International Trade: application exercises

1 Balance of Payments

Exercise 1.1 :
CA is the current account, Sp the private savings, I investment, G the public
spending and T the taxes.

1. Show that CA = (Sp − I) − (G − T ). What does a surplus of the current

account mean?

2. Rewrite this equation and explain how private spending can be used for
different purposes.

Exercise 1.2 : (source GUILLOCHON B. and KAWECKI A. Economie

internationale. 4th edition. Dunod. Paris 2003)
Is a deficit of the current account compatible with a surplus of the official
settlement balance (sum of the current account balance, the capital account
balance, and the nonreserve portion of the financial account balance) ? What is
the sign of the balance of official reserve transactions? Have the official reserves
increased or decreased?

Exercise 1.3 :
1. Explain how each of these transactions enters the balance of payments
and write them down in a simplified version of the balance of payments.

-a- French exports worth 2 milliards of euros, paid in foreign currency.

- b- A firm residing in France buys for 1 milliard of euros financial services
to a firm residing in a foreign country.
-c- An outflow of foreign direct investment worth 7,5 milliards of euros paid
in foreign currency.
-d- An inflow of foreign direct investment worth 3 milliards of euros paid in
foreign currency.
-e- The European commission pays a subsidy worth 0,45 milliard of euros.
-f- A firm residing in France pays the wages of workers living in Switzerland,
equal to 0,15 milliard of euros.

2. Using the balance of payments, explain the relationship between the

current account and the evolution of the exchange rate (with the main economic
partners).

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2 The Ricardian model of trade

Exercise 2.1 :(source GUILLOCHON B. and KAWECKI A. Economie inter-

nationale. 4th edition. Dunod. Paris 2003)
Consider two countries, North (N) and South (S). Both produce two goods,
1 and 2, using labor L. aij is the cost, in terms of labor, of producing one unit
of good i in country j. Set a1N = 2 ; a2N = 4 ; a1S = 3 and a2S = 12.
Both countries are endowed with the following amount of labor: LN = 4000
and LS = 9000. yij is the production of good i in country j and yj is the
national income of country j, measured in terms of good 1, which is chosen as
the numeraire. p is the price of good 2 in terms of good 1. Consumers in both
countries have the same preferences: d1j = 0, 5yj and d2j = 0, 5(yj /p).

1. State the characteristics of each country in autarky. Illustrate graphically.

2. What is the comparative advantage of each country? If both countries

open to trade, what is the free trade equilibrium price?

3. At this equilibrium price, how much do both countries produce, consume

and trade? Explain graphically. How can the gains from trade be evaluated?

4. Determine the wages in free trade in both countries. What is the rela-
tionship between wages and labor productivities?

Exercise 2.2 :
Consider two countries, Home (H) and Foreign (F). Both countries produce
two goods (1 and 2) using a single production factor, labor. Labor productivity
in each country in each sector is equal to:
Home: a1H = 10λ a2H = 10λ with λ ≥ 0.8
Foreign : a1F = 8 a2F = 2

Good 1 is chosen to be the numeraire: p, y, w are respectively the price of

good 2, the national income and the minimum wage, all expressed in terms of
units of good 1.

1. Compare the situation of both countries. Do they both have interest in

trading? If yes, in which interval is the free trade equilibrium price ? Explain
each step of the answer.

2. How do the gains from trade appear for each country? Under which
conditions does free trade generate gains from trade for both countries?

3. Labor endowments for both countries are noted LH for Home and LF =
4LH for Foreign. Consumers in both countries have the same preferences: d1j =
0.5yj and d2j = 0.5yj /p (j = H, F ).

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 Write the equilibrium free trade price, p, as a function of the parameter
λ in the case where free trade generates gains from trade for both countries.
Illustrate graphically the relationship between the equilibrium free trade price
and the parameter λ in the axis (λ, p). Provide an interpretation of the graph.

4. State the relationship between the ratio of wages in free trade, wH /wF ,
the equilibrium free trade price and the parameter λ. Illustrate graphically this
relationship in the axis (p, wH /wF ) for λ = 1.

5.“Competition from countries with low wages is an insurmountable handi-

cap for the competitiveness of developed countries.” Discuss this assertion using
the previous example.

