SECTION I: TRADE THEORY

1. The Principle of Comparative Advantage A. EXERCISES Exercise 1: What are the limits of the absolute advantage model in international trade? Exercise 2: How does the Ricardian Model improve the understanding of international trade? Exercise 3: State and discuss the assumptions underlying the Ricardian Model. Which of these assumptions could be easily relaxed? Exercise 4: In the Ricardian model, can both countries sell the goods in which they specialize at post trade relative prices that are equal to pre-trade relative prices? Explain. Exercise 5: To what are the slopes of the production possibilities frontiers equal? What changes occur if the axes of the production possibilities diagrams are inverted? Exercise 6: Is it possible to interpret the relative costs as opportunity costs? Why is it better to read the theory of comparative advantage in terms of opportunity costs instead of labour theory of value?

A Workbook in International Trade Exercise 7: Comment upon: „Each country has a comparative advantage for some good”. Exercise 8: Comment upon: „Theories in international trade use the assumptions that the resources are fully allocated both before and after trade and that the technology does not change. If the same resources are used both before and after trade, then the world output cannot increase. Therefore there is no scope for gains from international trade at world level.” Exercise 9: If theories of international trade prove that free trade raises welfare at world level, why then most states use import protection? Exercise 10: Comment upon: "An introductory economics course should drive home to students the point that international trade is not about competition, it is about mutually beneficial exchange (…) What a country gains from trade is the ability to import things it wants. Exports are not an objective in and of themselves: the need to export is a burden that a country must bear because its import suppliers are crass enough to demand payment."1

1 Krugman, P. – “What Do Undergrads Need to Know about Trade?”, AEA Papers and Proceedings, May 1993, p. 23-26.

Trade Theory B. PROBLEMS Problem 12: In countries A and B the labour requirements (expressed as number of workers) for the production of goods X and Y are given in the table below:

A B

X 5 3 Y 2 6

In which good should each country specialise according to the theory of absolute advantage? How much would each country gain after specialisation, supposing that each has 120 workers? Problem 2: Suppose that the labour requirements (expressed as number of workers) for goods X and Y produced by country A and country B respectively are given in the table below: A B

X 5 6 Y 2 12

Using the absolute advantage model, identify the possibilities of specialisation that each country has. Does the answer change if the Ricardian model is used instead? Problem 3: With reference to problem 2, calculate the relative costs for goods X and Y in the two countries.

2 Adapted after Winters, A. – International economics (Fourth Edition), Routledge, London, 1992, p. 16.

A Workbook in International Trade Problem 4: On the basis of the relative costs calculated above, show the specialisation each country will choose after giving up autarchy as well as the trade flows that will emerge. Problem 5: If the relative price of good X in terms of good Y is 0.2 can you specify the relative price of good Y in terms of good X? Problem 6: If the relative prices of the two goods are the same in both countries, how will the two countries specialise? (To have a numerical example, please use the data from problem 2 turning the labour requirement of good X in country A into 1). Problem 7: With respect to problem 2, determine the lower and upper limits for post-trade relative price of good X in terms of Y, having in mind that the post-trade relative price should be an incentive for each country to specialise. Is it necessary to reiterate the same logic in order to determine the post-trade relative price of good Y in terms of X? Explain the answer you give. Problem 8: Suppose that in country A the relative price of good X in terms of good Y is 0.2 and country A has a comparative advantage for product X compared to country B. What can you state as to the relative price of good Y in terms of good X in country B? Problem 9: With reference to problem 2 and assuming that each country has 120 workers, determine and graph the production possibilities frontiers in countries A and B. We will use the simplifying assumption that there are no economies of scale in the two countries.

