Practice Analytical Questions–Econ 471

Answers are found under the “Answers” title below.

For optimal learning experience, it is important that you address these
questions (actually solve them in full in your notebook) without looking
up the answers. After you are done addressing them in full, you can
check your answers.

1. Consider Egypt and Tunisia in a Ricardian world (includes all the assumptions of the Ricardian
model). Each country produces two goods, wheat (W) and cotton (C). The labor hours required to
produce one unit of each good in each country is:

W C

Tunisia 1 1/2

Egypt 5/2 1

a. What is the opportunity cost of cotton in each country. In which good does Egypt have comparative
advantage? Briefly explain. Also, write down the range for the equilibrium international price of
cotton once the two countries decide to trade. (6 points)

b. Each country has 1200 labor hours available. Draw the graph of the production possibility frontier
(PPF) for each country and show the points of specialization on each graph. Briefly explain how the
two countries can benefit from free trade with each other (also mention which good does each country
produce and export. This is called the “Pattern of Trade”). Illustrate the pattern and welfare benefits of
trade on your graphs. (14 points)

2. a. Consider the same Ricardian model as in question 1 above with all the information included.
Draw the world relative supply (RS) for the above problem. Fully label your graph. (5 points)

b. Now, suppose that the world relative demand is drawn such that the equilibrium international
relative price of wheat is at 2. Explain which country benefits most from free trade in this case?
Briefly explain. (4 points)

c. Now suppose that the population (labor supply) of Egypt triples to 3600 labor hours while that of
Tunisia stays the same as before. Show the effect of this increase in labor supply in Egypt on the RS
graph and explain the possible effect of this increase on the TOT of Egypt. (7 points)

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d. From your analysis above, consider trade between a very large country (with a large labor
supply/large population) and a small country in a Ricardian model. Which country do you expect to
reap the largest gains from free trade? Why? (4 points)

3. From the table of labor costs in question 1 above, calculate the productivity of labor in each sector.
Also calculate the wage (the same as productivity) received for each worker in specialization and free
trade. Write down the ratio of relative productivities and relative wage of labor in the two countries (in
terms of the same good- suppose the international relative price of wheat is 2.2) and discuss how it is
possible for a higher wage country (Tunisia) to have comparative advantage in one of the goods and
become an exporter of that good. Show your work. (20 points)

4. There are critiques of free trade argue that international trade between developing and developed
countries is “unfair” to the developing country, i.e., it is an “unequal exchange” in the following sense:
a developing country that say, produces a cheap good like toys (e.g., teddy bears), has to produce
many of such goods (say, 4000 toys at $5 each) and use many hours of labor to produce them in order
to be able to exchange them for one (expensive) good like a car (at $20,000) produced in a developed
country, possibly with many fewer workers. Therefore it is argued that trade is somehow “unfair” to
the developing country. Does this argument make sense? Use the Ricardian model of comparative
advantage and the production possibility graphs for two countries (developed and developing) to
discuss the merits of this argument. (20 points)

5. Consider U.S. and Chile in a Ricardian world. Each country produces two goods, cars (C)
and computer software (S). The following table shows the per unit cost of each good in terms of labor
hours used. Each country has 2000 labor hours available.

Cars Software

U.S. 2.5 1
Chile 6 2

a. Which country has comparative advantage in cars? Write down the possible range for the U.S.
terms of trade (TOT) . Also discuss whether the equilibrium international relative price of cars can be
1. Why?
(6 points)

b. The world relative demand (WRD) for software is: QS/QC = 0.8/(PS/PC). Draw the WRS and the
WRD diagram for software (fully label your graphs) and illustrate the equilibrium international
relative price of software. In this case, which country gains the most from free trade in this case and,
what is the effect of international trade on the level of welfare of the other country? Explain. (14
points)

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6. Two countries, Greece and Spain have the following unit labor costs of producing cheese and
bread:

Cheese Bread

Greece 1/2 1/5

Spain 1/3 1/6

a. Which country exhibits absolute advantage in production of bread? To establish comparative

advantage, write down the opportunity cost of production of bread in both countries and establish the
pattern of comparative advantage. Which country has comparative advantage in production of bread?
(6 points)

b. Now suppose Greece and Spain each have 1500 hours of labor available. According to the pattern of
comparative advantage, draw the world relative supply of cheese (relative to bread) and identify the
range of the world relative price of cheese. Fully label your graph. (6 points)

c. Consider consumers in the two countries to have identical tastes and suppose the world relative
demand for cheese to be fairly large. Draw the world relative demand curve on your graph in part b.
and explain the likely equilibrium world relative price for cheese. In this case, do both countries
specialize? Explain your answer and discuss the pattern of production in each country. Also explain
which country reaps the greatest benefits from free trade. (8 points)

7. a. In question 6 above, what is the term of trade (TOT) for i) Greece and ii) Spain in part c. above?
(6 points)

b. Now suppose the labor force in Spain grows two folds, to 3000 labor hours. Redraw the new world
RS curve and explain what is the possible/likely effect of this growth of labor force on the TOT of
Spain. (Consider the RD curve to be the same as in part c. above, i.e., demand for cheese is high). (8
points)

c. From part b above, what is the likely effect of an increase in the size of a country on its TOT? In
general, do small or large countries benefit most from free trade in the Ricardian world? Explain. (6
points)

8. a. Consider question 6 again. Write down the productivity of labor for each good in each country in
a table form and write down the ratio of productivities of each good in the two countries. (6 points)

b. Now suppose the equilibrium international relative price of cheese is 2.4. Write down the relative
wage {(wage in Spain)/(wage in Greece)} in the two countries and use the relative productivity ratios
to explain how a high wage country may have relative cost effectiveness (comparative advantage) in
production of a particular good. [Explain which country has a higher wage here and why that economy
has comparative advantage in the production of one of the two goods]. (14 points)

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9. In Bangladesh, it takes 500 labor hours to produce one TV set. In the same country, it takes 2 hours
of labor to produce one unit of textiles. The unit labor costs for the same goods in the U.S. are 100
labor hours to produce one TV and 1 labor hour to produce one unit of textiles.

a. Write down the information above in a table form and determine which country has absolute
advantage in production of textiles. Which country has comparative advantage in textiles? Write down
the opportunity cost of textiles in each country to accompany your answer. Also determine the range
of international relative price of TV sets. (6 points)

b. U.S. and Bangladesh have each 2000 labor hours. Draw the world relative supply curve for TVs.
Given that the international equilibrium relative price of a TV set is 200, draw the relative demand
curve (that would generate this price) and explain which country is producing which good. (8 points)

c. Draw the PPF graphs for the two countries and use the graphs to show the benefits of free trade.
Illustrate the points of production and consumption in free trade on your graphs. (6 points)

10. a. Given question 9 above, what is the wage for wage worker in each country in specialization and
free trade? Write down the ratio of wages (in terms of only one good). Show your work. (4 points)

b. Use the inequality describing the relative wage-relative productivity ratios to explain the pattern of
comparative advantage and trade. (6 points)

c. Now suppose that the productivity of labor in the textile sector in the U.S. triples. That is, the unit
labor cost of producing textiles in the U.S. is now 1/3 while all other unit labor costs in question 9 are
unchanged. Explain the pattern of comparative advantage and free trade in this case. Can we protect a
U.S. industry from losing to imports by increasing the productivity of its labor? Explain. (10 points)

11. Two countries, Babel and Potamia produce two goods, wheat (W) and milk (M) in a Ricardian
world. The following table shows the labor time per unit of production for each good in each country.

Wheat Milk

Babel 1 2

Potamia 3 5

a. Which country exhibits absolute advantage in production of milk? To establish comparative

advantage, write down the opportunity cost of production of milk in both countries and establish the
pattern of comparative advantage. Which country has comparative advantage in production of milk? (6
points)

b. Now suppose Babel has 400 and Potamia has 1000 hours of labor available. According to the
pattern of comparative advantage, draw the world relative supply of milk (relative to wheat) and
identify the range of the world relative price of milk. Fully label your graph. (6 points)

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c. Now consider the world relative demand for milk to be fairly small. Draw the world relative
demand curve on your graph in part b. and explain the likely equilibrium world relative price for milk.
In this case, do both countries specialize? Explain your answer and discuss the pattern of production in
each country. (8 points)

12. a. Consider question 11 again. Write down the term of trade (TOT) for i) Potamia and ii) Babel in
part c. above. (6 points)

b. Now suppose the labor force in Babel grows three fold, to 1200 labor hours. Redraw the new world
RS curve and explain if the RD curve is the same as in part c. above (i.e., demand for milk is low),
what is the possible/likely effect of this growth of labor force on the TOT of Babel. (8 points)

c. From part b above, what is the likely effect of an increase in the size of a country on its TOT? Do
small or large countries benefit most from free trade in the Ricardian world? Explain. (6 points)

13. a. Consider question 11 again. Write down the productivity of labor for each good in each country
in a table and form and write down the ratio of productivities of each good in the two countries. (6
points)

b. Now suppose the equilibrium international relative price of milk is 1.8. Write down the relative
wage {(wage in Babel)/(wage in Potamia)} in the two countries and use the relative productivity ratios
to explain how a high wage country may have relative cost effectiveness (comparative advantage) in
production of a particular good. [Explain which country has a higher wage here and why that economy
has comparative advantage in the production of one of the two goods]. (14 points)

14. Consider two countries, Syria and Lebanon in a Ricardian world. Each country produces two
goods: bread (B) and kebab (K). Each labor hour in Syria can produce 4 bread or 5 kebabs and each
labor hour in Lebanon can produce 5 breads or 8 kebabs. [Note: these are not labor hours required to
produce one unit of output!]. Each country has 1600 hours of available labor.

a. What are the unit labor costs of production (a LB and a LK) for each country? Which country has
comparative advantage in production of kebabs? Write down the relative cost ratios for bread for each
country and use it to determine the pattern of comparative advantage. Also draw the production
possibility frontier for both countries and show the points of specialization in production for both
countries. Fully label your graphs. (10 points)

b. Use the relative cost of production of bread in each country to draw a world relative supply curve
for bread. Fully label your graph. (5 points)

c. What should the relative international price for kebab be so country of Syria reaps the largest gains
from free trade? Explain briefly. (5 points)

15. Consider question 14 above again.

a. Suppose the equilibrium international relative price of bread is 1.4. Write down the relative wage for
the two countries (in terms of the same good). Also write down the relative productivity ratios for each

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good in the two countries and use these ratios to help determine comparative advantage of each
country in each good. Are both countries specializing here? (10 points)

b. Note that in the Ricardian model, wage (which is basically the productivity of labor) does not
change before and after free trade in either country. Supposing that both countries specialize, how
exactly do the inhabitants of these countries benefit from free trade, i.e., how are they able to increase
their consumption of the two goods after free trade? Explain. (10 points)

16. Consider Peru producing two goods, wool and corn in an H-O type world. Wool is relatively labor
intensive and corn is the relatively capital intensive activity.

a. What is the effect of an increase in the price of wool on the incomes of capital and labor in Peru?
Analyze (in writing) this effect and explain if you would expect both goods to become relatively more
labor or relatively more capital intensive once the price of wool increases. Use a graph to accompany
your answer. (10 points)

b. Suppose that Peru engages in free trade with another country that is relatively capital abundant.
Explain the pattern of comparative advantage and trade between Peru and the other country. Also
write down which group in Peru will oppose the free trade agreement and why. (10 points)

