Econ 231(002) -Introduction to International Economics

Department of Economics
University of Waterloo

Solution key for assigned questions from textbook:

Chapter 1
1. We saw that not only is GDP important in explaining how much two
countries trade, but also,
distance is crucial. Given its remoteness, Australia faces relatively high costs
of transporting imports and exports, thereby reducing the attractiveness of
trade. Since Canada has a border with a large economy (the U.S.) and
Australia is not near any other major economy, it makes sense that Canada
would be more open and Australia more self-reliant.

2. Mexico is quite close to the U.S., but it is far from the European Union
(EU). So it makes sense that it trades largely with the U.S. Brazil is far from
both, so its trade is split between the two. Mexico trades more than Brazil in
part because it is so close to a major economy (the U.S.) and in part because
it is a member of a free trade agreement with a large economy (NAFTA).
Brazil is farther away from any large economy and is in a free trade
agreement with relatively small countries.

3. Skip question 3

4. As the share of world GDP which belongs to East Asian economies grows,
then in every trade
relationship which involves an East Asian economy, the size of the East Asian
economy has grown. This makes the trade relationships with East Asian
countries larger over time. The logic is similar for why the countries trade
more with one another. Previously, they were quite small economies,
meaning that their markets were too small to import a substantial amount.
As they became more wealthy and the consumption demands of their
populace rose, they were each able to import more. Thus, while they
previously had focused their exports to other rich nations, over time, they
became part of the rich nation club and thus were targets for one another’s
exports.

5. As the chapter discusses, a century ago, much of world trade was in

commodities that in many ways were climate or geography determined.
Thus, the UK imported goods that it could not make itself. This meant
importing things like cotton or rubber from countries in the Western
Hemisphere or Asia. As the UK’s climate and natural resource endowments
were fairly similar to those in the rest of Europe, it had less of a need to
import from other European countries. In the aftermath of the Industrial
Revolution, where manufacturing trade accelerated and has continued to
expand with improvements in transportation and communications, it is not
surprising that the UK would turn more to the nearby and large economies in
Europe for much of its trade. This is a direct prediction of the gravity model.

Chapter 2
1. a. The production possibility curve is a straight line that intercepts the
apple axis at 400(1200/3) and the banana axis at 600(1200/2).

Banana

600

400 Apple

b. The opportunity cost of apples in terms of bananas is 3/2.

c. Labour mobility ensures a common wage in each sector and competition

ensures the price of
goods equal their cost of production. Thus, the relative price equals the
relative costs, which
equals the wage times the unit labour requirement for apples divided by the
wage times the unit labour requirement for bananas. Since wages are equal
across sectors, the price ratio equals the ratio of the unit labour requirement,
which is 3 apples per 2 bananas.

2. a. The production possibility curve is linear, with the intercept on the

apple axis equal to 160(800/5) and the intercept on the banana axis equal to
800(800/1).
Banana

800

160 Apple

b. The world relative supply curve is constructed by determining the supply

of apples relative to the supply of bananas at each relative price. The lowest
relative price at which apples are harvested is 3 apples per 2 bananas. The
relative supply curve is flat at this price. The maximum number of apples
supplied at the price of 3/2 is 400 supplied by Home while, at this price,
Foreign harvests 800 bananas and no apples, giving a maximum relative
supply at this price of 1/2. This relative supply holds for any price between
3/2 and 5. At the price of 5, both countries would harvest apples. The relative
supply curve is again flat at 5. Thus, the relative supply curve is step shaped,
flat at the price 3/2 from the relative supply of 0 to 1/2, vertical at the
relative quantity 1/2 rising from 3/2 to 5, and then flat again from 1/2 to
infinity.

Relative price of apple

5
1.5

1/2 Relative quantity of apple/relative

quantity of banana

3. a. The relative demand curve includes the Points (1/5, 5), (1/2, 2), (1, 1),
(2, 1/2).

b. The equilibrium relative price of apples is found at the intersection of the

relative demand and relative supply curves. This is the Point (1/2, 2), where
the relative demand curve intersects the vertical section of the relative
supply curve. Thus the equilibrium relative price is 2.
c. Home produces only apples, Foreign produces only bananas, and each
country trades some of its product for the product of the other country.
d. In the absence of trade, Home could gain three bananas by foregoing two
apples, and Foreign could gain by one apple foregoing five bananas. Trade
allows each country to trade two bananas for one apple. Home could then
gain four bananas by foregoing two apples while Foreign could gain one
apple by foregoing only two bananas. Each country is better off with trade.

