1. BA 187 Midterm Answers Covers Krugman & Obstfeld, Chapters 1-5, 12

2. Question 1. Agree or Disagree? William Daley, the U.S. Commerce Secretary, warned early this year “that last year’s financial crisis could become this year’s trade crisis”. What we know: – Current Account + Capital Account = Balance of Payments = 0 Last year’s 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.

3. 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 foreign’s terms of trade. Hence an export subsidy by foreign country, improves home country terms of trade. Home’s export good is more valuable. Result is Home can achieve a higher level of welfare than before foreign’s 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.

4. Effects of Foreign’s Export Subsidy F Export subsidy has exact opposite effect on internal versus external prices to an import tariff. F Internal price of export good Y rises. (RS shifts in). F Foreign produces more Y & less X (RS shifts in). (RD shifts out). F Foreign consumes less Y & more X (RD shifts out). F Terms of trade worsen for Foreign and improve for Home. RD 0 RS 0 (P X /P Y ) 0 (q X + q* X )/(q Y + q* Y ) Relative Quantity of X P X /P Y Relative Price of X (P X /P Y ) 1 RD 1 RS 1

5. 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 don’t get full benefit of gains from specialization in production.

6. 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: L X = L 0 X = Skilled labor to produce software only. L Y = L 0 Y = Unskilled labor to produce clothing only. Mobile Factor is Capital, K K 0 = K X + K Y Next diagram shows how abundance of skilled labor leads to PPF bowed in direction of Good X, Computer Software.

7. K0K0 K0K0 QYQY QXQX 1 X KXKX KYKY PPF 0 X = Q 0 X (K X, L 0 X ) Y Y = Q Y (K Y, L 0 Y ) Capital in Good X, K X Capital in Good Y, K Y A. Provide a diagram and brief explanation for the shape of the PPF of a developed country and what it implies for that country’s pattern of trade. PPF 1 X = Q 1 X (K X, L 1 X )

8. K0K0 K0K0 QYQY QXQX 1 X KXKX KYKY PPF 0 X = Q X (K X, L 0 X ) Y Y = Q Y (K Y, L 0 Y ) Capital in Good X, K X Capital in Good Y, K Y 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). PPF 1

9. 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 VMP X Return, r VMP Y New Total Capital Stock, K 1 VMP Y r KXKX KYKY r’ K1YK1Y K1XK1X

10. Summary for the Specific Factor Model Part A: 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: Part B: Growth in capital, the mobile factor, results in a parallel shift outwards of the Developed country’s 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: 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.

11. 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.

12. (P X /P Y ) * Opening trade changes relative prices Assuming identical utility function for Home & Foreign PPF F PPF H Home & Foreign PPF’s differ due to differences in technology or factor endowments. 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 AFAF AHAH Autarky Equilibrium at A H and A F QHQH QFQF C*C* New equilib. consumption at C *. Each country has different prod’n ;point.

13. 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.

14. 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. w/r P X / P Y Good XGood Y K/L Wage-rental ratio, SS Factor Price Equalization Stolper- Samuelson

15. B. Trade, Distribution & Welfare Factor Price Equalization Theorem 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 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 – 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.

16. Labor, L K0K0 [K/L] H X OXOX 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. [K/L] H Y L0XL0X L0YL0Y K0XK0X K0YK0Y O0YO0Y L1XL1X L1YL1Y K1XK1X K1YK1Y + - - + O1YO1Y KK + Good X Good Y

17. 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 prod’n 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 prod’n of Good Y. – Thus output of capital-intensive Good Y increases while output of labor-intensive Good X falls.

18. Bonus Questions Bonus 1. (2 points) Is it surprising that both the steel company CEO’s 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 didn’t. 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.

19. 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. (Doesn’t that bode well for the WTO’s effectiveness in the future?) – Current head is from New Zealand and other from Thailand. Bonus Questions