Charles van Marrewijk, 2017 International Trade Oxford University Press

Transcription

1 Review questions Chapter 1 QUESTION 0-1 The difference between GDP converted by the current and the PPP exchange rate can be illustrated with a simple example. Assume that Germany and Poland both produce every year a thousand machines (to remove oil remains) and five hundred pedicure treatments. Machines can be traded between both countries while pedicure treatments cannot be traded. Further assume that the current exchange rate is one euro for four Polish zloty, the hourly wage in Germany is 10 euro and the number of hours it takes to produce one machine or to give one pedicure treatment in both countries is given in the following table: Number of hours to produce one unit Germany Poland Machine Pedicure treatment 2 2 a. If machine producers do not make any profit, what is the price of a machine in Germany (in euro) and in Poland (in zloty)? b. What is the hourly wage rate in Poland? c. If also pedicures do not make any profit, what is the price of a pedicure treatment in Germany (in euro) and in Poland (in zloty)? d. What is the GDP figure in Germany (in euro) and in Poland (in zloty)? e. What is the PPP exchange rate between the euro and the zloty? f. Convert the Polish GDP figure to euro with the current exchange rate and the PPP exchange rate. Explain the difference between these two figures. Answers: a. The price of a machine in Germany is 100 euro (hourly wage of 10 euro times 10 hours to produce a machine). Without any barriers to trade the price of a machine in Poland should be the same as in Germany. Therefore the price of a machine is 400 Zloty in Poland (price of machine in Germany times exchange rate). b. It takes 20 hours to produce a machine in Poland. Given a price of 400 Zloty per machine, the hourly wage should be 20 Zloty (400/20). c. The price of a pedicure treatment in Germany is 20 euro (hourly wage of 10 euro times 2 hours to finish a pedicure) and in Poland 40 Zloty (hourly wage of 20 Zloty times 2 hours to finish a pedicure). d. GDP in Germany is 110,000 euro (price of machine 100 euro 1000 machines + price of pedicure treatment 20 euro 500 treatments) and in Poland 420,000 Zloty (price of machine 400 Zloty 1000 machines + price of pedicure treatment 40 Zloty 500 treatments). e. The PPP exchange rate is based on the price of an equal basket of goods in two countries. By assumption the basket of goods produced in Germany and Poland is equal. Both countries

2 produce 1000 machines and 500 pedicure treatments. Therefore the PPP exchange rate is equal to 1 euro for 3.82 Zloty (GDP Poland divided by GDP Germany). f. Converted by the current exchange rate Poland has a GDP of 105,000 euro. Using the PPP exchange rate, the GDP of Poland is 110,000 euro (small deviations may occur as a result of rounding). Using the PPP exchange rate gives a higher number because it takes proper account of the relatively high productivity in the pedicure sector. QUESTION 0-2 Trade statistics are not always reliable. It is a well-known fact that there is a discrepancy between figures on the value and number of products leaving a country and the figures on the value and number of products entering another country as reported by the national statistical agencies. The table below gives a striking example. Indonesian sawnwood exports to major trading partners in thousand m 3 according to Indonesian statistics (export) and statistics of importers (import) export import % diff export import % diff export import % diff Japan China Malaysia Source: Johnson (2002), Documenting the undocumented, Tropical Forest Update, vol. 12, no. 1. a. Why do statistics on exports and imports differ between different national statistical agencies? b. What do you think is the main source of discrepancy in the case of Indonesian sawnwood? Answers: a. A large number of factors can be responsible for the discrepancy in trade statistics. Time lags: A ship may load its cargo in one statistical year and deliver it in the next statistical year. Also the reference period between statistical agencies may differ. Classification: Different statistical agencies may classify the same goods under different headings (different industrial classification, goods or services). Valuation: Import values mostly include costs of insurance and freight while export values do not. Furthermore, different methods of currency conversion may cause discrepancies. Errors and estimations: Statistical agencies do not count every single product entering or leaving a country but often use estimation methods. Furthermore, reporting officials may be trained badly. Illegal activities: Smuggling and underinvoicing may also imply that trade is recorded in one country and not in another. b. The differences in import and export statistics of Indonesian sawnwood are too spectacular to be associated with unintentional errors or differences. The statistics show that illegal logging is still big business in Indonesia. Illegally logged wood is smuggled out of Indonesia (and is not

3 recorded in the export statistics) and only (partially) re-appears in the statistics when it arrives at its destination. QUESTION 0-3 According to World Bank data China s GDP at market prices (in current US dollar) was $10,355 billion in In that same year the GDP at market prices (in current US dollar) in the USA was $17,419 billion. a. Your neighbour argues that China is the biggest economy in the world since Could she be right, or not? Explain why, or why not. According to World Bank data the export of goods and services was 22.6 percent of GDP in China in 2014 and 23.1 percent of GDP in Guatemala in that same year. b. The same neighbour of question a argues that China is actually a more open economy than Guatemala in Could she be right this time, or not? Explain why, or why not. Answers: a. She actually is right: China does have the biggest economy in the world since When comparing the value of the total production of goods and services of one country with another country one should correct for price differences between the countries, so-called PPP (purchasing power parity) corrections. Once corrected for price differences China s GDP PPP (in current international dollar) is $ billion in 2014, which is slightly bigger than American GDP which remains at $17,419 billion since it serves as the benchmark. No need to provide these numbers, of course. If the student argues that the neighbour is wrong I will evaluate the quality of the argument. b. I think she is right again. Although percentage wise the Guatemalan economy appears to be slightly more open trade-wise than the Chinese economy (23.1 versus 22.6 percent), this simplistic view does not take the enormous size difference of the two countries into consideration. In general, it is much harder for a large country such as China to have higher relative exports than it is for a small country such as Guatemala. If a good is shipped 4000 km within Chinese borders it is still not included in China s exports. If instead a good is shipped less than 25 percent of that distance from any point within Guatemala it is part of Guatemalan exports for sure. The only country with a similar economic size as China is the USA, which exports 13.5 percent of GDP. The country closest in economic size to Guatemala is Bulgaria, which exports 65 percent of GDP. From a broader perspective, China is now closely connected to other parts of the world through numerous supply chains and other trade- and investment flows. From that perspective it certainly is better integrated / more open than Guatemala. QUESTION 0-4 Gross National Income (GNI); 2013, billion Country GNI, current US $ GNI PPP, current international $

4 China 9,000.. Netherlands The table above is based on the World Development indicators and provides (rounded) information on total GNI in 2013 for two countries. As you can see, the table is incomplete since the PPP data is missing. a. What does PPP stand for? Briefly explain in words the difference between GNI in current US $ and in PPP current international $. b. The Worldbank uses the USA as the benchmark country for PPP corrections. As a consequence, the USA s GNI in current US $ is the same as its GNI in PPP current international $. Based on your knowledge of the development level of China and the Netherlands relative to the USA provide guesstimates of the missing values in the GNI PPP, current international $ column in the table. Carefully explain what you did. Answers: a. PPP stands for Purchasing Power Parity. The current US $ information is based on a country s GNI estimates in local currency converted to US $ using the (average) exchange rate for the period under consideration. PPP data correct for price differences between countries which imply that exchange rate comparisons are a poor indicator of actual purchasing power (and thus the value of production) in a country. Since prices tend to be lower in developing countries, particularly regarding non-traded goods and services, the PPP correction tends to increase the GNI estimates for developing countries. b. The actual (rounded) table looks like this: Gross National Income; 2013, billion Country GNI, current US $ GNI PPP, current int. $ China 9,000 16,000 Netherlands There is, of course, no need to get the exact numbers right. What we need is the following general knowledge based reasoning: Since China s development level is lower than that of the USA its GNI PPP level should be substantially larger than its GNI level in current $. Since the development level of the Netherlands is similar to that of the USA its GNI PPP level should be similar to its GNI level in current $. Chapter 2 QUESTION 0-5 Please answer the brief review questions below. a. Which five main types of globalization debates can we distinguish? b. What grows faster since 1960: world income or world trade? c. Is it appropriate to compare the growth rates in question b? Explain why, or why not.

5 d. On a per capita basis: is there a trend noticeable in the growth rates for income and trade? Answers a. Cultural, Economic, Geographical, Institutional, and Political Globalization. b. On average, the world income level has been growing faster than the world trade level. c. It is not entirely appropriate to compare the growth rates of income and trade since income is on a value-added basis and trade is not. We return to this issue in Chapter 15. d. The growth rate for per capita trade is volatile and fluctuates around a value of about 3.8 percent per year since The growth rate of income per capita is more stable; it declined in the period and has been fairly steady at around 1.3 percent per year since then. QUESTION 0-6 Briefly discuss the development of global income per capita over the past 2000 years and indicate if (using national average income per capita levels for comparison) global income inequality has been steady, rising, or falling over this period. Explain. Answer In the first 1000 years income per capita at the world level was steady. There was a slow increase in the period and a much more rapid increase since then; linked to the industrial revolution which started in England around that time. Global income inequality has been rising for the past 2000 years: the leading nation in terms of income per capita gains an ever larger advantage over the global average income level while, particularly since the industrial revolution, the lagging nations seem to be left further behind. At the end of the chapter we briefly discuss how global income inequality (measured using the Gini index) peaked in the 1970s and 1980s and has been declining since the second half of the 1990s, particularly as a result of the rise of income per capita in China and (to a lesser extent) India. In view of imminent demographic changes, however, we expect this decline to be reversed again in the 2020s. We return to some of these issues in Chapter 17. QUESTION 0-7 What are two main ways to measure increased economic globalization? Briefly explain. Answer One way to measure increased economic globalization is to relate an international interaction indicator, such as international trade flows or international capital flows, to a general indicator of rising economic activity, such as global income. Economic globalization then rises if the international interaction indicator rises more quickly than the general indicator, that is if international trade- or

6 capital flows rise faster than global income. Another way to measure increased economic globalization is to focus on price differences for similar goods or services on different markets. If this price gap diminishes there is more intensive international competition and economic globalization also rises. Chapter 3 QUESTION 0-8 Imagine you work at the Statistical Bureau of Singapore and have to record the value changes in GDP, GNI, exports and imports. What value changes do you record when? a. A shipload of 1,000 trousers arrives from India that has cost the Singapore importer 5 Singapore dollars per piece. This shipload is immediately re-exported to the USA for 6 Singapore dollars per piece. b. A bundle of 1,000 trousers has been purchased from a Singapore producer for 5 Singapore dollars per piece. This bundle is exported to the USA for 6 Singapore dollars per piece. c. The same transaction is executed as in question a, but this time the Indian producer of trousers has to pay 1 Singapore dollar per trouser to a Singapore investor who has helped to establish the Indian trouser factory. d. An Indonesian nanny returns home after babysitting in Singapore for four months. She takes her total wage of 1,000 Singapore dollars with her. e. An Indonesian woman, married to a Singapore man, returns home and gives her parents 1,000 Singapore dollars. Answers: The table below gives the change in national income and trade statistics that you should record as an employee of the Statistical Bureau. Table: Change in national income and trade statistics in Singapore dollar GDP GNP Export Import a b c d e QUESTION 0-9

7 If there is more money flowing into a country than there is flowing out, that country has a positive balance of payments; if, on the other hand, more money flows out than in, the balance of payments is negative. Source: Wikipedia encyclopaedia, January 2006 ( a. Is the definition above correct? Explain. In this book, we follow the accounting principle that this balance is equal to zero. In practice, different definitions for the balance of payments exist. They sometimes exclude reserve assets or short-term capital account transactions from the balance, such that imbalances are possible. Consider the following quote: The US is able to attract funds from the rest of the world to finance its balance of payments deficit. b. Explain the quote with the help of equation 3.9. What happens when the US is unable to attract funds from the rest of the world? Suppose that the Chinese central bank publishes a report that blames expected balance of payments surplus reductions on lower trade tariffs (taxes on imports) and higher oil prices. c. Which Balance of Payments definition does the Chinese central bank probably use? Explain how tariff reductions and higher oil prices can contribute to a lower surplus. When a country has a deficit in its balance of payments, politicians and the press often portray this as a cause of major concern. This concern is groundless for two reasons: (1) there never is a deficit, and (2) it is not necessarily bad if there is a deficit. d. Explain for both reasons whether you agree or disagree. e. Can you explain why politicians and the press are often concerned? Answers: a. The definition is not in accordance with the definition of the balance of payments as given in the book. According to the accounting definition, because the balance of payments is a balance, there can be no surplus or deficit. With money flowing out (capital account deficit), there is balance, and with money flowing in (capital account surplus) there is also balance. b. Excluding reserve assets and/or short term financial flows, the US can run a balance of payments deficit (see equation 3.9). By definition, this is caused by a current account deficit. If the US is unable to attract outside funds for its current account deficit, this deficit will cease to exist. If the United States is unable to borrow from abroad (capital account surplus), it will not be able to afford all its foreign purchases, beyond its own sales to foreigners (current account deficit). c. The State Administration of Foreign Exchange probably excludes reserve asset transactions in its balance of payments definition. Lower trade tariffs probably induce higher imports. Ceteris paribus this decreases the balance on good, decreasing the current account surplus. Higher oil prices imply that China has to pay more for its imports. Ceteris paribus, this reduces the current account deficit, and thereby the balance of payments surplus.

8 d. There never is a balance of payments deficit in the sense that the overall balance is always equal to zero. This must be so because it is an accounting identity. Therefore, we agree with statement (1). Of course, there can be deficits and surpluses on various sub-items of the balance of payments. If there is a deficit on one of the sub-items, or if we define the balance of payments in a different way, this does not necessarily imply something bad. Capital mobility, for example, requires that both countries have offsetting deficits and surpluses on their capital and current accounts. Nevertheless, they are both better off. So we also agree with statement (2). e. The concern of politicians and the press usually builds when a country is incurring debts vis-à-vis foreigners through a current account deficit (capital account surplus). These debts have to be serviced and repayed in the future. Such dependence on foreign financing does not feel right to politicians, since they feel that this could also translate into political dependence. Whether this is actually the case is open to debate. QUESTION 0-10 The developments of the Chinese and US current account balance since 1990 are shown in the graph below. The current account is a flow variable. It represents the build-up of net foreign claims by an economy. Many US politicians blame China for their country s growing current account deficit and negative international investment position. Current account balance, USD billion China USA Source: based on data from World Development Indicators online. a. Why do US politicians blame China for their deficit, while the Chinese current account surplus is initially fairly small compared to the US deficit? b. The current account balance is not exactly equal to changes in the international investment position. Can you explain why this is so? c. The Chinese and US economies both attract a lot of foreign direct investment (FDI). Does this represent a capital inflow or outflow?

