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

2. Question 1. Agree or Disagree? “Trade unions are right to be concerned that trade liberalization worsens income inequality.” Bill Jordan, Director General International Confederation of Free Trade Unions The answer is: Agree within countries but Disagree between countries. In both Specific Factor model and H-O model, trade benefits skilled labor and harms unskilled labor: – Specific Factor Model: Skilled labor wins while unskilled labor losses from opening trade assuming country exports good produced with skilled labor and capital. – H-O Model: Abundant factor, skilled labor, wins while scarce factor, unskilled labor, losses from opening trade assuming country exports skilled labor-intensive good. These results are derived in Questions 4 & 5 respectively. H-O model predicts factor prices equalize across countries so statement false between countries. Similar reasoning true for Specific Factor model (although somewhat more complex).

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 country’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 country’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 Export subsidy has exact opposite effect on internal versus external prices to an import tariff. Internal price of export good Y rises. (RS shifts in). Foreign produces more Y & less X (RS shifts in). (RD shifts out). Foreign consumes less Y & more X (RD shifts out). 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? “Increasing the mobility of labor and/or capital within a country not will not only reduce internal opposition to the expansion of a country’s international trade but also will lead to greater gains in the real income for the country.” Comment on this statement. Two questions to answer here: Uncertain Mobility and Reduced Opposition to Free Trade - Uncertain Both factors are mobile in H-O model but still have “winners” and “losers” from opening up trade. Increased mobility may reduce losses & opposition relative to Specific Factor model but it will not eliminate either the losses or opposition. True Mobility and Greater Gains to Free Trade - True When both factors are mobile a country’s PPF is almost everywhere above the PPF with fixed factors. So specialization leads to higher level of utility with mobile factors. Looking for knowledge that more flexibility in production leads to more efficient use of existing factors and so higher output.

6. Question 4. Agree or Disagree? “(W)e need to construct concrete and powerful alliances of trade union solidarity across national boundaries (to fight moves towards freer trade)”. Prof. Dana Frank, UC-Santa Cruz “The free trade-off” in the SJ Mercury News, 9/5/99 Question 4. Agree or Disagree? “(W)e need to construct concrete and powerful alliances of trade union solidarity across national boundaries (to fight moves towards freer trade)”. Prof. Dana Frank, UC-Santa Cruz “The free trade-off” in the SJ Mercury News, 9/5/99 Given your knowledge of short-run models of trade, do you agree or disagree that such alliances between unionized labor across countries are even possible? Answer is in terms of Specific Factor model (SR trade model). Unionized labor is most likely to be unskilled labor and less likely to be skilled labor. Question is asking if unskilled labor can form coalition across countries to prevent trade. Know from result of Specific Factor Model in Prob. Set #3: Trade reduces wages of unskilled labor in developed country. Trade increases wages of unskilled labor in developing country. Unskilled labor across both countries does not have a common interest in preventing trade. Prof. Dana Frank is thus advocating a position that is unlikely to be accomplished given each group’s economic incentives.

7. Question 5. Specific Factor Model A major difference between the U.S. and its trading partners is that it has a relative abundance of skilled labor versus unskilled labor. Assume: 1) only skilled labor (plus capital) can be used to produce computer software, 2) only unskilled labor (plus capital) can be used in producing clothing, and 3) that capital is mobile between computer software and clothing. Despite its abundance of skilled labor relative to other countries, the U.S. faces a shortage of skilled labor relative to its needs. As a result, the Congress recently passed a bill that doubled the number of H1-B visas available to skilled labor coming to work in the U.S. from other nations. Despite its abundance of skilled labor relative to other countries, the U.S. faces a shortage of skilled labor relative to its needs. As a result, the Congress recently passed a bill that doubled the number of H1-B visas available to skilled labor coming to work in the U.S. from other nations. 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.

8. K0K0 K0K0 QYQY QXQX X KXKX KYKY 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 U.S.’s PPF between software and clothing. What does its shape imply for the U.S.’s pattern of trade? PPF 0 X = Q 0 X (K X, L 0 X )

9. 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 the increase in H1-B visas in the U.S. on its PPF, terms of trade, and overall level of welfare? Assume whatever the effect is that is going to be large enough to be significant. Provide a brief explanation of your results along with the appropriate diagram(s). X = Q X (K X, L 1 X ) PPF 1

10. CC. What are the likely effects of the increase in H1-B visas in the U.S. 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). Which groups do you think should have lobbied against the increase in H1-B visas? Who should have lobbied for the increase? wXwX wYwY Skilled Labor, L X Unskilled Labor, L Y Capital, K 0 = K X + K Y VMP 0 KY VMP 0 KX rYrY rXrX KYKY KXKX VMP 1 KX 2. 5. 4. 3. 6.6. VMP 0 L X VMP 0 LY VMP 1 LY L0YL0Y L0XL0X 1. L1XL1X

