Institute of Business Administration

International Trade
Professor Aadil Nakhoda

Neha Virani | 19530

HW Assignment 1

Question 1.

Global trade has a tendency to affect almost all nations, in one way or another. Usually, trade
between two countries almost always results in mutual benefits. When a country engages in a
voluntary transaction, both the buyer and the seller are at an advantage. This is regardless of
size of the economy, because when countries use their finite resources to produce something
they are most productive at making, they are able to exchange or trade that with the good they
want to consume, and are having a hard time producing. Another way trade benefits are
mutual is because trade allows a country to export a product that’s made with the locally
abundant resources, whilst importing the goods that are made with resources they are
relatively scarce in. This also leads to specialization which can be beneficial. Moreover,
current resources can also be traded for future ones.

However, some economists argue that size does matter. A larger country has a larger
consumer base, larger set of resources, larger opportunities to produce in bulk with less
average cost and have greater variety of the export spread. On the other hand, trade can be
more important for small economies specifically because the benefits of comparative
advantage are proportional to the difference between the relative prices in the world market
and the relative prices that prevail in home markets. And this difference is likely to be greater
for a smaller economy. The country also benefits from innovation and competition leading to
greater productivity. A country closed to trade usually has extreme underdevelopment, and
poverty. Examples include China, India, Hungary, and Mexico. Mexico is a good example of
a small economy gaining largely from trading more. They have introduced trade friendly
policies, resulting in a greater GDP and a rise in real wages, and decline in poverty.

In short it can be said that in smaller nations, trade benefits the lower income households by
providing goods in better affordable prices, with more variety, and higher quality. All in all, it
is important to note that while trade does not harm countries as a whole, it might add to the
income equality and harm the industries that compete with imports.

Question 2.

GSP+, Generalized Scheme of Preferences, was awarded to Pakistan in 2014 by the European
Union, and had recently been extended till 2022. The general idea behind GSP+ is to help
developing nations, like Pakistan, to be able to benefit from a few preferences that allow then
to participate more fully in international trade, reduce poverty, and move towards sustainable
economic growth. The preferences through GSP+ are:

- Preference over approximately 6300 tariff lines

- Offers duty free export to support vulnerable economies, including Pakistan
- EBA, Everything but Arms scheme, which provides access without any regulations
In 2018, almost 34% of Pakistan export were to the EU whereas 10% of Pakistan’s imports
are from the EU. The exports mainly consist of textile and clothing items, and imports
comprise of:

- Machinery and Appliances 25.5%

- Transport Equipment 16.5%
- Pharmaceuticals 15.5%

In between 2013-2017, Pakistan’s export to EU increased by 47.5%, of which 76% where

under the GSP+ scheme.

Figure 1: GSP+ EU Imports (2018)

After the GSP+, Pakistan was facing stable growth, with almost 5.28% of GDP growth in 2017
which was the highest ever. During the GSP+ periods there were also reforms that helped
different industries, such as; relief measures introduced in the 2017 Textile Package, lowest
interest rate to grant loans to industries, tax and duty exemptions, infrastructure facilities
for SEZ’s, as well as an increase in the production of cotton by 7.6% in 2018.

Figure 2: Pakistan's Textile Exports to EU (2013-2017)

Despite all of it, Pakistan was unable to take advantage of its GSP+ status only because of its
inability to produce efficiently at low costs. Lack of efficiency was due to inability of making
huge investments on machinery to produce efficiently, as well as heavy taxation from
government. The other reason was the law-and-order situation in Pakistan which prevented
overseas buyers from being aware of anything good that comes from Pakistan. Strong
political influence managed to deteriorate things further by keeping cotton prices high and
making them less competitive in the global market.
Question 3.

The gravity model clearly states that greater the size of an economy, greater will be the
volume of its imports and exports. It also states that the higher the value of GDP, the lesser
the distance between them. The model works in the following way:

This formula incorporates a constant, trade flow, distance and divides them by the economic
dimensions measured of a country. It can be seen that distance is inversely proportional to the
size or trade, while the GDP of the economy is directly proportional.

The model predicts that having a greater value of GDP is an attractive factor in terms of
trade, whereas for the distance the greater the worse. It also incorporates many cultural and
historical factors within the model that can help further analyze it. According to the model,
the value of trade between Pakistan and India should be large in size, than what it is
presently. This is because both countries are neighbors, reducing transport costs and distance.
And India has a fairly large GDP.

Here, India plays the role of the bigger country or economy, and Pakistan the smaller. Despite
that this model fails to link how political factors and major historic trauma plays a huge part
in trade as well which is why, contrary to the predicted value, trade between the two has
suffered. This can be linked to the political problems, resulting in policies that do not favor
open trade. It involves huge formalities too, delaying the process and difference in currencies
and tariffs as well. These are just some of the factors that deter trade and the gravity model
alone, fails to predict the trade size accurately.

Question 4.

a.
China has the absolute advantage in both – cloth and wheat.

b.
Pakistan has a comparative advantage in wheat, as it only has to forego 1 unit of cotton to
produce 1 unit of wheat.
China, on the other hand, has a comparative advantage in cotton as the opportunity costs ratio
are 0.8 units of cotton to 1 unit of wheat.

c.
For a beneficial trade, Pakistan must only produce wheat, and China only cotton. In such a
case, all resources will go towards the product the country chooses to specialise in. Wheat
production should increase to 10 units per labour from Pakistan in the global markets, and
cotton should increase to 18 units per labour hour from china to global markets.
Question 5.

a.
Maximum number of laptops at home is 3000/40 (bedsheets = 0), = 75
Maximum number of laptops at foreign is 3000/60 (bedsheets =0) = 50
Maximum number of bedsheets at home is 3000/4 (laptops = 0) =750
Maximum number of bedsheets at foreign is 3000/10 (laptops = 0) =300

b.
Home should produce bedsheets.
Foreign should produce laptops, 10>6 as foreign has less opportunity cost in producing
laptops.

c.
The relative price of bedsheets is between the opportunity costs. This would be between 0.1
and 0.167.
The relative price of laptops is between the opportunity costs. This would be between 6 and
10.

d.
The maximum relative price would be 10.

