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Homework 3

Vidit Dhawan

Heckshcer-Ohlin Model 2

1. This exercise uses the Heckscher-Ohlin model to predict the direction of trade. Consider the production of hand-made rugs and assembly line robots in Canada and India.

  • a. Which country would you expect to be relatively labor-abundant, and which capital- abundant? Why?

Answer Given Canada’s relatively small population (30 million compared with more than 1 billion in India) and level of development, it is a safe assumption that L CAN / K CAN < L IND / K IND . That is, there is more capital per worker in Canada, making it capital- abundant compared with India. Similarly, India would be labor abundant.

  • b. Which industry would you expect to be relatively labor-intensive, and which is capital-

intensive? Why? Answer: Given the amount of capital required to produce robots and the amount of labor required to produce rugs, one would expect that L ROBOT / K ROBOT < L RUG / K RUG , making

robots capital intensive and rugs labor intensive.

  • c. Given your answers to (a) and (b), draw production possibilities frontiers for each

country. Assuming that consumer preferences are the same in both countries, add indifference curves and relative price lines (without trade) to your PPF graphs. What do

the slopes of the price lines tell you about the direction of trade?

Answer:

Homework 3 Vidit Dhawan Heckshcer-Ohlin Model 2 1. This exercise uses the Heckscher-Ohlin model to predict

Canada’s no-trade production and consumption of robots and rugs corresponds to a relative price of robots that is lower than that in India. This is shown by the flatter sloped relative price line in Canada.

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d. Allowing for trade between countries, redraw the graphs and include a “trade triangle” for each country. Identify and label the vertical and horizontal sides of the triangles as either imports or exports.

Answer:

Vidit Dhawan d. Allowing for trade between countries, redraw the graphs and include a “trade triangle”

2. Leontief ’s Paradox is an example of testing a trade model using actual data observations. If Leontief had observed that the amount of labor needed per $1 million of U.S. exports was 100 instead of 182, would he have reached the same conclusion? Explain.

Answer: If the amount of labor required for $1 million of U.S. exports was 100 person- years instead of 182, then the capital/labor ratio for exports would have been $25,500 per person. Because this is larger than the corresponding ratio for imports, this test would have provided support for the Heckscher-Ohlin theorem. That is, the United States (which was assumed to be capital-abundant in both cases) would have been shown to export capital-intensive goods. In actuality, however, Leontief ’s test showed exactly the opposite.

3 According to the Heckscher-Ohlin model, two countries can equalize wage differences by either engaging in international trade in goods or allowing skilled and unskilled labor to freely move between the two countries. Comment.

Answer: Allowing skilled workers to migrate to skilled-labor scarce countries and unskilled workers to migrate to unskilled-labor scarce countries reduces the ratio of skilled/unskilled workers in the skilled-labor-abundant country and raises it in unskilled- labor-abundant country. This increases the wage ratio between skilled and unskilled labor in the skilled-labor-abundant country and lowers it in the unskilled-labor-abundant country. When the two countries trade in goods that embody these factors, the skilled- labor abundant country will export the skilled-labor-intensive good. By doing so, it effectively sends a lot of skilled workers and a few unskilled workers to the unskilled

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labor- abundant country. Likewise, when it imports the unskilled-labor-intensive good, it effectively imports a few skilled workers and a lot of unskilled workers. The net effect is skilled workers in the unskilled-labor-abundant country see a fall in their wage relative to unskilled labor and unskilled workers experience a rise in their relative wage, similar to that of migration.

4. According to the standard Heckscher-Ohlin model with two factors (capital and labor) and two goods, movement of Turkish migrants to Germany would decrease the amount of capital-intensive products produced in Germany. Discuss whether this is true or false, and explain why.

Answer: An increase in a factor of production raises the production of the good that uses that factor intensively and reduces the production of the other good.

5. Imagine a two good H-O economy which imports automobiles and exports wheat. Suppose the

production of these two goods use only capital and labor. If the government raises a tariff on the import of automobiles it will raise the domestic price of autos. Suppose the price of wheat remains constant. Explain as a result of this tariff who in the economy will gain and who will lose in real terms?

Answer: With an increase in price of Auto relative demand shifts in favor of Auto production and hence relative demand for Capital goes up (relative demand for labor goes down). This will lead to a decrease in L-K ratio employed in the two sectors which lowers real Wage rates and increases real rentals.

