International Economics
                           Econ 4401
                     Midterm Exam Key
                             Tim Uy
          Name:
          Student Number:
          1 Short Answer Questions (30 Points)
          1. [5] Give five reasons (or five theories that explain) why countries trade.
          Acceptable answers include:
          Different endowments
          Different technologies
          Increasing returns to scale
          Different preferences
          Love for variety
          Consumption smoothing
          or the corresponding models.
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                   2. [6] Name and define two types of foreign direct investment (FDI). For each
                   type of FDI, state the location(s) where such investment is usually made. Explain
                   why that is the case.
                   Horizontal FDI: replicating the production process in a foreign coun-
                   try; usually conducted in a rich or developed country.
                   Vertical FDI: breaking up the production process and producing in-
                   termediate goods in a foreign country, usually a developing one.
                   3. [6] Consider a 2 x 2 x 2 Heckscher-Ohlin model where country 1 is capital-
                   abundant (country 2 capital-scarce) and the two factors (capital and labor) are
                   used to produce good 1, which is capital-intensive, and good 2, which is labor-
                   intensive.  Following the liberalization of trade, what good(s) does country 1
                   export? What about country 2? Who gains and loses in country 1? What about
                   winners and losers in country 2? Explain.
                   Country 1 exports good 1; country 2 exports good 2. Producers of
                   good 1 gain in country 1; good 2 producers lose. The opposite is true
                   in country 2.
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        4. [4] How does faster economic growth in developing countries like India and
        China impact workers and consumers in the developed world? What are the pros
        and cons to trading with these developing nations?
        Many possible answers to this question. For example, consumers gain
        with lower prices and more variety as a result of foreign imports. Work-
        ers are also affected in different ways. Some get laid off due to import
        competition; others get higher wages as a result of greater demand for
        their skills or the services they provide.
        5. [3] What are some of the policy instruments countries use to regulate trade?
        Name at least three and explain the differences between these policy tools.
        Many possible answers to this question as well. Tariffs, quotas, and
        voluntary export restraints are some examples. A tariff is essentially a
        tax on the price of foreign imports. A quota is a limit on the quantity of
        foreign imports allowed into the country. A voluntary export restraint
        stipulates that a country will export no more than what is specified in
        the agreement.
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                    6.  [3] How can trade benefit an entire country and create winners and losers
                    within that country at the same time? In the models that we’ve seen in class, are
                    there any models for which an entire country suffers following the liberalization
                    of trade? Justify your answers.
                    Trade can create winners and losers within a country even when the
                    country gains as a whole because different types of workers/producers
                    earn different returns. For example, in the HO case mentioned in ques-
                    tion 3, good 1 producers in country 1 gain because the price of the good
                    they produce goes up following trade liberalization; the converse is true
                    for good 2 producers in country 1. There are no models discussed in
                    class for which trade is bad for the entire country. The only possible
                    exception to this is related to the trade diversion argument that occurs
                    when countries do not liberalize simultaneously.
                    7.  [3] How can a 1% drop in output or income be followed by a 5% drop in
                    trade? What does your answer to this question mean for firms that are consid-
                    ering producing overseas? What other factors play a role in the location-choice
                    decision made by firms in an increasingly global economy?
                    Vertical specialization. See the reading related to this. Many factors
                    play a role in the location-choice decision made by globally-minded
                    firms: production costs (labor, raw materials, etc), transport costs, in-
                    frastructure, etc.
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