Solution Manual for Introduction to International Economics , 3rd Edition

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Instructor’s Manual
To Accompany
Introduction to International
Economics
3rd Edition
DOMINICK SALVATORE
Professor of Economics
Fordham University
New York

CONTENTS
Introductory Comments …….…………………………………………………………………...
*Chapter 1: Introduction to the Global Economy ………………………………………….. 1
Part One: International Trade Theory
*Chapter 2: Comparative Advantage ……………………………………………………….. 7
*Chapter 3: The Standard Trade Model …………………………………………………….. 15
*Chapter 4: The Heckscher-Ohlin and Other Trade Theories ………………………………. 23
Additional Essays and Problems for Part One ………………………………………………….. 31
Part Two: International Trade Policy
*Chapter 5: Trade Restrictions: Tariffs ……………………………………………………... 36
*Chapter 6: Nontariff Trade Barriers and the Political Economy of Protectionism ………… 43
Additional Essays and Problems for Part Two ………………………………………………… .. 50
Part Three: International Trade and Investment Relations
*Chapter 7: Economic Integration …………………………………………………………... 53
Chapter 8: Growth and Development with International Trade …………………………… 59
Chapter 9: International Resource Movements and Multinational Corporations …………... 66
Additional Essays and Problems for Part Three ………………………………………………… 72
Part Four: The Balance of Payments and Exchange Rates
*Chapter 10: The Balance of Payments ……………………………………………………… 74
*Chapter 11: Foreign Exchange Markets and Exchange Rates ……………………………… 80
*Chapter 12: Exchange Rate Determination …………………………………………………. 85
Additional Essays and Problems for Part Four …………………………………………………. 92
Part Five: Open Economy Macroeconomics
*Chapter 13: Automatic Adjustments with Fixed and Flexible Exchange Rates …………… 94
*Chapter 14: Adjustment Policies …………………………………………………………... 103
Additional Essays and Problems for Part Five ……………………………………………... 110
Part Six: The Operation of the International Monetary System: Past, Present, and Future
*Chapter 15: Flexible versus Fixed Exchange Rates, European Monetary System,
and Macroeconomic Policy Coordination ……………………………………. 112
*Chapter 16: The International Monetary System: Past, Present, and Future ………………… 119
Additional Essays and Problems for Part Five ……………………………………………….. . 126
* = Core Chapter

INTRODUCTORY COMMENTS
Purpose of this Manual
The purpose of this manual is to facilitate the use of the text by the Instructor. It contains the
detailed outline of each chapter, lecture guides with suggestions on how best to present the material
in each chapter, the answer to the end-of-chapter review questions and problems, and a set of 15
multiple-choice questions with answers for each chapter.
The Instructor who feels that more questions and problems would be useful can consult my small
and popular paperback Theory and Problems of International Economics (4th ed., 1996) in the
Schaum's Outline Series, which includes a wealth of additional multiple-choice questions and
solved problems and the Study Guide prepared for this text by Professor Arthur Raymond of
Muhlenberg College. At the end of each of the six parts of this Manual there are also additional
essays and problems with answers that can be used for class exams.
Course Outlines
Some Instructors might want to skip Chapters 8 and 9, thus leaving 13 chapters (besides the
introductory chapter) – one for each week of the semester, leaving one week for review and the
midterm examination, and one week for review and the final examination.
I would give the midterm after Parts One, Two, and Three, which cover international trade, and the
final on all chapters covered at the end of the semester.
A Personal Note to You, the Instructor
I welcome any comment, suggestion, or opinion that you may have on the use of the text. You can
correspond directly with me or through John Wiley, and I will personally acknowledge your letter
and comment on your suggestions. I will, of course, consider your comments for the next Edition of
the text and would gratefully acknowledge any such contribution.
D.S.

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*CHAPTER 1
(Core Chapter)
INTRODUCTION
OUTLINE
1.1 We Live in a Global Economy
Case Study 1-1 The Dell and Other PCs Sold in the United States Are Anything But
American!
Case Study 1-2 What Is an “American” Car?
1.2 The Globalization Challenge
Case Study 1-3 Is India’s Globalization Harming the United States?
1.3 International Trade and the Nation’s Standard of Living
Case Study 1-4 Rising Importance of International Trade to the United States
1.4 The International Flow of Labor and Capital
Case Study 1-5 Major Net Exporters and Importers of Capital
1.5 The Subject Matter of International Economics
1.6 Current International Economic Problems
1.7 International Institutions and the World Economy
1.8 Organization of the Text
Appendix: International Trade Data, Sources and Information
A1.1 International Trade Data
A1.2 Sources of Additional International Data and Information
KEY TERMS
Globalization Microeconomics
Anti-globalization movement Macroeconomics
Interdependence Open-economy macroeconomics
International trade policy International finance
Balance of payments World Trade Organization (WTO)
Foreign exchange markets International Monetary Fund (IMF)
Adjustment in the Balance of Payments United Nations (UN)