Trade Theory Problem 10: With respect to the results obtained for problem 9, determine and graph the world production possibilities frontier. Identify the point on this graph corresponding to a complete specialisation of the two countries. For this point, show the quantities produces of each good at the world scale. In case that complete specialisation is achieved in both countries, is it possible to determine the post-trade relative prices for good X and Y? Explain. Problem 11: Mark with T (true) or F (false) the statements below and explain the answers you choose: a. If a country has absolute advantage for good X, it also has

comparative advantage for good X; b. If a country has comparative advantage for good X, it also has

absolute advantage for good X. Problem 12: Suppose each of the two countries A and B produces two goods: X and Y. Labour is assumed to be the only factor of production. The labour requirements (expressed as number of workers) for each country and each good are given in the table below: A B

X 5 10 Y 10 40

The following assumptions are also made: - Labour is perfectly mobile between the domestic sectors but is

completely immobile internationally; - There is free trade; - There are no transportation costs; - There are no economies of scale (unit labour requirements are

constant with changes of output); - There is perfect competition;

A Workbook in International Trade - Consumer preferences are identical in both countries, being thus

possible to determine an aggregate world demand curve. Considering the information above: a. Indicate in what commodity countries A and B have an absolute

advantage; b. Indicate in what commodity countries A and B have a comparative

advantage (after having determined the comparative costs); c. Show the pattern of specialization as well as the trade flows that will

emerge; d. Suppose country A has 500 workers while country B has 400

workers, determine and graph the pretrade production possibilities frontiers;

e. Assuming full specialisation, determine the limits of the post trade relative prices for the two goods and calculate the post trade output for each good;

f. Supposing the relative post trade price of good X is 0.4, determine the relative post trade price of good Y and the gains from trade.

Problem 13: There are two countries (A and B), two goods (X and Y) and only one factor of production (labour). With one unit of labour the following quantities of goods can be produced in each country: A B

X 2 4 Y 5 8

Indicate in what commodity countries A and B have a comparative advantage.

Trade Theory Problem 14: The prices of commodities X and Y (in lei and euros respectively) are given in the table below:

Romania (ROL) EU (EUR)

X 500,000 15 Y 1,000,000 45

For which commodity (or commodities) does Romania have absolute and/or comparative advantage over the European Union, knowing that the exchange rate between the two currencies is EUR 1 = ROL 30,000? What changes occur with regard to absolute and comparative advantages if the exchange rate becomes 1 euro = ROL 40,000? Comment upon these changes. Problem 15: Suppose two countries (A and B) and five commodities (P1, P2, P3, P4 and P5). The labour inputs (expressed in hours of labour) for each commodity in each country are given in the table below:

A B P1 1 10 P2 2 8 P3 5 5 P4 6 4 P5 9 3

For which commodity (commodities) does country A have absolute and/or comparative advantage? What trade pattern will emerge after specialisation?

A Workbook in International Trade Problem 16: There are two countries (A and B) and five commodities (P1, P2, P3, P4 and P5). The labour inputs (expressed in hours of labour) for each commodity in each country are given in the table below:

A B P1 1 10 P2 2 8 P3 5 5 P4 6 8 P5 8 10

For which commodity (commodities) does country A have absolute and/or comparative advantage? What other information is needed in order to determine the trade pattern that emerges after specialisation? Problem 17: There are two goods (X and Y) produced in each of the five countries (A, B, C, D and E). The labour requirements (expressed in labour hours) for each good in each country are given in the table below:

A B C D E X 2 3 4 5 6 Y 8 9 10 10 10

Which are the trade specialisation options for the two countries? Which are the factors that determine the choice of one of them?

Trade Theory C. ANSWERS Answer to Problem 1: country A has absolute advantage in good Y, and country B has absolute advantage in good X. Before trade, country A can produce 12 units of good X and 30 units of good Y, while country B can produce 20 units of product X and 10 units of product Y. The world autarchic output totals 32 units of X and 40 units of Y. If international trade and specialization occur country A will produce 60 units of Y while country B will produce 40 units of X. Thus, trade is beneficial for each country as, using the same resources, each country can consume larger quantities of goods. Also, at world level, the total consumption rises compared to the autarchic situation following a better use of resources. Answer to Problem 2: according to the absolute advantage model, country A should specialize in the production of both goods, while country B should specialize in none, which is impossible to put into practice. The Ricardian model solves out this dilemma, and offers a solution for mutually advantageous specialization, as follows in problems 3 and 4. Answer to Problem 3: the relative cost of X is 2.5 in country A and 0.5 in country B; the relative cost of Y is 0.4 in country A and 2 in country B. Answer to Problem 4: country A will specialize and export good Y and will import good X; country B will specialize and export good X and will import good Y. Answer to Problem 5: the relative cost of good Y is 5. Answer to Problem 6: according to the Ricardian model, the two countries have no incentive to specialize and trade. Answer to Problem 7: the relative post-trade price of good X should be no less than 0.5 and no more than 2.5; in order to determine the limits of the relative post-trade price of good Y it is not necessary to reiterate the same logic. The relative price of good X multiplied by the relative price of good Y is always equal to 1.

