International Economics Dr.

McGahagan Pugel -- Chapter 4 Problems

Problem 4.1. Heckscher-Ohlin and Production technologies According to Heckscher-Ohlin (in contrast with Ricardo) all countries have the same set of production technologies available to them. You can buy a backhoe to dig a ditch in Nanking or in Nanty Glo. The reason countries may make different choices from the same set of production technologies is that they have different factor prices, which in turn reflects the fact that they have different factor endowments. Differences in factor endowments are the basis for trade in the HO model. Problem 4.2. Zero sum game? Trade in the HO model, like trade in the Ricardian model, is a positive sum game. The welfare of the "representative consumer" in both countries increases as a result of trade. Problem 4.3. Factor abundance and factor intensity. Note that factor abundance relates to national endowments and factor intensity to industries. We compare factor abundances by comparing the ratios of two factors across countries: in this problem, the labor/land ratio in Pugelovia is 20 / 3 = 6.67 the labor/land ratio in ROW is 80 / 7 = 11.43 ROW is labor abundant and Pugelovia is land-abundant (since 3 / 20 is greater than 7 / 80) Since the labor-abundant country is expected to have a comparative advantage in the labor-intensive industry, we would expect the ROW to export cloth and Pugelovia to export wheat. Problem 4.4. Deriving a supply curve from a production possibility frontier. Consider an example similar to that in problem 9. Assume there are only 3 states in the US, namely Pennsylvania (PA), Iowa (IA) and South Dakota(SD). With the factor endowments present in these states, they can produce at a maximum: Maximum production of wheat PA IA SD 50 200 250 Maximum production of corn 150 200 100 Opportunity cost of corn 1/3 unit of wheat 1 unit of wheat 2.5 units of wheat

The supply curve can actually be drawn without drawing the PPF. Note that Pennsylvania is the low opportunity cost producer for corn, and therefore has a comparative advantage in corn. It will therefore be the first of the three states to produce corn. Suppose the price of wheat is one dollar a bushel (we will assume this remains constant). What will Pennsylvania do if the price of corn is 33 cents a bushel? 34 cents a bushel? (at 33 cents a bushel, it would make 0.33 * 150 = $ 49.50 from corn production and $ 1 * 50 = $ 50 from wheat production, so it would produce wheat; at 34 cents a bushel, it would make 0.34 * 150 = $ 51 from corn production, so it would produce corn). At a price of 33.33 cents or greater, PA produces 150 units of corn -- our first point on the supply curve for corn. What price for corn gets Iowa to switch to corn production? What is total US corn production when PA and IA both produce corn? (answer: $ 1 and 350, so we have a second point on our supply curve for corn). What price for corn gets South Dakota to switch to wheat production? What is total US production? (answer: $ 2.5 and 450, so we have a third point on our supply curve for corn).

Problem 4 (continued) Hence our supply curve for corn is (if we connect the points directly) or, if we use a step function (which more literally translates our numbers into a graph):

The graph on the left looks more like what we are used to seeing as a supply curve, and can be justified if we assume that production conditions differ WITHIN each of the states, so that (for example) some farmer in Pennsylvania has land which cannot be used to grow wheat, so he will grow corn at any positive price. What about the supply of wheat? Note that even if the price of wheat stays at $ 1.00 a bushel, the rising price of corn will drive farmers out of wheat and into corn. The supply of wheat depends on its price RELATIVE TO corn, not just on its dollar price. You should see that if --P.wheat / P.corn = $ 3.00 or more, all producers produce wheat, for a US total of 500 wheat and zero corn [Note that this means that P.corn / P.wheat is less than 1 / 3, so Pennsylvania drops corn production] -- P.wheat/P.corn more than $ 1.00 but less than $ 3.00, SD and IA produce wheat, for 450 wheat and 150 corn (only PA produces corn). -- P.wheat / P.corn is less than 1.00 but more than 0.40, only SD produces wheat, for 250 wheat and 350 corn. -- P.wheat / P.corn is less than 0.40, even SD switches to corn, for a US total of zero wheat and 450 corn These points ARE the points of the production possibility frontier of the country taken as a whole, so the PPF graph (on the next page) looks more like a Heckscher-Ohlin PPF rather than a Ricardo PPF. If we construct an example with 50 states, the PPF would look even more curved. If we construct an example with 3,142 counties (the number of counties in the US), it will look very curved indeed. The 3-state PPF example is reproduced on the next page.