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LECTURE GUIDE
1. As the first chapter of the book, the general aim here is simply to define the field of study of
international economics and point out its importance in today's interdependent world.
2. The material in this chapter can be covered in three classes. I would utilize one class to cover
Sections 1-2 and the second class for Sections 3-5. I would spend most of the third class on
Section 6 to identify the major current international economic problems facing the United
States and the world and to show how international economics can suggest ways to solve them.
This should greatly enhance students' motivation.
ANSWERS TO REVIEW QUESTIONS AND PROBLEMS
1. Globalization refers to the openness and the free exchange of goods, services, resources,
technologies, moneys, and ideas around the world. The advantages of globalization are that it
increases efficiency in production and leads to higher income for the nation’s workers.
Globalization often also makes available a greater range of cheaper and or better products to
the nation’s consumers, and provides opportunities for higher returns a greater risk
diversification to the nation’s investors. The disadvantages of globalization is that it often
leads to job losses and lower wages for low-skilled labor in advanced nations and harm (i.e.,
it is a “brain drain” for) the nations of emigration. Financial globalization and unrestricted
capital flows can also lead international financial crises. It is these disadvantages and
negative aspects of globalization have given rise to a strong anti-globalization movement,
which blames globalization for sacrificing human and environmental well-being to the
corporate profits of multinationals.
2. International economic relations differ from interregional (i.e. within a country) economic
relations in that nations usually impose some restrictions on the flow of goods, services, and
factors across their borders, but not interregionally or internally (i.e., not across regions of the
same nation). In addition, international flows are to some extent hampered by differences in
language, customs, and laws. Furthermore, international flows of goods, services, and
resources give rise to payments and receipts in foreign currencies, which change in value
over time.
3. A rough measure of the economic relationship among nations, or their interdependence, is
given by the ratio of their imports and exports of goods and services to their gross domestic
product (GDP). The imports and exports as a percentage of GDP are much larger for small
industrial and developing countries than they are for large countries.
4. The United States relies less on international trade for its high standard of living than most
other nations because it is continental in size with immense natural and human resources. As
such, it can produce with relative efficiency most of the products it needs. Contrast this to the
position of a small nation, such as Switzerland, which can specialize and export only a small
range of commodities and imports all the others. In general, the larger the nation the smaller

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is its economic interdependence with the rest of the world.
5. Even though the United States relies only to a relatively small extent on international trade, a
significant part of its high standard of living depends on it. The United States must import
many commodities that it cannot produce and several needed minerals that it does have. More
important quantitatively to its economic well-being, however, are the many commodities that
the United States could produce domestically but only at relatively higher cost.
6. The immigration of skilled people benefits the United States because it raises the skill level,
average income, and the growth rate of the nation. The cost arises from immigration of
unskilled people and from the job competition which migrants provide to native workers.
7. Capital flows across national boundaries in search of higher returns and to diversify risks.
8. The major international economic problems facing the world today are:
(1) slow growth and high unemployment in advanced nations after “the great recession”;
(2) the rise of trade protectionism in advanced countries in a rapidly globalizing
world;
(3) excessive volatility and large disequilibria in exchange rates;
(4) structural imbalances in advanced economies and insufficient restructuring in
transition economies;
(5) deep poverty in many developing countries, and
(6) resource scarcity, environmental degradation, and climate change.
9. The most important economic international economic and political institutions
are:
(1) The World Trade Organization (WTO), which regulates international trade;
(2) World Bank, which provides loans to developing countries for development programs
aimed at reducing poverty;
(3) International Monetary Fund (IMF), which oversees the conduct of international
financial relations and provides borrowing facilities for member nations in
temporary balance of payments difficulties;
(4) United Nations (UN), which seeks to facilitate cooperation in international law,
international security, economic development, social progress, and human rights
issues.
10. The problems facing the world today affect the United States and you as an individual
as follows:
(1) Slow growth and high unemployment in advanced nations after “the great recession”
means slower growth and higher unemployment for the United States than otherwise
in our interdependent world and very likely less job opportunities and stagnant wages
for you also.

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(2) Trade controversies between the United States, Europe, and Japan and emerging
market economies, such as China, can result in trade restrictions or even trade wars,
which would reduce the volume and the gains from trade and the flow of international
investments and the benefits resulting from them. As an individual, you can be caught
losing your job and a stagnant income.
(3) Excessive exchange rate volatility and misalignments discourage foreign trade and
investments, reduce specialization in production and the benefits from trade, which
means higher prices for your imported goods and services, more expensive travel.
(4) Structural imbalances (excessive and unsustainable trade and budget disequilibria) in
advanced countries and insufficient restructuring in transition economies mean slower
growth than possible as advanced nations try to eliminate or reduce their structural
imbalances and transition economies redouble their efforts to complete the restructure
of their economies. This also means possibly job opportunities for you and stagnant
wages.
(5) Deep poverty in many developing nations in the world mean that the United States and
other rich countries need to provide more foreign aid and open their markets more
widely to the exports of the world’s poorest countries. This can result in your paying
higher taxes and facing more job and income pressures.
(6) Resource scarcity, environmental degradation, and climate change means that the price
of food and raw materials is likely to increase in the future and the United States and
other countries need to spend more to protect the environment and prevent damaging
climate change. All this means higher costs for all of us.
MULTIPLE-CHOICE QUESTIONS
1. Which of the following statements about globalization is false?
a. it increase economic efficiency
b. it cannot be avoided
c. it benefits all people
d. none of the above
2. The anti-globalization movement blames globalization for
a. increasing income inequalities in the world
b. child labor
c. environmental pollution
d. all of the above
3. The criticism of the anti-globalization movement is
a. all wrong