A Workbook in International Trade Answer to Problem 8: the relative price of good Y in country B (before trade) is less than 5. Answer to Problem 9: the production possibilities frontier in country A is:

xxPPA ⋅−= 5.260)( ; the production possibilities frontier in country B is:

xxPPB ⋅−= 5.020)( . Answer to Problem 10: the world production possibilities frontier can be described by the following function: x⋅− 5.080 , [ )40,0∈x

=)(xPPW 60 , x = 40 x⋅− 5.2160 , ( ]64,40∈x

The full specialization point is (40,60), meaning that the world output of good X is 40 and the world output of good Y is 60. The relative world price of good X and the relative world price of good Y cannot be determined in this point. More information is needed with regard to consumer preferences. Answer to Problem 11: both statements are false. Answer to Problem 12: a. country A has absolute advantage in both goods; b. country A has comparative advantage for good Y and country B has comparative advantage for good X; c. country A will specialize in and export good Y and will import good X, while country B will specialize in and export good X and will import good Y; d. the autarchic production possibilities frontiers are: - For country A:

xxPPA ⋅−= 5.050)( ,

Trade Theory - For country B:

xxPPB ⋅−= 25.010)( The post-trade world production possibilities frontier is: x⋅− 25.060 , [ )40,0∈x

=)(xPPW 50 , x = 40 x⋅− 5.070 , ( ]140,40∈x e. the relative post trade price of good X will be no less than 0.25 and no more than 0.5, while the relative price of good Y will be no less than 2 and no more than 4. Assuming full specialization, the world output of good X is 40 and the world output of good Y is 50. f. the relative post trade price of good Y will be 2.5. The gains from trade derive from the favourable change in the consumption curves. Thus, in country A and B, respectively, the consumption will be described by the following equations:

164.0)(504.0)(

+⋅−=+⋅−=

xxCxxC

B

A

Answer to Problem 13: country A has comparative advantage in Y and country B has comparative advantage in X. Answer to Problem 14: when the exchange rate is EUR 1 = ROL 30,000, Romania has absolute advantage in X and the EU has absolute advantage in Y. A new exchange rate, EUR 1 = ROL 40,000, will lead Romania to have absolute advantage for both goods. The comparative advantage does not depend on the exchange rate. Thus, Romania will always have comparative advantage in Y and EU in X. Answer to Problem 15: country A has comparative and absolute advantage in goods P1 and P2, and country B has comparative and absolute advantage in goods P4 and P5. Neither country is interested in trading good P3.

A Workbook in International Trade Answer to Problem 16: country A will tend to specialize in the goods from the upper part of the table, while country B will tend to specialize in the goods from the lower part of the table. The exact pattern of specialization cannot be described unless the consumers’ preferences are known. For instance, country A can specialize in good P1, and country B in the rest of the goods. Also, country A can specialize in P1, P2 and P3, and country B in P4 and P5. All the other possibilities can be taken into account, having in mind the above-mentioned note and the fact that each country should have at least a good to specialize in (P1 for country A, and P5 for country B). Answer to Problem 17: the answer to problem 17 is very similar to that to problem 16. The exact pattern of specialization can be determined only if consumers’ preferences are revealed. The most competitive country for the good X is A, followed by B, C and so on. The most competitive country for the good Y is E, followed by D, C and so on. There are several options for specialization and trade. For instance only A produces good X and sells it to all the other countries, buying in exchange good Y. Also, countries A and B can both specialize in the production of X selling it to the remaining three countries in exchange for Y. And the examples may continue.

