Jim Whitney Economics 311

February 15, 2012

Problem Set 2: Key

1. a. State the formula for a country's terms of trade.
    Terms of trade = (Px/Pm)*100.
b. The terms of trade for many lesser developed countries (LDCs) have been declining for many years. Decide whether the following is true or false, and use the Terms of trade indexes handout to support your answer: "Rising terms of trade is a necessary and sufficient condition for economic growth."
    False: 
    Not necessary: Chile, Egypt, Mexico and Ecuador grew despite a fall in ToT.
    Not sufficient: Madagascar and Rwanda did not grow despite a rise in ToT.
 
2. a. State each of the following theorems, which are based on the Heckscher-Ohlin model: (1) the Heckscher-Ohlin (HO) theorem, (2) the factor-price equalization (FPE) theorem, and (3) the Stolper-Samuelson (SS) theorem.
    (1) The Heckscher-Ohlin (HO) theorem: each country tends to export goods which make relatively intensive use of the country's relatively abundant factors of production.
    (2) The factor price equalization (FPE) theorem: Globalization tends to make factor prices converge across countries.
    (3) The Stolper-Samuelson (SS) theorem: free trade raises the real income of a country's abundant factor and lowers the real income of the country's scarce factor.
  b. Consider South Korea, a small country which starts out as relatively labor-abundant.
 
(1) What does the Heckscher-Ohlin theorem predict for South Korea's pattern of trade when it it is a labor-abundant country?
   Since South Korea (SK) is labor-abundant, it should export labor-intensive goods.
(2) Illustrate an initial PPF for South Korea, putting capital-intensive products on the horizontal axis. Then suppose that South Korea promotes a high rate of domestic savings and capital formation. Illustrate how the country's production possibilities frontier will change over time.
   See diagram to right. Accumulation of capital boosts production more on the axis for K-intensives than for L-intensives.
    Answer key checklist: Did you shift the PPF out on both axes--just more on the K-intensive goods axis (capital does help both industries, it just helps the K-intensive goods industry more).
(3) Could growth of this type eventually reverse South Korea's direction of trade? Explain briefly.
    Yes, SK's trade direction could reverse, since with enough K, South Korea could become relatively capital-abundant. SK would then export K-intensive goods. That's what happens in the diagram to the right.

 

3.

Suppose you download some data about Denmark, a small, capital-abundant country. The data report the percentage price changes resulting from Denmark's move to freer trade for each of the following items: Denmark's export products, import-substitute products, labor and capital. Unfortunately, the data got scrambled. All you end up with are the following unlabeled percentage changes:
    +16%, -8%, -20%, +40%.
According to the Heckscher-Ohlin model, how would you match these values and what they most likely correspond to? Explain briefly.
        DPK = +40%; DPX = +16%; DPMsubs = -8%; DPL = -20%
    (1) Since Denmark is K-abundant, it will export K-intensive goods and import L-intensive goods.
    (2) As Denmark specializes according to its comparative advantage, changes in factor-market demands will make DPK > DPL.
    (3) Since X depends more on K and less on L than Msubs does, DPX > DPMsubs.
    (4) Since all products use some K and some L, no product price will change as much as either input price, so: [DPK > (DPX > DPMsubs) >DPL].
     

4.

Suppose the home country is capital-abundant and that there are two types of products, capital-intensive advanced goods (A) and labor-intensive basic goods (B), produced with two resources, capital (K) and unskilled labor (L). Different people have different employment situations and different consumption patterns too.
    In each cell of the table below, use the notation "+, -, 0, ?" to indicate whether Heckscher-Ohlin style free trade would cause the individual's welfare to rise, fall, remain the same or change in an uncertain direction. Briefly explain how you made your decisions.
 
  Consumption pattern
Endowment/Employment:    a: Consumes
 only A		    b: Consumes
some A and B		 c: Consumes
only B
A. An owner of capital used in the advanced goods industry + + +
B. An owner of labor employed in the advanced goods industry - - -
C. An owner of capital used in the basic goods industry + + +
D. An owner of labor employed in the basic goods industry - - -
        (1) As shown in the previous problem, PK rises more than any product price, and PL falls more than any product price. So K-owners can buy more of any bundle of goods they choose, and L-owners can afford less of any bundle they choose. This demonstrates that the real income (purchasing power) of the abundant factor rises, and the real income of the scarce factor falls.
    (2) Since the same factor must earn the same income in a competitive industry no matter where it is employed, the same results apply whether the factor is employed in industry A or B.
    Note: The SS theorem implies that when MDCs trade with LDCs, unskilled labor cannot escape a fall in real income no matter what it tries to buy or where it tries to work.
 

 

5.

