FEB13085: International Trade Policy Problem Set 1 Solutions PDF

FEB13085: International Trade Policy FEB13085: International Trade Policy Problem Set 1 Solutions Lecturer: Dr. Aksel Erbahar Teaching Assistant: Elizabeth Oluwajimi Heckscher-Ohlin (HO) model 1. Consider a Heckscher-Ohlin (HO) setting with a country that produces two products, product A and product B. The country is inhabited by L identical workers and K units of capital. Assume that the production of A is relatively labor-intensive. The full-employment conditions for the two factors are given as: aAL yA + aBL yB = L and aAK yA + aBK yB = K, where aiL and aiK are the optimal amount of labor and capital chosen by the firms (given factor prices), and yi is total production for i ∈ {A, B}. (a) Derive the Rybczynski theorem and show the magnification effect. (Hint: follow the steps used to derive the Stolper-Samuelson theorem in lecture slides). Solution: Totally differentiate the two equations to get: aAL dyA + aBL dyB = dL and aAK dyA + aBK dyB = dK, Divide the two equations by L and K respectively. Then, denote λiL = yi aiL /L and λiK = yi aiK /K as the fractions of labor and capital employed in industry i respectively. By writing percentage changes as dx/x = x̂, we get: λAL ŷA + λBL ŷB = L̂, (1) λAK ŷA + λBK ŷB = K̂, (2) Use equations (1) and (2) to write: ŷB = L̂ λAL − ŷA , λBL λBL (3) ŷA = K̂ λBK − ŷB. λAK λAK (4) 1 FEB13085 Problem Set 1 Plug (3) into (4) to get: λBK K̂ λBK λAL − ŷA L̂ + λAK λAK λBL λAK λBL nλ λ − λ λ o λBK K̂ BK AL AK BL ⇒ ŷA = L̂ − λAK λBL λAK λBL λAK λBK L̂ − λBL K̂ ⇒ ŷA =. λBK λAL − λAK λBL ŷA = Since λAK + λBK = 1 and λAL + λBL = 1: λBK λAL − λAK λBL = λBK − λBL = λAL − λAK > 0, where the inequality holds because good A is labor intensive. Thus, we have that: ŷA = λBK L̂ − λBL K̂ > L̂ when λBK − λBL L̂ > K̂. (5) L̂ > K̂. (6) Doing the same analysis with respect to ŷB gives: ŷB = λAL K̂ − λAK L̂ < K̂ λAL − λAK when Equations (5) and (6) state the Rybcyznski theorem: an increase in a factor endowment will increase the output of the industry using it intensively, and decrease the output of the other industry. The effect is more than proportional, emphasizing the magnification effect. (b) Assume that a financial crisis devastates the economy and reduces the capital-labor ratio to less than aAK /aAL. Show the effects of this change on the production levels of the two goods. Solution: See the Appendix of the lecture slides. Applied to this setting, a reduction of K/L to levels below aAK /aAL would result in the country specializing in the labor-intensive good A, with the production of good B reaching zero. Trade and Wages 2. Imagine that there are two sectors: the labor intensive manufacturing sector and the land intensive agriculture sector. Answer the following questions with intuition, but feel free to use graphs or equations. (a) In a Heckscher-Ohlin (HO) setting, describe how real wages in the European Union would be affected by a potential free trade agreement with Vietnam. Assume that relative to Europe, Vietnam is a labor-abundant country. 2 FEB13085 Problem Set 1 Solution: A free trade agreement with Vietnam would lower the relative price of the labor intensive good (manufacturing). Using the Stolper-Samuelson theorem (and emphasizing the magnification effect), one can show that EU real wages would decline (see lecture slides for derivation). Note that this result will hold under the assumption that both countries produce both goods (which lead to factor price equalization) and factor intensity reversals do not occur. (b) Describe how the effect would differ if we assume that there is another factor (capital) that is mobile between the industries, but labor and land are now “specific” to their respective industries. Solution: Similar to the HO model, a decrease in the relative price of manufactured goods would lower the returns to the factor used intensively in manufacturing, which is labor in this question. As a result, workers won’t be able to afford as much of any of the two goods (hint: assume that manufactured good prices stay the same and agricultural prices rise). (c) Between the HO and the specific-factors models, which one do you think is more realistic? Make sure to refer to factor price equalization. Solution: In the short-run, the specific-factors model is more realistic as many factors are often immobile due to sectors requiring a specific skill set (land is a good example). This immobility might also be due to workers unable to geographically migrate to locations of the expanding sectors. In the long-run, workers can adopt the skills that the expanding sector requires through education (this is where government policy can play a role). Hence, one can argue that the HO model might be better suited in a long-run setting. Since the HO model predicts factor price equalization (under the usual assumptions–see lecture slides), it falls short of depicting the reality where countries often differ in their factor prices. In fact, many empirical papers in the international trade literature have failed to demonstrate the relevance of the HO model, unless Ricardian technological differences are incorporated. In the specific-factors model, factor price equalization need not occur because factor prices are sensitive to endowments (see lecture slides), and this makes the model more realistic as well. Multiple Choice Questions 1. Which of the following is not true regarding the specific-factors model? a. Trade will raise the relative price of the good that a country exports. b. Trade might cause countries to fully specialize. 