International Trade: Theory and Policy, 11th Edition Solution Manual

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Instructor’s ManualForInternational Economics: Theory and PolicyEleventh EditionPaul R. KrugmanPrinceton UniversityMaurice ObstfeldUniversity of California, BerkeleyMarc J. MelitzHarvard UniversityPrepared byHisham FoadSan Diego State University

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Table of ContentsChapter 1Introduction ............................................................................................................. 1Chapter 2World Trade: An Overview ..................................................................................... 3Chapter 3Labor Productivity and Comparative Advantage: The Ricardian Model ................ 7Chapter 4Specific Factors and Income Distribution ............................................................. 13Chapter 5Resources and Trade: The Heckscher-Ohlin Model .............................................. 21Chapter 6The Standard Trade Model .................................................................................... 29Chapter 7External Economies of Scale and the International Location of Production ......... 37Chapter 8Firms in the Global Economy: Export Decisions, Outsourcing,and Multinational Enterprises ............................................................................... 43Chapter 9The Instruments of Trade Policy ........................................................................... 51Chapter 10The Political Economy of Trade Policy ................................................................. 60Chapter 11Trade Policy in Developing Countries .................................................................. 69Chapter 12Controversies in Trade Policy ............................................................................... 73Chapter 13National Income Accounting and the Balance of Payments .................................. 80Chapter 14Exchange Rates and the Foreign Exchange Market: An Asset Approach ............. 89Chapter 15Money, Interest Rates, and Exchange Rates ........................................................ 100Chapter 16Price Levels and the Exchange Rate in the Long Run ......................................... 110Chapter 17Output and the Exchange Rate in the Short Run ................................................. 119Chapter 18Fixed Exchange Rates and Foreign Exchange Intervention ................................ 130Chapter 19International Monetary Systems: An Historical Overview .................................. 141Chapter 20Financial Globalization: Opportunity and Crisis ................................................. 152Chapter 21Optimum Currency Areas and the Euro .............................................................. 161Chapter 22Developing Countries: Growth, Crisis, and Reform ........................................... 171

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Chapter 1Introduction■Chapter OrganizationWhat Is International Economics About?The Gains from Trade.The Pattern of Trade.How Much Trade?Balance of Payments.Exchange Rate Determination.International Policy Coordination.The International Capital Market.International Economics: Trade and Money■Chapter OverviewThe intent of this chapter is to provide both an overview of the subject matter of international economicsand to provide a guide to the organization of the text. It is relatively easy for an instructor to motivate thestudy of international trade and finance. The front pages of newspapers, the covers of magazines, and thelead reports on television news broadcasts herald the interdependence of the U.S. economy with the rest ofthe world. This interdependence may also be recognized by students through their purchases of imports ofallsortsofgoods,theirpersonalobservationsoftheeffectsofdislocationsduetointernationalcompetition, and their experience through travel abroad.The study of the theory of international economics generates an understanding of many key events thatshape our domestic and international environment. In recent history, these events include the causes and

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2Krugman/Obstfeld/Melitz•International Economics: Theory & Policy,Eleventh Editionconsequences of the large current account deficits of the United States; the dramatic appreciation of thedollar during the first half of the 1980s followed by its rapid depreciation in the second half of the 1980s;the Latin American debt crisis of the 1980s and the Mexican crisis in late 1994; and the increasedpressures for industry protection against foreign competition broadly voiced in the late 1980s and morevocally espoused in the first half of the 1990s. The financial crisis that began in East Asia in 1997 andspread to many countries around the globe and the Economic and Monetary Union in Europe highlight theway in which various national economies are linked and how important it is for us to understand theseconnections. These global linkages have been highlighted yet again with how a bust in the Americanhousing market rapidly spread throughout the world, turning into a global financial crisis through linkagesacross international capital markets. At the same time, protests at global economic meetings and a risingwave of protectionist rhetoric have highlighted opposition to globalization as exemplified by both Brexitand the recent U.S. presidential campaign. The text material will enable students to understand theeconomic context in which such events occur.Chapter 1 of the text presents data demonstrating the growth in trade and the increasing importance ofinternational economics. This chapter also highlights and briefly discusses seven themes that arisethroughout the book. These themes are (1) the gains from trade, (2) the pattern of trade, (3) protectionism,(4) the balance of payments, (5) exchange rate determination, (6) international policy coordination, and (7)the international capital market. Students will recognize that many of the central policy debates occurringtoday come under the rubric of one of these themes. Indeed, it is often a fruitful heuristic to use currentevents to illustrate the force of the key themes and arguments that are presented throughout the text.

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Chapter 2World Trade: An Overview■Chapter OrganizationWho Trades with Whom?Size Matters: The Gravity Model.Using the Gravity Model: Looking for Anomalies.Impediments to Trade: Distance, Barriers, and Borders.The Changing Pattern of World Trade.Has the World Gotten Smaller?What Do We Trade?Service Offshoring.Do Old Rules Still Apply?Summary■Chapter OverviewBefore entering into a series of theoretical models that explain why countries trade across borders and thebenefits of this trade (Chapters 3–12), Chapter 2 considers the pattern of world trade that we observetoday. The core idea of the chapter is the empirical model known as the gravity model. The gravity modelis based on the observations that (1) countries tend to trade with nearby economies and (2) trade isproportional to country size. The model is called thegravity model,as it is similar in form to the physicsequation that describes the pull of one body on another as proportional to their size and distance.The basic form of the gravity equation isTij=A×Yi×Yj/Dij. The logic supporting this equation is that

