ECON 371International Economics: Trade
Fall 2022
Assignment #4
1. For the sake if simplicity, we will concentrate on two countries: South Korea and Vietnam. The
model assumes that multi-national firms use mainly three factors of production: capital, (K), skilled
labor (H), and unskilled labor (L). Let us assume that nominal wages in Vietnam for skilled
workers WH and unskilled workers WL are lower than in South Korea. Let us also assume that the
relative wage of skilled workers WH/WL is higher in Vietnam than in South Korea. Finally, assume
that capital costs and trade costs apply unfirmly across all activities in the value chain.
A schematic global production process can be described by the following five stages in
chronological order:
A) Research and development, product design: H/L=4;
B) Assembly of basic parts and components: H/L=1/4;
C) Production of parts and components: H/L=1/2;
D) Marketing, distribution, and sales of finished goods: H/L=2;
E) Back-office activities (accounting, customer services): H/L=3/4;
a. Rank the five activities (A–E) on a global value chain line like the one below, ordered from
lowest to highest degree of sophistication.
Lowest H/L
Highest H/L
b. Suppose that initially only the two least sophisticated activities are performed in Vietnam,
while the other three are performed in Korea. Show how the value chain is “sliced” (i.e.,
the dividing line between Vietnamese and Korean production) and calculate the average
H/L ratios in Korea and in Vietnam.
NOTE: You can assume that equal amounts of factors of production are used in each stage.
c. Now suppose that Vietnam and South Korea enter a free-trade agreement, which causes a
substantial drop in trade costs between these two countries. As a result, one additional
activity in the value chain stage is offshored to Vietnam. How is the slicing of the value
chain affected? What happens to the average H/L ratio in each country? Calculate and
explain.
d. What is the effect of the free-trade agreement on the relative wage of skilled workers
WH/WL in each country? Analyze the impact using a chart that displays relative supply and
demand for skilled labor. Would free trade foster income inequality in Vietnam? Would
free trade foster income inequality in Korea?
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2. Answer the questions below based
on this diagram, which represents
the situation for a monopolistically
competitive firm in the short run
after a country has opened up to
trade. You may assume that point
A is the long-run equilibrium without trade (“autarky”) and NA is the
number of firms in the autarky (no
trade) equilibrium and when the
country “opens up” to trade.
a. Explain the meaning of the
two demand curves: what is
the difference between d2 and D/NA? Why is d2 flatter?
b. How does the firm try to maximize its profits in this situation? What pulls it away
from the autarky equilibrium at point A? Where does the firm try to operate, at B
or B, and why? Where does the firm end up producing, at B or B, and why? Would
the firm be making profits, break even, or incur losses at each of these points?
c. What adjustments are set in motion by the situation you have just described in part
b? Specifically, will firms enter or exit the industry, and why? What will happen to
output, average cost, price, and profits for each domestic firm in the long-run
equilibrium with trade? Use a similar chart to fully explain what happens in moving
to the long-run equilibrium with trade.
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