Go To Answer Directly
Problem Set 2
There are two countries, denoted by i = 1, 2. Each country produces a mass (continuum) of traded goods N _{i} and of nontraded goods P _{i} . Each good is produced by an individual monopolist. There is no overlap between the goods produced by one country and those produced by the other country. All consumers have a utility given by
^{�} � N 0 
� 
1/α 


dk 
, 

where α ∈ 
(0, 1), and N = N _{1} + P _{1} + N _{2} + P _{2} is the total (maximum) number 

of goods. The goods are ordered as follows: 

• 
k ∈ [0, P 1 ] =⇒ Non traded good produced by country 1 

• 
k ∈ 
[P _{1} , N 1 + 
P 1 ] =⇒ Traded good produced by country 1 

• 
k ∈ 
[N _{1} + P 1 , P 1 
N 1 + 
P 1 
+ 
N 2 
] =⇒ Traded good produced by country 2 

• 
k ∈ 
[N _{1} + 
+ N 2 
, N ] =⇒ Traded good produced by country 2 
The price charged by producer of good k is denoted by p _{k} . One will denote
σ = 1/(1 − α) and µ
= σ/(σ − 1).
1. Compute the demand function for each of the four types of goods, as
a function of its price, the aggregate nominal national income of each country Y _{i} , and other producers’ prices. Show that the contribution of other producers’ prices can be summarized using these two price indices=:
The production function for any good k is given by y _{k} = q _{k} l _{k} ,
where q _{k} is the quality of the manager hired by the ﬁrm (each ﬁrm uses exactly 1 manager), and l _{k} is its labor input. w _{i} is the wage of raw labor in country i.
2. Show that the price charged by a ﬁrm with managerial quality q _{k} in
country i is
w i
p _{k} = µ
q k
.
Compute the output and employment of a ﬁrm as a function of its managerial quality, wages, aggregate income and price indices, in the four cases.
1
1
3. Compute the proﬁt of a ﬁrm in the four cases, denoted as functions
π _{P} _{1} (q ), π _{N} _{1} (q ), π _{N} _{2} (q ), π _{P} _{2} (q ).
We now try to characterize the wage schedule ω _{i} (q ), which tells us how much a manager of quality q earns in country i. Firms chose their managerial quality by maximizing π (q ) − ω (q ), where π (.) is the relevant proﬁt function for the type of ﬁrm being considered.
4. Show that if two types q, q ^{�} are both employed by exporting ﬁrms in
country i, then it must be that ω _{i} (q ) − ω _{i} (q ^{�} ) = π _{N} _{i} (q ) − π _{N} _{i} (q ^{�} ),
and that a similar equality holds if they are both employed by nonexporting ﬁrms.
We assume each individual is endowed with one unit of labor exactly, and q units of managerial quality. In country i, managerial quality is distributed over [0, q¯ _{i} ], with c.d.f F _{i} (q ), and density F _{i} ^{�} (q ) = f _{i} (q ). Furthermore, total labor force in country i L _{i} is such that L _{i} > N _{i} + P _{i} . People have to fully specialize between being a manager or a worker.
5. Show that in equilibrium if a manager type q is employed in an exporting
ﬁrm then any manager with q ^{�} > q is also hired by an exporting ﬁrm.
We thus look for an equilibrium such that in country i, there exists two critical values q _{P} _{i} , q _{N} _{i} such that q _{P} _{i} < q _{N} _{i} and if q ∈ [0, q _{P} _{i} ] , the worker supplies labor if q ∈ [q _{P} _{i} , q _{N} _{i} ] , the worker becomes a manager in the nontraded sector if q ∈ [q _{N} _{i} , q¯ _{i} ], the worker becomes a manager in the traded sector
6. What are the values of q _{P} _{i} and q _{N} _{i} ? What are the values of the price
indices p¯ _{i} as a function of the wages w _{i} , the critical levels q _{P} _{i} and q _{N} _{i} , and the
distributions of managerial quality?
7. So that the wage schedule for managers is given by
ω (q _{P} _{i} )
=
w _{i} + π _{P} _{1} (q ) − π _{P} _{1} (q _{P} _{i} ), q ∈ [q _{P} _{i} , q _{N} _{i} ]
w _{i} + π _{P} _{1} (q _{N} _{i} ) − π _{P} _{1} (q _{P} _{i} ) + π _{N} _{1} (q ) − π _{N} _{1} (q _{N} _{i} )
How does the return to managerial quality evolve when one moves up the quality ladder, if σ > 2?
8. Show that Y _{i} = µw _{i} L _{i} F (q _{P} _{i} ) and that the model can be closed either by
–Writing one of two (redundant) labor market clearing conditions and pick
ing a price normalization
2
–Writing one of two (redundant) trade balance equilibrium conditions and
picking a price normalization.
