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Midterm Exam – International Economics S2021 – Solutions
Instructor: Giampiero M. Gallo
Teaching Assistant: Miguel Alque′zar Yus
March, 18
The due date for the Midterm is Friday, 11:45h AM (Italian time). Provide explanations of your find-
ings/choices. When faced with numerical exercises, please write down carefully the main intermediate
algebraic/logical steps that bring you to a particular result. The procedures are much more important than
the results per se in determining the grade.
Problem 1. – Worth 20 points
Please choose 4 out of the following 8 key terms. For each of these four terms, first define each of these
concepts. Second, search for a (news) article and/or video that describes these concepts (so a specific article
and/or video per concept). Briefly explain how the article or video relates to the concept, and how this
relates to the textbook definition of the term.
1. Factor price equalization (FPE)
2. Regional Trade Agreements
3. Labor abundance
4. Production possibilities curve (PPC)
5. Non-tariff barriers
6. Quota rents
7. Deadweight loss
8. Increasing returns to scale
Solution. Grading depends on explanation of the term and relevance of the news article and/or
video the student has found, and how the content thereof is linked to the definition of the
concept.
Problem 2. – Worth 20 points
Read the article “Give us liberty to buy those foreign cheeses”. Based on this article and other (news)
sources, answer the following questions. If you use other sources, make sure to cite them accordingly.
i) Explain in detail the main ideas of the news article.
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ii) What are the economic motivations of a “Buy Local” policy
iii) Which political principle is invoked when applying these policies Mention at least two more cases in
which it is also involved.
iv) How will such policy impact the agents involved
v) Which unintended externalities could a buy local policy have (other than direct economic implications)
Solution. Grading depends on explanations provided and how they related to the topic dis-
cussed.
Problem 3. – Worth 5 points
Consider an economy with two goods and two factors, both mobile across sectors but not across countries.
Trade between a skill-abundant North and a skill-scarce South, both using Northern technology:
(A) harms skilled workers in the North and unskilled workers in the South because it induces factor price
equalization
(B) harms skilled workers in the South and unskilled workers in the North because it induces factor price
equalization
(C) harms both skilled and unskilled workers in the South because they use the wrong technology
(D) benefits both skilled and unskilled workers in the South because they use a more efficient technology
Solution. (B) By the Rybczynski theorem, the North produces relatively more skill-intensive good than
the South. When they trade, goods price converge because Northern consumers demand more Southern
unskill-intensive goods and Southern consumers more of the Northern skill-intensive good. This implies
PNh
PNl
< P Ih P Il < PSh PSl , which induces in both countries a change in the relative price of factors that is more pronounced than the change in relative goods price (by the Stolper-Samuelson effect). In the end, factors are equalized across countries because both use the same technology and sell goods at the same price, which requires factor prices to be equal in order for marginal cost to be equal. The fact that the Northern (Southern) skill premium increases (falls) by more than the relative price of the skill-intensive good implies that skilled workers there gain (lose) purchasing power even in terms of the good that has become relatively more expensive (cheaper), which coincides with this statement b). Problem 4. - Worth 5 points Consider two countries using the same technology to produce two goods with two factors, labor and capital. Immigration into one of them: 2 (A) raises trade if it is migration from a third country (B) raises trade if it is migration among trading partners (C) raises trade if it is migration into the labor-abundant country (D) raises trade if it is migration into the capital-abundant country Solution. (C) In this setting, which is consistent with H-O, as well and in all other comparative models, two countries trade more the more dissimilar they are, and hence any migration flow that makes the labor- abundant country even more labor-abundant is expected to increase the volume of trade. Why does this happen Because the labor abundant country further increases its relative supply of labor-intensive good, which further reduces the relative price that it is able to charge in autarky, thereby inducing even more its own consumers to demand more foreign produced capital intensive good, and foreign consumers to demand its labor-intensive good, i.e. more trade. Problem 5. - Worth 5 points An export subsidy: (A) has the same welfare effect as an import tariff (B) has the same welfare effect as a voluntary export restriction (C) may induce a positive terms of trade effect for the country adopting it (D) may induce a negative terms of trade effect for the country adopting it Solution. (D) An export subsidy is an amount paid by the government to firms for the goods they export. This induces a partial substitution between domestic and foreign demand, supported by a drop in the price charged to foreign consumers, and an increase in the price charged to domestic consumers, i.e., a terms of trade deterioration for the country adopting the subsidy.) Problem 6. - Worth 5 points Consider two countries with the same preferences and using the same technology to produce two goods with two factors, labor and capital. Capital outflows from one of them towards a third country closed to trade: (A) makes workers worse off in both countries (B) makes workers better off in both countries (C) makes workers worse off in both countries if, and only if, capital flows out of the capital-abundant country (D) makes workers worse off in both countries if, and only if, capital flows out of the labor-abundant country 3 Solution. (A) Irrespective of the source country, capital outflows from the integrated economy implies a drop in the relative endowment of capital and hence a reduction in the relative supply of capital-intensive good, which increases