Tariff on Auto imports P A ↑ >0 and so does the cost of production. Since Auto is capital intensive domestic Q A demand for K↑R↑ and R/P A ↑ & R/P W

Similarly can show P A ↑=> L/K↓ =>MPL↓W↓ and W/P A ↓ & W/P W

Rent earners win and Wage earners lose

6 Using a HO framework discuss the effects of U.S.-China trade on Skilled-Unskilled wage gap in US and China. Do we actually see these predicted effects on skilled-unskilled wage gaps in the two countries? Are you satisfied with this HO explanation of rising skilled-unskilled wage gap in US?

Answer: HO would predict that as result of trade between skilled scarce China and skilled abundant US, price of skilled intensive products increase in US (decrease in China) according to SS this should lead to an increase in wages of skilled labor (a reduction of wages of unskilled labor). We expect the opposite to happen in China. That is as result of US-China trade we expect skilled-unskilled wage gaps to increase in US and to decrease in China.

We observe the increase in skilled-unskilled wage gaps in US but we do not see the wage gap reductions we expected to see in China. If anything this has actually increase in

China. HO explanation is not quite satisfactory because, first we are see conflicting effects,

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second US trade with NIC’s constitutes only a small fraction of total U.S spending; this is too small to explain the increased gap.

7. Laxland and Workland are two identical countries except that people in Workland work twice as hard of those in Laxland. Under all the usual HO assumptions what would be your prediction of the patterns of trade between these two countries? What do we know about wage rates before and after trade in these two countries?

Answer)

Workland exports Q L-int

products to Laxland and imports Q K-int products

Vidit Dhawan second US trade with NIC’s constitutes only a small fraction of total U.S spending;

Q K-int

Vidit Dhawan second US trade with NIC’s constitutes only a small fraction of total U.S spending;

Q L-int

(b) An increase in Capital Endowment and the shift in PPF

Vidit Dhawan second US trade with NIC’s constitutes only a small fraction of total U.S spending;

FPE theorem tells us that with equal technology wages and rents would be equal across countries. In Workland workers twice as hard as those in Laxland, this is as if they have twice labor force. If wage rates in Laxland is W in Workland it would be 2W.

8. In 2008, the Ukraine successfully negotiated terms to become a member of the World Trade Organization. Consequently, countries such as those in Western Europe are shifting toward free trade with the Ukraine. What does the Stolper-Samuelson theorem predict about the impact of the shift on the real wage of unskilled labor in Western Europe? In the Ukraine?

Answer: According to the Stolper-Samuelson theorem, the real wage of unskilled labor in Western Europe will experience a decrease in real earnings because Western Europe is skilled-abundant relative to the Ukraine and will specialize in the skilled intensive good. By trading with the Ukraine, the relative price of the skilled-intensive

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good will rise. This leads to an increase in the real earnings of skilled labor and a decrease in the real wage of unskilled labor. The situation would be opposite in the Ukraine, where the real wage of unskilled labor would increase.

9. The following are data on U. S. exports and imports in 2007 at the two-digit harmonized schedule (HS) level. Which products do you think support the Heckscher- Ohlin theory? Which products are inconsistent?

 

Exports

Imports

HS Code

Products

($ billions)

($ billions)

  • 22 Beverages

3.6

14.7

  • 30 Pharmaceutical products

40.7

55.6

  • 52 Cotton

4.9

0.8

  • 61 Apparel

1.9

33.3

  • 64 Footwear

1.0

17.6

  • 72 Iron and steel

15.4

12.4

  • 74 Copper

5.0

6.4

  • 85 Electric machinery

124.9

212.1

  • 87 Vehicles

73.6

131.9

  • 88 Aircraft

83.0

18.4

  • 94 Furniture

7.0

30.1

  • 95 Toys

7.0

27.6

Source: International Trade Administration, U.S. Department of Commerce.

Answer: Because the United States is relatively abundant in skilled labor and scarce in unskilled labor, as predicted by the Heckscher-Ohlin model the U. S. imports unskilled- labor–intensive goods such as apparel, footwear, furniture, and toys. Assuming pharmaceutical products use skilled labor, U. S. imports of these goods are contrary to the prediction of the model. Both skilled labor and capital are used intensively in the production of aircraft, and given that the United States has abundance in both factors, the export of this good supports the Heckscher-Ohlin model. However, the model is unsupported by the import of electric machinery and vehicles as both goods also use intensively skilled labor and capital. The export of cotton is also likely to contradict the Heckscher-Ohlin model because the United States is relatively land scarce.

