not gain anything, as the new tariff is a prohibitive one;
d. the deadweight loss is USD 125,000.
Answer to Problem 3: the welfare gain is equal to 250 million monetary

units.
Answer to Problem 4: the welfare loss is equal to 250 million monetary

units.
Answer to Problem 5: the effective rate of protection is 20%.
Answer to Problem 6: the effective rate of protection is 0%.
Answer to Problem 7: the effective rate of protection is 16.67%.
Answer to Problem 8: the effective rate of protection is 10%; if the tariff

on imported commodities is higher than 30%, the effective rate of
protection is negative.
Answer to Problem 9: the effective rate of protection is 42.5% and a.

38.75%; b. 42.5%; c. 45%; and d. 0%, respectively.
Answer to Problem 10: it can range between 0% and 100%.
Answer to Problem 11: the consumers’ surplus decreases by USD 37.5

million, the producers’ surplus increases by USD 13.3 million and the
government revenues increase by USD 36.8 million; there is a positive
net welfare effect of USD 12.6 million, which is possible for a large
country.
Answer to Problem 12: a. yes, country A does not import at all; b.

internal trade creation effect – A starts to import from B, which is a
customs union member; c. external trade creation effect – A starts to
import from C, an outside country, due to a reduction in external import
tariff rate.
Trade Policy
2. Other Instruments of Trade Policy
A. EXERCISES
Exercise 1:
If, compared to a tariff, an import quota or a voluntary export limit does
not bring money to the state budget, then why do governments use these
instruments?
Exercise 2:
Can an import quota have an ambiguous net welfare effect on the country
imposing it? Discuss.
Exercise 3:
Why does a nation “voluntarily” accept to restrict its exports?
Exercise 4:
Should Home be glad that Foreign subsidizes its exports? Discuss.
Exercise 5:
Does the use of export subsidies produce different welfare effects than
dumping? Why?
Exercise 6:
A government is considering assisting one of its increasing cost industries
and one of its decreasing cost industries. From the international trade
implications, which should it assist and why?
Exercise 7:
Consult recent economic newspapers and identify the following issues:
a. 5 reports with international trade content;
b. Importance of each report's news for the Romanian economy.
Exercise 8:
Present arguments for and against optimal tariff, market failure, infant
industry, income policy.
B. PROBLEMS
Problem 1:
In a small country the domestic demand function is
p D (q ) = −0.05 ⋅ q + 150 and the domestic supply function is
p S (q ) = 0.1 ⋅ q + 50 . The quantity is given in thousands of tonnes and the
price is given in USD.
Determine the level of the import quota that would have the equivalent
effect to a 10% import tariff applied to a free-trade price of USD 100.
Problem 2:
With reference to problem 1, determine the consumers’ loss, the
producers’ gain and the importer’s rents corresponding to the introduction
of the above-mentioned import quota.
What can you state as to the net welfare effect?
What differences are there between the impact of an import tariff and the
impact of an import quota?
Why would a government prefer an import quota instead of an import
tariff?
Problem 3:
Given a small country with the national demand curve and the national
supply curve defined in problem 1, suppose that the national government
negotiates a voluntary export restraint (VER) with the rest of the world.
Thus, the foreign exports to the small country cannot exceed 200
(thousand tonnes). Assuming that the free-trade price is USD 100:
a. Determine the domestic price after the introduction of the VER;
b. Determine the changes in the quantities produced, consumed and
imported in the small country;
c. Show who gains and who loses as the result of the VER and calculate
the welfare effects for each winner and loser;
d. Determine the net welfare effect and compare it to the net effect of a
tariff and of an import quota.
Trade Policy
Problem 4:
In a small country the domestic supply curve is p S (q ) = 0.25 ⋅ q + 7,500
and the domestic demand curve is p D (q ) = −0.25 ⋅ q + 15,000 .
The quantity is given in number of units and the price is given in EUR.
When the world price is EUR 10,000 the imported quantity is 10,000
units. The domestic government decides to grant a subsidy worth EUR
500 per unit to the domestic producers.
a. Show the evolution of the domestic price, of the domestic supply and
demand, and the evolution of imports;
b. What will the total amount of subsidies be?
c. How will the producers’ surplus change? What about the consumers’
surplus?
d. Calculate the net welfare effect resulted after the introduction of a
domestic subsidy and comment upon it.
Problem 5:
In a small country, when the world price is EUR 5,000 the domestic
supply equals 60,000 tonnes. The government grants a unit subsidy worth
500 EUR/tonne within a subsidization programme worth EUR 32.5
million.
Identify the change in the domestic supply and calculate the welfare
effects produced by the domestic subsidy.
Problem 6:
In a small country the domestic supply curve p S (q ) = 0.2 ⋅ q + 8,000 is and
the domestic demand curve is p S (q ) = −0.1 ⋅ q + 24,000 .
The quantity is given in units. If the world price is EUR 20,000, how
much will the domestic producers export?
Problem 7:
With reference to problem 6, suppose the government introduces a unit
export tariff of EUR 1,000.
a. Will the world price change? What about the domestic price?
b. Who gains and who loses after the introduction of the export tariff
and how much?
c. Why would a small country use export tariffs?
Problem 8:
With reference to problem 6, suppose the domestic government
introduces an export subsidy of 10%.
a. Will the world price change? What about the domestic price? Explain
the price evolutions.
b. Identify the winners and losers of this government measure and
quantify the welfare effects.
Problem 9:1
In a one-period game in strategies CC and ~C~C, the payoffs to countries
A and B are as follows:
CC ~C~C
CC (4,2) (5,4)
~C~C (3,7) (2,1)
Determine whether there is equilibrium to this game. If there is, what is it

and why? If not, why does none exist? Prove your answer.
Problem 10:
In an infinite-period game in strategies CC and ~C~C, A's payoffs in each
period are as follows (B's are symmetric, so that B makes the same
calculation):
CC ~C~C
CC 1024 200
~C~C 1600 576
a. Calculate the interest rate that would make CC equilibrium in this

game.
b. Is CC the only equilibrium to this game? Prove your answer.
1
Problems 9 and 10 are presented in Kwoka, John E. Jr., "Course on Industrial
Organization", manuscript, George Washington University, Fall 1995.
Trade Policy
C. ANSWERS
Answer to Problem 1: 200 thousand tonnes.
Answer to Problem 2:
the consumers’ loss is USD 9,000,000; the producers’ gain is USD
5,500,000, the importers’ rents are USD 2,000,000. The net welfare effect
cannot be determined accurately using solely the information provided so
far.
Answer to Problem 3: a. the domestic price will be USD 110; b. the

domestic production will rise by 100 thousand units, the domestic
consumption will decrease by 200 thousand units and the imported
quantity will decrease by 300 thousand units; c. the consumers lose USD
9,000,000, the producers gain USD 5,500,000, while the foreign
exporters gain USD 2,000,000 d. the net welfare effect is a loss of USD
5,500,000.
Answer to Problem 4: a. the domestic price will remain the same (EUR
10,000); b. the domestic supply rises from 10,000 units to 12,000 units;
the domestic demand remains constant (20,000); the imports decrease
from 10,000 units to 8,000 units; c. the total amount of subsidies is EUR
6,000,000; d. the consumers’ surplus will not change, while the
producers’ surplus will rise by EUR 5,125,000; the net welfare effect is a
loss of EUR 875,000.
Answer to Problem 5: the domestic supply rises from 60,000 tonnes to