9 d. If the current account remains unchanged, which offsetting capital account transactions can occur to maintain a balance of payments (use Figure 3.3)? e. Suppose the US government wants to improve relations with China and does so by giving emergency assistance after a flooding of the Yangtze River. How does this affect the Chinese balance of payments? Answers: a. The current account balances in the graph represent the overall balance for an economy. You can also construct bilateral balances, for example between the US and China. If you would do that you could see that China at times runs a large current account surplus vis-à-vis the US. But this is partially offset by a deficit vis-à-vis the rest of Asia, resulting in an overall much smaller surplus. So US polticians blame China not for its overall balance but for its bilateral balance, which can explain a major part the overall US current account deficit. b. The changes in the international investment position in a given year are caused by the current account balane in a given year plus the change in the valuation of the outstanding investment position. The latter can, for example, change through exchange rate developments, which affect the dollar returns of assets. If the US has its external liabilities mainly denominated in dollars and its external assets in foreign currency, then a depreciation of the dollar will increase its external assets and leave its external liabilities unaffected. Overall this will improve the US international investment position. c. Attracting FDI results in a surplus (lower deficit) on the capital account which is a capital inflow. d. If the current account remains unchanged, then higher FDI should result in some offsetting transaction on the capital account. This can be higher foreign exchange reserves, higher investment assets (portfolio or other), or lower investment liabilities (portfolio or other). e. Emergency assistance would show up in the form of higher credit current transfers to China on the current account. The offsetting transaction could be any of the capital account balance sheet items in Figure 3.3. QUESTION 0-11 Suppose that you live in the hermetically closed nation of North Korea. The economy has no outside economic links with the rest of the world. You save money in the bank and know that North Korean banks have the highest interest rates in the world. a. What do you know about the saving and investment relationship in North Korea? b. As a saver, do you favour capital mobility? Explain. c. Do you expect the relationship between saving and investment to change after capital market integration? What will happen to the North Korean current account? Explain. d. What impact does the Feldstein-Horioka puzzle have on your answer to question c?

10 Answers: a. Given that North Korea is a closed economy, we know that domestic savings equals domestic investments exactly. b. Given that North Korean interest rates are the highest in the world, these interest rates will probably fall with capital market integration. This lowers the return on your savings and you would be unhappy with that. c. Theoretically, the saving and investment relationship should alter after capital market integration. Firms can attract capital from abroad more cheaply, causing a capital inflow and thus a current account deficit. d. The Feldstein-Horioka puzzle is the high correlation between savings and investment. In our North Korea example this would lead to a lower current account deficit as firms are less responsive to differences between international interest rates. Chapter 4 QUESTION 0-12 The table below gives the units of labour needed to produce one ship, one bicycle and one airplane in Russia and the European Union. Units of labour needed for the production of one unit Ship Bicycle Airplane Russia EU a. Which country has an absolute advantage in the production of ships, bicycles and airplanes? b. What is the EU s comparative advantage if we look only at ships and bicycles? c. What is the EU s comparative advantage if we look only at bicycles and airplanes? d. Can you infer from your calculations in b and c which product the EU will export for sure and which product it will surely not export? Answers: a. In the EU the labor input into the production of all three goods is lower compared to Russia. The EU therefore has an absolute advantage in all three goods. b. Russia needs twice (2 = 200/100) as many workers to produce a ship and 5/3 times (50/30) as many workers to produce a bicycle. Russia is thus relatively less efficient in producing ships, implying that the EU is relatively more efficient in the production of ships. The comparative advantage of the EU is therefore in ships. c. Russia, the EU needs 5/3 times (50/30) more workers to produce a bicycle and 5/2 times (500/200) more workers to produce an airplane. Russia is thus relatively less efficient in

11 producing airplanes, implying that the EU is relatively more efficient in the production of airplanes. The comparative advantage of the EU is therefore in airplanes. d. It should be immediately clear that the EU will surely not export bicycles. Both airplanes and ships can be produced relatively more efficiently compared to bicycles. Furthermore it can be derived that Europe produces airplanes relatively more efficiently compared to ships. Russia needs 5/2 more workers for airplanes, compared to twice (2) more workers for ships. Europe will therefore export airplanes for sure and will not export bicycles. Whether or not Europe will export or import ships cannot be determined from the provided information. QUESTION 0-13 Some politicians and trade activists argue that developing countries should not participate in the global economy as their industries cannot compete with their Western counterparts. According to these observers, trade does not benefit the developing countries and will only result in the exploitation of the labour force. Let s analyse this argument in a simple Ricardian framework. Suppose there are only two countries, Indonesia and the USA, producing only two goods, clothes and machines. Labour is the only factor of production. The table below shows how many man-hours are needed in Indonesia and the USA to make one unit of clothes or one machine. Assume that 2,000 man-hours are available in the USA and 36,000 in Indonesia. Number of man-hours needed to produce one unit Indonesia USA Clothes 50 3 Machine a. Explain which country has a comparative advantage in which product. b. What is the autarky price of machines in Indonesia and the USA? c. Indicate exactly what range of prices for machines should be offered on international markets for both countries to profit from international trade. What will Indonesia and the USA import and export? d. Explain in a consistent graph with production possibility frontiers why both countries gain from trade when prices on the international markets are within the range you indicated for question c. Some trade activists who think that developing countries are exploited on the international market may not be convinced by your arguments above. They claim that even in the Ricardian framework trade is based on unequal wages between developed and developing countries. e. Explain whether wages are unequal in the example of Indonesia and the USA. If both countries trade with each other, what is the maximum and minimum difference between the wage rate in Indonesia and the USA? f. Discuss whether abolishing trade is an effective instrument to raise Indonesian wages. Use the observations you made in your analysis above.

12 clothes Charles van Marrewijk, 2017 International Trade Oxford University Press Answers: a. Indonesian workers take almost 17 times (50/3) as long to produce one unit of clothes compared to the United States and 20 times as long for a machine. The United States therefore has a comparative advantage in the production of machines and Indonesia in the production of clothes. b. In autarky the price of machines in Indonesia is 2 units of clothes (100 hours to produce machine / 50 hours to produce clothes) and in the United States 5/3 units of clothes (5 hours to produce machine / 3 hours to produce clothes). c. The price of machines should be in between 5/3 and 2 units of clothes (and not equal to 2 or 5/3!) for both countries to profit from international trade. In this case Indonesia will specialize in the production of clothes and export them in exchange for machines. The US, on the other hand, will specialize in the production of machines and exchange them for clothes on the international market. d. Indonesia can at most produce 720 clothes (36,000 man hours / 50 hours per unit of clothes) or 360 machines (36,000 man hours / 100 hours per machine). With this information we can draw the production possibility frontier (PPF) for Indonesia as shown below. The same can be done for the United States which can produce at most 667 clothes (2,000 man hours / 3 hours per unit of clothes) or 360 machines (2,000 man hours / 5 hours per machine). At a price of, for example, 11/6 clothes for one machine, Indonesia will specialize in the production of clothes and the US in the production of machines. From these production points one can draw the new budget lines. As the new budget lines for both countries are above the PPF (the consumption possibilities in autarky), both countries gain from trade. 800 PPF Indonesia PPF USA 600 Budget line Indonesia Budget line USA machines e. In the Ricardian model productivity levels are country-specific, which implies that wages are unequal. In this exercise, at a world market price for machines of 11/6 clothes, for example, five hours work of a US worker (one machine) is exchanged for the produce of 92 hours of work for an Indonesian worker (50 hours per unit of clothes 11/6 clothes). When both countries trade, the US wage rate per hour is at least 50/3 times larger and at most 20 times larger than the

13 Indonesian wage. This is because the production price of clothes should be lower in Indonesia than in the US, such that 50W I < 3W US. At the same time, the production price of machines should be higher in Indonesia compared to the US, such that 100W I > 5W US. f. From an economic point of view, abolishing free trade will not help the Indonesian workers. It may be true that their wages are not fair, but they do reflect the Indonesian productivity levels. Indonesian wages would be even more miserable without trade. In the Ricardian model, welfare of the Indonesian workers even decreases if free trade is abolished because all national welfare accrues to workers (as the only factor of production). QUESTION 0-14 Three countries, Hungary, Bulgaria, and Czech Republic, have Ricardian technologies as listed in the table below and can produce two types of goods, namely butter and beer. Number of labor units required to produce one unit of output Country Butter Beer Hungary 2 4 Bulgaria 3 7 Czech Republic 4 5 a. Which country has an absolute advantage in the production of beer and which country in butter? Explain. b. The three countries start to trade with each other without any impediments whatsoever. Which country will export butter and which country will export beer (comparative advantage)? Explain. c. What happens to the country not mentioned in your answer to question b? Which good will it export? Your friend argues that it will lose from engaging in international trade for sure. Is she right? Explain. Answers a. Hungary has an absolute advantage in the production of both butter and beer, it requires the least labour units to produce these goods. b. Bulgaria will export butter because it has relatively the best technology to produce this. Since 3 < 2 < 4 Bulgaria would have to give up 3 units of beer to produce one unit of butter, which is less than the other two countries. The same reasoning in reverse shows that the Czech Republic will export beer for sure. c. Your friend is wrong. Hungary will never loose from international trade. We can only determine which good Hungary will export if we have more information on the price of butter relative to beer in the international trade equilibrium. If that price is equal to Hungary s autarky price the country will reach the same welfare level as in autarky. If the price of butter is higher than in autarky, Hungary will export butter and gain from trade. If the price of butter is lower than in autarky, Hungary will export beer and also gain from trade.

14 QUESTION 0-15 Two countries, China and India, have Ricardian technologies as listed in the table below and can produce three types of goods, namely tea, rice, and pork. Number of labour units required to produce one unit of output China India Tea 2 4 Rice 3 7 Pork 4 5 a. Which country has an absolute advantage in the production of tea? Which country has an absolute advantage in the production of rice? Which country has an absolute advantage in the production of pork? Explain. b. The two countries start to trade with each other without any impediments whatsoever. Which country will produce and export tea? Which country will produce and export rice? Which country will produce and export pork? Be detailed in your answer and explain your reasoning carefully. Answers a. China has an absolute advantage in the production of all three goods as the production of one unit requires less labour units; more specifically: 2<4; 3<7; 4<5. b. Note that China is two times more productive than India for the production of tea (4/2=2). China is more than two times more productive than India for the production of rice (7/3>2). China is less than two times more productive than India for the production of pork (5/4<2). This means China s largest comparative advantage is in the production of rice, such that China will produce and export rice for sure. At the same time, this means that India s largest comparative advantage is in the production of pork, so India will produce and export pork for sure. Without further information on the demand structure of the two economies or the equilibrium price level under free trade, it is not possible to determine which country/countries will produce tea and which country will export tea. Chapter 5 QUESTION 0-16 Suppose there are two goods, buildings and necessities, in a neoclassical world with two factors of production, capital and labour. The production of necessities is relatively labour intensive. Draw a (big) Lerner diagram which is consistent with the provided information. Explain how this can be used to show that there is a one-to-one correspondence between factor prices and final goods prices as long as both goods are produced.

15 Answer: An example diagram is given below, where p b is the price of buildings, p n is the price of necessities, w is the wage rate, and r is the rental rate. Consistency requires that the unit value isocost line is tangent to the unit value isoquants of both goods and that the point of intersections with the capital axis is 1/r and with the labour axis is 1/w. 0 0 To show that there is a one-to-one correspondence the student must argue that: If you give me the prices p b and p n, I can determine the unit value isoquants for both goods and there is only one unit value isocost line tangent for both goods. The interception with the axes provides me with the factor prices. If you give me the factor prices w and r, I can determine the unit value isocost line. The building isoquant that is tangent to this line provides with the inverse price of buildings. Similarly for necessities. Taken together this means there is a one-to-one correspondence between the price of final goods and the rewards to the factors of production. (this can be used to show factor price equalization) QUESTION 0-17 Dwell produces desktop computers using high-skilled labourers (H) and low-skilled labourers (L) with constant returns to scale. To maximize profits, it wants to minimize its cost of production. Computers are relatively intensive in low-skilled labour production and Dwell is a price taker on the labour market. The market for computers is perfectly competitive. a. Draw a production isoquant for computers and an isocost line. Indicate in your graph the number of high-skilled workers and the number of low-skilled workers involved in the production process. Dwell forecasts an increase in demand for its newest model and doubles its production. b. Draw the new situation in your graph of question a.

16 c. What happens to the isocost line and production isoquant? Why? How many new labourers does Dwell hire? d. What impact does the production change have on Dwell s profitability? Answers: a. See the figure below. 0 0 b. See the figure below. 0 0 c. Compared to the initial situation, Dwell doubles its output, so it needs double the amount of inputs under constant returns to scale. This shifts both the isocost line (for the doubling of inputs) and the production isoquant (for the doubling of output) outwards. Dwell needs to hire twice as many high- and low-skilled labourers to double its production. d. Dwell is operating in a perfectly competitive market. Its profitability is zero regardless of its scale.

17 QUESTION 0-18 Dwell computers has just doubled production. It wants to maintain its production level when it is confronted with a wage increase for high skilled-labour. a. Draw the initial situation in a graph with a production isoquant and an isocost line. Indicate the change in the isocost line after the wage increase. b. What implications does this have for Dwell s production process of computers? What happens to Dwell s demand for high-skilled labour? Dwell does some research and development and manages to improve its production process. As a consequence, producing computers after the innovation becomes more low-skilled labour intensive. c. Show in your graph the effect of this technological innovation. Does this alter the input mix of high- and low-skilled labour? d. What would be the consequences of this kind of technological development for wages of skilled and non-skilled workers? Answers: a. See figure below. 0 0 b. The production process of computers now has a higher low-skilled labour composition. The demand for high-skilled labour falls as a consequence of the wage increase. c. The input mix of high and low skilled workers changes. Relatively more low-skilled labourers are employed due to their increased productivity.

18 0 0 d. The demand for low-skilled labour rises. Consequently, it is likely that their wages will increase. The demand for high-skilled labour falls. It is likely that their wages will fall. QUESTION 0-19 The Russians and the Germans both like vodka and beer. Suppose that these are the only two products they consume and produce. Moreover, suppose that as a result of regulations vodka and beer initially cannot be traded between Russia and Germany. Beer is produced with the help of machines largely controlled by computers. Beer breweries are therefore capital intensive. The production process of vodka, on the other hand, is more traditional and therefore quite labour intensive. Because of its large population and lack of capital goods, the wage rental ratio (w/r) is initially lower in Russia than in Germany. a. Explain whether the relative price ratio of vodka in terms of beer (p vodka /p beer ) will be higher in Russia or in Germany in the initial situation (without trade). Suppose that, after intensive international consultations, the regulations for vodka and beer are lifted, such that these goods can now be freely and costlessly exported and imported. In response, Russia starts to produce more vodka and less beer while Germany starts to produce more beer and less vodka. Russia exports vodka in exchange for beer. b. Once the two countries can trade, will the price ratio of vodka in terms of beer (p vodka /p beer ) be higher in Russia or in Germany? c. What will happen to the wage rental ratio in Russia and Germany? Why? d. The trade liberalizations in Russia and Germany have not remained unchallenged. Explain which groups of people are likely to protest against the liberalizations. e. What can the politicians in Russia and Germany do in response to these protests?

