Suggested Solutions to Assignment 3 - Wilfrid Laurier University

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EC 239. Introduction to International Trade. Instructor: Sharif F. Khan. Department of Economics. Wilfrid Laurier University. Winter 2010. Suggested Solutions to ...
EC 239 Introduction to International Trade Instructor: Sharif F. Khan

Department of Economics Wilfrid Laurier University Winter 2010

Suggested Solutions to Assignment 3 (Optional) Part B

Short Questions

B1. Question # 8 of Ch 5 (8th ed. of the textbook) Immiserizing growth occurs when the welfare deteriorating effects of a worsening in an economy’s terms of trade swamp the welfare improving effects of growth. For this to occur, an economy must undergo very biased growth, and the economy must be a large enough actor in the world economy such that its actions spill over to adversely alter the terms of trade to a large degree. This combination of events is unlikely to occur in practice. B2. Question # 9 of Ch 5 (8th ed. of the textbook) India opening should be good for the U.S. if it reduces the relative price of goods that China sends to the U.S. and hence increases the relative price of goods that the U.S. exports. Obviously, any sector in the U.S. hurt by trade with China would be hurt again by India, but on net, the U.S. wins. Note that here we are making different assumptions about what India produces and what is tradable than we are in Question #6 of Ch 5. Here we are assuming India exports products the U.S. currently imports and China currently exports. China will lose by having the relative price of its export good driven down by the increased production in India. B3. Question # 10 of Ch 5 (8th ed. of the textbook) Aid which must be spent on the exports from the donor country increases the demand for those export goods and raises their price relative to other goods. There will be a terms of trade deterioration for the recipient country. This can be viewed as a polar case of the effect of a transfer on the terms of trade. Here, the marginal propensity to consume the export good by the recipient country is 1. The donor benefits from a terms of trade improvement. As with immiserizing growth, it is theoretically possible that a transfer actually worsens the welfare of the recipient.

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B4. Question # 11 of Ch 5 (8th ed. of the textbook) When a country subsidizes its exports, the world relative supply and relative demand schedules shift such that the terms of trade for the country worsen. A countervailing import tariff in a second country exacerbates this effect, moving the terms of trade even further against the first country. The first country is worse off both because of the deterioration of the terms of trade and the distortions introduced by the new internal relative prices. The second country definitely gains from the first country’s export subsidy, and may gain further from its own tariff. If the second country retaliated with an export subsidy, then this would offset the initial improvement in the terms of trade; the “retaliatory” export subsidy definitely helps the first country and hurts the second. B5. Question # 1 of Ch 6 (8th ed. of the textbook) Cases a and d reflect external economies of scale since concentration of the production of an industry in a few locations reduces the industry’s costs even when the scale of operation of individual firms remains small. External economies need not lead to imperfect competition. The benefits of geographical concentration may include a greater variety of specialized services to support industry operations and larger labor markets or thicker input markets. Cases b and c reflect internal economies of scale and occur at the level of the individual firm. The larger the output of a product by a particular firm, the lower its average costs. This leads to imperfect competition as in petrochemicals, aircraft, and autos. B6. Question # 6 of Ch 6 (8th ed. of the textbook) This is an open-ended question. Looking at the answer to Question B11 (Question # 11 of Ch 6) can provide some hints. Two other examples would be: Biotechnology and Aircraft design. Biotechnology is an industry in which innovation fuels new products, but it is also one where learning how to successfully take an idea and create a profitable product is a skill set that may require some practice. Aircraft design requires both innovations to create new planes that are safer and or more cost efficient, but it is also an industry where new planes are often subtle alterations of previous models and where detailed experience with one model may be a huge help in creating a new one.

