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Winter 2013- Professor Sule Ozler Economics 121 MIDTERM-1

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This exam has three sections. Each section has multiple questions. Sections I is for 30 points, Section II is for 20 points, section III is for a total of 50 points. I. MULTIPLE CHOICE: Choose any number of alternatives for each of the questions (there might be one correct answer or more than one). You will get credit only if you choose the right answer(s). If you choose more alternatives when there is one, even if one of the alternatives is the correct answer you will not get any credits. You also will not get any credits if you chose only one of the possible correct answers. (There are 6 questions- 5 points each.)

1) Why does the gravity model work? A) Large economies have relatively larger areas which raises the probability that a productive activity will take place within the borders of that country. B) Large economies became large because they were engaged in international trade. *C) Large economies tend to have large incomes and tend to spend more on imports. D) All of the above. *E) Large economies attract large shares of other countries spending because they produce a large range of products. 2) A country will be able to consume a bundle which is not attainable solely from domestic production if *A) the world relative prices differ from its relative domestic costs B) the country specializes in one product C) the world relative prices equal the domestic relative costs

D)none of the above

3) What percentage of all world production of goods and services is exported to other countries? A) 10% *B) 30% C) 50% D) 100% E) none of the above.


Given the information in the table above, we would expect specialization of both countries if the world equilibrium price of widgets to cloths were:

*A) 1 * B) 1.5 C) 2.5 D) 3 * E) 0.75

5) The argument that trade generates gains for all workers may not be true because: *A) We might not know the consumption basket of workers. B) technology gains are concentrated among low-skill workers. C) * Workers might not be mobile between sectors, if they have specific skills. D) all of the above

6) The Heckscher-Ohlin model of international trade uses the following concepts to explain trade patterns.

A) absolute advantage *B)factor abundance; *C)factor intensity D)factor usability

II. SHORT ANSWER QUESTIONS: (2 questions) Be brief in your answers. State your reasoning. Do not use diagrams. (20 points total) 1) The US labor movement- which mostly represents blue-collar workers rather than highly educated workers- has traditionally favored limits on imports from less affluent countries. Is this a rational policy in view of the interest of union members? In answering this question use the Ricardian model.

Answer: In the Ricardian model, labor gains from trade through an increase in its purchasing power (we have one factor of production and everybody gains from trade). This result does not support labor union demands for limits on imports from less affluent countries.

2) Consider a two good (cloth and food) two factor economy (land and labor) where factors of production are substitutable for each other. Suppose that cloth is labor intensive and food is land intensive. What is the impact of an increase of cloth price relative to food price on the real returns to the two factors of production? Answer: An increase in the relative price of cloth, PC /PF, is predicted to: raise income of workers relative to that of landowners, w/r. raise the ratio of land to labor services, T/L, used in both industries. Thus, it raises the marginal productivity of labor in both industries and lowers the marginal productivity of land in both industries. raise the real income of workers and lower the real income of land owners.

III. Analytic questions (2 questions 25 points each). Show your work.

1) (This question has two parts, note the point allocation is different). Consider a two good (cloth and food), three factor (capital, land and labor) and a two country specific factors model. Land is specific to food production while capital is specific to cloth production.

Home is relatively better at cloth production and foreign at food production. The demand structure for home and the foreign is the same.

a) (10 points)Allow for international trade to take place between these countries. Draw the world relative demand curve, the pre-trade supply curves for both of the countries, indicating the foreign country with a star. What happens to the price of cloth relative to food for the domestic country and the foreign country with trade?

For domestic country price of cloth relative to food increases, for the foreign decreases.

b) In the home country, how does trade impact wages of workers? Draw a diagram and explain. (9 points) What happens to the returns for capital owners, and land owner? Why? (6 points).

To consider the impact of relative food price increase, let us suppose that the price of cloth increases while food price stays the same.

Wages increase but price of cloth increases more. Because: Recall MPLC x PC = w, where MPLC is marginal product of labor in cloth. Since labor moves to this sector as a result of wage increase, marginal product of labor decreases. Therefore, real wage in terms of cloth decreases. At the same time, since nominal wage rate increases but the price of food does not increase, real wage in terms of food increases. Thus the overall impact on the workers is ambiguous. It depends on their consumption basket.

Owners of capital are definitely better off. Real wages of workers have fallen, so the profits of capital owners in terms of what they produce rises. Since PC rises relative to PF their income in terms of food also goes up.

Owners of land are definitely worse off.

They lose for two reasons. Relative wages in terms of food rises, squeezing their income. The rise of PC reduces purchasing power of any given income.

2) This question has 5 parts, they are 5 points each.

Consider a Ricardian model. Assume that Home and Foreign produce two goods, televisions and cars, and use the following information to answer the questions that will follow. Also note that both good are demanded in both countries.


Home country Wage TV=12 MPLTV (marginal productivity of labor in TV)= 2 PTV (Price of TV) =?

Wage car =? MPLC (marginal product of labor in car)=? PC (Price of car)=4

Foreign country Wage TV* = ? MPLTV* (marginal productivity of labor in TV)= ? PTV* (Price of TV) =3

Wage car* =6 MPLC* (marginal product of labor in car)=1 PC* (Price of car)=?

a. Fill in the questions marks for the domestic country


Wage TV= MPLTV x PTV (where x indicates multiplication)- you have to recall here that MPLTV is 1/unit labor requirement of TV, which is constant, thus average product is equal to marginal product.

Plug in the numbers PTV= 6

For both goods to be produced Wage car =12. Use Wage car=MPLC x PC gives MPLC=3

b. Express PTV and PC in terms of marginal products. What is the no-trade relative price of televisions at Home?


MPLC= 3, MPLTV= 2, and PTV / PC= MPLC / MPLTV= 3/2 (here note that the opportunity cost of TV in terms of cars is MPLC / MPLTV). You can see this by supposing that unit labor requirement for TV is alt, unit labor requirement for car is alc, which means that MPLC / MPLTV= alt/alc

c. Fill in the question marks for the foreign country

Answer: Wages are equal in both sectors which is 6 (because there is demand for both goods). Wage* TV= MPLTV* x PTV* Plug in the numbers MPLTV*= 2. Use Wage car*=MPLC* x PC* gives PC*=6

d. Express PTV and PC in terms of marginal products. What is the no-trade relative price of televisions in the foreign country?


MPLC*=1, MPLTV*= 2, and PTV* / PC*= MPLC* / MPLTV*= 1/2


Suppose the world relative price of televisions in the trade equilibrium is PTV / PC = 1. Which good will each country exports? Briefly explain why.

Answer: Home will export cars and Foreign will export televisions because Home has a comparative advantage in cars whereas Foreign has a comparative advantage in televisions. To see this note that the opportunity cost of tv in terms of car at home is MPLC/MPLTV=3/2 and in the foreign it is MPLC*/MPLTV*=1/2