UC3M

INTERNATIONAL TRADE
Problem Set 1

Part 1 - The Introduction

1. How the relative importance of the foreign sector is usually measured in most countries? i

2. Surprisingly enough, the relative size of the foreign sector is bigger in Belgium than in Japan
or USA. Could you explain this fact?

3. Could the relative size of exports (with respect to GDP) can be higher than 100 %?

4. In most regions the transportation costs as percentage of the total cost has been dropping, but
tis has not been the case in the developing Asia (which includes China, India and Indonesia).
Could you explain this surprising fact?

Part 2 - Ricardo Model (The Intuition)

INSTRUCTIONS - For each of the following two questions choose the correct answer. Justify why
the answer you chose is correct but ALSO explain why the other choices are incorrect. Midterm and
final exams are multiple choice, thus the objetive of this questions, besides reviewing class material,
is to prepare you towards both exams.

1 - Mytown (M) and Yourtown (Y) have just opened their borders to free trade. Mytown is
exporting Laptops (L) while Yourtown exports Food (F) , then it MUST be the case that the
labor requirements satisfy (where ai,c represents the labor requirements in country c in order
to produce one unit of good i.

a) aM,L > aY,L

b) aM,L < aY,L
c) aM,F > aY,F
d) aM,L /aY,L < aM,F /aY,F

2 - Northon (N ) and Southon (S) have just opened their borders to free trade. Two goods
are produced: mobile phones (m) and champagne (c). The labor requirements are such that
aN,m = 2aS,m and aN,c = 4aS,c (where ai,g represents the labor requirements in country i in
order to produce one unit of the good (g). From the provided data we can deduct that:

a) Norton has an absolute advantage in the production of champagne and a comparative

disadvantage in the production champagne.
b) None of the other.
 c) Norton has an absolute disadvantage in the production of Mobile Phones and a
comparative advantage in mobile phones
d) Southon has an absolute advantage in both goods and has a comparative advantage
in mobile phones.

3 - Build a numerical example with two goods (different than the one presented in the Magistral
session), where you can prove that a country that is more productive in both commodities can
still benefit from trading with a country that is less productive in all sectors. HINT: Compensate
with more workers the country with the worst technology (next session you will understand
why is necessary to do this).

4 - i) A country should exports the goods with low production costs and import the goods with
high domestic production costs. Is this statement true or false? (justify your answer) ii) Many
people (many well known politicians among them) believe that free trade is beneficial only if a
country is strong enough to withstand foreign competition. Do you agree with this statement?

Part 3 - Ricardo Model (The Math)

5 - Consider two countries, Mytown and Yourtown. Two goods are produced: mobile phones
and champagne. In Mytown the unit labour requirements for mobile phones and champagne
are 10 units and 10 units respectively. In Yourtown the unit labour requirements for mobile
phones and champagne are 40 and 10 units respectively. Mytown has a labor force of 100 units
while Yourtown has a labor force equal to 200 units.

a) Describe the absolute and relative (comparative) advantages from each country.
b) Find the equation that represents the production possibility frontier (PPF) of Mytown
and YourTown and draw a graph of each.
c) Find the autarchy equilibrium prices and explain why is this the case.
d ) Consider the relative price P m/P c = 2. If firms maximize profit, at this relative prices
find the production levels from each country (also show this result in the PPF graphs you
draw for each country).
e) Find the GDP of both countries if P m/P c = 2 (you can use your answer to the previous
question). Hint: GDP is the value of production of a country, that is: GDP = Pm Qm +
Pc Qc . Since we only have information about relative prices (i.e. Pm/Pc) and we know
nothing about absolute prices, the value of GDP is not a number and it will be in terms
of one of the prices. Another choice is to find the GDP in terms of Mobile Phones or
Champagne.
f ) It is time for consumers to maximize their utility and derive the demand function. In
order to make the exercise more simple, assume that each country has one representative
consumer that receives all the GDP as incomer (i.e. GDP = Y). Find the demand for
mobile and champagne for each country when P m/P c = 2. Before answering the question,
you need a demand function. Probably you larned fron Antonio that if the utility function
1/2 1/2
is U (CM , CC ) = CM CC , where CM represents the quantity consumed of mobile phones,
 and CC the consumption of champagne, then the demand for champagne is Dc = Y /(2Pc )
and the demand of mobile is represented by Dm = Y /(2Pm ). I you do not remember that,
do not worry, just take the demand functions as the data from this problem set. Now all
you have to do is to substitute the GDP data and the relative price information into the
demand function and you will find the demand for each good in each country.
g) Is P m/P c = 2 a world equilibrium relative prices? (are exports are equal to imports?)
h) Has welfare increase? Prove for Mytown that welfare has increase (i.e. compare the con-
sumption before trade and after trade). MAKE A GRAPH OF THIS RESULT (if you
want to prove it also for Yourtown, you are welcome to do it). You also have have an al-
ternative method: you can substitute the consumption quantities into the utility function
and see if the utility has increased after trade. To calculate the consumption levels under
autarchy can be a little bit tricky since at autarchy prices, firms are willing to produce at
any point along the PPF, then which point you should choose in order to calculate the
GDP (=Y)? Very easy, since at autarchy prices any point along the PPF gives the same
level of GDP, you can choose an arbitrary point.
i ) Now assume that Yourtown has 400 workers instead than 200. What your intuition tells
you about the change in welfare at Yourtown if they open to trade? With how many
workers is the welfare higher? With 400 or 200?