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4Krugman/Obstfeld/Melitz•International Economics: Theory & Policy,Eleventh Editionlarge countries have large incomes to spend on imports and produce a large quantity of goods to sell asexports. This means that the larger that either trade partner is, the larger the volume of trade between them.At the same time, the distance between two trade partners can substitute for the transport costs that theyface as well as proxy for more intangible aspects of a trading relationship such as the ease of contact forfirms. This model can be used to estimate the predicted trade between two countries and look foranomalies in trade patterns. The text shows an example where the gravity model can be used todemonstrate the importance of national borders in determining trade flows. According to many estimates,the border between the United States and Canada has the impact on trade equivalent to roughly 1,500–2,500miles of distance. Other factors such as tariffs, trade agreements, and common language can allaffect trade and can be incorporated into the gravity model.The chapter also considers the way trade has evolved over time. Although people often feel thatglobalization in the modern era is unprecedented, in fact, we are in the midst of the second great wave ofglobalization. From the end of the 19th century to World War I, the economies of different countries werequite connected, with trade as a share of GDP higher in 1910 than in 1960. Only recently have trade levelssurpassed pre–World War I trade. The nature of trade has changed, though. The majority of trade is inmanufactured goods with agriculture and mineral products making up less than 20% of world trade. Evendeveloping countries now primarily export manufactures. A century ago, more trade was in primaryproducts as nations tended to trade for things that literally could not be grown or found at home. Today,the motivations for trade are varied, and the products we trade are increasingly diverse. Despite increasedcomplexity in modern international trade, the fundamental principles explaining trade at the dawn of theglobal era still apply today. The chapter concludes by focusing on one particular expansion of what is“tradable”—the increase in services trade. Modern information technology has expanded greatly what canbe traded as the person staffing a call center, doing your accounting, or reading your X-ray can literally behalfway around the world. Although service outsourcing is still relatively rare, the potential for a largeincrease in service outsourcing is an important part of how trade will evolve in the coming decades. Thenext few chapters will explain the theory of why nations trade.■Answers to Textbook Problems1.We saw that not only is GDP important in explaining how much two countries trade, but also,distance is crucial. Given its remoteness, Australia faces relatively high costs for transporting importsand exports, thereby reducing the attractiveness of trade. Because Canada has a border with a large

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Chapter 2World Trade: An Overview5economy (the United States) and Australia is not near any other major economy, it makes sense thatCanada would be more open and Australia more self-reliant.2.Mexico is quite close to the United States, but it is far from the European Union (EU), so it makessense that it trades largely with the United States. Brazil is far from both, so its trade is split betweenthe two. Mexico trades more than Brazil in part because it is so close to a major economy (the UnitedStates) and in part because it is a member of a trade agreement with a large economy (NAFTA).Brazil is farther away from any large economy and is in a trade agreement with relatively smallcountries.3.No, if every country’s GDP were to double, world trade would not quadruple. Consider a simpleexample with only two countries: A and B. Let country A have a GDP of $6 trillion and B have aGDP of $4 trillion. Furthermore, the share of world spending on each country’s production isproportional to each country’s share of world GDP (stated differently, the exponents on GDP inEquation 2-2,aandb,are both equal to 1). Thus, our example is characterized by the table below:CountryGDPShare of World SpendingA$6 trillion60%B$4 trillion40%Now let us compute world trade flows in this example. Country A has an income of $6 trillion andspends 40%of that income on country B’s production. Thus, exports from country B to country A areequal to $6 trillion×40%=$2.4 trillion. Country B has an income of $4 trillion and spends 60% ofthis on country A’s production. Thus, exports from country A to country B are equal to $4trillion×60%=$2.4 trillion. Total world trade in this simple model is $2.4+$2.4=$4.8 trillion.What happens if we double GDP in both countries? Now GDP in country A is $12 trillion, and GDPin country B is $8 trillion. However, the share of world income (and spending) in each country hasnot changed. Thus, country A will still spend 40% of its income on country B products, and countryB will still spend 60% of its income on country A products. Exports from country B to country A areequal to $12 trillion×40%=$4.8 trillion. Exports from country A to country B are $8 trillion×60%=$4.8 trillion. Total trade is now equal to $4.8+$4.8=$9.6 trillion. Looking at trade beforeand after the doubling of GDP, we see that total trade actually doubled, not quadrupled.4.As the share of world GDP that belongs to East Asian economies grows, then in every traderelationship that involves an East Asian economy, the size of the East Asian economy has grown.This makes the trade relationships with East Asian countries larger over time. The logic is similar towhy the countries trade more with one another. Previously, they were quite small economies,

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6Krugman/Obstfeld/Melitz•International Economics: Theory & Policy,Eleventh Editionmeaning that their markets were too small to import a substantial amount. As they became wealthierand the consumption demands of their populace rose, they were each able to import more. Thus,while they previously had focused their exports to other rich nations, over time they became part ofthe rich nation club and thus were targets for one another’s exports. Again, using the gravity model,when South Korea and Taiwan were both small, the product of their GDPs was quite small, meaningthat despite their proximity, there was little trade between them. Now that they have both grownconsiderably, their GDPs predict a considerable amount of trade.5.As the chapter discusses, a century ago much of world trade was in commodities, which were inmany ways climate or geography determined. Thus, the United Kingdom imported goods that it couldnot make itself. This meant importing things like cotton or rubber from countries in the WesternHemisphere or Asia. As the United Kingdom’sclimate and natural resource endowments were fairlysimilar to those of the rest of Europe, it had less of a need to import from other European countries. Inthe aftermath of the Industrial Revolution, where manufacturing trade accelerated and has continuedto expand with improvements in transportation and communications, it is not surprising that theUnited Kingdom would turn more to the nearby and large economies in Europe for much of its trade.This result is a direct prediction of the gravity model.

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Chapter 3Labor Productivity and ComparativeAdvantage: The Ricardian Model■Chapter OrganizationThe Concept of Comparative Advantage.A One-Factor Economy.Relative Prices and Supply.Trade in a One-Factor World.Determining the Relative Price after Trade.Box: Comparative Advantage in Practice: The Case of Babe Ruth.The Gains from Trade.A Note on Relative Wages.Box: The Losses from Nontrade.Misconceptions about Comparative Advantage.Productivity and Competitiveness.Box: Do Wages Reflect Productivity?The Pauper Labor Argument.Exploitation.Comparative Advantage with Many Goods.Setting Up the Model.Relative Wages and Specialization.