Exercise 2.3 :
Consider a typical framework of the trade model with comparative advan-
tages. Consider two countries, A and B, two goods, 1 and 2, and one production
factor, labor L. cji is the unit labor cost for sector i in country j.

cA A B B
1 = 4, c2 = 2, c1 = 1, c2 = 8

p is the relative price of good 2 in terms of good 1, y is the national income

expressed in units of good 1. Demand functions are identical in both countries:
 
y
d1 = by and d2 = (1 − b)
p
Labor endowments are respectively LA and LB .

1.What are the comparative advantages of both countries?

2. In which interval is the equilibrium free trade price situated?

3. Express the equilibrium free trade price as a function of the parameters b,

LA and LB in the case free trade generates gains from trade for both countries.

4. Suppose both countries have the same size: LA = LB .

-a- Illustrate graphically the relationship between p and b. How d the gains
from trade in country A vary with the parameter b? For which values of b are
the gains from trade maximum/equal to zero?
-b- Interpret the preceding result by showing how demand affects the distri-
bution of the gains from trade.

5. Suppose both countries have different sizes. Country B is larger than

country A: LB = δLA , with δ > 1.
-a- Illustrate graphically the relationship between p and δ for b = 1/2.
-b- Interpret this result by discussing the following assertion: “Large coun-
tries benefit less from international trade than small countries”.

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3 The Heckscher-Ohlin model of trade1

Exercise 3.1 :
Consider the typical HOS setting: two goods, 1 and 2, are produced using
two production factors: labor L and capital K. yi is the production of good i,
and Ki and Li are respectively the amounts of capital and labor used in sector
i. Demand functions write:

y1 = K10,2 L0,8
1
y2 = K20,8 L0,2
2

Good 1 is chosen as the numeraire. p is the price of good 2 in units of good

1. y is the national income in units of good 1. w is the wage and r is the capital
reward, both expressed in units of good 1.
ki is the capital intensity of sector i: ki = Ki /Li .

1. Write the relationships that characterize the optimal allocations of ressources.

Explain the different steps. Express k1 as a function of w/r and k2 as a function
of w/r. Illustrate graphically.

2. Write the relationships between p and w/r. Illustrate graphically.

3. The country is endowed with K = 800 units of capital and with L = 400
units of labor. What are the limit values of w/r? What are the limit values of
k1 and k2 ? What are the values of p for which the countries specializes entirely?
Explain. Illustrate graphically.

4. Let b be the share of national income, in terms of good 1, allocated by

consumers to the consumption of good 1: d1 = by. y is the national income in
terms of good 1 (0 < b < 1). In autarky, is can be showed that
 
w 0, 2(1 − b) + 0, 8b K
=
r 0, 8(1 − b) + 0, 2b L

Suppose b = 0, 75. What are the values of w/r, k1 and k2 in autarky?

Illustrate graphically.

5. The country opens to free trade. The country is assumed to be a small

country. The world price p is equal to 0.6. State the Stolper-Samuelson theorem.
Is the theorem verified here? Explain why. Does the result depend on the good
chosen to be the numeraire?

Exercise 3.2 :
1 These
two exercices are from the course at the University Paris-Dauphine. B. Guillochon
and A. Kawecki

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 Consider two countries A and B, two goods 1 and 2, two production factors,
capital K and labor L.
Good 1 is chosen to be the numeraire. p is the price of good 1. Yj is the
national income of country j, wj the wage in country j and rj the capital reward
in country j.
Production functions are :

y1 = K10,25 L0,75
1
y2 = K20,75 L0,25
2

Labor endowments are:

KA = 80; LA = 80; KB = 30; LB = 70

1. Explain the relationship between p and w/r.

2. Suppose the demand functions are identical: D1j = 0, 5Yj and D2j =
0, 5Yj , j = A, B. What is the good exported by country A in free trade? Do
these specializations follow the law of factor proportions ?

3. Suppose that the two countries trade freely, however the demand functions
are now different. In each country, demand functions are: D1A = 0, 25YA
and D1B = 0, 9YB . Which country exports which good? Is the law of factor
proportions verified? Explain why.

4. Both countries refuse to trade goods. However, capital flows between

countries is allowed. Labor is still immobile. Demand functions are the ones
described in question 2. Knowing that capital flows towards the location with
the highest reward, characterize the equilibrium situation for each country in
terms of w/r and p. Discuss the result.

4 The standard model of trade

Exercise 4.1:
Brazil increases its production of coffee because of an extension in the land
suitable for cultivation. Depending on the reaction of the world price of coffee,
explain why this increase in coffee production may increase/decrease welfare in
Brazil. Illustrate graphically.

