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Answers to Textbook Problems in Ch6

1.

Note how welfare in both countries increases as the two countries move from production patterns governed by domestic prices (dashed line) to production patterns governed by world prices (straight line).

2.

In panel a, the reduction of Norway’s production possibilities away from fish cause the production of fish relative to automobiles to fall. Thus, despite the higher relative price of fish exports, Norway moves down to a lower indifference curve representing a drop in welfare.

In panel b, the increase in the relative price of fish shifts causes Norway’s relative production of fish to rise (despite the reduction in fish productivity). Thus, the increase in the relative price of fish exports allows Norway to move to a higher indifference curve and higher welfare.

An increase in the terms of trade increases welfare when the PPF is right-angled. The production

point is the corner of the PPF. The consumption point is the tangency of the relative price line and the highest indifference curve. An improvement in the terms of trade rotates the relative price line about its intercept with the PPF rectangle (since there is no substitution of immobile factors, the production point stays fixed). The economy can then reach a higher indifference curve. Intuitively, although there is no supply response, the economy receives more for the exports it supplies and pays less for the imports it purchases.

3.

?2012 Pearson Education

Chapter 6 The Standard Trade Model 25

4.

The difference from the standard diagram is that the indifference curves are right angles rather than smooth curves. Here, a terms of trade increase enables an economy to move to a higher indifference curve. The income expansion path for this economy is a ray from the origin. A terms of trade improvement moves the consumption point further out along the ray.

The terms of trade of Japan, a manufactures (M) exporter and a raw materials (R) importer, is the world relative price of manufactures in terms of raw materials (pM/pR). The terms of trade change can be determined by the shifts in the world relative supply and demand (manufactures relative to raw materials) curves. Note that in the following answers, world relative supply (RS) and relative demand (RD) are always M relative to R. We consider all countries to be large, such that changes affect the world relative price.

a. Oil supply disruption from the Middle East decreases the supply of raw materials, which increases

the world relative supply of manufactures to raw materials. The world relative supply curve shifts out, decreasing the world relative price of manufactured goods and deteriorating Japan’s terms of trade.

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

the world RS. The world relative supply curve shifts out, decreasing the world relative price of manufactured goods and deteriorating Japan’s terms of trade.

c. U.S. development of a substitute for fossil fuel decreases the demand for raw materials. This

increases world RD, and the world relative demand curve shifts out, increasing the world relative price of manufactured goods and improving Japan’s terms of trade. This occurs even if no fusion reactors are installed in Japan since world demand for raw materials falls.

d. A harvest failure in Russia decreases the supply of raw materials, which increases the world RS.

The world relative supply curve shifts out. Also, Russia’s demand for manufactures decreases, which reduces world demand so that the world relative demand curve shifts in. These forces decrease the world relative price of manufactured goods and deteriorate Japan’s terms of trade. e. A reduction in Japan’s tariff on raw materials will raise its internal relative price of manufactures

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

5.

6. The declining price of services relative to manufactured goods shifts the isovalue line clockwise so

that relatively fewer services and more manufactured goods are produced in the United States, thus reducing U.S. welfare.

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Chapter 6 The Standard Trade Model 26

7.

These results acknowledge the biased growth which occurs when there is an increase in one factor of production. An increase in the capital stock of either country favors production of good X, while an increase in the labor supply favors production of good Y. Also, recognize the Heckscher-Ohlin result that an economy will export that good which uses intensively the factor which that economy has in relative abundance. Country A exports good Xto country B and imports good Yfrom country B. The possibility of immiserizing growth makes the welfare effects of a terms of trade improvement due to export-biased growth ambiguous. Import-biased growth unambiguously improves welfare for the growing country.

a. The relative price of good X falls, causing country A’s terms of trade to worsen. A’s welfare may

increase or, less likely, decrease, and B’s welfare increases.

b. The relative price of good Y rises, causing A’s terms of trade to improve. A’s welfare increases

and B’s welfare decreases.

c. The relative price of good X falls, causing country B’s terms of trade to improve. B’s welfare

increases and A’s welfare decreases (they earn less for the same quantity of exports).

d. The relative price of good X rises, causing country B’s terms of trade to worsen. B’s welfare may

increase or, less likely, decrease, and A’s welfare increases.

8. Immiserizing growth occurs when the welfare deteriorating effects of a worsening in an economy’s

terms of trade swamp the welfare improving effects of growth. For this to occur, an economy must undergo very biased growth, and the economy must be a large enough actor in the world economy such that its actions spill over to adversely alter the terms of trade to a large degree. This combination of events is unlikely to occur in practice. 9. India opening should be good for the United States if it reduces the relative price of goods that

China sends to the United States and hence increases the relative price of goods that the United States exports. Obviously, any sector in the United States hurt by trade with China would be hurt again by India, but on net, the United States wins. Note that here we are making different assumptions about what India produces and what is tradable than we are in Question #6. Here we are assuming India exports products that the United States currently imports and China currently exports. China will lose by having the relative price of its export good driven down by the increased production in India. 10. What matters for welfare are the external terms of trade. Suppose that country X exports good A and

imports good B, while country Y exports good B and imports good A. The export subsidy in country X will raise the internal price of the export good A, leading to an increase in production of good A and decrease demand of good A. As a result, the world price of the good A falls. The tariff on good A in country Y will increase production and decrease demand for good A in country Y, leading to a reduction in the world price of good A relative to good B. Thus, the terms of trade in country X falls and the terms of trade in country Y rise. Country X is worse off, while country Y is better off.

If instead country Y had imposed an export subsidy on good B, then the internal price of good B would rise. Production of good B rises and demand for good B falls. As a result, the world price of good B falls. The net effect on welfare is ambiguous and depends on the relative declines in the world prices of goods A and B.

?2012 Pearson Education