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8Krugman/Obstfeld/Melitz•International Economics: Theory & Policy,Eleventh EditionDetermining the Relative Wage in the Multigood Model.Adding Transport Costs and Nontraded Goods.Empirical Evidence on the Ricardian Model.Summary■Chapter OverviewThe Ricardian model provides an introduction to international trade theory. This most basic model of tradeinvolves two countries, two goods, and one factor of production, labor. Differences in relative laborproductivity across countries give rise to international trade. This Ricardian model, simple as it is,generates important insights concerning comparative advantage and the gains from trade. These insightsare necessary foundations for the more complex models presented in later chapters.The text exposition begins with the examination of the production possibility frontier and the relativeprices of goods for one country. The production possibility frontier is linear because of the assumption ofconstant returns to scale for labor, the sole factor of production. The opportunity cost of one good in termsof the other equals the price ratio because prices equal costs, costs equal unit labor requirements timeswages, and wages are equal in each industry.After defining these concepts for a single country, a second country is introduced that has different relativeunit labor requirements. Supply and demand curves relative to general equilibrium are developed. Thisanalysis demonstrates that at least one country will specialize in production. The gains from trade are thendemonstrated with a graph and a numerical example. The intuition of indirect production, that is“producing” a good by producing the good for which a country enjoys a comparative advantage and thentrading for the other good, is an appealing concept to emphasize when presenting the gains from tradeargument. Students are able to apply the Ricardian theory of comparative advantage to analyze threemisconceptions about the advantages of free trade. Each of the three “myths” represents a commonargument against free trade, and the flaws of each can be demonstrated in the context of examples alreadydeveloped in the chapter. The first myth is that trade is driven by absolute advantage. This chapter clearlydemonstrates that it is comparative advantage that matters. The second is the pauper labor argument, withpoor countries having an “unfair advantage”in trade given low-cost labor. The chapter highlights that thegains from trade are irrelevant to the source of comparative advantage. Finally, the myth of workers inpoor countries being exploited by trade is exposed by asking whether these workers would be better offwithout trade. As the numerical example in this chapter demonstrates, the answer is a resounding“no.”

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Chapter 3Labor Productivity and Comparative Advantage: The Ricardian Model9Although the initial intuitions are developed in the context of a two-good model, it is straightforward toextend the model to describe trade patterns when there areNgoods. Comparative advantage in this modelis driven by relative wages between countries rather than relative prices. However, the implication thatcountries will export goods for which they have the lowest opportunity cost remains.TheN-good model is used to discuss the role that transport costs play in making some goods nontraded.As transport costs rise, the gains from trade decrease, and in some cases they are completely eliminated.The chapter ends with a discussion of empirical evidence of the Ricardian model. The authors are carefulto point out that, while the rather simplified model cannot explain all trade patterns, the basic predictionthatcountries tend to exportgoodsforwhich they haveacomparativeadvantage(highrelativeproductivity) has been confirmed by a number of studies.■Answers to Textbook Problems1.a.The production possibility curve is a straight line that intercepts the apple axis at 400 (1,200/3)and the banana axis at 600 (1,200/2).b.The opportunity cost of apples in terms of bananas is 3/2. It takes 3units of labor to harvest anapple but only 2 units of labor to harvest a banana. If one forgoes harvesting an apple, this freesup 3 units of labor. These 3units of labor could then be used to harvest 1.5 bananas.c.Labor mobility ensures a common wage in each sector, and competition ensures the price ofgoods equals their cost of production. Thus, the relative price equals the relative costs, whichequals the wage times the unit labor requirement for apples divided by the wage times the unitlabor requirement for bananas. Because wages are equal across sectors, the price ratio equals theratio of the unit labor requirement, which is 3 apples per 2 bananas.

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10Krugman/Obstfeld/Melitz•International Economics: Theory & Policy,Eleventh Edition2.a.The production possibility curve is linear, with the intercept on the apple axis equal to 160(800/5) and the intercept on the banana axis equal to 800 (800/1).b.The world relative supply curve is constructed by determining the supply of apples relative to thesupply of bananas at each relative price. The lowest relative price at which apples are harvested is3 apples per 2 bananas. The relative supply curve is flat at this price. The maximum number ofapples supplied at the price of 3/2 is 400 supplied by Home while, at this price, foreign harvests800 bananas and no apples, giving a maximum relative supply at this price of 1/2. This relativesupply holds for any price between 3/2 and 5. At the price of 5, both countries would harvestapples. The relative supply curve is again flat at 5. Thus, the relative supply curve is step shaped,flat at the price 3/2 from the relative supply of 0 to 1/2, vertical at the relative quantity 1/2 risingfrom 3/2 to 5, and then flat again from 1/2 to infinity.

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Chapter 3Labor Productivity and Comparative Advantage: The Ricardian Model113.a.The relative demand curve includes the points (1/5, 5), (1/2, 2), (2/3, 3/2), (1, 1), (2, 1/2).b.The equilibrium relative price of apples is found at the intersection of the relative demand andrelative supply curves. This is the point (1/2, 2), where the relative demand curve intersects thevertical section of the relative supply curve. Thus, the equilibrium relative price is 2.c.Home produces only apples, Foreign produces only bananas, and each country trades some of itsproduct for the product of the other country.d.In the absence of trade, Home could gain 3 bananas by forgoing 2 apples, and Foreign could gainby 1 apple forgoing 5 bananas. Trade allows each country to trade 2 bananas for 1 apple. Homecould then gain 4 bananas by forgoing 2 apples, while Foreign could gain 1 apple by forgoingonly 2 bananas. Each country is better off with trade.4.The increase in the number of workers at Home shifts out the relative supply schedule such that thecorner points are at (1, 3/2) and (1, 5) instead of (1/2, 3/2) and (1/2, 5). The intersection of the relativedemand and relative supply curves is now in the lower horizontal section, at the point (2/3, 3/2). Inthis case, Foreign still gains from trade, but the opportunity cost of bananas in terms of apples forHome is the same whether or not there is trade, so Home neither gains nor loses from trade.5.This answer is identical to that in Answer3. The amount of “effective labor” has not changedbecausethe doubling of the labor force is accompanied by a halving of the productivity of labor.6.This statement fails to connect wages and productivity. Though wages in China are undoubtedlylower than they are in the United States, the reason for this is that productivity is significantly lowerin most industries in China. The diagram in the box titled “Do Wages Reflect Productivity?” showsthat Chinese productivity is less than 10% that of the United States, corresponding to much lower

