BA 187 Midterm Answers

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BA 187 Midterm Answers

• Covers Krugman Obstfeld, Chapters 1-5, 12

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Question 1. Agree or Disagree? William Daley,
the U.S. Commerce Secretary, warned early this
year that last years financial crisis could
become this years trade crisis.

• What we know
• Current Account Capital Account Balance of
  Payments 0
• Last years financial crisis in Russia and then
  Brazil resulted in a flight to quality by
  investors
• Large capital flows into US from developing
  countries
• Resulting in a large capital account surplus for
  US this year.
• By definition of Balance of Payments this implies
  an increasingly large trade deficit (X-IM).
• This increase in the trade deficit leads to calls
  within the US for protectionist policies to stop
  the inflow of imports. This is the trade crisis
  Daley is talking about. We see it most keenly in
  the steel industry and its calls for tariff
  barriers and quotas on imports.

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Question 2. Agree or Disagree? The popular and
political reaction to foreign country export
subsidies are that they constitute unfair
competition to our domestic producers. Instead
Krugman writes when foreign governments
subsidize their exports to the U.S., the
appropriate response from a national point of
view should be to send them a note of thanks! Do
you agree or disagree? Be sure to provide a
specific rationale for your answer.

• As illustrated by the next slide, an export
  subsidy by a foreign country reduces foreigns
  terms of trade.
• Hence an export subsidy by foreign country,
  improves home country terms of trade. Homes
  export good is more valuable.
• Result is Home can achieve a higher level of
  welfare than before foreigns export subsidy. So
  agree.
• Could focus on effects on import industry alone.
  In this case import-specific factors or
  import-intensive factors lose, while
  export-specific or export-intensive factors gain.
  So disagree.

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Effects of Foreigns Export Subsidy

• Export subsidy has exact opposite effect on
  internal versus external prices to an import
  tariff.
• Internal price of export good Y rises.
• Foreign produces more Y less X (RS shifts in).
• Foreign consumes less Y more X (RD shifts out).
• Terms of trade worsen for Foreign and improve for
  Home.

Relative Price of X
PX/PY
RS0
(PX/PY)0
RD0
Relative Quantity of X
(qX qX)/(qY qY)
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Question 3. T, F, or U? For the U.S. to
gain from trade, before the U.S. opens its
markets to another nation, that nation must first
open its markets to U.S. goods. Question
from CNNfn web poll on trade. (Roughly 3000
people had responded to the question as of
10/6/99 with 59.2 of the respondents saying the
statement was true, while 40.8 of the
respondents said the statement was false.)

• FALSE - It is not necessary for the other country
  to open itself up to trade in order for the US to
  benefit.
• By opening itself up to trade with foreign
  country, US consumers benefit. They can buy the
  import good more cheaply through trade than from
  US producers. This is a welfare gain (gains from
  exchange).
• By not opening itself up to trade with the US,
  foreign country denies its consumers the benefits
  of trade with US.
• Welfare is not as high as it could be because
  dont get full benefit of gains from
  specialization in production.

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Question 5. Specific Factor Model
Assume that the major difference between
developed and developing countries is that
developed countries have an abundance of skilled
labor while developing countries have an
abundance of unskilled labor. Only skilled labor
(plus capital) can be used to produce computer
software. Only unskilled labor (plus capital) can
be used in producing clothing. Assume that
capital is mobile between computer software and
clothing.

• Let Good X Computer Software, Good Y
  Clothing.
• Specific Factor is Labor
• LX L0X Skilled labor to produce software
  only.
• LY L0Y Unskilled labor to produce clothing
  only.
• Mobile Factor is Capital, K
• K0 KX KY
• Next diagram shows how abundance of skilled
  labor leads to PPF bowed in direction of Good X,
  Computer Software.

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A. Provide a diagram and brief explanation for
the shape of the PPF of a developed country and
what it implies for that countrys pattern of
trade.
Y
Y QY(KY , L0Y)
QY
1
PPF0
KY
K0
QX
X
Capital in Good Y, KY
KX
K0
X Q0X(KX, L0X)
Capital in Good X, KX
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B. What are the likely effects of an increase in
the capital stock of the developed country on its
PPF, terms of trade, and overall level of
welfare? Provide a brief explanation of your
results along with the appropriate diagram(s).
Y
Y QY(KY, L0Y)
QY
1
PPF0
KY
K0
QX
X
Capital in Good Y, KY
KX
K0
X QX(KX, L0X)
Capital in Good X, KX
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C. What are the likely effects of an increase in
the capital stock of the developed country on the
wage rates of skilled labor and unskilled labor,
and for the return on capital? Provide a brief
explanation of your results along with the
appropriate diagram(s).
Return on Capital, r
VMPX
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Summary for the Specific Factor Model

• Part A A Developed country will have an
  abundance of skilled labor relative to unskilled
  labor. This will lead to the PPF being bowed out
  in the direction of Good X, Computer software, as
  the diagram illustrates.The Developed country
  will export Good X.
• Part B Growth in capital, the mobile factor,
  results in a parallel shift outwards of the
  Developed countrys PPF. It is likely the terms
  of trade remain unchanged (RS does not shift).
  Hence it is clear that the welfare of the
  Developed country will increase. You can show
  this explicitly.
• Part C Growth in capital, the mobile factor,
  results in an expansion of the graph determining
  the return on capital.
• Return on Capital falls as a result of the
  increase in capital stock.
• More capital will be employed in both Software
  and Clothing industry.
• Result will be a rise in the VMP of both types of
  labor. With fixed supply of each type of labor,
  wages of both skilled and unskilled labor will
  increase.

