1 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 ) 2 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. RD 3 (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: 4 (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 bette ...

1. 1
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.

2. (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
)
2
Relative Quantity of
Electronics (Q
E
/ Q

3. 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.
RD
3
(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

4. 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:

5. • The real wage in the US: increases/decreases
Briefly explain why:
• The real wage in Mexico: increases/decreases
Briefly explain why:
4
(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

6. individual better off.
Q
C
Q
E
5
(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.

7. 6
Q
F
/ Q
S
P
F
/ P
S
RD
RS
Q
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,

8. 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).
(c) Using the graph on the right, show what happens to the
world relative supply of
furniture.
(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.

9. 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.

10. Name __________________________
8
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?

11. 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

12. $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 __________________________

13. 9
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.

14. 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?

15. Name __________________________
10
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).

16. • 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 __________________________
11
$4.00
$4.50
$5.00

17. $5.50
$6.00
0
100
200
300
400
500
600
D
S
Q
P