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B7. Question # 7 of Ch 6 (8th ed. of the textbook) a. The relatively few locations for production suggest external economies of scale in production. If these operations are large, there may also be large internal economies of scale in production. b. Since economies of scale are significant in airplane production, it tends to be done by a small number of (imperfectly competitive) firms at a limited number of locations. One such location is Seattle, where Boeing produces airplanes. c. Since external economies of scale are significant in semiconductor production, semiconductor industries tend to be concentrated in certain geographic locations. If, for some historical reason, a semiconductor is established in a specific location, the export of semiconductors by that country is due to economies of scale and not comparative advantage. d. “True” scotch whiskey can only come from Scotland. The production of scotch whiskey requires a technique known to skilled distillers who are concentrated in the region. Also, soil and climactic conditions are favorable for grains used in local scotch production. This reflects comparative advantage. e. France has a particular blend of climactic conditions and land that is difficult to reproduce elsewhere. This generates a comparative advantage in wine production. B8. Question # 8 of Ch 6 (8th ed. of the textbook) The Japanese producers are price discriminating across United States and Japanese markets, so that the goods sold in the United States are much cheaper than those sold in Japan. It may be profitable for other Japanese to purchase these goods in the United States, incur any tariffs and transportation costs, and resell the goods in Japan. Clearly, the price differential across markets must be non-trivial for this to be profitable. B9. Question # 9 of Ch 6 (8th ed. of the textbook) a. Suppose two countries that can produce a good are subject to forward-falling supply curves and are identical countries with identical curves. If one country starts out as a producer of a good, i.e., it has a head start even as a matter of historical accident, then all production will occur in that particular country and it will export to the rest of the world. b. Consumers in both countries will pay a lower price for this good when external economies are maximized through trade and all production is located in a single market. In the present example, no single country has a natural cost advantage or is worse off than it would be under autarky.

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B10. Question # 10 of Ch 6 (8th ed. of the textbook) External economies are important for firms as technology changes rapidly and as the “cutting edge” moves quickly with frequent innovations. As this process slows, manufacturing becomes more routine and there is less advantage conferred by external economies. Instead, firms look for low cost production locations. Since external economies are no longer important, firms find little advantage in being clustered, and it is likely that locations other than the high-wage original locations are chosen. B11. Question # 11 of Ch 6 (8th ed. of the textbook) i. Very likely due to the need to have a common pool of labor with such skills. ii. Somewhat likely due to the need for continual innovation and learning. b. i. Unlikely since it is difficult to see how the costs of a single firm would fall if other firms are present in the asphalt industry. ii. Unlikely because they are industries in which technology is more stable than in other industries such as software services or cancer research. c. i. Highly likely because having a great number of support firms and an available pool of skilled labor in filmmaking are critical to film production. ii. Highly likely because film making is an industry in which learning is important. d. i. Somewhat likely in that it may be advantageous to have other researchers nearby. ii. Highly likely because such research builds on itself through a learning-bydoing process. e. i. Unlikely because it is difficult to see how the existence of another timber firm with lower costs to another timber firm. ii. Unlikely due to the relatively stable technology involved in timber harvesting.

a.

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Part C

Problem Solving Questions

Read each part of the question very carefully. Show all the steps of your calculations to get full marks.

C1.

Question # 5 of Ch 5 (8th ed. of the textbook)

The terms of trade of Japan, a manufactured goods (M) exporter and a raw materials (R) importer, is the world relative price of manufactured goods in terms of raw materials (PM /PR). The terms of trade change can be determined by the shifts in the world relative supply and demand (manufactured goods relative to raw materials) curves. Note that in the following answers, world relative supply (RS) and relative demand (RD) are always M relative to R. We consider all countries to be large, such that changes affect the world relative price. Assume that the initial world relative supply is RS 1 , the initial world relative demand is RD1 and the initial equilibrium world relative price of manufactured P goods in terms of raw materials is  M  PR Figure C1.

1

  , which are illustrated in all of the subplots in 

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a. Oil supply disruption from the Middle East decreases the supply of raw materials, which increases the world relative supply. The world relative supply curve shifts out, which is shown as a rightward shift from RS 1 to RS 2 in Figure C1(a/b). As a result, the equilibrium world relative price of manufactured goods P decreases from  M  PR

1

2

 P   to  M  , deteriorating Japan’s terms of trade.   PR 

b. Korea’s increased automobile production increases the supply of manufactured goods, which increases the world relative supply. The RS curve shifts out, which is shown as a rightward shift from RS 1 to RS 2 in Figure C1(a/b). As a result, the P equilibrium world relative price of manufactured goods decreases from  M  PR P to  M  PR

