STUDY QUESTIONS

1. Why is the H.O. model called the factor-proportions theory?

2. According to the Heckscher-Ohlin model, what is the income distribution result when a country
opens to free trade?
a. The owners of abundant factors lose, and owners of scarce factors gain.
b. Everyone gains from trade because free trade is always beneficial.
c. The owners of abundant factors gain, but the effect on the owners of scarce factors is ambiguous
d. Owners of a country’s abundant factors gain from trade, but owners of a country’s scarce factors
lose.
Answer: D
3. The Heckscher-Ohlin model predicts that among countries that trade, factor prices will
a. Diverge due to the technological changes triggered by trade
b. Converge due to the connection between output prices and factor prices,
c. Converge due to factor mobility
d. Diverge due to the presence of specific factors.
Answer: B
4. Wage inequality has been on the rise in virtually all high-income industrial economies since the
1970s. The causes are probably numerous, but the leading explanation for the greatest share of the
increase in inequality is
A) the growth of trade with developing countries.
B) the growth of trade with other high income industrial countries.
C) technological change which increased the relative demand for skilled workers.
D) technological change which increased the relative demand for unskilled workers.
Answer: C

FOOD

QFA
A B
QFB

VA VB

QCA QCB CLOTH

5. The above figure shows two isovalue lines V A and VB at the same relative price P C/PF. A
and B are two production patterns. The quantities of cloth and food produced in each case are
indicated by QCA; QCB and QFA; QFB respectively. Based on the above, which of the following
is correct?
A) When relative price = PC/PF, GDP produced at A (VA) equals GDP produced at B (VB)
because they both lie on the same PPF.

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 B) When relative price = PC/PF, GDP produced at A (VA) is greater than GDP produced at B
(VB).
C) If the nation produces at A when relative price = PC/PF, it is maximizing its GDP.
D) GDP is maximized at A if the relative price PC/PF decreases.
Answer: D

6. Assume that Norway and Sweden trade with each other, with Norway exporting fish
to Sweden, and Sweden exporting Volvos (automobiles) to Norway. Illustrate the
gains from trade between the two countries using the standard trade model, assuming
first that tastes for the goods are the same in both countries, but that the production
possibility frontiers differ: Norway has a long coast that borders on the north Atlantic,
making it relatively more productive in fishing. Sweden has a greater endowment of
capital, making it relatively more productive in automobiles.
Answer:

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).

7. In the trade scenario in the above problem, due to overfishing, Norway becomes unable to
catch the quantity of fish that it could in previous years. This change causes both a reduction
in the potential quantity of fish that can be produced in Norway and an increase in the
relative world price for fish,
a. Show how the overfishing problem can result in a decline in welfare for Norway.
b. Also show how it is possible that the overfishing problem could result in an
increase in welfare for Norway.

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Answer:

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.

8. Japan primarily exports manufactured goods, while importing raw materials such as
food and oil. Analyze the impact on Japan’s terms of trade of the following events:
a. A war in the Middle East disrupts oil supply.
b. Korea develops the ability to produce automobiles that it can sell in Canada and
the United States.
Pf /Pa.
c. U.S. engineers develop a fusion reactor that replaces fossil fuel electricity plants.
d. A harvest failure in Russia.
Answer:
The terms of trade for 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.

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 a. An 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 because 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.

9. Countries A and B have two factors of production, capital and labor, with which they
produce two goods, X and Y. Technology is the same in the two countries. X is capital intensive;
A is capital-abundant.
Analyze the effects on the terms of trade and on the two countries’ welfare of the
following:
a. An increase in A’s capital stock.
b. An increase in A’s labor supply.
c. An increase in B’s capital stock.
d. An increase in B’s labor supply.
Answer:
These results acknowledge the biased growth that 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 that uses intensively the factor which that economy has in
relative abundance. Country A exports good X to country B and imports good Y from 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.

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10. If a firm's output more than doubles when all inputs are doubled, production is said to occur
under conditions of
A) increasing returns to scale.
B) imperfect competition.
C) intra-industry equilibrium.
D) constant returns to scale
E) decreasing returns to scale.
Answer: A

11. One advantage of the specialization that results from international trade is that countries can
take advantage of
A) scale economies.
B) production diversification
C) smaller countries.
D) taste reversals.
E) lower transport costs.
Answer: A

12. Internal economies of scale will ________ average cost when output is ________ by ________.
A) reduce; increased; a firm
B) increase; increased; a firm
C) reduce; increased; the industry
D) increase; increased; the industry
E) reduce; reduce; the industry
Answer: A

13. Why is it that if an industry is operating under conditions of internal scale economies then the
resultant equilibrium cannot be consistent with the pure competition model?
Answer: Because once one firm will becomes bigger than another, or if one firm began the industry,
then no other firm will be able to match its per unit cost, so that they would be driven out of the industry.