11. 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 skilled labor, the specific factor for software, results in a shift outwards of the Developed country’s PPF mostly in the direction of software, good X. It is likely the terms of trade (TOT) fall (RS shifts out as relatively more X produced). Welfare of the Developed country will likely increase even with fall in TOT. You can show this explicitly. Part C: Part C: Growth in skilled labor, the specific factor for software, results in: Increase in supply of skilled labor, which will reduce wage of skilled labor. Increase in VMP of Capital in software. New equilibrium with higher return on capital in both industries Also have more capital employed in software and less in Clothing VMP of unskilled labor falls due to less capital in Clothing industry, so wage of unskilled labor also falls. Labor opposes H1-B legislation, Capital favors it. Labor opposes H1-B legislation, Capital favors it.

12. Question 6. Heckscher-Ohlin Model Assume the major difference between a developed and a developing country is that developed countries have an abundance of skilled labor while developing countries have an abundance of unskilled labor. Both types of labor are used in producing both goods; Internet applications are skilled labor-intensive, and clothing is unskilled labor-intensive. Let Good X = Clothing which is unskilled labor-intensive. Let Good Y = Internet Apps. which are skilled labor-intensive. Both Factors are mobile. Developed country (DC) is skilled labor-abundant. Less Developed country (LDC) is unskilled labor-abundant. Abundance of skilled labor in developed country leads to PPF bowed in direction of Good Y, Internet Apps. Abundance of unskilled labor in developing country leads to PPF bowed in direction of Good X, Clothing.

13. (P X /P Y ) * Opening trade equalizes relative prices PPF LDC PPF DC 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 C*C* Q DC Q LDC New equilib. consumption at C *. Each country has different prod’n ;point. Assuming identical utility function for DC & LDC A LDC A DC Autarky Equilibrium at A DC and A LDC

14. 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 that is intensive in the factor that is relatively scarce. Consumption patterns, in contrast, converge. Both countries move to higher levels of utility after trade.

15. B. How is opening up trade likely to affect the relative returns of skilled labor and unskilled labor in the developed country? In the developing country? Provide a brief explanation of your results along with an appropriate diagram. w S /w U P X / P Y Good XGood Y L S /L U Wage ratio, SS Factor Price Equalization Stolper- Samuelson

16. 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. International trade will bring about the equalization in the relative and absolute returns to homogenous factors of production across nations. Relative wages of skilled vs. unskilled labor converge between DC’s and LDC’s with opening of trade. 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. Who Gains? Skilled labor gains in DC and unskilled labor gains in LDC. Who Loses? Unskilled labor loses in DC and Skilled labor loses in LDC.

17. Unskilled Labor, L U LS0LS0 [L S /L U ] H X OXOX C. What are the likely effects of an increase in skilled labor of the developed country (holding relative factor prices constant) on the amount of Internet applications and clothing produced in the developed country? What happens to the level of employment of skilled and unskilled labor in Internet applications? Does unskilled labor benefit? [L S /L U ] H Y LU0XLU0X LU0YLU0Y LS0XLS0X LS0YLS0Y O0YO0Y LU1XLU1X LU1YLU1Y LS1XLS1X LS1YLS1Y + - - + O1YO1Y LSLS + Good X Good Y Skilled Labor, L S LS1LS1

18. C. The Rybczinski Theorem At constant product prices, an increase in the endowment of skilled labor will increase by a greater proportion (magnification effect) the output of Internet Apps. (Good Y), and will reduce the output of clothing (Good X). Assume that the supply of skilled labor increases. – Constant product prices imply constant relative wages, (w S /w U ). – But relative factor returns can remain constant only if L S /L U and productivity of L S and L U remain constant in prod’n of both goods. – To fully employ new capital, while keeping L S /L U constant in both goods, requires fall in output of unskilled labor-intensive Good X to release enough unskilled labor to absorb increase in skilled labor to be used in prod’n of Good Y. – Thus output of skilled labor-intensive Good Y (Internet Applications) increases while output of unskilled labor-intensive Good X (Clothing) falls.

19. Bonus Questions Bonus 1. (3 points) “It is clear that our nation is reliant upon foreign oil. More and more of our imports come from overseas.” Who said it, why is it funny, and why might it matter to Americans in November? – George W.Bush Jr. said it. – Its funny because all imports, not more and more of our imports, are produced outside the U.S. by definition. – It matters because it was said by someone who might be the next President of the U.S. 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.

20. Bonus 3. (2 points) The World Bank and the IMF held a big meeting at the end of September. Where was the meeting held? What was the ratio of police to demonstrators? – World Bank/IMF meeting took place in Prague, Czech Republic. – Ratio of police to demonstrators was approx 1:1. There were roughly 10,000 police and 10,000 demonstrators. Bonus Questions