International Economics

M.Sc. in Management Engineering

Politecnico di Milano
October 24, 2016

Contents
1 International Trade
1.1 Ricardo: technological change . . . . .
1.2 Ricardo: three countries . . . . . . . .
1.3 Ricardo: a new good . . . . . . . . .
1.4 Ricardo: three goods . . . . . . . . . .
1.5 Heckscher-Ohlin . . . . . . . . . . . .
1.6 Heckscher-Ohlin: Stolper-Saumuelson
1.7 Commercial Policies . . . . . . . . . .
1.8 Commercial Policies . . . . . . . . . .

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2
2
5
7
8
10
11
13
14

International Trade

1.1

Ricardo: technological change

In Honduras and Guatemala two goods are being produced, coconut (C) and textile (T ), using exclusively
labor as a production input. Technology has constant returns to scale and is characterized in the following
table:

units of labor for 1kg of coconut

units of labor for 1mt of textile
total units of labor available

Honduras
4
8
1200

Guatemala
3
2
200

Consumers in both countries share the same preferences, which are described by the following utility
function:
U

C4T 4

where C and T denote the quantities of coconut and textile consumed, respectively. Answer to the following
questions:
1. Which country have the absolute and comparative advantage in the production of each good?
2. Determine the equilibrium production/consumption in autarky.
3. Let open the two countries to free trade. What is the pattern of specialization? What is the free-trade
relative price?
4. Quantify the benefits of free trade in terms of the variation in collective utility before and after free
trade, i.e. the welfare variation.
5. Suppose that in Honduras a group of management engineers improve the production technology in both
sectors, allowing to produce 1kg of coconut and 1mt of textile with 3 and 6 units of labor respectively.
What happens to the pattern of specialization? And to welfare? Discuss.
Solution.
1. Guatemala has an absolute advantage in the production of both goods. Guatemala has a comparative
advantage in the production of textile, while Honduras in the production of coconut. Indeed,
aH
4
C
=
8
aH
T

<

3
aG
= C
2
aG
T

where aij denotes the unit labor requirement for the production of good j in country i.
2. The problem for country i is
3

max

U = C4T 4

sub.

L = aiC C + aiT T

C,T

which delivers the following system of equations

(
ai
T
3C
= aCi
T

L = aiC C + aiT T
2

Figure 1: PPF: Honduras and Guatemala

Notice that 3T /C is the marginal rate of substitution, M RSC,T = (U/C) / (U/T ), while the ratio
aiC /aiT is the marginal rate of transformation, M RTC,T . The latter is the slope of the productionpossibility frontier, which is the constraint; displayed in figure 1. The autarky equilibrium relative price,
PC /PT , is equal to the slope of the production possibility-frontier, since, under perfect competition, the
price of good j is equal to its marginal cost of production, Pj = M Cj = w aij , where w is the real
wage rate. Therefore, to obtain equilibrium quantities (consumed and produced), solve the system for
Guatemala:
(
C = 50
3 G
PC
,
= , Uaut
= 42.04
PT
2
T = 25
and for Honduras:
(
C = 225
T = 37.5

PC
1 H
= , Uaut
= 143.76.
PT
2

3. The relative demand schedule is obtained as the equality between the marginal rate of substitution and
the relative price:
3

T
C

PC
.
PT

This demand function holds for both countries, as consumers share the same preferences. It can also be
obtained by solving the consumers problem, with a generic budget constraint (e.g. PC C + PT T = I).
The relative supply schedule can be found graphically, in the space (C/T, PC /PT ); see figure 2. The freetrade equilibrium is given by their intersection, which happens to be in C/T = 3 at a free-trade relative
FT
price of (PC /PT )
= 1. The pattern of specialization dictates that the two countries fully specialize in
the production of the goods in which they have their comparative advantage. Then we have to find the
equilibrium consumption levels under free-trade. For each country, we have to maximize consumption
subject to the budget constraint: the equilibrium production valued at the free-trade relative price. In

Figure 2: Free-trade equilibrium: relative demand and relative supply.

other words, the consumption-possibility frontier widens above the production-possibility frontier; see
figure 3. For instance, in Guatemala we have:
3

max

U = C4T 4

sub.