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12Krugman/Obstfeld/Melitz•International Economics: Theory & Policy,Eleventh Editionwages in China. Thus, even though wages are higher in the United States than they are in China, it isnot clear that it is cheaper to produce all goods in China. Given higher productivity, some goods maystill be cheaper to produce in the United States, despite higher wages.7.Wages in China will be determined by productivity in both the manufacturing and the service sectors.Wages are a function of labor productivity and the price of the good or service being traded. Thatservices are generally not traded across borders does influence their price, allowing a different priceto be charged in the United States as compared to China, for example. However, the presence of aservicesectorwillstillinfluencewagesinboththemanufacturingandservicesectors.Asproductivity in the service sector increases, Chinese wages will rise. Wages will also rise as the pricereceived for manufactured goods increases with trade. Thus, wages are a function of productivity andprices in all sectors.8.One explanation for a lower cost of living in China is that there is high labor productivity in theservice sector. This high productivity level will cause the price of services in China to be significantlylower than those in the United States or Europe. Because services are generally nontradable, theseprice differences can persist even with international trade. If services could be traded, then we wouldexpect the price of services to rise in China and fall in the United States and Europe. However, mostservices are nontradable and thus living costs in China tend to be lower than in the United States andEurope.9.As more and more services become tradable, the gains from trade will increase, because the gainsfrom trade increase as the share of nontraded goods decreases. As more and more goods becometraded, more opportunities for maximizing comparative advantage through specialization are realizedand more countries will be able to focus resources on those industries in which they have the highestproductivity.10.The world relative supply curve in thiscase consists of a step function, with as many “steps”(horizontal portions) as there are countries with different unit labor requirement ratios. Anycountries to the left of the intersection of the relative demand and relative supply curves export thegood in which they have a comparative advantage relative to any country to the right of theintersection. If the intersection occurs in a horizontal portion, then the country with that price ratioproduces both goods.

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© 2018Pearson Education, Inc.Chapter 4Specific Factors and Income Distribution■Chapter OrganizationThe Specific Factors Model.Box: What Is a Specific Factor?Assumptions of the Model.Production Possibilities.Prices, Wages, and Labor Allocation.Relative Prices and the Distribution of IncomeInternational Trade in the Specific Factors Model.Income Distribution and the Gains from Trade.The Political Economy of Trade: A Preliminary View.Income Distribution and Trade Politics.Case Study: Trade and Unemployment.International Labor Mobility.Case Study: Wage Convergence in the European Union.Case Study: Immigration and the U.S. Economy.SummaryAPPENDIX TO CHAPTER 4: Further Details on Specific Factors.Marginal and Total ProductRelative Prices and the Distribution of Income

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14Krugman/Obstfeld/Melitz•International Economics: Theory & Policy,Eleventh Edition■Chapter OverviewIn Chapter 3, the Ricardian model of trade was introduced with labor as the single factor of productionexhibiting constant returns to scale. Although informative, this model fails to highlight the observedopposition to free trade. In this chapter, the Specific Factors model is presented to gain a betterunderstanding of the distributional effects of trade. After trade, the exporting industry expands, while theimport competing industry shrinks. As a result, the factor specific to the exporting industry gains fromtrade, while the factor specific to the import competing industry loses from trade. However, the aggregategains from trade are greater than the losses.The Specific Factors model assumes that there is one factor that is mobile between sectors (commonlythought of as labor) and production factors that are specific to each sector. The chapter begins with asimple economy producing two goods: cloth and food. Cloth is produced using labor and its specificfactor, capital. Food is produced using labor and its specific factor, land. Given that capital and labor arespecific to their respective industries, the mix of goods produced by a country is determined by share oflabor employed in each industry. The key difference between the Ricardian model and the Specific Factorsmodel is that in the latter, there are diminishing returns to labor. For example, production of food willincrease as labor is added, but given a fixed amount of land, each additional worker will add less and lessto food production.As we assume that labor is perfectly mobile between industries, the wage rate must be identical betweenindustries. With competitive labor markets, the wage must be equal to the price of each good times themarginal product of labor in that sector. We can use the common wage rate to show that the economy willproduce a mix of goods such that the relative price of one good in terms of the other is equal to the relativecost of that good in terms of the other. Thus, an increase in the relative price of one good will cause theeconomy to shift its production toward that good.With international trade, the country will export the good whose relative price is below the world relativeprice. The world relative price may differ from the domestic price before trade for two reasons. First, as inthe Ricardian model, countries differ in their production technologies. Second, countries differ in terms oftheir endowments of the factors specific to each industry. After trade, the domestic relative price will equalthe world relative price. As a result, the relative price in the exporting sector will rise, and the relativeprice in the import competing sector will fall. This will lead to an expansion in the export sector and acontraction of the import competing sector.

