International Economics Home Exam 3H

EVALUATION GUIDELINES - Take-home examination EXC 36031 International Economics Department of Economics Start date: 04.05.2020 Time 09:00 Finish date: 04.05.2020 Time 12:00 For more information about formalities, see examination paper. Evaluation guideline. The below answers are minimum answers. To obtain a very good grade, better explanations are required. Problem 1: Ricardian trade theory Consider two countries, Switzerland and France. Both countries can produce cheese and wine, and always consume strictly positive amounts of both goods. Their unit labor requirements and labor endowments are summarized below. Unit labor requirements Labor endowment Cheese Wine Switzerland 100 10 1000 France 200 10 1000 1.1) What does absolute advantage mean? Absolute advantage means that one country is more productive than the other country in producing a good. This means that the unit labor requirement is lower. Which country has an absolute advantage in cheese? Switzerland has an absolute advantage in cheese. Which country has an absolute advantage in wine? No country has an absolute advantage in wine. The unit labor requirement is the same in both countries. 1.2) Explain what we mean by the opportunity cost of cheese in terms of wine. Opportunity cost is the amount of one good one has to sacrifice in order to obtain one unit of the other good. What is the opportunity cost of cheese in terms of wine in Switzerland? The opportunity cost of cheese in terms of wine in Switzerland is 10. In order to increase cheese consumption with one unit, 100 units of labor is needed. These 100 units of labor could have produced 10 units of wine. What is the opportunity cost of cheese in terms of wine in France? The opportunity cost of cheese in terms of wine in France is 20. 1.3) What does comparative advantage mean? A country has a comparative advantage in producing a good if the opportunity cost of producing this good is lower than the opportunity cost of producing the same good in other countries. Which country has a comparative advantage in cheese? Switzerland has a comparative advantage in cheese (10<20) Which country has a comparative advantage in wine? The opportunity cost of producing wine in terms of cheese in Switzerland is 1/10. In France the opportunity cost of producing wine in terms of cheese is 1/20. France has opportunity cost in production of wine. 1.4) What is the autarky relative price of cheese in terms of wine in Switzerland? And in France? The autarky relative price of cheese in terms of wine is the opportunity cost. Thus the autarky relative price of cheese in terms of wine is 10 and 20 in Switzerland and France, respectively. Suppose France and Switzerland start trading with each other, and the equilibrium relative price turns out to be strictly in between the autarky relative prices of the two countries. 1.5) Which goods does France produce in this trade equilibrium? How much does it produce of each good? France produces only wine in the traded equilibrium. This is because the relative price is in between the autarky relative prices. Thus France produces 100 units of wine in the traded equilibrium. All labor, 1000 units, is used to produce wine. It takes 10 units of labor to produce one unit of wine. Thus, the resulting production of wine is 1000/10=100. 1.6) Which goods does Switzerland produce in this trade equilibrium? How much does it produce of each good? By the same logic, Switzerland only produces cheese in the traded equilibrium. Switzerland produces 10 units of cheese. 1.7) Explain how trade may benefit both France and Switzerland. This question can be answered in different ways. You can calculate relative wages with and without trade. You can illustrate with the use of production possibility frontiers and the consumption line with trade (the budget line). Or you can go through the following logic: Without trade, the opportunity cost of wine in terms of cheese in Switzerland is 1/10. In France, the opportunity cost of wine in terms of cheese is 1/20. Since the traded relative price is between the two countries’ opportunity costs, Switzerland can buy wine from France for a lower opportunity cost (in terms of cheese) relative to producing it itself. Without trade, the opportunity cost of cheese in terms of wine in France is 20. In Switzerland it is 10. Since the traded relative price is in between the two countries’ opportunity cost, France can buy cheese for a lower relative price in Switzerland relative to the opportunity cost of producing it itself. Problem 2: Specific factor Consider a country, Norway, that produces two goods, wheat and fish. Wheat is produced with workers and tractors. Fish is produced with workers and fishing boats. Workers are mobile between the two industries while tractors are specific to the wheat industry and fishing boats are specific to the fish industry. Since there is a specific factor in each of the two industries, there is decreasing returns to labor in both industries. 