We normalize prices so that w _{1} = 1
9. Show that the highest wage in country 1 is
ω (¯
q
1
)
=
1 + (µ − 1)µ
−σ
(¯
q
σ −1 _{−} _{q} σ −1 _{)} ^{�} _{Y} 1 _{p}_{¯} σ −1
1
N 1
1
+(µ − 1)µ ^{−}^{σ} (q
^{−}^{1} ^{−} ^{q} P 1
σ
N 1
σ −1 _{)} ^{�} _{Y} _{1} _{p}_{¯} σ −1 ^{�} _{.}
1
+
Y 2
p¯
σ −1 ^{�}
2
10. We now look at the eﬀect of increases in international trade in country
one, by assuming a marginal increase in N _{1} , dN _{1} > 0, compensated by a fall
in P _{1} , dP _{1} = −dN _{1} , so that the total number of goods in country 1 remains
constant. We measure inequality by the ration between the highest and the
lowest wage.
Show that, holding Y _{i} and p¯ _{i} constant, this shift increases inequality. Why?
11.
How would you go about evaluating the indirect contribution of the
induced changes in Y _{i} and p¯ _{i} in country 1?
3
14.462 Advanced Macroeconomics
Spring 2004
Problem Set 2 Solution
1. First let’s ignore that some goods are nontraded. The ﬁrst order condition of the consumer problem is
��
0
N
c
α
l
dl
�
1 −1
α
c
α−1
k
= λp _{k}
where λ is the multiplier on the budget constraint. Solving for c _{k} and substituting
into the budget constraint to solve for λ, we get the demand functions
c _{k} =
p
−σ
k
_{p}_{¯} 1−σ
Y
where Y is income and p¯ = � ^{�}
N
0
1
p ^{1}^{−}^{σ} dk � ^{1}^{−}^{σ} is the consumption based price index.
l
Taking into account nontradability, we get
c _{k} =
⎧
⎪ ⎪ ⎨
⎪
⎩ ⎪
�
Y 1
_{¯} 1−σ
p
1
p
−σ
k
,
Y 1
p¯
1−σ
1
+
Y 2
p¯
1−σ
2
�
Y 2
_{¯} 1−σ
p
2
p
−σ
k
,
p
−σ
k
^{,}
k ∈ [0,
P 1
]
k ∈
[P _{1} ,
P 1
+
N 1
+
N 2
]
k
∈
[P _{1} + N _{1} + N _{2} , N ]
2. Proﬁts up to a constant are given by � p
k −
p _{k} = µ ^{w} ^{i} . Then output is given by
q k
w i
q k
�
p
−σ
k
, so proﬁt maximization implies
y _{k} =
⎧
⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎨
⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎪ ⎩
Y 1
_{p}_{¯} 1−σ
1
�
µ
w 1
q k
^{�} −σ
,
�
Y 1
p¯
1−σ
1
+
Y 2
p¯
1−σ
2
� �
µ
1 ^{�} −σ
w
q k
�
Y 1
p¯
1−σ
1
+
Y 2
p¯
1−σ
2
� �
µ
w 2
q k
^{�} −σ
Y 2
p¯
1−σ
2
�
µ
2 ^{�} −σ
w
q
k
,
,
,
k ∈ [0,
P 1
]
k ∈
[P _{1} ,
P 1
+
N 1
]
k ∈
[P _{1} +
N 1
,
P 1
+
N 1
+
N 2
]
k ∈ [P _{1} + N _{1} + N _{2} , N ]
and employment is
l _{k} =
⎧
⎪
⎪ ⎪
⎪ ⎪
⎨ ⎪
⎪
⎪ ⎪ ⎪ ⎪ ⎪ ⎩
�
�
_{Y} _{1}
(µw _{1} ) ^{−}^{σ}
_{p}_{¯} 1−σ
1
1−σ
q
k
+ _{p}_{¯}
Y 2
+
p¯
1−σ
2
,
Y 1
^{�} (µw _{1} )
1−σ
q
k
^{−}^{σ} ,
_{p}_{¯} 1−σ
1
Y 1
p¯
1−σ
1
1−σ
2
Y 2
,
^{�} (µw _{2} ) ^{−}^{σ}
1−σ
q
k
_{Y} _{2}
p¯
1−σ
2
(µw _{2} ) ^{−}^{σ}
1−σ
q
k
,
k ∈ [0, P _{1} ]
k ∈ [P _{1} , P _{1} +
N _{1} ]
k ∈
[P _{1} +
N 1
,
P 1
+
N 1
+
N 2
]
k ∈ [P _{1} + N _{1} + N _{2} , N ]
1
3. Proﬁts functions are
2
The price indices must satisfy
7.
only need to determine what happens at the critical values. Clearly it must be equal
to w _{i} at q _{P} _{i} . If it is below w _{i} the agent would rather be a worker, if it is above
w _{i} , then ﬁrms in the nonexporting sector would rather hire a manager with ability
slightly less that q _{P} _{i} . The schedule must also be continuous at q _{N} _{i} .
If it jumps up,
3
exporting ﬁrms would rather hire a manager with ability slightly less than q _{N} _{i} . If
it jumps down, nonexporting ﬁrms would rather hire a manager with ability slighty
above q _{N} _{i} . Continuity in combination with the result from part 4. implies the wage
schedule for managers
ω (q ) =
�
w _{i} +
π _{P}
_{1} (q ) − π _{P} _{1} (q _{P} _{i} )
w _{i} + π _{P} _{1} (q _{N} _{i} ) − π _{P} _{1} (q _{P} _{i} ) + π _{N} _{1} (q ) − π _{N} _{1} (q _{N} _{i} )
q ∈ [q _{P} _{i} , q _{N} _{i} ]
q ∈
[q
N i
, q¯ _{i}
]
where for simplicity we set the schedule equal to w _{i} to the left of q _{P} _{i} . Taking deriva
tives
�
4
Using the formulas for the price indices, this reduces to the identity Y _{1} + Y _{2} = Y _{1} + Y _{2} .
f _{2} (q )dq
�
10. As N _{1} + P _{1} remains unchanged, there is no change in q¯ _{P} _{1} . Thus the only eﬀect comes through a decrease in q _{N} _{1} . As the highest wage depends negatively on q _{N} _{1} , this leads to an increase in inequality. What happens is that the returns to managerial quality increase over the range [q _{N} _{1} , q _{N} _{1} _{+}_{d}_{N} _{1} ].
11. You could go through a nightmare of algebra if you wanted to.
5