Problem Set 2 Fall 2016 Economics 433 Professor Kala Krishna The Pennsylvania State University Due September 20 in class. Do all questions. Please...

Problem Set 2

Fall 2016

Economics 433

Professor Kala Krishna

The Pennsylvania State University

Due September 20 in class.

Do all questions. Please write or type clearly. You do not need to calculate

the points on the graph, just label them as needed.

1: Consider a Ricardian Model of Trade. There are two countries, Home

and Foreign, who produce two goods Food and Clothing, using one factor of

production, Labor. The unit input requirements are given by the table below

in the two countries.

Goodn  Country Home Foreign

Food                    3         9

Clothing              9          3

Home has 30 units of labor while foreign has 90 units. Food is consumed in

a one to one ratio relative to clothing at all prices by both countries. Use graph

paper below.

a: Draw the world PPF under trade. If the price of clothing is 1; what is

the price of food under free trade? What are equilibrium wages (what a unit of

labor earns) in each country?

b: Depict the trading equilibrium and the prices, production, imports and

exports by each country in your graph. You do not need to solve for it alge-

braically, just on graph paper.

c: What happens to equilibrium prices if labor migrates from foreign to home

so that home has 90 workers and foreign has 30. Labor that migrates then has

the same productivity as native labor.

d: Would labor that stayed behind in Foreign gain or lose from this mi-

gration? Why? (What happens to the budget set of a Foreign worker? If it

expands, he must gain.)

e: Suppose productivity abroad quadrupled, that is, the unit labor require-

ments fell to 1/4 of the levels above. (Note that in this case Foreign has an

absolute advantage in both goods.) What happens to world prices? Do home

workers gain from foreign becoming more productive ? Do foreign workers gain

from its productivity improvement? (Comparisons should be relative to the

outcome in part b)

f: Can the PPF when labor is mobile between countries lie strictly outside

the world PPF through trade or must it touch it somewhere? Can you give

conditions under which they would touch at some point and when they would

not? (Hint: consider what happens when one country has an absolute advantage

in both goods and when this is not the case.)

1

g: Given your answers to part f:, how would you respond to the following

quote:

Given the lack of trade barriers today, there are orders of magnitude more

gains to be had from permitting labor migration than trying to further liberalize

trade.

2. This problem asks you to think of issues using a relative demand and sup-

ply framework more generally. The U.S. and the rest of the world(ROW) are

the two countries in the world. They make two goods, Food (F) and Wine (W)

The U.S. exports W:

a: What would be the e¤ect of an advertising campaign to promote W in

the ROW? ( Assume that the advertising campaign makes foreigners demand

more W relative to F at any relative price.) What would shift? What would

happen to relative prices in the world? Would the U.S. gain or lose from such

advertising if advertising is essentially costless?

b: A war destroys half of ROWs productive capacity shrinking its Production

Possibility Frontier (PPF) uniformly inwards for all goods. What would shift?

What would happen to prices in the world? Would the U.S. gain or lose? What

about ROW?

c: Suppose that the US consumes mostly wine while the rest of the world

consumes mostly food. Would there be a secondary burden of foreign aid given

by the US to the ROW? Could the US reduce this secondary burden by giving

its aid in barrels of wine? Why/Why not?

3: This question asks you to think of how trade can result in gains due to

increasing competition and variety. You do not need to do any algebra. Just

draw the graphs needed.

Suppose there two countries of equal size, i.e., both have the same number

of people, S. There are n symmetric rms. Each individual has demand for

the output of a representative rm denoted by q(p; P; n) where p is the rms

price, P is the overall average price in the market, and n is the number of

rms. q(p; P; n) is decreasing in p, increasing in P and decreasing in n. With S

individuals, the demand for a rm is thus Sq(p; P; n): Let c be marginal cost and

F be the xed cost of production. Firms behave monopolistically competitively

and choose p to maximize prots taking P and n as given. Assume all rms are

symmetric so that in equilibrium p = P and that rms enter till price equals

average cost, i.e., prots are 0.

a: Depict the prot maximizing price charged by a representative rm for

given P and n. You do not need to do any algebra. Just to draw demand and

the prot maximizing price.

b: Show that the maximized prots of the rm are higher when its costs fall.

(Hint: variable prots are also the sum of the di¤erence in marginal cost and

marginal revenue over units produced)

c: As n rises, what happens to the prot maximizing price? What is the

intuition? Call this relation the PP curve.

d: Does an increase (or decrease) in S shift the PP curve? Why?

2

e: As n rises, what happens to output per rm in symmetric equilibrium and

therefore to average cost? What is the economic intuition here? Call this curve

CC:

f: Does an increase in S shift CC? Why?

g: Depict the equilibrium n and p without and with trade where trade is just

a doubling of S?

h: Explain what the e¤ects of trade are on prices, variety and welfare.