Exercise 4.2: (source Krugman P. and Obstfeld M. International Trade.

6th edition. De Boeck)
1. Under what conditions does an international transfer between countries
deteriorate the terms of trade of the donor?

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 2. In reality, an important share of international aid for developing countries
is conditional. For example, France may finance an irrigation project in Africa,
under the condition that the pumps, pipelines and other building materials be
bought to French producers. How does this conditionality affect the impact of
international transfers on each country’s terms of trade? Is this conditionality
important for the donor? Can you imagine a situation in which the conditional
aid deteriorates the situation of the developing country?

5 Location theory

Exercise 5.1:
A firm must choose the location of its production plant. The firm can pro-
duce in Morocco, or in France, or in both countries. France is the main market,
with a demand worth 40. The Moroccan demand is worth 5. Morocco has lower
production costs: 6 for each unit produced, and 7 in France. The price of the
good is equal to 10 in both countries. A fixed cost equal to 30 must be paid for
each production plant. If the firm sells locally, she does not pay any transaction
costs. However, in order to sell abroad she must pay t per unit sold on the
foreign market.

1. Show that the profit of the firm is equal to 80 if she produces in both
countries.

2. Show that if the firm chooses to concentrate her production in France,

she sill have a profit equal to 105 − 5t, and equal to 150 − 40t if she locates in
Morocco.

3. Suppose Morocco and France do not share any trade agreement. Trade
costs are thus high: 6 per unit sold. Show that the firms prefers to produce in
both countries. Explain why.

4. Morocco and France sign a free trade agreement, which decreases the
international trade costs to 2 per unit sold abroad. Show that the firm prefers
to concentrate production in France and export to Morocco. Explain why.

5. If Morocco and France decrease their trade costs to 1 per unit sold abroad,
show that the firm prefers to locate its production in Morocco. Explain why.

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6 Monopolistic Competition

Exercise 6.1: (source Krugman P. and Obstfeld M. International Trade. 6th

edition. De Boeck)
Consider the automobile industry in country A. There are n symmetric firms,
selling annually a total of 900000 cars. Demand addressed to a given car pro-
ducer can be written as:
−P ∗ )
h i
X = S n1 − (P30000

X is the number of cars sold by the firm, S the total sales of the industry,
P the price set by the firms and P ∗ the average price of other producers. Firms
are assumed to consider the price of competitors as given. Total cost is given
by C = 750000000 + 5000X.

1. What is the name of this market structure? Show that the firms produce
under increasing returns to scale.

2. Show that the more there are producing firms, the higher the cost to
produce one unit. Illustrate graphically the average cost as a function of n.

3. Write the inverse demand function. Get the marginal revenue of the
representative firm. Write the profit maximization condition. What is the
equilibrium price ? Illustrate the price graphically on the preceding graph.
Note: This is equivalent to showing that the more there are firms, the lower the
equilibrium price.

4. What is the equilibrium number of firms and the equilibrium long term
price?

5. Consider country B in which the annual total sales of cars is equal to 1,6
millions automobiles. As for country A, give the equilibrium number of firms
on the market and the equilibrium long term price in the automobile industry
in country B.

6. Suppose both countries can trade cars without trade costs. The new
integrated market thus has total sales equal to 2.5 millions of cars. What are
the consequences of the creation of the integrated market? Summarize the
effects on the equilibrium number of firms and the equilibrium price in a table
comparing each national market with the integrated market.

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7 Trade policy

Exercise 7.1 :
Suppose the demand and supply functions for a good i in a country j are
given respectively by

Qdi = 140 − 20pi et Qsi = 20pi − 20

where pi is the price in monetary units.

1. Illustrate graphically the demand and supply curves of good i. Indicate

the equilibrium price and the quantities produced and consumed without trade.

2. Suppose the country enters free trade. The world price is pi = 2. The
world supply of good i is infinitely elastic at pi = 2. There are no trade costs.
-a- What is the equilibrium price in the country ?
-b- What are the amounts of good i produced, consumed and traded?
-c- Calculate the value of the consumer and producer surplus.

3. The government of country j sets an ad-valorem tariff of 50% on its

imports of good i.
-a- Give the definition of an ad-valorem tariff.
-b- Determine graphically the new equilibrium price in country j. Give the
impact of the tariff on consumption, production, trade and income.
-c- On what do these effects depend?
-d- Calculate the level of tariff for which there would be no imports.
-e- Calculate and show graphically the consumer and producer surplus

4. The government sets a quota on imports equal to 40 units of good i.

-a- Evaluate and discuss the consequences of the quota on the different
agents.
-b- Compare with the effects of the tariff.