Trade Theory

2. The Specific Factor Model A. EXERCISES Exercise 1: Assess each statement below and identify which factor of production is specific and which is mobile: a. Land is used solely for agriculture; b. Capital is needed to produce both food and office machines; c. No high-skilled workers are needed in the mining industry. Exercise 2: In the Specific Factor Model, the production possibility frontier is a curve and not a straight line, as in the Ricardian Model. Explain what assumption(s) lead to this difference. Exercise 3: An error has been deliberately introduced in the following statements. Read the lines below and make the correction: A country manufactures food and cars. It uses labour and land for the production of food and it employs labour and capital in the car industry. The workers in the car industry negotiate a salary raise becoming thus better off than farmers. Their action leads to an increase in the food production as compared to cars. Consequently the price of land rises, while capital becomes cheaper. In the end owners of capital gain and owners of capital lose. Exercise 4: Suppose relative price of food in terms of manufactures rises, what changes occur in the domestic distribution of income? Exercise 5: Suppose a country is a net exporter of manufactures and a net importer of food. Capital is specific to the manufacturing industry, land is specific to agriculture and labour is the mobile factor.

A Workbook in International Trade Who will lobby for trade restrictions: the capital owners, the land owners, industry workers or farmers? Exercise 6: Why, according to the Specific Factor Model, the slope of the economy’s allocation of labour line is always equal to –1? B. PROBLEMS Problem 1: There are two goods obtained in a country: food and steel. Food is produced using labour and land, while steel is produced using labour and capital. Thus, labour can be used in either sector, while land and capital are both specific factors that can be used only in the production of one good. For a given capital supply, the production function for steel is:

LSs xq ⋅= 2 , where LSx stands for the labour input for steel. Also, for a given land supply, the production function for food is:

LFF xq = , where LFx stands for the labour input for food. Assuming that there are 16 workers in total in the whole country: a. Graph the production functions for steel and food, respectively; b. Determine and graph the economy’s allocation of labour; c. Determine and graph the production possibility frontier; d. Explain why the production possibilities frontier is a curve (and not a

line, as in the Ricardian model). Problem 2: With reference to problem 1, suppose that the proportion of steel and food prices is PS:PF = 2. The price of food is 400 USD/tonne. Determine: a. The price of steel; b. The quantities produced in both sectors (steel and food); c. How the labour is allocated between the two sectors; d. The wage rate in this economy.

Trade Theory Problem 3: With reference to problem 2, explain the changes that occur in the quantities produced in both sectors (steel and food), in the allocation of labour and in the wage rate, if the price of food rises by 10% and the price of steel rises by 20%. Show these changes in the four-quadrant diagram. C. ANSWERS Answer to Problem 1: b. the economy’s allocation of labour is described by the following curve: 16+−= LFLS xx ; c. the production possibilities

frontier is given by the following curve: 2162 SF qq −⋅= Answer to Problem 2: a. the price of steel is 800=SP USD/tonne; b. the quantity of steel is 22=Sq tonnes (approximately 2.83 tonnes) and the quantity of food is 24=Fq tonnes (approximately 5.65 tonnes); c. there are 8 men-months in the food industry and also 8 men-months in the

steel industry; d. the wage rate in this economy is USD2

200

(approximately USD 141. 42). Answer to Problem 3: the quantity of food decreases to 5.4 tonnes, while the quantity of steel rises to 2.95 tonnes; the quantity of labour decreases in the food industry to 7.3 man-month and it increases in the steel industry to 8.7 man-month; the new wage rate will be approximately USD 162.73, showing thus in increase by approximately 15%.

A Workbook in International Trade

3. The Heckscher – Ohlin Model A. EXERCISES Exercise 1: Is factor abundance an absolute notion or a relative one? How do you define a labour abundant country? Exercise 2: If Home is labour abundant compared to Foreign and labour and capital are the only factors of production, in which factor is Foreign abundant? Explain. Exercise 3: If, given two goods having different production functions and two factors, one product is intensive in one factor, can one be sure that the other good is intensive in the other factor? Explain your answer. Exercise 4: Suppose a two-factor economy (with labour and terrain) producing two goods, food and cloth. Food is terrain intensive, while cloth is labour intensive. How will the land owners react to an import tariff on cloth? Exercise 5: How can factor constraint(s) affect the shape of the production possibilities curves? Compare the Specific Factor Model to the Heckscher-Ohlin Model. Exercise 6: Why the equalization of factor prices never totally happens in reality? Exercise 7: What is the Leontieff paradox? Does it prove that the Heckscher-Ohlin Model is wrong? Explain.