17. Consider an economy that produces two goods: furniture (F), and clothing (C) using two factors of
production, K and L. Both goods exhibit the same K/L ratios (intensity of the use of factors is the same
for both goods).

a. What does the PPF of this economy look like? Is it bowed out, bowed in, or simply a straight line?
Use the box diagram in the text (p. 73) to derive the PPF when K/L are the same for both countries.
Fully label your diagram (suppose there are 100 units of K and 100 units of L available to this
economy). (12 points)

b. Analyze the effects of an increase in the price of clothing on the income of each factor of production
(K and L). Does the result of the Stolper-Samuelson theory hold here? Why or why not? (8 points)

18. Australia's economy produces meat and wheat in an H-O type world. Meat is the relatively land
intensive activity and production of wheat is relatively labor intensive.

a. What is the effect of an increase in the amount of labor on production of wheat and wheat in
Australia? Use a graph to accompany your written answer. (10 points)

b. In trading with another country, Japan (also in an H-O world), Australia is considered relatively
land abundant. Use a RS/RD graph to show the relative price of wheat in autarky for both countries
and in free trade. Which group would oppose free trade in Australia and why? What is the effect of
free trade on (consumer) welfare in Australia? (10 points)

19. Consider question no. 18 above. Suppose now that there is some migration of labor into Australia
(but between Australia and Japan, Japan is still relatively labor abundant, even after the migration of

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labor into Australia. Instead of assuming there is labor migration, you can just as well assume high
birth rates in Australia).

a. How does this increase in labor in Australia affect the ratio of production of meat versus wheat in
that country? (You can disregard trade with Japan here--assume Australia in autarky.) (10 points)

b. In trading with Japan, once Australia's labor supply increases, would you expect the TOT of
Australia to fall or increase? Use a RS/RD graph to show TOT effect of an increase in labor supply in
Australia (no change in Japan). (10 points)

20. Consider David Ricardo’s depiction of effects of free trade in favor of the repeal of the Corn Laws
in England. His approach considered only one factor of production, labor. Now let’s examine what
would have been the result of an analysis where other factors of production would be present.
Consider Britain and Spain each producing two goods, corn and textiles. Production of corn uses land
and labor, as does production of textiles. Textiles is the relatively labor intensive activity. Spain is the
relatively land abundant country. Both countries operate in an H-O type model.

a. Which country has a lower relative price of corn in autarky? Which good does England have
comparative advantage in free trade? Discuss the income distribution effects of free between Britain
and Spain on the real incomes of labor and land in Britain. Do you think Ricardo could have used this
model to repeal the Corn Laws in England? Why or why not? (10 points)

b. Use a graph of RS/RD to show the income distribution effect of free trade on incomes of labor and
land in Britain. How does an increase in world relative demand for corn affect the TOT of Britain?
Show this effect on your graph and briefly explain. (10 points)

21. Peru and Argentina produce two goods, wool and corn in an H-O type world. Each good uses two
factors of production, labor and land. Wool is the relatively land intensive activity. Peru is the
relatively labor abundant country.

a. Draw the RS curve (for corn relative to wool) for each country on a graph. Also draw the world RS
curve (fully label your graph). Use the Stolper-Samuelson effect to discuss the income distribution
effects of free trade between Peru and Argentina. Which group in Argentina will lose and hence
oppose the free trade pact? (8 points)

b. Use graphs of PPF to show the welfare effects of free trade between Argentina and Peru. [Show
conditions of autarky --in production and consumption--versus free trade and label all lines and curves
in your graph]. (6 points)

c. How do you reconcile the welfare effects of free trade with the income distribution effects of free
trade where a particular group loses as a result of free trade? Briefly explain. (6 points)

22. India and Bangladesh produce two goods, jute and cotton in an H-O type world. Each good uses
two factors of production, labor and capital. Both jute and cotton have identical K/L ratios.

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a. Do both countries then have to have identical relative endowments of capital to labor (i.e., identical
capital- labor ratios)? Why? (8 points)

b. Draw the PPF of both countries. How do the relative costs of jute to cotton differ for these
countries in autarky? Discuss the possible benefits of free trade in this case. Can you identify the
pattern of comparative advantage and trade? (4 points)

c. Draw a world relative supply and world relative demand graph and show the equilibrium world
relative price of jute to cotton. Discuss the importance of the assumption of different factor intensities
in producing the various results of the H-O model. (8 points)

23. a. Both the implications of Ricardo's principle of comparative advantage and the H-O model are
based on a differences in production characteristics between two countries. Explain the differences in
assumptions and implications of both models in i) producing the welfare effects of free trade and ii) in
producing the income distribution effects of free trade. (12 points)

b. In further support of your argument above, suppose Ricardo would have picked the H-O model to
explain the benefits of free trade to the British Parliament and get their vote for free trade. Suppose
Britain produces cotton and corn and Britain is relatively labor abundant and cotton is the relatively
labor intensive activity. If David Ricardo had explained the results of H-O model in this way, would
he had been able to get the members of the British parliament (land owners) to vote in favor of the
repeal of the corn laws? Use the Stopler-Samuelson effect to answer this question. (8 points)

24. Consider Brazil and Chile in an H-O world. Each country produces two goods, beef and grapes.
Both goods use labor and land. Beef is the relatively land intensive activity and Brazil is the relatively
land abundant country.

a. Which country has comparative advantage in production and export of grapes? Do any of these
countries specialize in production of only one good? Why or Why not? (6 points)

b. Use a graph of RS/RD curves to show the autarkic relative price and the world equilibrium relative
price of grapes. Show the TOT of Chile on your graph. (6 points)

c. How do the wages compare in these countries after free trade? How about rents on land? How does
the reality differ from the strict assumptions of the H-O model to produce these results? Explain. (8
points)

25. Consider question 24 above again.

a. In free trade, what would be the effect of an increase in the amount of land in Brazil on i) TOT of
Chile and ii) TOT of Brazil? [Use a graph of world RS/RD to show the effect of an increase in land for
Brazil on the TOT of the two countries]. (6 points)

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b. Analyze the effect of such increase in land in Brazil on the level of welfare of Brazil in free trade.
Draw a graph of PPF for Brazil to accompany your answer. (Hint: PPF of Brazil shifts due to increase
in land. So you need to show two effects, one is the effect on PPF and the other on TOT of this
country due to increase in productivity of land). (6 points)

c. Now consider the effect of an increase in land in Chile on i) TOT of Chile and ii) TOT of Brazil.
Generally speaking, what happens to your trade partner's TOT if you grow in i) your abundant factor,
or ii) in your scarce factor? Explain. (8 points)

26. Consider two countries U.S. and Brazil producing two goods, textiles and wine, in a H-O model
setting: textiles use labor relatively more intensively while wine uses capital relatively intensively. U.S
is considered the relatively capital abundant country.

a. Use a RS/RD diagram to show the relative price of textiles to wine in each country in autarky and in
free trade. Fully label your graph. (4 points)

b. Fully discuss the mechanism by which the distribution of income among various factors is affected
with free trade (following the Stolper-Samuelson effect). Who opposes free trade in the U.S.? (8
points)

c. Use the graphical PPF analysis to show the overall welfare benefits of free trade. How do you
reconcile the fact that some groups lose in free trade (part b. above) with the welfare analysis of free
trade? Briefly explain. (8 points)

27. Consider U.S. and Brazil again as in question 26 above.

a. Use graphical depiction of the iso-cost lines to show that wages and rents in the two countries are
exactly equal after free trade, although before free trade their wages and rents are not the same (this is
the illustration of the factor price equalization theorem). Also explain if you would expect any
migration of labor to take place between U.S. and Brazil if after free trade in goods, such migration is
allowed.
(10 points)

b. What are the factors/reasons that in reality, prevent the two countries from having exactly the same
wages and rents after free trade is enacted? List the three relevant factors and briefly explain each.
(10 points)

28. a. One may expect that a “scarce” factor tends to have its wages bid up more easily than an
“abundant” factor -- a factor already in ample supply with low wages-- when a country starts to engage
in free trade. This seems an "intuitive" result of considering scarcity. Is this the conclusion reached by
the H-O model of trade? Explain. (10 points)

b. Discuss the income distribution implications of the H-O model for a scarce versus an abundant
factor and explain whether or not the implications of this theory comply with an “intuition” about
scarce factor’s wages stated above, and explain why. (10 points)

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29. a. Consider the case of free trade between Peru and Mexico in a standard H-O model. Each country
produces two goods: food and clothing, using only two factors of production, labor and land. Food is
the relatively land intensive activity. In autarky, the relative price of land is higher in Peru than in
Mexico.

a. Establish the pattern of comparative advantage and trade. Also explain if you expect each country to
specialize in the production of each good in free trade. (4 points)

b. Draw the RS curves for food for each country in autarky. Also draw the world RS curve and the
world RD curves and show the TOT of Mexico on your graph. (6 points)

c. Analyze the income distribution effects of free trade in each country. Explain which group in each
country would oppose free trade. (4 points)

d. Use the graphical analysis of the PPF to show the welfare benefits of free trade. Show the trade
triangles on your graph. Fully label your graphs. (6 points)

30. a. Consider again the premises of question 26 above. Now suppose there has been an increase in
the endowment of labor in Brazil. How does this increase in labor affect i) the autarkic relative price of
textiles in Brazil, ii) the terms of trade (in free trade) for Brazil? Use the RS/RD diagram to show the
effect of an increase in the endowment of labor in Brazil. (10 points)

b. In general, does growth in a relatively abundant factor of a country tend to increase or lower the
terms of trade for that country? Explain. (4 points)

c. How does an increase in the endowment of labor in Brazil affect the terms of trade of U.S. in free
trade? How do you think the level of consumer welfare is affected in the U.S.? (6 points)

31. Consider the soft drink industry as a monopolistically competitive sector. In free trade, a typical
firm's MR = MC and P = AC conditions are characterized as follows: MR = MC: P=
0.4 + 2/n
F
P = AC: P= n + 0.4
S

Where F = $10,000 and S = 2,000,000 units.

a. Calculate the equilibrium number of firms and the average price of soft drinks in free trade. Show
your work. (6 pints)
b. Now, suppose that U.S. imposes autarky in the soft drink industry and therefore, the size of the
market is cut in to half. Calculate the autarkic price and the number of firms (variety of soft drinks). (8
points)

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c. Would you prefer free trade in soft drinks to autarky? List the benefits you receive from free trade in
soft drinks. Would you label this type of trade as "inter- industry" trade or, "intra-industry" trade? (6
points)

32. Consider South Korea and China in an H-O world. Each country produces two goods, cars and
toys. Toy is a relatively labor intensive activity and Korea is considered relatively capital abundant.
Suppose that both sectors, toys and cars, exhibit increasing returns to scale technology. The PPF for
each country is bowed in.

a. Draw the PPF of both countries and explain the pattern of specialization and free trade for both.
Show the benefits of free trade on your graph. (12 points)

b. List and briefly explain ALL sources of gain from free trade in this case.
(8 points)

33. Suppose two countries, U.S. and Canada in autarky. Each country produces two goods, cars and
trucks. Both goods exhibit increasing returns to scale technology in their production processes. Both
have identical factor endowments, identical tastes (cars and trucks are equally liked by all consumers),
and identical technologies.

