# Answers to Sample Test 1

Professor Choi, E355 E-1 Name: Last_____________, First __________

# 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?

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

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

aLC = 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: pT/pC = aLT/aLC = 40/30.

U.K.: pT/pC = a*LT/a*LC = 50/40.

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

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

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

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

5. 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.

6. Find the factoral terms of trade.

UK: p*T = a*LT w*

= 50 w* = 13

US: pC = aLC w

= 30 w = 10.

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

w/w* = (10/30) ÷ (13/50) = 50/39.

That is, wage rates are not equalized by trade.

# The Heckscher-Ohlin Model

## 2. (15 points)

There are only two continents, America and Arabia, on the planet. 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 as needed.

Will free trade of outputs ensure the factor prices are equalized? Explain.

1. Answer: 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?

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

3. Suppose that America was exporting agricultural products to Arabia. President Obama imposes a trade embargo on Arabia. 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, pag, in America. Since agriculture is capital intensive, r (the return to capital) declines, but w increases in America (The Stolper-Samuelson Theorem).

In contrast, 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 Bush signed a new immigration bill which would encourage the 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 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 (the importable, y2) and decreases the output of the capital-intensive good (the 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 export supply?

Note first that national income increases as L increases.  I = wL + rKSince 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, we observe:

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

3. In 2016 GDP of the United States was \$18 trillion, whereas that of China was \$9 trillion. If China’s growth rate of 7 percent per year is sustained and the US grows at 2 percent per year, when will China surpass the US in terms of GDP? (show calculations)

7% - 2% = 5%. 70/5 = 14 years.

Escher, Belvedere 1958.