< Answer Keys for Mid-term Exam > E 101: International Trade

(Professor: Young-Han Kim) Exam Date: August 19, 2008

1. What is the relationship between the recent information technology (IT) revolution and the volume of world trade? (Explain the relationship using Gravity model.) (10 points)

O The relationship between the recent information technology revolution and the volume of

world trade can be explained through Gravity model as follows. o The recent trends of international trade can be characterized by the fact that the majority

of trade is between larger economies located closely. And this trends can be

characterized by Gravity model, ij

jiij D

YAYT = , which shows that the trade volume

increases when the economic size of trading countries is bigger, and the distance (transaction costs) between trading countries are lower.

o Globalization is the second feature characterizing recent trends of international trade.

Globalization is characterized by i) sharp reduction of physical transaction costs by information and communication technology revolution, and ii) rapid reduction of legal and institutional transaction cost (as tariff and non-tariff trade barriers.). As a result of globalization, the physical and legal distance between trading country is sharply decreased, and this results in more rapid increase of the trade volume.

IT revolution sharply decreases the physical distance (Dij), which is the denominator in the Gravity model, and as a result, the trading volume is increased dramatically due to the reduction in transaction costs.

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2. Consider a Ricardian world where there are only two countries, Home and Foreign country, and two commodities, Color HD TV and Automobile, and one mobile factor, labor. In addition, units of labor requirement for the production of each unit of commodity are given as in the following table.

Unit of labor requirement Color TV Automobile Foreign Country aLC*= 3 aLA* = 9 Home Country aLC= 2 aLA = 2 i) Which country has the comparative advantage in the production of Color TV and Automobile?

(Explain why.) (7points) o A country which has a lower opportunity cost to produce C-TV has the comparative

advantage in the production of C-TV. Foreign countrys opportunity cost of producing C-TV is lower than the Home country

opportunity cost to produce C-TV: (aLC*/ aLA*=3/9) < (aLC/ aLA=2/2 =1.) - Therefore, the Foreign country has the comparative advantage in producing commodity

C-TV, and Home country has comparative advantage in the production of Automobile: (aLA/ aLC = 2/2=1) < (aLA*/ aLC*=9/3=3). ii) Assume that the initial endowment of economic resources (labor endowments) of Home country

12 units of labor, while Foreign country is endowed with 36 units of labor. In case both countries specialize in the sector of comparative advantage, and participate in free trade according to an international price, (PA/PC)I=2, i.e., one unit of automobile is exchanged with 2 units of C-TVs in world markets, what is the level of gains from trade to Foreign country measured in the units of Automobile? (10 points)

o Because the Foreign country has comparative advantage in the production of C-TV, she

will specialize in the production of C-TV, and produces 12 units of C-TV. That is, using her total labor endowments, 12 units of labor, Home country can produce 6 units of Automobile: (L/ aLA)=(12/2)=6.

- Then, under free trade regime, Foreign country can obtain 6 units of airplane by trading according to international price (PA/PC)I= 3), while Foreign country could produce 4 units of Airplane under autarky system.

- Therefore, the gains from trade for the Foreign country measured in the units of airplane is 2 unit ( 6 - 4 = 2).

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3. Explain Heckscher-Ohlin Theorem about the trade pattern based on the following assumption. Assume that there are two mobile factors as labor (L) and Capital (K). In addition, there are two industries as electronic equipments and food industry in two countries, Home country (H) and Foreign country (F). Moreover, assume that the relative endowment of labor/land ratio in each country is given as follows: (L/K)Home =3, (L/K)Foreign =5. In addition, the input requirements ratio for the automobile industry is (L/K)Automobile-industry=2 while the input requirement ratio for software-industry is (L/K)Software-industry=3. (Assume that two countries have symmetric technologies, and there is no transaction cost in international trade.)

i) What would be the trade pattern if Home and Foreign country get into free trade relationship from

autarky? (i.e., which country exports what commodity) ? (Explain why) (10 points) o According to Heckscher-Ohlin model, Foreign country, which is endowed with labor

relatively more abundantly than the Home country [(L/K)Home = 3 < (L/K)Foreign = 5], will have comparative advantage in the software industry, which is more labor intensive than the automobile [(L/K)Software-industry = 3 > (L/K)Automobile-industry =2 ].