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b. all correct
c. is only partly correct
d. is impossible to answer
4. Which of the following products are not produced at all in the United States?
a. coffee, tea, cocoa
b. steel, copper, aluminum
c. petroleum, coal, natural gas
d. typewriters, computers, airplanes
5. International trade is most important to the standard of living of:
a. the United States
b. Switzerland
c. Germany
d. England
6. Over time, the economic interdependence of nations has:
a. grown
b. diminished
c. remained unchanged
d. cannot say
7. A rough measure of the degree of economic interdependence of a nation is given by:
a. the size of the nations' population
b. the ratio of its population to its GDP
c. the ratio of a nation's imports and exports to its GDP
d. all of the above
8. Economic interdependence is greater for:
a. small nations
b. large nations
c. developed nations
d. developing nations
9. International economics deals with:
a. the flow of goods, services and payments among nations
b. policies directed at regulating the flow of goods, services and payments
c. the effects of policies affecting international trade and finance on the welfare of
the nation
d. all of the above

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10. International trade theory refers to:
a. the microeconomic aspects of international trade
b. the macroeconomic aspects of international trade
c. open-economy macroeconomics or international finance
d. all of the above
11. Which of the following is not the subject matter of international finance?
a. foreign exchange markets
b. the balance of payments
c. the basis and the gains from trade
d. policies to adjust balance of payments disequilibria
12. International trade is similar to interregional trade in that both must overcome:
a. distance and space
b. trade restrictions
c. differences in currencies
d. differences in monetary systems
13. The opening or expansion of international trade usually affects all members of society:
a. positively
b. negatively
c. most positively but some negatively
d. most negatively but some positively
14. An increase in the dollar price of a foreign currency usually:
a. benefit U.S. importers
b. benefits U.S. exporters
c. benefit both U.S. importers and U.S. exporters
d. harms both U.S. importers and U.S. exporters
15. Which of the following statements with regard to international economics is true?
a. it is a relatively new field
b. it is a relatively old field
c. most of its contributors were not economists
d. none of the above.

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*CHAPTER 2
(Core Chapter)
COMPARATIVE ADVANTAGE
OUTLINE
2.1 Introduction
2.2 Mercantilists’ Views on Trade
Case Study 2-1 Mercantilism Is Alive and Well in the Twenty-First Century
2.3 Trade Based on Absolute Advantage: Adam Smith
2.4 Trade Based on Comparative Advantage: David Ricardo
2.5 Gains from Trade with Comparative Advantage
2.6 Comparative Advantage with Money
Case Study 2-2 The Petition of the Candlemakers
2.7 Comparative Advantage and Opportunity Costs
Case Study 2-3 Labor Productivities and Comparative Advantage
2.8 Production Possibility Frontier with Constant Costs
2.9 Opportunity Costs and Relative Commodity Prices
2.10 Basis and Gains from Trade Under Constant Costs
Appendix: Comparative Advantage with More than Two Commodities and Nations
A2.1 Comparative Advantage with More than Two Commodities
A2.2 Comparative Advantage with More than Two Nations
KEY TERMS
Basis for trade Labor theory of value
Gains from trade Opportunity cost theory
Pattern of trade Production possibility frontier
Mercantilism Constant opportunity cost
Absolute advantage Relative commodity prices
Laissez-faire Complete specialization
Law of comparative advantage Small-country case

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LECTURE GUIDE
1. This is a long and crucial core chapter and may require four classes to cover adequately.
In the first lecture, I would present Sections 1-4 and assign review questions 1-3.
2. In the second lecture of Chapter 2, I would concentrate on Sections 5-6 and carefully explain the
law of comparative advantage using simple numerical examples, as in the text. Both sections are
crucial. Section 5 explains the law of comparative advantage and Section 6 establishes the link
between trade theory and international finance. I find that the numerical explanations before the
graphical analysis really helps the student to truly understand the law. The simple lawyer-
secretary example should also render the law more immediately relevant to the student. I would
also assign Problems 4-7.
3. In the third lecture, I would cover Sections 7-9 and assign Problems 8-10.
4. In the fourth lecture, I would Section 10 and go over problems 4-10. The appendixes could be
made optional for the more enterprising students in the class.
ANSWERS TO REVIEW QUESTIONS AND PROBLEMS
1. The mercantilists believed that the way for a nation to become rich and powerful was to
export more than it imported. The resulting export surplus would then be settled by an inflow
of gold and silver and the more gold and silver a nation had, the richer and more powerful it
was. Thus, the government had to do all in its power to stimulate the nation’s exports and
discourage and restrict imports. 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. The mercantilists thus preached
economic nationalism, believing that national interests were basically in conflict.
Adam Smith, on the other hand, believed that free trade would make all nations better off.
All of this is relevant today because many of the arguments made in favor of restricting
international trade to protect domestic jobs are very similar to the mercantilists arguments
made three or four centuries ago. That is why we can say that “mercantilism is alive and well
in the twenty-first century”. Thus we have to be prepared to answer and demonstrate that
these arguments are basically wrong.
2. According to Adam Smith, the basis for trade was absolute advantage, or one country being
more productive or efficient in the production of some commodities and other countries
being more productive in the production of other commodities.
The gains from trade arise as each country specialized in the production of the commodities
in which it had an absolute advantage and importing those commodities in which the nation
had an absolute disadvantage.

