- 1 -Information on the Midterm Examination # 1: International Economics & Finance

Midterm examination date: 03/10/2011 (Thursday: 2.30 – 3.40 pm) Room: 8-155, VC Midterm examination format: The following is the general format of the mid-term examination.

[Total points: 40] [Exam duration: 70 minutes](1) 17 multiple choice questions (2 points each 34 points): [Syllabus Sections II, III, and IV]

(2) 1 problem solving question (6 points) [Syllabus Section IV]

Multiple Choice Answers: For each question, choose only 1 answer that is most appropriate. All the answers must be written inside the bluebook.

Any answers on the question sheets will not be counted. Problem Solving Answer:

Quality, not mere quantity, of the materials in the answers is most important. Since written communication skill is very important in the business world as well as in school, the way

your answers are organized and presented will be important in grading. You will lose points if your answers are not well organized or your handwriting is illegible.

Pens should be used in the examinations instead of pencils to make your answers more legible. Moving in and out of the classroom during an examination:

You are expected to stay in the room until the final submission of your examination. Please refresh yourself before the examinations.

Calculator: Calculators are allowed during the examinations. But borrowing or lending calculators are not allowed.

Cellular Phone: Either set it on vibration mode or turn it off as courtesy to the fellow classmates.

Partial view of the examinationYour Name:______________________________________________

*************** INSTRUCTIONS ****************

1. Write down your name both on this question sheet and the blue answer book.2. Write down your multiple choice answers inside the blue book, not on the question sheets. Only the answers in the blue

book will be counted, and any answers written on the question sheets will be ignored.3. Submit both the question sheet and the blue book after the examination. Failure to submit both will invite penalty.4. Please do not leave the room until your final submission of the examination. (75 minutes)

Midterm Lee

I. Choose only 1 answer that is the most appropriate. (2 points each)

1. #%^^^^*()__++*&%$ (a) *(&%$#@)

(b) &(%^#$(c) ^$#@%((d) @%$*&%^

2. $%#*&……………………….

II. Country XYZ tries to ……………………. (6 points)[Note: Write the essay answers clearly and neatly. The contents should be precise and well organized. Points will be

deducted if the answers are not easily legible.]

Midterm Exam Checklist: International Economics & Finance: Eco 3250

- 2 -

Don’t be late for the exam. The proctor(s) will be in the classroom at least 10 minutes before the start of the exam. No extra time will be allowed for being late for the exam.

You will receive the bluebook and the question sheet (double sided) which is inside the blue book.

o There are multiple versions of the exam.

Make sure to write down your name on both the blue book and the question sheet.

You must return both the question sheet and the blue book in the way you have

received.

Your exam cannot be graded if you don’t return the question sheet.

o Since the exam copies are counted, make sure to take only 1 copy per person.

Put down all the answers in the blue book. Only the answers from the blue book will be used as

the basis for grading. Your answers in the question sheet will be ignored.

Use pen instead of pencil.

Until you finish and submit the exam, you are not allowed to leave the classroom. Therefore,

make sure to refresh yourself before the exam.

Cell phones must be turned off , and put away . You will not be allowed to use your

cell phone for any purpose during the examination.

Calculators are allowed. But lending and borrowing of the calculators are not allowed.

Best way to estimate your course grade is to add up the scores from your midterm exam and final exam. Then look at the grading guidelines on page 3 of our syllabus packet.

Our department policy prohibits extra credit assignments to improve grades.

My best wishes!!

--- Jae W. Lee ---

- 3 -[Summary-Review Part I] Especially important topics are marked with blue font.

I. An Overview of International Economics: International trade and financeII. Theories of International Trade

1. Law of Comparative Advantage: David Ricardo[Comparative Advantage Theory: Keypoints] International specialization and trade based on comparative advantage in terms of labor productivity would be beneficial to all the participating countries.[Example] 2 country/ 2 product case: The following is a John Stuart Mill's version of Ricardo's theory.