a. Draw graphs of PPF for both countries and show the benefits of trade. Can you identify a pattern
of specialization and free trade? Why or why not? (8 points)

b. How do the income distribution effects of free trade compare (suppose there are two factors of
production capital and labor, both producing fairly similar goods, cars and trucks. That is, the
factor intensities are the same for both goods]? (5 points)

c. Now suppose tastes are highly favorable to cars and there is very little demand for trucks. Use the
diagram to argue if it is possible for one country in the increasing returns to scale graphs to not benefit
from free trade (and actually be hurt by the possibility of free trade). You can draw a new graph to
show this case. Fully label your graph. (7 points)

34. The H-O model describes the benefits of free trade among countries with different factor
endowments producing goods with different factor intensities. On the other hand we can have a world
with increasing returns to scale in both goods where the two countries are identical in every aspect.

a. Discuss the differences between the two models in the following areas: i) pattern of specialization
and trade, ii) factor price equalization between countries after free trade, iii) income distribution
effects of free trade in each country. (15 points)

b. What types of goods (goods that are very different from each other or goods that are similar) are
traded in each model? What types of countries in the world engage in either type of trade (based on H-
O or based on increasing returns to scale)? (5 points)

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35. Japan is suspected of dumping flat panel displays (FPD) produced by a large corporation in that
country onto the U.S. market.

a. Draw a graph of "monopoly" production and pricing of FPD in Japan and show a case of persistent
dumping on your graph. Use the concept of price elasticity of demand to explain the difference in the
price of this good inside and outside of Japan. (12 points)

c. Explain the possible sources of welfare benefits for consumers if Japan was previously acting in
autarky and now it suddenly is engaged in reciprocal dumping with a firm in the U.S. (8 points)

36. A cosmetics producer in a monopolistically competitive industry faces the following conditions:

P = n (F/S) + c
P = c + 1/(bn)

Where the size of the market is $1,960,000 units. The fixed cost of production is F = $10,000 million
and b = 1. The marginal cost of production of cosmetics is c = $5.

a. Calculate the equilibrium price of a unit of cosmetics and the number of firms in autarky. Also,
calculate the level of production of each firm in this industry. Show your work. (10 points)

b. Now this country merges in free trade with another identical country. What are the new equilibrium
price and the number of firms in the industry? What is the level of production of each typical firm in
this industry in free trade? Show your work. (10 points)

37. A monopolist firm in an economy faces the following demand curve:

Q = 48 - .02 P
The total cost of production of this firm is:
TC = 300Q + 100Q 2
Where Q is the level of production of this good, P is price per unit and TC is the total cost of
production.

a. Calculate the domestic monopoly price, output, and level of economic profits. Show your work. (10
points)

b. Now suppose this firm faces free international competition at a world price of P = $1800 per unit.
Calculate the level of output and the economic profits of this firm in free international competition.
Show your work. (10 points)

38. a. Consider the same firm as in question 37 above. Now suppose this firm is engaged in persistent
dumping. The international price of this good is again $1800 per unit. Calculate the amount of exports
and sales at home and the price charged by this firm at home. Show your work. (10 points)

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b. What are the consumer welfare effects of dumping for i) the economy in which dumping occurs, ii)
for the economy where the monopoly firm is located and where the market is protected. In what sense
does the economy-in which dumping occurs - would consider it objectionable? (10 points)

39. a. Consider a labor intensive good that is being produced by an industry in a developed (capital
abundant) country. Although labor on this country is relatively expensive, this good is produced with a
sufficiently low AC so that it represents an export item for the developed country. Explain how this is
possible. Use a graph to analyze this issue and accompany your written explanation. (8 points)

b. Consider two countries A and B. Country A produces computer software in an industry that faces
external economies of scale. Both countries have the same AC curve in production of software, but A
has already started the industry and is producing this good. Discuss if country B would lose or benefit
from trading with A (importing software from A) and how it may lose or benefit. Explain also if
country A's welfare would be enhanced (if so, in what way?) by exporting to B. Use a graph to
accompany your answer. (12 points)

40. a. Contrast dynamic economies of scale with that of external economies of scale. Draw a graph for
each and briefly explain. (10 points)

b. The semiconductor industry officials in a country lobby the government for protection from imports
based on the infant industry argument. Use a graph and some written explanation to articulate the case
made by these industry officials. What forms could this protection take? (10 points)

41. Consider the production of frozen food in the U.S. characterized by a monopolistic competitive
market structure. The two essential characteristics, MR = MC and
P = AC are written below:

P = n F/S + c , P = c + 1/(bn)

For this industry in the U.S., c= $ .5, the fixed cost of production is $ 1000 and the size of the market
is 22,500 cases of beer. The value of the adjustment coefficient ‘b’ is .5 (b = .5).

a. Calculate the number of firms and the equilibrium price of a frozen food entree in the U.S. Show
your work. (8 points)

b. Now suppose U.S. trades with Germany, another producer of this good with the same market
characteristics. The size of German market is exactly the same as the U.S. market and Germany has
the same number of firms as the U.S. in autarky. Explain, i) what are the sources of benefits from free
trade here, ii) would you expect the number of beer firms in free trade between U.S. and Canada to be
double that of the firms in autarky for each country? Why or why not? (12 points)

42. Consider trade in natural gas between Russia and Kazakhstan. Russia is the importer of natural gas
from Kazakhstan. Russia’s industry officials have charged Kazakhstan with “dumping” its natural gas.

c. What observations by Russians would lead them to believe that Kazakhstan is indeed engaged in
persistent dumping of its natural gas? Use a graphical analysis to show the case of dumping by

13
 Kazakhstan’s gas industry. What is the effect of the dumping of natural gas on the level of welfare
of consumers of natural gas in Russia? (12 points)

d. Explain the welfare effects of reciprocal dumping of natural gas in both countries. In this case,
would you expect the international price of natural gas to be higher or lower than in part a. above?
(8 points)

43. The car industry officials in India have lobbied for protection from imports of cars on the grounds
of “infant industry” argument.

a. Use a graph to illustrate the characteristics of an infant industry and why protection of the
domestic industry may be justified in India. (10 points)
b. In the recent decades, many developing countries in the world have used the infant industry
argument to protect manufacturing and other relatively capital intensive durable consumer
products. Use the H-O theorem to argue whether you think the claims of “infant industry
argument” in these industries are in fact legitimate in the developing world or, do the owners of
capital have other motives for protection of durable consumer good industry in these countries?
(10 points)

44. Iran has faced a trade embargo since 1980. Some analysts believe that this state of near autarky
has been actually good for the economy of Iran as it has allowed the country to develop many of its
domestic manufacturing industries to meet the domestic demand. Evaluate this statement in light of the
following models: i) the H-O model (suppose Iran is relatively labor abundant and there is constant
returns to scale technology), ii) monopolistic competition (suppose many of Iran’s products are
produced by monopolistic competitive firms), iii) dynamic increasing returns to scale (suppose Iran’s
consumer products exhibit this technology form). (20 points)

45. Consider Portugal and Spain in a H-O world. Both countries use two factors of production, labor
and capital in the production of their goods. Portugal is the relatively labor abundant country.

a. Once free trade in goods takes place, according to the strict assumptions of the H-O world, would
you expect any migration of labor between the two countries? Why or why not? Explain conditions
under which labor would move between countries even if free trade in goods and services were
allowed. (7 points)

b. Use a graphical analysis to show the production and welfare effects of immigration of labor
between Portugal and Spain. Discuss how both countries may gain from labor migration. (6 points)

c. Now suppose labor productivity in Portugal rises (due to say, an increase in capital in that
country). What is the effect of this increase in productivity on your analysis of part b. above
regarding the migration of labor? Draw the change on your graph and briefly explain. (7 points)

46. a. Explain the difference between foreign direct investment (FDI) and portfolio investment in
international trade. (4 points)

14
b. List and briefly analyze the advantages and disadvantages of FDI for the economy of the host
country. List three sources of advantage and two possible sources of disadvantage for the host country.
(8 points)

c. What are the advantages and disadvantages of FDI for the multinational firm that engages in FDI in
a developing country? List two sources of advantage and disadvantage in this case. Also, explain how
the economy of the country of origin (where the headquarters of the multinational firms reside)
benefits from FDI. (8 points)

47. The car industry officials in Egypt have lobbied for protection from imports of cars on the grounds
of “infant industry” argument.

a. Use a graph to illustrate the characteristics of an infant industry and why protection of domestic
industry may be justified. (6 points)

b. Use a graph of supply and demand for cars to explain the effects of a tariff on domestic production,
consumption, and consumer welfare level in Egypt. Of the two tools of protection of domestic
industry, tariffs and import quotas, explain which is the better policy for protection of domestic
industry and why.
(10 points)

c. If the car industry in Egypt is relatively capital intensive while Egypt is a relatively labor abundant
country, what is the effect of tariff on the income of labor and capital? Who should oppose tariffs on
cars in Egypt? (4 points)

48. Consider Morocco and Spain in an H-O world. Both countries use two factors of production, labor
and capital in the production of their goods. Morocco is the relatively labor abundant country.

a. Once free trade in goods takes place, according to the strict assumptions of the H-O world,
would you expect any migration of labor between the two countries? Why or why not?
Explain conditions under which labor would move between countries even if free trade in
goods and services were allowed. (7 points)

b. Use a graphical analysis to show the production and welfare effects of immigration of
labor between Morocco and Spain. Discuss how both countries may gain from labor
migration. (6 points)

c. Now suppose labor productivity in Morocco rises (due to say, an increase in capital in that
country). What is the effect of this increase in productivity on your analysis of part b.
above regarding the migration of labor? Draw the change on your graph and briefly
explain. (7 points)

49. Consider trade in oil between Russia and Kazakhstan. Russia is the importer of oil from
Kazakhstan and Kazakhstan’s export supply of oil to Russia is perfectly inelastic. In an attempt to
increase its own domestic production of oil, Russia imposes an import tariff against the imports of
oil from Kazakhstan.

