ECON306: Class Test 1, 16 March 2009

Solution Guide

Section A
Question 1

(a) Cultural affinity: E.g. Ireland trades considerably more with the US than the gravity
model would have predicted because the two countries share a common language and a
significant percentage of the US population are Irish descendents.

MNCs: E.g. Ireland trades considerably more with the US than the gravity model would
have predicted because Ireland plays a special role as a host to many US MNCs; the
theory of MNCs provides two crucial elements for the existence of MNCs.

Geography: E.g. Netherlands and Belgium trade considerably more with the US than the
gravity model would have predicted because both countries are located near the mouth
to the Rhine, Western Europe’s longest river, which runs past Germany’s industrial
heartland.

Trade agreements: Country A can trade more with country B than country B does with
country C if country’s A and B have signed favourable trade agreements which minimize
or eliminate trade barriers between the two countries.

Borders: More trade tends to occur between provinces of 1 country than trade between
provinces of different countries of similar distance because of formalities. Similarly,
two countries with less restrictive formalities could trade more than two countries with
more restrictive formalities (excluding formal trade barriers such as import tariffs and
quotas), e.g. bureaucracies / red tapes at borders).

(b)
a LC a LW
i. OC C 60 / 30 2 or OC W 0 .5
a LW a LC

* *
a LC a LW
OCC* *
100 / 200 0.5 or OCW* *
2
a LW a LC

QC
corresponding to vertical section of RS curve =
QW
L* / aLC
*
600 / 100
0.2
L / aLW 900 / 30
 PC/PW

aLC
2 RS
aLW

*
a LC
*
0.5
a LW

L* / aLC
*
QC/QW
0.2
L / aLW

PC
ii. 0.5 2
PW

iii. When the two countries trade, Foreign will specialize in cloth production and Home
will specialize in widget production and trade will take place based on the world
relative price of cloth of 1. For every 1 unit of cloth Foreign exports, it will receive 1
unit of widgets in return from Home, which is more than the 0.5 units of widgets
Foreign would have obtained if it had produced widgets domestically. Similarly, for
every 1 unit of widgets Home exports, it will receive 1 unit of cloth in return from
Foreign, which is also more than the 0.5 units of cloth Home would have obtained if
it had produced cloth domestically.

(c) The relative productivity rankings are as follows:

Good A unit labour B Unit Labour Relative A

requirement (ai) requirement (ai*) Productivity Adv
(ai*/ai)

Corn 2 20 10
Avocado 6 48 8
Tomato 5 20 4
Apples 7 20 2.86
Wheat 12 6 0.75

If wA/wB=5: A will produce only Corn and Avocado for export,

B will produce Tomatos, Apples and Wheat.

(d) Differences

The Ricardian and the H-O models make different assumptions about the determinants
of production and also differ in their details. [The Ricardian model assumes that there
is only one factor of production, the basis for trade is differences in relative unit
labour requirements and trade it is mutually beneficial, i.e. it is possible that everyone
 can gain from trade. The H-O model assumes two factors of production, identical
technologies across countries, the basis for trade is differences in relative factor
endowments, and although trade is mutually beneficial, it benefits the one factor of
production in one country at the expense of the other.]

Similarities

In spite of these differences in their details, these two models share a number of
features. [i) the productive capacity of an economy can be summarized by its PPF, &
differences in these frontiers give rise to trade; ii) production possibilities determine a
country’s relative supply schedule; iii) world equilibrium is determined by the world
relative demand & the world relative supply schedule which lies between the national
relative supply schedules.] Because of the differences in detail and these common
features, these two models may be viewed as special cases of a more general model, the
standard trade model. The standard trade model makes no explicit assumptions about
factors of production (comparative advantage is given) and can be applied to real world
trade analysis regardless of the number of factors of production employed. Also, there
are many important issues in international economics whose analysis can be conducted in
terms of this general model, with only the details depending on which special model you
choose.

Question 2

a)
i. P = c + 1/(bn)

AC = (nF)/S + c

Long run equilibrium:

AC = P
(nF)/S + c = c + 1/(bn)
n = [S/(Fb)]1/2
= [50 000/{500 000 x (1/1000)}] 1/2
= 10

ii. n = [S/(Fb)]1/2
= [100 000/{500 000 x (1/1000)}] 1/2
= 14

iii. n = [S/(Fb)]1/2
= [150 000/{500 000 x (1/1000)}] 1/2
= 17

iv. Home (closed economy) long-run equilibrium: P = AC = 200

Foreign (closed economy) long-run equilibrium: P = AC = 171
Integrated economy long-run equilibrium: P = AC = 158
 The long run equilibrium price and average cost are lower in the integrated economy
compared with the two closed economies. The larger the industry size in terms of
number of firms, the more competition there is. The CC curve shifts to the right, that
is, a given P=AC is consistent with a larger number of firms. At the initial long run
equilibrium n, P>AC and economic profits will be generated. As a result, more firms will
enter the industry, reducing P (increased competition) and AC (more firms so each firm
produces less).

b) Interindustry trade
Interindustry trade is international trade in goods from different industries. The basis
for interindustry trade is comparative advantage. The pattern of trade is determined
by the underlying differences between the countries: the country with a comparative
advantage in producing a good will produce and export that good.

Intraindustry trade
Intraindustry trade is international trade in goods from the same industry, that is,
trade in differentiated goods (monopolistic competition). Intraindustry reflects EOS.
The pattern of intraindustry trade itself is unpredictable.

Relative importance of each type of trade

The relative importance of intraindustry & interindustry trade depends on how similar
countries are.
If countries are similar in their K/L-ratios, then little interindustry trade will take place
and intraindustry trade will be dominant. Conversely, if K/L-ratios are very different,
then trade will be based on comparative advantage and there will be no intraindustry
trade based on EOS.

Standard formula for calculating importance of inter- and intraindustry:

| exp orts imports |

I 1
| exp orts imports |

In comparative advantage models, I = 0. In EOS models, I = 1 (if a country’s exports &

imports within an industry are equal). An index value between zero and unity indicates
the relative importance of each type of trade.

c) This is explained by the Stolper-Samuelson theorm:

Assuming constant returns to scale, perfect factor mobility within the country and
incomplete specialisation, a relative increase in the price of the capital-intensive good
will increase the real return to capital and reduce the real return to labour (i.e.:
the (w/r) .
Assume a1 > a2 (good 1 is capital intensive relative to good 2)

a a1 (autos)

a2 (cloth)

Proof:

Profit maximisation by perfectly competitive firms and no specialisation, implies:

r/p1 = MPK1 = j1 (a1), r/p2 = MPK2 = j2 (a2), w/p1 = MPL1 = h1 (a1), w/p2 = MPL2 = h2 (a2)

A decrease in P2/P1 leads to a decrease in w/r both a1 and a2 decrease, therefore:

MPKi increases and MPLi decreases

r/p1 and r/p2 increase and w/p1 and w/p2 decrease

the real return to capital has increased while the real wage rate has decreased.
Section B

1. C
2. D

3. A
4. E

5. A
6. A

7. E

8. E

9. E
10. D

11. C

12. A

13. D
14. E

15. C