1) Before specialization/trade One Person - Day LaborWheat(bushel) Textile (yard)

U. S. 60 20Germany 20 10Total 80 30

[For a mysterious reason, Kreinin switched U.K. to Germany in this example. U.S. workers can outperform German workers by 3/1 (= 60 bushel/20 bushel) in wheat. U.S. workers can outperform German workers by 2/1 (= 20 yards/10 yards) in textile U.S. has comparative advantage in wheat, and Germany has comparative advantage in textile.

2) After specialization One Person - Day LaborWheat(bushel) Textile (yard)

U. S. 120 0Germany 0 20Total 120 20

3) Exchange rate: Range for mutually beneficial trade For U.S.: commodity exchange rate (W/T) before specialization is 60 bush.= 20 yds W/T = 60/20 = 3/1.

Since U.S. will specialize in wheat production and export, only the exchange rate below 3/1 will induce U. S. to engage in trade 3/1 is the maximum W/T exchange rate.

For GERMANY: exchange rate (W/T) before specialization is 20 bush.= 10 yds W/T = 20/10 = 2/1. Since U.K. will specialize in textile production and export, only the exchange rate above 2/1 will induce U. K. to engage in trade 2/1 is the minimum W/T exchange rate.

Exchange rate (W/T) range within which a mutually beneficial trade will take place: 2/1 < W/T < 3/14) Comparison of Total Production before & after International Specialization Select an exchange rate within above range: (e.g.) W/T = 2.5/1 Use the exchange rate to show the total value of both W and T production in common unit.

Before specialization: 80 bush. + 30 yds = 80 bush. + 30 (2.5) bush. = 155 bush. After specialization: 120 bush. + 20 yds = 120 bush. + 20 (2.5) bush. = 170 bush. International specialization increased total value produced Mutually beneficial trade can take place.

2. Law of Reciprocal Demand: John Stuart Mill

[Commodity Terms of Trade: Barter Terms of Trade] 2 commodity case: Commodity exchange rate (W/T) is the same as commodity terms of trade. More than 2 commodity case: Commodity terms of trade (Tc) = (PX /PM) (100)

where PX : Export price index PM : Import price index TC is frequently used as a measure of whether a country’s trade position has improved or

deteriorated over time since the base period. If Tc > 100 : improvement of Tc If Tc < 100 : deterioration of Tc

If Tc = 100 : no change in Tc

(ex) PX = 160 PM = 150Year PX PM

Base year (e.g. 1983) 100 100This year (e.g. 2000) 160 150

Tc = PX / PM = (160/150) 100 > 100: Compared to the base year 1983, Tc has improved in 2000

- 4 -[Meaning] The exchange rate depends on the strength (elasticities) of the reciprocal demand (each country’s demand for the

other country’s product).3. Factor Proportions Theory: Heckscher-Ohlin Theory [Theory in Brief] International specialization and trade based on factor proportions (K/L) would be beneficial to all the

participating countries.

(Example) Kreinin uses Germany as a labor abundant country , and U.S. as a capital abundant country.I would rather call them country A and country B, because Germany is a bad example of labor abundant country.

Country A: Labor (L) abundant country Product X: Labor (L) intensive productCountry B: Capital (K) abundant country Product Y: Capital (K) intensive product

Before Specialization After Specialization After TradeCountry A Labor supply high Wage rate low

Capital supply low Capital cost highSpecialize in X Px low & Py high Residents cannot afford to consume much of Y.

Export X Px Import Y Py Residents can buy more of Y in place of X utility up

Country B Capital supply high Capital cost lowLabor supply low Wage rate high

Specialize in Y Py low & Px high Residents cannot afford to consumemuch of X.

Export Y Py Import X Px Residents can buy more of X in place of Y utility up

Such a trade tends to result in equalization of commodity prices and factor prices. Commodity prices: Px was low in Country A, and high in Country B before trade The price gap narrows

after trade (equalization of commodity price). The same reasoning for Py. Factor prices: Labor price (w) was low in Country A, and high in Country B before trade The

wage gap narrows after specialization and trade. [The same is true with capital price] More rigorous presentation can be done with graphs, utilizing indifference curve and product transformation

curve: [Optional][Strength over Ricardo’s Law of Comparative Advantage]* Both labor and capital are used in the analysis Partially explains inter-country productivity difference. More sophisticated tools of analysis used Partial specialization , instead of unrealistic complete specialization, is introduced. Exchange rate determination is explained without introducing an outside theory. (Law of Comparative