Decide whether each of the following is or is not consistent with the HO model, and explain your decision in each case:
a. "You implement that Nafta (the North American Free Trade Agreement),...and you're going to hear a giant sucking sound of jobs being pulled out of this country...."
    Not consistent. Jobs go up in export industries and down in import-competing industries. Overall employment does not change.
b. "[For the U.S.,] Nafta's benefits would fall on skilled labor, while the unskilled would suffer a slight decline in real income."
   Consistent. SS => lower PL for unskilled labor, but higher PK for human capital can result in benefits for skilled labor.
c. "An unrestricted U.S.-Mexico free-trade agreement will be a disaster for [unskilled] workers in both countries."
   Not Consistent. FPE => lower PL for the US, but higher PL for Mexico.
d. With Nafta, overall, "American [unskilled] workers would benefit from the increased supply of lower-cost Mexican products and from increased U.S. sales to Mexico."
   Not Consistent. SS => unskilled labor wages fall more than the drop in import prices.
e. "International wage-cutting competition...shifts our desirable high-wage and skilled industries and jobs to other countries."
   Not Consistent. HO => in K-abundant countries, high-skill industries expand with globalization.
f. For a capital-abundant country, in the long run, free trade will raise the price of unskilled labor in the country's export industries and lower the price of unskilled labor in the country's import-competing industries.
   Not Consistent. HO is a long-run model that allows factors of production to migrate between industries. In equilibrium, equivalent factors will earn the same income throughout the economy.
 

6.

Consider the following breakdown of the export markets of DCs and LDCs:
  Share of exports sold to...
DCs LDCs
DC exports 72% 28%
LDC exports 55% 45%
a.  Which trade is most clearly accounted for by the HO model? Why?
    DC-LDC trade is most likely HO. HO depends on unequal relative factor endowments, which applies best between richer and poorer countries.
b.  What sorts of trade might be especially prominent for the other cases?
    Technology-based trade: DCs trade newly developed products with each other.
    Variety-based trade: Intra-industry trade in differentiated products.
 

 

7.

Suppose that steel output in South Korea is produced by a domestic monopoly.
a. Suppose South Korea engages in no trade in steel. Use a domestic-market supply and demand diagram to depict an initial equilibrium in which South Korea's steel monopolist charges a price above the competitive equilibrium. Label the monopoly price Pm, and label the efficient competitive price Pc.
    In the diagram to the right, Pm is labeled as Pa, and the efficient price, Pc, is where Ddom and MCdom cross.		 ps2keyf7.gif (3194 bytes)
  b. Now suppose that the world price of steel is between Pm and Pc. Depict South Korea's free-trade equilibrium. Indicate South Korea's ordinary gain from trade and its additional gain from trade due to the competition introduced into its steel industry.
    In the diagram to the right, the ordinary gains from trade = B, and the additional gains from competition = A.		  
 

 

Fact check

8.

This question deals with passages from, Buy American--Why Not? (Los Angeles Times (2009)), an editorial from the Los Angeles Times. The parentheses report the class survey results regarding how many "believe or agree" with the statement.
a. Passage1 (83%): "[T]he United States is almost alone among the major developed nations and China in not having a significant "buy domestic" government procurement program." 
      Fact check this statement. Tip: Look under "Government procurement policies" in the index of your text.
    The US government does not lack a "buy domestic" program. Instead, it is unique in using "explicit laws" that "openly discriminate against foreign suppliers." Domestic preference margin: 6% in general; 12% for suppliers in labor-impacted areas, and 50% for defense items.
b. Passage 4 : "[T]he usually credible Peterson Institute estimated that such an initiative ["Buy American"] would save or create a meager 9,000 jobs" (77%). "But out of a total U.S. labor force of 155 million, the correct answer has to be at least a couple million or more because we are talking about transitioning so much of the U.S. economy -- most of nearly $3 trillion in annual government purchases -- to domestic-only origins" (71%).
      Fact check: (1) Which number do you think is a better estimate of the number of domestic jobs that would be created by a "Buy American" requirement, 9,000 or "a couple million or more"? (2) Why do you think the two estimates vary so much?
    (1) The "couple million" refers to the jobs that might be created to sell to the government, but the 9,000 is closer to the net change in jobs from expanded government purchases versus jobs lost in other industries as the US shifts back toward autarky.
    (2) The Peterson study nets out job gains in one sector against jobs lost elsewhere. The editorial considers just the jobs created to sell to the government but doesn't take into account where those workers will come from (the jobs they had before).
c. Passage 5 (62%): "In his first inaugural speech, President Franklin Roosevelt said that the nation's greatest task was "to put people to work." At the time, 13 million Americans were unemployed, and the economy was much better balanced between manufacturing and services."
      Fact check: How many people were reported as unemployed in 1933? Link: http://www.gpoaccess.gov/eop/2009/B35.xls.
    12.83 million, which matches what the editorial states.
d. Passage 6 (96%): "Now, however, there are nearly 30 million effectively unemployed Americans, according to Bureau of Labor Statistics figures for July."
      Fact check: How many people were reported as unemployed in July, 2009? Link: http://www.bls.gov/web/cpseea9.pdf
    14.462 million, about half of what the editorial states.
    (How do you think the editorial comes up with a number that is so much larger?)
e. Passage 7 (73%): The United States, with its enormity and geographic diversity, simply cannot prosper in the long term with less than 12% of its GDP coming from manufacturing. 
      Opinion check: Would you agree with a similar assertion about agriculture? Why or why not?
    There are many sensible responses to this question. It is likely that very few people have a firm idea about what should be the minimum amount of GDP to come from agriculture to ensure prosperity. But that is just as true for other sectors, including manufacturing.
    If you were among the 73% who agreed with this statement from the editorial, I would be curious to know how you settled on 12% as the necessary minimum. For the actual percentage of U.S. GDP that comes from "agriculture, forestry, fishing and hunting" combined, check out the website: http://www.gpoaccess.gov/eop/2009/B12.xls