3 FEB13085 Problem Set 1 c. Trade will benefit the owners of the factor specific to the export good. d. Trade will hurt the owners of the factor specific to the import good. e. Trade might benefit the owners of the mobile factor. 2. The Stolper-Samuelson theorem states that: a. When a country opens up to trade, the factor used intensively in producing the export good will gain. b. An increase in the relative price of a good increases more than proportionally the real return to the factor used intensively in the production of that good, and reduces the real return to the other factor. c. An increase in the relative price of a good increases the real return to the factor used intensively in the production of that good, and more than proportionally reduces the real return to the other factor. d. An increase in a factor endowment will increase the output of the industry using it intensively, and decrease the output of the other industry. e. An increase in a factor endowment will increase the output of the industry using it intensively, without changing the output of the other industry. 3. According to the Heckscher-Ohlin model, countries have comparative advantage in the good that: a. Employs a relatively large amount of their abundant factor. b. Employs a relatively large amount of the factor whose price there is relatively high. c. Uses intensively their scarce factor. d. Requires proportionately more of every factor than the goods they import. e. Increases their proportional endowment of their scarce factor. 4. The Factor Price Equalization result of the Heckscher-Ohlin model implies that: a. All workers are equally productive. b. If a country fails to trade, its skilled workers will earn no more than its unskilled workers. c. Trade causes the return to human capital to be the same as the return to physical capital. d. Free trade causes identical factors in different countries to be paid the same. e. In order for countries to trade freely, they must tax wages so that firms in all countries pay the same. 5. According to the Heckscher-Ohlin model of international trade, if a country reduces its trade barriers, it will: a. Export a good in which it has a comparative disadvantage. 4 FEB13085 Problem Set 1 b. Specialize in an industry with increasing returns to scale. c. Increase its tariff revenue. d. Expand production of the good that uses intensively its scarce factor. e. See its factor prices become more similar to those in other countries. 6. Suppose that a country starts in autarky, then opens to international trade and begins to export bicycles. Both the Ricardian and the Heckscher-Ohlin (HO) models have predictions on what will happen in this country. Which of the following is a prediction of the HO model but not a prediction of the Ricardian model? a. Output of bicycles will increase. b. Labor will move from another sector of the economy into the bicycle sector. c. The technology in the bicycle sector will improve. d. Consumers in the country will have access to a larger variety of bicycles. e. The real wage of the country’s scarce factor will fall. 7. France produces clothing (C) and food (F) using labor and capital. The clothing industry is labor-intensive, while the food sector is capital-intensive. The production possibility frontier is given by the black curve in the graph below, and the current equilibrium is at point 1. France’s production possibility frontier After a certain shock, the production possibility frontier adjusts, and the new equilibrium is at point 2. What might have happened? a. France improved its technology for producing clothing. b. France opened up to free trade and started exporting clothing. c. The French increased their demand for clothing. d. The French increased their demand for food. 5 FEB13085 Problem Set 1 e. France’s labour force has increased. 8. Which inequality describes the “Leontief Paradox”? (using the notation K=capital, L= labor, X=exports, M =imports, U S=United States, U K=United Kingdom) US UK KX X < a. K LX LX US US KM X b. K < LX LM US UK KX X c. K > LX LX US US KM X > d. K LX LM US UK KM X e. K < LX LM 9. Many economists have argued that the Heckscher-Ohlin model is “hopelessly inadequate as an explanation for historical and modern trade patterns”. Which of the following arguments cannot substantiate this claim? a. Factor prices vary dramatically across countries. b. Trade liberalization has reduced the real income of low-skilled workers in developing countries. c. Trade liberalization has increased the real income of high-skilled workers in developed countries. d. Even in the long run, factors are not perfectly mobile. e. Prices of capital-intensive products have declined in capital-abundant countries. 10. Which of the following is not a finding by Autor, Dorn, and Hanson (2016)? a. US regions relatively more exposed to Chinese import competition suffered relatively more job losses in manufacturing. b. US regions relatively more exposed to Chinese import competition had a relatively larger fall in employment-to-population ratios. c. US regions relatively more exposed to Chinese import competition had a relatively larger fall in average wages. d. US regions relatively more exposed to Chinese import competition had a relatively larger increase in per capita unemployment benefits. e. US regions relatively more exposed to Chinese import competition had a relatively larger increase in emigration. 6

FEB13085: International Trade Policy Problem Set 1 Solutions PDF

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