SOLUTIONS TO INTERNATIONAL ECONOMICS EXAM ONE, FALL 1999

 1.        Use the classical model of international trade to answer the following questions. The table below shows the number of hours of labor necessary to produce one unit of each good:

a.        (5 points.) Which country has absolute advantage in which good and why?

Brazil has an absolute advantage in both goods because they can produce them more efficiently (fewer hours per unit). Brazil produces a jar of S in 3 fewer hours than required in A, and a bottle of T in 4 fewer hours than required in A.

b.       (5 points.) Which country has comparative advantage in which good and why?

Argentina has a comparative advantage in T because their opportunity cost (and autarky relative price, Pt/Ps) is 2 jars of S per bottle of T, while Brazil’s opportunity cost (Pt/Ps) is 4 jars of S per bottle of T.

Brazil has a comparative advantage in S because their opportunity cost (and autarky relative price, Ps/Pt) is 0.25 bottles of T per jar of S, while Brazil’s opportunity cost (Ps/Pt) is 0.5 bottles of T per jar of S.

c.        (5 points.) How many units (jars) of Salsa will Argentina produce in international trade equilibrium if they are endowed with 8000 hours of labor per year? How many units (bottles) of Tequila will Argentina produce? 

Argentina’s comparative advantage in T implies complete specialization in T, producing 1000 bottles of T per year (found as 8000 hr/yr divided by 8 hr/bottle of T) -- no production of S.

d.       (5 points.) How many units (jars) of Salsa will Brazil produce in international trade equilibrium if they are endowed with 4000 hours of labor per year? How many units (bottles) of Tequila will Brazil produce?

Brazil’s comparative advantage in S implies complete specialization in S, producing 4000 jars of S per year (found as 4000 hr/yr divided by 1 hr/bottle of S)-- no production of T.

e.        (5 points.) What are the limits on Argentina’s wage rate relative to the wage rate in Brazil if trade is to flow between these two countries according to comparative advantage?

0.25 < Wa/(E x Wb) < 0.5 -- That is, A’s wage must be between 1/4 and 1/2 times the wage in B (when both are measured in the same currency), because B is twice as productive in T and 4 times as productive in S.
OR
2 < Wb/(E x Wa) < 4. That is, B’s wage must be between 2 and 4 times the wage in A (when both are measured in the same currency), because B is twice as productive in T and 4 times as productive in S.

f.         (10 points.) Using your answers to parts a-d, illustrate a hypothetical international trade equilibrium, including production and consumption points, CICs, and trade volumes for a given but permissible value of the international terms of trade. Write your assumed international terms of trade here:

NOTE: The terms of trade must be between the autarky prices: 1/4 <  Ps/Pt <1/2
For example:
One (1) unit (jar) of Salsa trades for one-third (1/3) units (bottles) of Tequila.
                 OR
Three (3) unit (jars) of Salsa trades for one (1) unit (bottle) of Tequila.

GRAPH DRAWN IN REVIEW SESSION

2.      Consider the following data on two countries, A and B:

a.       (5 points.) Which country is capital abundant and why?

Australia has the greater K/L ratio and therefore has more capital per worker. This is the quantity definition of capital abundance.

b.      (5 points.) Which country is labor abundant and why?

 Bolivia has the greater L/K ratio and therefore is labor abundant by the quantity definition.

c.       (5 points.) Supposing that the good T (toupees) is labor intensive relative to good S (Sombreros), which country will have a comparative advantage in the production of T? Explain your answer.

Bolivia has a comparative advantage in T, according to the Heckscher-Ohlin Theorem, which states that a country will have a comparative advantage in the good that is intensive in the factor with which they are relatively well endowed. This endowment reduces the opportunity cost of producing the good.

d.      (5 points.) Which country will have a comparative advantage in the production of S? Explain your answer. 

Australia has a comparative advantage in S (the relatively K-intensive good), according to the Heckscher-Ohlin Theorem, which states that a country will have a comparative advantage in the good that is intensive in the factor with which they are relatively well endowed.

e.       (5 points.) Which factors gain and which lose when trade is opened between the two countries? Explain carefully.

According to the Stolper Samuelson Theorem, the abundant factor gains while the scarce factor loses. In Australia, capitalists gain as rents rise, but laborers lose as wages fall. In Bolivia, capitalists lose as rents fall, but laborers gain as wages rise.

f.         (10 points.) Draw two national supply and demand curves diagrams for good T (one diagram for each country) to illustrate the autarky and trade equilibria for each of the two countries including the autarky prices, the international price, and the quantities consumed, produced and traded.

SEE ATTACHED GRAPH.

TRUE/FALSE 

1.      F    A country's index of openness can never exceed 100 in value.

2.      T    As measured by the index of openness, the United States is relatively closed, and yet, it was the world's largest exporter in 1994.

3.      T      Countries have trade surpluses when they export more than they import.

4.      F    Most of world trade is in the form of manufactured consumer goods such as TVs, stereos, VCRs, and running shoes.

5.      T    If individuals have money illusion, they react to changes in certain prices without regard to simultaneous changes in other prices.

6.      T      Technological progress in country A's S industry would increase the opportunity cost of T.

7.      F    A country must have absolute advantage in a good in order to have comparative advantage in the good.

8.      F      According to the Rybczynski theorem, if a country increases its endowment of capital and prices remain constant, then its output of both the capital and labor intensive goods will rise.

9.      T    In the HO model, tastes are assumed to be identical across countries to rule out differences in demand determining the direction of trade.

10.  T    The assumption that the two goods are made using different factor intensities raises the likelihood of incomplete specialization after trade begins. 

11.  F      According to the factor price equalization theorem, free international trade will result in wages equaling rents worldwide.

12.  T      According the Stolper Samuelson theorem, the scarce factor in any given country will lose from international trade.

13.  T    Even if some people are hurt by international trade, the HO model predicts that free international trade improves the standard of living for the country as a whole.

14.  F    In a two country world, at least one country must lose from trade.

15.  T    A country gains more from international trade the more its terms of trade differ from its autarky price.

16.  T    Per capita real GDP levels provide one possible measure of a country's standard of living.

17.  T    If a country were to experience an increase in its factors of production, its production possibilities frontier would shift outward.

18.  F      Developed countries get all the gains from trade when they trade with developing countries.

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