Problem Set 8

Due 5/5/97

Theory

1. Nicholson Problem 17.6.

2. Suppose that a country has identical consumers with utility functions U(X,Y) = X^(1/2) * Y^(1/2). Further, the production possibilities frontier is given by X^2 + 2 * Y^2 = 128. For EACH of these parts, illustrate your result graphically.

(a) Solve for the competitive equlibrium in a closed economy. That is, suppose that consumers and producers take prices as given and maximize utility and prices. What price ratio is such that supply = demand? Briefly explain why this is efficient.

(b) Suppose that the country is small and can trade with the rest of the world at price ratio R_row=Px_r/Py_r = 1. For which good does this country have a comparative advantage? What good should the country import and what good should the country export?

(c) What are the free-trade consumption and production choices? Write out each condition which determines equilibrium and a one sentence interpretation. The conditions are: (1) MRS(Xc,Yc) = R_row, (2) RPT(Xp,Yp) = R_row, (3) R_row = - (Yp-Yc)/(Xp-Xc), and (4) (Xp,Yp) on the PPF?

(d) Suppose that producers of the import good lobby the government for a tariff on imports, and so the government implements a tariff of .5 on imports. Suppose Px_r=Py_r=1. What are the new consumption choices and production choices? Your answer should state each condition for equilibrium and give one sentence motivating it. [Hint: The price ratio paid by consumers and received by producers domestically is R_dt = Px_r/(Py_r+t). The conditions for equilibrium are now (1) MRS(Xc,Yc) = R_dt, (2) RPT(Xp,Yp) = R_dt, (3) R_row = - (Yp-Yc)/(Xp-Xc), and (4) (Xp,Yp) on the PPF.]

(e) What is the loss in consumers' utility from the tariff?

(f) Now suppose that the country is large, so that the rest of the world bears part of the burden of the tariff (which is still .5). In particular, suppose that the world price of the import falls by .25 as a result of the tariff, so that when the tariff is in place, Py_r = .75 (but domestic prices still differ from world prices due to the tariff as above). Now compute the consumption and production choices. What is the change in consumers' welfare from the tariff? Interpret.

Applications

1. Using Krugman's articles as a guide, briefly critique the following statements:

(a) Like Coke and Pepsi, U.S. and Japan are competitors, and when Japan is more productive, this will come at the expense of the U.S.

(b) Trade policy, not domestic policy, is the most important determinant of our well-being in the U.S., and the recent stagnation in living standards is a result of the U.S. losing out to its competitors.

(c) We should be worried about China's expanding economy because they will be a huge new competitor for jobs.

(d) U.S. trade deficits are mainly due to unfair trade practices by our trading partners and trade with low-wage countries.

(e) Ruinous wage competition will lead the entire world into poverty under free trade, since we can't possibly compete with countries who pay workers only a few dollars a day. [Your answer should address the issue of why the analogy of two companies engaging in ruinous price competition does not apply to countries.]

2. Assume that capital and labor are the only factors of production and that they are immobile. Briefly answer the following questions, in each basing your answer on the standard general equilibrium trade diagram used in class. You don't have to reinvent the wheel in this problem, just provide a short, correct interpretation of the diagram.

(a) Does the standard result that trade makes a country better off depend on the wages in the other country, or on any notion of "fair" trade?

(b) Suppose that there are two goods, a capital-intensive good and a labor-intensive good. What is the difference between a country's production choices in autarky (no trade) and the country's production choices when the country trades with a lower-wage country?

(c) If the government imposed quotas on the labor-intensive good, as proposed by some politicians, what would happen to the country's overall welfare relative to free trade?

3. Suppose a country has market power and could exploit it through an optimal tariff. What does Krugman argue is the benefit of sticking to free trade anyway? [be brief].