4. The increase in the number of workers at Home shifts out the relative
supply schedule such that the corner Points are at (1, 3/2) and (1, 5), instead
of (1/2, 3/2) and (1/2, 5). The intersection of the relative demand and relative
supply curves is now in the lower horizontal section, at the Point (2/3, 3/2). In
this case, Foreign still gains from trade but the opportunity cost of bananas
in terms of apples for Home is the same whether or not there is trade, so
Home neither gains nor loses from trade.

5. This answer is identical to that in 3. The amount of “effective labour” has

not changed.

Chapter 4:
2. a. The box diagram has 600 as the length of two sides (representing
labour) and 60 as the length of the other two sides (representing land).
There will be a ray from each of the two corners representing the origins. To
find the slopes of these rays we use the information from the question
concerning the ratios of the production coefficients. The question states that
aLC/aTC = 20 and aLF/aTF = 5.
Since aLC/aTC = (Lc/QC)/(TC/QC) = LC/TC we have LC = 20TC. Using the same
reasoning,
aLF/aTF = (LF/QF)/(TF/QF) = LF/TF and since this ratio equals 5, we have LF = 5TF.
We can
solve this algebraically since L = LC + LF = 600 and T = TC + TF = 60.

The solution is LC = 400, TC = 20, LF = 200 and TF = 40.

b. The dimensions of the box change with each increase in available labour,
but the slopes of the rays from the origins remain the same. The solutions in
the different cases are as follows.
L = 800: TC = 33.33, LC = 666.67, TF = 26.67, LF = 133.33
L = 1000: TC = 46.67, LC = 933.33, TF = 13.33, LF = 66.67
L = 1200: TC = 60, LC = 1200, TF = 0, LF = 0. (complete specialization).

c. At constant factor prices, some labour would be unused, so factor prices

would have to change, or there would be unemployment.

3. What matters is not the absolute abundance of factors, but their relative
abundance. Poor countries have an abundance of labour relative to capital
when compared to more developed countries.

4. In the Ricardian model, labour gains from trade through an increase in its
purchasing power. This result does not support labour union demands for
limits on imports from less affluent countries. The Heckscher-Ohlin model
directly addresses distribution by considering the effects of trade on the
owners of factors of production. In the context of this model, unskilled U.S.
labour loses from trade since this group represents the relatively scarce
factors in this country. The results from the Heckscher-Ohlin model support
labour union demands for import limits. In the short run, certain unskilled
unions may gain or lose from trade depending on in which sector they work,
but in theory, in the longer run, the conclusions of the Heckscher-Ohlin
model will dominate.

6. The factor proportions theory states that countries export those goods
whose production is intensive in factors with which they are abundantly
endowed. One would expect the United States, which has a high
capital/labour ratio relative to the rest of the world, to export capital-
intensive goods if the Heckscher-Ohlin theory holds. Leontief found that the
United States exported labour-intensive goods. Bowen, Leamer and
Sveikauskas found for the world as a whole the correlation between factor
endowment and trade patterns to be tenuous. The data do not support the
predictions of the theory that countries’ exports and imports reflect the
relative endowments of factors.
Chapter 5:

5. The terms of trade of Japan, a manufactures (M) exporter and a raw

materials (R) importer, is the world relative price of manufactures 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 (manufactures 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.
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, decreasing the world relative price of manufactured
goods and deteriorating Japan’s terms of trade.

b. Korea’s increased automobile production increases the supply of

manufactures, which increases the world RS. The world relative supply curve
shifts out, decreasing the world relative price of manufactured goods and
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 RD, and the world relative demand curve shifts out,
increasing the world relative price of manufactured goods and improving
Japan’s terms of trade. This 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 RS. The world relative supply curve shifts out. Also,
Russia’s demand for manufactures decreases, which reduces world demand
so that the world relative demand curve shifts in. These forces decrease the
world relative price of manufactured goods and deteriorate Japan’s terms of
trade.

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 RS and decrease Japan’s RD, which
increases the world
RS and decreases the world RD (i.e., world RS shifts out and world RD shifts
in). The world
relative price of manufactures declines and Japan’s terms of trade
deteriorate.

7. 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 favours production of Good X, while an increase in the labour
supply favours 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 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.

8. Immiserizing growth occurs when the welfare deteriorating effects of a

worsening in an economy’s terms of trade offset 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.

Skip Question 10 & 11.