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Adam Smith believed in free trade and laissez-faire, or as little government interference with the
economic system as possible. There were to be only a few exceptions to this policy of laissez-
faire and free trade. One of these was the protection of industries important for national defense.
3. Ricardo’s law of comparative advantage is superior to Smith’s theory of absolute advantage in
that it showed that even if a nation is less efficient than or has an absolute disadvantage in the
production of all commodities with respect to the other nations, there is still a basis for beneficial
trade for all nations.
The gains from trade arise from the increased production of all commodities that arises when
each country specializes in the production of and exports the commodities of its comparative
advantage and imports the other commodities.
A nation that is less efficient than others will be able to export the commodities of its comparative
advantage by having its wages and other costs sufficiently lower than in other nations so as
to make the commodities of its comparative advantage cheaper in terms of the same currency
with respect to the other nations.
4. a. In case A, the United States has an absolute and a comparative advantage in wheat and the
United Kingdom in cloth.
In case B, the United States has an absolute advantage (so that the United Kingdom has an
absolute disadvantage) in both commodities.
In case C, the United States has an absolute advantage in wheat but has neither an absolute
advantage nor disadvantage in cloth.
In case D, the United States has an absolute advantage over the United Kingdom in both
commodities.
b. In case A, the United States has a comparative advantage in wheat and the United Kingdom
in cloth.
In case B, the United States has a comparative advantage in wheat and the United Kingdom
in cloth.
In case C, the United States has a comparative advantage in wheat and the United Kingdom
in cloth.
In case D, the United States and the United Kingdom have a comparative advantage in neither
commodities.
5. a. The United States gains 1C.
b. The United Kingdom gains 4C.

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c. 3C < 4W < 8C.
d. The United States would gain 3C while the United Kingdom would gain 2C.
6. a. 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.
b. In the United States, Pw=$1.50 and Pc=$2.00.
c. In the United Kingdom, Pw=£1.00 and Pc=£0.50.
7. The United States has a comparative disadvantage in the production of textiles. Restricting
textile imports would keep U.S. workers from eventually moving into industries in which the
United States has a comparative advantage and in which wages are higher.
8. Ricardo’s explanation of the law of comparative is unacceptable because it is based on the labor
theory of value, which is not an acceptable theory of value.
The explanation of the law of comparative advantage can be based on the opportunity cost
doctrine, which is an acceptable theory of value.
9. The production possibilities frontier reflects the opportunity costs of producing both
commodities in the nation.
The production possibilities frontier under constant costs is a (negatively sloped) straight line.
The absolute slope of the production possibilities frontier reflects or gives the price of the
commodity plotted along the horizontal axis in relation to the commodity plotted along the
vertical axis.
10. a. See Figure 1.
b. In the United States Pw/Pc=3/4, while in the United Kingdom, Pw/Pc=2.
c. In the United States Pc/Pw=4/3, while in the United Kingdom Pc/Pw=1/2.
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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MULTIPLE-CHOICE QUETIONS
1. The Mercantilists did not advocate:
a. free trade
b. stimulating the nation's exports
c. restricting the nations' imports
d. the accumulation of gold by the nation
2. According to Adam Smith, international trade was based on:
a. absolute advantage
b. comparative advantage
c. both absolute and comparative advantage
d. neither absolute nor comparative advantage
3. What proportion of international trade is based on absolute advantage?
a. all
b. most
c. some
d. none
4. The commodity in which the nation has the smallest absolute disadvantage is the commodity
of its:
a. absolute disadvantage
b. absolute advantage
c. comparative disadvantage
d. comparative advantage
5. If in a two-nation (A and B), two-commodity (X and Y) world, it is established that nation
A has a comparative advantage in commodity X, then nation B must have:
a. an absolute advantage in commodity Y
b. an absolute disadvantage in commodity Y
c. a comparative disadvantage in commodity Y
d. a comparative advantage in commodity Y
6. If with one hour of labor time nation A can produce either 3X or 3Y while nation B can
produce either 1X or 3Y (and labor is the only input):
a. nation A has a comparative disadvantage in commodity X
b. nation B has a comparative disadvantage in commodity Y
c. nation A has a comparative advantage in commodity X
d. nation A has a comparative advantage in neither commodity