19 Answers: a. The production of vodka is labor intensive and the production of beer capital intensive. Because labor is relatively cheaper in Russia than in Germany, it will be relatively cheaper to produce vodka in Russia. Equivalently, because capital is relatively more expensive in Russia than in Germany, it will be relatively more expensive to produce beer is Russia. Consequently the price of vodka relative to beer will be lower in Russia than in Germany. b. With the regulations in force two separate markets existed for vodka, both in Germany and Russia. Prices for vodka between the two countries could therefore differ. Lifting the regulations will create one market for vodka for both countries. Consumers in both countries therefore face the same price for vodka. Similarly, the price of beer will also be equal in Germany and Russia. The price of vodka relative to beer will be therefore be the same in Russia and Germany. c. From the Factor Price Equalization proposition we can derive that the wage rental rate will become equal in Russia and Germany. The wage rental rate will rise in Russia since p vodka / p beer rises in Russia, which increases the wage rate and decreases the rental rate (Stolper- Samuelson). In Germany the wage rental rate will decrease because in this country p vodka / p beer declines. d. Russian capital-holders and German laborers will be oppose the trade liberalizations. The compensation for their inputs does not only decrease in nominal terms but also in real terms, as can be derived from the Jones magnification effect. e. The problem for politicians in Russia and Germany is that a group of people is worse off in real terms. However, due to the gains from specialization, the country as a whole is better off. An income redistribution scheme could therefore in principle make all the citizens of a country better off. QUESTION 0-20 We ask you to clarify the situation of Question 0-19 graphically. Assume that the unit value isoquant for beer is equal for Russia and Germany (it is the numéraire). a. Draw the unit value cost lines and unit value isoquants for both vodka and beer for both Russia and Germany in a situation of autarky. b. What will happen to the price of beer and vodka in both Russia and Germany if both countries start to trade? c. Draw the new unit value isoquants and unit value cost lines in the figure of question a in a situation in which Russia and Germany engage in international trade. d. What happens to the wage rates and rental rates in both countries? Answers:

20 a. The production of beer is capital intensive and the production of vodka labor intensive. The unit value isoquant of beer is therefore situated more to the Northwest as compared to the unit value isoquant of Vodka. Furthermore, it is given that the w/r ratio is higher in Germany. The slope of the unit value cost line of Germany is therefore steeper than the slope of the unit value cost line of Russia. With this information the Lerner diagram can be drawn. It is shown in the figure below. We see that the price of vodka is lower in Russia than in Germany, as argued in question 5.4a. 0 0 b. The unit value isoquant of beer is equal in Russia and Germany. This means that also the price of beer is equal in Russia and Germany. When going from a situation of autarky to a situation of trade, prices in the two trading partners will equalize. Nothing will happen with the price of beer because it is already equal between Russia and Germany. The price of vodka is not equal in Germany and Russia however. As noted above, the price of vodka is higher in Germany than in Russia. The price in the two countries will equalize when both countries are going to trade. The price of vodka in Germany is therefore likely to decrease and in Russia to increase. c. In question b we learned that the price of beer remains equal when Germany and Russia are going to trade. The unit value isoquant of beer will therefore remain equal in both situations. The German price of vodka is likely to decrease however and the price of Russian vodka to increase until the price of vodka is equal in both countries. The new Lerner diagram is shown below.

21 0 0 d. When countries engage in free trade factor prices will equalize between the two countries. The figure above shows that the wage rate in Germany decreases and in Russia increases. The rental rate on the other hand increases in Germany and decreases in Russia. Chapter 6 QUESTION 0-21 Armenia is a small country (changes in endowments do not result in price changes for factor inputs or final goods prices). Suppose that it produces two goods, Manufactures and Food. It produces these goods in a Heckscher-Ohlin world using high-skilled labour (H) and low skilled labour (L). Manufactures make relatively intensive use of H and Food is relatively L intensive. About 3 million Armenians are high-skilled, while 1 million people are low-skilled. a. Draw the situation described above in an Edgeworth box. Put the origin of Food in the Southwest corner and the origin of Manufactures in the Northeast corner. Measure high-skilled labour (H) on the horizontal axis and low-skilled labour (L) on the vertical axis. Draw the contract curve, one efficient point of production, and the isoquants of both goods through the chosen efficient production point. b. What indicates in the Edgeworth box the level of output of a good? c. How can you determine the production levels of rice and clothes in full employment equilibrium? After the fall of the Soviet Union and the declaration of Armenian independence, the socioeconomic situation in Armenia deteriorates rapidly. As a consequence, people are voting with their feet. Estimates show that two million people have emigrated from Armenia since independence. It is the best (high-skilled) people who are emigrating. d. Show the effects of the Armenian emigration in the Edgeworth box you have drawn in question a. e. What are the effects on the production of Manufactures and Food? What do we call this effect in theory?

22 Answers: a. The Edgeworth Box consistent with the information provided in the question is given below. L contract curve O m isoquant manufactures L m / H m isoquant food L f / H f O f H b. The output level of a good in the Edgeworth Box is indicated by the isoquants. The further away the isoquant is from its origin, the higher the production level. It is important not to confuse this with the straight lines drawn in the Edgeworth Box in section 6.3 of the book, which indicate the cost-minizing capital-labor ratio in a sector for a given wage-rental ratio. Expansion and contraction in a sector for that particular wage-rental ratio takes place along these straight lines, where production obviously increases the further away the point is from its origin (that is, the longer the line). The point of intersection of such straight lines in an Edgeworth Box must be on the contract curve. c. As explained in section 6.3, we need to take three steps to derive the distribution of capital and labour over food and manufactures in the economy. Given the prices of the final goods we can determine the wage rates for high skilled and low skilled workers, say w H and w L, using the Factor Price Equalization proposition of chapter 5, provided both goods are produced in equilibrium. Once we know w H and w L, we can derive the optimal (cost-minimizing) capitallabor ratios for both goods (see the figure above). These capital-labor ratios do not change as long as the final goods prices do not change. Using the full employment conditions and the capitallabor ratios we can derive the equilibrium allocation of capital and labor in the Edgeworth Box, and thus the production levels in both sectors. d. See the figure below.

23 L O m O m L m / H m L f / H f O f H e. The production of food increases and the production of manufactures decreases. f. Yes it does. The share of production taken up by agriculture has increased dramatically, while the share of industry has fallen. QUESTION 0-22 Suppose there are two countries (Cuba and India) in a neoclassical world with two factors of production (human capital and unskilled workers) able to produce two goods (merchandise and food). We will assume that the production of merchandise is relatively human capital intensive and that Cuba has 400 units of human capital and 800 units of unskilled workers while India has 300 units of human capital and 800 units of unskilled workers. Draw a production possibility frontier for Cuba in international trade equilibrium consistent with the information above and illustrate clearly what happens in this diagram when the amount of human capital rises, given that Cuba is a small country. What happens to trade flows? Explain. Answer: An example diagram is given below. Food is on the vertical axis and we must make sure that Cuba is initially exporting merchandise (since it is relatively human capital abundant and merchandise are relatively intensive in the use of human capital). This implies that the production point must be south-east of the consumption point, as illustrated. When the amount of human capital increases the ppf shifts out with a bias in the direction of merchandise. When Cuba is small the world equilibrium price does not change and Cuba produces more merchandise and less food along the Rybczynski line (from Pr 0 to Pr 1 ). The income line shifts parallel outward and in view of homothetic preferences the income expansion path is a line from the origin through point C 0, leading to the new consumption point C 1. Clearly, the level of trade increases.

24 Food Charles van Marrewijk, 2017 International Trade Oxford University Press C 1 C 0 Pr 0 Pr 1 O Merchandise QUESTION 0-23 Since Deng Xiaoping took over leadership of China in 1978, tariffs have decreased dramatically. In 2001, China even joined the WTO, sending a signal to the world that tariff reduction will continue in the future. The effects of the opening up of China to international trade are heavily debated within the media. Some commentators claim that trading with China is a good thing because products become cheaper. Others stress the negative effect it has on some Western sectors, such as the clothes industry. Let s analyse the integration of China in the world economy with the Heckscher Ohlin factor abundance model. Assume, to make things easy, that there are only two countries: China and the Western world (the Western world is considered to be one country). China is relatively labour abundant and the Western world relatively capital abundant. Furthermore, assume that only two goods are consumed and produced in China and the Western world. These are clothes (produced relatively labour intensively) and computers (produced relatively capital intensively). a. Draw a consistent graph in which you indicate the autarky production and consumption points of China and the Western world with the help of production possibility frontiers and utility curves. b. Explain intuitively whether the relative price of clothes in the Western world is higher or lower compared to the relative price of clothes in China when both China and the Western world are in autarky. How can you see this price difference in your graph? c. Explain what will happen to the prices of clothes and computers in the Western world when the Western world and China start trading. d. What effect will this have on the consumption of clothes and computers and on the production of clothes and computers in the Western world? Indicate the new consumption and production point in the graph with the help of a budget line and a new utility curve (if your graph becomes messy, please draw a new graph).

25 e. Is integration of China into the world economy a good thing for the Western world? Use the observations you made above in your analysis. Also comment on the distribution of welfare between industries and owners of production factors. Answers: a. The figure below shows the autarky situation in both China and the Western world. Note that the production possibilities curve of the Western world is flatter than the production possibilities curve of China because the Western world is capital abundant and China labor abundant. As a consequence, in autarky the Western world produces and consumes relatively a lot of computers and China a lot of clothes. Clothes Autarky production and consumption in China Autarky production and consumption in WW PPF China PPF WW Computers b. The price of clothes (expressed in computers) is in autarky relatively higher in the Western world compared to China. This is the case because China is relatively well endowed with labor, which makes labor relatively cheap in China and therefore producing the labor abundant good, clothes in this case, is relatively cheap. The figure below shows that with the budget-lines the autarky prices can be derived from the figure. It can be seen that clothes are relatively cheap in China compared to the Western world.

26 Clothes P co /p cl China P co /p cl WW Computers c. When the Western world and China start trading, prices of clothes and computers equalize. Therefore the relative price of clothes rises in China and decreases in the Western world. The relative price of computers falls in China and increases in the Western world. d. The figure below shows how the equalization of prices will affect production and consumption in the Western world. The budget line becomes steeper because the relative price of computers increases. This leads to an increase in the production of computers and a decrease in the consumption of computers. As a consequence the production of clothes decreases and its consumption increases. Clothes Computers e. The analysis shows that integration of China into the world economy leads to an increase in total welfare. So for the Western world as a whole integration is a good thing. The welfare gain is however unequally distributed within the Western world. Computer manufactures and capitalowners gain from the integration while clothes manufactures and workers lose. This may give rise to frictions.

27 QUESTION 0-24 Equation 6.7 in the book shows the autarky wage-rental ratio and relative price ratio. Using this information and the analysis in chapter 6, determine the changes in (i) the wage rental rate, (ii) the final goods price ratio, (iii) the welfare level, (iv) the production level of manufactures, and (v) the production level of food if: a. The capital stock K increases. b. The labour force L increases. c. The capital intensity of manufactures decreases. d. The share of income spent on manufactures increases. Answers: The table below gives the changes in the different endogenous variables. Note that one cannot comment on the change in welfare when the utility function (determined partly by m ) changes. It is not possible to compare different utility functions. w/r-ratio p m /p f Welfare Production M Production F K increases L increases α m decreases δ m increases? QUESTION 0-25 Bangladesh is a developing country which ranks high in the top of unskilled-labour intensive manufacturing exporters. These exports consist mainly of textiles. The Multi-Fibre Agreement (MFA), which imposed all kinds of restrictions on world trade in textiles, was officially ended at the start of We will analyse its impact with the help of the graphs below. The top graph shows the unit value isoquants for both goods. The bottom graph is an Edgeworth Box.

28 rice 0 0 a. Use the top graph to determine the optimal production point in the Edgeworth box (bottom graph). b. What happens if the price of clothes increases as a result of the end of the Multi-Fibre agreement in 2005? Draw the new situation in both graphs. In isolation, the MFA agreement would affect Bangladesh as you have analysed in question b. In addition, however, the labour force in Bangladesh has also expanded rapidly. c. Expand the Edgeworth Box and analyse the combined effect of a labour force increase with a price increase for clothing. How does this impact the production level of Rice? Answers: a. By drawing the unit value cost line in the Lerner diagram, one can derive the two production points (A and B). The slope of a line connecting a production point with the origin of the graph will give you the capital-labor ratio of that product. These ratios can be used in the Edgeworth box to derive the optimal production point. See the graphs below.

29 rice 0 0 production point b. In chapter 5 we have already discussed the effects of price changes on unit value isoquants and isocost lines. An increase in the price of clothes will shift its unit value isoquant inward. Drawing the new unit value cost line gives two new production points (A' and B') in which the capitallabor ratios for both goods have decreased. With these new ratios the new production point in the Edgeworth box can be determined, see the graphs below. rice 0 0

30 c. In question b we saw that a rise in the price of Clothes will lead to an increase in the production of Clothes and a decrease in the production of Rice. An increase in the labor endowment, on the other hand, will decrease the production of Clothes and increase the production of Rice for given final goods prices (Rybczynski). It should be clear that the total effect of these two forces on the production of Clothes is indeterminate; production can either increase or decrease depending on the particular situation. The Edgeworth box below shows the two effects. The price change pushes the production point from P to P'. The increase of the labor endowment pushes the production point from P' to P''. Chapter 7 QUESTION 0-26 Briefly answer or comment on the questions and remarks below. a. What is, according to you, the main consequence of market power for firms? Why? b. In an oligopolistic setting with Cournot competition we derived firm A s reaction curve. Give a short definition of this reaction curve.