15
 a. Use a graphical analysis to show how the burden of tariff is shared by the two countries.
Also analyze the effects of this tariff on Russia’s TOT and welfare level. (12 points)

b. Now consider Russia to be a small country in its imports of oil from the rest of the world
(Kazakhstan included). Use a graphical partial equilibrium analysis to show the welfare and
TOT effects of a tariff on imports of oil into Russia. Fully label your graph. (8 points)

50. Consider again the question above with Russia and Kazakhstan as two producers of oil. Russia’s
industry officials have charged Kazakhstan with “dumping” its oil.

a. What observations by Russians would lead them to believe that Kazakhstan is indeed
engaged in persistent dumping of its oil? Use a graphical analysis to show the case of
dumping by Kazakhstan’s oil industry. What is the effect of the dumping of oil on the level
of welfare of consumers of oil in Russia? (12 points)

b. Explain the welfare effects of reciprocal dumping of oil in both countries. In this case,
would you expect the international price of oil to be higher or lower than in part a. above?
(8 points)

51. Consider two countries H and F each producing an aggregate good, using a CRS production
technology that needs labor and capital. H is the relatively labor abundant country.

a. Draw a graph and show the production and welfare effects of allowing labor to freely migrate
between the two countries. Also discuss the income distribution effects of this migration. Fully label
your graph.
(7 points)

b. Now assume that the amount of capital in country H decreases. On your graph in part a (with a
different color!) show the effect of this decline on capital in the rate of migration as compared to part
a. above. Also explain the effect of this decline in amount of capital on the equilibrium real wage
between the two countries. (7 points)

c. Now suppose the countries H and F in the question are producing two goods instead of one (as in an
H-O model). In free trade in goods, the factor prices will equalize. How does a tariff on the import of
the labor intensive good affect the incentive for migration of labor between the two countries? In
which direction will the migration flow? Explain. (6 points)

52. a. What are the two significant differences between foreign portfolio and foreign direct
investment? List and briefly explain. (4 points)

b. Compare the welfare and income distribution effects of FDI (into a developing country, originating
from a developed country) with the welfare and income distribution effects of free trade in goods (with

16
no FDI) in an H-O model where one country is relatively labor abundant (the developing country) and
the other is relatively capital abundant. (8 points)

c. How do you compare the welfare and income distribution effects of FDI between industrialized
countries with welfare and income distribution effects of trade in goods in an IRS based technology of
production between countries? Briefly explain. (8 points)

53. a. Britain imposes a tariff against imports of clothing from the rest of the world. Use a graphical
partial equilibrium analysis of a tariff in a small country and discuss the TOT, welfare and income
distribution effects of a tariff in Britain. Consider Britain to be relatively capital abundant. (10 points)

b. Instead of a tariff, Britain is about to impose a quota (at a rate equivalent to a tariff in part a above).
Use a partial equilibrium graph to discuss the welfare and TOT effects of the quota for Britain. Also
explain if quota or tariff is a preferred policy from the point of view of economists and why. (10
points)

54. The European Community (EU) imports cocoa from Ghana in an H-O world. The EU is proposing
a tariff on cocoa from Ghana. The EU is considered relatively capital abundant and cocoa is a
relatively labor intensive activity.

a. Use a partial equilibrium set of graphs (with upward sloping supply and downward sloping demand
curves) and show the TOT, welfare, and income distribution effects of a tariff on imports of cocoa into
EU. Discuss these effects for both Ghana and EU. (10 points)

b. Now suppose Ghana's export supply of cocoa is perfectly inelastic. Use a set of graphs to show the
TOT and welfare effects of a tariff on Ghana's cocoa for both EU and Ghana. Fully label your graph.
(10 points)

55. a. List and briefly explain the 3 sets of arguments depicting the benefits of going from limited to
free trade offered by economists. (9 points)

b. List the various arguments provided by countries, justifying their reasons for imposing trade
barriers. Which argument(s) provide an economically justifiable reason for government intervention in
free market? (6 points)

c. From part b above, would this intervention have to be a trade-related policy? What is the best
method of protecting a domestic industry and why is it the best method? (5 points)

56. Consider labor migration between France and Algeria. Assume each country produces two goods:
food and cars. Car is a relatively capital intensive activity. France is relatively capital abundant and
Algeria is relatively labor abundant. Capital and labor can not cross the borders between France and
Algeria.

17
a. Use the assumptions of the H-O model for these countries and explain whether in the strict sense of
the H-O model there would be any need for migration of labor once free trade in goods is allowed. List
all the major reasons that in reality would lead to migration of labor (which direction?) in-spite of free
trade in goods. (10 points)

b. Use the depiction of analysis of labor migration in chapter 7 to state the assumptions of the model,
and use a graph to explain the welfare and income distribution effects of labor allowing labor
migration from one to the other country. State how are these results different from the H-O results for
welfare and income distribution. (10 points)

57. a. Now take the graphical analysis of question 1 section b above and assume that due to a civil
strife in Algeria, some of the capital stock in that country is destroyed. Draw a new graph similar to
question 1 section b and illustrate the effect of this decrease in capital stock in Algeria on i) the
migration level for labor and ii) equilibrium real wages and real rents on capital in Algeria and France.
(10 points)

b. Again, take the graphical analysis of question 1 section b above and now assume that labor supply
in France increases (unrelated to migration from Algeria-you can assume higher birth rates in France).
Use the same graphical analysis to illustrate the effect of this increase in labor supply on i) the
equilibrium real wage in France and Algeria and ii) the real rents in these two countries. (10 points)

58. a. List and explain the elements of the theory of multinational enterprise. How is FDI different
from foreign "portfolio" investment? (6 points)

b. What are the effects of FDI on i) real wage in the developing country, ii) real wage in the developed
country, iii) real rents to capital in the developing country iv) real rents to capital in the developed
country? (8 points)

c. What are the sources of potential increase in welfare from FDI in a "host" developing country?
What are the potential disadvantages? List and briefly explain each. (6 points)

59. Consider trade in avocados between two large countries, U.S. and Mexico. The U.S. is the
importer of avocados, a relatively labor intensive good.

a. Draw a pair of graphs for avocados in free trade for both countries and show the amounts of import
for U.S. and exports for Mexico. (6 points)

b. Now consider the effects of an import tariff by the U.S. Use your graph to illustrate the case of a
tariff. Also explain the effects of the tariff in the U.S. on i) TOT of U.S., ii) level of welfare in U.S.,
iii) real wage in the U.S. and iii) TOT and welfare level in Mexico. Which factor of production in the
U.S. would favor such a tariff? (14 points)

60. Now consider the case of U.S. and Mexico again, but consider U.S. to be a small country as an
importer of avocados. The domestic supply of avocados in the U.S. is described by Q = 100 + 40 P
and the domestic demand by Q = 400 - 10P, where Q is measured in tons and P is price per ton.

18
a. Calculate the domestic equilibrium price for the U.S. If the international price of this good is $ 4
per ton, calculate the level of imports of avocados for the U.S. and show all this on a graph. (10 points)

b. Now suppose U.S. imposes an import tariff on this good. What is the effect of this tariff on i) the
TOT of U.S., ii) on the level of welfare of U.S., iii) on the amount of imports of avocados into the
U.S., iii) income distribution effects of this tariff for the U.S., iv) TOT and welfare effect for Mexico?
Briefly analyze each question above. (10 points)

Answers:
1. a. The opportunity cost of cotton in Tunisia is 1/2; for Egypt this figure is 2/5. So clearly, Egypt
has comparative advantage on cotton. The international equilibrium price cotton will be between
.4 and .5.
b.
Egypt
Tunisia W
W

C C

Egypt specializes in cotton while Tunisia specializes in wheat. The CONSUMPTION POSSIBILITY
FRONTIER for both countries lies outside their PPF showing the increased possibilities for
consumption and increased welfare.
Egypt produces and exports cotton and Tunisia produces and exports wheat to Egypt.

2.

19
a.

PW /PC
RD
WRS
2.5

2.0

QW /QC
1

The lower "step" in this world RS curve is due to Tunisia's home relative costs of wheat. The other
step is Egypt's relative cost of wheat. On the horizontal axis, the "step" in world supply function is
found by finding QW /QC in specialization. Tunisia specializes in wheat, producing 1200 bushels of
wheat, and Egypt specializes in cotton, producing 1200 units of cotton. So the step is at 1200/1200 =
1.

b. If the world RD (in graph) intersects with the WRS such that the international relative price of
wheat is 2, then Tunisia would produce both wheat and cotton while Egypt specializes in cotton. Egypt
reaps the largest benefits from trade and Tunisia is indifferent between trading and not trading.

c. In this case, the denominator of the ratio of the specialized production of wheat to cotton will triple,
to 1200/3600 = 1/3. So the step function moves to the left, the step moving from 1 to 1/3. It is now
possible for the RD--which crossed the RS on the lower step (price = 2)--to now intersect the RS on
the higher step (depending on how close to the vertical axis it was originally drawn). If RD intersects
RS on relative cost of 2.5, then Egypt will stop specializing and Tunisia will specialize in wheat. So
the TOT (relative price of cotton) of Egypt will go from .5 to .4. The TOT has "deteriorated' for Egypt.

d. The largest gains, according to our analysis, go to the small country! The large country (in part c. it
is Egypt) has to produce both goods and in our Ricardian world, this means staying on its PPF. The
world relative price will be equal to the large country’s autarkic relative price so the large country will
be indifferent between trade and autarky.

3. PRW T = 1 PRW E = 2/5 PR CT = 2 PRCE = 1

20
PRW T /PRW E = 5/2 PR CT /PR CE = 2

Wage in Tunisia in terms of wheat is = 1 . For Egypt, wage in terms of cotton is 1. Since in the
international market one bushel of wheat is worth 2.2 units of cotton, this means that Tunisian workers
earn 2.2 units of cotton. Hence in terms of cotton

The ratio of wages: WT / WE = 2.2/1 = 2.2

Therefore,

PRW T /PRW E = 2.5 > WT / WE = 2.2 > PR CT /PR CE = 2

Here, Tunisia is the high wage country (the Tunisian workers earn more than double their Egyptian
counterparts), yet its RELATIVE PRODUCTIVITY in wheat is higher than the ratio of wages in the
two countries. Therefore, although Tunisia is the higher wage country, it does have comparative
advantage (is relatively cheaper) in the production of wheat.

4. The important point here is to look at the alternative to free trade, that is, autarky. In free trade it
costs the developing country 4000 toys to get one car. If the country were in autarky and needed to
produce its own cars, the relative cost of a car in terms of forgone toys will be even higher; perhaps
5000 toys have to be sacrificed to produce one car. In this ‘static’ case, it pays the economy of
developing country to specialize in toys and exchange them with cars from a developed country. The
graphical illustration is similar to question 1 where trade allows a country to sacrifice less of its own
resources to buy a particular good, like a car.

Developing C.
cars

Toys

5. a. U.S. has comparative advantage in cars as it has a lower relative cost of production of cars. As US
is the exporter of cars, its TOT = relative price of cars to software in international trade. Hence this
relative price varies between the two countries cost ratios, that is between 2.5 and 3.

21
 WRD

PS/PC

WRS
.40

.33

1.25 2 QS/QC

b. The WRS is a step function with “steps” at .33 and .4. The World Relative Demand needs to be
drawn and the intersection of WRS and WRD determines the equilibrium international relative price
of software. The WRD is a hyperbola and it crosses the WRS in only one point. This intersection point
is either where relative price is .4 or where relative price is .33, or, the relative quantity is 1.25. In
other words, there are only three possibilities to try and find the intersection of WRD with the step
function of WRS. So if we consider for a relative Q of 1.25 what the relative price implied would be
for WRD, we find that: 1.25 = .8/ /(PS/PC) or PS/PC = .64. Therefore, one point on the WRD is rel Q =
1.25 and relative price = .64. If we try a relative price of .4 in the demand relationshp, relative quantity
is 2. This latter point is indeed also on the WRS. Therefore Rel P = .4 and Rel Q = 2 is on both WRD
and WRS and it is the equilibrium point. The international relative price is .4 and Chile gains the most
here. It costs Chile .33 to produce software and it can sell it for .4 (the highest relative price of
software). U.S. is indifferent between trade and autarky as the international relative price of software
is the same as its home cost.

6. a. Spain has absolute advantage in bread since it has a lower unit labor cost for bread. The
opportunity cost of bread in Spain is .5 and that of Greece is 2/5 = .4 so Greece has comparative
advantage in bread.

b.
WRD
PC/P B
WRS
2.5

QC/QB
3/5
6/5

22
The lower "step" in this world RS curve is due to Spain's home relative cost of cheese. The other step
is Greece's relative cost of cheese. On the horizontal axis, the "step" in world supply function is found
by finding QC/QB in specialization. Spain specializes in cheese, producing 1500/(1/3) units, and
Greece specializes in bread, producing 1500/(1/5) units of cotton. So the step is at 3/5. The
international equilibrium price of cheese will be between 2 and 2.5.

c. The world RD (in graph) intersects with the WRS such that the international relative price of cheese
is at the highest level at 2.5. In this case, Greece produces both goods and Spain will specialize!