Problem 4.4 (continued) The three-state Production Possibility Frontier (PA in red, IA in blue, SD in magenta):

Problem 4.5 and 4.6 See the very thorough answer to problem 4.5 in the back of the book (p. 679). Make sure you understand that the (absolute value of the) slope of the price line shows the relative price of cloth, P.cloth / P.wheat, or more generally will show the relative price of the good on the horizontal axis. The text notation is a bit confusing. When the text labels a line Price = 0.5 W/C, they mean that it takes only half a unit of wheat to buy a unit of cloth, so that P.cloth / P.wheat is 0.5. Be sure to be able to translate the text notation into relative prices accurately. Therefore, as the price line becomes flatter, the relative price of cloth drops, and production shifts out of cloth and into wheat. Note that in the graph on p. 679 that as the terms of trade improve, the representative consumer moves to a higher indifference curve, so the representative consumer's welfare improves. [The text language expects the answer that the country's welfare improves, which may be misread as saying that the welfare of everyone in the country improves]. For problem 4.6, note that at P.cloth / P.wheat = 2.0, the county is at its autarky point S0. As the relative price of cloth drops, the quantity of cloth demanded increases, and since the production of cloth is decreasing, the country will be importing cloth. If the relative price of cloth increased to more than 2.0, the country would export cloth. Problem 4.7. Puglia, Pasta and Togas. Look at the graph on p. 680 and see if you can answer the questions without reading the provided answer. Again remember that the prices shown by the price lines are P.pasta / P.togas. When P.pasta / P.togas = 4, it takes 4 togas to buy a unit of pasta. Add the trade triangle to the graph when P.pasta / P.togas = 3.

Problem 4.8. Terms of trade. Refer to the graph on p. 55, portraying international equilibrium. The autarky price P.cloth / P.wheat in the US was 2.0, and in the rest of the world (ROW) was 0.67. The text presentation assumed that the world price after trade was 1.0, so that the ROW would export cloth to the US. Supposing that the relative price of cloth rises to 1.3, this is a terms-of-trade improvement for ROW, and a terms of trade deterioration for the US. ROW will expand its production of cloth and will move to a higher indifference curve as the price line becomes steeper (try to add a S2 and a C2 to the PPF graph of the rest of the world, and sketch in the price line and the new, higher indifference curve). Note that you can use the supply and demand graphs in Part B of figure 4.4 to see what is happening to producer and consumer surplus in the US and in ROW when price rises to 1.3. Problems 4.9. Multi-person Production Possibility Frontier. See problem 4 for a detailed example. See the text explanation on p. 680. Maximum output of wheat Person B Person C Person D Person A 2 1 2 1 Max. output of cloth 1 1 3 2 Opportunity cost of wheat 0.5 cloth 1 cloth 1.5 cloth 2 cloth Color on graph blue magenta green red

Note that B is the LOW OPPORTUNITY COST producer of wheat, and will be the first to enter into wheat production; Person A is the HIGH OPPORTUNITY COST PRODUCER of wheat, and will be the last to enter into wheat production. The production pattern will therefore be: P.wheat / P.cloth Less than 0.5 Between 0.5 and 1 Between 1 and 1.5 Between 1.5 and 2 Above 2.0 Wheat production 0 2 3 5 6 Cloth Production 7 6 5 2 0 Producers of Wheat Cloth None A, B, C, D B only A,C,D B,C A,D B,C,D A only A,B,C,D None