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ECO 441—Fall 2015 Prof. Miguel Iraola

Name _________________________

Problem Set #2

(Due Wednesday, November 9)

1. Heckscher-Ohlin Model: Suppose that a free-trade equilibrium exists in a two-country, two-good, two-factor world. Assume that the two goods, chemicals (C) and electronic appliances (E), both employ capital (K) and labor (L), and that both factors are perfectly mobile across sectors. Also assume that: • The US is relatively capital-abundant • Mexico is relatively labor-abundant. • Chemicals are relatively capital-intensive. • Electronic appliances are relatively labor-intensive. • Assume that tastes and technologies are identical in the two countries.

(a) On the graph below, sketch the relationship between relative product price, relative factor price and relative factor use in each industry in the US and Mexico. (Under the assumption of identical technologies, the same curves can be used to describe the relationships in both the US and Mexico.)

(L/K)

wage-rental ratio (w/r)

(P E / P

C )

Relative Quantity of Electronics (Q

E / Q

C )

Relative price of Electronics (P

E / P

C )

(b) On the graph below, sketch & label the relative supply curves of the two countries.

• Briefly explain why they differ:

• Then, sketch & label the world relative supply curve.

(c) Using the graph in part (a), label the relative price of electronics, the relative wage (w/r), and each industry’s relative employment of labor-to- capital in each country prior to trade (i.e. in autarky). Then make the following comparisons (write >, <, or =):

(PE/PC)US ______ (PE/PC)Mexico

(w/r)US ______ (w/r)Mexico

(KE/LE)US ______ (KE/LE)Mexico

(KC/LC)US ______ (KC/LC)Mexico

(d) Before trading, is the real wage higher in the US or Mexico? Briefly explain why. (e) Now suppose that the US and Mexico trade freely. Which good will Mexico export to US? (f) Describe the effect of free trade on:

• The relative price of electronics (PE/PC) in the US.: increases/decreases

• The relative wage (w/r) in the US: increases/decreases Briefly explain why:

• The real wage in the US: increases/decreases

Briefly explain why:

• The real wage in Mexico: increases/decreases Briefly explain why:

(g) Of the four groups below, who are the “winners” and who are the “losers” from the freeing of trade between the US and Mexico?

• Capital owners in the US: winners/losers

• Capital owners in Mexico: winners/losers

• Workers in the US: winners/losers

• Workers in Mexico: winners/losers (h) Suppose the PPF for the US is given by the graph below. Using this graph, demonstrate that in theory, all individuals in the US could be made better off by trading freely with Mexico. • Briefly describe what sort of policy would be necessary in practice to make every

individual better off.

Q C

Q E

(i) TRUE/ FALSE (Explain your answer briefly): Under free trade, an expansion of Mexico’s capital endowment leads to a reduction in US’s overall welfare.

(j) TRUE/ FALSE (Explain your answer briefly): After Mexico’s capital endowment increases, US would now be better off if it did not trade with Mexico.

Q F / Q

P F / P

RS Q

2. Heckscher-Ohlin Model: The graph below shows the production possibilities frontier of a country that produces two goods: semi-conductors (S) (skill-intensive) and furniture (F) (unskilled labor-intensive). Assume that this country engages in free trade, and that it has a relatively high ratio of skilled labor to unskilled labor compared to the rest of the world (i.e. this country is skill-abundant). (a) Which good will this country export to the rest of the world?

Consider the effect of an increase in the population of unskilled labor in this country. In particular:

(b) Using the graph on the left, show the effect on the country’s production possibilities frontier (sketch the new PPF).

(d) What happens to the country’s terms of trade and to its overall welfare?

3. TRUE/ FALSE (Explain your answer briefly): In the Heckscher-Ohlin Model with two countries and two goods, a country that produces both goods in the free trade equilibrium neither gains nor loses from trade.

4. TRUE/ FALSE (Explain your answer briefly): The predictions of the Heckscher- Ohlin Model are consistent with the fact that wage inequality, as measured by the ratio of skilled to unskilled wages, increased in both the US (a skill-abundant country) and in Mexico (abundant in unskilled labor) as trade between the US and Mexico was liberalized.

Name __________________________

5. Suppose that there are external economies of scale in the production of cars, so that car production is subject to a forward-falling supply curve (downward-sloping industry average cost curve). The graph below shows the industry average cost curves in two countries. Suppose also that the world car industry originated in country A, where all 200 cars per year are currently produced. However, as indicated by the graph, the cost of car production is potentially lower in country B due to B’s greater relative endowment of capital.

a. What prevents individual car producers in Country B from entering the world market,

even though the current level of world output could be produced more efficiently if all production was relocated to Country B?

b. Suppose that Country B’s government wants to develop a domestic car industry by

temporarily banning imports of Country A’s cars. What is the minimum domestic market size (i.e. minimum domestic demand at the current world price) that would be necessary for this policy to foster a globally competitive car industry in Country B (i.e. one that would be more efficient than Country A’s)? Briefly explain how temporary protection of B’s market (e.g. by temporarily banning imports) might improve welfare in both Country B and the world as a whole.

$0 $1 $2 $3 $4 $5 $6 $7 $8 $9 $10 $11 $12 $13 $14

0 50 100 150 200 250 300 350 400

ACA ACB

Q (industry # cars per year)

$ mill. per car

Name __________________________

6. Monopolistic Competition and Intra-Industry Trade Suppose that the market for motorcycles is characterized by monopolistic competition, and that there are FOUR countries (Si=40,000) Si denotes motorcycles sold in each country. Take the following assumptions as given:

• All firms in each country have identical cost structures and symmetric demand curves, so that they set the same price and share the market equally. Hence each firm sells Si / ni, where ni represents the number of firms in country i and Si denotes the market size in country i.

• The fixed cost of production for a firm in the motorcycle industry is F = $1,000,000 and the variable cost per finished motorcycle (= constant marginal cost) is equal to c = $1,000.

• Under autarky, the market price in each country is given by: Pi = c + 1/(ni/100). a. Calculate the equilibrium number of firms (ni*) in each country’s market without

trade. Show your work and circle your final answer.

b. Calculate the autarky equilibrium price of a motorcycle in each country.

c. Now suppose that the four countries form a free trade agreement for motorcycles,

so that their markets are completely integrated. Calculate the equilibrium number of firms in the integrated world market (nworld*).

d. Calculate the free trade equilibrium price of a motorcycle.

e. Briefly explain why production is more efficient under free trade. Is it related to the presence of internal economies of scale?

f. Are producers in the integrated market making positive profits?

Name __________________________

7. Welfare effects of a tariff

Suppose the domestic demand and supply of handbags in a SMALL open economy are given by: QD = 1300 – 200P; QS = -700 + 200P (shown in the diagram below.) (a) What is the equilibrium price and quantity in autarky?

(b) Suppose the world price is equal to $4.5 per handbag. What are the free trade

levels of:

• domestic consumption? _________

• domestic production?_________

• imports? ______________ (b) Suppose now that the government collects a tariff $0.3 on handbag imports. Using the graph below, identify the effects of this tariff on the following. When calculating changes in surplus, be sure to indicate whether the change is positive (gain) or negative (loss).

• the new domestic price of handbags: ___________

• the new domestic production of handbags: ________

• total change in producer surplus: ____________

• new domestic consumption: ____________

• total change in consumer surplus: ____________

• government’s revenue: ___________

• country’s total efficiency loss: __________

• net change in country’s total welfare: ________

Name __________________________

$4.00

$4.50

$5.00

$5.50

$6.00

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