65,000 tonnes; the domestic producers gain USD 31,250,000, making
thus the net welfare loss USD 1,125,000.
Answer to Problem 6: 20,000 units.
Answer to Problem 7: a. the world price remains the same but the
domestic price decreases by EUR 1,000 (becoming thus equal to EUR
19,000) b. the consumers gain EUR 45,000,000, the producers lose EUR
67,500,000 and the government gains EUR 5,000,000; the net welfare
loss in the country is EUR 17,000,000.
Answer to Problem 8: a. the world price remains the same, while the
domestic price rises to EUR 22,000; b. the consumers lose EUR
60,000,000, the producers lose EUR 130,000,000 and the government
loses EUR 100,000,000; the net welfare loss becomes EUR 30,000,000.
Answer to Problem 9: A has a dominant strategy of CC, since its

payoffs to CC are both greater that the corresponding payoffs to ~C~C. B
does not have a dominant strategy since ~C~C is better if A goes CC, but
CC is better if A goes ~C~C.
There is still equilibrium since A will pick CC, and B knows A will pick
CC, so that B should pick ~C~C. Therefore, the equilibrium is (CC,
~C~C) = (4,2).
Answer to problem 10: a. CC produces an infinite series of payoffs of

1024, with a present value of 1024 + 1024/r.
~C~C results in 1600 + 576/r.
CC is rational for any r < 448/576 = .78.
Trade Policy
3. Review Questions
A. LOW-DIFFICULTY QUESTIONS
Define the concept of strategic trade policy.
Derive and explain the import demand curve and the export supply curve.
Describe: the infant industry argument; the strategy of IS

industrialization; economic dualism.
Describe the elements of a game of strategy in normal form.
Effects of a tariff.
The concepts of consumer and producer surplus. Do they accurately

measure the costs and benefits of trade policy?
Explain: market failures; marginal social benefit; theory of the second

best; collective action.
Give an example of paired transactions in the balance of payments.
Non-tariff barriers to trade.
Present briefly the following trade policy instruments: local content

requirement; export credit subsidies; national procurement; red-tape
barriers; voluntary export restraints.
Provide examples of preferential trading agreements. Discuss their

particularities.
Symptoms of dualism.
Tariff barriers to trade.
The national income accounts.

B. MEDIUM-DIFFICULTY QUESTIONS
Costs and benefits of a tariff.
Describe the following strategic structures: symmetric PD game; PD vs.

Chicken-Stag Hunt game.
Discuss the following argument advocating strategic trade policy:

"Industries are desirable if they have high value added per worker."

"Industries are desirable if they pay high wages."

"Industries are desirable if they make use of high technology."
Discuss the market failure argument against free trade.
Discuss the terms of trade argument of a tariff and a subsidy.
Dual labor markets and trade policy.
Effects of a customs union: trade creation and trade diversion.
Effects of alternative trade policies.
Effects of economic sanctions on exports.
Effects of export subsidies and import quotas.
Gains from free trade: economic and political arguments.
Industry experiences with strategic trade policies (steel, aircraft, semi-

conductors).
Market failure justifications for infant industry protection.
National experiences with strategic trade policies (Japan, France, U.S.A.).

Trade Policy
Politics and the case for free trade.
Present the logic for trade negotiations in games like PD, Chicken and
Stag Hunt.
Problems with the infant industry argument.
Saving and the current account.
Strategic structures of two-firm competition.
The national income identity for an open economy.
The origin and working of the Common Agricultural Policy.
The Uruguay Round of trade negotiations.
Trade effects of the Single European Act.
Why might IS industrialization be more successful in large developing

countries such as Brazil than in smaller nations such as Ghana?
WTO and multilateral trade negotiations.
C. HIGH-DIFFICULTY QUESTIONS
The balance of payments accounts.
Basic economics of economic sanctions (trade elasticity and success

factors).
Compare a tariff and a quota in the presence of monopoly.
Discuss the preference orderings for a small country and a large country
in trade negotiations.
Do government budget deficits worsen the current account?

Do you agree that import restrictions would necessarily reduce a current
account deficit?
Imperfect competition and strategic trade policy.
Problems with and success factors of trade strategies in developing

countries.
Prove that the optimum tariff is positive.
Tariff analysis in general equilibrium.
Technology and strategic trade policy.

SECTION III: RESEARCH GUIDE
1. Trade Integration
A. EXTERNAL OPENNESS
Openness of economy: The sum of merchandise exports and imports as a

share of Gross Domestic Product (GDP). Alternative measures include
the ratio of exports to domestic sales or imports to domestic consumption.
The index of effective exposure (the IEE index): The index measures
the share of a firm’s revenues and costs exposed to exchange rate shocks.
The exposure of a sector or a commodity to exchange rates is derived
both through reliance on imported inputs production and through sales to
external markets1. The estimated form of the IEE index is the following:
IEE i,t ≡ χ i,t −

