International Economics

Professor:Kaniska Dam
Problem Set 4
1. One economy can produce good 1 employing labor and capital and good 2 employing labor and land.
The total labor supply is 100 units. Given the capital supply, the production of both goods depend on
the quantities of labor in the following way:
Labor on good 1
0
10
20
30
40
50
60
70
80
90
100

Output of good 1
0.0
25.1
38.1
48.6
57.7
66.0
73.6
80.7
87.4
93.9
100

Labor on good 2
0
10
20
30
40
50
60
70
80
90
100

Output of good 2
0.0
39.8
52.5
61.8
69.3
75.8
81.5
86.7
91.4
95.9
100

(a) Draw the figure of the production function of good 1 and good 2.
(b) Draw the Production Possibilities Frontier. Why is it curve?

2. The curves of the marginal product of labor from problem 1 are the following:
Employed workers
10
20
30
40
50
60
70
80
90
100

MpL in sector 1
1.51
1.14
0.97
0.87
0.79
0.74
0.69
0.66
0.63
0.60

MpL in sector 2
1.59
1.05
0.82
0.69
0.61
0.54
0.50
0.46
0.43
0.40

(a) Suppose the price of good 2 in relation to good 1 is 2. Determine graphically the wage and labor
distribution between sectors.
(b) Using the figure determine the production of each sector. Afterwards, confirm graphically that the
slope of the production possibilities frontier in that point is the same as the relative price.
(c) Suppose the relative price of good 2 lowers to 1. Repeat (a) and (b).
(d) Calculate the effects of the price change over the rent of the specific factors of both sectors.

3. In the text, we have examined the impact of the increments in the supply of capital and land. But, what
happens if the supply of the mobile factor, work, increases?
(a) Analyze the quantitative effects of an increase in the labor supply in the specific factors model,
when the price of both goods remain constant
(b) Using the graph, find the effect in the equilibrium of the example of problems 1 and 2, given the
relative price of 1, when the labor supply increases from 100 to 140.

4. Consider an industry (say the computer chip industry) where a monopolist is the unique producer in the
Home country. Home demand for computer chips is given by the following inverse demand function:

P = a bQ,
where P is the price and Q is the quantity demanded. The monopolist faces a marginal cost of production
equal to c. Assume that a > c. Now suppose that there is a second country, Foreign, which is identical
to Home and in which computer chip is also produced by a monopolist facing the same inverse demand
function P = a bQ and the same marginal cost c. Assume that the computer chip produced by the
two firms is identical from the point of view of consumers. Suppose that a process of trade integration
removes all trade barriers for the Home chip producer to sell in the Foreign market, but the Foreign
chip producer has to incur a per unit transport cost t if it wants to sell computer chips at Home. The
marginal cost of the Foreign producer when selling at Home is thus c + t. Denote by Q the quantity
sold by the Foreign producer in the Home market and by Q the quantity sold by the Home producer in
the Home market. Let us focus for now on the equilibrium in the Home market and ignore firm behavior
in the Foreign market throughout the exercise.
(a) Set up the problem of choosing the profit-maximizing level of production Q for the Home firm.
Make the assumption that the Home Firm takes Q as given (or fixed) when maximizing profits.
Express the optimal Q as a function of parameters and Q . Similarly, express the optimal Q as a
function of parameters and Q.
(b) Use the expressions obtained for Q and Q in the last two parts to solve for Q, Q , and P in terms
of only parameters. Under what relation between t, a and c, will the Foreign firm not sell in the
Home market?
(c) The Foreign producer is considering the possibility of becoming a multinational firm by setting up a
chip production plant in the Home market. By doing so, the Foreign producer would avoid paying
the transportation cost t. But, setting up the production plant requires a fixed cost equal to F .
Solve for the equilibrium P , Q and Q under this new arrangement. Also, compute the profits of
the Home and the Foreign producer.
(d) Compare the profits of the Foreign firm under this new arrangement with the profits when the
Foreign firm exports computer chips. Using this, derive a condition (relation between t, a, b, c and
F ) to describe when will the Foreign firm become a multinational? Discuss the effect of a, t, and
F on this choice and interpret the results.
5. In Krugmans monopolistic competition model, suppose that the utility function takes on the CES form:

U(x1 , x2 ) = x1 + x2 ,

0 < = ( 1)/ < 1.

Maximize the above subject to the budget constraint, p1 x1 + p2 x2 I. Suppose industry 1 is monopolistically competitive, whereas industry 2 is perfectly competitive. Both industries use labor and capital as
inputs of production. Let the marginal costs be denoted by c(w, r), and the fixed costs in the industry
by c(w, r). That is, the fixed costs use labor and capital in the same proportions as the marginal costs.
(a) Obtain an expression for the relative demand x1 /x2 as a function of prices.
(b) The elasticity of substitution is defined as dln(x1 /x2 )/dln(p2 /p1 ). What is the value of the elasticity
of substitution for this utility function?
(c) Obtain an expression for the demands x1 and x2 as a function of prices.
(d) What do these expressions imply about the elasticity of demand?
(e) Write down the relationship between the prices of goods and factor prices. Does the StolperSamuelson Theorem still apply?
(f) Write down the full-employment conditions for the two factors. Does the Rybsczynski Theorem
still apply in some form?