C = 100 T.

C,T

Therefore, equilibrium production and consumption in Guatemala are:

(
(
Tprod = 100
Tcons = 25
Cprod = 0
Ccons = 75
while in Honduras they are:
(

Tprod = 0
Cprod = 300

Tcons = 75
Ccons = 225

4. The welfare is higher in free-trade than in autarky. Indeed,

UfGt

56.99

UfHt

170.96.

H
5. The comparative advantage in Honduras remains unchanged, with aH
C /aT = 1/2. The world relative
demand remains unchanged as well. However, the world relative
supply
must
be modified: the full



G
G
specialization point now moves to the right, at C/T = LH /aH
/
L
/a
=
4.
The resulting freeC
T
FT0

trade equilibrium relative price is then (PC /PT )

= 3/4. In Guatemala, production and consumption

Figure 3: Free-trade equilibrium: production-possibility vs. consumption-possibility.

are now:
(

( 0
Tcons = 25
0
Ccons = 100

Tprod = 100
0
Cprod = 0

while in Honduras are:

(

Tprod = 0
0
Cprod = 400

Tcons = 75
0
Ccons = 300

Notice that Honduras suffers a negative shock in the terms of trade, i.e. Pexport /Pimport . Yet, welfare
is still higher in free-trade than in autarky (which is always true) and than in the previous free-trad
situation (which is not always true!).

1.2

Ricardo: three countries

Consider a world economy made up by three countries: A, B, and C. Each country can produce two goods,
food (F ) and vodka (V ), using labor as the unique production input. Labor endowments and production
technologies are characterized in the following table:
country A
1
5
10

units of labor for 1 unit of food (F )

units of labor for 1 unit of vodka (V )
total units of labor available

country B
3/4
1
6

country C
1
1/2
4

Consumers in both countries share the same preferences, which are described by the following utility
function:
U

= F 5V

2
5

where F and V denote the quantities of food and vodka consumed, respectively. Answer to the following
questions:
5

1. Determine the equilibrium production and the relative price of food in autarky.
2. Let open the two countries to free trade. What is the pattern of specialization? Determine consumption
and production in free trade, as well as the free-trade relative price of food.
3. Suppose that, in country A, the production technology in the vodka sector improves until is equal to
that in country C. What happens to the pattern of specialization? And to the relative price of cheese?
Solution.
1. The chain of comparative advantage,
aA
1
aB
3
aC
F
F
F
= < B
= < C
= 2,
A
5
4
aV
aV
aV
implies that country A has a comparative advantage in the production of food, country C in the production of vodka, while country B stands in the middle. The autarky equilibrium relative price are equal
to the ratio of unit labor requirements, because of perfect competition; that is,






PF
1 PF
3 PF
= ,
= ,
= 2.
PV A
5 PV B
4 PV A
The equilibrium is found by solving, for each country i = {A, B, C},
(
(
(
ai
M RSF,V = aiF
FA = 6
F B = 24/5
V

,
V A = 4/5
V B = 12/5
Li = aiF F + aiV V

(
F C = 12/5
,
V C = 16/5

2. The free-trade equilibrium relative price is (PF /PV )f t = 3/4, which is found by the intersection of the
relative world demand,
3V
2F

PF
,
PV

and the relative world supply, which can be found graphically, by construction. The pattern of specialization requires that F A+B+C /V A+B+C = 2, which implies that A and C fully specialize in the
A
C
production of goods F and V , in quantities Fprod
= 10 and Vprod
= 8 respectively, while country B
B
B
produces both goods, in quantities Fprod
= 36/5 and Vprod
= 3/5. Instead, consumption is found by
using the consumption possibilities frontier (which is given by the valuation of home production at the
world relative price) and is equal to
(
(
(
A
B
C
Fcons
=6
Fcons
= 24/5
Fcons
= 32/5
,
,
.
A
B
C
Vcons = 3
Vcons = 12/5
Vcons = 16/5
Notice that country B enjoys the same level of consumption as in autarky; indeed, the relative price
didnt changed when moving to free trade.
3. After the technological improvement, country A becomes effectively identical to country C. The world
relative supply does change: nobody produces food anymore at price 1/5 and the full specialization point
moves to F A+B+C /V A+B+C = 2/7. The resulting free-trade equilibrium relative price is (PF /PV )f t0 =
2, at total relative quantity F/V = 3/4.