∑ j m j,t p j,t qij,t
∑ j p j,t qij,t
Where
- i ≡ the commodity index;
- j ≡ the input index, j=1,…n;
- t ≡ the time index;
- χ i,t ≡ share of exports in total sales of commodity i in period t;
- m j ,t ≡ share of imports in domestic consumption of commodity j in
period t;
- pi,t , qij ,t ≡ total expenditure on input j in production of i in period t.
1
Goldberg, Linda S. “Measuring external openness: the index of effective exposure”,
C.V. Starr Center for Applied Economics, New York, 1990.
When there are no imported inputs into production, the sectoral level of
exposure is identical to the traditionally used export to production ration.
IEEi,t equals zero either when there is no exposure of sector i through
imports or exports, or when the sales exposure equals the input exposure.
When IEEi,t takes on positive values, it can be stated that production of
commodity i has net export exposure; when IEEi,t takes on negative
values, it can be stated that production of commodity i has net import
exposure.
B. TRADE DEPENDENCE
Major export category: Major exports are those that account for 50
percent or more of total exports of goods and services from one category.
If no single category accounts for 50 percent or more of total exports, the
economy is classified as diversified.
Index of concentration (the H index or Hirschman concentration

index): The geographical concentration of a nation’s trade depends on the
number of countries with which it trades and on the more or less equal
distribution of its trade among these countries2.
n 2 n
⎛ ak ⎞ 100
H geo = ∑ ⎜⎜
⎝ A
100 ⎟⎟ =
⎠ A ∑ ak 2
1 1
where ak are the imports (exports) from (or to) the other countries, and
n
∑a1
k = A.
When a country’s trade is completely monopolized by another country,

the value of the index is 1002/2 = 100. The index would assume the value
of zero if we had an infinite number of countries possessing each an
infinitely small share in the trade of the country examined.
2
Hirschman, A.O. “National Power and the Structure of Foreign Trade”, Berkeley:
University of California Press, (1945), 1980, 98-101, 157-162.
Research Guide
Index of preference (the R index): The index computes the degree of

preference of the imports of a country X for the other countries3.
U . A.
R= ⋅ 100
W . A.
Where:
- U.A. or the “un-weighted average of the shares” is:
1 ⎛ i1 i i ⎞
U . A. = ⋅ ⎜⎜ + 2 + L + n ⎟⎟ ⋅ 100 ;
n ⎝ E1 E 2 En ⎠
- W.A. or the “weighted average of the (percentage) shares” is
i1 i i
⋅ E1 + 2 ⋅ E 2 + L + n ⋅ E n
E E2 En
W . A. = 1 ⋅ 100 =
E1 + E 2 + L + E n
i1 + i2 + L + in
= ⋅ 100 ;
E1 + E 2 + L + E n
- E1, E2,…, En denote the total amounts of exports of the various
countries with which X trades;
- i1, i2,…, in denote the various amounts of imports taken by country X
from these countries.
If both averages are equal, and the index consequently is equal to 100, the
relative distribution of X’s trade indicates no preference for either small
or large countries. If the index rises above 100, this implies that, on the
whole, higher percentages are secured in the smaller trading economies
(high percentages associated with small trade totals); and if it falls below
100, higher percentages are secured in the larger trading countries.
If a Country stands for X, the weighted average of the percentage shares
which she holds in the total exports of other countries is simply the share
she occupies through her imports in the exports of all other countries
lumped together.
3
Idem, 88-89, 155-156.
Trade intensity (the T coefficient of trade intensity)4: This coefficient

helps in analyzing the determinants of bilateral trade flows. For two
regions, i and j:
X ij X.j
Tij = :
X i. X ..
Where:
- Xij = region i’s exports to region j;
- Xi.= region i’s total exports;
- X.j= region j’s total imports;
- X..= total world exports (imports).
The ratio of Xij/Xi. measures region j’s share in region i’s total exports,
while the ratio of X.j/X.. measures region j’s share in total world imports.
When T equals one, the region j’s share in region i’s exports equals the
region j’s share in total world imports, or the region j’s average share in
all regions’ exports. When T>1 (<1), the commercial link between i and j
is superior (inferior) that times against the average (than does the world
as a whole). Other way to say it is that the intensity is greater (less) than
expected given their share in total world imports.
Indebtedness: Standard World Bank definitions5 of severe and moderate

indebtedness - severely indebted means either of the two following ratios
is above critical levels: present value of debt service to Gross National
Product, GNP (80 percent) and present value of debt service to exports
(220 percent); moderately indebted means either of the two ratios exceeds
60 percent of, but does not reach, the critical levels. For those not-debt-
statistics-reporting economies, another methodology refers to the
following classification: severely indebted means three of four following
4
Developed and used by Yamazawa, Ippei. “Structural Changes in World Trade Flows”,
in Hitotsubashi Journal of Economics, 11(2) (1971): 11-21, and Drysdale, P. and R.
Garnant, “Trade Intensities and the Analysis of Bilateral Trade Flows in a Many-Country
World: A Survey”, in Hitotsubashi Journal of Economics, 22(2) (1982): 62-84.
5
The World Bank. Trends in Developing Economies 1993. Waschington D.C., 1993.
Research Guide
ratios are above critical levels: debt to GNP (50 percent), debt to exports
(275 percent), debt service to exports (30 percent), and interest to exports
(20 percent); moderately indebted means three of the four ratios exceed
60 percent of, but do not reach, the critical levels.
2. Specialization
A. COMPARATIVE ADVANTAGE
Revealed comparative advantage (RCA): Comparative advantage is

usually specified with respect to pre-trade relative prices, whereas
empirical researchers in international economics confront trade data
generated by trade flows in post-trade equilibrium. It is mainly this
difficulty, which led to the notion of “revealed comparative advantage” in
empirical research. 6
Net exports/total trade ratio (Nxij): The measure expresses net exports
of commodity j as a percentage of total trade in commodity j, for country
i. The ratio is defined formally as:
X ij − M ij
Nxij = ⋅ 100
X ij + M ij
Where:
- Xij country i’s exports of commodity j;
- Mij country i’s imports of commodity j.
Net imports are indicated by a negative sign. The measure yields ratios
ranging from +100, where a commodity is exported but not imported, to -
100, where a commodity is imported but not exported. A positive sign
does not necessarily indicate RCA; nor does a negative sign necessarily
suggest revealed comparative disadvantage (RCD). However, an increase
in the ratio may be taken as a likely indication of some strengthening of
RCA.
6
Balassa, B. - Comparative Advantage, Trade Policy, and Economic Development. New
York: NYUP, 1989. and Ariff and Hill
Research Guide
Export performance ratio (Epij): The measure expresses the share of

country i’s export of commodity j in total world exports of commodity j,
as a ratio of the share of country i’s total exports of manufactures in the
world total exports of manufactures. The ratio is defined formally as:
X ij X im
E pij = :
X wj X wm
Where:
- Xwj world exports of commodity j;
- Xim country i’s total manufactured exports;
- Xwm world total exports of manufactures;
An export performance ratio of one suggests “normal” export

performance of commodity j relative to the size of country i as an
exporter of manufactures. By the same token, an Epij of two indicates that
the commodity j’s share in country i’s exports is twice the corresponding
world share. An export performance ratio of more than unity is usually
taken as an indication of RCA, while a rise in the ratio supposedly
suggests a strengthening in terms of RCA.
Export specialization ratio (Esij): The measure is based on the ratio of

the share of a commodity in total merchandise exports of a country, to the
commodity’s share in world merchandise exports. It is an indication of
the extent of commodity specialization in a country’s exports relative to
that of other exporting countries.
X ij X wj
E sij = :
Xi Xw
Where:

- Xi country i’s total merchandise exports;
- Xwj world exports of commodity j;
- Xw world total of merchandise exports.
An index exceeding unity, or one which is increasing, is a priori evidence

of some RCA or particular policy interventions to facilitate exports, or
both.
Statistical analysis: Simple coefficients of variation, correlation, and

regression are used to explain RCA characteristics. They give measures
of the diversification profile of exports in time or relative to other
countries or products.
Contribution to trade balance indicator:7 measures the comparative

advantage of a country/region in relation to other country/region. The
indicator compares, in thousandths of GDP, the trade balance recorded
for a product in relation to a theoretical trade balance that would exist if
there were no comparative advantage or disadvantage. The theoretical
balance (the case if there is no specialization) is calculated to a specific
product’s share of total trade. Without specialization, the trade balance
for a product should correspond to the product’s share of total trade. The
theoretical balance is obtained by multiplying the product’s percentage
share of total trade by the total trade balance. The difference between the
recorded and theoretical balances, expressed in thousandths of GDP, is
calculated as follows:
[
CTB = (X p − M p ) − (X − M ) ⋅
(X + M p )⎤ 1000
p
⋅
(X + M ) ⎥⎦ GDP
where Xp and Mp are exports and imports of product “p”
"Specialization" (comparative advantage) occurs when a country exports

a major part of its production. The "contribution to trade balance"
indicator is then positive. Conversely, there is "de-specialization"
(comparative disadvantage) when a country imports a major proportion of
a certain type of product in order to satisfy domestic demand. The
7
Allen, Tim. “Specialization of candidate countries in relation to EU”, Statistics in Focus,
EUROSTAT, 6/2001.
Research Guide
"contribution to trade balance" indicator is then negative. Thanks to this

indicator, it is possible to identify a country’s strengths and weaknesses
in relation to specific products and compare them with those of its
competitors.
An alternative measurement8, in thousandths of total trade:
⎡ x ik − mik x i − mi xik + mik ⎤
CTB = = ⎢ − ⋅ ⎥ ⋅1000
⎣ x i + mi x i + mi x i + mi ⎦
Where
- i = country;
- k= commodity (branch);
- x = exports;
- m=imports.
By definition, the sum of CTB over all commodities is zero. The

indicator is additive, thus the values of commodities can be aggregated to
the necessary level. In time, a more intense specialization is indicated
when RCA or RCD become more pronounced, and reduced specialization
is present when RCA or RCD decline.
Domestic resource cost (DRC):9 This indicator measures the cost in

domestic resources of labor and capital of earning a unit of foreign
exchange. DRC compare the value added in world market prices of some
branch with the domestic resources of labor and capital used to generate
the output concerned.
(Value added in domestic prices) i

DRC i =
(Value added in world market prices) i
where Value added is measured from the input-output tables as value of
output less the value of intermediate inputs used in production, evaluated
at domestic prices and world market prices, respectively.
8
UN/ECE. “Economic Survey of Europe”, vol. 1, 2002, 142.
9
Hare, P. and Fomin, P. – “Industrial Competitiveness in Romania”, in Economic
Systems (17:2), June 1993, 97-123, and Hughes, G. and Hare, P. – “The International
Competitiveness of industries in Bulgaria, Czechoslovakia, Hungary, and Poland”, Oxford
Economic Papers 46, 1994, 200-221.
For the numerator, one may also use the direct valued added (labor costs
+ capital costs), as shown in the input-output table.
An equivalent indicator is the short run measure of social profit (SPRS)

estimated as value added at world market prices per unit of sales at world
market prices.10
Low values of DRC correspond to the more competitive branches, and
high values correspond to uncompetitive branches of the economy. The
least competitive of all are those branches with negative value added at
world market prices.
B. TRADE STRUCTURE
Export similarity coefficient (the Finger-Kreinin similarity index,

XS): The ESC estimates the product or market similarity of exports
between two countries or groups of countries.11
⎛ X ij X kj ⎞
XS ik = ∑ min ⎜⎜⎝ X i ⋅100, X k ⋅100⎟⎟⎠ ,
j
Where:
- XSik is the market (or product) similarity coefficient between the
exports of i country group (or country) and that ones of the k group
(or country);
- Xij = i country exports to the j market (or for the j product);
- Xi = total manufactured exports from i country;
- Xkj = k country exports to the j market (or for the j product);
- Xk = total manufactured exports from k country.
10
Further analysis may include the medium term and long term measures by taking
account of the shadow costs of labor and capital. For details see papers in footnote 9 and
bibliography therein cited.
11
The coefficient was defined in Finger, J.M. and M.E. Kreinin, “A Measure of Export
Similarity and its Possible Uses”, The Economic Journal 89, December, 1979, and used
by ECE/UN, “The Relative Performance of South European Exports of Manufactures to
OECD Countries in the 1970s: An Analysis of Demand Factors and Competitiveness”,
Economic Bulletin for Europe, 34, 1982.
Research Guide
The coefficient for many n countries is given by the following measure:

⎛ X1 j X2j X nj ⎞
XS n = ∑ min ⎜⎜⎝ X 1 ⋅100, X2
⋅100, L ,
Xn
⋅100 ⎟
⎟
⎠
j
A coefficient equal to 100 indicates a perfect matched similarity, while a
value of zero shows completely different market (or product) structures.
The measure is also used to appraise a country’s structural change over
time12:
XS (a, b ) = min ( X ia , X ib ) ⋅100 ,