14. Is it possible for an equilibrium that is consistent with purely competitive conditions to arise in an
industry with positive scale economies? If so, explain how this could happen. If not, why not?
Answer: Yes. If the scale economies were external to the firm, then there is no reason why the firms may
not be in perfect competition.

15. What is meant by an "industrial district" and what are the three main sources of the economic
advantages derived from locating in such a district?
Answer: An industrial community is a geographical concentration of firms in the same industry. Silicon
Valley and Bollywood are modern examples. The advantages are (1) specialized suppliers, (2) labor
market pooling, and (3) knowledge spillovers.

16. The long-run market supply curve in the presence of internal economies of scale is ________, and in
the presence of external economies of scale, it is ________.
A) downward sloping; downward sloping
B) upward sloping; horizontal
C) horizontal; upward sloping

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D) downward sloping; horizontal
E) upward sloping; downward sloping
Answer: A

17. If a firm increases its output in the ________ and unit costs ________, then the firm is experiencing
________ of scale.
A) long-run; decrease; economies
B) short-run; decrease; economies
C) long-run; decrease; diseconomies
D) short-run; decrease; diseconomies
E) long-run; increase; economies
Answer: A

18. A product is produced in a monopolistically competitive industry with scale economies. If this
industry exists in two countries, and these two countries engage in trade with each other, then we
would expect
A) each country will export different varieties of the product to the other.
B) the country in which the price of the product is lower will export the product.
C) the country with a relative abundance of the factor of production in which production of the product is
intensive will export this product.
D) neither country will export this product since there is no comparative advantage.
E) the countries will trade only with other nations they are not in competition with.
Answer: A

19. For each of the following examples, explain whether it is a case of external or internal
economies of scale:
a. Most musical wind instruments in the United States are produced by more than a
dozen factories in Elkhart, Indiana.
b. All Hondas sold in the United States are either imported or produced in
Marysville, Ohio.
c. All airframes for Airbus, Europe’s only producer of large aircraft, are assembled in
Toulouse, France.
e. Hartford, Connecticut, is the insurance capital of the northeastern United States.
Answer:
Cases a and d represent external economies of scale as industry production is concentrated in
a just a few locations. The benefits of geographical clustering include a greater variety of
specialized services to support industry operations, access to a larger pool of specialized
labor, and thicker input markets.
Cases b and c represent internal economies of scale because a single firm/plant is producing
the output for the whole industry. As the output of a single firm increases, average costs will
fall. This can lead to imperfect competition as it supports a limited number of firms in an
industry.

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 There may be a case made for external economies leading to losses from trade, however.

Consider the diagram above. Country A is an established producer and produces at quantity QA and price
PA. If country B were to enter into the industry, its initial startup cost would be at CB. Because this is
greater than PA, country B will import this good. However, if country B were to be closed off from trade,
then production would be at QB and price would be PB. Thus, trade actually represents a situation worse than
autarky for country B and protection may be warranted. However, actually identifying these situations is
difficult, and protection may lead to unintended consequences (such as retaliatory tariffs).

20. Give two examples of products that are traded on international markets for which
there are dynamic increasing returns. In each of your examples, show how innovation
and learning-by-doing are important to the dynamic increasing returns in the industry.
Answer:

Dynamic increasing returns occur whenever average costs fall with cumulative output. In other words, a
learning curve exists that favors established producers over startups.

Two industries characterized by dynamic increasing returns are biotechnology and aircraft design.
Biotechnology is an industry in which innovation fuels new products, but it is also one where learning
how to successfully take an idea and create a profitable product is a skill set that may require some
practice. Aircraft design requires innovations to create new planes that are safer or more cost efficient, but
it is also an industry where new planes are often subtle alterations of previous models and where detailed
experience with one model may be a huge help in creating a new one.

21. Evaluate the relative importance of economies of scale and comparative advantage in

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causing the following:
a. Most of the world’s aluminum is smelted in Norway or Canada.
b. Half of the world’s large jet aircraft are assembled in Seattle.
c. Most semiconductors are manufactured in either the United States or Japan.
d. Most Scotch whiskey comes from Scotland.
e. Much of the world’s best wine comes from France.