7. a. TOT for Greece is P of its export/ P of its import good = 1/2.5. The TOT for Spain is 2.5.

b. The new world RS will shift forward!! This is due to the fact that Spain has now 3000 labor hours
and will produce 3000*3 units of cheese in specialization. So the new RS is the dotted step function in
graph above! The point of specialization now is at 6/5. Previous to this increase in labor hours, TOT of
Spain was 2.5. Now after the new RS intersects the RD, the TOT for Spain falls to a price between 2
and 2.5.

c. As the size of a country grows, the benefits of trade for that country are eroded (note that the
comparative advantage is arrived at totally independently of the number of workers. But the
distribution of benefits of trade between two countries works against the large country in the Ricardian
model. This is an important point.)

8. a. The table of productivities:

C B
Greece 2 5
Spain 3 6

PRCS/PR CG = 3/2 ; PR BS/PR BG = 6/5

b. Wage in Spain = 3 cheese

Wage in Greece = 5 bread. Since 1 cheese exchanges for 2.4 bread, then Wage in Spain is 3*2.4 = 7.2
cheese. Therefore, WS/WG = 7.2/5 = 1.44

PRCS/PR CG = 3/2 > WS/WG = 7.2/5 = 1.44 > PR BS/PR BG = 1.2

Wage in Spain is 1.44 times that of the wage in Greece, yet, Spain's relative productivity in cheese is
higher than the ratio of wages, so Spain has comparative advantage in cheese (can produce cheese
relatively cheaper!).

9. a. Table of unit labor costs:

23
 TV Tex

U.S. 100 1
Bangladesh 500 2

U.S. has absolute advantage in the production of textiles as its unit labor costs are less than that of
Bangladesh. The opportunity cost of textiles in the U.S is 1/00 and in Bangladesh is 1/250.
Bangladesh has comparative advantage in textiles. The range for the international relative price of TV
is 100 and 250.

b.
PTV/PTex

WRS
250

WRD
100

2/100 QTV/QTex

This means specialization is taking place!! So, U.S. is only producing TV sets and Bangladesh is only
producing textiles!

24
c.
Bangladesh U.S.
tex
tex

TV TV

10. a. WU.S. = 1/00 of TV; WB =1/2 of unit of textiles. As each unit of TV exchanges with 2oo
textiles, then W in U.S. in terms of textiles is 2.
WU.S./WB = 4

b. PRTVU.S. /PRTVB = 5 > WU.S./WB = 4 > PRTexU.S. /PR Te xB = 2

The relative productivity of TV in U.S. is larger than that of relative wages in the U.S. Therefore U.S.
has a lower relative cost of producing TVs or it has comparative advantage in TV production.

c. Here the table is:

TV Tex

U.S. 100 1/3

Bangladesh 500 2

So the relative cost of textiles in U.S. is now 1/300 which is smaller than that of Bangladesh's. So now
the pattern of comparative advantage changes: U.S. actually has comparative advantage in textiles.
Therefore by increasing productivity of labor, a country may preserve its comparative advantage in a
particular industry.

25
11. a. Babel has absolute advantage in milk. The opportunity cost of milk in Babel is 2; for Potamia
this figure is 1.66. So clearly, Potamia has comparative advantage on milk.

b.

PM/PW
RD
WRS
2.0

1.66

QM/QW
1/2

The lower "step" in this world RS curve is due to Potamia home relative costs of milk. The other step
is Babel's relative cost of milk. On the horizontal axis, the "step" in world supply function is found by
finding QM/QW in specialization. Potamia specializes in milk, producing 1000/5 units, and Babel
specializes in wheat, producing 400/1 units of cotton. So the step is at 200/400 = 1/2. The international
equilibrium price of milk will be between 1.66 and 2.0.

c. The world RD (in graph) intersects with the WRS such that the international relative price of milk is
at the lowest at 1.66. In this case, Potamia is likely to produce both goods and Babel will specialize!

12. a. TOT for Potamia is P of its export/ P of its import good = 1.66. The TOT for Babel is 3/5 = .6

b. The new world RS will be shifted back!! This is due to the fact that Babel has now 1200 labor
hours and will produce 1200/1 = 1200 units of wheat in specialization. So the new RS is the dotted
step function in graph above! The point of specialization now is at 1/6. Previous to this increase in
labor hours, TOT of Babel was 3/5 = .6. Now after the new RS intersects the RD, the TOT for Babel is
1/2, which is the same as its domestic relative cost, so its TOT has fallen.

c. As the size of a country grows, the benefits of trade are eroded as that country may need to produce
both goods for its large population! A small country-in trade with a much larger country- reaps the
biggest gains from international trade in the Ricardian model.

13. a. The table of productivities:

W M
Babel 1 1/2
Potamia 1/3 1/5

26
PRW B/PRW P = 3 ; PRM B/PRMP = 2.5

b. Wage in Babel = 1 wheat

Wage in Potamia = 1/5 milk. Since 1 milk exchanges for 1.8 wheat, then Wage in Potamia is
1/5*1.8 = .36 wheat

PRW B/PRW P = 3 > WB/WP = 1/.36 = 2.77 > PRM B/PRMP = 2.5
Wage in Babel is 2.77 times higher than wage in Potamia, yet, Babel's relative productivity in wheat is
higher than the ratio of wages, so Babel has comparative advantage in wheat.

14. Table of productivity:

B K

Syria 4 5
Lebanon 5 8

So unit labor costs are:

B K
Syria 1/4 1/5
Lebanon 1/5 1/8

The relative opportunity cost of bread in Syria is (1/4)/(1/5) = 1.25, and for Lebanon, the figure is
1.66. Therefore, Syria should specialize in bread and Lebanon in kebabs!

Syria Lebanon
B
B

Kebab K

27
b.
PB/PK

World RS

1.25

QB/QK

c. If the international relative price for Bread is 1.6, then Syria's cost of producing bread is 1.25, and
Syria gains the most from international trade as it will have the highest TOT possible..

15. a. WS = 4 bread; WL = 8 kebabs. As each unit of bread gets you 1.4 kebabs, then WS = 4*1.4 =
5.6 kebabs in Syria.

PRBL /PR BS = 5/4 < WL/WS = 8/5.6 < PR K L /PR KS = 8/5

The relative productivity of kebab in Lebanon to Syria is higher then the relative wages of Lebanon to
Syria, so Lebanon has comparative advantage in kebabs.
Both countries are specializing here as the international relative price is between the two domestic
prices.

b. The inhabitants of each country can produce one good relatively cheaper and sell it for more than it
costs them to produce at home, and then buy the other good relatively cheaply from the world market.
In this manner, their real purchasing power has increased!

16.
a. According to the Stolper-Samuelson effect, the increase in the price of the labor intensive good
(wool) helps increase wages in greater proportion than the price increase, and reduces the income of
capital, r. As wages go up, every employer switches to a more K-intensive technique of production.
This is borne out by the graph:

28
 w/r

corn

PWool/ K/L
PC

As w/r increases, both sectors become more K- intensive.

b. As Peru is relatively labor abundant, it has comparative advantage in the production and export of
the labor-intensive good, wool. And the other country should produce and export corn. Due to S-S
effect, income of labor goes up more than proportionately, and that of capital falls. So capitalists in
Peru would oppose free trade.

17. a. Using the box diagram for allocation of labor and capital between the two sectors, we have a
square with each sides measuring 100 units of L and 100 units of K.

Because K/L are the same for both sectors (for simplicity we can assume that the ratio for K/L is 1).
Then the "contract" curve of the production isoquants will be the diagonal line from the origin of F to
that of C. Hence the PPF for this economy is a straight line--similar to Ricardo's model!

29
 F

b. Since the ratio of P C/PF is fixed domestically (similar to Ricardo's model), an increase in price of
say, clothing will lead to specialization! By writing out the unit cost = price equation,
PC = waLC + raKC (and actually we can assume, a LC = a KC = 1), so PC = w + r which means that w and
r are indeterminate! (one equation and two unknowns!). So, changes in PC can translate into many
possible outcomes for rise in both w and r or rise in one factor's income and a fall in the other factor's
income, etc…

18.

Omeat
Omeat’

Land

Owheat Labor

30
Using the Rybczynsy effect, we know that the production of wheat grows more than proportionately
and production of meat falls.

b. This implies that in autarky, Japan produces wheat relatively cheaply or that RS of Japan lies to the
right of Australia's (in the graph):

Austra.

PW /PM Japan

RD

QW /QM

In autarky, Australia has a higher relative price of wheat than in Japan. With free trade, relative price
of meat goes up for Australia, benefiting landowners more than proportionately and hurting the
workers. Therefore, workers would oppose free trade pact here. However, using the PPF graphs of the
two countries, we can show that the welfare of all consumers (in both countries) goes up with free
trade.

19. a.

PM/PW World RS

QM/Q
W

31
Since the ratio of meat to wheat is the question, we need an RS graph. RS of Australia in this case
would shift to the left as labor increases in that country. Due to Rybczynsky effect, the quantity of
wheat production (in the denominator here) rises and the production of meat falls.

b. As meat is Australia's export good, its TOT is shown on the vertical axis of the graph above. The
RS would shift to the left (quantity of wheat production in Australia goes up). Hence, TOT of
Australia improves (as seen on the graph).

20. a. Spain does! England has comparative advantage in textiles!

As trade takes place between Spain and England, the income of the abundant factor (labor) in England
would increase and that of land would fall. In trying to repeal the Corn Laws, Ricardo was dealing
with the land owners as members of the parliament and they would not have voted to reduce their own
income by allowing free trade!!

b. PT/PC is the TOT of England. With free trade, relative price of textile goes up in England hence
labor wins and land loses.

As demand for corn goes up, in the graph, the RD curve has to move to the left (corn is in the
denominator), hence TOT of Britain falls (graph below):

PT/PC RS for
England

WRS
World
RD

QT/QC

21. a. As Peru is relatively labor abundant, it can produce corn relatively cheaply. In free trade, for
Peru the relative price of corn goes up. According to Stolper-Samuelson effect, production shifts to
corn in Peru. Since corn is relatively L-intensive, and wool is relatively K-intensive, at the old wage
and rent, an excess demand for labor and an excess supply for capital develops. Hence, the real wage
in Peru rises while real rent falls. The opposite happens in Argentina where labor loses. Labor groups
in Argentina oppose free trade.

32
 WRS
Argentina

PC/PW Peru

WRD

QC/QW

b.

Argentina
W Peru
W

Corn Corn

33
c. The welfare effects accrue to all consumers in Argentina. The positive welfare effects are diffused
and small for each consumer, but large overall. On the income distribution side, the group of workers
lose as their real wage goes down. For this group the losses are concentrated and possibly large for
each worker but overall loss is relatively small as this is the loss to the scarce factor in the country.
The losing group is very vocal and organized in its opposition to free trade.

22. a. Yes! If K/L are the same for both industries (and also the same good is produced with the same
production technology in both countries as the H-O model assumes) then, the K/L of each good has to
be the same as the relative abundance of these factors for each country, implying the two countries
have the same K/L endowment ratio! They have a constant cost (of just 1) for each good in terms of
the good forgone. And they have identical domestic relative costs of production.

b.