31 c. Why is firm A s iso-profit curve horizontal at the point of intersection with its reaction curve, while firm B s iso-profit curve is vertical at the point of intersection with its reaction curve in Figure 7-5? Answers a. The answer may vary a bit depending on what you think is most important, but two possible answers to this question are: The creation of a deviation between market price and marginal costs as a result of the markup pricing rule. The influence of firm interaction on market prices, for example through either price or quantity competition. b. Firm A s reaction curve depicts all its optimal responses (with maximum profits for firm A), given the quantity produced by firm B (or by all other firms in a more-than-2 firms setting). c. Firm A takes the quantity produced by firm B (a horizontal line in the figure) as given and chooses its maximum profits. All other points along that line must thus have lower profits, which is why the iso-profit line is horizontal (its derivative is horizontal). Similarly, firm B takes the quantity produced by firm A (a vertical line in the figure) as given and chooses its maximum profits. All other points along that line must thus have lower profits, which is why the iso-profit line is vertical (its derivative is vertical). QUESTION 0-27 Briefly comment on this statement: as explained in section 7.3 of the book, the main welfare impact of a rise in firm market power in a sector of the economy is the creation of a sub-optimal economic outcome in autarky because of the deviation between the marginal rate of transformation (MRT) and the marginal rate of substitution (MRS) in equilibrium. Hint: carefully look at equation 7-2. Answer In general, the statement is correct. Other things equal, a rise in firm market power in a sector creates a deviation between MRT and MRS and thus a sub-optimal outcome under autarky. A subtle point to make, however, is that other things may not be equal in the sense that there could also be firm market power in other sectors. Suppose, for example, that there are two sectors in the economy, A and B. Initially firms in sector A have no market power, while firms in sector B do have market power. As explained in section 7.3 this creates a sub-optimal outcome in autarky. Now suppose that firms in sector A also have some market power; a careful reading of the section (and a careful look at equation 7-2 will show that this initially reduces the degree of sub-optimality regarding the autarky outcome as it is the relative market power between sectors that determines the deviation between MRT and MRS. In particular, if the relative market power in the two sectors (as measured by the elasticity of substitution) is the same in the two sectors there is no deviation

32 between MRS and MRT. (this also holds under suitable conditions in a more complete and complex environment in which there are multiple firms in both sectors with oligopolistic competition). QUESTION 0-28 What are pro-competitive gains from trade? Briefly describe the main mechanism underlying these gains from trade under Cournot competition. Answer Pro-competitive gains from trade arise from the increased competition between firms in a situation of market power, which lowers the mark-up of price over marginal costs and thus reduces the distortion between the marginal rate of transformation (MRT) and the marginal rate of substitution (MRS) in equilibrium. Under Cournot competition firm A equates marginal revenue and marginal costs, which leads to mark-up pricing, as follows: p (1 q A ) = c(q q ε(q) A), see equation 7-5. The more firms there are, the lower firm A s market share q A /q, hence the lower the mark-up of price over marginal costs. 1 QUESTION 0-29 The national electricity markets in the Nordic countries (Denmark, Finland, Norway, Sweden) used to be protected from foreign competition and dominated by one power company. At the end of the 20 th century, far reaching reforms were introduced establishing one integrated electricity market. A common power exchange was established (Nord Pool), international transmission links were opened to other players and border tariffs were abolished. In the 21 st century, the Nordic electricity market was opened up even more by establishing trading links with Poland and Germany. We are analyze these developments using the imperfect competition framework of Markusen and concentrate on the Swedish electricity market. a. Illustrate the Swedish electricity market when there was only one power company in a graph with electricity on the vertical axis and other products on the horizontal axis. Draw the production possibilities frontier and the utility curve for which consumers maximize their utility. Indicate clearly what amount of electricity is sold and for what price. b. Why can the Swedish monopolist charge an electricity price far above marginal cost? Is it fair to charge a price above marginal costs? c. Assume that Sweden first establishes an integrated electricity market with Norway. Draw the new situation in your figure of question a. What happens to the quantity of electricity produced and to electricity prices on the Swedish market? d. Explain who are the winners and who the losers from the integrated electricity market with Norway. e. What happens to your figure of question a if more countries enter the common electricity market? Is this an attractive development?

33 Answer a. The figure below shows the monopoly situation of the Swedish electricity market in the Markusen framework. Note that the monopoly equilibrium point is below the perfect competition equilibrium point. This is in contrast to figure 7.6 in the book, where the monopoly good is on the horizontal axis, instead of the vertical axis. The figure shows that equilibrium electricity production is below the perfect competition outcome. From the slope of the budget line the relative price of electricity can be derived. It can be seen (by comparing it to the slope of the ppf) that the price of electricity is above marginal cost. b. The Swedish monopolist can charge a price far above marginal cost because (i) it is the only company selling electricity and (ii) demand for electricity is relatively inelastic (the Swedish winter nights are rather long without electric light). A price above marginal cost is not necessarily unfair. A power company has to pay somehow for its initial investment on the power plant. However, as the construction of power plants is subsidized by many governments, power companies may use their monopoly power to earn extra profits above the fixed investment cost. In this sense an electricity price far above marginal costs is unfair. c. More electricity firms will become active on the Swedish market when a common electricity market with Norway is established. This leads to a decrease in the price of electricity (see equation 7.6 of the book). This can be illustrated in the graph of question a by increasing the slope of the budget line, as shown in the figure below. The equilibrium point consequently moves from mon to Nor. At this point the amount of electricity offered has increased.

34 d. The figure in question c shows that the Swedish consumers are clear winners of the integrated electricity market. Utility goes up from U mon to U Nor. The Swedish monopolist is losing at home, because the company is no longer able to charge the price that maximized its monopoly profits. The Norwegian firm gains from access to the Swedish market. This firm can now also make profit in Sweden. However, at home the Norwegian firm loses because the Swedish firm now also has access to the Norwegian market. On a net basis, both monopolists lose. e. The larger the market for electricity, the closer the equilibrium point will move to a situation of perfect competition. This is shown in the figure below where opt is the perfect competition equilibrium. Consumers will benefit because utility rises. The question is at which point electricity producers are no longer able to cover their initial investments. At that point the Swedish government might want to preserve some of the monopoly power of the Swedish electricity producer. QUESTION 0-30

35 Let us analyse the gains and losses associated with the entry of the Norwegian electricity firm on the Swedish market more formally. Recall that there was initially only a Swedish monopoly producer on the Swedish electricity market. In the new situation a Norwegian firm is allowed to sell electricity in Sweden. Assume that Figure 7.2 in the book gives the demand for electricity in Sweden and the marginal revenue and cost curve for the Swedish monopolist in the initial situation. a. Copy Figure 7.2 of the book. What are the consumer surplus and producer surplus in a situation of monopoly? b. Indicate in the same figure a possible total quantity of electricity supplied and the associated price level if the Norwegian firm is allowed to compete on the Swedish market, assuming that there are no transport costs. What is the consumer surplus and producer surplus in this new situation? c. Who gains and who loses from the entry of the Norwegian firm? What are the pro-competitive gains from trade? Assume now that the Norwegian firm faces positive transport costs when delivering electricity to the Swedish market. We assume that it is still profitable for the Norwegian firm to supply electricity to Swedish consumers. d. What is the quantity of electricity supplied and the associated price level if the Norwegian firm faces positive transport costs? e. Who gains and who loses from the entry of the Norwegian firm if there are positive transport costs? Explain whether the gains and losses are equal to the situation without transport costs. Answer a. An example figure is provided below. In red the producer surplus is indicated and in blue the consumer surplus. The consumer surplus is the area below the demand curve and above the price level. The producer surplus is equal to the profit of the monopolist. This is (p c)q. Price demand P mon c MC MR Q mon Quantity

36 b. When the Norwegian firm enters the Swedish electricity market, an oligopoly situation arises. You should remember from the chapter that total output supplied goes up and the price level goes down when a market moves from a situation of monopoly to a situation of oligopoly. Possible price and quantity levels are indicated in the figure below. The figure also indicates in blue the new consumer surplus and in red the new producer surplus. Price demand P mon P oli c MC MR Q mon Q oli c. The figure below shows the changes in consumer and producer surplus when going from a situation of monopoly to a situation of oligopoly. It can be seen that the Swedish consumers are the clear winners. The consumer surplus is enlarged with the green and yellow area. The producer surplus increases with the orange area but decreases with the green area. Because the green area is larger than the orange area, the former Swedish monopolist is losing. The loss for the Swedish monopolist is even larger than the areas in the figure below suggest. Remember that in the new situation the Swedish monopolist will have to share the producer surplus with the Norwegian electricity firm. Hence, the former Swedish monopolist loses and the Norwegian electricity firm gains (also note that we do not analyze the Norwegian electricity market). The pro-competitive gains from trade are the total increase in surplus. This is equal to the yellow and orange area. Price demand P mon P oli c MC MR Q mon Q oli

37 d. The transport costs make it more costly for the Norwegian firm to supply electricity to the Swedish market. Hence, the former Swedish monopolist keeps more market power as compared to the situation in which there are no transport costs. Total quantity supplied will be lower and the price level will be higher compared to the situation of no transport costs. However, the total quantity supplied will be higher and the price level lower as compared to the situation of full monopoly, at least as long as the Norwegian firm provides some electricity to the Swedish market. e. The same analysis as in question d applies here. Again the result will be that the Swedish consumers and the Norwegian firm are winners and the former Swedish monopolist loses. However, gains and losses are smaller compared to the situation in which there were no transport costs. Chapter 8 QUESTION 0-31 International trade flows in 2013 (US $ billion, rounded) World total export 18,000 Sector 85 Electrical Electronic Equipment world export 2,000 China total export 2,200 Sector 85 Electrical Electronic Equipment China export 550 China total import 2,000 Sector 85 Electrical Electronic Equipment China import 450 a. What does the Grubel-Lloyd index measure? On the basis of the empirical information in the table above: calculate the Grubel-Lloyd index for sector 85 for China. Provide a suitable interpretation. b. What does the Balassa index measure? On the basis of the empirical information in the table above: calculate the Balassa index for sector 85 for China. Provide a suitable interpretation. c. In light of your answer to question a is the Balassa index you calculated in question b for sector 85 in China a good indicator or not? Provide a suitable interpretation. Answers a. The Grubel-Lloyd index measures the extent of intra-industry trade flows (simultaneous imports and exports of similar types of goods [in the same sector]). It is given by: 1 abs( ) = = 0.9. This is a high level of intra-industry trade. b. The Balassa index measures a sector s revealed comparative advantage, an indication of the export performance of that sector relative to a group of benchmark countries. The table only provides world exports, so that must be chosen as the group of reference countries. The Balassa index is then: ( 550 2,000 )/( ) = Sector 85 does have a revealed comparative advantage. 2,200 18,000 c. Each answer must be evaluated on its own merit. I would argue, however, that the Balassa index for sector 85 in China is not such a good indicator of the export performance of that sector since the Grubel-Lloyd index is so high (90%). Although the Balassa index suggests that the relative export performance of this sector is quite high (2.25) we thus realize that a similarly calculated

38 import performance index would also be quite high (namely ( 450 2,000 )/( ) = 2.025, to be 2,000 18,000 precise; no need to calculate this, of course). In some sense the sector is thus simultaneously strong and weak. In reality, some parts of the production process in this sector are strong in China (mainly the final assembly stage) while other parts are not. QUESTION 0-32 Chapter 8 introduces the Constant-Elasticity-of-Substitution (CES) utility function, which provided a breakthrough for intra-industry trade theory. Suppose that a consumer with this type of utility function (see equation 8-2) consumes three goods: coffee, tea and milk. a. Use a numerical example to show that if ρ = 1 the consumer is indifferent to consuming three units of coffee or three units of a mix of the goods. b. Use a numerical example to show that if 0 < ρ < 1, the consumer prefers to purchase a combination of goods. For the rest of this question we assume that each good is consumed in the same quantity. Section 8.3 then rewrites the utility function to distinguish between a love-of-variety effect and a claim on real resources (see equation 8-3). Suppose that ρ = 0.5 and assume that one unit of each good is consumed. c. Rewrite the utility function for coffee, tea, and milk to mimic equation (8-3). How large is the claim on real resources? How large is the love-of-variety effect? d. Use an example to illustrate how the love-of-variety effect represents a multiplier-like role in the utility function (use equation 8-3). Answers: a. Using equation (8.2) with ρ = 1 implies that the utility level attained from consuming three units of coffee is equal to: (3 1 ) 1/1 = 3. Similarly, consuming 1 unit of coffee, 1 unit of tea, and 1 unit of milk leads to the same utility value: ( ) 1/1 = 3. Since consumers are indifferent to bundles of goods with the same utility value, our consumer is indifferent to consuming three cups of coffee and consuming one cup of coffee, one cup of tea, and a glass of milk. b. We conduct the same experiment as above in question a, but now with ρ = 0.5. The utility level attained from consuming three cups of coffee is: (3 0.5 ) 1/0.5 = 3. The utility level from consuming one unit of each good is: ( ) 1/0.5 = 9. In this case the consumer therefore prefers to consume a combination of goods. c. Analogous to equation (8.3) we get: U = ( c 0.5 N i=1 ) 1/0.5 = (Nc 0.5 ) 2 = N 2 c = N[Nc], where the term in square brackets on the right is the claim on real resources and the term N denotes the love-of-variety effect. In the example used in question b, the claim on real resources is 3 1 = 3, the love-of-variety effect is 3, and total utility is 3 3 = 9. d. If we increase the extent of the market (that is, an increase in N), the claim on resources rises, for example if we consume 1 unit of 4 different goods the claim on real resources is 4 1 = 4.

39 Simultaneously, the love-of-variety effect, which acts as a multiplier on the claim on resources, increases to 4. Total utility rises to 4 4 = 16. Note that, in addition to the extra utility derived from the consumption of more goods, we have a utility increase due to the greater variety in consumption. QUESTION 0-33 "One definition of an economist is somebody who sees something happen in practice and wonders if it will work in theory." a. How does this joke relate to the theory of intra-industry trade? Though the theory of intra-industry trade was an important breakthrough, much remains to be done. Several economists take issue with the parameter ε in the model. b. Give two reasons why economists might be concerned about this parameter. The merits of globalisation are subject to fierce debates. One of the issues that anti-globalisation advocates raise is the perceived decrease in the number of varieties in the world. Everybody buys the same brands and shops at the same stores. c. What can the theory of intra-industry trade say about this issue? Answers: a. In practice, international trade flows are often between similar types of goods. More importantly, the majority of international trade flows turns out to be of this type. This was an embarrassment until 1979 because existing trade theories were unable to provide an explanation. Only then did Paul Krugman develop a working theoretical model that explained the real world practice. b. A first concern is that the parameter ε is both a measure of the price elasticity of demand and the elasticity of substitution. Clearly, these two economic concepts need not be equal to each other in practice. Therefore, a more robust theoretical model would have different parameters for both elasticites. A second concern is that the parameter ε is related to consumer preferences, while it also provides a measure of increasing returns to scale in equilibrium. More specifically, the ratio of average costs over marginal costs can be used as a measure of scale economies. In this model the production level is f(ε 1)/m in equilibrium (equation 8.9), which requires fε labour, so the average costs are fε/(f(ε 1)/m ) = mε/(ε 1). The marginal labour costs are simply m, so this measure of scale economies reduces to ε/(ε 1). Clearly, it is strange when economies of scale are directly related to consumer preferences rather than production technology. c. The theory of intra-industry trade covered in the chapter does not offer an explanation for this phenomenon. It stresses that people love variety and the number of varieties will increase with

40 international trade. The perceived decrease in product varieties by some people, which they attribute to international trade, is thus not explained in this model. In an alternative specification the production level for a particular variety may adjust (rise) in trade equilibrium, thus leading some varieties to disappear. Note that, in general, this effect is not strong enough to lower the total number of varieties available for consumption. If we look at two identical countries who each consume 500 varieties in autarky and some 20% of those varieties disappear after allowing for international trade, the total number of varieties available for consumption still rises as a result of trade in both countries (from 500 to 800), despite the fact that 200 varieties disappeared. In that sense, a perceived decline in the number of varieties may well go in hand with a rise in the actual number of varieties available for consumption. QUESTION 0-34 China and Australia both produce fireworks. The demand and supply structure in both economies is given by the Dixit-Stiglitz model, with an elasticity of substitution equal to 2 in both countries. Since continually firing the same crackers is quite boring, there is a love-of-variety effect for all consumers. The fireworks market is much larger in China than in Australia. In both countries the marginal labour input requirement is 1 and the fixed labour input per variety is 2.5. The Chinese labour employment in the fireworks industry is 10 million people. The Australian labour employment in the fireworks industry is 10 thousand people. a. How many varieties will be supplied to the Australian and Chinese market in the autarky equilibrium? b. How many varieties will be consumed in each country in the free trade equilibrium? c. Does international trade increase the production efficiency in the two countries? Does international trade increase output? d. What is the domestic market share of Australian producers if international trade is allowed? e. Who benefits and who loses from international trade in this model? Are the benefits equally shared between Australia and China? f. Describe how the Ethier interpretation would alter the analysis of international trade of fireworks. How does it affect the benefits of international trade, in comparison with the Krugman interpretation? Answers: a. Since the fixed labour input f = 2.5 and the elasticity of substitution ε = 2, such that εf = 5, simply applying equation 8.10 gives: China 10 million divided by five is 2 million varieties and Australia 10 thousand divided by five is 2 thousand varieties. b. In the trading equilibrium the total number of varieties simply equals the autarky number of varieties in China and Australia taken together. So there will be two million two thousand varieties consumed in the free trade equilibrium.