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7. With reference to the statement in Question 6:
a. Px/Py=1 in nation A
b. Px/Py=3 in nation B
c. Py/Px=1/3 in nation B
d. all of the above
8. With reference to the statement in Question 6, if 3X is exchanged for 3Y:
a. nation A gains 2X
b. nation B gains 6Y
c. nation A gains 3Y
d. nation B gains 3Y
9. With reference to the statement of Question 6, the range of mutually beneficial trade
between nation A and B is:
a. 3Y < 3X < 5Y
b. 5Y < 3X < 9Y
c. 3Y < 3X < 9Y
d. 1Y < 3X < 3Y
10. If domestically 3X=3Y in nation A, while 1X=1Y domestically in nation B:
a. there will be no trade between the two nations
b. the relative price of X is the same in both nations
c. the relative price of Y is the same in both nations
d. all of the above
11. Ricardo explained the law of comparative advantage on the basis of:
a. the labor theory of value
b. the opportunity cost theory
c. the law of diminishing returns
d. all of the above
12. The Ricardian trade model has been empirically
a. verified
b. rejected
c. not tested
d. tested but the results were inconclusive
13. The Ricardian model was tested empirically in terms of differences in
a. relative labor productivities costs in various industries among nations
b. relative labor costs in various industries among nations

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c. relative labor productivities and costs in various industries among nations
d. none of the above
14. A difference in relative commodity prices between two nations can be based upon a difference
in:
a. factor endowments
b. technology
c. tastes
d. all of the above
15. In the trade between a small and a large nation:
a. the large nation is likely to receive all of the gains from trade
b. the small nation is likely to receive all of the gains from trade
c. the gains from trade are likely to be equally shared
d. we cannot say

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*CHAPTER 3
(Core Chapter)
THE STANDARD TRADE MODEL
OUTLINE
3.1 Introduction
3.2 The Production Frontier with Increasing Costs
3.3 The Marginal Rate of Transformation
3.4 Community Indifference Curves
3.5 Equilibrium in Isolation
3.6 The Basis and the Gains from Trade with Increasing Costs
3.7 Equilibrium Relative Commodity Prices with Trade
Case Study 3-1 Specialization and Export Concentration in Selected Countries
3.8 Terms of Trade
Case Study 3-2 The Terms of Trade of the G-7 Countries
Case Study 3-3 The Terms of Trade of Developed and Developing Countries
3.9 Specialization, Trade and Deindustrialization
Case Study 3-4 Job Losses in High U.S. Import-Competing Industries
Case Study 3-5 International Trade and Deindustrialization in the United States, the European
Union, and Japan
Appendix: The Equilibrium Relative Commodity Price with Trade and the Terms of Trade
A3-1 The Equilibrium Relative Commodity Price with Trade, with Demand and Supply
A3-2 Offer Curves and the Terms of Trade
KEY TERMS
Increasing opportunity costs Equilibrium relative commodity
Marginal rate of transformation (MRT) prices with trade
Community indifference curve Incomplete specialization
Marginal rate of substitution (MRS) Terms of trade
Autarky Deindustrialization
Equilibrium relative commodity price in Offer curve
isolation Reciprocal demand curve

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LECTURE GUIDE
1. In the first lecture of Chapter 3, I would cover Sections 1-5 and assign Review Question and
Problems 1-3. Section 3 is the most difficult here and Section 5 is the most important, and so
I would spend a bit more time covering them.
2. In the second lecture, I would cover Sections 6 and 7. Section 6 presents the basic trade model,
and is essential for the student to master it completely. Section 7 derives the supply curve and
the demand curves for the commodity from the production frontier and the community
indifference curves. This is the most difficult section, but it is essential because it shows how the
equilibrium-relative commodity price is determined with specialization in production and trade.
3. In the third lecture, I would cover the rest of the chapter, starting with Case Studies 3-1 and 3-2
and then going on to discuss the terms of trade. The last section on specialization, trade and
deindustrialization is likely to be of great interest to the students and lead to a great deal of class
discussion. I would make the Appendix optional for more advanced students in the class.
ANSWERS TO REVIEW PROBLEMS AND QUESTIONS
1. a. Increasing opportunity costs arise because resources or factors of production are not
homogeneous (i.e., all units of the same factor are not identical or of the same quality) and
not used in the same fixed proportion or intensity in the production of all commodities.
This means that as the nation produces more of a commodity, it must utilize resources that
become progressively less efficient or less suited for the production of that commodity. As
a result, the nation must give up more and more of the second commodity to release just
enough resources to produce each additional unit of the first commodity (i.e., it faces
increasing costs).
b. In the real world, the production frontiers of different nations will usually differ because of
differences in factor endowments and technology.
2. a. See Figure 1 on the next page.
b. The slope of the transformation curve increases as the nation produces more of X and
decreases as the nation produces more of Y. These reflect increasing opportunity costs as
the nation produces more of X or Y.
3. a. See Figure 2.
b. Nation 1 has a comparative advantage in X and Nation 2 in Y.
c. If the relative commodity price line in autarky has equal slope in both nations. This is rare.
4. a. See Figure 3. Points B and B’ are the production points in Nations 1 and 2, respectively, with
specialization and trade and E and E’ are the consumption points.
b. Nation 1 gains by the amount by which community indifference curve III (point E) is above
indifference curve I (point A). Nation 2 gains to the extent that community indifference curve
III’ (point E’) is above indifference curve I’ (point A).