India C Bangladesh
C

J
Jute

The relative domestic price of jute is 1 for both countries (as K/L are the same for each good in either
country- essentially we assume the same production technology for both goods--the cost of increasing
one good is just one unit of another good forgone).

c.
PJ/PC

WRS
1

QJ/QC

Clearly, to derive the distinctive results of the H-O model with respect to the benefits of free trade as
well as the income distribution effects of free trade, we need the assumption of different intensities of

34
factors of production used in the production of the two goods. Otherwise the model collapses into
identical sets of constant cost PPF. There is no comparative advantage here!!

23. a. Differences in assumptions:

- The Ricardian model assumes there in only one factor of production.
- This implies the opportunity cost of production of each good is constant.
- The main source of difference between two countries, leading to comparative advantage, are the
different opportunity costs of production based on different "labor" technologies. If the world relative
price is in between the two domestic costs, then both countries specialize: produce only the good in
which they have comparative advantage.
- There is also no adverse income distribution of free trade here. As there is only one factor of
production whose real income rises in free trade, no one would oppose free trade!
In the H-O model:

- the source of comparative advantage is the existence of two factors used with different relative
intensities in the production of the two goods. The two countries also have different relative
abundance of these factors.
- The H-o Model produces similar welfare effects of free trade to that of the Ricardian model: the
consumption possibility frontier moves out in free trade and consumer welfare goes up.
- The H-O model produces income redistribution effects of free trade. The scarce factor loses in free
trade while the abundant factor wins.
- In the H-O model there is no specialization in production.

b. Here Britain has comparative advantage in cotton. As a result of free trade the abundant factor wins
and the scarce factor-land-loses. Therefore, the landowners who were also the members of parliament
would have opposed the repeal of the corn laws in Britain at that time.

24. a. Brazil has comparative advantage in beef. Chile is good in grapes! So Chile needs to produce
more and export grapes in free trade. No country specializes in production of any of these goods as the
production level for each good changes marginally with a change in its relative price. Therefore,
production of the export good increases but the country does not specialize in that good.

b. The TOT of Chile is the relative price of grapes, it is shown in the graph below:

35
 WRS
Brazil

P G/PB Chile

TOT
of
WRD
Chile
QG/QB

c. The factor price equalization theorem implies that wages in Brazil and Chile would be exactly equal
in free trade. This is due to the fact that price of a good is the same in both countries after free trade
and of course for each good, the model assumes the production technology to be the same for both
countries. Also would the rents on land be equal after free trade.
In reality, the assumptions of the model do not hold in the real world:

i. The production technology for producing a good is different in each country. One country may have
a higher level of labor productivity in one or more sectors, hence wages fail to equalize even in free
trade.
ii. Both countries have to produce both goods (same bundle of goods) in free trade. In reality some
goods are the specialties of only one of the trading partners.

iii. There are transportation costs, tariffs and other regulated or fixed price policies by government of
one (or both) of the trading partners to prevent equalization of prices of goods. Hence factor prices
will not equalize either.

25. a. Due to the Rybczynski effect, as the amount of land rises, the production of beef rises more than
proportionately in Brazil. Therefore the WRS of Beef moves to the right.

36
 The new WRS
WRS

PB/P G

The New
World
WRD
Rel price

QB/QG

The TOT of Brazil falls. The TOT of Argentina improves.

b. There are two effects: the positive welfare effects due to growth and the negative welfare effect due
to TOT deterioration create an ambiguous net effect on welfare in Brazil.

Lower
TOT for
Brazil

c. If land increases in Chile, the production of its import competing good, beef, will rise more than
proportionately. Hence the WRS curve above will shift to the right (similar to the increase in beef
production in Brazil) and the relative price of beef will fall. Hence the TOT of Chile will rise and the
TOT of Brazil will fall. In general, if you grow in your abundant factor your TOT falls (export biased
growth), while if you grow in your scarce factor, your TOT rises (in a large country H-O model of
trade).

26. a. Since Brazil has a relative abundance in labor, it can produce the labor intensive good (textile)
relatively cheaply, or, it produces a disproportionately large amount of textiles. So its RS curve is on
the right hand side (below).

37
 WRS
U.S.

PT/PW Brazil

WRD

QT/QW

The intersection of RD and RS for Brazil projected on the vertical axis shows the autarkic relative
price of textiles for Brazil. The world relative price of textiles is in between the two autarkic prices for
the two countries.

b. For U.S., price of wine rises in free trade. Therefore, the level of production of wine and with it
demand for factors of production rises in that sector. According to the Stolper-Samuelson effect, the
returns to the factor used intensively in wine goes up more than proportionately (in real and nominal
terms--that is capital), and the returns to the other factor falls (in real and nominal terms). This is due
to the fact that the wine sector uses a lot of K and a little L, and the release of factors from the other
sector is in the opposite direction: a little K and a lot of L are released! At the original wage and rent,
an excess demand for K develops so rents go up and by a similar reasoning, wages fall. Therefore
capital wins and labor loses in the U.S. so that labor opposes free trade pact in the U.S. The opposite
happens in Brazil: capital owners will oppose free trade in Brazil.

c.

U.S. W Brazil
W

T T

38
Benefits of trade are diffused across many consumers, being small for each but the total effect being
large. The costs to employment or wages of scarce factor are concentrated but large for each losing
factor, so the opposition tends to be vocal and organized.

27. PW = W a LWine + r aKWine

PT = W a LT + r aKT

As the unlit labor costs are the same for both countries, the only difference is the prices of T and W in
autarky-U.S. will have a relatively higher W and a lower r in autarky.

r
r US Brazil

W
Wage

After free trade, these parallel lines will also have the same intercepts (as P of wine and P of textiles
are the same for both countries). So that Wage in U.S. = W in Brazil and r in U.S. = r in Brazil. Since
after free trade in goods, wages are exactly the same in both countries, even if migration of labor
would be allowed, it would not happen!

b.There are several reasons: 1. In reality, technology levels are not the same in these countries. 2.
Countries do not produce the same bundle of goods. 3. There are tariffs, regulated prices,
transportation costs, etc. that would render prices different and hence wages would be different,
creating incentives for migration from Brazil to the U.S.

28. a. Scarcity usually implies a higher return! W

In the graph if the supply of a factor falls--i.e. if the factor is

Relatively more scarce, then its price will rise.
D

Q
of L

39
In the H-O model a scarce factor does have a relatively high return (e.g., for U.S. wages are relatively
high as it is relatively labor scarce), but in free trade, the demand for scarce factor, in fact, falls so the
scarce factor does lose. Therefore the intuition of high returns in scarcity is only true before trade takes
place, not in the event of free trade!!

b. According to the h-O model, once free trade takes place, the price of the good intensive in the
abundant factor goes up. So production moves towards that good. As demand for factors of production
rise and these factors are released by the other sector, at the original wages and rents, an excess
demand for the abundant factor develops. (Reasoning is the same as question 1b). Therefore the
returns to the abundant factor go up more than proportionately and the returns to the scarce factor fall.

29. a. Land is the scarce factor in Peru, so Peru has comparative advantage in production of clothing
(C) which uses labor more intensively. Mexico has comparative advantage in food. Neither country
would specialize here as the PPF is in fact bowed out and the cost of producing more of one good in
terms of the other good forgone keeps on going up!

b.

WRS
Peru

PF/PC Mex RS

World
Rel price
WRD

QF/QC

The relative price of food in autarky for Mexico is shown on the graph; it is the lower of the two
relative prices in autarky. The world relative price of food is also shown. This is also the TOT of
Mexico.

c. Due to S- S effects, in Mexico land wins and labor loses. The opposite happens in Peru. In Peru,
land owners oppose free trade. In Mexico, labor would oppose free trade.

40
d.

Peru C Mexico
C

F F

The overall welfare effect is positive for both countries as community indifference curves move up.

30. a. i) On a RS graph for Brazil alone, clearly the RS moves to the right and hence the price of T
falls in Brazil

ii) also the world relative price of T falls, implying the TOT of Brazil falls.

WRS

PT/PW WRS
'

WRD

QT/QW

b. In general a growth in the abundant factor leads to more S of this good and hence lower TOT for the
economy.

c. U.S. TOT is the inverse of Brazil's so that one goes up! As TOT improves, the welfare of US goes
up as the trade line -the relative price of the export good--moves up further (more steeply than the
previous TOT), so a higher community indifference curve can be reached in the U.S.

31. a. P = .4 + 2/n and P = (10/2000 )n + .4, so .4 + 2/n = (10/2000)n + .4

41
n2 = 400, n = 20 firms, P = .4 + 2/10 = .5 or 50 cents

b. 0.4 + 2/n = (10,000/1,000,000) n + 0.4

n2 = 200, n = 14 (approximately!)

P = .4 + 2/14 = $.54 or 54 cents a can of soft drink.

c. Yes, I would prefer free trade to autarky. The benefits are lower price of a soft drink and greater
variety of soft drinks for consumers!

32. a.

Toy
S. China
Korea
Toy
A
B

Cars Cars

Point A on each graph shows the points of specialization. Points B show the consumer welfare level.
The connecting slope is the world relative price of computers.

b. The sources of gain here are : i) due to increasing returns to scale and enlarged market size. As
production moves to points of specialization, average costs fall and productivity goes up. ii) due to
comparative advantage (H-O). South Korea is relatively capital abundant and has comparative
advantage in computers, its trade with China leads to benefits of trade discussed in the H-O model.

42
33. a.

Tr U.S.
Tr. .

Car
Car

The benefits of trade occur due to specialization here: larger market size and economies of scale in
production lead to increased production of both goods in specialization and trade. The pattern of
specialization and trade are not determined here as there are no differences between these countries
and therefore no basis upon which to determine which country should produce which good.

b. The income distribution effects of trade are insignificant here. Similar goods are being produced
with similar intensities of use of factors here.

c. This means the relative price of cars will be very high….as in the graph, the price of cars could be
so high as to produce the TOT line drawn for US on the right hand side graph. In this case, US would
greatly benefit from trade while Canada’s TOT will leave its welfare level below autarky!

34. a. i) In the H-O world there is no specialization and the pattern of trade is well defined. With the
general case of IRS, there is specialization and the pattern of trade is not determined.
ii) in the H-O world, factor prices equalize across countries after free trade. In IRS, if one good is
relatively labor intensive and the other one is relatively capital intensive, trade would in fact drive a
wedge between the factor prices between countries since each country specializes in one good. For
example for the country that produces the labor intensive good, its wage level rises with free trade
while in the other country that produces the capital intensive good, wage levels will fall. If however
trade is in similar goods, and is characterized by intra industry trade, then factor prices are similar
before and after trade.
iii) in H-O there are strong income distribution effects of free trade. In IRS, if trade takes place
between similar goods, the income distribution effects are insignificant.

b. In H-O trade take place between goods that are different (e.g. one if L-intensive and the other is K-
intensive). This is called inter-industry trade. With IRS, countries may specialize in production of
some variety of similar goods (intra-industry trade). Trade between developing and developed
countries mostly follows the H-O model while trade between developed countries follows that of IRS
and is intra-industry.