Trade Theory Exercise 83: Comment upon: “The world’s poorest countries cannot find anything to export. There is no resource that is abundant – certainly not capital nor land, and in small poor nations not even labour is abundant”. Exercise 9: In a situation in which Romania has scarce resources relative to the European Union in producing cars, discuss the impact of removing trade barriers in car industry for: a. Romanian car buyers; b. Romanian car industry owners; c. Romanian car industry workers; d. Romanian oil industry owners. B. PROBLEMS Problem 1: Two goods (cloth and steel) are produced using two factors of production (labour and capital – L and K, respectively). The production functions for the two goods are given in the table below:

K (units) L (units) Steel

(1 tonne) 20 10

Cloth (100 metres)

5 4

Identify the good that is intensive in labour and the good that is intensive in capital. Explain how you came to this conclusion.

3 Krugman, P., Obstfeld, M. – International Economics. Policy and Trade (Second Edition), HarperCollins Publishers, New York, 1991, p. 85

A Workbook in International Trade Problem 2: With reference to problem 1, a country is endowed with 600 units of labour and with 1000 units of capital. Determine and graph the production possibilities frontier for this country, on the basis of capital and labour constraints. Problem 3: With reference to problem 2, what changes occur with respect to the supply of steel and cloth if the domestic labour endowment increases from 600 units to 700 units? (Rybczynski Effect) Problem 4: With respect to problem 1, suppose that the price of cloth is USD 50, while the price of steel is USD 140. Determine the wage and rent rates that make possible the simultaneous production of both goods. If the price of cloth increases by 8%, how will the wage and rent rates alter? (Stolper – Samuelson Effect) Problem 5: Suppose that Home (domestic economy) has 100 million workers and 300 million acres of land, while Foreign (foreign economy) has 500 million workers and 1000 million acres of land. There are two goods produced in each economy: food and cloth. Both goods require land and labour, as follows:

Land (units) Labour (units) Food (1 tonne) 10 40

Cloth (100 metres) 8 50 Which good will Home tend to export? Discuss your answer. Problem 6: With reference to problem 5, graph the production possibilities frontiers for both Home and Foreign.

Trade Theory Problem 7: With reference to problem 5, suppose that prices of goods before trade are those given in the table below:

Home Foreign Food price (USD) 180 288 Cloth price (USD) 200 240

Also suppose that after specialisation and trade the prices of goods will be USD 242 for food and USD 220 for cloth. How will the wage and rent rates evolve in both economies after specialisation and trade? Explain this evolution. Also comment upon the changes in income distribution that occur in both economies after specialisation and trade. C. ANSWERS Answer to Problem 1: steel is capital intensive and cloth is labour intensive, because steel requires more units of capital per unit of labour (4) compared to cloth (2.5). Answer to Problem 2: the production possibilities frontier is given by the equation below: 5025.0 +⋅− Cq , [ )4.43,0∈Cq

=PP 1325.39 , Cq = 43.4 6048.0 +⋅− Cq , [ )200,4.43∈Cq

A Workbook in International Trade Answer to Problem 3: the new production possibilities frontier will be: 5025.0 +⋅− Cq , [ )33.133,0∈Cq

=PP 66.16 , Cq = 133.33

704.0 +⋅− Cq , [ )175,33.133∈Cq The quantity of cloth rises to 133.33 units and the quantity of steel decreases to 16.66 units. Answer to Problem 4: the wage rent is USD 10 and the rent rate is USD 2; after the cloth price increase, the wage rate will be USD 12.6 and the rent rate will be USD 0.664. Answer to Problem 5: Home will tend to export cloth (the labour intensive good), as it is labour abundant. Answer to Problem 7: the Home wage rate, before trade, is USD 3.11, while the rent rate is 5.55; the Foreign wage rate, before trade, is 0.53, while the rent rate is 26.67; after trade the wage rate becomes 1.467 and the rent rate becomes 18.332.

