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Solutions Problem Set 3

April 12, 2013
Exercise 1
We have to maximize the utility function subject to the budget constraint. The purpose is
deriving the demand for both varieties, 1 and 2. The rst-order conditions can be written as follows:
0c
1
1
= `j
1
0c
1
2
= `j
2
(1)
If we derive both equations in (1), we will come up with the following equality:
c
1
c
2
=
_
j
1
j
2
_

1
1
=
_
j
2
j
1
_ 1
1
(2)
Now, by taking logs on both sides of (2), we will obtain our elasticity of substitution (dened as
@ ln

c
1
c
2

@ ln

p
1
p
2

):
0 ln
_
c1
c2
_
0 ln
_
p1
p2
_ =
1
1 0
o (3)
Logically, the substitutability between both varieties will be the higher the closer is 0 to 1. Now we
have to observe the relation between the previous elasticity and the demand for each variety. By
using (2), we can express c
1
in terms of c
2
and plug it into the budget constraint as follows:
j
2
c
2
+j
1
c
1
= j
2
c
2
+j
1
c
2
_
j
2
j
1
_ 1
1
= 1
1
and then
c
2
_
j
2
+j
1
1
2
j

1
1
_
= 1
that is
c
2
=
1
j
2
_
1 +
_
p1
p2
_

1
_ =
1j
1
2
j
2
_
j
1
2
+j
1
1
=
1
j

2
_
j
1
2
+j
1
1
, where
1
1 0
o (4)
By symmetry, or by using (2) and (4), we can similarly derive that
c
1
=
1
j

1
_
j
1
2
+j
1
1
, where
1
1 0
o (5)
This implies that, when the number of varieties is very high (not only 2, like in this example) the
elasticity of demand of each variety with respect to its own price is exactly o. In that case the
demand for each variety will be increasing in the following price index:
1 =
_
n

i=1
j
1
i
_ 1
1
(6)
Exercise 2
In this case, the total cost of producing good 1 will be (1 +c) C
1
(n, r) and the total cost of
producing good 2 is C
2
(n, r). Industry 1 is a monopolistically competitive sector (with xed costs
proportional to marginal costs) and industry 2 is a perfectly competitive sector. In both cases we
will need to use the zero prot conditions, since in the monopolistically competitive industry the
operating prots are exactly oset by the xed costs. Therefore,
_
_
_
j
1
= (1 +c) c
1
(n, r)
j
2
= c
2
(n, r)
_
_
_
(7)
By applying Shepards lemma (we will explain this in class) to both expressions in (7), we can obtain
that
dj
1
= (1 +c) (a
1L
dn +a
1K
dr)
dj
2
= (a
2L
dn +a
2K
dr)
(8)
where a
iL
=
dci(w;r)
dw
and a
iK
=
dci(w;r)
dr
. Then, we can transform the expressions in (8) to obtain
percentage variations:
dj
1
j
1
=
(1 +c) a
1L
n
(1 +c) c
1
(n, r)
dn
n
+
(1 +c) a
1K
r
(1 +c) c
1
(n, r)
dr
r
=
_
a
1L
n
c
1
(n, r)
_
dn
n
+
_
a
1K
r
c
1
(n, r)
_
dr
r
dj
2
j
2
=
_
a
2L
n
c
2
(n, r)
_
dn
n
+
_
a
2K
r
c
2
(n, r)
_
dr
r
(9)
2
By dening
0
iL

a
iL
w
ci(w;r)
0
iK

a
iK
r
ci(w;r)
= (1 0
iL
)
(10)
we can restate (9) as
^ j
i
= 0
iL
^ n +0
iK
^ r
and writing in matricial form
_
_
^ j
1
^ j
2
_
_
=
_
_
0
1L
0
1K
0
2L
0
2K
_
_

_
_
^ n
^ r
_
_
In order to see whether the Stolper-Samuelson theorem applies, we need to solve for
_
_
^ n
^ r
_
_
. Our
assumptions are that the price of the labor-intensive sector grows more than the price of the capital
intensive sector (that is, 0
1L
0
2L
and ^ j
1
^ j
2
). Then, by inverting the matrix 0 we can get, after
rearranging, that
_
_
^ n
^ r
_
_
=
1
j0j
_
_
0
2K
0
1K
0
2L
0
1L
_
_

1
_
_
^ j
1
^ j
2
_
_
(11)
where j0j = 0
1L
0
2K
0
1K
0
2L
(12)
which implies that
^ n = ^ j
1
+ (^ j
1
^ j
2
)
0
1K
0
2K
0
1K
^ j
1
and hence
^ r < ^ j
1
As a result, we can say that the Stolper-Samuelson theorem still holds in this situation: when the
price of the good intensive in labor rises, the wage goes up by a higher percentage than such price.
Therefore, the remuneration of labor increases in real terms. By the same token, using the labor
and capital market clearing equations, it is possible to prove (raising either the stock of labor or the
stock of capital) that the Rybczynski theorem holds as well. We can not guarantee the validity of
these theorems when the xed cost in industry 1 is not strictly proportional to the marginal cost.
Q = o
_
1
:

1
30000
(j j)
_
(13)
Expression (13) species the individual rm demand in this monopolistically-competitive sector.
The rms are supposed to be very numerous, so that they can not aect importantly the average
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price j, which is taken as given. The technology is identical for both countries (H and 1) and given
by the following total cost function:
TC = 750000000 + 5000Q
o
H
= 900000
o
F
= 1160000
We will solve now for the (long-run) equilibrium price and the number of rms in country H (in
autarky). It could be done similarly for country 1. It is then straightforward to infer that variety
will be larger, prices lower and welfare higher under free trade (when o = o
H
+o
F
= 2060000). In
order to equalize marginal revenue with marginal cost (condition for prot maximization in every
rm) we need to derive rst the inverse demand function. To that purpose, we can solve for j in
(13):
j = j + 30000
_
1
:

Q
o
_
then
Revenue per rm = jQ =
_
30000
:
+ j
_
Q30000
Q
2
o
(14)
By dierentiating (14) with respect to Q, we will get the marginal revenue, which must be equalized
to the marginal cost (5000) to derive the following expression:
60000
o
Q =
30000
:
+ j 5000 (15)
and since, by symmetry, we know that j = j, then from (15)
30000
:
= j 5000 (16)
Moreover, in the long-run equilibrium the zero-prot condition implies that
j = j = TC = 5000 +
750000000
Q
(17)
Given that, clearly from (13), Q =
S
n
, we can use (16) and (17) to write
30000
:
=
750000000:
o
i.e.
:
2
=
30000o
750000000
(18)
In particular, for o
H
= 900000 we can derive that
: = 6
Q = j = 10000
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Prices will be lower and variety higher when the size of the market increases, which determines
that free trade will always be superior (in terms of welfare) to autarky. The reasons (lower markups
facing higher elasticity of individual demand) were already commented in class.
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