43
35. a.
P, AC
MC

World P

Quantity
Q dom Q

Since the demand is infinitely price elastic, then the monopolist has no choice but to charge the
international customers the world price that is already given to it. But, at home, where the monopolist
has some power (due to the protected domestic market), the demand is not infinitely elastic and so the
monopolist sets the price from a downward sloping demand curve.

b. The reciprocal dumping leads to the creation of some competition in the home monopoly industry
and hence, it leads to a lower price of the good and higher consumer welfare. So for Japan, the
reciprocal dumping means that Japanese consumers get a lower price for that good due to some degree
of competition created.

36. a. P = n (F/S) + c, P = c + 1/bn

n (F/S) + c = c + 1/bn so, n{(10,000/1,960,000)} + 5 = 5 + 1/n n2 = 196 n= 14 firms,

P = 5 + 1/14 = $5.071
X = S/ n = 1,960,000/14 = 140,000 units for each typical firm.

b. S ' = 2*1,960,000 so now, n2 = 392 n' = 19 (rounded to 19)

Use MR = MC, P' = (1/19)+ 5
P' = $5.05

X' = S '/n' = 3,920,000 /19 = 206,315.8

37. a.
For the domestic monopoly price, write P = 48/.02 - Q/.02
P = 2400 - 50 Q
Hence, TR = 2400 Q - 50 Q 2
And MR = 2400 - 100 Q

TC = 300 Q + 100 Q 2
MC = 300 + 200 Q

44
MC = MR 2400 - 100 Q = 300 + 200 Q; Q = 7 units
P = 2400 - 50 (7) = $ 2050 per unit.

b. At free trade, P = $1800

MC = P 300 + 200 Q = 1800 Q = 7.5 units

For economic profits, we can calculate the AC and then subtract it form the price to get profits per unit
of output. AC = 300 + 100 Q
AC = 300 + 100 (7.5) = $1050
P = 1800, P - AC = per unit profit = 1800 - 1050 = $ 750

Total profits = $750 * 7.5 = $5625

38. a. In this case again, MC = P, 300 + 200 Q = 1800 Q = 7.5 units

To see how much of this is sold at home and how much is exported,
MR of domestic sales = MR of foreign sales = 1800

MR of domestic sales = 2400 - 100 Q = 1800 So, Q = 6 units are sold at home.
This implies 1.5 units are exported.

Domestic price level P = 2400 - 50 Q = 2400 - 50 * 6 = $ 2100 per unit

b. i) As dumping creates some competition for the firm in the economy where dumping occurs, it may
lower the price charged to consumers. So consumer welfare may go up.

ii) Consumers lose in the protected economy, as the price charged by the firm exceeds both the
monopoly price and of course, the free trade price.

As there are economic profits in operation of large (monopoly) firms, the firms in the protected market
may have an unfair advantage in grabbing these profits! Especially, where there are economies of
scale in production and AC falls with greater volume of output and sales, then the firms in the
unprotected market, -where dumping, occurs- may find themselves in a disadvantageous position as
they can not produce more and export to the other country market and hence can not lower their AC
through higher level of production! They lose "in competition" to the other firms!

39. a.
There must be external economies of scale where by historically, a cluster of firms (though they
produce a labor intensive good) has formed in the developed country. The fall in AC of the industry
due to economies of scale, as demand increases, compensates for the high cost of labor in production
of the labor intensive good. So this country, having historically been in the market, dominates
production and export of this good!

45
 World D
AC

Developing AC of industry in developed

country AC country
curve

b. Since the price (AC) would fall due to B's demand (being added to A's), certainly the consumers in
B would receive a lower price than if they had to start the industry and produce the good themselves!
So with lower price, consumers in B would benefit.

Also for A's consumers, as A + B demand lowers the price of the good, consumers in A benefit as
well.

A's D
AC
A + B demand

AC

40. a. In external economies of scale, each firm is small and the synergy between firms allows the
industry (and not the single firm's) AC to fall as output rises.

Dynamic economies of scale may be internal (at the level of a single firm) or external. But the main
distinguishing feature between them is that in the dynamic scale economies, it is the cumulative output
of the firm or industry that falls over time due to learning by doing.

46
 AC AC

Industry Firm or
industry

Q
Cumulative Q

c. The AC curve for the industry in the country may be below that of the rest of the world's (ROW).
But with no accumulated knowledge, cost of production is high (point a). Protection form the
world market allows this good to be produced and sold at home, so learning can take place via
increased accumulated production. Hence AC and then price would fall over time. After some
time, the industry may be on the same footing as the other ones in the world market! Tariffs,
quotas, and various types of subsidies are used to protect a firm or industry form world
competition.

AC
Country's infant industry average cost

Point a
ROW AC

Cumulative output

41. a. P = n (F/S) + c, P = c + 1/(bn), so, P = n (1000/22500) + .5 and P = .5 + 1/(.5n). Solving for n

and P, n(1000/22500) = 1/(.5n), n2 = 45, n= 6 (whole number). Therefore, P = .5+1/(.5*6) = $0.833

b. i) The benefits of free trade due to larger market size are lowered price of the frozen food and
greater variety of frozen food for consumers. ii) the number of frozen food firms will less than double
to allow each remaining firm to produce a bit more for the larger market, so the price can drop (falling
average cost of production).

47
42. a. If the price of gas is higher inside Kazakhstan than outside that country, and, there is a
“protected” market for natural gas in Kazakhstan. With this observation, one can say that persistent
dumping is occurring.

P, MC

MC

Pw

Russian consumers will get their natural gas cheaper so it is likely to enhance their level of welfare.

b. In reciprocal dumping, prices fall because two firms will mutually “raid” each other’s market!
Where all costs are identical between firms, strangely, reciprocal dumping may lead to trade where
none would have been necessary, but the impact of such reciprocal dumping is to reduce price of the
good internationally. So it is likely that the price of natural gas in reciprocal dumping would be less, as
competition between two firms would drive the price down.

43. a.
AC

AC

Cumulative output

The case of dynamic economies of scale (learning by doing over time) would characterize an infant
industry. [Also a case of external benefit for subsidizing education, skill training, etc. would justify
protection of domestic industry to help increase the output of the good characterized as having an

48
externality]. Here, the assumption is that the home infant industry will grow under protection and
given time, will become more efficient due to learning by doing phenomenon and then the protection
can be lifted so the industry may compete “freely” and ably in the world market.

b. If the industry under protection is indeed a competitive home industry, then there is likely to be
some positive effects of learning by doing over time. But if the domestic industry asking for protection
from imports is indeed a monopoly- usually one large producer of a good sanctioned by government-
then the protection simply gives “power” to the monopoly to charge a high price and there is no
pressure to learn anything new to make the operations more efficient over time. Of course, if the
industry is capital intensive, protecting it means the rewards to capital will go up more than
proportionately (the Stolper-Samuelson effect) and the capitalists reap all the benefits! This is usually
the main reason why industry owners (owners of capital) ask for “infant industry” protection to
continue indefinitely!

44. i) If Iran acts according to the H-O model, then a move towards near autarky clearly hurts
consumer welfare. Using a PPF analysis, we have established that welfare is higher at free trade than
any other situation, if the world acts according to the H-O model! ii) if many of Iran’s industries are
dominated by monopolistic competitive firms, then a loss of free trade increases the average price of
the products and also lowers the variety available to consumers in Iran., iii) in this case, if we assume
that Iran’s industries can become more efficient over time under the “protection” from imports due to
the economic embargo, then the embargo has a positive dynamic effect on Iran’s economy.

45. a. No. No movement of labor would take place from Portugal to Spain. According to H-O theory,
the wages across countries will be equal after free trade in goods are allowed. However, in the real
world, where the strict assumptions of H-O do not hold, under the following conditions, migration
would still take place even with free trade in goods. The reasons are:
- transportation costs would make prices in two countries different. Also pricing policies imposed by
the government may make prices different in free trade.
- Technologies used in the production of goods are not identical across countries. In this case,
country with the more advanced technology has higher labor productivity and higher wages.
- Countries produce different bundles of goods and services. H-O theory would require the
production of the same goods in both countries in order to derive the factor price equalization idea.

49
b.

MPL MPL
Port. Spain
b

Area abc is gained (by Spain). It shows the net increase in world production (the area under MPL
curve up to labor employment signifies the total production). In this case, Spain’s welfare goes up due
to increased production. If workers send some of their earnings back home to Portugal (workers’
remittances), then Portugal would benefit too.

c. This will lead to a rightward shift of MPL in Portugal to the right (on the graph) and hence some of
the migrant workers may want to come back to Portugal, leaving the equilibrium wage a bit higher
than before.

46. a. Portfolio investment takes place due to differences in interest rates or rates of return on assets in
countries. FDI takes place due to special opportunity for production and not due to differential interest
rates. Also, in portfolio investment, actual funds cross the borders and money flow from one country
to another. But in FDI, funds may be raised where the MNE is infact seeking to invest. Not much flow
of funds may take place in this case.

b. Advantages: - increased technical efficiency…increased production.

- relieving unemployment
- possibility of earning foreign exchange
- increased tax revenue from MNE operations
- realization of increasing returns to scale technology in large international markets.
Disadvantages: - Monopoly power of the MNE
- provision of few new skills where the only form of activity is assembly line type work
- political power of some MNEs that may threaten sovereignty of a country.
- In countries with no adequate environmental standard, MNEs who pollute air or water in the
process of production, etc. may harm the environment of the economy (external costs of
production).

c. Advantages: - Jumping tariff walls

- access to low cost factors of production
- access to raw materials

50
- Ensuring a larger market share in a region where the MNE operates.
Disadvantages: - risk due to political instability of the country, risk of appropriation by government.
- lack of knowledge of local laws, regulations, Gov. policy, etc.
- lack of knowledge of local language, culture.
- Long distance communication and higher costs due to increased distance
- MNEs have to pay higher salaries to their personnel who work in other countries…

The economy of the country of origin benefits due to increased profits of the MNE which is part of
national income, also lower prices for consumers of goods MNE produces.
However, the income distribution may turn against low skilled labor when a company moves its labor-
intensive operations outside.

47. a.

AC

AC of
Egy.

Cumulative output

The case of dynamic economies of scale (learning by doing over time) would characterize an infant
industry. Also a case of external benefit for subsidizing education, skill training, etc. would justify
protection of domestic industry to help increase the output of the good characterized as having an
externality.

b. Domestic production rises, domestic consumption falls, and the level of consumer welfare falls (the
net loss is areas b + d). Of tariffs and quotas, tariffs are preferred as quota rents create conditions for
corruption and "rent seeking activity".

51
 Price
S

Pw + t

Free
Trade P

Quantity

c. As the price of capital intensive good goes up due to tariffs, then according to Stolper-Samuelson
effect, the real income of capital rises while that of workers falls. Workers would oppose a tariff.

48. a. No! No movement of labor would take place from Morocco to Spain. According to H-O theory,
the wages across countries will be equal after free trade in goods are allowed. However, in the real
world, where the strict assumptions of H-O do not hold, under the following conditions, migration
would still take place even with free trade in goods. The reasons are:
- transportation costs would make prices in two countries different. Also pricing policies imposed by
the government may make prices different in free trade.
- Technologies used in the production of goods are not identical across countries. In this case,
country with the more advanced technology has higher labor productivity and higher wages.
- Countries produce different bundles of goods and services. H-O theory would require the
production of the same goods in both countries in order to derive the factor price equalization idea.

c. Area abc is gained (by Spain). It shows the net increase in world production (the area under
MPL curve up to labor employment signifies the total production). In this case, Spain’s
welfare goes up due to increased production. As workers send some of their earnings back
home to Morocco (workers’ remittances), then Morocco's aggregate income level will rise
too.