Trade Theory

4. The Standard Trade Model A. EXERCISES Exercise 1: What does the slope of isovalue line mean? Exercise 2: Why, in autarchy, must production and consumption lie on the same line? Exercise 3: What does “terms of trade” mean? Exercise 4: When one’s country terms of trade improve, what can you state about that country’s change in welfare? Exercise 5: Why does the production possibility frontier shift out more in one direction than in the other? Exercise 6: What are export-biased and import-biased growths? Exercise 7: What happens to a country’s terms of trade when there is a domestic export-biased growth? Exercise 8: Define can immiserizing growth. Exercise 9: When can immiserizing growth occur?

A Workbook in International Trade Exercise 10: Why does transfer of income not affect relative supply? Exercise 11: Suppose country A has a higher marginal propensity to spend on food than country B. Country A exports food while country B exports cloth. If country A grants a loan to country B, how will the donor’s terms of trade change? Exercise 12: Define the Metzler’s paradox. B. PROBLEMS Problem 1: Suppose a country’s production possibilities frontier is defined by the equation below:

72033)( 2 +⋅−−= xxxf , where )(xf is the quantity produced of good Y, and x stands for the quantity produced of good X. How many units of good Y will the country manufacture assuming full allocation of resources and a 5 units’ production of good X? What is the price ratio ( YX PP )4 for the above-mentioned quantities produced? Determine the corresponding isovalue line. What is the total domestic output when PY is EUR 10? Problem 2: With reference to problem 1, suppose the relative price of good X rises from 43 to 53. What changes will there be in the country considered above with reference to the quantities produced of good X and Y and, assuming constant PY, to domestic output?

4 PX is the price of good X and PY is the price of good Y.

Trade Theory Problem 3: With reference to problem 1, how much will the production of Y and the price ratio change, knowing that the production of X rises from 5 to 8? Problem 4: With reference to problem 1, suppose an indifference curve defined as follows:

484387)( +=x

xh ,

where ),0( ∞∈x and )(xh is the quantity consumed of good Y, while x is the quantity consumed of good X. Supposing YX PP = 43, determine the quantities consumed of each good. Is the country in question autarchic or is it opened to international trade? Comment your answer. Problem 5: With reference to problems 2 and 4, for a rise in relative price of X from 43 to 53, determine the new indifference curve and the changes that occur in the country’s trade flows. Comment upon these changes. C. ANSWERS To Problem 1: 530 units of Y; price ratio is 43; isovalue line is

74543)( +⋅−= xxVV ; total domestic output is EUR 7,450. To Problem 2: production of X rises from 5 to 10 units; production of Y decreases from 530 to 290 units; domestic output rises from EUR 7,450 to EUR 8,200. To Problem 3: production of Y decreases from 530 to 392 units; the relative price of X rises from 43 to 49. To Problem 4: the quantity consumed of good X is 3 units and the quantity consumed of good Y is 613 units; the country in question is

A Workbook in International Trade opened to international trade and it exports 2 units of X and imports 83 units of Y. To Problem 5: the new indifference curve will be

918.484918.0

387)(1 +−

=x

xh ; the curve moves to the right, meaning an

improvement in welfare; the exports of X will rise from 2 to 6.382 units, and the imports of Y will rise from 83 to 338.25 units.

Trade Theory

5. The New Trade Theory A. EXERCISES Exercise 1: Define economies of scale. Exercise 2: What is the difference between internal economies of scale and external economies of scale? Exercise 3: On what does the gap between the marginal revenue and price depend, for a monopolistic firm? Exercise 4: Why, for a monopolistic firm, does the marginal revenue curve always lie below the demand curve? Exercise 5: Explain mathematically why – when the average costs are a decreasing function of output – marginal cost is always less than average cost (hint: use an example, say from problem 3). Exercise 6: What is intraindustry trade? Exercise 7: When does intraindustry trade occur? Compare it to interindustry trade. Exercise 8: Suppose that two countries produce and mutually exchange office machines. Does this mean that none of them has any comparative advantage in office machines at all?