Advantage needed an outside theory, Law of Reciprocal Demand)[Limitations/Exceptions] Some of the limitations are corrected in more advanced versions of the theory. The theory depends on the assumption of full price flexibility. Imperfect competition reduces such flexibility. The original Heckscher-Ohlin theory uses only K and L to explain trade pattern, which would be ineffective in

explaining the trade in raw materials. (e.g.) oil and minerals, lumber, rubber, etc. The original Heckscher-Ohlin theory uses factor proportions to explain trade pattern while assuming the same

tastes in different countries, which would be ineffective in explaining the certain exceptional trades. (e.g.) Sea urchins, jelly fish, etc.

Assumption of "no factor reversal " may be unrealistic in some cases. (e.g.) Steel may be produced in capital-intensive way as in Western countries, and also in labor-intensive way as

in China during 1950's. (e.g.) Another example is textile products, which can be produced either in labor-intensive or in capital-

intensive ways. The original Heckscher-Ohlin theory is static in nature.

(e.g.) Textile: UK US Japan Hong Kong, Philliphines, etc. Taiwan, Korean China ??? Assumptions on labor mobility:

Inter-industry within a country: perfect mobility inter-country: perfect immobility

[Empirical Evaluations] In general, the theory explains trade pattern reasonably well for manufacturing industry. But it performs poorly

for non-manufacturing industries. (e.g.) oil and minerals, lumber, rubber, etc.

- 5 - In general, it explains trade patterns reasonably well for DC-LDC trade and inter-industry trade, but not intra-

industry trade which involves products with similar factor intensity. Needs supplementary trade theories based on product cycle, economies of scale, product differentiation, etc.

4. Selected Alternative (Supplementary) Trade Theories: A brief description(a) Product Cycle Theory: Raymond Vernon

This theory stresses the standardization process of products. Industrial countries tend to export non-standardized products, whereas less-industrialized countries tend to

export standardized products. Product Cycle :

1. Initial stage : A new product tends to be non-standardized. It is initially produced at home for domestic market and foreign market. During this stage, various experiments will be done to vary production method and product attributes.

2. Later stage where some degree of standardization is achieved: Production of the product may be carried out in foreign affiliates of home companies in less industrialized countries --> Import it back home for domestic sales or export it to other countries.

3. Final stage where standardization is completed: Foreign companies in less industrialized countries would become competitors of the home company that introduced this product in the first place.

This theory can explain intra-industry trades.: (e.g. memory chips, cellular phones, consumer electronics….)(b) External Economies of Scale:

External economics of scale: industry expansion --> improvement of infra-structure, expanded supply and factor sources, etc., all of which benefit the companies in the industry in terms of cost reduction.

Once a country starts specializing in a particular product --> External economies of scale in the industry producing that product --> Cost reduction in that industry enhances its competitiveness --> Further expansion of the industry and export of the product --> More economies of scale and competitiveness --> repetition of the process.... (e.g.) Swiss watch industry, U.S. Silicone Valley, industrial centers in many countries.

This theory cannot explain why a particular product was selected for specialization in the beginning. Instead, it shows what can happen once the product shows initial success.

This theory can explain intra-industry trades. (e.g.) auto parts, computer parts, watches, …(c) Product Differentiation : Monopolistic Competition:

Monopolistic competition: Many sellers of differentiated product who enjoy some degrees of monopoly in their differentiated product sub-categories.

Monopolistic competitors in different countries produce differentiated products and export them. The involved countries may have similar factor proportions.

This theory can explain intra-industry trades.(e.g.) automobiles, motor cycles (Harly Davidson vs. Suzuki: 700cc), movies, TV programs, apparels, etc.

III. International Factor Movements and Related Issues1. International Labor Movements and Brain Drain Issues

Wage rate differences: Putting aside non-economic reasons for international migration of labor, labor tends to move from low wage countries to high wage countries. This eventually reduces wage differences between countries.

