ECB 223International EconomicsSample Examination #1

Question #1

Assume there are two countries, England and Portugal, and two commodities, Cloth (C), and Wine (W). Assume labor is the only input in the production process.

In England if all labor is committed to the production of Cloth, the maximum total output of Cloth is 8 units. In England if all labor is committed to the production of Wine, the maximum total output of Wine is 2 units.

In Portugal if all labor is committed to the production of Cloth, the maximum total output of Cloth is 12 units. In Portugal if all labor is committed to the production of Wine, the maximum total output of Wine is 6 units.

(A) Calculate the opportunity cost of one unit of wine (1W) in both Portugal and England. Which country has a comparative advantage in Wine?

The Portuguese opportunity cost of one unit of wine is two units of cloth, whereas the English opportunity cost of wine is four units of cloth. Since the opportunity cost for producing wine in Portugal is lower than in England, the Portuguese have comparative advantage in wine production.

(B) What are the limits to mutually beneficial trade?

If the Portuguese were to trade their wine for English cloth, they would demand at least two units of cloth per unit of wine, since those are the limits of their production capabilities. Likewise, if the English were to trade their cloth, they would want at least one unit of wine per four units of cloth. If the countries were to achieve mutually beneficial terms of trade, they would settle on a ratio that is between these two figures.

(C) Consider the “price” of one cloth for one wine (1C / 1W). Which country will not trade at this price? Why?

Portugal will not trade at this price, because with the same resources required to produce one unit of wine, they could produce two units of cloth.

(D) On two diagrams, one for England and the other for Portugal, draw each country’s pre-trade (autarky) production/consumption possibilities frontier.

(E) Suppose trade takes place at a “price” of three cloth for one wine (3C / 1W). On the diagrams, for each country illustrate the gains from trade by appropriately rotating the post-trade consumption possibilities frontier.

(F) In the context of this example, explain the Principle of Comparative Advantage.

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Question #2

Consider a world of two countries, Italy and France, and two goods, shoes and perfume. The opportunity cost of 1 bottle of perfume is 8 pairs of shoes in Italy and 3 pairs of shoes in France.

Assume trade between the two countries takes place at the exchange ratio (price) of 5 pairs of shoes for 1 bottle of perfume. Which country is more likely to capture a disproportionately larger share of the gains from trade? Why? Be sure to discuss the relevance of demand conditions.

Since France has a lower opportunity cost in perfume production, they will hold the comparative advantage in perfume, and will choose to specialize in perfume production. As the French will specialize in perfume, their demand for shoes will be satisfied by the Italian shoemakers, and the Italian desire for perfume will be satisfied by the French. For every 8 pairs of shoes that Italy produces, they can trade these shoes to the French and receive 1.6 bottles of perfume. Similarly, France can trade 1 bottle of perfume to the Italians and receive 5 pairs of shoes. Under these terms of trade as opposed to autarky, the Italians receive an additional 0.6 bottles of perfume while the French receive an additional two pairs of shoes. For the French, the additional two pairs of shoes are worth 0.67 bottles of perfume which is greater than the value that the Italians receive. Therefore, the French capture a larger share of the gains of trade.

Question #3

Consider a 2x2x2 example of two countries (Korea and Brazil), two commodities (steel and autos) and two factors of production (labor and capital). Assume that at a given wage-rental ratio (3/2), the capital-labor ratio in the steel industry is (5/2) while the capital-labor ratio in the automobiles industry is (10/3). If, after trade opens up Brazil exports automobiles, is Brazil a capital-abundant country or a labor-abundant country? Explain using the Heckscher-Ohlin model.

The automobile industry is one that is described as requiring more capital than the steel industry, simply because the ratio of 10/3 is larger than 5/2. If Brazil chooses to specialize in production of the good that requires more capital than labor, using the Heckscher-Ohlin model, it would stand to reason that Brazil is indeed a capital abundant country, while Korea is a labor abundant country.

Question #4

Assume a trading world of two nations, India and Japan. India is abundant in labor while Japan is abundant in capital. Who is more likely to be in favor of trade restrictions against imports (against free trade)--Japanese trade unions or Indian trade unions. Why?

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Explain using the concept of “factor price equalization”. Be sure to include relevant technical details.

Since Japan is a capital abundant nation, goods that require extensive labor to produce are highly unlikely to be produced in Japan. It would be much more likely that Japan chooses to import its labor-intensive goods from India, a labor abundant country. Anti-import trade restrictions would result in an increase in the prices of Indian imports in Japan, while the prices of Japanese imports in India would follow suit. As Indian labor-intensive imports are now more expensive in Japan, the Japanese would look for cheaper alternatives, such as domestically produced labor-intensive goods. This would cause an increase in the demand and price of Japanese produced labor-intensive goods, and would therefore be beneficial to Japanese trade unions. Question #5

Assume there are two countries, Canada and Mexico, and two commodities, oil and timber. Assume that Canada has a comparative advantage in timber.

What does the offer curve represent? Why does the offer curve have a convex shape.

The offer curve is a graphical representation of the quantities of one good that a nation is willing to export in exchange for receiving another quantity of an imported good. In this specific case, the offer curves for Canada and Mexico represent the quantities of oil and timber that the countries are willing to trade and receive. The offer curve is convex due to the diminishing marginal returns in goods.

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