1.3

Ricardo: a new good

(This exercise is taken from the midterm exam of the a.y. 2015/16.)
Consider two economies, NATO (N) and ASIA (A). They both produce two goods, food (F) and machines
(M). Production requires only labor, according to the following technology, with constant returns to scale:

units of labor for one unit of food (F )

units of labor for one unit of machines (M )
total units of labor available

NATO N
4
8
200

ASIA A
16
12
480

Consumers in both countries share the same preferences, described by the following utility function:
U

= F 5M 5

where F and M are the quantities of food and machines consumed, respectively. Answer the following
questions:
1. Is there any country holding an absolute advantage in the production of both goods? And who has the
comparative advantage in the production of machines?
2. Find the autarky equilibrium in both countries: production, consumption, and the autarky relative
price of machines.
3. Find the free trade equilibrium: production and consumption, in both countries, and the world relative
price of machines.
4. From now on, assume that wages are given: w = 5 in Nato and w = 2 in Asia. Then, introduce another
tradable good, services (S), whose production requires 3 and 15 units of labor in NATO and ASIA
respectively. Moreover, assume that all the labor endowment in both countries is still employed in the
production of the other two goods, F and M, and there is perfect competition in the factor (labro)
market. In which country services are going to be produced?
Solution.
1. NATO has an absolute advantage on both goods, while ASIA has a comparative advantage in the production of machines.
2. In autarky, consumption and production coincide. The problem is to maximize utility given the resource
constraint of each country. The resulting optimality condition for NATO is
3M
2F

1
,
2

3M
2F

4
.
3

while for ASIA is

Use the resource constraints, 200 = 4F + 8M and 480 = 16F + 12M for NATO and ASIA respectively,
to obtain the equilibrium quantities: FN = 30, MN = 10 and FA = 18, MA = 16. The equilibrium price
is the ratio of unit labor requirements: PM /PF = 2 in NATO and PM /PF = 3/4 in ASIA.
3. The world relative demand is
3M
2F

=
7

PF
PM

The relative supply is instead derived graphically, with only one step in F/M = 5/4. The equilibrium
is exactly at that step, with a relative price of PF /PM = 6/5. NATO is completely specialized in food
production while ASIA in machines production, for total quantities of FN = 50 and MA = 40. To
find consumption, we first need to derive the countries budget constraints, by valuing production at
world prices: FN = 50 65 MN and MA = 40 56 FA . Use the optimality condition for consumption,
PF
3M
5
2F = PM = 6 , to obtain:
(
FN = 30
MN = 24

and

(
FA = 20
MA = 16

4. We can derive prices as P = aw, given the prevailing wages. Therefore, services have a price of
PSN = 3 5 = 15 in NATO while a price of PSA = 15 2 = 30 in ASIA. Hence, services are going to be
produced in NATO. (One can also check that, at these prices, the pattern of specialization of food and
machines is consistent with point (3).)

1.4

Ricardo: three goods

Consider a world economy made up by two countries: Alf a and Beta. Each country can produce three
goods: trucks (T ), vests (V ), and magazines (M ). Labor is the only factor of production and unit labor
requirements are defined in the following table:

Alf a
Beta

trucks (T )
8
32

vests (V )
3
6

magazines (M )
5
18

We take as given the wage rate in both countries: 27 in Alf a and 9 in Beta, per unit of labor. Answer
to the following questions:
1. Determine the equilibrium production and commercial specialization in free trade, for both countries.
2. Graphically depict the relationship between the relative labor supply and the relative wage. If, for
instance, labor supply in Beta increases, what happens to specialization? And to the relative wage?
3. Introduce transportation costs that are 50% of the production costs. What happens to trade flows?
What is the maximum level of transportation costs that still allows trade between the two countries?
Solution.
1. The chain of comparative advantage is
a
T
aT

8
a
5
a
3
V
< M
=
<
= .

