3. A Model of Trade

Question 1

According to the Ricardian Model of Comparative Advantage, when opening up to trade, countries…

1.
2.

+ Whas one counter-assumption?

Answer 1

• countries specialize on producing and exporting goods in which they have a comparative advantage (where labor is relatively more productive)
• countries benefit since overall consumption possiblities expand as a result from trade
• do really all citizens benefit from trade? -> depends on strong assumptions

Question 2

What are the strong assumptions that the ricardian model relies on?

1.
2.
3.

Answer 2

• perfect substitutability of production factors
• the production of both goods only needs the same production factor (labor) as an input
• labor can more flexibly across production sectors (PPFs are linear)

-> this makes specialization very simple and oftern result in complete/full specialization

Question 3

With a concave PPF, specialization…

In other words, if we get rid of the assumption of perfect substitutability (i.e. workers cannot completely flexibly move across production sectors anymore due to diminishing marginal product), the PPF becomes… and….

Answer 3

…. is much harder and some workers are likely “import competing” now

…. concave and when it opens up to trade, its much less likely that it fully specializes its production

Question 4

Whats the Shrinking Sector? What happens here?

Answer 4

• = import competing sector
• if we have no perfect substitutabuility and the PPF becomes concave, then a country is less likely to fully specialize and some workers stay in the shrinking sector

Question 5

According to the Ricardian model of comparative advantage, countries specialize on (and export) goods for which they have a…

Answer 5

… comparative advantage.

Question 6

Comparative Advantages are reflected in….

Explain:
1.
2.
3.

Answer 6

prices

-> assume price for a good in a country is lower than the world market price (we have not opened to world market yet)
-> this price reflects the opportunity cost and shows that the country has a comparative advantage in the production of the good, relative to world marke price
-> so, country will produce more of this good and export it when the world market opens

Question 7

Whether a country exports or imports depends on…

Answer 7

prices

1. if world price above a price within the country, we export
2. if world price below the price within the country, we import

Question 8

How can we calculate the new world market equilibrium when a country enters the world market?

Whats the import demand curve? Which shape does it have?

Answer 8

• assume, price within is higher than in world market (within: Home; World: Foreign)
• ie we become importer, and we ship from Foreign to Home UNTIL PRICE DIFFERENCE is ELIMINATED
  _____
• Import demand curve of Home = Difference between Qty that home consumers demand - Qty that home producers supply at each price
• MD = D-S
  -> downwards sloping, because as the price decreases, the quantity of imports demanded increases

in equilibrium: MD = XS

Question 9

Whats the export supply curve of Foreign?

Answer 9

• the difference between the Quantity that foreign producers supply - quantity that foreign producers demand at each price

XS = S-D

Question 10

Whats the formula for the new world market equilibrium when a country enters the world market?

Answer 10

MD = XS
-> home demand - home supply = foreign supply - foreign demand
-> world demand = world supply

Question 11

What happens if there is no full specialization in the Ricardian model?

1.
2.
3.

Answer 11

• some workers still work IN sectors producing goods that are mostly imported (import competing sector)
• producer surplus in the importing sector shrinks via opening up to trade, i.e. everyone stuck in this sector will lose (eg low skilled workers)
• still, the countries overall welfare will grow via trade (independent of whether the country becomes an imporer or exportee) ,i,e, in principle, the welfare winners should compensate the losers and still everyone is better offW

Question 12

What happened in Germany witht the rise of East Germany?

1.
2.
3.

Answer 12

• substantial net job losses in regions specialized in import-competing indistries, eg manufacturing
• even stronger net gauns in jobs in regions specialized in export oriented industries
• on aggregate, many (400k) additional jobs created in germany due to trade with china and eastern europe

Question 13

Income effects due to international trade occur because…

1.
2.

Answer 13

• production factors cannot switch quickly and without any cost from one sector to another -> factors stuck in import competing sectors typically lose from trade
• trade nonetheless produces overall gains in the sense that those who gain could better compensate those who lose while still remaining better off than before, i.e. if done properly, everyone can benefit