Answers to Sample Test 1

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The Ricardian Model

1. (15 points)

In a Ricardian world, two countries are producing two goods, textiles (T) and cars (C). Labor is the only factor of production being paid. The following table gives the number of man-years it takes to produce a unit of each commodity in two countries, the United States and the United Kingdom.

Labor Requirements

Country	cars	textiles
U.K.	aLC = 40	aLT = 50
U.S.	aLC = 30	aLT = 40

1. Which country has an absolute advantage in the production of textiles?

   a_LT = 40 < a*_LT = 50. So the US has an absolute advantage in textiles.

   Which country has an absolute advantage in the production of cars?

   a_LC = 30 < a*_LC = 40. So the US has an absolute advantage in cars.

2. What is the relative price of textiles in each country under autarky?
   US: p_T/p_C = a_LT/a_LC = 40/30.

   U.K.: p_T/p_C = a*_LT/a*_LC = 50/40.

   Show which country has a comparative advantage in the production of textiles.

   40/30 > 50/40 implies UK has a comparative advantage in textiles.

   Show which country has a comparative advantage in the production of cars.

   30/40 < 40/50 implies US has a comparative advantage in cars.

   Suppose the world prices are as follows:

   p*_C = $10, p*_T = $13.

   Which country will export textiles?

   40/30 > 13/10 > 50/40 implies that the UK exports textiles.

   Find the factoral terms of trade.

   UK: p*_T = a*_LT w*

   = 50 w* = 13

   US: p_C = a_LC w

   = 30 w = 10.

   w = 10/30, w* = 13/50.

   w/w* = (10/30) ÷ (13/50) = 50/39

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The Heckscher-Ohlin Model

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2. (15 points)

          There are only two continents, America and Arabia, in a distant planet of an adjacent solar system Utopia. Although they are only 50,000 light years away, trade between Utopians and earthlings are prohibited due to lack of inter-galactic transportation. Trade takes place only between the two continents on Utopia. In each continent there are two castes, laborers and capitalists. Agriculture is capital-intensive in America but labor-intensive in Arabia. On the other hand, manufactures (including oil) are labor-intensive in America and capital-intensive in Arabia. Use diagrams to illustrate your answers if necessary.

1. Will free trade of outputs insure equalization of factor prices? Explain.

             Not necessarily. Since the factor intensities of the two industries are reversed in the two countries, factor price equalization may not occur. If the factor endowments of the two countries are in the same cone of diversification, then factor price equalization will occur.

2. Suppose that America is abundant in capital and Arabia is abundant in labor. Which continent will export agricultural products? What can you say about the pattern of trade between the two continents?

             One cannot predict the pattern of trade because a factor intensity reversal occurs in this situation. America may export or import the agricultural products.

             If America exports agricultural products, then Arabia, a labor-abundant country, is importing the agricultural products which are intensive in labor. Thus, a Leontief paradox occurs in Arabia.

             If America imports agricultural products, then America, a capital-abundant country, is importing capital-intensive good; hence a Leontief paradox occurs in America. This example also illustrates that a Leontief paradox always occurs when a factor intensity reversal occurs.

3. Suppose that Americans were exporting agricultural products to Arabia. After a diplomatic negotiation with the Talibans breaks down, President Obama imposes a trade embargo. If the autarky state persists, which caste, capitalists or laborers, in each continent will gain from the embargo?

   A trade embargo results in a decline in the price of the exportable, p_ag, in America. Since the agriculture is capital intensive, r (the return to capital) declines, but w increases in America (The Stolper-Samuelson Theorem).

   On the other hand, the embargo increases the price of agricultural products in Arabia. The Stolper-Samuelson Theorem suggests that w* rises and r* falls since agriculture is intensive in labor in Arabia. Thus, capitalists lose and laborers gain in both countries.

3. (10 points)

To respond to a labor shortage which is expected to persist until the end of this century, President Obama signed a new immigration bill which would encourage immigration of Northern Europeans to the U.S. The export sector as a whole is known to use capital intensively.

1. How does this influx of immigrants affect the employment in the import and export sectors in the U.S.?

             The Rybczynski Theorem states that this increase in L increases the output of the labor intensive good (importable, y₂) and decreases the output of the capital-intensive good (exportable, y₁). Thus, employment in the export sector declines, whereas it increases in the import sector.

   

2. If the immigrants have the same tastes as Americans, how will the influx affect our import demand and the export supply?

   Note first that national income increases as L increases.

   I = wL + rK

Since consumers have homothetic preferences, this increase in income increases consumption of both goods, x₁ and x₂.

Let good 1 be the exportable, and good 2 the importable as we assumed throughout the semester. Because trade is balanced

p₁(y₁ - x₁) = p₂(x₂ - y₂).

The increase in immigration implies that both x₁ and x₂ must increase. Since x₂ and y₂ both increase, it appears at first glance that the direction of change in import (x₂ - y₂) is ambiguous. However, since export (y₁ - x₁) decreases, import (x₂ - y₂) also decreases. In this situation, immigration reduces trade flows.

The country was importing good 2, which is labor intensive. Apparently, the country was labor abundant (also the statement that there is labor shortage indicates that this is the case). Since labor is being imported, the need to import labor-intensive good declines. This also shows that importing labor is a substitute for importing labor-intensive good.