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I. Japan primarily exports manufactured goods, while importing raw materials such as food and oil. Analyze the impact on Japans terms of trade of the following events: a. A war in the Middle East disrupts oil supply. b. Korea develops the ability to produce automobiles that it can sell in Canada and the United States. c. U.S. engineers develop a fusion reactor that replaces fossil fuel electricity plants. d. A harvest failure in Russia. e. A reduction in Japans tariffs on imported beef and citrus fruit.
The terms of trade of Japan, a manufactures (M) exporter and a raw materials (R) importer, is the world relative price of manufactures in terms of raw materials (pM/pR). The terms of trade change can be determined by the shifts in the world relative supply and demand (manufactures relative to raw materials) curves. Note that in the following answers, world relative supply (RS) and relative demand (RD) are always M relative to R. We consider all countries to be large, such that changes affect the world relative price. a. Oil supply disruption from the Middle East decreases the supply of raw materials, which increases the world relative supply. The world relative supply curve shifts out, decreasing the world relative price of manufactured goods and deteriorating Japan's terms of trade.2 points b. Koreas increased automobile production increases the supply of manufactures, which increases the world RS. The world relative supply curve shifts out, decreasing the world relative price of manufactured goods and deteriorating Japan's terms of trade. 2 points c. U.S. development of a substitute for fossil fuel decreases the demand for raw materials. This increases world RD and the world relative demand curve shifts out, increasing the world relative price of manufactured goods and improving Japan's terms of trade. This occurs even if no fusion reactors are installed in Japan since world demand for raw materials falls. 2 points d. A harvest failure in Russia decreases the supply of raw materials, which increases the world RS. The world relative supply curve shifts out. Also, Russias demand for manufactures decreases, which reduces world demand so that the world relative demand curve shifts in. These forces decrease the world relative price of manufactured goods and deteriorate Japan's terms of trade. 2 points e. A reduction in Japans tariff on raw materials will raise its internal relative price of manufactures. This price change will increase Japans RS and decrease Japans RD, which increases the world RS and decreases the world RD (i.e., world RS shifts out and world RD shifts in). The world relative price of manufactures declines and Japans terms of trade deteriorate. 2 points

II. Evaluate the relative importance of economies of scale and comparative advantage in causing the following: a. Most of the worlds aluminum is smelted in Norway or Canada. b. Half of the worlds large jet aircraft are assembled in Seattle. c. Most semiconductors are manufactured in either the United States or Japan. d. Most Scotch whiskey comes from Scotland. e. Much of the worlds best wine comes from France. (Total 10 points)
a. The relatively few locations for production suggest external economies of scale in production. If these operations are large, there may also be large internal economies of scale in production. 2 points b. Since economies of scale are significant in airplane production, it tends to be done by a small number of (imperfectly competitive) firms at a limited number of locations. One such location is Seattle, where Boeing

produces. 2 points c. Since external economies of scale are significant in semiconductor production, semiconductor industries tend to be concentrated in certain geographic locations. If, for some historical reason, a semiconductor is established in a specific location, the export of semiconductors by that country is due to economies of scale and not comparative advantage. 2 points d. "True" scotch whiskey can only come from Scotland. The production of scotch whiskey requires a technique known to skilled distillers who are concentrated in the region. Also, soil and climactic conditions are favorable for grains used in local scotch production. This reflects comparative advantage. 2 points e. France has a particular blend of climactic conditions and land that is difficult to reproduce elsewhere. This generates a comparative advantage in wine production. 2 points

III. There is substantial inequality of wage levels between regions within the United States. For example, wages of manufacturing workers in equivalent jobs are about 20 percent lower in the Southeast than they are in the Far West. Which of the explanations of failure of factor price equalization might account for this? How is this case different from the divergence of wages between the United States and Mexico (which is geographically closer to both the U.S. Southeast and the Far West than the Southeast and Far West are to each other)? (15 points)
Conditions necessary for factor price equalization include both countries (or regions) produce both goods, both countries have the same technology of production, and the absence of barriers to trade. (5points)The difference between wages different regions of the United States may reflect all of these reasons; however, the barriers to trade are purely "natural" barriers due to transportation costs. U.S. trade with Mexico, by contrast, is also subject to legal limits; together with cultural differences that inhibit the flow of technology, this may explain why the difference in wage rates is so much larger. (10points)