2.1) What does marginal productivity of labor mean? Marginal productivity of labor denotes the increase in production when use of labor increases with one unit. Since there are decreasing returns to labor in both industries, marginal productivity decreases with the use of labor. Students may well illustrate the answer with a graph. 2.2) What is the relationship between marginal productivity of labor and the demand for labor? Marginal productivity of labor is the increase in production from adding one more unit of labor. The value of this is the price of the good times the marginal product. Firms will hire workers as long as the value of the marginal productivity of labor is higher than the cost of hiring one more worker. Thus the demand curve for labor is the price times the marginal productivity of labor. Students may well illustrate with a graph. 2.3) Discuss how labor is allocated between the two industries and how the allocation of workers determines production in each of the two industries. Here the students are meant to use the following diagram. It shall be allowed that the students copy and paste the graph. Evaluation shall be based on explanations. 2.4) Discuss how the relative price of wheat to fish determines wages, rents to farmers and fishing boat owners. Here students are meant to use the following graph to illustrate the labor market. Copy and paste is acceptable. Again evaluation shall be based on explanations. 2.5) Norway considers starting trading with Sweden. In Sweden the price of wheat is lower than in Norway while the price of fish is higher. How will trade affect incomes for farmers, fishing boat owners and workers in Norway? Here students can use a version of the following graph. Evaluation shall be based on explanations. It is important that in the question is asked about the effect of a price increase on one good and a price decrease on the other good. Therefore, the effect on the nominal wage (as well as the real wage) is ambiguous. 2.6) Even if some groups will lose from trade, in principle trade may benefit all groups. Explain how. The gains from trade for those who gain are larger than the losses for those who lose from trade. Thus, those who gain can compensate the losers and still be better off. Students may use the following graph to illustrate. The graph demonstrates that consumption of both goods may increase because of trade. Problem 3. The Heckscher-Ohlin model. Assume that in the long run, farmers and fishing boat owners can invest in the industries they prefer. Therefore, in the long run, there are only two factors of production. These are labor and capital. Norway is well endowed with labor relative to Sweden. Sweden is well endowed with capital relative to Norway. Also assume that the use of labor to capital is higher in wheat production than in the fisheries. Discuss effects of free trade between Norway and Sweden in the long run. Here the students may take the answers to problem 2 as their point of departure. In the short equilibrium, profitability in the Norwegian fishing industry has increased. Similarly the profitability in the Swedish wheat production has increased. Norwegian fisheries and Swedish wheat production will therefore expand. As Norwegian fisheries expand labor becomes increasingly scarce while Swedish capital becomes increasingly scarce. The price of labor in Norway (wages) and the price of using capital in Sweden (rents) will therefore increase. In Norway therefore, both industries tend to use less labor relative to capital than before. The marginal productivity of labor therefore increases. Real wages in therefore increase. Real rents to capital decrease. In Sweden real rents to capital increases while real wages decrease. This is the Stolper Samuelson theorem. In the traded situation, Norway exports fish and imports wheat. Students are welcome to discuss the Heckscher Ohlin model in more detail. Explanations shall be credited. Problem 4. Tariffs 4.1) Discuss welfare effects of a tariff on imports of goods. This question invites the student to use the following graph. The students must understand the concepts of consumer and producer surplus, the distinction between small and large countries and the terms of trade effect of a tariff for large countries. Further explanations shall be credited. 4.2) Discuss use of infant industry protection in order to stimulate growth in an industry. Here students should be able to discuss external increasing returns to scale. An industry with external increasing returns to scale may need a subsidized start in order to growth competitive over time. Students should be credited if they demonstrate their arguments with a graph. Explanations, however, shall be most important for evaluation. An alternative strategy may be to use the discussion of the HO-model by Mundell (1957). In this discussion of the model, capital mobility is allowed for. The discussion demonstrates that trade and capital mobility may be substitutes. Both trade and capital mobility may ensure equalization of goods prices and factor prices. By using tariffs in a trade equilibrium in the HO model, a country may attract capital inflow to a capital-intensive industry. Thus, a tariff may stimulate growth in this industry. However, within the HO model, such capital flows do not increase welfare relative to free trade.