Where:
- XS (a, b ) is the similarity index between two export vectors a, and b;
- Xia is the share of commodity i in the total exports of a given country
in base year;
- Xib is the same share in a subsequent year.
It is assumed that the lower index value (higher dissimilarity) points to

more serious structural change in the country under consideration. The
lower the value of the index between two years the more dissimilar are
the two vectors and this is interpreted as a measure of structural change.
The values of the index range between one (identical structures) and zero
(completely dissimilar structures).
Cluster analysis:13 is a statistical technique for identifying relatively

homogeneous groups of cases according to their quantitative features.
One of the versions is K-means cluster analysis, which is used to cluster
large numbers of observations, with squared Euclidean distance (the sum
of the squared differences over all the variables) employed to identify a
specified number of clusters. The algorithm used for determining the
membership of clusters is based on nearest centroid sorting. The values
obtained for each cluster are simply the standardized average values of
the variables for cases in the clusters.
12
This exercise is proposed in UN/ECE. “Economic Survey of Europe”, vol. 1, 2002,
139-141.
13
The presentation borrows from UNIDO. Industrial Development Report 2002/2003.
Vienna, 2002, 148.
C. INTRA-INDUSTRY TRADE
Intra-Industrial Trade index (IIT): Intra-industry trade is defined as the

two-way trade within the same industry. Trade is considered to be “two-
way” trade when the value of the minor flow represents at least 10 per
cent of the major flow14:
min (Xkk’it, Mkk’it) / max (Xkk’it, Mkk’it) > 0.10

Where:
- X, M stand for values of exports and imports;
- k for declaring country and k’ for the partner country;
- i for product and t for year.
The intensity of intra-industrial trade is computed using the formula15:
IIT = {1 -
∑ X ijk − M ijk } 100
∑ X ijk + M ijk
Where:
- i refers to the product categories that make up each “industry” j and k
identifies countries;
- X and M are exports of a country and imports by a partner
correspondingly of product i.
The index of IIT varies between 0 (complete inter-industry trade) and 100
(complete intra-industry trade).
The literature distinguishes further between horizontal and vertical IIT.
The latter (IITv) consists of exchange of similar goods of different quality
and the former (IITh) comprises exchange of similar goods that are
differentiated by characteristics rather than quality.16
14
UN/ECE. “Economic Survey of Europe”, vol. 1, 2002, 146.
15
The index was originally proposed in Grubel, Herbert G., and P. J. Lloyd, Intra-
Industry Trade: The Theory and Measurement of International Trade in Differentiated
Products, London, 1975.
16
The presentation follows Aturupane, Chonira, Simeon Djankov and Bernard Hoekman.
“Determinants of Intra-Industry Trade between East and West Europe”. Draft paper,
World Bank, August 1997.
Research Guide
Horizontal IIT is defined to exist for trade in product i in industry j that

satisfies the criterion:
ExportUVijk
1−α ≤ ≤ 1+α
importUVijk
Vertical IIT comprises trade where:
ExportUVijk
p 1−α
importUVijk
or
ExportUVijk
f 1+α ,
importUVijk
where UV stands for unit value (of exports and imports, respectively).
Relative unit values of exports and imports are utilized to disentangle

horizontal from vertical IIT. The underlying assumption is that relative
prices tend to reflect differences in qualities. Thus, vertical IIT is defined
as two-way trade in a product whose per kilogram unit value of exports
(measured f.o.b.) relative to its per kilogram unit value of imports
(measured c.i.f.) falls outside a specified range of ±α (commonly α=0.15
or α=0.25).
Trade in products whose relative unit values fall within the range ±α is
defined as horizontal IIT. For example, if the difference between the unit
values is less than 15%, then there is IITh when
ExportUVijk
1 / 1.15 ≤ ≤ 1.15
importUVijk
Once IIT has been separated into the two types at the product category
level, trade flows are aggregated over the categories to compute vertical
and horizontal IIT at the industry level.
D. TRADE AND DEVELOPMENT
Technology-related level of income index (Yjx): The analysis is based

on the observation that the advanced countries tend to have higher export
shares of high-technology products than less developed countries.17 The
index makes a link between a country’s level of development and the
expected income level for a certain category of commodity.
i
⎛ X ij ⎞
Yjx = ∑ Yix ⎜⎝ X j ⎟⎠
,
Where:
- x stands for estimation in contrast with the actual figure;
- Xij = country j’s exports of commodity i;
- Xj = country j’s total exports;
- Yix = income index for world exports of commodity i, and
j
⎛ X ij ⎞
Yix = ∑ Y j ⎜⎝ X i ⎟⎠
Where:
- Xi = world exports of commodity i
- Yj = income level index of country j, and
(
Y j = y j y n ⋅100)
Where:
- yj = GDP per inhabitant of country j;
- yn = the biggest world level of GDP per inhabitant.
The results should read as follows: if a country’s estimated income level

surpasses the real level then that country exceeds the expectations as
regards the technological level of its exports. For a useful visual
interpretation of estimates, Yjx may be linearly regressed in terms of Yj,
when a sufficiently large number of data are available, and compared
with the resulted hierarchy of countries and commodities.
17
The original study is Michaely, Michael. “Income Levels and the Structure of Trade.”,
Paper presented to the Symposium on “The Past and Future of the New Economic Order”,
Stockholm, 1978. The topic is also discussed in Yeats, Alexander J. Trade and
Development Policies. Leading Issues for the 1980s” New York: St. Martin’s Press, 1981.
Research Guide
3. Trade Performance
A. FOREIGN TRADE INDICES
Export/import price index: Price index for measuring changes in the

aggregate price level of a country’s merchandise exports and imports
over time.
Terms of trade: The relative level of export prices compared with import
prices, calculated as the ratio of a country’s index of average export price
to the average import price index.
B. EXPORT PERFORMANCE
Constant-Market-Share analysis (CMS): The method represents a

statistical normalization procedure, which decomposes the change in a
country’s exports into “demand” and “competitiveness” components.18
The underlying assumption is that a country’s share in world markets
should remain unchanged over time. The actual growth in exports is
divided into competitiveness, commodity-composition and market-
distribution effects. Thus, a country’s aggregate market share in a multi-
country, multi-product market may be decomposed into:
a. The product pattern component which reflects the part of a country’s
market share gain (loss) resulting from the concentration of its
exports in products for which demand is growing faster (slower) than
total import demand;
b. The market pattern component which reflects that part of an increase
(decrease) in a country’s market share ascribed to the orientation of
its exports toward relatively rapidly (slowly) growing countries;
c. The performance component of market share change, which
corresponds to the difference between the actual change in the market
18
Economic Commission for Europe / United Nations. Economic Bulletin for Europe.
Vol.34, 1982, and Vol. 35, 1983; Leamer, E.E., and Stern, R.M.. Quantitative
International Economics. Boston: Allyn and Bacon, 1970, 171-183.
share and the change ascribed to the two demand components defined
above.
For each exporting country/region (i) and importing country/region (j),

variables are defined as follows:
Xij = export of commodity i to market j, in the base year

