Assignment 1: International Trade

1. Is global trade more important to countries with smaller economies than larger
economies? Please discuss with examples.
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.
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 smaller counties, trade benefits the lower income households by providing goods in
better affordable prices, with more variety, and higher quality.
Lastly, 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.

2. Pakistan was awarded the GSP Plus status by the European Union (EU). Discuss
the trading pattern between Pakistan and the EU and briefly discuss the benefits
from the GSP Plus status to Pakistan.

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.

3. Discuss the gravity equation in relation to international trade. How does the
gravity equation predict trade between Pakistan and India?

The gravity model says that greater the size of an economy, greater will be the volume of
its imports and exports. The model works in the following way

Here, we can see that distance is inversely proportional to the size or trade, while the
GDP of the economy is directly proportional.
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.
But 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.
4. Which country has the absolute advantage in the production of cloth? Which
country has the absolute advantage in the production of wheat? b) Which country
has the comparative advantage in the production of cloth? Which country has the
comparative advantage in the production of wheat? c) Discuss the benefits if
Pakistan and China are to trade?
a) China has absolute advantage in production of wheat and cloth.
b) China has a comparative advantage in production of wheat and Pakistan has a
comparative advantage in production of cloth.
c) If Pakistan and China trade the world output for wheat will be at its maximum because
Pakistan will allocate all its resources in the production of cloth and China will allocate
all its resources in the production of wheat.

5. Suppose the per unit labor requirement for the production of laptops in Home is
40 and in Foreign is 60. On the other hand, the per unit labor requirement for the
production of bedsheets in Home is 4 and in Foreign is 10. We assume a total of
3000 hours of labor in both Home and Foreign.

5a) Determine the maximum production of laptops and bedsheets in Home and
Foreign respectively.
Maximum number of laptops at home is 3000/40 = 75
Maximum number of laptops at foreign is 3000/60 = 50
Maximum number of bedsheets at home is 3000/4 =750
Maximum number of bedsheets at foreign is 3000/10 =300

5b) List the goods Home and Foreign should produce if they both are open to trade.
Home should produce bedsheets. Foreign should produce laptops, 10>6 as foreign has
less opportunity cost in producing laptops.
5c) Determine the range of the relative price in which either country specializes in
the production of one good.
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.
 5d) Determine the maximum price (in terms of the relative price) at which there will
be more laptops in the home country than the labor hours can produce.
The maximum relative price would be 10.

6. A country opts for free trade while some workers remain unemployed in the import
competing sector. Why? Given that real wage rate in Germany is higher than in Pakistan,
how will internationally trade affect real wages in the two countries under conditions of
perfect labor mobility.

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.

7. Consider two countries (Japan and South Korea) that produce good 1 and good 2.
Good 1 is produced with labor and capital, good 2 is produced with labor and
land. Initially, both countries have the same supply of labor, capital and land. The
capital stock in Japan then grows. This change shifts out both the production
curve for good 1 as a function of labor employed and the marginal product of
labor. Nothing happens to the production and marginal product curves for good 2.
c)Japan has a plethora of capital hence 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) 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).

8. A country produces two crops, cotton and tea. The equilibrium wage equals the
marginal product of labor times the price of output. If the price of cotton increases
by 20 percent with no changes in the price of tea, what will happen to the labor
demand for cotton, tea and the equilibrium wage rate?

Equilibrium wage equals =MPL x Output.

20% increase in Pc
The rise in the price of cotton shifts the tea production to cotton production hence causing
the total cotton production to increase. This will have a simultaneous decrease in the
production of food causing an increase in the wage rates in the cotton sector due to rising
prices but less in proportion to the price rise. The economy produces on the production
possibility frontier where its slope is equal to the relative price of cloth. Hence as the price
of cotton increases, production moves down towards the right along the production
possibility frontier showing a lower output of tea and higher output of cotton.

9. Suppose an hour’s labor produces 5 units of barley and 3 kilos of rice in Pakistan
and 15 units of barley and 8 kilos of rice in China. Explain which country will
export barley and which country will export rice given both countries have a
comparative advantage in the production of at least one good.

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.
China: 1B=0.53R
Pakistan: B = 0.6R
China: 1R= 1.875B
Pakistan : 1R=0.1.66B
10. Suppose the United Kingdom has a population of 55 million and a capital stock of
US $ 110 billion. The Russian Federation has a population of 150 million and a
capital stock of US $ 225 billion. Which country is labor abundant and why? If the
production of shoes is labor intensive and the production of microwave ovens is
capital intensive, which country would export microwave ovens? Please discuss.

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 (1.5)
Thus, Russia being labour abundant would export leather shoes and the UK would
export microwave ovens.

11. Suppose the production of leather is labor intensive and the production of engine
oil is capital intensive. Determine the impact of a rise in the relative price of
leather on the wage-rental ratio and the labor-capital ratio. Please explain using
diagrams.

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.

12. Using UN Comtrade, list the total exports in 2019 from the United Kingdom and
France in the industry assigned for your term paper.

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

13. Using UN Comtrade, list the total imports into Germany in 2019 in the industry
assigned for your term paper.
 Total Imports Germany
Food and Live animals $78,636,583,208
Beverages and Tobacco $9,699,876,350

14. Using UN Comtrade data (latest data available), determine whether countries with
larger surface areas are likely to export more agricultural products. In order to
conduct this exercise, consider the exports of agricultural products from three
largest and three smallest European countries (according to surface areas). Use
the list of ‘Western Europe and Others Group’ in the link below to determine the
list of countries:

The largest and smallest countries according to their surface area and their value of
agricultural exports are as follows:
Largest countries according to Surface Area ( km2 )
1. Turkey: 785350
2. Norway: 625217
3. France: 549087
Value of agricultural exports ( $ )
1. Turkey: $16,208,986,279
2. Norway: $12,729,513,923
3. France: $66,576,583,635
Smallest countries according to Surface Area ( km2 )
1. Belgium: 30530
2. Luxembourg: 2590
3. Malta: 320
Value of agricultural exports ( $ )
1. Belgium: $43,221,431,845
2. Luxembourg: $1,373,157,494
3. Malta: $314,548,904

Note that data has been extracted from data.worldbank.org. The data displays that there is
a positive relationship between agricultural exports and the area of a country. The top 3
countries have significantly higher agricultural exports than the three smallest countries.
Therefore, we can deduce that more land leads to higher exports of crops in accordance
with the Heckscher-Ohlin Model, where a country exports goods that uses a factor of
production the country is abundant in. However, a smaller country like Belgium has
much more crop exports than many larger countries. As a result, the HO model does not
always triumph, as smaller countries too can produce and export larger quantities because
of specialization that gives them a comparative advantage as per the Ricardian Model.