Problem Set 1

Question 1

what is international trade?

Answer 1

International trade is trade between the residents (individuals, businesses, nonprofit organizations, or
other forms of associations) of two countries. Trade involves the voluntary exchange of goods, services,
or money. International trade occurs because the parties to the transaction believe that they benefit
from the voluntary exchange.

Question 2

difference between absolute and comparative advantage?

Answer 2

The difference between absolute advantage and comparative advantage is that the former looks at
absolute differences in productivity, while the latter looks at relative productivity differences. The
difference between the theories exists because comparative advantage incorporates the concept of
opportunity costs in determining which good should be produced.

Question 3

why are Leontif’s findings a paradox?

Answer 3

Leontief’s findings are called a paradox because his research results on the U.S. trade position were not
consistent with the intuitively correct Heckscher-Ohlin model, and were in fact, exactly the reverse of
what the model predicted.

Question 4

what are country-level theories useful for?

Answer 4

The country-level theories are useful for explaining interindustry trade (trade in which countries
exchange goods produced in different industries) among nations; however, they are not helpful in
explaining intraindustry trade (trade in which countries exchange goods produced in the same industry).
The latter form of trade accounts for approximately 40 percent of world trade, yet cannot be predicted
by country-level theories

Question 5

difference between interindustry and intraindustry trade?

Answer 5

The difference between interindustry trade and intraindustry trade is that the former involves two
countries exchanging goods produced in different industries (for example, the exchange of British
raincoats for American beer), while the latter involves two countries exchanging goods produced in the
same industry (for example, Ford exports American-made cars to Japan, while Mazda exports Japanese made cars to the United States).

Question 6

portfolio investment vs foreign direct investment?

Answer 6

The difference between portfolio investment and foreign direct investment is related to the question of
control. Portfolio investments represent passive holdings of stocks, bonds, or other financial assets,
which entail no active management or control of the issuer of the securities by the foreign investor.
Foreign direct investment represents acquisition of foreign assets for the purposes of control.

Question 7

how do political factors influence international trade?

Answer 7

Political factors influence international trade and investment when firms choose to invest in a foreign
factory as a means of avoiding trade barriers, and when firms invest in foreign countries in order to take
advantage of economic incentives offered by host governments.

Question 8

what is the theory of comparative advantage

Answer 8

The theory of comparative advantage suggests that a country will export those goods and services for
which it is relatively more productive than other nations and import those goods and services in which
other nations are relatively more productive.

Question 9

country vs firm-based theories?

Answer 9

Country-based theories of trade focus on explaining interindustry trade (trade in which countries
exchange goods produced in different industries) rather than intraindustry trade (trade in which
countries exchange goods produced in the same industry). The reason for this is that country-level
theories use the country as a unit of analysis, and examine differences in the characteristics of
a country (such as land, labor, and capital) to explain trade between nations. In contrast, firm-based
theories use the firm as a unit of analysis and focus on differences between firms (such as ownership
advantages) to explain trade between countries

Question 10

Why does intraindustry trade occur under the New Trade theory?

Answer 10

Under the New Trade theory, intraindustry trade occurs due to the impact of economies of scale on
trade in differentiated goods. This allows firms to specialize in specific areas to realize economies of
scale to create a competitive advantage leading to trade within the same industry across national
borders

Question 11

opportunity cost =

Answer 11

opportunity given up/opportunity pursued

Question 12

trade can occur under the theory of comparative advantage when:

Answer 12

each country has comparative advantage

Question 13

why does international trade occur?

Answer 13

Both parties to the transaction benefit
– Exports spark additional economic activity
– Imports provide higher quality and/or less expensive
products
– Improve competitiveness

Question 14

describe the early country-based theories

Answer 14

Early Country-Based Theories
– Focused on the individual country
– Useful for describing trade in commodities
– Price is an important component of the customer’s purchase
decision

Question 15

describe the modern firm-based theories

Answer 15

Modern Firm-Based Theories
– Focus on the firm’s role in promoting international trade
– Useful in describing patterns of trade in differentiated goods
– Brand Name is an important component of the customer’s
purchase decision

Question 16

what are the four country-based theories?

Answer 16

1. mercantilism
2. absolute advantage
3. comparative advantage
4. relative factor endowments (Heckscher-Ohlin)

Question 17

what are the four firm-based theories?