- In the same way, Home country has comparative advantage in the automobile industry. O Therefore, Foreign country will export software to Home country, and Home country

will export automobiles to the Foreign country. ii) If Home country and Foreign country open their markets to free trade according to an

international relative price of Automobile, which is between Autarky prices of two countries, explain the income redistribution effects in the Foreign country according to Heckscher-Ohlin model. (10 points) [[ Explain using a diagram!!]]

O The income redistribution effects of free trade is determined by the impacts of free trade

on the factor prices in each country. In the Heckscher-Ohlin model, which assumes a perfectly competitive market, changes in factor prices is caused by the changes in the prices of traded goods, with one-to-one relationship as shown in the following diagram.

O If both countries free trade, then the relative price of two commodities converges to the

same international price. Therefore, the relative prices of production factors of trading countries are converged to the same level in two countries. So called, factor price equalization effect occurs as a result of free trade.

O Therefore, in the foreign country, the relative price of software (Psoftware/Pautomobile) in

foreign country is increased as a result of free trade, resulting in the increase of the relative price of labor (w/r).

- Therefore, in the foreign country, as a result of free trade, the income of workers

will be increased while the relative income of capital owner is decreased.

0 The above income redistribution effects can be shown through the following diagram: - The Foreign relative price of the software is increased from (PSo/PAuto)1 to (PSoft/PAuto)I

and as a result, the relative factor prices of labor (wage/rent) is also increase to (w/r)I.

Automobile

Software

(PSoft/PAuto)Foreigh

(PSoft/Pauto)I

(w/r)I

iii) Compare the income redistribution effects of free trade in Heckscher-Ohlin model and

Ricardian model. (Explain the reason for different income redistribution effects of free trade in two models.) (5 points)

o In Ricardian model, there is no income redistribution effects of free trade, because there is only

one, single perfectly mobile production factor, labor, and after the free trade, labor can be reallocated to a sector with comparative advantage with no time lag.

O However, in Heckscher-Ohlin model, two factors were assumed with each factor used more

intensively in each different industry. - Therefore, after the free trade, the price for the factor, which is used more intensively in the

export industry is increased, while the price for the factor used more intensively in the import goods is decreased.

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4. i) Assume that country A produces 2 commodities, oil and automobile and has comparative advantage in the oil production. Explain the impacts of the biased growth in the production oil on the social welfare when country A is a small country in the world oil market. (Explain using a diagram) (7 points.)

O There is no change in terms of trade even after the biased growth in the production of

automobile, if country A is a small economy in the world oil market. In this case, the biased growth in the oil production improves the social welfare (from U1 to U2) because the expansion of PPF (production possibility frontier) caused by the biased growth expands the CPF (consumption possibility frontier) without any change of the CPFs slope as shown in the following diagram.

U1

U2

U2U1

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ii) If country A becomes a large economy in the oil industry, and world aggregate

demand curve for oil becomes perfectly price elastic (with an invention of new energy source), what would be the effects of biased growth in the oil production on the social welfare of country A? (Explain using a diagram) (8 points)

o If the world relative price of the oil is perfectly elastic, even after the biased growth in oil

production in a large economy, there is no change in terms of trade (TOT) even if the world relative supply of oil is increased as in the following diagram.

- Therefore, the impacts of biased growth on the social welfare would be positive,

exactly same as the case when the economy is small economy in the world oil market, with no influence on the world oil price.