Brain Drains issues: sensitive issues

2. International Investments (International Capital Flows) (a) Short-term Investment Vs. Long Term Investments

The classification of an international capital flow (investment) into short-term or long-term investment is made by the nature of assets acquired not by how long investors hold them.

For assets with maturity dates such as treasury bills, commercial papers, government bonds, corporate bonds, etc., the classification will be based on the specified maturity dates.

- 6 - For assets with no maturity dates such as stocks and real estate properties, an investment in such

assets will be automatically classified as a long-term investment regardless the intended length of the holding of the assets.

1) Short-term Capital Flow (Investment): Short-term investment: Investment in foreign securities with less than 1 year maturity Such capital flow is frequently induced by interest rate differences. Holding other things the same,

short-term capital tend to move from low interest rate countries to high interest rate countries. Interest rate induced capital flows tend to reduce the interest rate differences.

2) Long-term Capital Flow (Investment): Investment in foreign stocks, real estate properties as well as the securities with maturities of one

year or longer. It does not matter how long these are held how long the investor intends to keep the securities.

As for investments in stocks and real properties, they are considered as long-term investments regardless how long they are held.

Such capital flow is frequently induced by rate-of-return differences, where rate of return can be either interest rate or rate of profit. Holding other things the same, long-term capital tend to move from low rate of return countries to high rate of return countries.

Rate of return induced capital flows tend to reduce the rate-of-return differences.(b) Portfolio Investment vs. Direct Investment

1) Portfolio Investment: Investment with no intent to control Portfolio investment includes equity investment involving less than 10 % of a foreign entity's equity.

It also includes all the investments in bonds and short-term securities, which do not carry voting right.(e.g.) Investment in 90 % of a foreign company's corporate bond is a portfolio investment. investment, because bonds to not carry voting right.

2) Direct Investment: Foreign Direct Investment (FDI): Direct Investment: Investment with intent to control, i.e. 10 % or more of equity investment in

a foreign entity. (e.g.) purchase of 12 % of the outstanding Toyota stocks. Parent and Foreign Affiliate: Parent is the company that makes a direct investment (10 % or

more of equity investment) abroad, and the target company becomes its foreign affiliates. Subsidiary: If a parent company's direct investment is more than 50 % of foreign affiliate's

equity (outstanding stocks), the affiliate becomes the parent's subsidiary. Motives for Direct Investments Abroad:

In general, a firm tries to maximize its profit [or the present value (PV) of its profit flows] international difference in profit rate is a prime motive for direct investments

[example of maximizing PV of profit flows over time: McDonalds in Russia] Lengthy discussions in the textbook can be stated in a concise way as follows:

Profit = TR - TC = PQ - [wL + rK + other costs]where

TR: total revenue TC: total cost w: wage rate L: labor input r: cost of capital K: capital input

Some firms are after revenue potential in foreign countries (TR), some are after cost saving potential (TC), and others for both. All of them are ultimately after higher profit.

In practice, international comparison of rates of return cannot be complete without adjusting for risk factors affecting various countries known as "country risk". Country risk includes foreign exchange risk, economic risk, political risk, etc.

Measurements of country risk factors are difficult. Nevertheless, many sources publish their own measurements of country risk.

3. Transnational Corporation (TNC) [or Multinational Corporation (MNC)] and Transfer Pricing(a) Transfer Pricing: http://www.transferpricing.com/

International trade theory such as Factor Proportions Theory assumes that commodities are traded on world markets between independent firms at "market determined price" (arm's -length prices). In practice, however, about one-quarter of today's world trade in manufactures is conducted within firms, because TNCs tend to be vertically integrated companies.

- 7 - Various components (intermediate products) are produced by a TNC's foreign affiliates or

subsidiaries located in many countries The components are transferred from one unit of the TNC to another unit. The values of the components for such intra-firm transfers are usually determined by the TNC in the way that would maximize its after-tax global profit. These arbitrary prices are called transfer prices.

Transfer prices are set in such a way that the profits in high tax countries would be undervalued, whereas the profits in low tax countries would be overvalued. more global profits after taxes (income taxes or/and tariffs).