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Salvatore’s Introduction to International Economics, 3rd Edition Instructor’s Manual
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5. a. The equilibrium-relative commodity price in isolation is the relative price that prevails in
the nation without trade or in autarky.
b. The equilibrium-relative commodity price in isolation for the commodity plotted along the
horizontal axis is given by the (absolute) slope of the tangent of the production frontier and
the community indifference curve at the point of production and consumption in the nation
in isolation.
c. The nation with the lower equilibrium relative commodity price in isolation or autarky has
a comparative advantage in the commodity measured along the commodity axis and a
comparative disadvantage in the commodity measured along the vertical axis.
6. See Figure 4 on the next page.
Supply curve AFB for commodity X in Nation 1 (SX) in the left bottom panel is derived
From production points AFB, respectively, at PA (not shown in the figure) < PF < PB on the
production frontier of Nation 1 in the top panel. Nation 1’s demand curve AHE in the left
bottom panel (DX) is derived, respectively, from tangency points of community indifferences
and trade lines at points A, H and E in the top panel. SX and DX for Nation 2 in the right
panel are derived in an analogous way.
From both bottom panels, we see that only at PB = PB’ would the quantity of exports of
commodity X supplied by Nation 1 exactly match the quantity demanded of imports of
commodity X of Nation 2. Thus, PB = PB’ is the equilibrium relative commodity prices with
trade.
7. a. The reason for incomplete specialization under increasing costs is that as each nation
specializes in the production of the commodity of its comparative advantage, the relative
commodity price in each nation moves toward each other (i.e., become less unequal) until
they are identical in both nations. At that point, it does not pay for either nation to continue
to expand the production of the commodity of its initial comparative advantage. This occurs
before either nation has completely specialized in production.
b. Under constant costs, each nation specializes completely in production of the commodity of
its comparative advantage (i.e., produces only that commodity). The reason is that since it
pays for the nation to obtain some of the commodity of its comparative disadvantage from
the other nation, then it pays for the nation to get all of the commodity of its comparative
disadvantage from the other nation (i.e., to specialize completely in the production of the
commodity of its comparative advantage).
8. See Figure 5.
Nations 1 and 2 have identical production frontiers (shown by a single curve) but different
tastes (indifference curves). In isolation, Nation 1 produces and consumes at point A and
Nation 2 at point A’. Since PA < PA’, Nation 1 has a comparative advantage in X and Nation 2
in Y.

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Salvatore’s Introduction to International Economics, 3rd Edition Instructor’s Manual
3-6
With trade, Nation 1 specializes in the production of X and produces at B, while Nation 2
specializes in Y and produces at B’ (which coincides with B). By exchanging BC = B’C’ of X
for CE = C’E of Y with each other (see trade triangles BCE and B’C’E’), Nation 1 ends up
consuming at E on indifference curve III (higher than indifference curve I at point A) and
Nation 2 consumes at on indifference curve III’ (higher than indifference curve I’ at point A’).
9. a. If the terms of trade of a nation improved from 100 to 110 over a given period of time,
the terms of trade of the trade partner would deteriorate by about 9 percent over the same
period of time [(100-110)/110 = -0.09 =0.9%].
b. A deterioration in the terms of trade of the trade partner can be said to be unfavorable to the
trade partner because the trade partner must pay a higher price for its imports in terms of
its exports.
c. This does not necessarily mean that the welfare of the trade partner has decreased because
the deterioration in its terms of trade may have resulted from an increase in productivity
that is shared with the other nation.
10. It is true that Mexico's wages are much lower than U.S. wages (they are about one fifth of the
average wage in the United States), but labor productivity is much higher in the United States
and so labor costs are not necessarily higher than in Mexico. In any event, trade can still be
based on comparative advantage.
MULTIPLE-CHOICE QUESTIONS
1. A production frontier that is concave indicates that the nation incurs increasing opportunity
costs in the production of:
a. commodity X only
b. commodity Y only
c. both commodities
d. neither commodity
2. The marginal rate of transformation (MRT) of X for Y refers to:
a. the amount of Y that a nation must give up to produce each additional unit of X
b. the opportunity cost of X
c. the absolute slope of the production frontier at the point of production
d. all of the above
3. Which of the following is not a reason for increasing opportunity costs:
a. technology differs among nations
b. factors of production are not homogeneous
c. factors of production are not used in the same fixed proportion in the production of all
commodities
d. for the nation to produce more of a commodity, it must use resources that are less and
less suited in the production of the commodity

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Salvatore’s Introduction to International Economics, 3rd Edition Instructor’s Manual
3-7
4. Community indifference curves:
a. are negatively sloped
b. are convex to the origin
c. should not cross
d. all of the above
5. The marginal rate of substitution (MRS) of X for Y in consumption refers to the:
a. amount of X that a nation must give up for one extra unit of Y and still remain on the
same indifference curve
b. amount of Y that a nation must give up for one extra unit of X and still remain
on the same indifference curve
c. amount of X that a nation must give up for one extra unit of Y to reach a higher
indifference curve
d. amount of Y that a nation must give up for one extra unit of X to reach a higher
indifference curve
6. Which of the following statements is true with respect to the MRS of X for Y?
a. it is given by the absolute slope of the indifference curve
b. declines as the nation moves down an indifference curve
c. rises as the nation moves up an indifference curve
d. all of the above
7. Which of the following is not true for a nation that is in equilibrium in isolation?
a. it consumes inside its production frontier
b. it reaches the highest indifference curve possible with its production frontier
c. the indifference curve is tangent to the nation's production frontier
d. MRT of X for Y equals MRS of X for Y, and they are equal to Px/Py
8. If the internal Px/Py is lower in nation 1 than in nation 2 without trade:
a. nation 1 has a comparative advantage in commodity Y
b. nation 2 has a comparative advantage in commodity X
c. nation 2 has a comparative advantage in commodity Y
d. none of the above
9. If actual Px/Py exceeds the equilibrium relative Px/Py with trade
a. the nation exporting commodity X will want to export more of X than at equilibrium
b. the nation importing commodity X will want to import less of X than at equilibrium
c. Px/Py will fall toward the equilibrium Px/Py
d. all of the above