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Chapter 4Specific Factors and Income Distribution15Suppose that after trade, the relative price of cloth increases by 10%. As a result, the country will increaseproduction of cloth. This will lead to a less than 10% increase in the wage rate because some workers willmove from the food to the cloth industry. The real wage paid to workers in terms of cloth (w/PC) will fall,while the real wage paid in terms of food (w/PF) will rise. The net welfare effect for labor is ambiguousand depends on relative preferences for cloth and food. Owners of capital will unambiguously gainbecause they pay their workers a lower real wage, while owners of land will unambiguously lose as theynow face higher costs. Thus, trade benefits the factor specific to the exporting sector, hurts the factorspecific to the import competing sector, and has ambiguous effects on the mobile factor. Despite theseasymmetric effects of trade, the overall effect of trade is a net gain. Stated differently, it is theoreticallypossible to redistribute the gains from trade to those who were hurt by trade and make everyone better offthan they were before trade.Given these positive net welfare effects, why is there such opposition to free trade? To answer thisquestion, the chapter looks at the political economy of protectionism. The basic intuition is that the thoughthe total gains exceed the losses from trade, the losses from trade tend to be concentrated, while the gainsare diffused. Import tariffs on sugar in the United States are used to illustrate this dynamic. It is estimatedthat sugar tariffs cost the average person $7 per year. Added up across all people, this is a very large lossfrom protectionism, but the individual losses are not large enough to induce people to lobby for an end tothese tariffs. However, the gains from protectionism are concentrated among a small number of sugarproducers, who are able to effectively coordinate and lobby for continued protection. When the lossesfrom trade are concentrated among politically influential groups, import tariffs are likely to be seen. Ohio,a key swing state in U.S. presidential elections and a major producer of both steel and tires, is used as anexample to illustrate this point with both Presidents Bush and Obama supporting tariffs on steel and tires,respectively.Although the losers from trade are often able to successfully lobby for protectionism, the chapterhighlights three reasons why this is an inefficient method of limiting the losses from trade. First, the actualimpact of trade on unemployment is fairly low, with estimates of only 2.5% of unemployment directlyattributable to international trade. This fact is highlighted in a case study on the decline in U.S.manufacturingemployment,whichisoftenblamedoncompetitionfromChina.Manufacturingemployment had been falling long before the United States had any significant trade with China,suggesting that factors other than trade (at least with China) are responsible. Second, the losses from tradeare driven by one industry expanding at the expense of another. This phenomenon is not specific tointernational trade and is also seen with changing preferences or new technology. Why should policy be

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16Krugman/Obstfeld/Melitz•International Economics: Theory & Policy,Eleventh Editionsingled out to protect people hurt by trade and not for those hurt by these other trends? Finally, it is moreefficient to help those hurt by trade—by redistributing the gains from trade in the form of safety nets forthose temporarily unemployed and worker retraining programs to ease the transition from importcompeting to export sectors—than it is to limit trade to protect existing jobs.Finally, the chapter uses the framework of the Specific Factors model to analyze the distributional effectsof international labor migration. With free migration of labor across borders, wages must equalize amongcountries. Workers will migrate from low-wage countries to high-wage countries. As a result, wages in thelow-wage countries will rise, and those in the high-wage countries will fall. Though the net effect of freemigration is positive, there will be both winners and losers from migration. Workers who stayed behind inthe low-wage country will benefit, as will owners of capital in the high-wage country. Workers in thehigh-wage country will be hurt, as will owners of capital in the low-wage country. We also need toconsider the education levels of migrants relative to the country they move to. Immigrants to the UnitedStates, for example, tend to be concentrated in the lowest educational groups. Thus, migration is likely toonly have negative effects on the wages of the least educated Americans while raising the wages of thosewith more education.■Answers to Textbook Problems1.Texas and Louisiana are both oil-producing states. A decrease in the price of oil will reduce output inthese two states, hurting owners of capital and workers in the oil industry. Although some capital will beable to migrate to other sectors (for example, those that use oil as a factor of production), a significantfraction of capital is specific to the oil industry. By that same token, some workers in the oil industry haveskills that transfer to other sectors, and this transition will take time and is not costless.2.a.

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Chapter 4Specific Factors and Income Distribution17b.The curve in the PPF reflects diminishing returns to labor. As production of Q1increases, theopportunity cost of producing an additional unit of Q1will rise. Basically, as you increase thenumber of workers producing Q1with a fixed supply of capital, each additional worker willcontribute less to the production of Q1and represents an increasingly large loss of potentialproduction of Q2.3.a.Draw the marginal product of labor times the price for each sector given that the total laborallocated between these sectors must sum to 100. Thus, if there are 10 workers employed inSector 1, then there are 90 workers employed in Sector 2. If there are 50 workers employed inSector 1, then there are 50 workers employed in Sector 2. For simplicity, defineP1=1 andP2=2 (it does not matter what the actual prices are in determining the allocation of labor, onlythat the relative priceP2/P1=2).

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18Krugman/Obstfeld/Melitz•International Economics: Theory & Policy,Eleventh EditionIn competitive labor markets, the wage is equal to price times the marginal product of labor. Withmobile labor between sectors, the wage rate must be equal between sectors. Thus, the equilibriumwage is determined by the intersection of the twoP×MPLcurves. Looking at the diagramabove, it appears that this occurs at a wage rate of 10 and a labor supply of 30 workers in Sector1 (70 workers in Sector 2).b.From part (a), we know that 30units of labor are employed in Sector 1 and 70units of labor areemployed in Sector 2. Looking at the table in Question 2, we see that these labor allocations willproduce 48.6units of good 1 and 86.7units of good 2.At this production point (Q1=48.6,Q2=86.7), the slope of the PPF must be equal to−P1/P2,which is−½. Looking at the PPF in Question 2a, we see that it is roughly equal to−½.c.If the relative price of good 2 falls to 1.3, we simply need to redraw theP×MPLdiagram withP1=1 andP2=1.3.The decrease in the price of good 2 leads to an increase in the share of labor accruing to Sector 1.Now, the two sectors have equal wages (P×MPL) when there are 50 workers employed in bothsectors.Looking at the table in Question 2, we see that with 50 workers employed in both Sectors 1 and2, there will be production ofQ1=66 andQ2=75.8.ThePPFattheproductionpointQ1=66,Q2=75.78musthaveaslopeof-P1/P2=−1/1.3=−0.77.d.The decrease in the relative price of good 2 led to an increase in production of good 1 and adecrease in the production of good 2. The expansion of Sector 1 increases the income of the