Answer 17

1. country similarity theory
2. product life cycle
3. new trade theory
4. national comparative advantage

Question 18

describe mercantilism

Answer 18

Mercantilism is a sixteenth-century economic
philosophy that maintains that a country’s wealth is
measured by its holdings of gold and silver
– According to mercantilists, a country’s goal should be to enlarge these holdings by promoting exports and discouraging imports
• Because mercantilism does benefit certain members of society, mercantilist policies are still politically attractive to some firms and their workers
• Modern supporters of such policies are called
neomercantilists or protectionists

Question 19

describe absolute advantage

Answer 19

Adam Smith attacked the intellectual basis of
mercantilism
– Weakens a country
– In the process of avoiding imports at all costs, it squanders a
country’s resources producing goods it is not suited to produce
• Smith advocated free trade among countries
– Enlarges a country’s wealth
– Free trade enables a country to expand the amount of goods
and services available to it by specializing in the production of
some goods and services and trading for others

Adam Smith’s Absolute Advantage Theory: export those goods and services for which it is more productive than other countries are and import those goods and services for which other countries are more
productive than it is

Question 20

describe comparative advantage

Answer 20

What if one country has an absolute advantage in
both products?
– Theory of Absolute Advantage: No Trade Would Occur
– Theory of Comparative Advantage: Trade Should Still Occur
• David Ricardo’s Comparative Advantage Theory
– Relative Productivity Differences
– The difference between absolute and comparative advantage occurs because comparative advantage incorporates the concept of opportunity cost in determining which good a country should
produce
• The opportunity cost of a good is the value of what is given up to get the good

Question 21

describe relative factor endowments

Answer 21

Heckscher-Ohlin Theory: A country will have a comparative
advantage in producing products that intensively use resources
(factors of production) it has in abundance
– Factor endowments (or types of resources) vary among countries
– Goods differ according to the types of factors that are used to produce
them
• Pattern of Comparative Advantage
– Export products that use relatively abundant factors of
production
– Import products that need relatively scarce factors of
production

Question 22

describe country similarity theory

Answer 22

Interindustry trade is the exchange of goods produced by one industry in country
A for goods produced by a different industry in country B, such as the exchange of
French wines for Japanese clock radios
• Intraindustry trade is trade between two countries of goods produced by the same
industry
• In 1961, Swedish economist Steffan Linder sought to explain the phenomenon of
intraindustry trade
– He hypothesized that international trade in manufactured goods results from similarities of
preferences among consumers in countries that are at the same stage of economic development
– His country similarity theory suggests that most trade in manufactured goods should be between
countries with similar per capita incomes and that intraindustry trade in manufactured goods should
be common.
– Linder’s theory is particularly useful in explaining trade in differentiated goods such as automobiles,
expensive electronics equipment, and personal care products, for which brand names and product
reputations play an important role in consumer decision making
– Undifferentiated goods, such as coal, petroleum products, and sugar, are those for which brand
names and product reputations play a minor role at best in consumer purchase decisions

Question 23

describe new trade theory

Answer 23

New trade theory was developed in the 1970s and 1980s by Helpman,
Krugman, and Lancaster
– According to this theory, economies of scale occur if a firm’s average costs of producing a
good decrease as output of that good increases
• Like Linder’s approach, the new trade theory predicts that intraindustry trade
will be commonplace
• It also suggests MNCs within the same industry, such as Caterpillar and
Komatsu, Unilever and Procter & Gamble, and Airbus and Boeing, will
continually play cat-and-mouse games with one another on a global basis as
they attempt to expand their sales to capture scale economies
– Often they seek to harness some sustainable competitive advantage they enjoy as a means of
leveraging their own strengths and neutralizing those of their rivals

Question 24

what are the two main factors affecting the foreign direct investment decision?

Answer 24

1. avoidance of trade barriers

2. economic development incentives

Question 25

Passive holdings of securities
• Modern finance theory suggests that foreign portfolio investments will be
motivated by attempts to seek an attractive rate of return while reducing
the risk that can come from geographically diversifying one’s investment
portfolio

are:

Answer 25

foreign portfolio investments

Question 26

Acquisition of foreign assets for the purpose of controlling them
• FDI may take many forms, including purchase of existing assets in a
foreign country; new investment in property, plant, and equipment; and
participation in a joint venture with a local partner

are:

Answer 26

foreign direct investments