its relative price. Since capital is now worthier, its relative price will also increase, and by more (Stolper-Samuelson effect), which will make capitalists better off and workers worse off, in both countries. Problem 7. - Worth 10 points Derive the autarky equilibrium prices and quantities in country A (PA), B (PB), and C (PC) separately, and the free trade equilibrium price (PFT ), using the following conditions: DA : P = 200 10Q SA : P = 30 + 2Q DB : P = 150 5Q SB : P = 100 + 4Q DC : P = 120 2Q SC : P = 60 + 3Q Solution. We start by focusing on the autarky equilibrium. This is characterized by Demand=Supply as no waste is allowed, therefore “all production has to be eaten”. In such environment, we have that: DA = SA = 200 P10 = P 30 2 PA = 58.33, thus QA = 14.16 DB = SB = 150 P5 = P 100 4 PB = 122.22, thus QB = 5.55 DC = SC = 120 P2 = P 60 3 PC = 96, thus QC = 12 Focusing on the free trade equilibrium price PFT , we know that it has to lie somewhere between their prices. Furthermore, we know that world supply has to equal world demand. Despite that, we are no longer in a 2 country world, therefore we need to check the price such that suppliers make profits. For our convenience, let’s assume all countries are large, thus their respective demands affect the equilibrium outcome. Then: DA + DB + DC = Dtotal : 200 P 10 + 150 P 5 + 120 P 2 = 110 4 5P Because we need individual supplies to be weakly positive. Then we have that supply will depend on prices, such as: Stotal = 0 if p < 30 (no country will produce) Stotal = P 302 if 30 ≤ p < 60 (only A will supply) 4 Stotal = P 302 + P 60 3 if 60 ≤ p < 100 (country A and C will supply) Stotal = P 302 + P 60 3 + P 100 4 if p ≥ 100 (everyone will supply) Then, solving them one by one, such that total demand equals total supply. We have that the only price for which the equality conditions are fulfilled is PFT = 88.77 Problem 8. - Worth 15 points Consider two countries, A and B, with the technologies given below: Table 1: Hours of Labor Required to Produce S or T Country A Country B S 10 50 T 4 10 i) Calculate the pre-trade relative price of S and T in both A and B. Is there a basis for mutually beneficial trade Why or why not ii) Compute the conditions for the relative wage rate WB/(E ×WA) under which there will be trade. E is the price of one unit of A’s currency in terms of B’s currency. iii) Suppose now that E = 5, and that the wages WA = 1 and WB = 1 each of them expressed in units of the country specific currency. Everything else held constant, what would happen to the trade patterns iv) What options are available to A to resolve this situation Solution. i) In A PS/PT = 2.5 while in B we have PS/PT = 5. Yes, there is a basis for mutually beneficial trade given by different pre-trade relative prices. In particular A has a comparative advantage in the production of S. ii) 1 5 < WB E ×WA < 2 5 iii) In this exercise, we have that: WB E ×WA = 1 5 = 1 5 In order to understand how it affects trade patterns, we have to compute the prices of S and T for each country taking into account the wages. Then: PAS = E ×WA × 10 = 50 PAT = E ×WA × 4 = 40 5 PBS = WB × 50 = 50 PBT = WB × 10 = 10 Since PAS = PBS and PAT > PBT , we are in a scenario in which country A will import good T, while being
indifferent between importing or not good S. Similarly, country B is indifferent between importing or
not good S. Country A will have a trade deficit.
iv) Country A has multiple options to solve this imbalance. It could lower its wages, or increase its
productivity. Alternatively, it could also institute quotas/tariffs on good S coming from Country B.
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Problem 9. – Worth 15 points
Consider the graph above representing the national demand and supply of country A for a particular
good, where SB (SC) is the price at which country B (C) is able to trade such good with country A. Assume
country A trades with country B and applies a tariff on the imported good such that the price faced by
consumers in A is SB + t, where t is the tariff. Furthermore, we have that SB = 20 and SC = 30.
Using all the information provided in the graph, answer the following questions and briefly explain them:
i) in order to maximize the consumers surplus which country (B or C) should country A form a FTA
with
ii) What is the value of the tariff imposed Does it have the same absolute value for both countries
Assume the government convenes a delegation of producers and a delegation of consumers in order to ask
their opinion regarding the opportunity of forming a FTA, and whether to form it with country B or with
country C:
iii) how would the opinion of the delegation of producers and of the delegation of consumer differ
Assume that the government decides to form a FTA with country B:
iv) What is the effect of forming the FTA in terms of trade diversion and trade creation
v) define, using the letters in the figure, the change in the producer surplus, consumer surplus and
government revenues for country A after the formation of the FTA with country B
vi) what is the net effect on welfare in country A
vii) how is the welfare of country B and C affected
Solution.
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i) Since SB < SC , country A maximizes consumers surplus by forming an FTA with country B instead of country C. ii) Taking the graph as given, we have that the supply function has a slope of 1. Therefore, the tariff will have a value of 20 for both countries, being equal in absolute terms. iii) Producers would advice the government not to form any FTA. Consumers would advice to form a FTA, and if possible, with country B. iv) There is only trade creation, as country A will keep importing from country B, and will increase the volume imported. No trade diversion occurs as country A will not change its trading partner. v) Change in consumer surplus: a + b + c + d + e + f + g + h + i+ j + k + l + m + n (all letters) Change in producer surplus: -a - g Change in government revenue: - c - d - e - j - k - l vi) Net effect: b + h + i + f + m + n vii) While Country C will not be affected as it was not trading to begin with, Country B’s producers (in this particular market) are better off as they export more quantity. The net effect on producers in Country B is uncertain as the elimination of tariffs imply that some producers in certain markets will lose. 8