Problem_Set_3_solutions

AP/ECON3150International Trade

Problem set3Solutions

Problem1

a.Answer:the problem says that Home is K-abundant and that steel production in K-intensive.Therefore,Home’s PPF will be skewed towards

output.

steel output while Foreign PPF will be skewed towards wheat

b.Answer:Home no-trade equilibrium is at point E A,and Foreign no-trade equilibrium is at point E A.We will use subindex A to denote‘autarky’and T to denote‘trade’.With identical utilities,Home’s no-trade production and consumption of S and W corresponds to a relative price of wheat that is higher than that in Foreign.This is shown by the steeper-sloped relative price line in Home, p W p S A,than in Foreign, p W p S A.Di¤erences in capital and labor stocks between these two countries lead to Home’s comparative advantage in steel and p S p W A< p S p W A.

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c.Answer:Given that Home is K-abundant and that steel production in K-intensive,HO theorem predicts that Home will export steel and import wheat.For foreign,trade pattern will be just opposite:it will export wheat and import steel.

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d.Answer:Foreign exports wheat,so we nee to draw Foreign wheat exports supply curve and Home wheat import demand.At p W p S A,Foreign wheat market is balanced,i.

e.domestic wheat consumption equals produc-

tion and hence wheat exports is zero at this price.This is where Foreign wheat exports supply curve starts.At p W p S A,Home consumption of wheat equals production and at this price Home imports of wheat is zero.This is where home import demand curve starts.We know that p W p S A> p W p S A, therefore,the upward sloping Foreign export supply curve(Ex )and the downward-sloping Home import demand curve(Im)must cross each other

at some point.At the intersection point E,the equilibrium wheat price is p W p S T,Foreign would export Q T W units of wheat and Home would import the same amount.

Since the diagram only shows wheat equilibrium,this are not total gains

steel.

from trade,which must also include gains from trade in

The area between Home import demand for wheat and the world price is the total Home consumer surplus from buying wheat from Foreign.The

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area between the world price and Foreign export supply curve is the total Foreign producer surplus from selling wheat to Home.The sum of these two is the total gain from trade in wheat.Since the diagram only shows wheat equilibrium,this are not total gains from trade,which must also include gains from trade in steel.There would be a similar expression for gains from trade in agricultural machines.

e.Answer:The diagram below shows Foreign labor market equilibrium before and after trade.Relative labor supply is…xed at RS=L

K .RD S and RD W are relative demand for labor in S and W industries,respectively.The

total relative labor demand before trade is given by RD A=RD W K W K A+ RD S K S K A,where K W K A is the share of capital used in W industry before trade.When Foreign starts trading with Home,its domestic wheat price goes up so that more resources are devoted to wheat production,rising K W K A and moving total relative demand curve for labor closer to RD W.On the diagram,the new total relative labor demand curve is labeled as RD T.Since the relative demand for labor is increasing,the relative price of labor also rises from W R A to W R T.

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When labor gets more expensive,…rms in both industries will start using more of a cheaper factor(capital)and labor-capital ratio in both industries will fall.It implies that more capital is available per one worker in each industry so that the marginal product of labor will increase,triggering an

increase in both W

p W and W

p S

.It implies that the real income of workers will

increase in Foreign as a result of trade.The opposite is happening for capital -with less workers operating each machine,the marginal product of capital

will fall in both industries and R

p W and R

p S

will fall.Therefore,as the Stolper-

Samuelson theorem predicts,Foreign abundant factor(labor)wins from trade and scarce factor(capital)loses.

Problem2

Answer:An equal proportional increase in Home’s capital and labor does not change its relative factor endowments so that the labor/capital ratio is unchanged.With constant factor prices,your graph should show that the no-trade equilibrium doubles.Further,the no-trade equilibrium in Foreign is una¤ected because its size remained unchanged.At the original world relative price of computers,the quantity exported by Home exceeds the quantity Foreign wants to import,leading to a drop in the relative price.The lower free-trade relative price of computers decreases the rental on capital. However,labor is better o¤in real terms as a result of the increase in the relative price of computers from free trade.The pattern of trade remains the same although the amount traded has increased.

Problem3

a.Answer:

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b.Answer:Refer to the following diagram.At the no-trade price of (p C=p S),Home exports0units of computers,which is the starting point for the Home export supply curve.As the world relative price of computers rises, the exports of computers initially must rise on the export supply curve,as illustrated by Home’s exports of Q C1units when the world price is(p C=p S)1, with production at P1and consumption at C1.But for higher prices,it is possible that the export supply curve bends backward,as illustrated by the world price of(p C=p S)3,where the export supply is less than Q C1units,with production at P3and consumption at C3.

c.Answer:As the world-relative price for computers rises,this is a terms of trade gain for the Home country,which export computers.From the point of view of Home consumers,it is like a rise in income,so they consume more of both computers and shoes(the income e¤ect).On the other hand, the rise in the relative price of computers leads them to substitute away from this goo

d.When the relative price of computers is very high,Home country can trade very few computers for a lot of shoes At some point there would be too many shoes relatively to computers and Home consumers would prefer to consume more computers than selling them abroad.

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