International Trade Part II

8/8/2019 International Trade Part II

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Part II. From MMKM Text

1) (From MMKM 5) Redraw 5.8 for the case in which the world price ratio is lessthan the autarky price ratio.(You must draw a new figure here and explain briefly

in words.)

Ans.

In autuarky, the equilibrium is at point A and the country producing OX1 of X andOY1 of Y. Point A is also the autarky consumption point where the utility level is

U1. The autarky price ratio is greater than the world price ratio. If there is trade

at world price ratio, P, the equilibrium production may shift to point Q a nd the

country can gain in trade by moving consumption to point C at utility level U 3. If

the production does not change, the countrys consumption point shifts to point E

with utility level U2. So, the country can gain more by responding a change in

production at world price level p* and has both gains from exchange (movement

from point A to E) and gains from specialization (movement from point E to C).

At world price ratio P*(production at Q)

Production Consumption Trade

X-goods =OX2 X-goods =OX2 Import=X2X2

Y-goods = OY2 Y-goods=OY2 Export=Y2Y2

Y

Y2

Y1

Y2

Y1

O X2 X1 X1 X2 X

U1 U2 U3

Q

A

E

C

P*


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If production does not Change (produce at point A)

Production Consumption Trade

X-goods =OX1 X-goods =OX1 Import=X1X1

Y-goods = OY1 Y-goods=OY1 Export=Y1Y1

2) (From MMKM 5) Suppose that we change Fig 5.2 making preferencesdifferent in the two countries such that Home has an autarky equilibrium at Q

and Foreign has an autarky equilibrium at Q*. Is it possible for the countries

to gain from trade?

Fig-2: Mutual gains and basis for trade

The ultimate source and basis of gain from international trade is the difference in the

relative prices in autarky between two countries. In the fig-2, though the

preferences are different in two countries (UH for Home country and UF for Foreign

country utility level), the relative price ratio P* is the same for both the countries. So,

there is no basis for trade. Note that is the Home countrys PPF and ** is the

Foreign countrys PPF.

Hence, there is no possibility of gains from trade (as long as the relative autarky

prices differ).

Y

*

UF

UH

0 * X

Q*

Q

P*


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3) (From MMKM 8) Illustrate a case in which either or both countries couldspecialize completely in the presence of free trade. Does this possibility

invalidate the H-O theorem? What FPE?

Case 1: PPF is a straight line

Fig-3: Straight-Line PPF with CRS in both goods.

In fig-3, HH is the PPF of home country and FF is the PPF of Foreign country. Both

of the PPFs exhibits CRS and the same ratio K/L are used in producing both of the

goods. That is the factor intensity in producing both of the goods is same -a bit

relaxation of the different relative factor intensities assumption. But, due to different

factor endowments with same technology and tastes Home country can produce

more Y-goods (depicted by H) and Foreign country can produce more X -goods

(depicted by F). In autarky, Home country is producing and consuming at point E H;

and Foreign country is at point E F and both enjoying utility level U 1.

Since, the autarky price ratios are different, so there may be a basis for trade. If the

world price, P*, is reflected by the line HF , it may be possible that the Home country

will produce at point H and Foreign country will produce at F -a complete

Y

H

F

0 H F X

EH

E

EP*

U

U2


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specialization by the both countries. Both countries are consuming at point E on the

higher utility level U 2; and there is a gains from trade.

Case 2: PPF is Convex

Consider a case, where both countries (H and F) produce identical products with

identical K/L ratios. Also assume that, both the production of X and Y exhibits IRS.Both of the countrys PPF is depicted by the same convex curve . If tastes of both

the countries are symmetric, in autarky both the countries will produce and consume

at point E with utility level U 1. On the basis of comparative advantage and price

ratios, there is no basis for trade.

However, due to IRS in technology, if the world price ratio is depicted by the straight

line, , there is a possibility that both the country specialize in any one of the

goods; and consuming at point E in higher utility level U 2. So, there is a gain form

free trade.

Validity of the H-O and FPE Theorem:

The H-O Theorem: Under a set of assumptions, a country will export the

commodity that intensively uses its relatively abundant factor.