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Chapter 4Specific Factors and Income Distribution19factor specific to Sector 1 (capital). The contraction of Sector 2 decreases the income of thefactor specific to Sector 2 (land).4.a.The increase in the capital stock in Home will increase the possible production of good 1, buthave no effect on the production of good 2 because good 2 does not use capital in production. Asa result, the PPF shifts out to the right, representing the greater quantity of good 1 that Home cannow produce.b.Given the increased production possibility for Home, the relative supply of home (defined asQ1/Q2) is further to the right than the relative supply for Foreign. As a result, the relative price ofgood 1 is lower in Home than it is in Foreign.c.If both countries open to trade, Home will export good 1, and Foreign will export good 2.d.Owners of capital in Home and owners of land in Foreign will benefit from trade, while ownersof land in Home and owners of capital in Foreign will be hurt. The effects on labor will beambiguous because the real wage in terms of good 1 will fall (rise) in Home (Foreign) and thereal wage in terms of good 2 will rise (fall) in Home (Foreign). The net welfare effect for laborwill depend on preferences in each country. For example, if labor in Home consumes relativelymore of good 2, they will gain from trade. If labor in Home consumes relatively more of good 1,they will lose from trade.5.The real wage in Home is 10, while real wage in Foreign is 18. If there is free movement of labor,then workers will migrate from Home to Foreign until the real wage is equal in each country. If 4workers move from Home to Foreign, then there will be 7 workers employed in each country, earninga real wage of 14 in each country.

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20Krugman/Obstfeld/Melitz•International Economics: Theory & Policy,Eleventh EditionWe can find total production by adding up the marginal product of each worker. After trade, totalproduction is 20+19+18+17+16+15+14=119 in each country for total world production of238.Beforetrade,productioninHomewas20+19+18=57.ProductioninForeignwas20+19+…+10=165. Total world production before trade was 57+165=222. Thus, tradeincreased total output by 16.Workers in Home benefit from migration, while workers in Foreign are hurt. Landowners in Homeare hurt by migration (their costs rise), while landowners in Foreign benefit.6.If only 2 workers can move from Home to Foreign, there will be a real wage of 12 in Home and areal wage of 16 in Foreign.a.Workers in Foreign are hurt as their wage falls from 18 to 16.b.Landowners in Foreign benefit as their costs fall by 2 for each worker employed.c.Workers who stay at home benefit as their wage rises from 10 to 12.d.Landowners in Home are hurt as their costs rise by 2 for each worker employed.e.The workers who do move benefit by seeing their wages rise from 10 to 16.7.By restricting immigration, the drop in wages in the high-wage country is not as high as it wouldhave been had migration been open. By the same token, the increase in wages in the low-wagecountry is not as large as it would have been with open migration. Thus, migration restrictionsincrease the net gain from migrating to those lucky few who are able to move.

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Chapter 5Resources and Trade: The Heckscher-Ohlin Model■Chapter OrganizationModel of a Two-Factor Economy.Prices and Production.Choosing the Mix of Inputs.Factor Prices and Goods Prices.Resources and Output.Effects of International Trade between Two-Factor Economies.Relative Prices and the Pattern of Trade.Trade and the Distribution of Income.Case Study: North–South Trade and Income Inequality.Skill-Biased Technological Change and Income Inequality.Box: The Declining Labor Share of Income and Capital-Skill Complementarity.Factor-Price Equalization.Empirical Evidence on the Heckscher-Ohlin Model.Trade in Goods as a Substitute for Trade in Factors: Factor Content of Trade.Patterns of Exports between Developed and Developing Countries.Implications of the Tests.SummaryAPPENDIX TO CHAPTER 5: Factor Prices, Goods Prices, and Production Decisions.

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22Krugman/Obstfeld/Melitz•International Economics: Theory & Policy,Eleventh EditionChoice of Technique.Goods Prices and Factor Prices.More on Resources and Output■Chapter OverviewInChapter3,tradebetweennationswasmotivatedbydifferencesinternationallyintherelativeproductivity of workers when producing a range of products. In Chapter 4, the Specific Factors modelconsidered additional factors of production, but only labor was mobile between sectors. In Chapter 5, thisanalysis goes a step further by introducing theHeckscher-Ohlin theory.TheHeckscher-Ohlin theoryconsiders the pattern of production and trade that will arise when countrieshave different endowments of such factors of production as labor, capital, and land and where these factorsare mobile between sectors in the long run. The basic point is that countries tend to export goods that areintensive in the factors with which they are abundantly supplied. Trade has strong effects on the relativeearnings of resources and, according to theory, leads to equalization across countries of factor prices.These theoretical results and related empirical findings are presented in this chapter.The chapter begins by developing a general equilibrium model of an economy with two goods that areeach produced using two factors according to fixed coefficient production functions. The assumption offixed coefficient production functions provides an unambiguous ranking of goods in terms of factorintensities. (A more realistic model allowing for substitution between factors of production is presentedlater in the chapter with the same conclusions.) Two important results are derived using this model. Thefirst is known as theRybczynski effect. Increasing the relative supply of one factor, holding relative goodsprices constant, leads to a biased expansion of production possibilities favoring the relative supply of thegood that uses that factor intensively.The second key result is known as theStolper-Samuelson effect. Increasing the relative price of a good,holding factor supplies constant, increases the return to the factor used intensively in the production of thatgood by more than the price increase, while lowering the return to the other factor. This result hasimportant income distribution implications.It can be quite instructive to think of the effects of demographic/labor force changes on the supply ofdifferent products. For example, how might the pattern of production during the productive years of the“Baby Boom” generation differ from the pattern of production for post–Baby Boom generations? What

