International Economics
Problem Set 3
T.a.: Paolo D’Imperio
pdimperio@[Link]
Standard trade model
Problem: Suppose Indonesia and China are trading partners. Indonesia initially exports palm oil
to and imports lubricants from China.
• Using the standard trade model, explain how an increase in the relative price of palm oil—
in relation to lubricant prices—would affect production and consumption of palm oil for
Indonesia (assuming that the taste for both goods is the same in both countries).
If the relative price of palm oil increases in relation to the price of lubricants, this would
increase the production of palm oil.
Similarly, an increase in the relative price of palm oil in relation to the price of lubricants,
would reduce the production of lubricants.
An increase in relative price of palm oil leads to a shift along the indifference curve,
towards lubricants and away from palm oil for Indonesia.
This is because Palm oil is relatively expensive, hence consumers reduce palm oil
consumption in Indonesia (substitution effect).
This economy is an exporter of palm oil. When the relative price of palm oil rises, the
economy can trade a given amount of palm oil for a larger amount of lubricant imports.
Thus, the higher relative price of its export good represents an advantage and the economy
moves to a higher indifference curve (income effect).
•If the income effect of price change of palm oil is greater than the substitution effect,
what would happen to palm oil consumption in Indonesia?
Expensive palm oil increases the relative income of Indonesia.
The income effect would induce more for the consumption of both goods whereas the
substitution effect acts to make the economy consume less of palm oil and more of
lubricants.
However, if the income effect outweighs the substitution effect, then the consumption of
palm oil would increase in Indonesia.
𝐷𝑃 ↓ (𝑠𝑢𝑏. 𝑒𝑓𝑓𝑒𝑐𝑡) <↑ (𝑖𝑛𝑐. 𝑒𝑓𝑓𝑒𝑐𝑡) ; 𝐷𝐿 ↑ (𝑠𝑢𝑏. 𝑒𝑓𝑓𝑒𝑐𝑡) ↑ (𝑖𝑛𝑐. 𝑒𝑓𝑓𝑒𝑐𝑡)
Show the effects of a rise in the relative price of palm oil on the relative supply and
demand curves for Indonesia.
When the income effect of the price change is large enough, then consumption levels of both
goods rise.
But the substitution effect of demand dictates that the relative consumption of palm oil
decrease.
On the supply side the increase in the relative price triggers an increase in the relative
quantity of palm oil.
Use the PPF graph to show the effects of a rise/decline in the relative price of palm oil
on welfare in Indonesia (a country that exports palm oil).
𝑃
When 𝑃𝐿𝑃 ↑ increases, a country that initially exports palm oil is made better off, as illustrated
by the movement from D1 to D2.
𝑃
Conversely, if 𝑃𝐿𝑃 ↓ were to decline, the Indonesia would be made worse off; for example,
starting from D2 consumption might move back to D1.
Problem: Imagine the world having two countries producing wheat and cloth, with no difference in
preferences across the two countries. Home country exports cloth.
If the home country—exporting cloth—experiences a growth strongly biased towards
it, what would happen to the home country’s terms of trade?
The terms of trade of the home country would worsen.
This is because a strong biased production towards cloth would increase the home country’s
supply of cloth and shifts the supply curve to the right.
At the same time, the production of wheat would decline relative to the production of cloth.
An increased supply of cloth would reduce the price at the domestic and at the international
market.
The reduction in international price of cloth would worsen the terms of trade of the home
country as the home country exports cloth.
How would the terms of trade be affected if the home country’s production grows in
favor of wheat?
If the home country’s production grows in favor of wheat, the terms of trade would
improve in favor of the home country.
This is because wheat is imported by the home country.
Problem: Japan primarily exports manufactured goods (M), while importing raw materials (R) such
as food and oil. Analyze the impact on Japan’s terms of trade of the following events using the world
relative supply (RS) and relative demand (RD) with M relative to R. Consider all countries to be
large, such that changes affect the world relative price.
• A war in the Middle East disrupts oil supply.
Korea develops the ability to produce automobiles that it can sell in Canada and the
United States.
• A harvest failure in Russia.
Problem: Austria and Belgium have two factors of production, capital and labor, with which they
produce two goods, Cars (X) and Plastics (Y). Technology is the same in the two countries.
- Car production is capital-intensive; Plastics production is labor-intensive;
- Austria is capital-abundant. Belgium is labor abundant.
Hint 1: An increase in the capital stock of either country favors production of Cars, while an increase
in the labor supply favors production of Plastics.
Hint 2: Heckscher-Ohlin: an economy will export that good that uses intensively the factor which
that economy has in relative abundance. Austria exports Cars to Belgium and imports Plastics from
Belgium.
• Analyze the effects of an increase in Austria’s capital stock on the terms of trade.
• Analyze the effects of an increase in Austria’s labor supply.
Problem: Multiple choices questions. Solutions during the next lesson.
An import tariff will cause the relative demand for ________ to ________ and the relative
supply for ________ to ________.
A) exports; increase; exports; decrease
B) exports; increase; imports; decrease
C) exports; decrease; exports; increase
D) imports; decrease; imports; increase
E) imports; increase; imports; decrease
An export subsidy will cause the terms of trade of the ________ country to ________ and will
________ the country.
A) importing; suffer; benefit
B) exporting; improve; benefit
C) importing; improve; harm
D) importing; deteriorate; harm
E) exporting; deteriorate; harm
Problem: An export subsidy will cause the relative demand for ________ to ________ and
the relative supply for ________ to ________.
A) exports; increase; imports; decrease
B) imports; increase; imports; decrease
C) imports; decrease; imports; increase
D) exports; decrease; exports; increase
E) exports; increase; exports; decrease