Exercise 7.2 :
The United-States set a quota on their imports of sugar. The following
numbers are real, however approximated for simplicity. After the quota, the
national production increases from 5 to 6 millions tons and national consumption
decreases from 9 to 8 millions tons. The price for the American consumer is
now equal to 480 dollars a ton, while it is equal to 280 dollars a ton on world
markets.

1. What is the quota equal to?

2. Illustrate the situation graphically by showing the effects of the quota.

Why does the quota increase the price of sugar within the United-States?

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 3. Evaluate the loss for American consumers (in millions of dollars) gener-
ated by the quota.

4. Evaluate the gain (in millions of dollars) for American sugar producers.
How much would these producers be ready to pay (in terms of lobbying, ...) in
order to keep the benefit of the quota ?

5. Calculate the level of the rent of the quota. Who benefits from it?

8 Strategic trade policy and reciprocal dumping

Exercise 8.1 :
Consider two firms A and B from two different countries (respectively 1 and
2). Both firms produce a homogenous good. In country 1, the inverse demand
function is equal to p(Y ) = 5 − Y , with Y the aggregate consumption.
The firms in country 1 has the following cost function: CA (yA ) = 1 + ca yA .
The cost function of the competing firms is CB (yB ) = 1 + cb yB .

Competition on the local market

The unit transport cost from country 1 to country 2 is τ (τ > 0). Both firms
compete in Cournot competition on the market of country 1 (Firm 1 does not
export). Set the following costs: ca = 1 et cb = 1/2

1. When firm B sells on both markets, does she set identical prices on both
markets ?

2. Who incurs the trade cost?

3. Determine the reaction functions of both firms. Illustrate graphically.

4. Characterize the Cournot equilibrium on the market of country 1.

5. Is there a limit value of τ for which firm B does not sell on the market of
country 1 anymore?

6. If there is trade between countries, does country 1 gain or loose from

trade?

Competition on a third market

Suppose both firms export on a third market. Both firms incur the same
transport cost τ . The inverse demand function in the third country is equal to
p(Y ) = 5 − Y .

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 1. Write the reaction functions of both firms. Illustrate graphically. What
are the equilibrium conditions?

2. The government of country 1 sets a subsidy s for firms A for each unit
exported. Show the effects of this subsidy on firm A’s market share and on its
profit.

3. Country 1 and the third country sign a trade agreement which decreases
trade costs from τ to τ ∗ < τ for firm A. Evaluate the effects of the trade
agreement.

4. Progress in technology reduces the production cost for firm A: ca = 1/δ.

Evaluate the effects of this change.

5. Discuss the consequences of a production subsidy, a trade policy, and a

subsidy for research and development.

Exercise 8.2 : (source GUILLOCHON B. and KAWECKI A. Economie

internationale. 4th edition. Dunod. Paris 2003 )
Boeing and Airbus sell airplanes in Asia. The demand for airplanes is p =
100 − 0, 25(x + y), with p the price of an airplane in millions of dollars. x and y
are the respective numbers of airplanes produced by Boeing and Airbus. Both
firms compete under Cournot competition (competition on quantities).
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1. Total cost for each firm writes: C(x) = 500 + 25x and Cy = 500 + 25y.
What are the reaction functions for both firms? How much is produced and
what is the equilibrium price? Illustrate graphically in the axis (x, y).

2. What are the equilibrium costs and profits?

3. The American government gives to Boeing a subsidy s (in millions of

dollars) per airplane exported to the Asian market. Assume s < 75. What
are the new reaction functions of both firms? In equilibrium, how much is
produced? Give the equilibrium produced quantities and the price as a function
of s. Discuss the results and illustrate graphically.

4. Is there profit shifting? To the benefit of which firm? Has the aggregate
profit (of both firms) increased? Do the consumers in Asia gain of loose ?

5. Write the optimal subsidy for Boeing, i.e. the subsidy that maximizes the
collective welfare G. The collective welfare G is the profit of Boeing after subsidy
minus the cost of subsidy incurred by the American consumer: G = π − sx.

6. Give all the characteristics of equilibrium in the case of an optimal subsidy.

Illustrate graphically.

7. What happens if the subsidy reaches 75 ? Give the characteristics of

equilibrium in this case and compare with the case of the optimal subsidy. Do
the consumers gain or loose?

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