POil/PAuto RSO

RS1

RDO TOTAO

QOil/QAuto

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5. Explains the source of gains from intra-industry trade in monopolistic competitive industries based on the following model features:

i) The demand function for an individual firm producing differentiated commodities is given as: Q = S[1/n b(P P^)]

Q is an individual firms sales S is the total sales of the industry n is the number of firms in the industry b is a constant term representing the responsiveness of a firms sales to its price P is the price charged by the firm itself P^ is the average price charged by its competitors

In equilibrium, all firms charge the same price (P=P^). Therefore, the demand level for an individual firm is: Q = S/n The average cost function is given as: AC = TC/Q = F/Q +c where F is the fixed cost, and c is marginal cost. Assume that when intra-industry trade occurs, the market size, S, is increased to 2S. Based on the above model configuration, explain the source of gains from intra-industry trade using a diagram, which compares the equilibrium before and after the intra-industry trade in monopolistic competitive market. (Try to derive the equilibrium condition based on the above individual demand function and average cost function, if you can.) (15 points) O If an economy shows internal economies of scale, and the market structure is

monopolistic competitive market, each country can obtain gains from intra-industry trade. The source of gains from intra-industry trade is the gains from increased economies of scale by free trading.

O By intra-industry trade, each country specialize a specific type of commodity while the

market size of the commodity is increased to the summed market size of trading countries (US + Canadian market in this question.) Therefore, with the increased market size, the economies of scale effects become larger, reducing the average cost, and eventually, equilibrium price of the commodity.

O As a result of intra-industry trade, the variety of commodity is increased in each

country and at the same time, the equilibrium price of the commodity is decreased due to the economies of scale effects

O This effect of intra industry trade can be shown with a zero profit condition curve (P =

AC) shifting downwards. CC curve shifts down because the average cost is reduced due to the economies of scale after intra-industry trade. In a new equilibrium, the number of firms producing differentiated products is increased increasing the variety of commodity, and at the same time price level has been reduced as shown in the following diagram.

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[ The above CC curve represents the zero economic profit condition and PP curve represents profit maximization condition. These curves are derived in the following way: O In equilibrium, all firms charge the same price (P=P^) Q = S/n + 0 AC = TC/Q = F/Q +c = F (n/S) + c O Monopolistic Firm maximizes its profit by producing such that MR = MC - If demand curve is given as Q = A -BP MR = P Q/B ( TR = P(Q)*Q P = A/B Q/B ) MR = P Q/B = c ( MR = MC ) - Demand curve in the monopolistic competitive market is: Q = S[1/n b(P P^)] Q = S/n + SbP^ SbP Q = A BP ( B = Sb)

MR = P Q/B = c ( MR = MC ) MR = P Q/Sb = c (B = Sb)

P = c +Q/Sb = c + (S/n)/Sb = c +1/nb P = c + 1/n*b

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O Equilibrium in the monopolistic competitive market is achieved where P = c + 1/n*b = AC = TC/Q = F/Q +c = F (n/S) + c

ii) Explain income redistribution effects of intra-industry trade, and provide the economic intuition behind your answer. (8 points.) o In case of intra-industry trade, gains from trade occurs from the increased economies of scale as a result of increased market size when each firm produces a differentiated products, with no changes in the relative price of commodities. O Therefore, there is no negative impact on any factor price as a result of intra-industry trade There is no income redistribution effects in case of intra-industry trade The welfare of all economic agents is increased due to increased variety of consumable commodities at lower price after intra-industry trade. 6. Is dumping strategy a rational export strategy for a firm, which has a price-leadership in

its domestic market? (Explain why or why not, using a diagram). (10 points) O If the following two conditions are satisfied, dumping pricing strategy in the export market is a

rational (profit maximizing) strategy as shown in the following diagram.

i) If the exporting firm has a strong market power in its domestic market, while it is a price-taker in the foreign market,

ii) If the domestic market and foreign market are separated (i.e,, no arbitrage trade between two market is possible)

O As in the following diagram, it is rational to sell commodities in domestic market if MR in domestic market is higher than the export market charging a higher price as shown in the diagram - If the MR in the export market is higher than the domestic market, the commodities should be sold in the export market at the world price, which is lower than the domestic price.

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