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Chapter 5Resources and Trade: The Heckscher-Ohlin Model23does this imply for returns to factors and relative price behavior? What effect would a more restrictiveimmigration policy have on the pattern of production and trade for the United States?The central message concerning trade patterns of theHeckscher-Ohlin theoryis that countries tend toexport goods whose production is intensive in factors with which they are relatively abundantly endowed.Comparing the United States and Mexico, for example, we observe a relative abundance of capital in theUnited States and a relative abundance of labor in Mexico. Thus, goods that intensively use capital inproduction should be cheaper to produce in the United States, and those that intensively use labor shouldbe cheaper to produce in Mexico. With trade, the United States should export capital-intensive goods likecomputers, while Mexico should export labor-intensive goods like textiles. With integrated markets,international trade should lead to a convergence of goods prices. Thus, the prices of capital-intensivegoods in the United States and labor-intensive goods in Mexico will rise. According to theStolper-Samuelson effect, owners of a country’s abundant factors (e.g., capital owners in the United States, labor inMexico) will gain from trade, while owners of the country’s scarce factors (labor in the United States,capital in Mexico) will lose from trade. The extension of this result is the Factor Price Equalizationtheorem, which states that trade in goods (and thus price equalization of goods) will lead to an equalizationof factor prices. These income distribution effects are more or less permanent, given that factorabundances do not quickly change within a country. Theoretically, the gains from trade could beredistributed such that everyone is better off; however, such a plan is difficult to implement in practice.The political implications of factor price equalization should be interesting to students.After presenting the basic theory behind theHeckscher-Ohlin theory, the rest of the chapter examinesempirical tests of the model, beginning with a pair of case studies looking at income inequality in theUnited States. Wages paid to skilled workers in the United States have been rising at a much faster ratethan those paid to unskilled workers over the past few decades. At the same time, there has been a largeincrease in international trade. Given that the United States is relatively abundant in skilled labor, theHeckscher-Ohlin theorywould predict that increased trade should lead to higher wages for skilled workersand lower wages for unskilled workers. On the surface, this appears to be an empirical confirmation of thetheory. However, other studies argue that rising wage inequality can only partially be explained byincreased trade. According to the Heckscher-Ohlin model, the increase in skilled wages should be drivenby an increase in the price of skill-intensive goods following trade. However, skill-intensive goods priceshave not increased by nearly the same proportion as skilled wages. If rising wage inequality in a richcountry like the United States is driven by factor price equalization, then we should also observe anarrowing gap in developing countries that are exporting low-skill intensive goods. However, income

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24Krugman/Obstfeld/Melitz•International Economics: Theory & Policy,Eleventh Editioninequality in these nations is actually larger than in rich countries. Finally, trade between rich and poornations is simply not large enough to be entirely responsible for the size of the income gap. Rather, theincreasing skill premium is most likely due to skill-biased technical innovations like computers that haveincreased the productivities of skilled workers more than that of unskilled workers. This empiricalobservation can be modeled by introducing a three-factor production function using unskilled labor,skilled labor, and capital as inputs. Capital acts as a substitute for unskilled labor, but it is a complement toskilled labor. For example, a new machine can replace the work done by an unskilled laborer, but it needsa skilled worker to maintain and design it. With technological change, capital has become more productiveand increasingly displaces unskilled workers in both labor abundant developing countries and capitalabundant developed countries. This theory can help to explain labor’s decreasing share of total income inboth types of countries despite increased trade that would suggest a rising labor share of income indeveloping countries.Another empirical observation testing the validity of theHeckscher-Ohlin theoryis theLeontief paradox.This is the observation that the capital intensity of U.S. exports is actually lower than that of U.S. imports,exactly the opposite of what the theory would predict for a capital abundant country. Further evidence ofthis paradox is found in global data, with a country’s factor abundance doing a relatively poor job ofpredicting its trade patterns. Finally, the theory predicts a much larger volume of trade (given observeddifferences in factor endowments) than we actually see in the data. A country like China, for example, hasa significant abundance in labor. However, China’s net exports of labor-intensive goods are lower thanwhat the theory would predict. Similarly, U.S. net imports of labor-intensive goods are lower than whatwould be expected given its relative labor scarcity. An explanation for this “missing trade” is that theassumption of identical technology across countries is flawed. Rather, there are significant differences inproductivity across countries. That said, when the sample is restricted to trade between developed anddeveloping countries (i.e., North–South trade), theHeckscher-Ohlin theoryfits well. This is clearly seen inFigure 5-12, with low-skill countries like Bangladesh, Cambodia, and Haiti exporting products that areconsiderably less skill-intensive than the exports of more developed nations like France, Germany, and theUnited Kingdom. We can also see this pattern of trade changing as countries develop, as evidenced by theincreasing skillintensity of Chinese exports following China’s increased growth and development.Theseobservations have motivated many economists to consider motives for trade between nations that are notexclusively based on differences across countries. These concepts will be explored in later chapters.Despite these shortcomings, important and relevant results concerning income distribution are obtainedfrom theHeckscher-Ohlin theory.

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Chapter 5Resources and Trade: The Heckscher-Ohlin Model25■Answers to Textbook Problems1.a.The first step is to compute the opportunity costs of both cloth and food. We are given thefollowing resource constraints:aKC=2, aLC=2, aKF=3, aLF=1L=2000;K=3,000Each unit of cloth is produced with 2units of capital and 2units of labor. Each unit of food isproduced with 3units of capital and 1 unit of labor. Furthermore, the economy is endowed with2,000units of labor and 3,000units of capital. Given these values, we can define the followingresource constraints:2QC+QF≤2000➔Labor constraint2QC+3QF≤3000➔Capital constraintSolve these two constraints for the quantity of food produced:QF≤2000−2QCQF≤1000−2/3QCThis gives us two budget constraints for food production that mustbothbe met. The productionpossibilities frontier traces out these budget constraints for food and cloth production.Looking at the diagram, we see that production of both food and cloth will take place when therelative price of cloth is between the two opportunity costs of cloth. The opportunity cost of clothis given by the slopes of the two components of the production possibilities frontier above, 2/3and 2. When cloth production is low, the economy will be using relatively more labor to producecloth, and the opportunity cost of cloth is 2/3 a unit of food. However, as cloth production rises,the economy runs scarce on labor and must take capital away from food production, raising theopportunity cost of cloth to 2units of food.As long as the relative price of cloth lies between 2/3 and 2units of food, the economy willproduce both goods. If the price of cloth falls below 2/3, then the economy should completelyspecialize in food production (too low a compensation for producing cloth). If the price of clothrises above 2, complete specialization in cloth will occur (too low a compensation for producingfood).b.Note the input requirements for each good. One unit of cloth can be produced using 2units ofcapital and 2units of labor. One unit of food is produced using 3units of capital and 1 unit oflabor. In a competitive market, the unit cost of each good must be equal to the output price.

