Notes on exam in International Economics, 16 January, Answer the following five questions in a short and concise fashion: (5 points each)

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1 Question 1. (25 points) Notes on exam in International Economics, 16 January, 2009 Answer the following five questions in a short and concise fashion: (5 points each) a) What are the main differences between the Ricardian and the Heckscher-Ohlin model of trade? One versus two factors Technology versus relative factor abundance as a source of comparative advantage Opportunity cost constant in R, varies in HO Complete specialization in R, typically incomplete specialization in HO R can assess issues related to international wage differentials, while HO can assess issues related to internal income distribution. b) What does the factor price equalization theorem say? Free trade alone can equalize absolute (not only relative) factor prices, provided both countries continue producing both goods with free trade. c) What are the main differences between monopoly and monopolistic competition? Free entry and exit in monopolistic competition but not in monopoly (monopoly makes profits, in monopolistic competition a potential new entrant cannot make non-negative profits), in monopoly there is one firm whereas the number of firms is endogenous in monopolistic competition. Typically there is product differentiation in monopolistic competition so that each firm has market power over its own variety but other firms produce sufficiently close substitutes for profits to be exhausted in equilibrium. d) Explain why an increase in terms-of-trade has a positive effect on welfare. Because it makes it possible to get more imports from a given amount of exports (or get a given amount of imports for a smaller amount of exports). e) Explain briefly the so-called transfer problem. The question whether an income transfer from one country to another creates an additional burden for the donor because of a terms-of-trade deterioration. Was discussed in connection with German war reparations after WWI. Keynes argued that the reparations hurt the German economy not only because of the transfer itself, but because of a terms-of-trade deterioration as well. Ohlin explained that the effect of an income transfer on terms-of-trade depends on the spending pattern on the margin in the countries involved. Only if they differ, there will be changes in terms-of-trade and only if the donor country spends a higher proportion on its export good than the receiving country will there be a decrease in the donor s terms-of-trade. Question 2. (25 points)

2 According to the Krugman-Obstfeld book, interindustry trade reflects comparative advantage while intraindustry trade reflects scale economies and demand for product variation. a) Explain the difference between interindustry and intraindustry trade. (5) Interindustry trade is the exchange of different types of goods between countries, e.g. the exchange of food for clothes. Intraindustry trade is the simultaneous export and import within the same narrowly defined product group, e.g. exports and imports of cars. b) Explain why countries that are similar in terms of technology and relative factor endowments are predicted to have a relatively large share of intraindustry trade. (10) This can be seen by using a two-country, two-sector model where differences in technology or relative factor endowments create scope for trade according to comparative advantages at the same time as scale economies and product differentiation in one of the sectors create scope for intraindustry trade. Suppose the two sectors are producing food and cloth. Food is labor intensive while cloth is capital intensive. In the cloth industry there are internal scale economies and product differentiation. Because of consumer preferences for product variation, a cloth producer sells its particular variety of cloth to consumers in both countries. On the assumption that there are differences in relative factor endowments, the relatively capital abundant country will be a net exporter of cloth while the relatively labor abundant country will be net exporter of food. But all cloth producers in the labor abundant country will export some of its output, generating intraindustry trade in cloth. The trade pattern will look something like this:

3 Home (capital abundant) Cloth Food Interindustry trade Foreign (labor abundant) Intraindustry trade The smaller the difference in relative factor endowments, the less scope there is for specialization according to comparative advantage. This means that there is less net exports of food and cloth, implying that the upper part of the figure above (the part above the broken line) becomes smaller. This corresponds to a situation where the share of intraindustry trade in total trade becomes larger. c) What are the different sources of gains from trade between countries that conduct both interindustry and intraindustry trade? (10) Interindustry trade generates gains from specialization according to comparative (and gains from exchange), which leads to expanded consumption possibilities. Intraindustry trade generates gains in the form of better exploitation of scale economies, leading to lower average costs and lower consumer prices. Consumer prices may also be pushed downward by increased competition and squeezed markups. Intraindustry trade also generates benefits in terms of an increased availability of product variety. Question 3. (30 points) The effect of labour migration is very much debated and the outcome may differ depending on labour market institutions and on whether we are studying migration in an international or regional context. a) Use a one-good model to analyze the effect of labour migration on real wages and welfare assuming that there are two factors of production, capital and labour, and two countries, Home and Foreign. Home is relatively capital abundant compared to Foreign, there are constant returns to scale in production and all markets are competitive. (15) The marginal product of labor decreases with labor input, for a given capital stock. The initial situation is indicated by superscript 1 in the following diagram:

4 w/p w*/p* (w/p) 1 A (w/p) 2 =(w*/p*) 2 B (w*/p*) 1 C MPL* MPL migration Total labor supply With the initial allocation of the total labor supply between Home and Foreign (indicated by asterisk), the real wage is higher in Home than in Foreign. This creates incentive for labor migration from Home to Foreign. Migration will occur until real wages are equalized, indicated by superscript 2. Compared to the initial situation, real wages have fallen in Home and increased in Foreign. Total world welfare has increased because more output can be produced with the resulting allocation of labor. The increase in output is represented by the triangle ABC. Capital owners in Home benefit from the increased labor supply through an increase in the real return to capital, while the opposite happens in Foreign. b) Discuss how the conclusions in a) may change if labour markets are regulated and wages set by negotiations between trade unions and employers rather than characterized by perfect competition. (8) If wages are set by negotiations between trade unions and employers, the incentives for migration are likely to be significantly weaker. Collective bargaining makes it difficult for immigrant labor to undercut wages. Because of asymmetric information an employer is likely to hire a local workers rather than an immigrant worker if the pay is the same. Therefore, the probability of finding a job may be rather low. This probability matters for the migration decision. In this case migration may become highly pro-cyclical so that it increases when unemployment becomes low and decreases when unemployment becomes high. For highly specialized labor the probability of finding a job may be relatively high even during a downturn and therefore such workers may still migrate.

5 c) Suppose that Home and Foreign are identical with respect to endowments of labour and capital and that there are external economies in production making labour productivity increase with the scale of production. How might this change the conclusions of the effect of labour migration in a)? (7) If labor productivity increases with the scale of operation the curves showing the marginal product of labor (MPL) in the diagram above will be upward instead of downward sloping. If Home and Foreign are completely identical to start with, real wages will be the same and there are no incentives for migration. However, if there is a small shock that makes the allocation of labor deviate from a completely equal distribution, a process of migration from the country with the relatively smaller labor force to the country with the relatively larger labor force will start. A stable equilibrium will entail complete concentration of the labor force in out of the countries. Question 4. (20 points) In the current recession there have been calls for government support of export industries in most countries. One example of this is the call for government support of the car manufacturing industry in Sweden. What would be the expected long-term effects of subsidies to the Swedish car industry based on models of international trade? The easiest way to answer the questions is to assume that a subsidy to the car industry is tantamount to an export subsidy (analyzing the effect of a production subsidy would be even better but not needed to get full score) and that Sweden faces given world market prices. A costbenefit analysis of the subsidy would be captured by the following diagram: P S P*+s P* Exports with subsidy D Q

6 Exports increase because domestic output increases at the same time as domestic consumption decreases. There are efficiency losses associated with this, represented by the blue triangles. The left hand side triangle represents the loss that arise because there are now some potential consumers whose willingness to pay exceeds the world market prices, but who now will not consume Swedish cars because the price in Sweden is too high. The right hand side triangle represents the loss that arise because Swedish car producers are induced to produce cars although they cannot produce them at the same low cost as the producers selling in the world market. The subsidy also entails a redistribution of income from consumers and tax payers to the car manufacturers. If these are the only effects, the subsidy is bound to generate a welfare loss. However, there might be benefits associated with externalities or other types of market failures that the analysis above does not take into account. For instance, the car producers might generate knowledge spillovers that bring benefits to other firms operating in the economy. In that case, car production might generate marginal social benefits that should be factor into the analysis. An example is illustrated below: Marginal social benefit Q If output increases as the arrow shows, there are benefits for society captured by the area with blue borders. The net welfare effect of the subsidy would then be given by the difference between this area and the sum of the two triangles in the diagram above. Whether the car industry generates such social benefits is an open question. Any economic argument for subsidizing the industry however has to rely on the presence of such benefits.