  

1

2

  , deteriorating Japan’s terms of trade. 

c. U.S. development of a substitute for fossil fuel decreases the demand for raw materials. This increases world relative demand for manufactured goods, and the RD curve shifts out, which is shown as a rightward shift from RD 1 to RD 2 in Figure C1(c). As a result, the equilibrium world relative price of manufactured 1

2

P  P  goods increases from  M  to  M  , improving Japan’s terms of trade. This  PR   PR  occurs even if no fusion reactors are installed in Japan since world demand for raw materials falls.

d. A harvest failure in Russia decreases the supply of raw materials, which increases the world relative supply of manufactured goods. The world relative supply curve shifts out, which is shown as a rightward shift from RS 1 to RS 2 in Figure C1(d/e). Other things remaining constant, a harvest failure leads to a decrease in income of a representative household in Russia. So, Russia’s demand for both manufactured goods and raw materials decreases. Based on the assumption that the income elasticity of the demand for the manufactured goods is relatively higher than that of the demand for raw materials in Russia, we can predict that the decrease in the demand for the manufactured goods would be higher than the fall in the demand for raw materials in Russia. As a result, the world relative demand would decrease so that the world relative demand curve shifts in, which is shown as a leftward shift from RD 1 to RD 2 in Figure C1(d/e). These forces decrease the equilibrium world relative price of manufactured P goods from  M  PR

1

2

 P   to  M  and deteriorate Japan’s terms of trade.   PR 

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e. A reduction in Japan’s tariff on raw materials will raise its internal relative price of manufactures. This price change will increase Japan’s relative supply of manufactured goods and decrease Japan’s relative demand for manufactured goods, which increases the world relative supply of manufactured goods and decreases the world relative demand for manufactured goods, (i.e., RS shifts out and RD shifts in). These two effects are shown, respectively, as a rightward shift from RS 1 to RS 2 and a leftward shift from RD 1 to RD 2 in Figure C1(a/b). The equilibrium world relative price of manufactures declines from  PM   PR

C2.

 PM   PR

1

  to 

2

  and Japan’s terms of trade deteriorates. 

Question # 7 of Ch 5 (8th ed. of the textbook) These results acknowledge the biased growth which occurs when there is an increase in one factor of production. An increase in the capital stock of either country favors production of Good X, while an increase in the labor supply favors production of Good Y. Also, recognize the Heckscher-Ohlin result that an economy will export that good which uses intensively the factor which that economy has in relative abundance. Country A exports Good X to Country B and imports Good Y from Country B. The possibility of immiserizing growth makes the welfare effects of a terms of trade improvement due to export-biased growth ambiguous. Import-biased growth unambiguously improves welfare for the growing country. a. A’s terms of trade worsen, A’s welfare may increase or, less likely, decrease, and B’s welfare increases. b. A’s terms of trade improve, A’s welfare increases and B’s welfare decreases. c. B’s terms of trade improve, B’s welfare increases and A’s welfare decreases. d. B’s terms of trade worsen, B’s welfare may increase or, less likely, decrease, and A’s welfare increases.

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C3.

Question # 4 of Ch 6 (8th ed. of the textbook) Although this problem is a bit tricky and the numbers don’t work out nicely, a solution does exist. The first step in finding the solution is to determine the equilibrium number of firms in the industry. The equilibrium number of firms is that number, n, at which price equals average cost. We know that AC = F/Q + c, where F represents fixed costs of production, Q represents the level of sales by each firm, and c represents marginal costs. We also know that P = c + (1/bn), where P and b represent price and the demand parameter. Also, if all firms follow the same pricing rule, then Q = S/n where S equals total industry sales. So, set price equal to average cost, cancel out the c’s and replace Q by S/n. Rearranging what is left yields the formula n2 = S/Fb. Substitute in S = 900,000 + 1,600,000 + 3,750,000 = 6,250,000, F = 750,000,000 and b = 1/30,000. The numerical answer is that n = 15.8 firms. However, since you will never see 0.8 firms, there will be 15 firms that enter the market, not 16 firms since the last firm knows that it can not make positive profits. The rest of the solution is straight-forward. Using Q = S/n, output per firm is 41,666 units. Using the price equation, and the fact that c = 5,000, yields an equilibrium price of $7,000.

