Economics 3342 (Due on Feb 18, 10am)

Problem Set 1

20% mark penalty if submit between 10 - 11:59am. We will not

accept submission after 11:59am. Submit your answers to
LumiNUS.
1 The Ricardian Model (15pts)
Suppose that each worker in the home country can produce 4 backpacks or 20 calculators. Assume
that Home has 24 workers.
1. Graph the production possibilities frontier for the home country (with backpacks on the
horizontal axis). (1pts)

2. What is the no-trade relative price of calculators at Home? What is the opportunity cost of
producing one backpack? (1pts)
Suppose that each worker in the Foreign country can produce 8 backpacks or 10 calculators. Assume
that Foreign has 30 workers.
3. Graph the production possibilities frontier for the Foreign country (with backpacks on the
horizontal axis). (1pts)

4. What is the no-trade relative price of calculators in Foreign? (1pts)

5. Use the information provided at the beginning regarding Home, in which good does Foreign
have a comparative advantage and why? (1pts)
Suppose that in both the Home and Foreign country, the utility function is:
p
U = QB QC ,

where QB is the quantity of backpacks consumed, and QC is the quantity of calculators consumed.
6. What is the equilibrium allocation of labor between the two sectors in the Home country in
autarky? (1pts)

7. Add the indifference curve for each country to the figures you drew for parts (a) and (c).
Label the production possibilities frontier (PPF), the indifference curve (U1), and the no-
trade equilibrium consumption and production for each country. Label Home’s and Foreign’s
no-trade consumption as A and A∗ , respectively. (1pts)
Pb
Now suppose the world relative price of backpacks is Pc = 2.
8. What good will each country specialize in? Briefly explain why. (1pts)

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 9. Pin down the consumption bundle of the Home country in the trade equilibrium. (1pts)

10. Graph the new world price line for each country in the figures you drew for parts (a) and (c),
and add a new indifference curve (U2) for each country in trade equilibrium. (1pts)

11. Label the exports and imports for each country in the graphs you drew for parts (a) and (c).
(1pts)

12. Does each country gain from trade? Briefly explain why or why not. (1pt)

Now suppose that a new backpack design emerges, and the relative demand for backpacks is much
higher. The demand curve for backpacks shifts to the right, and pushes the world relative price of
backpacks to Pb /Pc = 5.

13. How will the Home country allocate their workers between calculator and backpack produc-
tion? (1pts)

14. How many backpacks and calculators will the Home country consume in new trade equilib-
rium? (1pts)

15. Does each country gain from trade under the new price? Explain why or why not. (1pts)

2 HO-1 (4pts)
Suppose we have two countries, A, and B, and two factors of production, labor and capital. The
country endowment is:

Labor Capital
Country A 30 90
Country B 60 15

Suppose good C is capital-intensive and good S is labor-intensive.

1. Which country will export C in trade? (1pts)

2. In country A, the production of which good decreases after trade?(1pts)

3. In country B, is the relative price of C higher or lower under trade, as compared to au-
tarky?(1pts)

4. According to the Stopler-Samuelson theorem, do you think the workers in country A will
support free trade policy?(1pts)

3 Factor Prices and Output Prices in HO Model (6pts)

Consider the following data for two industries within the Home country in autarky. Computers:

• Sales revenue = PC QC = 250

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 • Payments to labor = W LC = 100

• Payments to capital = RKC = 150

Shoe:

• Sales revenue = PS QS = 120

• Payments to labor = W LS = 90

• Payments to capital = RKS = 30

The production function for computers is:

QC = LαC KC1−α

and the production function for shoes is:

QS = LβS KS1−β

1. Which industry is capital-intensive?(1pts)

2. Compute α and β. (1pts)

Now the Home country opens up to trade, and experience the following price changes:

• Percentage increase in the price of computers = ∆PC

PC = 15%

• Percentage increase in the price of shoe = ∆PS

PS = 0%

3. Can you infer from the above information, in which industry does the Home country has
comparative advantage? If not, list the information you need in order to identify comparative
advantage. (1pts)

4. After trade, the production of which industry decreases? (1pts)

5. Will W LC /PC QC change after trade? What about RKC /PC QC ? (1pts)

6. According to the Stolper-Samuelson theorem, which factor gains in real terms, and which
factor loses? (1pts)