World trade and payments an introduction 10th edition caves solutions manual

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Chapter 8 Resource Trade, Outsourcing, and Product Fragmentation Chapter Organization 8.1

Given Resources and Footloose Production Processes – Natural Resource Endowments – Scarce Natural Resources and the Terms of Trade – The Newly Industrializing Countries and Footloose Production Processes

8.2

Footloose Inputs: The Joint Role of Absolute and Comparative Advantage – Who Produces What?

– National Tax Treatments and Absolute Advantage – Comparative Advantage and Dutch Disease

8.3

Outsourcing and the International Fragmentation of Production

8.4

Outsourcing and Advanced Country Wage Rates

8.5

Summary

Chapter Summary This chapter extends the basic trade models discussed in the previous chapters to account for the large fraction of trade not in final products. The chapter begins by presenting some empirical evidence on this subject and then proceeds to provide theoretical explanations for these facts. The introduction of trade in producer goods creates some modifications to the results presented earlier. Note that this chapter assumes that production occurs in stages, with raw materials being turned into intermediate goods, which are then assembled into final products.

The analysis also includes the migration of labor and the presence of international capital markets. A focal point of this analysis is the conclusion that movement of factors can serve as both a complement to and a substitute for trade in the goods produced by these factors. In addition, this chapter addresses the existence of multinational corporations.

Section 8.1 begins with one of the key ideas of this chapter. This is the notion that production occurs in stages and countries specialize in stages and not in final products. Natural resource endowments are discussed in the context that they are a major determinant of which processes each country will choose to undertake. In addition, trade in natural resources is addressed. The text also presents some specific trade shares of intermediate goods. Note that this analysis is somewhat uncertain due to problems of classifying a large number of goods, but the conclusion is relatively robust. The discussion of whether the relative price of resources is rising or falling relative to final products illustrates the fact that changes in the supply or demand for primary products can have important welfare consequences.

Chapter 8 Resource Trade, Outsourcing, and Product Fragmentation

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Section 8.1 continues to document the phenomenon whereby countries have experienced growth while importing intermediate goods and then exporting finished products. Production consists mainly of the assembly of raw materials. The term “footloose” production process refers to a process that requires no special inputs or skills and is attracted thus to any country where it will be profitable. The discussion concerning policy measures to attract these industries can be related to some of the arguments that arose during the recent debate over NAFTA, specifically arguments concerning the loss of low-skill manufacturing jobs to Mexico. The Heckscher-Ohlin theorem is used to explain how industries that generate low value-added per worker in the Unites States are most likely to be footloose and migrate to developing countries.

In previous models, the notion of comparative advantage was the sole determinant of trade patterns. The addition of intermediate inputs, however, may lead to absolute advantage being a key factor. Section 8.2 constructs a model of this type by using footloose sectors. Competitive profit conditions determine the maximum that can be offered to attract the footloose sector. This analysis reveals that both comparative and absolute advantage are important in determining the pattern of trade. Figure 8.1 reveals the main points of this section. The discussion of taxes illustrates the fact that differences in policies across countries will affect absolute advantages (but may not affect comparative advantages) and are thus important in this framework but not in the simpler trade models discussed earlier.

Section 8.3 addresses the issue of fragmentation of production through outsourcing. Reducing costs by outsourcing labor-intensive parts of production must be compared to increased costs of coordination to assess whether outsourcing is profitable. As output increases, the benefits of reduced average costs of production tend to rise in industries characterized by increasing returns while coordination costs tend to remain stable, thus making outsourcing more profitable.

Section 8.4 considers the issue of how outsourcing affects wages in advanced countries. It’s shown that outsourcing, under certain conditions, can be compared to a technological improvement for a home country’s labor-intensive good thus increasing the wage in that industry.

Key concepts introduced in this chapter include • there is a large volume of international trade that is not in final goods • trade in intermediate goods expands production opportunities • outsourcing has increased in recent years as the benefits of outsourcing from reducing average costs has outweighed the increased cost due to the need for coordination of production across countries

Suggested Answers to Textbook Questions 1

According to equation 8.4, if the foreign country becomes more efficient in producing food * (i.e., a LF becomes smaller), the vertical intercept for the foreign country shifts upwards while the slope remains the same. If foreign labor becomes equally more efficient in producing both goods, the vertical intercept does not change.

2.

If the country was originally capital abundant such that the initial endowment ray would pass through point C, the country would initially produce goods 2 and 3 with good 2 being the labor-intensive good of the two. International fragmentation would result in the country producing good 3 and B’ with the new unit-value isoquant being 3B’F1 (where B’ is slightly to the left of F on the solid line shown in figure 8.4). The resulting increase in the capital-labor ratio indicates an increase in the wage/renatl ratio.

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Caves/Frankel/Jones - World Trade and Payments: An Introduction, Tenth Edition

3.

(a) If the world price of clothing is $2, then the home country can offer the footloose factor at most $2.25 and the foreign country can offer only $1.50. Therefore, the footloose factor is attracted to the home country. Thus, the home country produces both food and clothing and the foreign country produces only food. Wages are found from competitive profit conditions. They will be $1 in both countries. (b) If the world price of clothing rises to $8, then the home country can offer the footloose factor at most $3.50 and the foreign country can offer $4. Therefore, the footloose factor is attracted to the foreign country. Thus, the foreign country produces both food and clothing and the home country produces only food. Wages are found from competitive profit conditions. They will be $1 in both countries. Wages do not change as they are determined by the world price of food and each country’s productivity in food production, none of which have changed. If the foreign country becomes more efficient in the food sector, then wages must rise. At a fixed world-clothing price, the return to the footloose factor used in clothing production must then fall. Thus, the foreign country may lose the footloose factor, resulting in a loss of the clothing sector.