C4.

Question # 5 of Ch 6 (8th ed. of the textbook)

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a. The equilibrium number of firms is that number, n, at which price equals average cost. We know that AC = F/Q + c, where F represents fixed costs of production, Q represents the level of sales by each firm, and c represents marginal costs. Since all firms are symmetric in this problem, in equilibrium they all will charge the same price. When all firms charge the same price, we know that Q = S/n holds where S equals total industry sales or the size of the market. Replacing Q by S/n in the average cost equation, we get AC = F/( S/n) + c=n(F/S)+c. It is given that F=$5 billion and the variable costs are equal to $17,000 per finished automobile. The variable cost for each unit of finished automobile is nothing but marginal costs, c. So, replacing F by $5 billion and c by $17,000 in the average cost equation, we get:  5,000,000,000  AC = n ×   + 17,000 S   It is also given that,

(1)

 150  (2) P = 17,000 +    n  We can find the equilibrium number of firms, n, by solving the following equation. P = AC  150   5,000,000,000  ⇒ 17,000 +   = n×  + 17,000 [Using Equation (1) and (2)] S  n     150   5,000,000,000  ⇒  = n×  S  n    150 S   ⇒ n2 =    5,000,000,000  150 S   So, n =  .  5,000,000,000 

(3)

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It is given that the initial size of the U.S. automobile market, SUS , is 300 million. So, the equilibrium number of firms in the U.S. automobile market, nUS , without trade is:

 150 SUS  nUS =    5,000,000,000 

[Using Equation (3)]

 150 × 300,000,000  ⇒ nUS =  = 9  5,000,000,000  So, n US = 3. It is also given that the initial size of the European automobile market, S EU , is 533 million. So, the equilibrium number of firms in the European automobile market, n EU , without trade is:

 150 S EU  n EU =    5,000,000,000 

[Using Equation (3)]

 150 × 533,000,000  ⇒ n EU =    5,000,000,000  So, n US = 3.999 ≅ 4.

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b. The equilibrium price of the automobiles in the U.S. without trade is: PUS = 17,000 + 150 nUS ⇒ PUS = 17,000 + 150 / 3 . So, PUS = 17,050. The equilibrium price of the automobiles in Europe without trade is: PEU = 17,000 + 150 n EU ⇒ PEU = 17,000 + 150 / 4 . So, PEU = 17,037.50 .

c. With free trade in automobiles between the U.S. and Europe, the size of the automobile market becomes SUS + EU = SUS + S EU = 300 + 533 = 833 million. So, the equilibrium number of firms in the U.S. and Europe combined, nUS + EU , with trade is:

 150 SUS + EU  nUS + EU =    5,000,000,000 

[Using Equation (3)]

 150 × 833,000,000  ⇒ nUS + EU =    5,000,000,000  So, n US + EU = 4.999 ≅ 5 . [Note: This result helps to explain some of the consolidation that has happened in the industry. Since trade has become more free in recent decades, e.g., Ford acquiring Jaguar, Daimler-Benz acquiring Chrysler, etc.] The new equilibrium price of the automobiles in the U.S. and Europe with trade is: PUS + EU = 17,000 + 150 nUS + EU ⇒ PUS + EU = 17,000 + 150 / 5 . So, PUS + EU = 17,030.

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d. The equilibrium prices in the united states are different in (c) than in (b) because in (c), with free trade, the number of automobile firms in the combined are 5 but in (b), without trade, the number of automobile firms in the U.S. are 3. An increase in the number of numbers raises the competition among firms. As a result, each firm charges a lower price in (c) than in (b). Prices fall in the United States as well as Europe to $17,030. Also, the variety of automobiles increases in both markets: in the United States, consumers were able to choose between three brands before free trade; now they can choose between five. In Europe, consumers were able to choose between four brands before free trade; now they can also choose between five brands. So, because of a lower price of automobiles and an increase in the variety of automobiles, the consumers in the U.S. and Europe are be better off with free trade.

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