41 c. The output of the firms stays the same. It is not affected by the number of varieties on the market. Furthermore, the efficiency of the firm does not change as its output level remains constant. d. The output of each firm is the same. The number of firms is equal to the number of varieties. The Australian market now has two million two thousand varieties. The Australian firms supply two thousand varieties of this total. The Australian market share is therefore two thousand divided by two million two thousand, or 0.1 percent. e. The consumers in both countries benefit from international trade as they are able to enjoy a wider variety of products. Producers still make zero profits and are therefore indifferent to international trade. Note that in this particular case the benefits of free trade are unevenly divided as the opening up to trade has virtually no effect for the large Chinese market, but results in a drastic increase in the number of varieties consumed (and therefore large trade benefits) in the small Australian market. f. In the Ethier interpretation, the benefits of variety arise in production. Production increases because more varieties of intermediate inputs are available. This increases output of the single final good by the two final good producers and therefore utility in both countries. The output increase is bigger in Australia than in China, since the increase in variety is bigger for the smaller county. So the benefits for Australia are bigger than those for China. QUESTION 0-35 The graph below shows an iso-elastic demand function in the Dixit-Stiglitz monopolistic competition model. Answer the questions below using this graph. a. Make a clear and consistent graph on the basis of the figure above to: Illustrate how the optimal price and quantity is determined Illustrate what happens if new firms enter the market b. How does Wilfred Ethier use this framework to explain intra-industry trade? In your answer, make sure you mention what type of intra-industry trade Ethier is focusing on.

42 Answers: a. An example graph is given below. The marginal revenue (MR) curve is an inward shift (by amount 1 1/ε, where ε is the price elasticity of demand; no need to mention this) of the demand curve. Optimal quantity is determined at MR = MC, see point C. The demand curve then determines the optimal price p. Operating profits are (p MC)q. If new firms enter the market the demand curve shifts in (see arrows), as does the MR curve (other arrows). The optimal production point is now determined by C, with lower quantity q but, because of iso-elastic demand, still the same price level p. Operating profits thus fall proportional to quantity. b. Wilfred Ethier focuses on the production and trade of intermediate goods, which is vertical intraindustry trade. In this setting monopolist firms produce a variety of intermediate goods. Each firm has market power and sets a constant mark-up of price over marginal costs. The supply of intermediates is limited by increasing returns to scale (IRS). Associated with the production process is a production externality effect, where production rises if a larger range of intermediate goods becomes available. International trade now allows firms to have productivity gains because the extent of the market rises, which leads to productivity increases (and two-way trade in intermediate goods). Chapter 9 QUESTION 0-36 Briefly answer the questions below. a. Rank world income, world trade, and world FDI flows since 1970 in terms of (long-run) growth rate and volatility.

43 b. Which parts of the world are most active in terms of outward- and inward FDI flows since 1970 if we distinguish between advanced, developing, and transition countries? What has been the main change in this distribution? c. What is the difference between greenfield FDI and cross-border M&As? Answers a. In the long-run, world FDI flows grow fastest, followed by world trade flows and world income flows. The ranking is the same regarding volatility: world FDI flows are the most volatile, followed by world trade flows. World income flows are the most stable of these three flows. b. The advanced countries are the main source and destination for FDI flows. The role of the transition countries is still limited, although rising since The role of developing countries has become substantially more important, particularly as a destination of FDI flows, but increasingly also as a source of FDI flows. c. Greenfield FDI occurs if a firms sets up (part of) a new production plant or opens a sales or maintenance office in another country. A cross-border M&A occurs if a firm acquires or merges with (part of) an existing foreign firm. QUESTION 0-37 Is multinational activity becoming more or less important since 1990? Briefly illustrate using some appropriate measures and comment on their suitability. Answers The chapter provides information that multinational activity, as associated and measured with FDI stocks and flows, is volatile but becomes more important over time in the long run. Other indicators of multinational activity provided in Figure 9.8 also suggest rising importance over time. QUESTION 0-38 a. Are international migration flows today (since the year 2000) in relative terms larger or smaller than a century ago (the period ) for Western Europe and the Western Offshoots? How about the direction of these flows? b. If we look to the future (up to 2050) and the continents (Asia, Africa, Latin America, Oceania, Europe, and North America): where do we expect large migration flows in absolute and relative terms? How about the direction of these flows? Why? c. Which regions of the world are most affected as source and destination of refugees? Answer

44 a. For the Western Offshoots (USA, Canada, Australia, and New Zealand) the migration flows are significantly smaller today then they were a century ago. The direction is the same: there is net immigration into these countries. For Western Europe, the relative migration flows are larger today then they were a century ago. Most importantly, however, these countries have switched from net emigration to net immigration position. b. In general people move from places with lower income levels to places with higher income levels, so there is net migration towards Oceania, North America, and Europe; in that order in relative terms. These flows are relatively important for these three continents. There is net migration from the other continents. The largest net flow in absolute terms is from Asia, since this is by far the most populous continent. In relative terms this flow is small. Also note that migration from one country in Asia to another country in Asia is not included in these flows (and that between country differences in income levels within Asia are enormous). The relative flow is also low for Africa, largely because migration is costly and many people cannot afford to migrate. The relative flow is more important, therefore, for Latin America, where income levels are higher than in Africa. c. The most important regions in the world both as a source and destination of refugees are the Middle East, Africa (particularly East and Central Africa), and Latin America (in that order). The impact for the advanced countries is more modest, although Europe is more affected than North America. Chapter 10 QUESTION 0-39 If economists ruled the world, there would be no need for a WTO. a. Do you agree with the statement above? Explain. b. Throughout the book we illustrate the benefits of free trade. Yet international trade negotiations are still steeped in terms such as concessions received and granted. Can you explain why this is so? c. What is a beggar-thy-neighbour policy? d. How is this related to the set-up of international trade organizations after the second World War? e. On which three main principles is the GATT based? f. Two main exceptions are given for the non-discrimination principle. Can you explain why these have been created? g. Why did the successive trade rounds change their negotiating technique at the Kennedy Round? h. Why do international trade negotiations give particular attention to non-tariff barriers? i. What is the new protectionism? j. Which concerns gave rise to the foundation of UNCTAD? Answers:

45 a. Free trade is in the interest of all countries, even if another country imposes tariffs on your exports. Therefore, (most) economists would abolish all international trade barriers, thereby removing the need for an international trade organization. b. We have also illustrated that free trade can have winners and losers, though the overall effect is usually positive. The losers of free trade are usually easily identifiable while the benefits of free trade are more widely spread There are therefore vested interests in maintaining the status quo; talks in terms of concessions when referring to an offer of trade liberalization, pointing out the losses that will occur due to the offer. c. An economic policy whereby one country tries to export itself out of its own economic problems by depreciating its currency and imposing tariffs on imports. d. Beggar-thy-neigbour policies greatly aggravated the economic depression and led to a steep fall in international trade flows. To prevent this from happening again, various international organizations were set up to promote international cooperation on international economic issues. e. Non-discrimination, Reciprocity, Prohibition on restrictions other than tariffs. f. Free trade areas or customs unions. These are agreements to remove all internal trade barriers. Non-discrimination would imply that this will then hold for all GATT members, which is not the general intent of such an agreement. Because they do represent a move towards freer trade, they are exempt from the non-discrimination clause. Developing countries. Some advanced economies grant preferential access to developing countries exports to help them develop. Non-discrimination would give this access to all Gattmembers including other advanced economies. Since countries would then be unwilling to enact these preferential trade agreements, discrimination is allowed in this respect. g. Initially, negotiations focused on different product groups. The most important suppliers and buyers would negotiate an agreement which was then extended to all GATT members. This made it difficult to get an overall view of granted and received concessions. Therefore, negotiators switched to focusing on linear tariff reductions, whereby important categories would receive exceptions. h. It is much harder to quantify the cost of non-tariff barriers, making it difficult to compare concessions in trade negotiations. Moreover, these non-tariff barriers are often hidden, such that countries claim to offer relatively free access while they maintain barriers. Therefore, international trade negotiations focused on removing these non-tariff barriers or replacing them with explicit tariffs. i. As tariff barriers decreased, countries sough to replace them with non-tariff barriers. This gave rise to the term new protectionism. j. The terms of trade of developing countries steadily became worse since the 1950s and 1960s. The fact that tariffs were most heavily levied on finished goods, making for high effective protection for finished goods, which are primarily exported by rich countries. Developed countries believed that they needed extra protection for their developing industries. This is incompatible with the principle of non-discrimination of the GATT. QUESTION 0-40

46 We investigate trade policy in this question from a purely neoclassical perspective. a. Draw a partial equilibrium diagram for Britain on the effects (for consumers, producers, and the government) of imposing a tariff on wheat (which is on net imported into Britain), on the assumption that Britain is a large country and is able to benefit in this framework from the fact that it is a large country. Explain. b. Briefly discuss and illustrate (for example using offer curves) why or how a trade policy which leads to a partial equilibrium welfare gain for Britain (for example if Britain imposes a tariff and is a large country) may be reversed in a general equilibrium framework. Answer: a. An example diagram is given below. You should discuss the benefits for producers (producer surplus) and the government (government revenue) and the costs for the consumers (consumer surplus falls). Since part of government revenue is paid for by foreigners who receive a lower price (Britain is a large country) the partial equilibrium net benefit may be positive. The graph should reflect this by making sure that the share of government revenue paid for by foreigners is larger than the sum of the two Harberger triangles. (you may note that the net world welfare effect is always negative). Label the various points in the diagram, of course. Price demand supply p tar +T T p ft p tar q s ft q s tar import tar q d tar q d ft Quantity b. You may point out two forces in particular. First, in a general equilibrium framework the partial equilibrium gains in one sector come at the expense of a possibly higher opportunity cost loss in other sectors. Second, foreign governments may retaliate against the tariff raised in Britain, thus starting a tariff war in which all countries, including Britain, are made worse off. This is illustrated using offer curves below, where E is the initial equilibrium, Britain wants to move to point G, the rest of the world (called A) wants to move to point F, and the net effect is a move to point H in which all countries are worse off.

47 A s import B s export A s offer with optimal tariff F A s offer E B s offer H G B s offer with optimal tariff A s export B s import QUESTION 0-41 Suppose that Hong Kong is a small, open economy in a neoclassical world. It can produce two types of goods, machines and agricultural products, using two inputs, capital and labour. Assume that Hong Kong is relatively capital abundant. Hong Kong is currently engaged in free trade, but it is contemplating to impose a 50 percent import tariff. Assume you are an advisor to the Hong Kong government. Draw a (big) consistent production possibility frontier illustrating trade flows under free trade and show what happens if an import tariff is imposed (general equilibrium framework). Explain to the government how imposing a tariff creates a welfare loss through a double distortion. Answer: An example diagram is given below, where Q* is the production point under free trade and Q 2 when an import tariff is imposed. To be consistent Hong Kong must be exporting machines and importing agricultural products.

48 Machines p world p world (1+t) Q* Q 2 C 2 C 1 C* U* U 2 U 1 0 Agriculture The welfare loss can be divided into two parts. The production effect reduces welfare from U* to U 1 as producers are facing distorted prices. The consumption effect further reduces welfare from U 1 to U 2 as consumers are also facing distorted prices at home. QUESTION 0-42 The world has recently witnessed the rise of a new movement vehemently opposed to international bodies such as the World Bank, the IMF, and the WTO. This movement consists of many different groups of people, usually opposing different elements of developments in the world economy. In view of this discontent, which apparently makes people so angry that they are willing to smash city centres, break windows, start fires, and fight with the police, it is good to discuss some of the issues raised by the protestors. For clarity, we focus the discussion on the WTO as it is the most important trade organization and was the first target of the demonstrators. Give your view on the claims below. The WTO is an undemocratic organization. The WTO promotes international trade that is bad for the environment. The WTO represents exclusively the interests of the developed nations and the multinationals. The WTO leads to the development of a monotone global culture that destroys the diversity of other cultures. The WTO promotes unfair trade. The WTO policies increase global inequality. The WTO policy of free trade destroys jobs. Answers: This if for discussion in class. There are arguments in favour and against most issues mentioned.

49 QUESTION 0-43 The European Union (EU) is considered to be a large country in this question. In the 1980s Japanese producers began to export many cars to the EU. To protect their domestic car industries, the governments of the EU countries pushed for protective tariffs. We analyse the impact of these tariffs in a partial equilibrium framework. a. What makes a partial equilibrium analysis partial? b. Draw a partial equilibrium figure of the EU car market. Indicate clearly the volume of Japanese imports before and after the imposition of the tariff. c. Is the tariff welfare improving for the EU? Why, or why not? The Japanese car manufacturers were not happy with the EU protection and started a lobbying process in Brussels to abolish the EU tariffs. These lobbying efforts were not completely successful, such that the tariffs are abolished in return for a voluntary restriction of car exports to the EU. d. Why do the Japanese firms prefer the voluntary export restraints (VERs) to the tariffs? e. What is the tariff-equivalent import quota (or rather VER in this question) for Japan in your figure of question b? Answers: a. In a partial equilibrium approach, we do not completely specifiy all actors and goods and relationships in an economy. These are assumed to be constant or to have a negligible effect on the issue we are looking at. A variety of economic variables is therefore taken as given and not determined within the economic model. b. The European Union is considered to be a large country, so the decrease in the demand for Cars on the world market will depress prices. Japanese imports logically fall after the implementation of the tariff. The figure below gives the desired overview of the EU car market.