Answer:
a. The relatively few locations for production suggest external economies of scale in production.
If these operations are large, there may also be large internal economies of scale in production.
b. Because economies of scale are significant in airplane production, it tends to be done by a small
number of (imperfectly competitive) firms at a limited number of locations. One such location is Seattle,
where Boeing produces airplanes.
c. Because external economies of scale are significant in semiconductor production, semiconductor
industries tend to be concentrated in certain geographic locations. If, for some historical reason, a
semiconductor is established in a specific location, the export of semiconductors by that country is due to
economies of scale and not comparative advantage.
d. “True” scotch whiskey can only come from Scotland. The production of scotch whiskey requires a
technique known to skilled distillers who are concentrated in the region. This labor market pooling
suggests external economies of scale. Also, soil and climactic conditions are favorable for grains used in
local scotch production. This reflects comparative advantage.
e. France has a particular blend of climactic conditions and land that is difficult to reproduce
elsewhere. This generates a comparative advantage in wine production.

22. It is fairly common for an industrial cluster to break up and for production to move to
locations with lower wages when the technology of the industry is no longer rapidly
improving—when it is no longer essential to have the absolutely most modern
machinery, when the need for highly skilled workers has declined, and when being at
the cutting edge of innovation conveys only a small advantage. Explain this tendency
of industrial clusters to break up in terms of the theory of external economies.

Answer:

The three forces driving external economies of scale are access to specialized suppliers, labor market
pooling, and knowledge spillovers. As these forces weaken, so too do the cost advantages of geographic
clustering. The location of production becomes increasingly driven by factor costs when industries move
away from external economies of scale toward traditional constant returns to scale.

23. Recently, a growing labor shortage has been causing Chinese wages to rise. If this

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trend continues, what would you expect to see happen to external economy industries
currently dominated by China? Consider, in particular, the situation illustrated in
Figure 7-4. How would change take place?

Answer:

Even with higher wages in China, the external economies of scale industries located in China may not
move to lower-wage countries. Consider Figure 7-4 in the text. China’s average cost curve lies
above Vietnam’s reflecting higher wages in China. However, the fact that Chinese industry is
established gives it a cost advantage over any Vietnamese firms who would enter into the industry and
face an initial cost higher than the established Chinese firms. Production would only shift to Vietnam
if China’s average cost curve were to shift up enough so that the new equilibrium price and cost in
China lies above the startup cost in Vietnam.

24. Which of the following goods or services would be most likely to be subject to (1) external
economies of scale and (2) dynamic increasing returns? Explain your answers.
a. Software tech-support services
b. Production of asphalt or concrete
c. Motion pictures
d. Cancer research
e. Timber harvesting

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Answer:
a. External economies of scale are likely due to the need to have a common pool of labor with technical
skills. Dynamic increasing returns may be likely due to the need for continual innovation and
learning.
b. External economies are unlikely because it is difficult to see how the costs of a single firm would fall
if other firms are present in the asphalt industry. Dynamic increasing returns are also unlikely as the
asphalt industry is pretty well established and learning curves are likely to be low.
c. External economies are highly likely because having a great number of support firms and an available
pool of skilled labor in filmmaking are critical to film production. Dynamic returns
are also likely because filmmaking is an industry in which learning is important.
d. External economies are somewhat likely in that it may be advantageous to have other researchers
nearby. Dynamic returns are highly likely because such research builds on itself through a learning-by-
doing process.
e. External economies are somewhat likely if there are a set of skills unique to the timber industry that
would lead to a clustering of timber firms and timber workers. Dynamic returns are unlikely as the
technology used in timber harvesting is relatively stable (i.e., a low learning curve).
25. In perfect competition, firms set price equal to marginal cost. Why can’t firms do this
when there are internal economies of scale?
Answer:
With internal economies of scale, there is imperfect competition, and firms set marginal revenue
equal to marginal cost. Unlike the case of perfectly competitive markets, under monopoly,
marginal revenue is not equal to price. Marginal revenue is always less than price under
imperfectly competitive markets because to sell an extra unit of output, the firm must lower
the price of all units, not just the marginal one. Furthermore, if internal economies of scale
are driven by large fixed costs, then setting price equal to marginal cost would actually lead to
negative profit for a firm that needs to set price above marginal cost to cover its fixed costs.

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