EC3016 2018 Exam Commentary PDF

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Examiners’ commentaries 2018Examiners’ commentaries 2018EC3016 International economicsImportant noteThis commentary reflects the examination and assessment arrangements for this course in the academic year 2017–18. The format and structure of the examination may change in future years, and any such ...

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Examiners’ commentaries 2018

Examiners’ commentaries 2018 EC3016 International economics Important note This commentary reflects the examination and assessment arrangements for this course in the academic year 2017–18. The format and structure of the examination may change in future years, and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading references Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2015). You should always attempt to use the most recent edition of any Essential reading textbook, even if the commentary and/or online reading list and/or subject guide refer to an earlier edition. If different editions of Essential reading are listed, please check the VLE for reading supplements – if none are available, please use the contents list and index of the new edition to find the relevant section.

General remarks Learning outcomes At the end of the course, and having completed the Essential reading and activities, you should be able to: •

discuss and explain specific policy issues such as ‘environmentalism as protectionism’; international dumping; the choice of an exchange rate regime; the desirability of free capital flows

•

apply a specific framework to illustrate the connection between a variety of models and approaches. Explain the connections between Ricardian, Heckscher–Ohlin and the specific factors models in trade theory, or between the ‘monetary approach’ and the ‘asset approach’ in exchange rate theory

•

explain how international economic theory has been shaped by real world events.

Planning your time in the examination Both Zone A and Zone B papers of EC3016 International economics have followed the same format in recent years. The paper is formed of two sections: A and B. Section A is compulsory and it consists of exercise-type questions. It carries 40 marks. Section B consists of essay-type questions and you are required to choose three questions from nine. Each essay carries 20 marks. In the three hours available, you should aim to spend around eighty minutes on Section A and around thirty minutes for each essay question in Section B. This leaves a few minutes to read the questions carefully and make a selection.

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EC3016 International economics

You will waste time if you start a question and then abandon it for one in which you believe you will perform better. It is worth taking the time to read through all the questions carefully and to think carefully before making a selection. Once you have started your essay, it usually makes sense to persevere and complete it, rather than switching to a new question halfway through.

What are the examiners looking for? The examiners are looking for a sound grasp of the economic theory in the subject guide and associated ‘Essential reading’, as well as a sense of the empirical validity of the models. Moreover, candidates should make use of examples and discuss theories through these examples. For example, when discussing exchange rate regimes, you need to show some familiarity with the Bretton Woods system, the exchange rate mechanism (ERM) or other systems. A working knowledge of current debates in the area of international economics, through reading The Economist or quality newspapers, will also be rewarded, particularly when addressed with reference to economic theory. A breadth of knowledge is important. You must have a good grasp of most, if not all, of the subject guide in order to perform well in Section A. The choice offered in the essays allows you to focus on areas that interest you and for which you have explored the ‘Further reading’. The level of depth of analysis expected is similar to that shown in the subject guide and suggested readings. You are expected to make use of diagrams and relevant equations to support your explanations and arguments. It cannot be overstressed that comments on the questions in the Examiners’ commentaries do not necessarily constitute model answers or sketches of model answers. These are intended to provide general guidelines and highlight basic concepts related to the examination question. Furthermore, the examiners are always looking to reward candidates who take an original approach to a question.

Key steps to improvement You are urged to consider the allocation of marks to each question and sub-question and to practise answering questions from past papers under timed conditions. You are advised to spend a few minutes reading the questions carefully before selecting the questions to be attempted. You should not answer more than three questions from Section B. If more than three questions are attempted, the first three will be marked. Extra credit is not awarded for attempting more questions than required. You would benefit from reading the question more carefully to ensure you are answering the question asked. In Section A, you should ensure that you do not forget to support your analytical results with some comments in order to show that you are able to interpret the solutions of the exercises. It is important that you tailor your answers to address the specific questions asked by picking and choosing the relevant and important points in order to build a line of argument. Avoid explaining entire models when it is not requested, as you should be able to employ them to provide a convincing argument. You would benefit from spending a few minutes organising your answers so that the flow of the argument is clear. You would benefit from ensuring that the appropriate level of depth of analysis is employed when answering the questions. You are advised to be patient, and not leave the examination until you are satisfied that you have thought as hard as possible about each question.