X.j = total exports of manufactures to market j, in the base year
Xi. = total exports of commodity i, in the base year
X= total exports of manufactures, in the base year
∆X.j = increase in manufactured exports to country j (value)
∆Xi .= increase in exports of commodity i (value)
∆X = increase in total manufactured exports (value)
qij = growth in imports of commodity i in country j*
q.j = growth in manufactured imports of country j *
qi. = growth in imports of commodity i *
q= growth in total manufactured imports *
Xijqij = increase in exports of commodity i to country j, assuming that
they grew at the same rate as country j's total imports of
commodity i
Xi.qi. = increase in exports of commodity i, assuming that they grew

at the same rate as total imports of commodity i
X.jq.j = increase in exports to country j, assuming that they grew at
the same rate as country j's total manufactured imports
Xq = increase in total manufactured exports, assuming that they
increased at the same rate as manufactured imports
Xi.q = increase in exports of commodity i, assuming that they
increased at the same rate as manufactured imports
X.jq = increase in exports to country j, assuming that they increased
at the same rate as manufactured imports
The calculations used to estimate the demand and competitiveness

components of export growth are as follows:
*
The growth rate is Mn / Mo – 1, where n is the end year and o the base year.
Research Guide
a. Exports by commodity groups
Demand growth effect = Xi.q
Effect of commodity pattern of

demand growth = Xi.qi.- Xi.q
Effect of the market distribution of

growth in demand for each commodity = ∑ X ij qij − X i. q i.
j
Total demand effects = ∑ X ij qij

j
"Competitiveness" effect = ∆Xi. - ∑ X ij qij

j
b. Exports by importing country
Demand growth effect = X.jq
Effect of the country distribution of

demand growth
= X.jq.j- X.jq
Effect of the commodity mix of demand

growth in each country
= ∑ X ij qij − X . j q. j
j
Total demand effects

= ∑ X ij qij
j
"Competitiveness" effect
= ∆X.j - ∑ X ij qij
j
c. Total manufactured exports (aggregate results)
Demand growth effect = Xq = ∑ Xi.q

i
Commodity pattern effect = ∑ (Xi.qi.- Xi.q)

i
Effect of the market distribution of the

growth in demand for each commodity = ∑∑ X ij qij − X i.qi.
i j
Total demand effects = ∑∑ X ij qij

i j
"Competitiveness" effect = ∆X - − ∑∑ X ij qij

i j
The changes in the product pattern, market pattern and performance

components experienced by all exporters to a given market add to zero.
The discrepancy between the constant-share norm and actual
performance has been labeled the "competitiveness effect". Thus when a
country fails to maintain its in world markets, the competitiveness term
will be negative and will indicate price increases for the country in
question greater than its competitors. A negative residual reflects a failure
to maintain market shares. The analysis provides information concerning
the extent to which the country in question is exporting to markets with
relatively unfavorable or favorable growth rates.
Coverage ratios: Ratios of exports to imports in given industry over

time. The indicator incorporates information about the destination of
production as well as the origin of consumption. A cautious note requires
the analysis to consider the possible changes in the coverage ratios due to
the underlying macroeconomic conditions (e.g. growth rates, exchange
rates’ fluctuation).
Research Guide
C. COMPETITIVENESS
The Competitive Industrial Performance (CIP) index:19 focuses on the

national ability to produce manufactures competitively. The CIP index is
constructed from four basic indicators of industrial performance
(performance variables):
- Manufacturing value added (MVA) per capita

- Manufactured exports per capita
- Share of medium- and high-tech activities in MVA
- Share of medium- and high-tech products in manufactured exports
The values for each of the four variables are standardized for the sample
to range from zero (worst performers) to one (best performers). The
composite index is calculated as a simple average of the four standardized
basic indicators.
Individual indices of performance I j ,i are standardized according to the
general formula
X j ,i − min( X j ,i )
I j ,i = ,
max( X j ,i ) − min( X j ,i )
where X j ,i is the ith country value of the jth performance variable.
Therefore the highest country in the ranking has a score of 1 and the
lowest a score of 0. The CIP index is the simple arithmetic mean of I1, i,
I2, i, I3. i, and I4, i. Thus
n
1
CIPi =
4 ∑ I j,i
j =1
19
The presentation is based on UNIDO. Industrial Development Report 2002/2003.
Vienna, 2002, 42, 148.
4. Macroeconomic Links
A. EXCHANGE RATE
Real Exchange Rate (RER): RER is defined as the nominal rate

adjusted by the inflation differential (domestic versus foreign)20.
Other things remaining the same, an increase in RER (a real depreciation)
raises the price of exportables relative to home goods, which encourages
the expansion of export supply. One cannot say that the home economy
as a whole has become more “competitive”, but one can say that traded
goods have become more “competitive” in relation to non-traded
production.
Effective Exchange Rate (EER): EER reflects the actual amount of

local currency paid (or received) per unit of foreign exchange of imports
c.i.f. (or exports f.o.b.).21 It is the nominal exchange rates plus the various
pricing charges superimposed upon the basic rate. The EER concept
pertains to the rate at which local currency units translate into foreign
currency for various transactions.
EER = R ⋅ (1 + S j ) ⋅ I wj I hj =
= R ⋅ (1 + T j ) ⋅ I wj I dj
Where:
- R=Nominal Exchange Rate (Domestic currency / Foreign currency)
- Sj= 1+sj+rj, and
- sj= the subsidy (or tax, in which case s is negative) per dollar of
exports fob of the jth commodity, expressed as a percent of the fob
price
- rj= the value of export encouragement schemes, other than subsidies,
expressed as a percent of the fob price
20
Little, I.M.D. et al. “Boom, Crisis, and Adjustment”, Oxford University Press, 1993.
21
Krueger, A.O. Foreign Trade Regimes and Economic Development. New York:
Columbia UP, 1978; Bautista, Romeo M. "Exchange Rate Adjustment Under Generalized
Currency Floating: Comparative Analysis Among Developing Countries.", World Bank
Staff Working Paper No. 436, October 1980.
Research Guide
- Tj= 1+nj+tj, and