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Salvatore’s Introduction to International Economics, 3rd Edition Instructor’s Manual
3-8
10. With free trade under increasing costs:
a. neither nation will specialize completely in production if both nations are large
b. at least one nation will consume above its production frontier
c. a small nation will always gain from trade
d. all of the above
11. Which of the following statements is true?
a. a nation’s demand curve of a commodity is derived from production points on the nation’s
production frontier.
b. a nation’s supply curve for a commodity is derived from community indifference curves
and trade lines
c. the price of the nation’s import commodity will fall as a result of international trade
d. none of the above
12. At a relative commodity price above equilibrium
a. the quantity demand of imports exceeds the quantity supplied of exports
b. the relative price of the commodity will rise
c. the commodity price will fall
d. none of the above
13. If the terms of trade increase in a two-nation world, those of the trade partner:
a. deteriorate
b. improve
c. remain unchanged
d. any of the above
14. A deterioration of a nation's terms of trade causes the nation's welfare to:
a. deteriorate
b. improve
c. remain unchanged
d. any of the above
15. Mutually beneficial trade cannot occur if production frontiers are:
a. equal but tastes are not
b. different but tastes are the same
c. different and tastes are also different
d. the same and tastes are also the same.

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Salvatore’s Introduction to International Economics, 3rd Edition Instructor’s Manual
4-1
*CHAPTER 4
(Core Chapter)
THE HECKSCHER-OHLIN AND OTHER TRADE THEORIES
OUTLINE
4.1 Introduction
4.2 Factor Endowments and the Heckscher-Ohlin Theory
4.3 The Formal Heckscher-Ohlin Model
Case Study 4-1 Relative Resource Endowments and the Comparative Advantage of Various
Countries
4.4 Factor-Price Equalization and Income Distribution
Case Study 4-2 Has International Trade Increased U.S. Wage Inequalities?
4.5 Empirical Tests of the Heckscher-Ohlin Theory
4.6 Economies of Scale and International Trade
Case Study 4-3 The New International Economies of Scale
4.7 Trade Based on Product Differentiation
Case Study 4-4 Growth of Intra-Industry Trade
4.8 Technological Gap and Product Cycle Models
Case Study 4-5: The World’s Most Competitive Economies
4.9 Transportation Costs and International Trade
4.10 Environmental Standards and International Trade
Appendix The Specific-Factors Model and Intra-Industry Trade Models
A4.1 The Specific-Factors Model
A4.2 A Model of Intra-Industry Trade
KEY TERMS
Relative factor prices International economies of scale
Heckscher–Ohlin (H–O) theory Differentiated products
Heckscher–Ohlin (H–O) theorem Intra-industry trade
Factor-proportions or factor-endowment theory Technological gap model
Factor–price equalization theorem Product cycle model
Stolper-Samuelson theorem Transportation costs
Specific-factors model Nontraded goods and services

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Salvatore’s Introduction to International Economics, 3rd Edition Instructor’s Manual
4-2
Leontief paradox Environmental standards
Increasing returns to scale Monopolistic competition
LECTURE GUIDE
1. This is one of the most important and difficult chapters in the book. It is also a long chapter and
requires four lectures to cover adequately.
2. In the first lecture, I would cover sections 1-3. Section 3 is one of the most important sections in
the book because it presents the H-O model. I would proceed slowly and carefully in explaining
Figure 4.1 and compare it to the standard trade model of Figure 3.4.
3. In the second lecture, I would cover sections 4 and 5. Section 4 on the factor-price equalization
theorem and income distribution is a difficult section. Case Study 4-2 should be of great interest
to the students and give rise to a great deal of class discussion.
4. In third lecture, I would cover sections 6-7, paying a great deal of attention to section 7 on trade
in differentiated products.
5. In fourth lecture, I would cover the rest of the chapter.
ANSWERS TO REVIEW QUESTIONS AND PROBLEMS
1. a. The Heckscher–Ohlin (H-0) theorem postulates that a nation will export those
commodities whose production requires the intensive use of the nation’s relatively
abundant and cheap factor and import the commodities whose production requires the
intensive use of the nation’s relatively scarce and expensive factor. In short, the relatively
labor-rich nation exports relatively labor-intensive commodities and imports the
relatively capital-intensive commodities.
b. Heckscher and Ohlin identify the relative difference in factor endowments among nations
as the basic determinant of comparative advantage and international trade.
c. The H-O Theory represent an extension of the standard trade model because it explains
the basis for comparative advantage (classical economists, such as Ricardo had assumed
it) and examines the effect of international trade on factor prices and income distribution
(which classical economists had left unanswered).
2. See Figure 1 on the next page.
a. The factor–price equalization theorem postulates that international trade will bring about
the equalization of the returns to homogeneous or identical factors across nations.
b. The Stopler-Samuelson theorem postulates that free international trade reduces the real
income of the nation’s relatively scarce factor and increases the real income of the nation’s
relatively abundant factor.