Y

U2

U1

0 X

E

E


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The FPE Theorem: Under identical CRS production technologies, free trade in

commodities will equalize relative factor prices through the equalization of relative

commodity prices, so long as both countries produce both goods.

Thus, it is evident from the first case that H-O theorem is partially valid with some

relaxation in factor intensity assumptions. In the 2nd case, C RS assumption is totallyrelaxed and H-O is not valid.

In case of FPE, It is clear that since the K/L ratio in both goods is the same in both

countries, then free trade does not cause any income distribution effects. Hence, the

FPE is not valid for both of the cases.

4) (From MMKM 8) In fig-8.4, why must the consumption points for both countrieslie on a common ray from the origin?

In this figure the consumption for both Home and Foreign country C h and Cf

respectively, lie on the same ray from the origin. This is because; the tastes and

preferences in both the countries are similar/homogeneous. Hence, all indifference

curves have same slope. As both countries faces same world price ratios with trade,

the tangency points between the indifference curves and price lines will be on the

same ray from origin. That is, in both points C h and Cf

MRS = Px/Py=P*

Y

h

Ah

Cf

f

I*h

Af I*f

P*

P*

0 h f X

Q

Ch

Qf


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5). Draw and explain the effects of a subsidy on production of X, as in Figure

MMKM 10.3. That is, you must draw the PPF, the old and new equilibrium and all the

relevant price lines (I.e. redraw figure 10.3), and also explain these effects in words.

Let, a subsidy is given to the production of X. In this case the consumers face the

world prices. Hence, the relationship among the producers, consumers and worlds

can be written as-

Px(1-s) qx Px*

-------- =------ = -------- ----- (1).

Py qy Py*

In autarky, the production takes place at point A with price ratio P*, which also

world price ratio. Now, the producers price is greater than the world as well as the

consumers due to subsidy. So, the production will move to point Q. This is because;

subsidy on X-goods encourages the producers to produce more of X -goods and less

of Y-goods. Consumption will take place along the world price line through Q. In the

figure, new consumption point is depicted by point C, in a lower indifference curve.

As a result, the consumers become worse off.

Thus, it can be said that, though government policy actions create a room for trade

(by producing at Q, the country consumes at C, less of X; thus export X), it is not

beneficial in social welfare perspective. It can be inferred that, the extra gain from

producing more of X and export of it is offset by government expense of giving

subsidies; and a decline in the national income level.

Y

P*

P

A

C

Q

P*=q

0 X

P denotes Producers Prices

q denotes Consumers prices

P* denotes world prices

s =rate of subsidy


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6). Explain briefly in what way the HOV, or factor content theorem, extends the

standard HO model.

Ans..

The Factor Content Theorem: For an arbitrary but equal number of goods and

factors, a ranking of the content of any factor in net exports divided by its content intotal output will duplicate the ranking of relative factor e ndowments.

The factor content theorem (HOV theorem) is a generalized version of the

commodity version (HO theorem) of the relationship between factor endowments

and trade flows. Both the theorem is based on same type of assumptions.

The HOV theorem basically states that a countrys relative factor abundances are

revealed by the countrys trade flows. That is, If the total production requirement for

any given factor exceeds the total consumption requirement, then the country must

be exporting the services of that factor; and vice versa. In effect, a country with

positive net exports of the services of a given factor must be relatively abundant in

that factor. Thus, HOV model is an extension of the HO model, which explains the

matter in a number of goods, factors and countries framework (HO model 2-2-2

model).

7). Have recent empirical studies (done in the 1980s) by Bowen, Leamer, and

Maskus, in general, confirmed or rejected the HOV theory? Explain.

Ans. A study by Keith Maskus (1985) attempted to as certain the implied factor

endowments in the US by examining the net exports and net imports of the services

of five broad categories of factors of production. This study revealed that, the US

data are shown to diverge from the value predicted by HOV theor em. As a result,

unrealistic outcome may be common in empirical applications of the theorem.

Another study is carried out by Bowen, Leamer and Sveikauskas (1987). This study

examined 12 different factors of production in 27 different countries. This study also

rejects the HOV theorem. That is, their empirical results showed that HOV theorem

is failed to predict trade better than a coin toss.

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International Trade Part II