XJTLU IBSS Year 2016/2017 Semester 2

ECO312: INTERNATIONAL ECONOMIC RELATIONS

Problem Set 3 Solutions
SECTION A
Please give a short answer. Indicate whether the statement is true or false and give an
explanation for your answer. Answer all questions.

A1. According to the gravity model, trade between the United States and Brazil is much larger
than trade between the United States and Argentina. True or False? Explain.

Answer Key:
True. Compared with Argentina, Brazil is larger (with a larger GDP) and closer to the US.

A2. The mercantilists believed trade was a zero-sum game that one nations gain was
anothers loss. They advocated export promotion and import restriction. True or False? Explain.

Answer Key:
True. The mercantilists believed for a nation to become rich and powerful was to export more
than it imported. However, since all nations could not simultaneously have an export surplus
and the amount of gold and silver was fixed at any particular point in time, one nation could
gain only at the expense of other nations.

A3. Based on absolute advantage, both nations can gain from specialization in production and
trade. Gains are distributed equally between these two nations. True or False? Explain.

Answer Key:
False. The gains from trade are divided among the trading nations are determined by the rate
at which commodities are exchanged for one another.

A4. In a two-nation, two-commodity world, mutually beneficial trades cannot happen between two
nations if one nation is less efficient than the other nation in the production of both commodities.
True or False? Explain.

Answer Key:
False. Even if one nation has an absolute disadvantage with respect to the other nation in the
production of both commodities, there is still a basis for mutually beneficial trade: the first
nation should specialize in the production and export of the commodity in which its absolute
disadvantage is smaller (this is the commodity of its comparative advantage) and import the
commodity in which its absolute disadvantage is greater (this is the commodity of its
comparative disadvantage).
The only exception is that the absolute disadvantage (that one nation has with respect to the
other nation) is in the same proportion for the two commodities.

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XJTLU IBSS Year 2016/2017 Semester 2

A5. A nation produces two commodities X and Y. The production possibility frontier of
commodities X and Y is a straight line. Moving along the production frontier, the opportunity
costs in the production of X change. True or False? Explain.

Answer Key:
False. The fact that the production possibility frontier is a straight line reflects the fact that
the opportunity cost is constant. The opportunity cost remains constant no matter from which
point on its production possibility frontier the nation starts.

A6. In trade between a small and a large nations, the small nation is likely to receive all of
the gains from trade. True or False? Explain.

Answer Key:
True. The small country is specialized completely in the production of the commodity of its
comparative advantage and the larger countrys production is not completely specialized.
Trade would take place at the pretrade relative commodity price in the larger country and the
Small country would receive all the gains from trade.

SECTION B
B1: Go through your daily newspaper and identify:
(a) Seven or eight news items that have international economics characteristics;
(b) The importance or effect of each of these problems on Chinas economy;
(c) The importance of each of these news item to you personally.

Answer Key:
Discuss in the class.

B2: Assume that both the United States and Germany produce beef and computer chips with the
following costs:
Table 1
United Germany
States (euros)
(dollars)
Unit cost of beef (B) 2 8
Unit cost of computer chips (C) 1 2

a) What is the opportunity cost of beef (B) and computer chips (C) in each country?
b) In which commodity does the United States have a comparative cost advantage? What about
Germany?
c) What is the range for mutually beneficial trade between the United States and Germany for
each computer chip traded?
d) How much would the United States and Germany gain if 1 unit of beef is exchanged for 3
chips?

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XJTLU IBSS Year 2016/2017 Semester 2

Answer Key:

a) In the United States: the opportunity cost of one unit of beef is 2 chips; the opportunity cost of
one chip is 1/2 unit of beef. In Germany: the opportunity cost of one unit of beef is 4 chips; the
opportunity cost of one chip is 1/4 unit of beef.
b) The United States has a comparative cost advantage in beef with respect to Germany, while
Germany has a comparative cost advantage in computer chips.
c) The range for mutually beneficial trade between the United States and Germany for each unit
of beef that the United States exports is: 2C < 1B < 4C
d) Both the United States and Germany would gain 1 chip for each unit of beef traded.

B3: Table 2: Production Possibilities in the United States (US) and United Kingdom (UK)
US UK
Wheat (bushels per hour) 4 1
Cloth (yards per hour) 3 2

(a) Table 2 shows the wheat (W) and cloth (C) production in the US and UK that can be
produced with one labor hour. Identify the commodity in which the US and UK have a
comparative advantage.
(b) Assume that labor is the only factor of production and is homogeneous. What is the
cost in terms of labor content of producing wheat and cloth in the US and UK? Suppose
the wag rate in the US is $6 per hour and the wage rate in the UK is 1 per hour. With
the exchange rate of 1=$2, is mutually beneficial trade possible to happen between the
US and UK? If so, what is the pattern of trade? What is the range of exchange rates that
will allow mutually beneficial trade to happen?
(c) Plot the production frontiers of the US and UK. Show the relative price of wheat (i.e.,
/ ) in both nations in autarky (no trade).
(d) Assume the no-trade or autarky points are (3W, 3/4 C) in the US and (1/2 W, 1C) in
the UK, respectively. With the opening of trade the US exchanges 1W for 1C with the
UK. Show graphically and explain for the US and UK the autarky point of production
and consumption, the point of production and consumption with trade, and the gains
from trade.

Answer Key:

a) The United States has a comparative advantage in wheat and the United Kingdom in cloth.
b) The cost in terms of labor content of producing wheat is 1/4 in the United States and
1 in the United Kingdom, while the cost in terms of labor content of producing cloth is
1/3 in the United States and 1/2 in the United Kingdom.

In the United States, Pw=$1.50 and Pc=$2.00. With the exchange rate of 1=$2,
Pw=$2.00 and Pc=$1.00 in the United Kingdom, so that the United States would be able
to export wheat to the United Kingdom and the United Kingdom would be able to export
cloth to the United States.
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XJTLU IBSS Year 2016/2017 Semester 2

$1.50 < 1.00 < $4.00 is the range of exchange rates that will allow mutually beneficial
trade to happen.

c) See Figure 1.

In the United States Pw/Pc=3/4, while in the United Kingdom, Pw/Pc=2.

d) See Figure 2.

The autarky points are A and A' in the United States and the United Kingdom,
respectively. The points of production with trade are B and B' in the United States and
the United Kingdom, respectively. The points of consumption are E and E' in the
United States and the United Kingdom, respectively. The gains from trade are shown
by E > A for the U.S. and E' > A' for the U.K.

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