A Workbook in International Trade Exercise 9: What conditions must be met in order for international dumping to occur? Exercise 10: What is reverse dumping? Exercise 11: What is reciprocal dumping? Exercise 12: How can external economies of scale in one country hamper domestic production and trade in another country that could potentially produce the goods more cheaply? Could “external economies” become an argument for protection? Is it any different from the “infant industry” argument? Exercise 13: What is the learning curve? In which sense is it different from “ordinary” economies of scale? B. PROBLEMS Problem 1: For a monopolist, the reverse demand curve is:

000,1010)( +⋅−= qqpD . When the quantity produced is 30 units, determine the gap between the price and the marginal revenue5. Problem 2: Derive a firm’s linear cost function knowing that its fixed costs are USD 50,000, while its marginal costs are always equal to USD 1,000. Why is the value of marginal costs a constant? Would it be possible for it to depend on quantity? Explain.

5 Note: the price is given in EUR, and the quantity in units.

Trade Theory Problem 3: With respect to problem 2, derive the average cost function. Problem 4: With respect to problems 1 and 2, determine the profit maximizing quantity, as well as the corresponding gap between price and marginal revenue. Problem 5: Suppose good X is produced by a monopolistically competitive industry in two countries: Home and Foreign. Home sales ( HS ) are 23,040,000 units, while Foreign sales ( FS ) are 6,553,600 units. The demand curve facing any producer of good X from both Home and Foreign is described by the equation below:

( )⎥⎦

⎤⎢⎣

⎡−⋅−⋅= PP

nSX

400,646,1611 ,

Where: - X stands for the firm’s sales; - S stands for the total sales of the industry; - n is the number of firms in the industry; - P6 is the price charged by the firm itself; - P is the average price charged by its competitors. The cost function for this industry is described by the following equation:

XXC ⋅+= 000,20000,040,104)( ,

where C stands for the total firm’s cost and X stands for the total firm’s sales. a. Derive the average cost function; b. Determine the number of firms in each country before trade; 6 Note: the prices are given in EUR.

A Workbook in International Trade c. Determine a firm’s average cost and the price in each country before

trade; d. Assuming trade breaks out between Home and Foreign, calculate the

changes in price, number of firms and average costs that occur in the industry analyzed;

e. Does trade make consumers in both countries better off? Explain. f. Is trade beneficial to producers of good X in both countries? Explain. g. Can you state how the production in the integrated market will be

shared between the two countries? Comment upon your answer. Problem 6: A manufacturer can get EUR 100 for each product sold domestically and EUR 80 for each product sold abroad. Suppose domestic sales rise to EUR 9,000, while foreign sales go up to EUR 5,600. If the manufacturer wants to expand his sales on either market by 1 unit, he will have to reduce the respective prices by EUR 1. Where will he be interested in selling more: on the domestic market or abroad? Explain. What would change if the value of foreign sales were EUR 4,800? C. ANSWERS To Problem 1: the gap is EUR 300. To Problem 2:

000,50000,1)( +⋅= qqC

To Problem 3: q

qAC 000,50000,1)( += , for 0>q

To Problem 4: the profit maximizing quantity is 450 units; the gap between price and marginal revenue is USD 4,500.

Trade Theory To Problem 5:

a. 000,20000,040,104)( +=X

XAC , for 0>X ; b. 1,920 firms Home and

1,024 firms Foreign; c. for Home, the average cost is equal to price and it rises to EUR 28,670; for Foreign, the average cost is equal to price and it rises to EUR 36,256.25; d. post trade price and post trade average cost are EUR 27,650; the total post trade number of firms in this industry is 2,176. To Problem 6: as long as both home and abroad he gets a marginal revenue of EUR 9 for expanding his sales, he can sell one unit more either home or abroad. If the value of foreign sales were EUR 4,800, the foreign marginal revenue would be EUR 19, greater than the domestic marginal revenue (EUR 9). Therefore, in this case, the manufacturer would be more interested in expanding his foreign sales.