50 price supply p 2 p 1 (1+t) tariff p 0 p 1 imports with tariff imports without tariff demand q 0 q 1 q 2 q 3 q 4 quantity increase producer surplus -/- = net loss; possible gain decrease consumer surplus government revenue c. The question whether welfare improved or not depends on the extent of the decrease in the world price after the tariff. The greater the market power of the importing country, the greater the effect on world prices. If the lower part of the increase in government revenue is greater (smaller) than the Harberger triangles, welfare increases (decreases). d. By voluntarily cutting back exports the Japanese can reap the rent that is associated with the reduction in output. The area marked government revenue will now be collected by someone else, this could be the Japanese producers (producer surplus) or some agents who own the rights to these imports. If the Japanese firms prefer the VER they believe that they can capture at least some of this rent. e. The tariff-equivalent quotum is in this case q3-q1. By installing this quota, instead of the tariff, the level of imports will stay constant. QUESTION 0-6

51 Briefly discuss and illustrate (for example using offer curves) why or how a trade policy which leads to a partial equilibrium welfare gain for Britain (for example if Britain imposes a tariff and is a large country) may be reversed in a general equilibrium framework. Answers: The student may point out two forces in particular. First, in a general equilibrium framework the partial equilibrium gains in one sector come at the expense of a possibly higher opportunity cost loss in other sectors. Second, foreign governments may retaliate against the tariff raised in Britain, thus starting a tariff war in which all countries, including Britain, are made worse off. This is illustrated using offer curves below, where E is the initial equilibrium, Britain wants to move to point G, the rest of the world (called A) once to move to point F, and the net effect is a move to point H in which all countries are worse off. A s import B s export A s offer with optimal tariff F A s offer E B s offer H G B s offer with optimal tariff A s export B s import Chapter 11 QUESTION 0-44 The rapid economic growth in China is accompanied by rapid growth in air travel, creating opportunities for Boeing (an American firm) and Airbus (a European firm) to sell their planes in China. We use the Cournot framework as in the Brander-Spencer model for our analysis. The figure below gives possible reaction curves and isoprofit curves for both Airbus and Boeing.

52 output Boeing Charles van Marrewijk, 2017 International Trade Oxford University Press a b c d output Airbus a. Make clear for each of the different curves in Figure 1 if it is a reaction curve or an isoprofit curve and to which of the two firms it belongs. Where is the Nash equilibrium without government intervention? Explain. b. Suppose that the European Commission (EC) would like to give Airbus a strategic advantage in China. It therefore gives an optimal (total welfare-maximizing) subsidy for every airplane Airbus sells to China. What does the EC do and how does it affect the curves in your figure? Explain. Answer a. The figure below illustrates. Maximum profits are reached if the firm is a monopolist and the other firm does not produce (indicated by q mon ). For a given level of the competitor s output the iso-profit curves are tangent to that level at the reaction curve (vertical for Boeing, horizontal for Airbus). The (straight line) reaction curves connect these points. The Nash equilibrium is at the point of intersection of the reaction curves. Given the output level of the other firm, neither firm can reach higher profits.

53 output firm B output Boeing Charles van Marrewijk, 2017 International Trade Oxford University Press Airbus reaction curve q mon,b Boeing iso-profit curve Nash equilibrium Airbus iso-profit curves Boeing reaction curve q mon,a output Airbus b. The figure below illustrates. The EC provides an optimal subsidy to Airbus such that its reaction curve shifts to the right just enough to intersect Boeing s reaction curve at point BS where the iso-profit curve for Airbus is tangent to Boeing s reaction curve. This maximizes European welfare in this setting. = firm A iso-profit curve = firm B iso-profit curve firm A reaction curve firm A reaction curve after subsidy q mon,b C BS firm B reaction curve output firm A q mon,a QUESTION 0-45 We could also imagine that Airbus and Boeing (see question 0-44) are competing with each other in a Bertrand framework (price competition), rather than a Cournot framework (quantity competition). Again the European Commission wants to stimulate the sales of Airbus in China.

54 price Boeing Charles van Marrewijk, 2017 International Trade Oxford University Press a. Draw the reaction curves and some isoprofit curves for both Airbus and Boeing in a Bertrand framework. Put the price of an Airbus aircraft on the horizontal axis and the price of a Boeing aircraft on the vertical axis. b. Should the European Commission subsidize or tax the aircraft Airbus sells to China? Draw the new situation in the figure when the European Commission optimally employs the instrument. How does the price demanded for aircraft change for both Airbus and Boeing? c. What will the US government think of the EU policy? d. Explain whether the Cournot or Bertrand framework is more appropriate to analyse competition between Airbus and Boeing. Answers: a. The figure below gives the iso-profit and reaction curves of Airbus and Boeing in a Bertrand framework. Boeing iso-profit Airbus iso-profits Bertrand 3 3 price Airbus b. Airbus reaches an iso-profit curve with a higher profit when the European Commission levies an export tax. In this case the reaction curve of Airbus shift to the right. A higher profit is reached in this case because it is credible that Airbus will not deviate from the new higher price. This was not the case when Airbus would have raised its price without the export tax. The optimal point for Airbus is where the iso-profit curve is tangent at the reaction curve of Boeing. At this point the highest possible sum of profit and tax revenue is reached. The European Commission will therefore have to introduce an export tax that exactly pushes the reaction curve to this point. This is shown in the figure below. It can be seen that the price of both Boeing and Airbus increases.

55 price Boeing Charles van Marrewijk, 2017 International Trade Oxford University Press Airbus iso-profits Boeing iso-profit Eaton- Grossman Bertrand 3 3 price Airbus c. The US government will like the employment of the export tax by the European Commission. At the new equilibrium also Boeing is at a higher iso-profit curve. d. It is not clear whether Boeing and Airbus compete by underbidding each other (Bertrand) or by setting quantities of airplanes produced (Cournot). Irwin and Pavcnik (2004) 1 report on the one hand that the chairman of Airbus admitted to pricing for market share we had to do it in order to get our feet in the door pointing to Bertrand competition. On the other hand, industry sources report that capacity constraints were not binding during the 1980s pointing to Cournot competition. This stresses the point that in practice it is difficult to determine what policy instrument to apply. One could argue however that the Cournot framework is the most appropriate because it allows for retaliation between the two governments, which we see in practice. But then again, governments are not always rational. QUESTION 0-46 Policies affecting rice production, consumption, and trade; selected countries, Production Consumption Trade Country Fuel Irrigation Price support Price assistance Rice distribution Export ban State trading Export license China yes no yes no no no yes no India yes yes yes yes yes yes yes no Indonesia no no yes yes yes no no yes Pakistan no yes no no no no yes no Philippines no no yes yes yes no yes no Thailand no no yes no no no no no Vietnam no no yes no no yes yes no Source: amended from USITC (2015): Rice: Global Competitiveness of the U.S. industry, publication number D.A. Irwin & N. Pavcnik, Airbus versus Boeing revisited: international competition in the aircraft market, Journal of International Economics 64, 2004, p

56 Rice is extremely important for Asian countries. The above information is taken from USITC (2015). It depicts information on intervention in the domestic rice market for a range of Asian countries for eight different types of policies, grouped together in three categories (production, consumption, and trade). India, for example, uses 7 policies for its rice market, while Thailand uses only 1 policy. Choose one of the 7 countries listed in the table and write a brief essay regarding the economic and policy implications of this country s intervention in the rice market relative to the eight other countries and possibly non-listed countries. Give brief associated advice to the government of your country regarding rice market intervention. Answers: It is an essay; the arguments will depend to some extent on the country of choice and potential outside countries this is compared to. Each essay is evaluated based on its own merits. A choice of India or Indonesia, for example, should probably point out that the government intervenes in so many ways that the outcome is unclear and inconsistent. Import subsidies and import restrictions? Consumer subsidies for a market in which the government intervenes in so many ways? Probably more efficient for the government not to intervene in the first place. One can point at the general trade policy effects for small countries or the retaliation threats for large countries. There seems little room for strategic trade policy. Some may argue that the government strives for selfsufficiency, but then why should the government do that? In fact, consumers in countries that do not strive for self-sufficiency hardly ever seem to be affected by famines, in contrast to countries that do strive for self-sufficiency, and so on. QUESTION 0-47 Wodgets are produced in Somewheria by one firm only under increasing returns to scale. You are an advisor to the government of Somewheria which wants to impose either a tariff on the imports of wodgets or an equivalent quotum (leading to the same quantity of imports as the tariff). What do you recommend to the government and why? Answer Since there is only one firm producing wodgets which is characterized by increasing returns to scale (so it is not easy for other firms to enter the market) you should recommend to the government to introduce a tariff rather than a quotum. If you use a quotum under these circumstances the monopolist can (ab)use its monopoly power once the quotum is filled (since there is no longer a threat from foreign competition), which leads to higher prices for consumers and thus a larger welfare loss for the country than the imposition of a tariff. QUESTION 0-48

57 In the state of Alusia there is only one producer of olive oil. The producer is highly regarded by the government of Alusia because it has been producing olive oil for centuries using traditional methods which give the olive oil a typical Alusian taste. After a long period of autarky, the Alusian government decides to open the borders to international trade and allow its citizens to consume a larger variety of products. The government is, however, concerned about the consequences of this policy for the olive oil monopolist. The figure below gives the demand for olive oil in Alusia, the marginal cost curve of the monopolist, and the price of olive oil on the world markets. 2 a. Indicate the autarky quantity supplied to the market and the price of olive oil in the figure above. b. What would be the production level of olive oil for the Alusian producer, the quantity imported, and the price of olive oil in Alusia under free trade? The Alusian government is considering protecting the olive oil industry by either imposing a tariff or introducing an import quota on the imports of olive oil. c. Suppose that the government introduces a tariff such that the world price plus the tariff is below the competitive price and olive oil is produced domestically. Indicate the domestic production level, the import level, the price level, the consumer surplus, producer surplus and the government revenue for this tariff rate. d. Determine what quota the government should impose which leads to the same level of imports as in question c. Indicate the domestic production level, the import level, the price level, the consumer surplus, producer surplus and the government revenue for this import quota. e. Explain whether you recommend the Alusian government to introduce a tariff or an import quota. Answers: a. To maximize profits a monopolist will produce at the point where marginal cost equals marginal revenue. The price and production of the monopolist can therefore quite easily be derived by drawing the marginal revenue curve as in the figure below. 2 Coming from non-mediterranean countries we crudely assume that olive oil is a homogenous good.

58 Price demand P mon MC MR P world q mon Quantity b. With free trade, domestic prices will be equal to world prices p world. At this price demand for olive oil will be equal to q free (see figure below) and domestic production will be zero because the world price is below the marginal cost line of the monopolist. Hence, imports will be equal to q free. Price demand MC MR P free q free Quantity Import c. With perfect competition the price for olive oil is equal to marginal costs. The competitive price can therefore be found at the point where the demand and marginal cost curves cross each other. See the figure below. The figure below also shows a tariff rate such that the world price plus the tariff is below the competitive price and olive oil is produced domestically. The monopolist will equalize marginal revenue (which is equal to the world price plus the tariff) and marginal costs. Domestic supply is therefore indicated by the marginal cost curve. Domestic demand is larger then domestic supply. Imports make up this difference. The consumer surplus is indicated in blue, the producer surplus in red and the government revenue green in the figure below. Consumer surplus is the section below the demand curve and above the world price plus the tariff. Producer surplus is the section between the marginal cost curve and the world price plus tariff. The government revenue is the amount of imports times the tariff (world price plus tariff minus the world price).

59 Price demand MC P world +t P world Dom. Prod. Import Quantity d. Due to the quota the demand curve of the monopolist shifts inwards to the point where the world price plus tariff crosses the marginal cost curve of the domestic producer. The domestic firm s marginal revenue curve is generated by the restricted demand curve. The domestic production and the price the monopolist demands can now be determined at the intersection of the marginal revenue and marginal cost curve. The figure below shows that the domestic olive oil producer can again exercise monopoly power. Consequently domestic production is lower than in question c and the price level higher than the world price plus tariff. Also imports will only be offered at the same price as the monopolist demands. Price demand MC P dom P world +t P world Dom. Prod. MR Import Quantity The consumer surplus and producer surplus are determined in the familiar way. They are indicated in blue and red respectively in the figure. Depending on the mechanism by which foreign producers acquire the import quota, also the Alusian government may have a revenue. When the Alusian government organizes an auction, the government is likely to gain the difference between the world price and the domestic price (indicated in green in the figure below). If the government gives the quotas for free to favorite foreign producers, the government has no direct gain. e. It would be best for the government not to introduce any trade restriction at all. Total surplus will be largest in this case (you can check that for yourself). If the government wants to protect the domestic olive oil industry it would be best to introduce a tariff. In this way the government

60 does not lose the yellow area as indicated in the figure in the answer to question d (and possibly the green area). Chapter 12 QUESTION 0-49 Briefly answer the following questions. a. What happened to the number of regional trade agreements (RTAs) since 1960? b. Which (type of) countries were initially (1960s to 1980s) more active in RTAs and which (type of) countries have become more active since the 1990s? c. What is shallow versus deep integration and how does it relate to the development of RTAs over time? Answer a. The number of RTAs increased rather slowly from 1960 to around 1993 and much more rapidly since then. b. Initially, Europe and the US (or advanced countries) were active players in signing RTAs. Since the 1990s developing countries have become much more active in signing RTAs, particularly the least developed countries since c. Shallow integration refers to simple free trade agreements (FTAs). Deep integration refers to more complicated economic integration agreements (EIAs) involving common policy, coordination, intellectual property rights, and so on. Over time RTAs have become more complicated and the share of EIAs has risen substantially compared to FTAs. QUESTION 0-50 The European Union has some minor grapefruit producers (mostly in Cyprus, Italy, and Greece) and imports most grapefruit from the USA. On all imports of grapefruit the European Union levies a common tariff. Recently, Turkey has expressed ambitions to conquer the European grapefruit market by planting many new grapefruit trees. These new farms are not yet as productive as their US counterparts (even when transport costs are taken into account) but will be cheaper once Turkey establishes a customs union with the European Union in agricultural products. Officials from the European Union worry about what will happen with the European grapefruit market and ask for your advice. a. Draw a partial equilibrium framework of the European grapefruit market. Draw the demand and supply of grapefruit within Europe and the supply curves of the USA and Turkey. Indicate clearly the price of grapefruit in Europe, European production and European imports of grapefruit. b. What happens to the imports, the production, and the price of grapefruit in Europe once it establishes a full customs union with Turkey? c. What are the welfare effects of a full customs union with Turkey for consumers, producers and the EU governments? What is the total welfare effect?