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Question 6. Heckscher-Ohlin Model
Assume that the major difference between
developed and developing countries is that
developed countries have an abundance of capital
while developing countries have an abundance of
labor. Assume also that there are two goods
semiconductor products which are
capital-intensive, and clothing which is
labor-intensive.

• Let Good X Clothing which is labor-intensive.
• Let Good Y Semiconductors which are
  capital-intensive.
• Both Factors are mobile.
• Developed country is capital-abundant.
• Developing country is labor-abundant.
• Abundance of capital in developed country leads
  to PPF bowed in direction of Good Y,
  Semiconductors.
• Abundance of labor in developing country leads to
  PPF bowed in direction of Good X, Clothing.

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A. Assuming that tastes are identical, show how
opening up trade between a developed and a
developing country affects (1) the relative
prices of the two goods, (2) production in each
country, and (3) welfare in each country. Provide
this diagram and a brief explanation for your
results.
Y
X
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A. The Effects of Trade

• Relative Prices converge with trade.
• As a result each economy increasingly specializes
  in the production of the good that is intensive
  in the factor they possess in abundance.
• Each country exports the good intensive in the
  factor they have in abundance. Import the good
  intensive in the factor that is relatively
  scarce.
• Consumption patterns, in contrast, converge. Both
  countries move to higher levels of utility after
  trade.

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B. How is opening up trade likely to affect the
relative returns of labor and capital in the
developed country? In the developing country?
Provide a brief explanation of your results along
with an appropriate diagram.
Wage-rental ratio,
w/r
SS
K/L
PX/ PY
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B. Trade, Distribution Welfare

• Factor Price Equalization Theorem
• International trade will bring about the
  equalization in the relative and absolute returns
  to homogenous factors of production across
  nations.
• Trade in final goods essentially substitutes for
  movement of factors between countries to equalize
  differences in relative factor returns.
• Stolper-Samuelson Theorem
• Free trade will result in an increase in the
  reward to the abundant factor and a decrease in
  the reward to the scarce factor, i.e. the
  relative return earned by the abundant factor
  will rise with the opening of trade.
• Assuming full employment before and after trade.
• Do not find complete factor price equalization of
  H-O theory.
• May be barriers to adjustment trade barriers,
  transportation costs, heterogeneous capital or
  labor, non-traded goods, imperfect competition,
  unemployed factors, etc.

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C. What are the likely effects of an increase in
the capital stock of the developed country
(holding relative factor prices constant) on the
amount of semiconductor products and clothing
produced in the developed country? Provide a
diagram along with a brief explanation.
Good Y
K0
K/LHX
OX
Labor, L
Good X
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C. The Rybczinski Theorem

• At constant product prices, an increase in the
  endowment of capital will increase by a greater
  proportion (magnification effect) the output of
  semiconductors (Good Y), and will reduce the
  output of clothing (Good X).
• Assume that the supply of capital increases.
• Constant product prices imply constant relative
  factor returns, (w/r).
• But relative factor returns can remain constant
  only if K/L and productivity of K and L remain
  constant in prodn of both goods.
• To fully employ new capital, while keeping K/L
  constant in both goods, requires fall in output
  of labor-intensive Good X to release enough labor
  to absorb increase in K in prodn of Good Y.
• Thus output of capital-intensive Good Y increases
  while output of labor-intensive Good X falls.

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Bonus Questions

• Bonus 1. (2 points) Is it surprising that both
  the steel company CEOs and labor union members
  are the biggest opponents of free trade in the
  U.S.? Provide a brief intuitive explanation (no
  diagrams!).
• Not surprising. Both groups are essentially in
  import-competing industries. We know that
  import-specific factors lose when nation moves to
  free trade, so it is not surprising they are both
  opponents of free trade.
• Bonus 2. (2 points) Wages for Mexican workers are
  roughly 1/5 those of American workers. Ross Perot
  claimed this fact (NAFTA) would suck U.S.
  business down into Mexico. It didnt. Why?
• Monetized Ricardo tells you the Export Condition
  depends on the nominal wage relative to the
  productivity of labor.
• Mexican wages relative to U.S. workers are low
  but their productivity relative to U.S. workers
  in most industries is even lower.

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Bonus Questions

• Bonus 3. (3 point) The World Trade Organization
  will hold a big meeting at the end of November.
  Where is the meeting to be held? What nationality
  is the Head of the WTO? (This is a trick bonus
  question.)
• WTO meeting takes place in Seattle, WA
• Two Director-Generals were chosen to split a
  single term as a political compromise. (Doesnt
  that bode well for the WTOs effectiveness in the
  future?)
• Current head is from New Zealand and other from
  Thailand.