Question 6.

Trade benefits the country as a whole - consumers are able to consume more goods at cheaper
prices, reflected by a higher utility level achieved. The owners of the specific factors in the
exporting industries also enjoy higher income. In this case the specific factor can be a skill
specific to the exporting industry, and workers possessing that specific skill gain. Workers in
the shrinking import competing sector do not have that specific skill to move to the exporting
sector and become unemployed. Even in this case, there will always be a redistribution policy
from the winners (consumers, workers with specific skills in the exporting sector) to the
losers (unskilled workers) such that everybody is better off.

In the long run, unemployed workers from the importing sector can obtain the specific skills
and switch to the exporting sector, resulting in a more efficient allocation of labour in the
economy.

Allowing for free movement of labor across countries will result in a migration of Pakistani
workers to Germany. Consequently, wages in Germany will fall as more immigrant workers
working with the same amount of capital (land) results in a lower MPL. The wage rate in
Pakistan rises on the other hand, as people move out from the country, the remaining labors
can work will more capital, and hence, their MPL goes up. Eventually, the wage rates in the
two countries will be equal.
Question 7.
A and b.

c.
This is what will happen: Japan has ample of capital hence it would end up exporting good 1
if trade is opened up, whereas good 2 would be imported from South Korea. On the contrary,
South Korea would export good 1 and import good 2 from Japan.

d.
Japan should be at the most benefit as capital effieciency alongside labour efficiency can
prove to be a magical combination. Good 1 uses capital and labour whereas good 2 uses
labour and land. If trade is opened up, Japanese capital owners would benefit and their labour
force would be put into production of such goods (like good 1). Land owners would suffer a
loss due to import competition. On the other hand, South Korean capital owners would suffer
a loss because good 2 does not require as much capital. Therefore, land owners in SK would
benefit from export if land and labour-intensive goods. Labour in SK will help produce these
goods (such as good 2).

Question 8.

A new equilibrium will be reached.

Equilibrium wage = MPL x Output > A 20% increase in Pc

As prices increase, production becomes more attractive to suppliers hence, the supply would
increase and the supply curve will shift on the right. This was more labor will be demanded to
produce cotton instead of tea. Thus, demand for labor required for production of cotton will
increase, also increasing the equilibrium as it is the product of marginal cost and output.
Question 9.

Barley to Rice:

China: 1B = 0.53R
Pakistan: 1B = 0.6R

Rice to Barley:

China: 1R = 1.875B
Pakistan : 1R = 0.1.66B

Pakistan will produce rice while China will produce Barley as the opportunity cost of
producing barley is less in China than in Pakistan giving each of them comparative advantage
in these products.

Question 10.

According to the Heckscher Ohlin Model, the Russian federation is more labour abundant.
Russia has 0.67 labour for every $ of capital which is more compared to the UK which has
0.5 labour. Hence the UK is capital abundant as they have $2 of capital per worker compared
to that of Russia. It actually makes sense to produce what the country is more capable of
producing given its capital stock to population ratio.

Thus, Russia being labour abundant would export leather shoes and the UK would export
microwave ovens. These countries can engage in trade to make it beneficial for the both of
them.

Question 11.

As per the theorem, if the price of capital-intensive good rises, then the price of capital will
rise, whereas the wage rate to labor will fall. Which actually makes sense as these products
have a derived demand. So, as there is an increase in the price of labor intensive good the
wages in the market would increase meaning the wage to capital ratio and looking at the
Stolper-Samuelson Theorem, we know while wage to rental ratio increases the labor to
capital ratio will decrease, because firms will try to hire more capital due to increase in
wages.

Question 12.

Total exports France United Kingdom

Food and Live animals $46,987,507,860 $20,074,757,166
Beverages and Tobacco $19,043,886,843 $10,193,516,689

Question 13.

Total Imports Germany

Food and Live animals $78,636,583,208
Beverages and Tobacco $9,699,876,350
Question 14.

Country Surface Area Agricultural Exports

France 549,087 USD 48.04 B
Spain 505,935 USD 43.79 B
Sweden 447,430 USD 8.81 B
Belgium 30,530 USD 37,7 B
Luxemburg 2,590 USD 1.10 B
Malta 320 USD 0.29 B

According to this data, the Heckscher – Ohlin Model proves to be correct as it insists that
countries must only produce those commodities for which they have ample resources. The
three largest countries, by area, export the three largest volumes of agriculture products,
proportionately. While the three smallest exporters are well compatible with their size ratios.
There is one exception to this: Sweden.

In this case, Sweden has a larger area but smaller exports when compared to Belgium. This
could be due to climate conditions, the kind of capital Sweden has, and the occupational skill
of its labour – all of which help explain why it may be inefficient at producing large
quantities of agricultural products. The Ricardian model is based on the basic premise of
comparative advantage. Every economy has unique and distinctive productivity – this
explains why smaller countries, land area wise, may enjoy higher efficiency.