52
 MPL MPL
Morocco Spain

b
a

c. This will lead to a rightward shift of MPL in Morocco to the right (on the graph) and hence some of
the migrant workers may want to come back to Morocco, leaving the equilibrium wage a bit higher
than before.

49. a.

Kazakhstan
Russia
D
S
P

Pw

Q Q

In this case, a tariff by Russia will simply lower the import (world) price of oil for Kazakhstan.
Russia’s TOT will rise and its welfare level will increase due to increase in TOT. All burden of tariff
is on Kazakhstan!

b. In this case, TOT does not change as Russia is a small country. All burden of tariff is borne by
Russians whose net welfare level falls by b+d.

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 P

Pw + t
Free trade P

Q
50. a. If the price of oil is higher inside Kazakhstan than outside that country, and, there is a
“protected” market for oil in Kazakhstan. With these two observations, one can say that persistent
dumping is occurring.

P, MC

MC

Pw

Russian consumers will get their oil cheaper so it is likely to enhance their level of welfare.

b. In reciprocal dumping, prices fall because two firms will mutually “raid” each other’s market!
Where all costs are identical between firms, strangely, reciprocal dumping may lead to trade where
none would have been necessary, but the impact of such reciprocal dumping is to reduce price of the
good internationally. So it is likely that the price of oil in reciprocal dumping would be less as
competition between two firms would drive the price down.

51. a. The two countries H and F each produce an aggregate good, using labor and capital. The
amount of capital in each country is fixed and capital can not migrate! Also, we assume no trade in
goods or services. Before migration of labor is allowed, H is the low wage country
Now, allowing for the migration of labor from the low (real) wage country to the high (real) wage
country, in the graph,

54
 MPL in MPL of F
MPL of H

(W/P)1 for F

(W/P)1 for

. Production and welfare: As migration occurs, the total level of world production increases by the
triangular area (arrow) in the graph. Although F gains this increase, one can imagine a division of this
increased production between the two countries, if migrant workers remit some of their income back
to H.
. Income distribution: As migration happens from H to F, real wages equalize. In H, real wage goes up
and the real return to capital falls. The opposite happens in F.

b. The decrease in capital stock in H decreases the MPL of labor in that country, leading to a shift
backwards of the MPL curve.

MPL of F
MPL of H

(W/P)1 for F

(W/P)1 for

This increases the amount of migration from H to F, and, the real wages (equilibrium) are lower for
both countries compared to the situation in part a., above. The real rents are higher everywhere.

c. Since H is the relatively labor abundant country, it will export the labor intensive good. So F is the
importer of the labor intensive good. A tariff on imports in F will raise the price of the import (labor
intensive) good inside F. Hence, due to Stopler-Samuelson effect, the rewards to the factor intensively
used in this good will rise more than proportionately and the rewards to the other factor will fall.

55
Therefore labor in F will have its wages rise. Since wages between the two countries are no longer the
same after a tariff, there is now an incentive for labor from H to migrate to F.

52. a. The portfolio investment is different from FDI:

i) FDI has the aspect of direct control of operation/ownership of a subsidiary. Foreign portfolio
investment does not include any control over the firm in the other country.
ii) FDI does not necessarily take place due to differences in interest rates between countries. Rather,
FDI takes place due to unique opportunity to acquire access to raw materials, make use of cheaper
labor, or ensure proximity to the international market where the firm intends to sell its product.

b.
- The welfare effects of FDI: - FDI may push the PPF of the developing country out due to technology
transfer hence increasing welfare. As the price of the product produced by the multinational may be
cheaper the consumers in the developed country will see their welfare rise.
- The income distribution effects of FDI: As the multinational goes to the developing country, demand
for labor there goes up hence the real wage of labor may rise there. The opposite happens in the
developed country. Hence in the developed country, real wage may fall while rents go up.

As we can see the effects are fairly similar to that of H-O model!

c.
- The welfare effects of FDI: here as the size of the market increases, price falls and welfare is
enhanced for all consumers.
- The income distribution effects: are not that significant as similar goods are being produced by
similar countries.
The effects of FDI are the same as those of trade in goods and services between developed (similar)
countries.

53. a.

56
 P

Dom price
after tariff

Free trade P

Quantity of import
competing good

i) TOT of Britain does not change since Britain is considered to be a small country.
ii) Welfare falls. The net fall in welfare is areas b + d (the triangles).
iii) Income distribution effects: As tariff is imposed on a labor intensive good, hence the price of the
labor intensive good rises internally. Therefore, according to the S - S effect, labor wins and capital
loses in Britain.

b. A quota has a similar effect to the tariff here.

Quot Tariff
equivalent
increase in the
domestic price
Free trade P

Quantity of import
competing good

The welfare effect is similar to the tariff as there is b + d net welfare loss.
The TOT does not change.

Quota creates rents that are received by individuals with import licenses. It is a form of rent seeking
activity as these quota rents may not go to government as revenues (if the government auctions the

57
 licenses, then the quota rents may be earned by the government). Hence quotas create incentives for
rent seeking activity and corrupt economic practices and are considered inferior to tariff.

54. a

EU Ghana

P P
S

P in
free
trade

Q
Q

a. i) TOT effects: The TOT of EU is improved, while that of Ghana deteriorates.

ii) welfare: In EU, the net welfare loss is is b + d - e and if b+d<e, then the welfare of EU increases.
As the TOT of Ghana falls, Ghana has an indisputable fall in its welfare.
iii) Income distribution: In EU, as price of cocoa rises, so does the real wage of labor (the real rents
fall).In Ghana, the price of cocoa falls and so does the wage of labor.

Ghan
b. a
D
S D
S
P

e : the TOT
Dom P deterioration
effect for
New Ghana
world
P

Q
Q

58
- The TOT of EU improves by the full amount of the tariff. Ghana's TOT falls by the full amount of
the tariff.
- EU's welfare improves due to TOT improvement. Ghana's welfare falls due to TOT deterioration.

55. a.
1. The reduction in tariffs increase efficiency in production (by gaining b + d dead weight losses due to
a tariff).
2. There are also extra gains due to IRS based production (lower price) as countries' markets are
integrated.
3. Producers do much better and become more cost effective sooner if they are presented with some
competition. The quality of products produced by firms in a country are likely to improve.

b. 1. The income distribution effects of free trade are not acceptable.

2. Government earns tariff revenues.
3. TOT improvement for a large country as it levies a tariff!
4. There may be domestic market failures (external benefits in production of a good). So the socially
optimal level of production is more than the free market would allow and there is need for government
intervention.
5. Anti dumping duties are a form of penalizing the economy that has its firms dumping their products.

Of all of these arguments only no. 4 is considered a justifiable reason for the government to get
involved.

c.
- The economists will argue that the best method for internalizing a domestic case of external benefits
is a domestic, not a trade related policy. The best method is considered to be a production subsidy to
the firm (which may exhibit dynamic economies of scale and need some government help to increase
its domestic production) and not a tariff.

59
 S
D
P Domestic
supply with
subsidy

Pd = Free Trade
Price + tariff
a
c d Free
b trade P

The reason why a subsidy is preferred is due to the fact it creates less distortion (only the triangle b is
the dead weight loss) than a tariff. The tariff raises the price of the good inside the country and hence
creates dead weight losses of b + d. The total cost of the subsidy to consumers is a+b which is raised
via a tax on their income, not by raising the price of the good (as in a tariff).

56. a. According to the H-O model, once free trade in goods is established, there will be no need for
labor to migrate: according to the factor price equalization theory, wages in the two countries will be
exactly equal when trade in good takes place!

In reality, three major assumptions of the H-O model are violated:

1. Countries do not use the same technologies in production.

2. They do not produce the same bundle of goods.
3. The prices even in free trade may not equalize due to transportation costs. There are also tariffs still
in pace.
Here migration takes place from Algeria to France.

b. Two countries each produce an aggregate good, using labor and capital. The amount of land in each
country is fixed and capital can not migrate! Also, we assume no trade in goods or services.
Now, allowing for the migration of labor from the low (real) wage country to the high (real) wage
country, in the graph,

60
 MPL in Alg. France's MPL
Algeria's
MPL

(W/P)1
France
(W/P)1

As migration happens from Algeria to France, real wages equalize. In Algeria, real wage goes up and
the real return to capital falls. The opposite happens in France. Welfare increases as there is some
increase in world production shown by the "rectangular" shape area in the graph. So the results are
similar to H-O!

57. a. The decrease in capital stock in Algeria decreases the MPL of labor in that country, leading to a
shift backwards of the MPL curve.

France's MPL
Algeria's
MPL

(W/P)1
France
(W/P)1

This increases the amount of migration and the real wages (equilibrium) are lower for both countries
compared to the situation in part b., question 1. The real rents are higher everywhere.

61
b.

France's MPL

Algeria's
MPL
(W/P)1
France

(W/P)1

An increase in labor supply in France reduces that country's real wage in "autarky". Note that the
equilibrium real wage in migration also goes down. So, I) the rate of migration is reduced, as real
wages in France fall, there is less of incentive for Algerians to go there. ii) equilibrium real wages in
France and in Algeria (in state of migration) falls and of course, the returns to capital increase in both
countries, compared to the state of migration (but with no increase in labor supply in France).

58. i) Firms are vertically integrated, they own their "up stream firms" that produce the components.
This is due to the difficulty of transacting with independent "up stream" firms. Also, this way any
externalities such as innovations, patent rights are internalized in the organization.

ii) Firms own subsidiaries in other countries. They look for the cheapest operations and some are in
other countries/locations.

The portfolio investment is different from FDI:

i) FDI has the aspect of direct control of operation/ownership of a subsidiary.
ii) FDI does not necessarily take place due to differences in interest rates between countries.

b. i) As demand for labor by FDI goes up, real wage may increase. ii) the opposite happens to
developed country real wage, they go down. iii) real rents in developing country fall. Iv) real rents in
the developed country rise.

c. Advantages: i) Some technology transfer, leading to improvement in productivity.

ii) relieving unemployment, iii) possibility of earning foreign exchange via exports of the MNC
iv) Access to international markets

Disadvantages: i) Some MNCs are bigger/more powerful than countries in which they invest in.

62
 ii) MNC's do repatriate their profits (and it can be large!).

59. a
U.S. Mexico

P P
S

P in
free
trade

Q
Q

b. i) U.S. TOT improves as the country unilaterally reduces its demand for Mexican avocado. ii) The
net welfare effect is b + d - e and if b+d<e, then the welfare of the U.S. increase.
iii) In the U.S., as price of avocados rise, so does the real wage of labor., iv) the TOT in Mexico falls
and so does the level of welfare in that country.
In the U.S. labor would favor a tariff.

60. a. The domestic equilibrium price is = P = 300/50 = $6 per ton

At price of $4 per ton, Q demanded is = 400 - 40 = 360

and quantity supplied at home is = 100 + 160 = 260. Therefore, imports are 100 tons.

63
 Domestic S
Price

Dom price
after tariff

Free trade P

Quantity

b. i) TOT of U.S does not change since U.S. is a small country.

ii) Welfare falls. The net fall in welfare is areas b + d. iii) the amount of imports fall. iv) TOT in
Mexico does not change (as U.S. can not change the world price of avocados) and neither does its
welfare level.

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