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Examiners’ commentaries 2018

Examination revision strategy Many candidates are disappointed to find that their examination performance is poorer than they expected. This may be due to a number of reasons, but one particular failing is ‘question spotting’, that is, confining your examination preparation to a few questions and/or topics which have come up in past papers for the course. This can have serious consequences. We recognise that candidates might not cover all topics in the syllabus in the same depth, but you need to be aware that examiners are free to set questions on any aspect of the syllabus. This means that you need to study enough of the syllabus to enable you to answer the required number of examination questions. The syllabus can be found in the Course information sheet available on the VLE. You should read the syllabus carefully and ensure that you cover sufficient material in preparation for the examination. Examiners will vary the topics and questions from year to year and may well set questions that have not appeared in past papers. Examination papers may legitimately include questions on any topic in the syllabus. So, although past papers can be helpful during your revision, you cannot assume that topics or specific questions that have come up in past examinations will occur again. If you rely on a question-spotting strategy, it is likely you will find yourself in difficulties when you sit the examination. We strongly advise you not to adopt this strategy.

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EC3016 International economics

Examiners’ commentaries 2018 EC3016 International economics Important note This commentary reflects the examination and assessment arrangements for this course in the academic year 2017–18. The format and structure of the examination may change in future years, and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading references Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2015). You should always attempt to use the most recent edition of any Essential reading textbook, even if the commentary and/or online reading list and/or subject guide refer to an earlier edition. If different editions of Essential reading are listed, please check the VLE for reading supplements – if none are available, please use the contents list and index of the new edition to find the relevant section.

Comments on specific questions – Zone A Candidates should answer ALL QUESTIONS of Section A (40 marks) and THREE questions from Section B (20 marks each). Candidates are strongly advised to divide their time accordingly. If more questions are answered than requested, only the first answers attempted will be counted. Section A Answer QUESTION 1 (PARTS 1 AND 2) from this section. Question 1 Part 1 Local demand and supply for a good in a small country (named A) are represented by the following equations: d QA = 10 − PA ,

QsA = PA

Demand and supply for the same good in the rest of the world are instead represented by the following equations: d QW = 100 − 30PW ,

QsW = 20PW

(a) Compute the autarky equilibrium in country A and represent it in a diagram. (2 marks) (b) Compute the price for the good in the rest of the world, find the equilibrium under free trade in country A and represent it by using appropriate diagrams. (3 marks)

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Examiners’ commentaries 2018

(c) By computing relevant indicators, compare autarky and free trade in terms of consumer surplus, local producer surplus and total welfare for country A (support your answer with appropriate diagrams). (4 marks) (d) Compute the new equilibrium, the imported quantity, the consumer surplus, the local producer surplus and total welfare if country A decides to introduce a tariff on imports equal to 2 (support your answer by means of appropriate diagrams). (4 marks) Reading for this question Subject guide (hereafter SG), Chapter 12. Approaching the question ∗ (a) Equalise demand and supply in country A to obtain: Q∗A = 5 = P A . ∗ (b) Compute the equilibrium in the rest of the world to obtain P W = 2. This implies a total S = 2. Therefore, 6 units will be imported. demand in A QdA = 8 and a local supply QA (c) Total welfare is higher under free trade, consumers’ surplus is higher under free trade and local producers’ surplus is lower under free trade. Compute as follows and relate to diagram 1:

(d) When compared to free trade, after introducing a tariff, local producers’ surplus increases, consumers’ surplus reduces and total welfare reduces. Compute as follows and relate to diagram 1:

Note that h + i represents government revenue form the tariff.