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Salvatore’s Introduction to International Economics, 3rd Edition Instructor’s Manual
4-4
c. The specific-factors model postulates that the opening of trade (1) benefits the
specific factor used in the production of the nation’s export commodity, (2) harms
the specific factor used in the production of the nation’s import-competing industry,
and (3) leads to an ambiguous effect (i.e., it may benefit or harm) the mobile factor.
d. Trade acts as a substitute for the international mobility of factors of production in
its effect on factor prices. With perfect mobility, labor would migrate from the low-
wage nation to the high-wage nation until wages in the two nations are equalized.
Similarly, capital would move from the low-interest to the high-interest nation until
the rate of interest was equalized in the two nations.
4. a. The Leontief paradox refers to the original Leontief’s finding that U.S. import
substitutes were more K-intensive than U.S. exports. This was the opposite of what
the H-O theorem postulated.
b. The Leontief paradox was resolved by including human capital into the
calculations and excluding industries based on natural resources. Recent research
using data on many sectors, for many countries, over many years, and considering
that countries could specialize in a particular subset or group of commodities that
were best suited to their specific factor endowments, provides strong support for
the H-O theorem.
c. The Hecksher-Olhin theory remains the centerpiece of modern trade theory for
explaining international trade today. To be sure, there are other forces (such as
economies of scale, product differentiation, and technological differences across
countries) that provide additional reasons and explanations for some international
trade not explained by the basic H-O model. These other trade theories complement
the basic H-O model in explaining the pattern of international trade in the world
today.
5. International trade with developing economies, especially newly industrializing
economies (NIEs), contributed in two ways to increased wage inequalities between
skilled and unskilled workers in the United States during the past two decades. Directly,
by reducing the demand for unskilled workers as a result of increased U.S. imports of
labor-intensive manufactures and, indirectly, by speeding up the introduction of labor-
saving innovations, which further reduced the U.S. demand for unskilled workers.
International trade, however, was only a small cause of increased wage inequalities in the
United States. The most important cause was technological change.
6. a. Economies of scale refer to the production situation where output grows
proportionately more than the increase in inputs or factors of production. For example,
output may more than double with a doubling of inputs.
b. Even if two nations were identical in every respect, there is still a basis for mutually
beneficial trade based on economies of scale. When each nation specializes in the
production of one commodity, the combined total world output of both commodities
will be greater than without specialization when economies of scale are present.
With trade, each nation then shares in these gains.
c. The new international economies of scale refers to the increase in productivity
resulting from firms purchasing parts and components from nations where they are
made cheaper and better, and by establishing production facilities abroad

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Salvatore’s Introduction to International Economics, 3rd Edition Instructor’s Manual
4-5
7. a. Product differentiation refers to products that are similar, but not identical. Intra-
industry trade refers to trade in differentiated products, as opposed to inter-industry
trade in completely different products.
b. Intra-industry trade arises in order to take advantage of important economies of
scale in production. That is, with intra-industry trade each firm or plant in industrial
countries can specialize in the production of only one, or at most a few, varieties
and styles of the same product rather than many different varieties and styles of a
product and achieve economies of scale.
c. With few varieties and styles, more specialized and faster machinery can be
developed for a continuous operation and a longer production run. The nation then
imports other varieties and styles from other nations. Intra-industry trade benefits
consumers because of the wider range of choices (i.e., the greater variety of
differentiated products) available at the lower prices made possible by economies of
scale in production.
8. a. According to the technological gap model, a firm exports a new product until
imitators in countries take away its market. In the meantime, the innovating firm
will have introduced a new product or process.
b. The criticism of the technological gap model are that it does not explain the size of
technological gaps and does not explore the reason for technological gaps arising in
the first place, or exactly how they are eliminated over time.
c. The five stages of the product cycle model are: the introduction of the product,
expansion of production for export, standardization and beginning of production
abroad through imitation, foreign imitators underselling the nation in third markets,
and foreigners underselling the innovating firms in their home market as well.
9. See Figure 2 on page 25.
10. A nation with lower environmental standards can use the environment as a resource
endowment or as a factor of production in attracting polluting firms from abroad and
achieving a comparative advantage in the production of polluting goods and services.
This can lead to trade disputes with nations with more stringent environmental
standards.
MULTIPLE-CHOICE QUESTIONS
1. The H-O model extends the classical trade model by:
a. explaining the basis for comparative advantage
b. examining the effect of trade on factor prices
c. both a and b
d. neither a nor b
2. A nation is said to have a relative abundance of K if it has a:
a. greater absolute amount of K

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