10. Data for soybean yield, production, and trade are provided below for 2007.

Yield

Production

Exports

Imports

(metric ton/hectare)

(100,000 metric ton)

(100,000 metric ton)

(100,000 metric ton)

Australia

2.44

3.2

0.3

1.0

Brazil

2.81

5785.7

2373.4

9.8

Canada

2.30

269.6

186.8

21.3

China

1.45

1272.5

45.7

3315.0

France

2.60

8.5

1.7

49.4

Ireland

3.13

40.8

2.0

8.4

Japan

1.64

22.7

0.1

416.1

Mexico

1.41

8.8

0.0

361.1

Russian Federation

0.92

65.0

1.7

12.5

United States

2.81

7286.0

2984.0

27.6

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Source: Food and Agriculture Organization

Suppose that the countries listed above are engaged in free trade and that soybean production is land intensive. Then answer:

  • a. In which countries does land benefit from free trade in soybeans? Explain.

Answer: Landowners in the United States, Brazil, and Canada benefit from free trade since the production of soybeans intensively uses land as a factor of production.

  • b. In which countries does land lose from free trade in soybeans? Explain.

Answer: Landowners in China, Mexico, Japan, Ireland, Russia, and France lose from free trade because the world-relative price of soybeans is lower than each country’s no- trade equilibrium price.

  • c. In which countries does the move to free trade in soybeans have little or no effect on the land rental? Explain.

Answer: The move to free trade in soybeans is likely to have little or no effect on the land rental in Australia and Russia because their import and export of the product is about equal.

The Specific Factors Model 1. Starting from equilibrium in the specific-factors model, suppose the price of manufactured goods falls so that wages fall from W’ to W in Figure 3.5 (below).

Vidit Dhawan Source: Food and Agriculture Organization Suppose that the countries listed above are engaged in

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  • a. Show that the percentage fall in wages is less than the percentage fall in the price

of manufacturing, so that the real wage of labor in terms of manufactured goods goes up. Answer: As seen in the diagram, both the price of manufactured goods and the wages decrease. The key to this exercise is to realize that the vertical distance of the decrease in wage is less than the vertical distance of ∆P M . MPL M . Therefore:

P M . MPL M >W

where ∆W represents the change in wage. Dividing both sides by the initial wage

W = P M . MPL M

P M / P M >∆W / W

This is the desired result: the percentage fall in the wage is less than the percentage fall in the price of manufacturing, so that the real wage of labor in terms of manufactured goods goes up

  • b. What happens to the real wage of labor in terms of agriculture?

Answer: Because the wage decreases and the price of agricultural goods remains the same, the amount of agricultural goods that can be bought by labor decreases. That is, real wage decreases in terms of agriculture. Because the wage decreases and the price of agricultural goods remains the same, the amount of agricultural goods that can be bought by labor decreases. That is, real wage decreases in terms of agriculture.

  • c. Are workers better off, worse off, or is the outcome ambiguous?

Answer: Because the real wage increases with respect to manufactured goods and decreases with respect to agriculture, the outcome will be ambiguous for workers. For some, who prefer to purchase a lot of agriculture, the price change means an overall loss in terms of how much they can buy. Others, who prefer to buy mainly manufactured goods, gain in terms of how much they can buy.

2. Read the article by Lori G. Kletzer and Robert E. Litan,“ A Prescription to Relieve Worker Anxiety,” Policy Brief 01-2, Institute for International Economics, Washington, DC, www.iie.com/publications/pb/pb01-2.htm. Then answer the following questions. a. Under the version of the Trade Adjustment Assistance (TAA) Act in the United States that they refer to, how many extra weeks of unemployment insurance are workers eligible for? What two criteria must they meet to qualify for this extra unemployment insurance?

Answer: Qualified workers may gain an additional 52 weeks of unemployment insurance UI payments, provided they are enrolled in an approved training program. A similar program, the North American Free Trade Agreement Transitional Adjustment Assistance (NAFTA-TAA) program, was created in 1993. For eligibility, workers must prove that

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they lost their job because of increased imports from, or a shift in production to, either Canada or Mexico.”

  • b. Consider the proposal for “wage insurance” that Kletzer and Litan make in their

article. What criteria would a worker need to meet to qualify for this insurance? What amount of extra income would they receive from the insurance?