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EC3016 International economics

Part 2 Consider a world with two countries, home (h) and foreign (f ). Both countries produce two goods, X and Y , using two inputs, labour (L) and capital (K). Output of each good in country j = {h, f } is given by the following production functions: X j = Zxj (K xj )α (Lxj )1−α ,

Y j = Zyj (K yj )β (Ljy )1−β

where 0 < α, β < 1 and α < β. Zxj is the total factor productivity (TFP) in sector X of country j. It reflects the efficiency with which sector X can convert one unit of an input bundle (combination of labour and capital) into output. Zyj has an analogous interpretation. Thus, TFP represents the level of technology in each sector. Assume perfect mobility of factors across the two sectors within each country and perfectly competitive markets. (a) Assuming autarky, and denoting prices by pxj and pyj , set up the profit maximisation problem of the firm in each sector in country j and obtain the first-order conditions. (4 marks) (b) Use the first-order conditions to express the capital-labour ratio of each sector as a function of the wage-rental ratio (wj /rj ). (3 marks) (c) Use the result from the previous part to derive an expression for the price ratio (pxj /pyj ). (5 marks) (d) Based on the expression in the previous part, explain how this model has both Ricardian and Hecksher–Ohlin forces to explain the differences in comparative advantage. (8 marks) (e) When these countries trade (suppose the world prices are p∗x and p∗y ), will factor price equalisation hold? Why or why not? Support your answer by using the expression for the price ratio derived in part (c). (7 marks) Reading for this question SG Chapters 2 and 3, also Krugman, P., M. Obstfeld and M. Melitz International Economics: Theory and Policy. (Boston, Mass.; London, Pearson/Addison–Wesley, 2014) Pearson global edition, tenth edition (hereafter KOM) Chapters 3–5. Approaching the question (a) Firms in each country, and in each sector, maximise profits. So, in sector X of country j = {h, f }, firms: pjx X j − wj Ljx − rj Kxj max j j L x ,Kx

subject to: X j = Zxj (Kxj )α (Lxj )1−α . The first-order conditions with respect to capital and labour are:

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pjx (1 − α)Zxj (Kxj )α (Ljx )−α = wj

(1)

pjx αZxj (Kxj )α−1 (Ljx )1−α = rj .

(2)

Examiners’ commentaries 2018

Similarly, for sector Y in country j = {h, f }, the first-order conditions with respect to labour and capital are: pjy (1 − β)Z yj (Kyj )β (Ljy )−β = wj

(3)

pjy βZyj (Kyj )β−1 (Ljy )1−β = rj .

(4)

(b) Divide equation (1) by (2), and (3) by (4), to get the capital–labour ratio of each sector as a function of the wage-rental ratio. Kyj

α wj K jx , j = 1 − α rj Lx

=

Ljy

β wj . 1 − β rj

(c) Dividing equation (1) by equation (3), gives us: pjx pjy

=

(1 − β)Z jy (Kyj/Ljy )β j

j

(1 − α)Zxj (Kx /Lx )α

which can be re-written by substituting for capital-labour ratios of the two sectors as: Z jy β β (1 − β)1−β pjx = pjy Zxj αα (1 − α)1−α



wj rj

β−α

.

(d) The price ratio is a function of (i) relative productivity Z jy Z xj , and (ii) the wage-rental ratio wj rj . As compared to the foreign country, a higher productivity in sector X relative to sector Y in the home country will imply a lower price of good X relative to good Y in home country. This is the Ricardian force leading to comparative advantage differences across countries. On the other hand, if home country is abundant in labour relative to capital as compared to the foreign country, it will result in lower wage-rental ratio in home and hence a lower price ratio (since β > α → β − α > 0). This is the Heckscher–Ohlin force leading to differences in comparative advantage. Therefore, in this model, relative prices in autarky, or comparative advantage, is determined by productivity differences as well as by relative factor endowment differences across the two countries. (e) When the two countries trade, firms will face world prices instead of autarky prices. Therefore, now we have that: p∗ = hence:

Z j β β (1 − β)1−β px∗ = yj ∗ py Zx αα (1 − α)1−α

Zxh αα (1 − α)1−α



wh rh

β−α

=

Z hy Z hx



wh rh

β−α

=

Zyh β β (1 − β)1−β

and so:



wj rj

β−α

Zyfβ β (1 − β)1−β Zxf αα (1 − α)1−α Zyf Zxf



wf rf



wf rf

β−α

β−α

leading to: wh = rh

Z fy /Zxf Z hy /Zxh

!1/(β−α)

wf . rf

This equation implies that the wage-rental ratio in country h is not equal to that in country f . This is because of the presence of the TFP terms. The presence of technological differences across sectors and across countries leads to the violation of FPE.

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EC3016 International economics

Section B Answer THREE questions from this section. Question 2 Explain the concept of comparative advantage by means of a two-country and multi-goods (more than 2) model.

Reading for this question KOM, pages 72–75. Approaching the question In a good answer you should use KOM pages 72–75 to explain that the same conclusions of the model with two goods can be obtained by employing a model with N goods. To this aim, set up the model. This requires to specify a world with two countries (Home and Foreign), each of these countries has only one factor of production (labour) but the number of goods is not two. There are N different goods indexed from 1 to N . Then, you should specify the countries’ technology as the unit of labour required for the produciton of each good. At this point you can introduce and discuss equation (3-6) of KOM. After this, you can now move to look at the pattern of trade and explain that it depends on only one thing: the ratio of Home and Foreign wages, as once we know this we can establish who produces what. To construct your agument and expain how to determine the patterns of trade, you can use the equations of the model at KOM page 73. You can also support your argument by providing a numerical example as in KOM Table 3-2. In answering this question it is important that you explain that the determination of the wage ratio in a multi-good setting is different and requires the definition of a derived demand. Again, in this part you can support your explanation with the numerical example in Table 3-2 of KOM. This also allows you to explain the determination of relative wages as in Figure 3-5 of KOM.

Question 3 With reference to the specific factors model, use the mobile factor market diagram to compare capital allocation between sectors for a given technology and international prices under the following: i. Autarky; ii. International trade depicted in terms of an increase in the price of the export good; iii. International trade depicted as a decrease in the price of the import good.

Reading for this question SG, pages 49–53. Approaching the question In a good answer you can use, and explain, Figure 4.1 of the subject guide as it can be thought of representing, in the first instance, a closed economy or autarky equilibrium. Then, suppose trade is possible and show that, in a trading equilibrium, world prices replace autarky prices. The relative price of the export good will tend to rise and the relative price of the import good will tend to fall, as compared with the autarky equilibrium. As a further step you can then use Figure 4.2 of the subject guide to analyse the effects of a rise in the price of a good (here you can also use a similar example as in the subject guide, where this good is software). By means of Figure 4.2 you can show that a rise in the price of software

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Examiners’ commentaries 2018

increases the marginal revenue product of capital in the software sector, and hence shifts the demand for capital in the software sector rightward. Equilibrium in the capital market moves leading to a reallocation of capital from the other good (i.e. textiles) to another (software) and, with fixed amounts of specific factors, implies an increase in the output of software and a decrease in the output of textiles. In Figure 4.2 the opening up to trade has been depicted in terms of a rise in the price of the export good (software), while keeping the price of the import good (textiles) constant, as numeraire. Since free trade will raise the relative price of the export good to the import good, you could instead keep the price of the export good (software) fixed and assume a reduction in the price of the import good (textiles). Therefore, you can use the capital market clearing diagram to show that a fall in the price of textiles has the same effect on capital allocation, outputs, and income distribution as a rise in the price of software.

Question 4 With reference to the political economy of trade policy, discuss the national welfare arguments against free trade. Reading for this question KOM, Chapter 10. Approaching...