Abuse of transfer pricing by foreign -based TNC's to reduce tax obligations in U.S. alarmed U.S. Congress, federal government, and some state governments. Some state governments, especially California government has tried to counter the abuse by using unitary tax, and congress as well as federal government introduced regulations to discourage such abuses. Presidential candidate Bill Clinton used this issue in his presidential campaign.

(b) Unitary Tax: Unitary tax had been used by some state governments in U.S. Unitary tax treats a TNC’s units as one unit which is interdependent in its business operation. As a

result, unitary tax uses a prorated global profit by a TNC as the tax base. Prorating can be based on sales or assets.

Unitary tax is used to counter TNCs' attempts to reduce their tax obligations via transfer pricing. California's Unitary Taxation has been seriously challenged by two TNCs; Barclays & Colgate.

4. M & A (Mergers & Acquisition) vs. JV (Joint Venture) in Foreign Direct Investment: [Optional]1) M & A: a popular method used: (e.g. Chrysler-Daimler and SUV…)2) Joint Venture: also a popular method used.

IV. Protection of Domestic Industries: Tariff Trade theories show that international trade can benefit all the participating countries, providing a strong case for free trade. In reality, however, all the countries use various forms of trade restriction (protection). Why? Tariff is the most frequently used method of protection. All the other methods of protection are often lumped

together in the category of Non-Tariff Trade Barriers (NTTB).1. Arguments for Protection: Selected List Infant Industry Argument: Friedrich List and Alexander Hamilton

Young industries with potential comparative advantage needs protection from mature foreign competitors until they grow up.

This argument is considered as the most economically reasonable argument for protection. However, the infant industries must have potential comparative advantage, and the protection must be a temporary one.

Employment Argument: Domestic recession tends to strengthen this argument. But protection reduces benefitfrom international trade, and results in many undesirable side effect. Besides, fiscal and monetary policies would be more effective in increasing employment without those side effects.

Cheap Foreign Labor Argument (Scientific Tariff Argument): frequently used by labor unions [Argument] Foreign workers receive a fraction of wages received by U.S. workers It is unfair

for U.S. workers to be forced to compete with such cheap foreign workers. To correctthis wage gap, tariff should be introduced to offset the wage differences. [Counter Argument] Cheap labor (low labor cost) should not be confused with low wage. Labor

cost depends not only on wage, but also on productivity.CL = wL / Q = w / (Q/L) = w / labor productivity

where CL : unit labor cost (labor cost)w: wage rate L: labor input Q: output Q/L: labor productivity

(ex) Wage rate ($) Labor productivity Unit labor costCountry A 10 40 10/40 = 0.25Country B 2 8 2/8 = 0.25

Comparison of wage rate: Country B's labor is much cheaper Comparison of unit labor cost: Labor cost is equal in both countries

(ex) Wage rate ($) Labor productivityCountry A 10 50Country B 1 4

- 8 - Which country's labor is cheaper? You can create an additional column for unit labor cost to find out. An alternative approach: Compare wage rates and labor productivities between the countries.

Wage rate: 10/1 = 10 : Wage rate is 10 times higher in Country Aproductivity: 50/4 > 10 : Productivity is more than 10 times higher in Country A

Therefore, labor in country A is cheaper. [Comments]

As long as labor market is perfect, wage rate difference fully reflects productivity difference Cheap labor argument based on wage rate comparison is invalid.

However, labor market is not perfect. In some cases, some governments artificially hold wage rate below their appropriate productivity levels Cheap labor argument is partially valid in such a case.

Countering Unfair Trade Practices: Anti-dumping tariff and countervailing tariff (against subsidies) National Security Argument: A reasonable non-economic argument. Revenue Argument: Tariff can be a source of government revenue. [Text p. 88] But with income tax and

VAT, tariff has lost its significance as a revenue source.2. Types of Tariff (Duty): Also read "U.S. Custom House Guide" for practical information.

{U.S. Customs and Border Protection: http://www.cbp.gov/ [new U.S. Customs website]} In U.S., tariffs are set by the Congress. As the result, political pressure from various interest groups may

have some influence on tariffs.(a) Ad Valorem tariff: Fixed percentage of the value of a commodity.