32
18
6
aM
aV

Specialization depends on the relative wage, w /w = 27/9. In particular, the rule is that a good is
produced in a country if and only if it is cheaper than in the other country; that is, good j is produced
in country i if and only if
wi aij

<

wi ai
j ,

where i denotes the country that is not i. Therefore, country produces both M and T , while
country produces V .

2. The equilibrium relative wage depends on the supply and demand of labor. We can plot them in the
diagram L/L vs. w/w , where denotes the foreign country, which is . The relative supply of labor
is a vertical line, which is given. The relative demand of labor can be formally derived from the demand
of goods (but we do not do it!); in general, it is a downward sloping relationship, as increasing the
relative wage can only be consistent with a diminishing relative labor supply (so that the home country
becomes more specialized and its wage rises). Therefore, increasing the labor supply of shifts the
relative labor supply (L/L ) to the left and increases the relative wage (w/w ).
3. With a tariff t = 50%, country cannot export anymore (since country would rather produce the goods
by itself !), while country could still export vests (since country would be indifferent between importing
or producing internally but for trade to be balanced, no trade will in fact occur in equilibrium!). The
maximum tariff, for each good, is obtained by equating the export price to the autarky price,

PTexp = PT w a
T (1 + tT ) = w aT tT = 33.3%
exp

PM
= PM
w a
M (1 + tM ) = w aM tM = 20%
exp

PV

= PV w aV (1 + tV ) = w a
V tV = 50%.

1.5

Heckscher-Ohlin

The small open economy Slavonia, where labor and capital are used to produce goods X and Y , is characterized by the following transformation curve:
X2
Y2
+
144
64

1.

Consumers in both countries share the same preferences, which are described by the following utility
function:
U

X2Y 2.

1. Find the equilibrium relative price of X and production levels in autarky.

2. Suppose that the international relative price of X is 3. Find the equilibrium levels of production and
consumption in a free-trade environment. Find also the change in welfare.
Solution.
1. Slavonias problem is as follows:
1

1
2

max

U = X2Y

sub.

Y2
X2
+
=1
144
64

X,Y

which can be solved by standard optimization techniques. That is, the Lagrangian is


1
1
Y2
X2

L = X2Y 2 + 1
144
64
and then we need to solve the following system

X = 0
L

Y = 0

L
= 0

of equations

1
2
1 1

2 X 2 Y 2 = 64 X
1
1
1
2
2
2
= 144
Y
2X Y

2
2
Y
X
144 + 64 = 1

which, by dividing the first with the second line, becomes

M RS
M RTX,Y
X,Y

z }| {

z}|{
X=4 2
Y
144 X

Y =6 2

Y 2X X 2 64 Y
144 + 64 = 1
The M RSX,Y is the marginal rate of substitution, which comes from the utility function and is defined
as the ratio between the marginal utility of good X and the marginal utility of good Y . The M RTX,Y
is instead the marginal rate of transformation, which comes from the production-possibility frontier (or
also transformation curve) and is defined as the marginal opportunity costs of good X in terms of good
Y . In equilibrium, they must be equal. Furthermore, in autarky, they are also equal to the equilibrium
autarky relative price PX /PY , which can be obtained by evaluating the M RSX,Y (or M RTX,Y ) at the
equilibrium quantities; that is, PX /PY = 3/2.

10

2. Since the free-trade relative price of X is higher than in autarky, Slavonia will export good X. To solve
for the equilibrium, start first from production (and only then move to consumption). The producers
problem is
max

PX XP + PY YP

XP ,YP

X2
YP2
+ P =1
144
64

sub.

which yields the following system

 
144 XP = PX F T = 3
64 YP
PY
YP2 + XP2 = 1
144

64

XP = 16/ 5

YP = 12/ 5

where subscript P denotes production. Then, we can value production at international prices to
get the countrys budget constraint: first, impose passage for (XP , YP ) and, second, impose slope of

FT
(PX /PY )
= 3, to get Y = 60/ 5 3X. In turn, the consumers problem is
1

max

XC ,YC

sub.