Answer: “Wage insurance would work as follows: Eligible workers would receive some fraction of their wage loss, which could vary by age and tenure of the worker for up to 2 years following the initial date of job loss, but would begin to be paid only when workers found a new job.” “To qualify for our proposed supplemental wage insurance benefit, workers need only document that they have been ‘displaced’ according to criteria similar to the operational definition of displacement used by the BLS in its Displaced Worker Surveys (plant or company closed or moved, elimination of position or shift, insufficient work); that they had served at their previous job for a minimum period of time: we suggest 2 years; and

that they have suffered an earnings loss (from old job to new job)

. .

.”

  • c. If Kletzer and Litan’s new plan for “wage insurance” had been adopted by the

United States, what would have been the budgetary cost in 1999 when unemployment was 4.2%? How does this compare with the amount that is now spent on unemployment insurance?

Answer: “Assuming a 50% replacement and subsidy rate, the table indicates that our wage insurance and health insurance program would have cost about $2.9 billion in 1999, when the national unemployment rate averaged 4.2%. “The total cost, less than $4 billion, might have been a major obstacle when federal

deficits were high and growing but is not a problem now, and in any event would be small in relation to the more than $20 billion that is now spent on unemployment

insurance

. .

.”

3. Suppose two countries, Canada and Mexico, produce two goods, timber and televisions. Assume that land is specific to timber, capital is specific to televisions, and labor is free to move between the two industries. When Canada and Mexico engage in free trade, the relative price of televisions falls in Canada and the relative price of timber

falls in Mexico.

  • a. In a graph similar to Figure 3-5, show how the wage changes in Canada because of a fall in the price of televisions, holding constant the price of timber. Can we predict that change in the real wage?

Answer: As shown by the following figure, real wage falls but by less than the percentage decrease in the price of televisions.

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Vidit Dhawan b. What is the impact of opening trade on the rentals on capital and
  • b. What is the impact of opening trade on the rentals on capital and land in Canada?

Can we predict that change in the real rentals on capital and land?

Answer: Because capital is specific to the television sector, the drop in the relative price of television will lead to a fall in the rental on capital. With Canada exporting timber, rental on land will rise because land is specific to the timber industry.

  • c. What is the impact of opening trade on the rentals on capital and land in Mexico? Can we predict that change in the real rentals on capital and land?

Answer: Through the exports of televisions, the relative price of televisions will rise in Mexico, which will lead to an increase in the rental on capital. By contrast, the rental on land will fall.

  • d. In each country, has the specific factor in the export industry gained or lost, and has the

specific factor in the import industry gained or lost?

Answer: In both cases, the specific factor in the export industry (i.e., land in Canada and capital in Mexico) gained whereas the factor specified to the import industry (i.e., capital in Canada and land in Mexico) loses when the two countries engage in trade.

4. Home produces two goods, computers and wheat, where capital is specific to computers, land is specific to wheat, and labor is mobile between the two industries.

Home has 100 workers and 100 units of capital, but only 10 units of land.

  • a. Draw a graph similar to Figure 3-1, with the output of wheat on the vertical axis and

the labor in wheat on the horizontal axis. What is the relationship between the output of

wheat and the marginal product of labor in the wheat industry as more labor is used?

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Vidit Dhawan Answer As more labor is added to the production of wheat, the marginal product

Answer

As more labor is added to the production of wheat, the marginal product of labor declines

so that although the output of wheat continues to increase, the output is increasing at a decreasing rate.

b. Draw the production possibilities frontier (PPF) for Home with wheat on the horizontal axis and computers on the vertical axis. Answer: See the following graph.

Vidit Dhawan Answer As more labor is added to the production of wheat, the marginal product

c. Explain how the price of wheat relative to computers is determined in the absence of trade. Answer: In the absence of international trade, the relative price of wheat is the slope of the line tangent to the PFF and Home’s indifference curve.

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d. Reproduce Figure 3-4 with the amount of labor used in wheat measuring from left to right along the horizontal axis, and the amount of labor used in computers moving in the reverse direction. Answer: See graph below.

Vidit Dhawan d. Reproduce Figure 3-4 with the amount of labor used in wheat measuring from

e. Assume that because of international trade, the price of wheat rises. Analyze the effect of the increase in the price of wheat on the allocation of labor between the two sectors.

Vidit Dhawan d. Reproduce Figure 3-4 with the amount of labor used in wheat measuring from

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The increase in the price of wheat shifts the PW MPLW curve upward to PW'MPLW so that the new equilibrium is at point B. The amount of labor used in wheat increases from 0WL to 0WL', although the amount of labor devoted to computer decreases from 0CL to 0CL'. Although the wage rises from W to W', the increase is less than the vertical shift of the PW MPLW curve given as ∆PW MPLW.