IV. During 1989 a wave of political change swept over Eastern Europe, raising prospects not only of democracy but also of a shift from centrally planned to market economies. One consequence might be a shift in how Western European uses its money: Nations, especially Germany, that during the 1980s were lending heavily to the United States might start to lend to nearby Eastern European nations instead. Using the analysis of the transfer problem, how do you think this should affect the prices of Western European goods relative to those from the United States and Japan? (Hint: how would the likely use of a dollar of financial resources differ in, say East Germany, from its use in the United States?) (15 points)
Given the difference in technological development between most Eastern European countries and the United States and Japan, the effects on Western European prices will depend, in the short run, on transfer problem issues and, in the long run, on the likely biases in Eastern Europe's growth. (5points) The transfer problem point is concerned with the consumption demands of countries which receive available international credit supplies. If loans to developing countries shift from availability to Latin American countries, which have a relatively high propensity to consume U.S. goods, to availability to Eastern European countries, which have a lower propensity to consume U.S. goods and a higher propensity to consume German goods, the price of German exports will rise relative to the price of U.S. exports. This would lead to an improvement in the terms of trade of Germany and a worsening of the terms of trade of the United States. (5points) Note, however, that in the long term, the analysis of terms of trade effects should also consider whether the biases in economic growth in Eastern Europe will be in sectors of the economy more closely aligned with the export industries of Germany or of the United States. The greater the similarity of the export-oriented industrial push in Eastern European with the existing industries in Germany, the greater the supply side reversal of the favorable German terms of trade movement which had arisen from the demand side forces of the transfer problem.


V. Assume that the monopolistic competitor produces tractors. He incurs fixed production costs of $120,000,000 and marginal costs of $8,000. The demand parameter is b=l/40,000. The total annual tractor sales in the Home market is 600,000 units. a. Graph the PP and CC curves for the Home tractor industry. b. How many tractor firms will exist in equilibrium? What will be the equilibrium price of a tractor? c. Confirm that this is a long run equilibrium. (Total 15 points)

AC 10828





s = b F

600000 1 120000000 40000

= 10 2


P =c+

F = 8000+2000 2 =10828 sb


IF PAC there will be economic profits, and more firms will enter the industries IF: PAC the economic profits will disappear and some firms will leave the industry. Only when P=AC,that is to say ,the economic profits is zero, and no more firms will enter the industry and no more firms will leave the industry. Then the market will be in long-run equilibrium. 5POINTS

VI. The nation of Acirema is small, unable to affect world prices. It imports peanuts at the price of $10 per bag. The demand curve is D = 400 10P. The supply curve is S = 50 + 5P. Determine the free trade equilibrium. Then calculate and graph the following effects of an import quota that limits imports to 50 bags. a. The increase in the domestic price

b. The quota rents c. The consumption distortion loss d. The production distortion loss (Total 20 points)
At a price of $10 per bag of peanuts, Acirema imports 200 bags of peanuts. A quota limiting the import of peanuts to 50 bags has the following effects:


20 10 Q 100 150 200 300 (4points) a. The price of peanuts rises to $20 per bag. (4points) b. The quota rents are ($20 - $ 10) *50 = $500. (4points) c. The consumption distortion loss is 0.5x 100 bags x $10 per bag = $500. (4points) d. The production distortion loss is0 .5 x 50 bags x $ 10 per bag =$250. (4points)

VII. In Home and Foreign there are two factors of production, land and labor, used to produce only one good. The land supply in each country and the technology of production are exactly the same. The marginal product of labor in each country depends on employment as follows: Number of Worker Employed Marginal Product of Last Worker 1 2 3 4 5 6 7 8 9 10 11 20 19 18 17 16 15 14 13 12 11 10

Initially, there are 11 workers employed in Home, but only 3 workers in Foreign. Find the effect of free movement of labor from Home to Foreign on employment,

production, real wages, and the income of landowners in each country? (15 points)


MPLF B E 18 14

14 10 A



5PONITS The marginal product of labor in Home is 10 and in Foreign is 18. Wages are higher in Foreign, so workers migrate there to the point where the marginal product in both Home and Foreign is equated. This occurs when there are 7 workers in each country, and the marginal product of labor in each country is 14. (3ponts) PRODUCTIN: Overall products increase by triangle EAB (3ponts) Landowners will be better off in HOME but worsen off in Foreign (4ponts)