- nj= the value of all surcharges against imports of commodity j per
dollar cif expressed as a percentage of the cif price
- tj= the ad valorem tariff on the jth commodity
- Iwj= world inflation index in jth category of exports and imports
- Idj= domestic inflation index in jth category of exports and imports
The EER indices for exports (EERx) and imports (EERm) may be
expressed by weighted geometric averages as follows:
EERx = ∏ (r ) w
i
i xi
EERm = ∏ (r ) wi mi
i
Where:
- wxi and wmi are the export and import weights, respectively, for the
∑ ∑
ith partner country ( w xi = wmi = 1);
i i
- ri is the index of the exchange rate (in units of the home currency per
unit of i's currency), relative to a base year level.
An export-weighted index of prices of foreign currencies in terms of the

currency would reflect the impact of a set of exchange rate changes on
the competitiveness of exports to domestic producers. Other things being
equal, an increase in EERx raises the average profitability of exporting,
encouraging expansion of export supply. On the other hand, an import-
weighted EER index would reflect the impact of the cost of imported
goods in terms of the home currency. Thus, EERm can be directly related
to the price of domestically produced goods competing with imports.
Other things remaining the same, a rise in the import-weighted EER
improves the average profitability of domestic import substitution, which
could draw resources away from export production.
B. OUTPUT
Effective Rate of Protection (ERP): The effective protection is defined

as the proportionate difference between free-trade value-added and tariff-
distorted value-added. An ERP estimate is the percentage by which
domestic value added (DVA) in a particular industry or activity exceeds
valued added measured at international prices (IVA) in the same activity.
In instances where tariffs and other charges translatable into tariff
equivalents are the only form of protection, the statistic is computed as
tj − ∑ a ji ti
i
ERPj =
1 − ∑ a ji
i
Where:
- tj is the tariff on the jth commodity;
- aji is the input of i per unit per unit of output of j.
All international prices are normalized at unity.
The numerator reflects the excess of DVA over IVA and the denominator
represents IVA (valued added measured at international prices). Measures
of effective protection can be interpreted as a measure of the change in
incentives caused by the trade regime from those that would occur under
free trade22.
Trade categories: At a feasible level of disaggregation, a common

statistics is computes as
C i − Pi
Ti =
Ci
Where:
- Ci is domestic utilization;
- Pi is domestic production.
22
Krueger, Anne O et al (eds.). Trade and Employment in Developing Coutries. Chicago:
UCP, 1981, 20-21.
Research Guide
Each commodity or sector is classified as exportable if Ti<Xo; import

competing if X0 ≤ Ti<X1; and non-competing if X1 ≤ Ti ≤ X2; where Xis
were chosen as cutoff points (e.g. 0.05, 0.5, 0.6). If X0 were set at zero,
for example, a negative Ti would mean the commodity or sector was
classified as an exportable23.
C. EMPLOYMENT
Labor coefficient (L): The concept is relevant for examining the effect
of a change in trade strategy24. The magnitude of change is captured by
the term “direct requirements of labor plus indirect requirements in home
goods” ( Ltj ) per unit of value added in the production and is computed as
E j + ⎛⎜ a hj h ⎞⎟ ⋅ V j
E
⎝ Vh ⎠
Ltj =
V j − M j + a hj [(V h − M h ) / V h ]
Where:
- Ej is total employment in jth commodity (measured in the most
appropriate unit available, e.g. man-hours of homogeneous labor
categories or a value unit such as the wage bill);
- Vj is the domestic value of output;
- Mj is the domestic value of purchased inputs;
- ahj is the input of home goods per unit of traded goods output;
- ahj*Eh/Vh stands for indirect labor requirements in home goods per
unit of output of the jth tradable;
- (Vh-Mh)/Vh is value added per unit of output of home goods.
The direct labor requirement per unit of DVA in the jth activity is
measured as
Ej
Ldj =
Vj −M j
23
Idem, 17.
24
Idem, 22-23.
Import penetration ratio (IP): IP can be computed according to the

following rule:
IP = imports sales − exp orts + imports

This indicator is used to assess the effect of trade on employment in the
following manner: One starts with the average number of employees in
the studied industries for a base year (t0). From this, the level of
employment in each industry is predicted considering what it would have
been had the ration of imports to domestic purchases remained constant
over the time period. The difference between the predicted figure and the
actual figure is taken to be the result of increased imports. The same
procedure is applied to those sectors where exports are important25.
25
This methodology is explained in Greenway, David (1983), 205.
Research Guide
5. Industrial Organization
A. MARKET STRUCTURE
Concentration: The usual measures of concentration are: number of

enterprises, size structure of enterprises as well as Herfindahl index and
concentration ratios (CR), i.e. share of one (CR1), two, three, four (CR4)
etc. largest enterprises on the total output of the industry. 26
Herfindahl index (H index) is a sum of all seller squared market shares.

It takes all enterprises into the account.
∑p
2
H= i
i =1
Where:
xi
pi = n
∑x
j =1
j
H index maximum = 1 (or 100%). H index minimum = 1/n shows the

even division of market shares. The H index enables to examine in what
measure the inequality of distribution of supply within the whole industry
changed.
Four-firm Concentration Ratio (CR4) is the share of output (domestic
supply) accounted for by the four largest sellers.
26
Zemplinerova, Alena and Josef Stibal, “Evolution and Efficiency of Concentration:
Manufacturing Industries in the Czech Economy 1989-1992.”, Working paper series 52,
CERGE-EU, Prague, 1994.
4
∑ xi
i =1
CR4 = n
∑ xi
i =n
Where:
xi ≥ xi+1
The share of the four biggest sellers in the total output is used for
identification of oligopoly situation.
One-firm Concentration Ratio (CR1) is share of total output accounted

for by the largest seller.
max xi
CR1 = = max pi
n
∑ xi
i =1
The share of the largest seller is used in order to identify the existence of
monopoly market situation.
B. ECONOMIES OF SCALE27
Typical size: This simple analysis uses size data derived from census size
distributions (sales or employment) as a proxy variable for the MES. The
results are normally related to an independent measure of scale
economies and evaluated by an econometric estimate between the two
variables.
27
The methods of measurement are presented in European Commission, “The Single
Market Review. Economies of Scale.”, Office for Official Publications of the European
Communities, 1997, 11-13.
Research Guide
Various proxy measures for MES are:

The arithmetic average
The average size of plants comprising the upper half of an industry’s size
distribution
The Florence median plant size, i.e. the size of the plant of the midpoint
of the size distribution in the sense that 50 per cent of industry size is
accounted for by plants in excess of the midpoint; formally, this is the
median of the first moment distribution (MFMD).
Common units of measurement are total assets, net assets, sales,

employment and value added.
Statistical cost analysis: The statistical approach relates costs to output

volume of plants or firms of different sizes. A large number of variables
should be taken into account in order to give significance to the results, as
for example differences in product mix, differences in the age of the
capital stock, differences in input prices, cumulative output volume.
Engineering estimates: The technique looks directly for opinions from

engineers and managers about the shape and position of the cost curves,
and so tries to estimate the minimum efficient scale (MES) directly based
on the use of the “best current practice” techniques.
Survivor test: The survivor technique attempts to identify the size class,
which is seen to be increasing its share of industry output over a period of
time, and suggests that the average size of this class represents MES. The
rationale is that the most successful size must be most efficient.
Product differentiation: The two main sources of product differentiation
for firms are advertising and R&D spending. The analysis distinguishes
first between different types of industries:
Type 1: Industries which engage in little advertising or R&D
Type 2-1: Industries engaged only in advertising (e.g. food, drink,
and tobacco)
Type 2-2: Industries engaged only in R&D (e.g. machinery,
instruments, and transport equipment)
Type 2-3: Industries engaged in both (e.g. cars, domestic electrical
appliances, pharmaceuticals)
Second, this typology is further used to investigate the mechanisms,

which relate the different types of economies of scale to the different
elements of structure for the four industry types.
Research Guide
6. Strategic Interaction
STRATEGIC STRUCTURES OF COMPETITION
Game theory: A generic two-person, symmetric normal form game of

strategic interaction is presented below.
Player B
Cooperate Not cooperate (~C)

(C)
Cooperate (C) Mutual consensus (MC) B prevails (BP) in

in issue area issue area
Player A
A prevails (AP) in issue No consensus (NC) in

Not cooperate (~C) area issue area
A strategic interaction modeled as a game consists of the following:

- Players: the negotiating parties;
- Strategies: the possible courses of actions, provided that the
behavioral options perceived by the players may be plausibly reduced
to cooperation ("C") or conflict ("~C") on a given issue;
- Outcomes: the set of all combinations of strategies that the players
could choose. Four possible outcomes are depicted in the figure
above. From the point of view of actor row they are: CC (mutual
consensus), ~C~C (no consensus), C~C (other's player winning), and
~CC (winning);
- Preferences: the ordered set of outcomes, which specifies how good
or bad each outcome is for each player. The way preferences are
deduced is fundamental for finding the predicted conclusion of the
negotiations in the form of one the four possible outcomes. Ordinal
preference order for each player simply ranks outcomes from best (4)
to worst (1).
In real negotiations, preferences are constrained by various economic,
political, or institutional variables. The most common deduced orders of
preferences associated with a typical game are given below:
~CC>CC>~C~C>C~C Prisoner's Dilemma

~CC>C~C>CC>~C~C Leader
~CC>CC> C~C>~C~C Chicken
~CC>C~C>~C~C>CC Hero
CC>~CC >~C~C>C~C Stag Hunt
CC>~CC >C~C>~C~C Harmony
~CC>~C~C>CC>C~C Deadlock
~CC>~C~C>C~C>CC Deadlock analogue
where the corresponding strategic structures are:
Chicken Hero
3,3 2,4 1,1 3,4
4,2 1,1 4,3 2,2
Stag Hunt Deadlock
4,4 1,3 2,2 1,4
3,1 2,2 4,1 3,3
Prisoner's Dilemma Deadlock analogue
3,3 1,4 1,1 2,4
4,1 2,2 4,2 3,3
Leader Harmony
2,2 3,4 4,4 2,3
4,2 1,1 3,2 1,1

A Workbook in International Trade

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SECTION I: TRADE THEORY

1. The Principle of Comparative Advantage

In which good should each country specialise according to the theory of

Using the absolute advantage model, identify the possibilities of

The following assumptions are also made:

- Consumer preferences are identical in both countries, being thus

Indicate in what commodity countries A and B have a comparative

For which commodity (or commodities) does Romania have absolute

For which commodity (commodities) does country A have absolute

For which commodity (commodities) does country A have absolute

Answer to Problem 1: country A has absolute advantage in good Y, and

Answer to Problem 2: according to the absolute advantage model,

Answer to Problem 3: the relative cost of X is 2.5 in country A and 0.5

Answer to Problem 4: country A will specialize and export good Y and

Answer to Problem 5: the relative cost of good Y is 5.

Answer to Problem 6: according to the Ricardian model, the two

Answer to Problem 7: the relative post-trade price of good X should be

Answer to Problem 8: the relative price of good Y in country B (before

Answer to Problem 9: the production possibilities frontier in country A

Answer to Problem 10: the world production possibilities frontier can be

160 − 2.5 ⋅ x , x ∈ (40,64]

Answer to Problem 11: both statements are false.

Answer to Problem 12: a. country A has absolute advantage in both

Answer to Problem 13: country A has comparative advantage in Y and

Answer to Problem 14: when the exchange rate is EUR 1 = ROL

Answer to Problem 15: country A has comparative and absolute

Answer to Problem 16: country A will tend to specialize in the goods

Answer to Problem 17: the answer to problem 17 is very similar to that

2. The Specific Factor Model

Answer to Problem 1: b. the economy’s allocation of labour is described

Answer to Problem 2: a. the price of steel is PS = 800 USD/tonne; b. the

Answer to Problem 3: the quantity of food decreases to 5.4 tonnes,

3. The Heckscher – Ohlin Model

Land (units) Labour (units)

Which good will Home tend to export? Discuss your answer.

Answer to Problem 1: steel is capital intensive and cloth is labour

Answer to Problem 2: the production possibilities frontier is given by

Answer to Problem 3: the new production possibilities frontier will be:

Answer to Problem 5: Home will tend to export cloth (the labour

4. The Standard Trade Model

To Problem 1: 530 units of Y; price ratio is 43; isovalue line is

To Problem 2: production of X rises from 5 to 10 units; production of Y

To Problem 3: production of Y decreases from 530 to 392 units; the

To Problem 4: the quantity consumed of good X is 3 units and the

opened to international trade and it exports 2 units of X and imports 83

To Problem 5: the new indifference curve will be

5. The New Trade Theory

To Problem 1: the gap is EUR 300.

To Problem 4: the profit maximizing quantity is 450 units; the gap

To Problem 6: as long as both home and abroad he gets a marginal

1. Basic Tariff Analysis

What is the level of the import tariff?

The demand in country A is satisfied by a single supplier country (the one

Answer to Problem 1: the tariff rate is 20%; the imported quantity

Answer to Problem 2: a. the free trade imports rise to 10 thousand units;

Answer to Problem 3: the welfare gain is equal to 250 million monetary

Answer to Problem 4: the welfare loss is equal to 250 million monetary

Answer to Problem 5: the effective rate of protection is 20%.

Answer to Problem 6: the effective rate of protection is 0%.

Answer to Problem 7: the effective rate of protection is 16.67%.

Answer to Problem 8: the effective rate of protection is 10%; if the tariff

Answer to Problem 9: the effective rate of protection is 42.5% and a.

Answer to Problem 10: it can range between 0% and 100%.