61 d. If the European Union still wants to pursue a full customs union with Turkey, is there a loophole to increase welfare on the grapefruit market? Answers: a. The figure below shows the partial equilibrium framework of the European grapefruit market. The price for grapefruit on the European market will be equal to P US +t. P D S p T + t p US + t p T p US Production Import Q b. Once the European Union establishes a full customs union with Turkey there will be no more tariffs levied on grapefruit from Turkey. Therefore the price of grapefruit decreases to P T. As can be seen in the figure below, this leads to a fall in European production, a rise in European consumption and consequently an increase in imports. It is important to note that imports no longer come from the United States. Grapefruit from the United States has become too expensive (including the tariff) and hence all imports come from Turkey. P D S p T + t p US + t p T p US Production Import Q

62 c. The figure below shows the changes in the different surpluses. European consumers gain from the full customs union because the price for grapefruit becomes lower. They gain the area between P US +t and P T (partly indicated in red because the other areas cover it). European producers do not like the customs union because some cannot produce competitively against the lower price. Hence producer surplus decreases with the blue area. Also the European government loses because they no longer receive tariff income. This is indicated in green in the figure below. This loss is mainly the result of trade diversion. The total welfare loss is the bright green area (trade diversion) minus the two red triangles (trade creation). In this case the trade diversion effect clearly dominates the trade creation effect. P D S p T + t p US + t p T p US Q d. Based on your analysis of the European grapefruit market a full customs union with Turkey is not recommendable. If the European Union still wants to pursue a full customs union, it could consider to also abolish trade tariffs on grapefruit imports from the United States. In this way the trade diversion effect is avoided and welfare on the European grapefruit market even increases. QUESTION 0-51 Briefly answer the following questions. a. What are the European Union s (EU) four freedoms? b. Briefly describe the history of EU integration. c. What are two main challenges for the EU? Answer a. The free movement of goods, persons, services, and capital. b. The EU started in the 1950s as a cooperation agreement between 6 countries for two core sectors. Since then the integration process has become ever more involved and many new

63 countries joined the EU, reaching 28 countries in After the result of the Brexit referendum it seems likely that for the first time a country will exit the EU (the UK filed for EU exit on 29 March 2017). The most far-reaching integration process consists of a sub-group of countries which established a single currency, the Euro Area or Eurozone countries. c. One can think, of course, of several important challenges facing the EU, but three particularly important issues that come to mind are the following: How to deal with the enormous diversity within the EU (rich and poor countries, big and small countries, at different geographical locations): which issues deserve highest priority and why. In this respect think of the proper response to the (2008) financial crisis. How to deal with the (Syrian) refugee crisis, which has put tremendous pressure on the willingness of countries to cooperate and make agreements. How to deal with the democratic deficit. People in different countries have a different influence at the EU level and decision making is only indirect. Giving more power to the European Parliament in a more one-man-one-vote system would potentially solve this deficit, but few countries and people living within the EU seem to be willing to go into that direction. Currently (2017), the mood seems to be swinging in the opposite direction, leading to the Brexit vote. QUESTION 0-52 Many papers have analysed the net welfare effect of regional trade agreements in a multi-country general equilibrium framework. Despite the analytical advances, however, the net welfare effect of regional trade agreements remains ambiguous. Two schools of economists have arisen. One school claims that regional trade agreements are likely to be more welfare enhancing. According to the other school, trade-diversion is likely to dominate trade-creation in most situations. Their disagreement is mainly on the importance of transport costs. a. Explain how the results of the general equilibrium model of Krugman (see Section 12.6) change when transport costs are introduced. b. Which regional trade agreements will economists mention when they want to stress that regional trade agreements are likely to be welfare enhancing? c. Which regional trade agreements will economists name when they want to indicate that regional trade agreements are likely to deteriorate welfare? Answers: a. In the model of Krugman it is assumed that every country or region consumes an equal share of all the product varieties in the world. This means that every region trades an equal share with all other regions in the world. This may be a good assumption when transport costs are absent. However, in a world with transport costs product varieties in neighboring regions are cheaper compared to regions far away. Regions are therefore more likely to trade more heavily with neighboring regions. Because also regional trade agreements are mostly signed with neighboring

64 countries, these agreements are likely to be more welfare enhancing than the Krugman model suggests. b. The answer to this question is open for discussion. A few examples of regional trade agreements, which were welfare enhancing, were the membership of the European Union of Great Britain, Ireland, Sweden and Austria. These countries have a relatively minor share of outside-eu trade due to their location. Hence trade diversion was likely to be small. This is probably also true for the members of NAFTA. c. A significant number of trading blocs between developing countries realize more trade between non-members and members than between the members of the trading bloc themselves. This is for example the case for COMESA and CARICOM. Trade diversion is probably larger for these trade agreements than trade creation. QUESTION 0-53 Most countries move from a relatively shallow type of economic integration to deeper types of economic integration. The main text describes, for example, that the European Union started out as a preferential trade agreement in 1951, a customs unions in 1968 and developed into a common market in Also for other regional trade agreements such a time line can be drawn. Search the Internet (or the main text) and do this for the regional trade agreements below. a. COMESA b. ASEAN c. EAEC d. CARICOM Answers: The table below shows the time line of the different organizations. It is noteworthy that only the European Union is at present a common market. COMESA ASEAN EAEC CARICOM PTA FTA Customs Union 2008 Future 1973 Common market Future Economic Union 1. ASEAN was established by signing the Bangkok agreement in This agreement established only an agenda for economic cooperation however and did not actually establish a preferential trade agreement. This only happened in 1977.

65 density Charles van Marrewijk, 2017 International Trade Oxford University Press 2. On the summit in Singapore in 1992 it was decided to establish a free trade area in 15 years. In the ASEAN Vision 2020 adopted in 1997 a time frame for the free trade area is no longer mentioned however. 3. The members of the Eurasian Economic Community claim to have created a customs union in Careful reading however shows that they are still implementing plans to harmonize trade policy towards non-members. 4. Establishment of the Caribbean Free Trade Association (CARIFTA). This was later transformed into the Caribbean Community and Common Market (CARICOM). Chapter 13 QUESTION 0-54 productivity The figure above shows a productivity distribution of firms in Somewheria. a. Briefly discuss how Melitz s model of firm heterogeneity under autarky and free trade identifies three types of firms under these different situations; illustrate these three firm types in a copy of the above figure with additional information. b. What are the additional gains from trade identified by Melitz? Relate your discussion to your copy of the figure. Answer: The figure below illustrates the main effects. a. We observe a ranking of firms: the least efficient firms are forced to exit the market, both in autarky and in free trade. Of the viable firms exporters tend to be more productive than firms producing only for the domestic markets (domestic firms). This can be explained by a selfselection effect: only the firms that are productive enough to pay for the fixed costs of exporting to another market can generate large enough operating profits to pay for these costs (hence exporters are more productive than domestic firms).

66 density Charles van Marrewijk, 2017 International Trade Oxford University Press b. Melitz identifies productivity gains from trade. This consists of two effects. First, the stronger international competition compared to autarky drives the least productive firms out of the market altogether (only the more productive firms survive, see arrow in figure). Second, within the set of surviving firms there is a shift in production towards the more productive firms as only those firms are able to export and expand production (right-hand side of the figure). (In contrast, production of domestic firms contracts because of the stronger competition.) Export cutoff productivity Trade cutoff productivity Autarky cutoff productivity exit market Produce for domestic market Produce for domestic market and export market productivity QUESTION 0-55

67 price, mc, mr c 3 demand c 2 c 1 quantity The figure above illustrates a demand schedule confronted by three types of firms, namely a firm with marginal cost level c 1, c 2, and c 3. a. Make a (large) copy of the figure. Draw in the marginal revenue curve. For each of the three firms determine (explain and draw in the figure): The quantity produced The price charged The operating profits received b. Explain briefly how the information from question a can be useful for determining which firms are engaged in export activity and which firms are not. Answer a. The figure below provides details. The marginal revenue curve has the same intercept and a slope twice as steep. Quantity is determined by the point of intersection of marginal costs with marginal revenue (E 1, E 2, and E 3 ). The associated quantities are given by q 1, q 2, and q 3 and prices by p 1, p 2, and p 3. Operating profits are the difference between price and marginal costs times quantity, as indicated (zero for number 3).

68 price, mc, mr p 3 E 3 c 3 demand p 2 (p 2 -c 2 )q 2 p 1 E 2 c 2 (p 1 -c 1 )q 1 E 1 c 1 mr q 3 q 2 q 1 quantity b. Question a shows that operating profits are lower for firms with higher marginal costs. If engaging in export activity requires a fixed cost to enter the market only sufficiently efficient firms with low marginal costs (such as firm 1) are able to recover these costs. QUESTION 0-3 In Box 13.4 it is stated that firm revenue makes a jump of size εf x at the export viability cut-off point. Explain in detail why. Answers: The reasoning is similar as for the viability jump explained in the Box. Below the export cut-off level ε 1 export revenue is zero. At the export cut-off level the fixed export costs f x have to be φ x recuperated, which requires an export level ε times as high, so the jump is εf x. QUESTION 0-4 Figure 13.4 depicts exporter premia. Apparently (without controls), exporting firms in general have about 33 per cent higher log value added per worker but only 3 per cent higher total factor productivity. Explain possible sources of this difference.

69 Answers: The most likely explanation for the fact that exporters have about 33% higher log value added per worker and only 3% higher total factor productivity is that exporting firms in general make more intensive use of some other type of input, such as physical capital or human capital, or are better able to use scale economies because of size effects; this is then responsible for part of the higher value added per worker. Nonetheless, the evidence shows that even if we control for these aspects (and fixed effects and size effects), exporting firms still tend to have higher productivity levels as measured by log TFP (namely 4%) Chapter 14 QUESTION 0-56 Briefly answer the questions below. a. For exporting firms, briefly comment on the distribution of these firms regarding: The number of products exported. The number of countries exported to. The value of exports. b. Do the same for importing firms. c. Briefly list three of Antras and Yeaple s six stylized facts. Answer a. Most exporting firms Trade very few (one or two) products with other countries. Trade with only a few (one or two) other countries. Have a very low export value; only a few firms exporting 6 or more products to 6 or more countries are responsible for the large majority of export value. b. This distribution looks the same from an import perspective. c. See the book for the list of facts. QUESTION 0-57 Several academics have wondered why a firm establishes a production plant abroad since this involves extra costs compared to home production (think, for example, of the cost of transferring people to a foreign country, of acquiring information, of overcoming language barriers, and of fighting cultural differences). a. What is required according to Dunning before firms establish or purchase production plants abroad? Describe all the conditions carefully. b. Give an example of every condition that is not mentioned in the main text.

70 c. How are the conditions modelled in the multinational model of Markusen and Venables (see section 14.6)? d. Why do all conditions have to be satisfied before a firm becomes a multinational? Answers: a. According to Dunning, three conditions need to be satisfied in order for a firm to establish or purchase a foreign production plant. This is the so-called OLI-approach. The conditions are: Ownership advantages: The firm needs to have a product or production process that is not accessible for other firms. Location advantages: It must be attractive for the firm to establish a production plant in another country instead of exporting the product. Internalization advantages: It should also be more profitable for the firm to own a foreign production plant itself instead of licensing its unique product or production process to a foreign production firm. b. The table below gives some examples. Condition Ownership Location Internalization Examples Firm-specific technology for example in the form of a patent, brand name, privileged access to factor markets, superior management skills Factor costs, natural resources, promotion of investments, barriers to trade Lower transaction costs, moral hazard, quality control, protection of reputation, keep technological secrets c. In the multinational model of Markusen and Venables ownership advantage is modeled as a fixed cost to establish a firm (f en ). An entrant has to incur a cost of f en and fixed plant cost f pl before it can start producing. The location advantages are the transport costs τ and the wage rate in a country. High transport costs and a low wage rate may stimulate a firm to establish a plant in another country at the additional plant cost f pl. The internationalization advantage is simply not included in the Markusen and Venables model. Firms can only choose between establishing a plant in another country and not establishing it. There is no possibility of licensing the product (which would also be senseless because it is a homogeneous product). d. In the real world all three conditions need to be satisfied before a firm will establish a production plant in another country. When there is no ownership advantage the firm does not have an obvious product to sell on the foreign market. When there is no location advantage the firm can better produce its product in its domestic plant. When there is no internalization advantage the firm can better license the product instead of producing it itself. So all three conditions need to be satisfied in order for foreign production to occur.

71 Endowment of capital Charles van Marrewijk, 2017 International Trade Oxford University Press QUESTION 0-58 The Markusen Venables general equilibrium model on national and multinational firms explains how the distribution of endowments, that is (human) capital and labor, over two countries A and B and the economic size of these countries can help to explain why we have (i) only national firms, (ii) only multinational firms, or (iii) a mix of national and multinational firms. It analyzes both inter- and intra-industry trade. The figure below identifies three areas, namely I, II, and III. Indicate which area belongs to (i), (ii), and (iii) mentioned above and explain why. Origin B I II III I Origin A Endowment of labor Answer Area I has (i) only national firms. In this area either the other country s market is too small in size to set up a subsidiary abroad or most trade is of the inter-industry type as capital-labor ratios are very different. Area III has (ii) only multinational firms. Capital-labor ratios are similar, so there is limited inter-industry trade. The size of the other country is also similar, so it is worthwhile to set up a subsidiary abroad. Area II has (iii) a mix of national and multinational firms as it is the transition from one type of regime to the other. QUESTION 0-59 Chapter 14 first describes some empirical observations on the foreign direct investment flows between countries. The Markusen and Venables model (see Section 14.6) explains some of the most important empirical observations. This question reviews the empirical observations and their theoretical explanations.

72 a. Are the FDI flows into the least developed nations large or small? What is the theoretical explanation for this in the Markusen and Venables model? b. Are the FDI flows into the developed nations large or small? What is the theoretical explanation for this in the Markusen and Venables model? c. What other factors could explain FDI flows between countries? Answers: a. FDI flows to the least developed countries, such as the African countries, are very small. This can be explained by the small size of the domestic markets of most African countries. Most African countries have a small level of GDP. Because of economies of scale, African countries are therefore an unattractive home base for production. In the Markusen and Venables model there is, however, also a factor that may make developing countries an attractive place to establish a plant. The abundance of low-skilled labor is accompanied by a low wage rate. This is attractive for production processes that are relatively low-skilled labor intensive. Judging by the small FDI flows to the least developed countries, this force is rather weak (or other issues may be involved; recall that the wage rate compared to productivity levels is important). b. FDI flows to the advanced countries in Western Europe and North America are large. This is in the first place explained by the large size of most domestic markets for advanced countries, making it an attractive home base for production due to economies of scale. Furthermore, endowment ratios are relatively comparable between developed countries, making it attractive for firms from developed countries to establish a plant in these countries. c. There are many factors not included in the Markusen and Venables model that also partly determine FDI flows. Some are listed in the answer to question b. Another important factor is the political and economic stability of a country. A firm would not like to invest in a country whose government is likely to expropriate plants or lets the value of the currency plunge by printing money. This is for some developing countries an additional reason not to invest. See also Chapter 15 on vertical FDI. QUESTION 0-60 Imagine a machine manufacturer operating in East Germany. Before the fall of the Berlin Wall the manufacturer is only producing for the national market and prohibited from exporting to other countries. After the fall of the Berlin Wall, the manufacturer is allowed to sell machines to other countries. In contemplating how to deal with the new situation the manufacturer uses the model of Markusen and Venables. She wants to sell the machines in four countries with the following characteristics:

73 West Germany is more advanced and capital abundant compared to East Germany. Because they are neighbouring countries, transport costs are low. Moreover, the German government provides a subsidy to East German firms establishing a plant in West Germany. Poland is also a neighbouring country with low transport costs. The Polish government does not provide a subsidy for the establishment of a plant. The level of development (measured by the endowment ratio) is more or less the same as in East Germany, but the Polish economy is considerably larger. As a result of newly introduced safety controls at the border, transport costs to the Czech Republic are very high. Like Poland, the Czech government does not provide a subsidy for the establishment of a new plant. East Germany and the Czech Republic are broadly equal in size and in level of development. Slovakia is not a neighbouring country, such that transport costs are high. The establishment costs for a plant are high due to a tax. Also Slovakia and East Germany have the same level of development, but the Slovakian economy is smaller than the East German economy. The manufacturer has to decide if she should establish a plant in the other country or produce the machines in East Germany and export the products. a. At which node of the decision tree in Figure is the manufacturer? b. Consider for each of the four countries if it is likely that the manufacturer establishes a new plant according to the Markusen and Venables model. In which country is the producer most likely to establish a plant and in which least likely? Answers: a. The firm has already headquarters in East Germany and therefore has to decide whether multiplant production is attractive. The firm is therefore at the node: multi-plant production? b. The table below shows whether a factor is favoring the establishment of a plant in a country (+) or discourages the establishment (-). All in all the East German machine manufacturer is most likely to establish a firm in de Czech Republic. Maybe a firm can also be established in Poland, but West Germany and Slovakia are least attractive to establish a new firm. Endowment Size Subsidy Transport cost Total West Germany Poland Czech Republic Slovakia

74 Chapter 15 QUESTION 0-61 Briefly answer the following questions. a. What are global supply chains? b. What is an indicator for the rise of global supply chains if we look at trade data? Why? c. How are global supply chains related to offshoring? d. What are backward linkages in trade flows? e. What are forward linkages in trade flows? Answer a. Global supply chains represent the international counterpart of the fragmentation process. Fragmentation refers to production processes being cut-up in separate stages, usually performed by different firms. In global supply chains these firms are located in part in other countries. b. An indicator is the decline in value-added to gross trade flows in international trade data, as this reflects the fact that a rising share of trade flows does not represent domestically added value but value added previously imported from abroad. (an alternative measure, as discussed later in the chapter, is the Grubel-Lloyd index). c. Offshoring implies the re-location of (part of) a production process to another country. This may be internal offshoring or external offshoring (to another firm). In either case, offshoring implies the creation of a global value chain or a rise in the international component of the global value chain. d. Backward linkages in trade flows refers to the share of foreign value added in a country s (or sector s) gross export flows; it thus refers to the value of trade created outside of the country and previously imported into the country. e. Forward linkages in trade flows refers to domestically created value added (by the exporting country) that is subsequently used as an intermediate input in the production process of the importing country. QUESTION 0-62 The figure below is taken from the World Trade Report Briefly explain the connection of the figure with Global Value Chains and the two main issues that (according to you) the above figure illustrates, and why.

75 Share of imports in parts and components, (percent) developed-developed other G20 developing- G20 developing Answer: Global value chains are becoming more important in trade flows over time. This cannot be deduced from the figure as it only focuses on the distribution of shares across groups of countries. By their very nature global value chains cross national boundaries and are reflected in international trade flows, in particular through imports of parts and components. The figure provides insights in the changing structure of global value chains by analysing changes in the distribution of imports of parts and components for different groups of countries. The figure illustrates (i) the declining role of advanced countries (developed-developed) in the share of imports in parts and components (the rising role of developing countries is its mirror image and does not have to be mentioned separately) and (ii) the rising links between advanced countries and G20 developing countries (developed-g20 developing rises rapidly) at the expense of the links between advanced countries and other developing countries (developed-other developing is falling over time). QUESTION 0-63 a. Explain why a (detailed) Grubel-Lloyd index can be used as an indicator of supply chains? b. Which types of countries (in terms of income per capita) are most involved in global supply chains if we use the Grubel-Lloyd index as an indicator, and which type of countries are not? Answer a. A country s global supply chain activity involves either the simultaneous import of components (intermediate goods) and export of final goods within a certain sector or the export of components and imports of final goods (or more complicated components) within that sector. In

76 either case the Grubel-Lloyd index, which measures the intensity of a country s simultaneous imports and exports within a sector, can be viewed as an indicator for the extent in global supply chain involvement. b. In general, the involvement in global supply chains rises if per capita income rises, although the variation between countries is substantial, particularly for the higher income countries. It is clear, however, that the least developed countries (low income countries) are hardly involved in global supply chains at all. QUESTION 0-4 Donald Trump became president of the USA in During the campaign he focused on America First and was particularly critical of Mexico and China. Mexico: Trump wants to create a big wall at the Mexican border to keep (illegal) immigrants out and argued that Mexico should pay for it. As possible sources of revenue, he threatens to raise an import tariff on Mexican goods of 35% and to tax Mexican remittances. China: Trump argues that China is a currency manipulator which results in a trade surplus. Trump threathens to impose an import tariff on Chinese goods of 45% in an effort to bring back the jobs America lost to China. To provide some background information the figure below shows the export (panel a) and import (panel b) of American goods in total and relative to Mexico and China. Since the original data are in current USD, the data are shown as a percentage of total average American trade (= (export + import)/2) in the relative year. Note that the scales in the two panels are the same and the total flows are depicted on the right-hand scales of the panels. For further guidance, the table below provides the percentages for the first and last year. Figure q2; American exports (panel a) and imports (panel b), % of American trade 36 a. American exports b. American imports USA total import; right-hand scale 108 USA total export; right-hand scale import from China export to Mexico 36 9 import from Mexico 36 export to China Table q2; American exports and imports 2001 and 2016, % of American trade

77 export export export import import import year USA all to Mexico to China USA all fr Mexico fr China Using the information provided above and the knowledge you gained throughout the Growth and Development course, write a brief essay for an educated lay audience (such as readers of The Economist) arguing what might happen in the world (in particular in America, Mexico and China) if Trump tries to push through the announced measures above. (answer questions on who gains or loses, how the above information plays a role, what other information we might need to properly address the issues raised, supply chains, migration flows, jobs in America, and so on) Answer: It is an essay, so each brief essay is evaluated on its own merits. Issues that, of course, play a role are the differences in developments relative to China and Mexico. The trade position relative to Mexico is relatively stable, with larger imports than exports, but the difference between these two not all that spectacular, certainly not in view of the large trade deficit of the USA as a whole. If we take into consideration the fact that these flows are closely linked through supply chains created after NAFTA, we realize that the imposition of tariffs and other restrictions (on capital flows in the shape of remittances) will drastically affect the competitive position of both countries. In this case both Mexico and the USA will weaken their international competitive position and create opportunities for other countries to take over. It is highly unlikely that this will create any jobs in America; it will also hurt Mexico in this respect, particularly since migration flows will be affected, as will remittance flows. The trade position relative to China is much more dynamic. It is true that exports to China have risen substantially (by 4 percentage points), but imports have risen even more spectacularly (by 15 percentage points). The supply chain connections relative to China are much weaker, but we know they are particularly important in the ICT sector, where America is world leader. Threathening this global ICT supply chain success seems an unwise policy from America s perspective as well. One can ague that the imposition of the measures suggested will only increase the speed at which Chinese firms will take over the earlier and later stages of the smile curve (R&D and marketing). Unlike the Mexico case, Chinese firms are actively involved in selling many other types of goods not clearly linked to US China supply chains. This will therefore not hurt American firms, only American consumers. Again this creates opportunities for firms in other countries, or for Chinese firms to become active in other countries to avoid the made in China label. It is, again an illusion to think that any jobs lost to China will return to America. If anything, they will be replaced by technology or moved to other low-skilled labour abundant countries, like Viet Nam and Bangladesh. Migration flows relative to China are not important, only the flows of Chinese students being educated in American universities. There is clearly a lot of information we do not yet have, such as the flows of services trade (where America has a comparative advantage), the more detailed structure of the trade flows (some

78 indications given above), the migration flows, the size of the remittances, the extent to which other countries can take over certain tasks, and so on. Chapter 16 QUESTION 0-64 a. What is hysteresis or path-dependency, and what is its importance for geographical economics? b. What does this imply for empirical research? The two-region geographical economics model predicts that manufacturing activity will spread over the two regions or agglomerate in one region depending on the size of three economic parameters: The (iceberg) transport cost (T) The elasticity of substitution (ε) The share of income spent on manufactures (δ m ) c. Do high transport costs lead to spreading or agglomeration of manufacturing activity? Explain. d. Does a high elasticity of substitution lead to spreading or agglomeration of manufacturing activity? Explain. e. Does a high share of income spent on manufactures lead to spreading or agglomeration of manufacturing activity? Explain. Answers: a. Hysteresis or path dependency shows that history matters regarding the equilibria. The effect of changes in transport costs depend on the initial distribution. This implies that it is difficult to discern what impact changes in the model parameters have, because they are dependent on what happened before. b. The existence of multiple equilibria and path dependency make it hard to empirically verify the predictions of geographical economics. The same change in parameters can have different outcomes depending on the initial setup. c. When there are high transport costs spreading becomes more attractive for firms. The costs of transporting the goods are so great that local production is more attractive. d. When there is a high elasticity of substitution consumers change from supplier rather quickly. This makes them very responsive to price differences between manufacturers. Therefore, these manufacturers cannot charge a higher price through transport costs and do they have to be located near their consumers. This makes firms spread more quickly. e. When a high share of income is spent on manufactures the impact of the manufacturing sector on income is also large. The increasing returns to scale that are possible with agglomeration are then more likely to occur, as all consumers would like to be close to production and benefit from high wages. Agglomeration is thus more likely.

79 Share of manufacturing workforce in region/city 1 Charles van Marrewijk, 2017 International Trade Oxford University Press QUESTION 0-65 Geographical Economics model 1 S B 0 1 S The figure above displays part of a diagram from the Geographical Economics model. a. What is the name of this diagram? b. Complete the diagram; what is on the axes?; what is the meaning of points B and S? c. What is the meaning of the arrows and why are some lines dashed? Answer The completed figure is given below. 1 sustain point S B break point 0 1 sustain point S Transport costs a. It is called the Tomahawk diagram. b. On the horizontal axis is the transport cost parameter (from 1 to infinity). On the vertical axis is the share of the manufacturing workforce in region/city 1 (or any alternative indication that works). B is the breakpoint (the point at which spreading of economic activity is no longer stable) and S are the sustain points (the points beyond which agglomeration of economic activity is no

80 longer stable). The arrows indicate short-run dynamics for a given level of transportation costs (either towards spreading or towards agglomeration). c. The dashed lines indicate unstable long-run equilibrium points (a small deviation in any direction leads to a different long-run equilibrium). QUESTION 0-66 Occasionally, the Chinese government contemplates building a tunnel underneath the Bohai Sea, more or less from Dalian to Yantai, see the figure below. Proposed Dalian Yantai tunnel Shenyang Beijing Tianjin Dalian CHINA Yantai Nanjing Suzhou Shanghai Hong Kong Taiwan Philippines Discuss the economic benefits to building a tunnel from Dalian to Yantai based on the Geographical Economics model. In particular: a. Which city / cities benefit most in relative terms? Why? b. Do you think Beijing Tianjin benefits? Why? c. Do you think Shanghai benefits? Why? Answers a. Simulations in general show (see also the online questions) that creating a direct infrastructure link between two locations, such as a bridge or a tunnel, tends to bring the largest relative

81 economic benefits to the cities directly involved in the link, that is Dalian and Yantai. These locations have the strongest relative reduction in trade costs and therefore the largest relative gain in economic attractiveness. It does not really matter which type of Geographical Economics model you have in mind. (a 2 nd best option would be to argue here that the North of China will benefit most, that is Dalian, Shenyang and Changchun (see also below). b. It is unlikely that Beijing / Tianjin benefits as the economic linkages between North China and Central/Southern China will be mostly through the Dalian Yantai connection rather than the Beijing Tianjin connection. Moreover, it is clear that the Dalian Yantai link will essentially not reduce the transport costs from Beijing Tianjin to any other part of China. In this sense it does not make Beijing Tianjin more attractive. c. The Shanghai region will likely benefit from the Dalian Yantai connection. The link itself creates economic benefits, generating economic activities that will partially make its way to Shanghai (and the harbor of Shanghai). Moreover, it is clear that the transport costs from Shanghai to the North of China (Dalian, Shengyan, and Changchun) will be substantially reduced, making the Shanghai area more attractive for business activities. QUESTION 0-67 This question reviews the general structure of the geographical economics model. a. How do consumers decide how much to spend on food and manufacturing goods? What is the share of income they will spend on food? b. Does every consumer spend an equal share of income on food? Why? c. How do consumers decide on their consumption level for a particular variety of manufactures? What is the share of their income they will spend on one variety? d. Is the wage rate for farm workers necessarily equal between the two regions? e. Is the wage rate for manufacturing workers equal between the regions? Answers: a. The optimally allocate their budget (generated by income) over the different types of goods (food and varieties of manufactures), taking the prices as given and based on their utility functions. In the standard specification, they spend a constant share 1 δ m of income on food. (the first stage optimization process is Cobb-Douglas) b. Yes, all consumers have the same utility function. c. Given how much income they want to spend on manufactures, equal to share δ m, they optimally allocate their budget over the different varieties depending on the price charged for different varieties and their utility function. The outcome is iso-elastic demand, as in Chapter 8. (the second stage optimization is CES Dixit-Stiglitz) The share of income spent on a particular variety i is derived in Chapter 8: p ic i δ m I = p 1 ε i N 1 ε j=1 p j, where p i is the price charged for variety i. Note that this share is not constant but depends on the price charged by the firm relative to the price charged by all its competitors.

82 d. No, farmers are not mobile between the regions. Their wage rates are only the same in the symmetric spreading equilibrium. e. Yes, in the long-run equilibrium the wage rate is the same for all manufacturing workers. QUESTION 0-68 Chapter 16 discusses the geographical economics model using graphs such as the one shown below. Two-region base scenario a. What does the line in the figure represent? b. Identify the long-run equilibria in the figure. Explain. c. How can you derive from the figure if a long-run equilibrium is stable or unstable? d. Can your determine from the above figure if manufacturing activity will agglomerate in the long run? e. Draw a new figure, similar to the one above but based on a different parameter setting, in which the agglomeration of manufacturing firms is the only stable long-run equilibrium. f. Draw a new figure, similar to the one above but based on a different parameter setting, in which the spreading of manufacturing firms is the only stable long-run equilibrium. Answers: a. The line represents the real wage of region 1 relative to region 2 for all short-term equilibria for all possible distributions of the manufacturing labor force. b. The points A, B, C, D, and E in the figure below are long run equilibria. At these points the distribution of workers with the given wage ratio provides no incentive for workers to migrate to another region or there is complete agglomeration.

83 c. You should check whether a small disturbance around an equilibrium will give rise to economic forces returning the economy to this equilibrium. If the line representing the short-run equilibria is downward sloping at a non-agglomeration long-run equilibrium workers have an incentive to return to the original equilibrium, which is then stable. This holds for equilibrium C. The two agglomeration equilibria A and E are also stable as it is not worthwhile for individual workers and firms to defect. d. No, this depends on the initial distribution of the workers. Between B and D they will spread. Before B agglomeration in region 2 will occur and after D agglomeration in region 1 will occur. e. An example is given below f. An example is given below