show your work on any calculations.
1) Home and Foreign both produce apples and bananas using only labor. 1 worker
working for 1 week (L=1) has the following productivity in each country:
Home Foreign
4 Bushels of Bananas 2 Bushels of Bananas
1 Bushel of Apples 1 Bushel of Apples
LH = 2000 worker-weeks LF = 1000 worker-weeks
• Does either country have an absolute advantage in the production of either
good? Explain why or why not. Which good is each country’s comparative
advantage? Explain. Remember opportunity cost is a critical piece of your
explanation.
• Draw each country’s pre-trade production possibilities frontier (PPF),
putting Bananas on the y-axis.
• Propose terms of trade between these two countries: describe each country’s
production/specialization decision, and how the post-trade “exchange rate”
between apples and bananas makes both countries better off. Be specific:
compare the pre-trade opportunity cost to the terms of trade and show that
each country gets a better deal than pre-trade. There is an obvious, easy
integer number for terms of trade here.
• Include a new line in your PPF graph that represents the new production and
terms of trade, and use the graph to show that each country has a better set of
consumption choices available after trade.
• Discuss how trade changes real wages in each country: compare real wages
across countries before trade, and discuss how each country’s wages change
after trade. Be sure to cover why one country has higher real wages,
and why the real wages change after trade.
2) Our HOME country produces 2 goods: clothing (C) and airplanes
(A). Clothing uses labor (L) and Sewing Machines (S), while airplanes uses labor
and capital (K). The labor market and both output markets are perfectly
competitive: labor is free to move between industries, and the marginal revenue
product of labor is the price of output times the marginal product of labor in that
industry (P*MPL).
HOME recently opened trade with FOREIGN. As a result, we have started
importing Clothing, and the price of clothing PC in our HOME market has fallen by
10%. Using the specific factors model, show how the two HOME industries will
respond to the lower price of clothing. Specifically, discuss the following points.
• For the moment, focus on the initial, pre-trade wage: how has each
industry’s profit-maximizing choice of L changed? Given those changes,
describe how the wage must change to establish a new full-employment
equilibrium in both industries.
• Use percentage change logic to discuss how real wages will change
(starting with a 10% decline in PC, discuss how the change in nominal
wage and the changes in price interact).
• Lastly, how do the changes in hiring in the two industries affect the
returns to the specific factors (sewing machines and capital)? Discuss
both nominal changes and real changes to RS and RK.
• Think about your previous answers in terms of winners and losers from
opening trade with FOREIGN. Briefly discuss your thoughts on the
politics of opening trade: who do you think will support or oppose free
trade?
3) Home and Foreign both share the same fixed proportion production technology
for shoes and computers:
– Labor Capital
Shoes 4 Labor per Shoe 1 Machine per Shoe
Computers 2 Labor per
Computer
3 Machines per
Computer
Both countries have 400 worker-hours to allocate. Home has 600 machines, while
Foreign has 300.
Before trade, shoes sell for $40 in each country. The pre-trade price of computers
is $30 in Home, but $60 in Foreign.
• Based on the information provided, identify the factor intensity of each good
(e.g. which good is labor intensive) and the factor abundance of each
county. Based on nothing but this information, what pattern of trade would
you expect if these countries start trading: who exports which good(s)?
• Write down an equation that represent the combinations of shoes and
computers that each country can produce using all its capital, and similar
equation for using all its labor. Explain why there is a unique combination
of shoes and computers that each country will produce. Calculate each
country’s production, and draw the graph from class that summarizes all this
information.
• Briefly discuss Home’s production of computers and shoes in light of your
answers about factor abundance and factor intensity.
Recall that all firms in a perfectly competitive industry earn zero economics profit
in the long run. This implies that Price = Average Total Cost. ATC is just the
price to produce one unit of the good here.
• Use the P = ATC condition across both industries to solve for the pre-trade
wage and rental price of capital in each country. Remember that workers get
paid the same wage in either industry, as does capital.
• After trade, assume that the price of shoes remains the same, but that the
single world price of computers is now $50. How does Home’s wage and
rental price of capital change? How about Foreign wages and rents?
• Briefly explain the economics of “Factor Price Equalization”: why does it
happen?
4) Short answer: “We should stop trading with China: the cheap goods they
produce with cheap labor that we buy from them are bad for America” Briefly
discuss this statement in light of the theories of trade we have covered. Obviously
you could write a lengthy paper on this topic. Keep it short: I’d suggest you think
through what “bad for America” looks like in each model. Which model do you
think is the best one to use to discuss this?
5) The Heckscher-Olin results are sometimes described as “Trading goods can
substitute for trading factors.” Explain this statement in light of your results from
Q3. Specifically,
• Why might someone describe the pre-trade factor prices and factor
abundances as a situation where Home wants to “export
capital”? Remember for now you can’t actually export factors.
• Post-trade, what happens to Home’s incentive to “export capital.” Why does
it change?