XC2 YC2
60
YC = 3XC
5

which yields the following system

 
YC = PX F T = 3
XC
PY
60
YC =
3XC

XC = 10/ 5

YC = 30/ 5

The resulting change in welfare can be obtained from the difference in overall utility, moving from
autarky to free trade,
UAU T
UF T

1.6

1
2

1
2

1
2

= X2Y

= XC YC

= 6.928
= 17.32

Heckscher-Ohlin: Stolper-Saumuelson

Consider a world economy made up by two countries: and . Production technology is identical across
countries and employs labor (L) and capital (K), which are perfectly mobile within countries but not across
countries, in order to produce either trucks (T ) or bread (B). Furthermore, is characterized by the following
transformation curve:
T2
B2
+
= 1,
196
81
while preferences are described by the following utility function:
U

= T 2B2.

1. Determine the equilibrium production and the relative price of bread in autarky in .
2. Suppose that bread production is intensive in labor, while trucks production is intensive in capital.
Also, suppose that is relatively more endowed with labor than . Can the international relative price
of bread be equal to 2 when the two countries engage in free trade? What would be the equilibrium
production in , given that relative price? And equilibrium consumption?
3. In , capitalists are opposing free trade policies and are asking for duties on imports. Are they acting
in their own interest, rightfully? And what about the interest of the whole country?
11

Solution.
1. In autarky, consumption and production are
(
B=

9
2
14

T =
with an equilibrium price of PB /PT = 14/9.

2. Yes, this would be in accordance with Heckscher-Ohlins theorem. The free-trade equilibrium yields
production of
(
BP = 81
130
TP =

98
130

BC =

65
130
130
130

while consumption of
(

TC =

3. Capitalists would oppose free-trade, rightfully so. See Stolper-Samulesons theorem.

12

1.7

Commercial Policies

The market for bananas in countries Home and Foreign is characterized by the following demand and supply
schedules:
DH = 100 20P H

S H = 20 + 20P H

DF = 80 20P F

S F = 40 + 20P F

1. Derive the schedules of import demand and export supply of bananas (from the excess demand and
excess supply schedules) and the equilibrium price and quantity that occurs in the world market.
2. Suppose that Home country introduces an ad valorem duty of 50% on imports of bananas. Show
graphically and analytically the new equilibrium in the world market.
(a) What will be Homes tax revenue from this maneuvre?
(b) How does total surplus change?
3. Suppose instead that Foreign country helps its exporters with a subsidy of 1$ for any exported banana.
Show graphically and analytically the effects of such policy.
Solution.
1. In autarky, market equilibrium occurs when supply equals demand. That is, equilibrium prices are
DH = S H

PH = 2

DF = S F

PF = 1

so that, for an international price 1 < P W < 2, Home will be an importer while Foreign will be an
exporter. The import and export schedules are defined as excess demand and excess supply,
IM P H = DH S H
EXP

=S D

80 40P W

= 40 + 40P W

and the world market equilibrium occurs when they are equal,
IM P H = EXP F

P W = 3/2,

with an associated traded quantity of QW = 20.

2. The introduction of the duty t creates a wedge between the price perceived in Home country (PtW,H ) and
the one perceived in Foreign country (PtW,F ), so that
(
PtW,H = (1 + t) PtW,F
PtW
PtW,F
We can use this fact to modify the import and export demand schedules as follows:
80 40 (1 + t) PtW,F

IM P H

EXP F

= 40 + 40PtW,F

The equilibrium yields PtW,F = 1.2 and PtW,H = (1 + t) PtW,F = 1.8, with an associated traded quantity
of QW
t = 8.

13

(a) The tax revenue, which is the government surplus, can be computed as:
GSt

t PtW,F QW
t

0.5 1.2 8 = 4.8.

