ECO2/3ITR
International Trade
Tutorial 5 Answers
True/False Questions
1. The Heckscher-Ohlin Model is an economics model that explains trade across
countries based on comparative advantages that arise from differences in
technology across nations. True or False? Explain.
Answer:
False. The Ricardian Model is based on differences in technologies across
countries while the Heckscher-Ohlin Model is based on differences in factor
endowments.
For the following question suppose we are in a HO world with two goods (one of
them is automobiles), two countries (one of them is Russia) and two production
factors, capital and labour. When Russia opens to trade, it imports automobiles, the
capital-intensive good.
2. According to the HO theorem Russia is labour-abundant. True or False? Explain.
Answer:
True. The HO theorem states that considering two goods and two factors each
country will export the good that uses intensively the factor of production it has
in abundance and will import the other good. Accordingly, Russia must be
labour abundant as it imports the capital-intensive good.
3. Consider two countries and two production factors: labour and capital. Country 1
has much more labour than country 2. Then, Country 1 is labour abundant and
country 2 is capital abundant. True or False? Explain.
Answer:
False. Factor abundance is a relative concept across countries. To determine
which country is labour abundant we need to first consider the relative quantities
of labour and capital in each country and then compare across nations.
4. According to the Heckscher-Ohlin Model one product can be capital intensive in
1
one country and labour intensive in another. True or False? Explain.
Answer:
False. In the Heckscher-Ohlin Model technologies are identical across countries.
Question 5
Assume a Heckscher-Ohlin model of trade. Australia (AUS) and New Zealand (NZL)
produce paper (P) and carpets (C) using two factors, capital (K) and labour (L), that
are mobile across sectors. Paper production is capital intensive and carpet weaving is
labour intensive. Further, Australia has 120 units of labour and 120 units of capital,
while New Zealand has 100 units of labour and 80 units of capital. The cost of labour
is w. The cost of capital is r.
a) Which country is capital abundant relative to the other country? Explain why.
Answer:
Capital and Labour relative endowments determine relative capital abundance.
Comparing relative endowments between AUS and NZL:
AUS NZL
120 K K 80
1 0.8
120 L L 100
It turns out that AUS is capital abundant relative to NZL.
b) In the diagram below, draw the relative supply of paper/ carpets for each
country in autarky. Explain any difference across countries.
Answer:
PP/PC RSNZL
RSAUS
(PP/PC)NZL
(PP/PC)FRA
RDAUS=RDNZL
QP/QC
2
Given that AUS is capital abundant its PPF is skewed toward the production of
paper. NZL is labour abundant so its PPF is skewed towards the production of
carpets. At any relative price of paper, this implies AUS produces more paper
relative to carpets than NZL. In Autarky, the AUS relative supply of paper lies to
the right of the NZL one. Preferences are identical so RD is the same in AUS and
NZL by assumption.
Now, suppose Australia and New Zealand are free to trade.
c) In the graph in point b) mark the relative price under free trade. Describe the
patterns of trade.
Answer:
AUS has a comparative advantage in paper as it has a lower opportunity cost in
AUS NZ
PP P
P
P PC . So AUS exports paper.
autarky for making it. In fact from b) C
NZL has a comparative advantage in carpets as it has a lower opportunity cost in
AUS NZ
PC P
C
PP PP
autarky for making them. In fact from b). . So NZL exports
carpets.
d) Assume the following PPF for Australia. Isovalue Z represents the PPF slope
at equilibrium point of production in autarky. Under free trade relative prices change
as the country adopts world relative prices. Considering the following options after
free trade: Isovalue X or Isovalue Y, what line is the most likely new equilibrium in
Australia after opening to free trade? Briefly explain.
Answer:
3
QC X
QC (1) PP PP
( )( )
<
PC Z PC Y
QC (2)
QP (1) QP (2) QP
Y
The most likely new equilibrium production pattern for Australia after opening to free
trade is represented by the slope of isovalue Y. The slope of the isovalues represent
the relative prices of the product on the horizontal axis with respect to the product on
PP
the vertical axis ( )
PC
. After opening to free trade Australia is exposed to a higher
relative price of paper. This implies a higher slope of the Australian isovalue (steeper
line). At the new relative prices Australia specialises more in the production of paper
(production of paper increases from point Q P(1) to point QP(2), and the production of
carpets shrinks from point QC(1) to point QC(2).
Now, suppose that paper production gives off large quantities of toxic bleach, which
dumped into rivers creates localized water pollution.
e) Moving from autarky to free trade what happens to water pollution in New
Zealand and Australia? Use the diagram below in order to explain your answer.
Answer:
4
PP/PC RSNZL RSW
RSAUS
(PP/PC)FT
RDAUS=RDNZL
QP/QC
Going from Autarky to free trade the paper sector in AUS expands while in
A US , FT AUS , A
QP Q
P
Q QC
NZL it shrinks, in fact from the diagram above C ,
N Z L , FT N ZL , A
QP Q
P
QC QC
while . So water pollution decreases in NZL.