[Advantages] equitable: good for the commodity with distinct grades of quality inflation protection of the tariff revenue[Disadvantage] administrative difficulty: Valuation is not simple.

(b) Specific tariff: Fixed amount[Advantages] administrative ease [Disadvantage] not equitable: good for the commodity with no distinct grades of quality no inflation protection of the tariff revenue

(c) Compound tariff: combination of Ad Valorem and specific tariffs[Advantages] advantages of both Ad Valorem and specific tariffs.[Disadvantage] disadvantages of both Ad Valorem and specific tariffs

3. Effects of Tariff Tariffs are used to protect domestic industries. Nevertheless, tariffs bring about a number of side effects.(a) Political/diplomatic effects: (negative effects)(b) Retaliations: (negative effects) Other countries affected by our tariffs can retaliate by raising their tariffs or introducing NTTB.

(c) Terms of Trade effect: (positive effect) But this effect is relevant only to large countries. Such an effect is possible only for countries with large domestic markets which would make foreign sellers

affected by the tariff reduce their prices to maintain their market shares in those markets.

(d) Real Income Effect: (negative) When Country X raises a tariff, there will be chain reactions through the world, which ultimately reduce the

real income of the world as a whole. This in turn brings about negative impact on Country X as well.(e) Domestic Welfare Effect: (negative)

1) Basic Concept: Consumer Surplus and Producer Surplus2) Domestic Welfare Effect of Tariff: Small Country Case

- 9 - Small country case is simpler than large country case. Once you understand small country case, it

becomes easier to understand large country case. Large country case introduces terms of trade effect, making the tariff-induced price increase less than the small country case.

Large country case is optional for this course. Just understand small country case.

[Small Country Case]

DD: domestic demand SS: domestic supply P1 : Equilibrium price before trade P2 : Price after trade and before tariff P3 : Price after tariff P2 P3 : unit tariff a b: Import quantity before tariff g h: Import quantity after tariff a g: Import substitution Consumer welfare loss: Loss of consumer surplus (welfare) by area P2P3 f d Transfer effect: Increase in producer surplus by area P2P3 e c Revenue effect: New tariff revenue by area e f m n Net welfare effect: Parts of consumer surplus lost by tariff are recovered by producers and

government. Net welfare loss is represented by the areas c e n and m f dwhich are not recovered by producers and government.

- 10 -4. Nominal versus Effective Rates of Tariff (Protection)

How protective is the tariff? Nominal tariff rate is not enough to assess how protective a tariff is. To assess real or effective rate of protection by a tariff, effective tariff rate can be calculated by taking into account other vital factors such as significance of the value of imported inputs and their tariffs in producing the product.

Effective protection on a product will be reduced if you will have to pay high tariffs on imported inputs.(a) [Formula for Effective Rate of Tariff]:

gj = (tj - a ij ti ) / (1 - a ij)

Where gj : effective tariff rate on jth producttj : nominal tariff rate on jth productti : nominal tariff rate on ith imported input

a ij : proportionate value of ith imported input in jth outputwhere 0 < a ij < 1

(ex) Let Computer Price: $ 1,000 Price of imported chipset: $ 200 tj : 30 % ti : 100 %a ij = 200/1,000 = 20 %

gj = (tj - a ij ti ) / (1 - a ij) = [0.3 – (0.2)(1.0)]/ (1 – 0.2) = 0.125 or 12.5 %

[Analysis]1) tj and ti :

If tj = ti : gj = (tj - a ij ti) / (1 - a ij) = tj (1 - a ij) / (1 - a ij) = tj

If tj > ti : gj = (tj - a ij ti) / (1 - a ij) > tj

If tj < ti : gj = (tj - a ij ti) / (1 - a ij) < tj

2) aij and gj : In general, an increase in aij magnifies the gap between tj and gj, and a decrease in aij reduces the gap

between tj and gj . If tj = ti : gj = tj : a ij no effect on gj => If tj > ti : gj > tj : a ij gj rises further above tj

a ij gj falls toward tj

If tj < ti : gj < tj : a ij gj falls further below tj

a ij gj rises toward tj

Consumers tend to react to nominal tariff rate, whereas producers tend to react to effective tariff rate.