(b) The total surplus is the sum of consumers, produces, and government surpluses. In the ex ante
equilibrium (with no duty), consumers and producers surpluses were


5 32 70
CS =
= 122.5
2

3
2 + 1 50
PS =
= 62.5
2
for a total surplus of T S = CS + P S = 185. Now, in the ex post equilibrium (with the duty),
consumers and producers surpluses are
(5 1.8) 64
= 102.4
2
(1.8 + 1) 56
P St =
= 78.4
2
for a total surplus of T St = CSt + P St + GSt = 185.6, which is greater. In general, the effect on
welfare of the duty is ambiguous when trading countries are of similar sizes, i.e. any country can
affect world prices. Indeed, was Home country a small country with no capacity to affect world
prices, the government revenues would never be able to offset the distortions in consumption and
production (i.e. dead weight losses) that are brought about by the duty. Its only when the country
is big enough that this could happen, i.e. that a duty could increase the countrys surplus.
CSt

3. The subsidy modifies the export schedule of Foreign country: at any given price (perceived by buyers
in the world market), the quantity supplied is larger. Accordingly, if the price in the world market
is PsW , which is also the price realizing in Home country, the price perceived by exporters is instead
PsW,F = PsW + 1. Therefore, the export schedule modifies as


EXPsF = 40 + 40PsW,F = 40 + 40 PsW + 1 EXPsF = 40PsW
and, by combining it to the previous import schedule, obtain PsW = 1 with QW
s = 40. The price perceived
by exporters is instead PsW,F = PsW + 1 = 2. It also follows that the cost of the subsidy is 1$ QW
s = 40$.

1.8

Commercial Policies

Sri Lanka is a small open economy that produces cocoa beans. Being small, it takes the cocoa beans price
as given, in world markets: P W = 12$. Producers in Sri Lanka have the following supply schedule
S

50 + 15P

400 10P.

while the demand schedule of consumers is

1. Determine the free trade equilibrium e the change in welfare with respect to autarky.
2. Suppose that Sri Lanka introduces a duty on imports of 5$ per unit. Determine the effects on international trade.
3. To improve the international competitiveness of its cocoa beans producers, the Sri Lankan government
is evaluating the following policies: (i) to introduce a subsidy on production of 5$ per unit, or (ii)
to introduce a subsidy on exports of 5$ per unit. Which of the two policies will be more effective in
increasing exports? And which one would be preferred by Sri Lankan consumers?
14

Solution.
1. In autarky, P = 14 and Q = 260. In free trade, given P W = 12, Sri Lanka imports cocoa beans:
IM P = 50. The increase in welfare is the area of the triangle that represents the difference between the
increase in consumers surplus and the decrease in producers surplus: T S = 0.5 (50 2) = 50.
2. The duty increases the domestic import price to P = 17. But, at this price, consumers would buy from
domestic producers only, who guarantee the autarky price. Therefore, this duty is prohibitive, since it
shuts down international trade.
3. A subsidy creates a wedge between the price Ps perceived by consumers and the price Psp /Pse perceived by
producers/exporters. The production subsidy (i) modifies the whole domestic supply schedule, shifting
it downwards,
Si

50 + 15Psp

50 + 15 (Ps + 5) = 125 + 15Ps

which would imply an autarky price of Ps = 11. Consumers would be happy, but producers have another
option: to produce and sell in world markets at P W = 12, getting

the subsidy in both cases. Thus,
the
equilibrium price must be the world price, with demand Di P W = 280 and supply S i Psp = P W + 5 =
305, making Sri Lanka a net exporter of cocoa beans, with EXP i = 25. Producers receive Psp = P W +5 =
17 for any unit they sell and the government pays GS i = s S i = 1525$.
Consider now the export subsidy (ii). The world price P W gives to producers the option to sell at
all of these
Pse = P W + 5 = 17 in world markets. Hence, they will supply S ii (Pse ) = 305, exporting


units. Consumers instead can buy in world markets at P W , with demand Dii P W = 280. Sri Lanka
becomes again a net exporter, with EXP ii = 25. The government surplus is GS ii = s S ii = 1525$,
since all the producers are exporting. That is, the policies (i) and (ii) are in practice identical.

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