Multiple Choice Questions 1.

Footloose industries are generally characterized by (a) high skill requirements. (b) simple assembly. (c) imported raw materials. (d) all of the above. (e) (b) and (c).

Answer: (e)

2.

Developing countries tend to export products that (a) use a lot of capital. (b) use large amounts of natural resources. (c) have low value added per worker in the US. (d) are near the beginning of the product cycle. (e) none of the above.

Answer: (c)

3.

Innovative goods are generally (a) produced in low income countries. (b) produced using capital intensive technology. (c) mass produced. (d) produced with skilled labor. (e) produced in high income countries over the entire life of the product.

Answer: (d)

Questions 4–9 refer to a situation where production is Ricardian in nature. Food is produced by labor alone, with the home country requiring 2 units of labor per unit of food and the foreign requiring only 1.

Clothing is produced with labor and an international footloose factor. Both the home and foreign country require 1 unit of labor per unit of clothing. The home country requires 2 units of the footloose factor and the foreign requires 3 per unit of clothing. The world price of food is $1.

Chapter 8 Resource Trade, Outsourcing, and Product Fragmentation

4.

Which of the following describes this situation? (a) The foreign country has comparative advantage in labor costs and the home country has an absolute advantage in attracting the footloose input. (b) The foreign country has comparative advantage in labor costs and absolute advantage in attracting the footloose input. (c) The home country has a comparative advantage in labor costs and an absolute advantage in attracting the footloose input. (d) The home country has a comparative advantage in labor costs and the foreign country has an absolute advantage in attracting the footloose input. (e) None of the above.

Answer: (a)

5.

If the world clothing price is $2, what is the most the home country can offer the footloose factor? (a) $0.50 (b) $0.75 (c) $1 (d) $1.50 (e) $1.75 Answer: (b)

6.

If the world price of clothing is $2, and the footloose factor requires $0.50 to be attracted, then (a) neither country attracts the footloose factor. (b) home produces food and the foreign country produces both goods. (c) both countries produce some clothing. (d) home produces both goods and the foreign country produces food. (e) the home wage rate will be higher than the foreign.

Answer: (d)

7.

If the world price of clothing is $2, and the return to the fixed factor is $0.50, then the home wage rate will be (a) $1.00 (b) $0.75 (c) $0.50 (d) $1.25 (e) $1.50 Answer: (a)

8.

If the world price of clothing rises from $2 to $3, and the return to the fixed factor remains at $0.50, then (a) wages in both countries will fall. (b) the amount that can be offered to the footloose factor will fall at home. (c) there will be no change in wages in either country. (d) the foreign country will be able to offer a greater return to the footloose factor. (e) the amount that can be offered to the footloose factor and wages will both rise at home.

Answer: (e)

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9.

If home productivity in food rises to one unit of labor per 2 units of food, then at a world price of clothing of $2, (a) the footloose factor will not be affected. (b) home wages will fall. (c) home production of clothing will expand. (d) the footloose factor will be attracted to the foreign country. (e) the home country can offer the footloose factor at most $0.25.

Answer: (d)

10. Fragmentation of production is most evident by (a) production of services as opposed to goods (b) increases in intra-industry trade (c) increases in inter-industry trade (d) increased trade in intermediate goods (e) more industries being characterized by monopolistic competition Answer: (d) 11. Which of the following is an example of a service link associated with outsourcing? (a) transportation (b) insurance (c) communication (d) all of the above (e) none of the above Answer: (d) 12. Most service link areas tend to exhibit (a) increasing returns (b) decreasing returns (c) constant returns (d) high variable costs (e) no fixed costs Answer: (a) 13. Outsourcing will become more prevelant as (a) coordination costs tend to rise as output increases (b) reductions in average costs increasingly exceed coordination costs (c) in industries characterized by decreasing returns (d) marginal costs rise due to increased product fragmentation (e) none of the above Answer: (b)

Chapter 8 Resource Trade, Outsourcing, and Product Fragmentation

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14. Outsourcing has become more common in recent years due to (a) reductions in the cost of service link activities (b) reductions in wages in less developed countries (c) increases in barriers to trade (d) higher costs of capital in advanced countries (e) the amount of outsourcing has remained stable for decades Answer: (a) 15. Which of the following increased the fastest in the 1990s? (a) world GDP (b) world trade (c) trade in parts and components (d) intra-industry trade (e) all of the above have increased at a similar rate Answer: (c) 16. Firms consider which of the following when deciding whether to outsource part of production? (a) relative wages (b) infrastructure (c) relative productivity (d) all of the above (e) none of the above Answer: (d) 17. Inputs that are internationally mobile will seek to be used in countries where (a) costs are low (b) returns are maximized (c) productivity is low (d) they have a comparative advantage (e) increasing returns exist Answer: (b) 18. Which of the following statements best describes the status of outsourcing in the US? (a) economists generally agree that outsourcing has reduced average wages of US workers (b) economists generally agree that outsourcing has led to a net decline in the number of jobs in the US (c) there is some evidence that the number of jobs created by insourcing exceeds those directly lost by outsourcing (d) outsourcing has become less common in recent years (e) outsourcing has reduced the standard of living of the average American Answer: (c)

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19. International trade in parts and components has increased rapidly in recent decades due to (a) rising incomes leading to larger scales of output (b) significant reductions in the costs of serivce link activities (c) steady reductions in barriers to trade (d) freeing up of domestic restrictions on service activities (e) all of the above Answer: (e) 20. Which of the following would be least likely to be outsourced by a firm in an advanced economy? (a) research and development (b) furniture production (c) footwear production (d) textile production (e) assembling of manufactured products Answer: (a)