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26Krugman/Obstfeld/Melitz•International Economics: Theory & Policy,Eleventh EditionQC=2K+2L➔PC=2r+2wQF=3K+L➔PF=3r+wThis gives us two equations and two unknowns (randw). Solve for the factor prices:w=PF-3rPC=2r+2(PF−3r)=2r+2PF−6r=2PF−4r***r=(2PF−PC)/4***w=(3PC−2PF)/4c.Looking at the two expressions in part (b), we see that an increase in the price of cloth will causethe rental rate of capital to fall and the wage rate to laborers to rise. This makes sense, as cloth isa labor-intensive good. An increase in its price will lead to greater production of cloth and anincrease in demand for the factor it uses intensively—labor.d.The capital stock increases to 4,000. The labor constraint will remain unchanged, keeping themaximum price of cloth at 2units of food. The new capital constraint is given by:2QC+3QF≤4,000.Solving forQFyields:QF≤1333−2/3QC.Thus, the minimum price of cloth is also unchanged at 2/3units of food. The only difference nowis that the production possibilities frontier will have a larger horizontal intercept (if cloth is on thehorizontal axis). Compared to Figure 5-1, the new production possibilities frontier will interceptthex-axis at 2,000 instead of 1,500.e.The actual production point for cloth and food will depend on the relative prices of cloth andfood. If we assume that the economy is producing at a point such that all resources are beingutilized (point 3 in Figure 5-1), then we can compute the quantities of cloth and food by settingthe resource constraints equal to one another:QF=1,333−2/3QC=2,000−2QC.2QC−2/3QC=2,000−1,333.4/3QC=667.QC=500.QF=1,333−2/3×500=1,000.

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Chapter 5Resources and Trade: The Heckscher-Ohlin Model27f.Prior to the expansion of the capital stock, the economy was producing 750units of cloth and500units of food. After the expansion, cloth productionfellto 500, while food productionincreasedto 1,000. This is precisely what theRybczynski effectpredicts will happen.2.The definition of cattle raising as land intensive depends on the ratio of land to labor used inproduction, not on the ratio of land or labor to output. The ratio of land to labor in cattle exceeds theratio in wheat in the United States, implying that cattle raising is land intensive in the United States.Cattle raising is land intensive in other countries as wellifthe ratio of land to labor in cattleproduction exceeds the ratio in wheat production inthatcountry. Comparisons between anothercountry and the United States are less relevant for this purpose.3.This question is similar to an issue discussed in Chapter 4. What matters is not the absoluteabundance of factors but their relative abundance. Poor countries have an abundance of labor relativeto capital when compared to more developed countries. For example, consider a large, rich countrylike the United States and a small, poor country like Guatemala. Though the United States has moreland, natural resources, capital, and labor than Guatemala, what matters for trade is the relativeabundance of these factors. The ratio of labor to capital is likely to be much higher in Guatemala thanin the United States, reflecting a relative scarcity of capital in Guatemala and abundance in the UnitedStates. This makes labor relatively cheaper and capital more expensive in Guatemala than in theUnited States. Notice that this difference in factor prices is not driven by how much labor Guatemalahas compared to the United States, but by the proportion of labor to other factors within each country.4.In the Ricardian model, labor gains from trade through an increase in its purchasing power. Thisresult does not support labor union demands for limits on imports from less affluent countries. TheHeckscher-Ohlin modeldirectly addresses distribution effects by considering how trade impacts theowners of factors of production. In the context of this model, unskilled U.S. labor loses from tradebecause this group represents the relatively scarce factors in this country. The results from theHeckscher-Ohlin modelsupport labor union demands for import limits. This is a rational policy aslabor unions representing unskilled workers are hurt directly by trade that favors the export of skill-intensive goods (and import of low-skill goods). However, the unions may be better served lobbyingfor resources to increase skill levels among its membership, given that the gains from trade overallwill exceed the losses to a particular sector.5.Specific programmers may face wage cuts due to the competition from India, but this is notinconsistent with skilled labor wages rising. By making programming more efficient in general, thisdevelopment may have increased wages for others in the software industry or lowered the prices ofthe goods overall. In the short run, though, it has clearly hurt those with sector-specific skills who

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28Krugman/Obstfeld/Melitz•International Economics: Theory & Policy,Eleventh Editionwill face transition costs. There are many reasons to not block the imports of computer programmingservices (or outsourcing of these jobs). First, by allowing programming to be done more cheaply, itexpands the production possibilities frontier of the United States, making the entire country better offon average. Necessary redistribution can be done, but we should not stop trade that is making thenation as a whole better off. In addition, no one trade policy action exists in a vacuum, and if theUnited States blocked the programming imports, it could lead to broader trade restrictions in othercountries.6.The factor proportions theory states that countries export those goods whose production is intensivein factors with which they are abundantly endowed. One would expect the United States, which has ahigh capital/labor ratio relative to the rest of the world, to export capital-intensive goods if theHeckscher-Ohlin theoryholds. Leontief found that the United States exported labor-intensive goods.Bowen, Leamer, and Sveikauskas found, for the world as a whole, the correlation between factorendowment and trade patterns to be tenuous. The data do not support the predictions of the theorythat countries’ exports and imports reflect the relative endowments of factors.7.If the efficiency of the factors of production differs internationally, the lessons of theHeckscher-Ohlintheorywould be applied to “effective factors,” which adjust for the differences in technologyor worker skills or land quality (for example). The adjusted model has been found to be moresuccessful than the unadjusted model at explaining the pattern of trade between countries. Factor-price equalization concepts would apply to the effective factors. A worker with more skills or in acountry with better technology could be considered to be equal to two workers in another country.Thus, the single person would be two effective units of labor. Thus, the one high-skilled workercould earn twice what lower-skilled workers do, and the price of one effective unit of labor wouldstill be equalized.

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