Problem Set 2Fall 2016Economics 433Professor Kala KrishnaThe Pennsylvania State UniversityDue September 20 in class.Do all questions. Please write or type clearly. You do not need to calculatethe points on the graph, just label them as needed.1: Consider a Ricardian Model of Trade. There are two countries, Homeand Foreign, who produce two goods Food and Clothing, using one factor ofproduction, Labor. The unit input requirements are given by the table belowin the two countries.Goodn Country Home ForeignFood 3 9Clothing 9 3Home has 30 units of labor while foreign has 90 units. Food is consumed ina one to one ratio relative to clothing at all prices by both countries. Use graphpaper below.a: Draw the world PPF under trade. If the price of clothing is 1; what isthe price of food under free trade? What are equilibrium wages (what a unit oflabor earns) in each country?b: Depict the trading equilibrium and the prices, production, imports andexports by each country in your graph. You do not need to solve for it alge-braically, just on graph paper.c: What happens to equilibrium prices if labor migrates from foreign to homeso that home has 90 workers and foreign has 30. Labor that migrates then hasthe same productivity as native labor.d: Would labor that stayed behind in Foreign gain or lose from this mi-gration? Why? (What happens to the budget set of a Foreign worker? If itexpands, he must gain.)e: Suppose productivity abroad quadrupled, that is, the unit labor require-ments fell to 1/4 of the levels above. (Note that in this case Foreign has anabsolute advantage in both goods.) What happens to world prices? Do homeworkers gain from foreign becoming more productive ? Do foreign workers gainfrom its productivity improvement? (Comparisons should be relative to theoutcome in part b)f: Can the PPF when labor is mobile between countries lie strictly outsidethe world PPF through trade or must it touch it somewhere? Can you giveconditions under which they would touch at some point and when they wouldnot? (Hint: consider what happens when one country has an absolute advantagein both goods and when this is not the case.)1g: Given your answers to part f:, how would you respond to the followingquote:Given the lack of trade barriers today, there are orders of magnitude moregains to be had from permitting labor migration than trying to further liberalizetrade.2. This problem asks you to think of issues using a relative demand and sup-ply framework more generally. The U.S. and the rest of the world(ROW) arethe two countries in the world. They make two goods, Food (F) and Wine (W)The U.S. exports W:a: What would be the e¤ect of an advertising campaign to promote W inthe ROW? ( Assume that the advertising campaign makes foreigners demandmore W relative to F at any relative price.) What would shift? What wouldhappen to relative prices in the world? Would the U.S. gain or lose from suchadvertising if advertising is essentially costless?b: A war destroys half of ROWs productive capacity shrinking its ProductionPossibility Frontier (PPF) uniformly inwards for all goods. What would shift?What would happen to prices in the world? Would the U.S. gain or lose? Whatabout ROW?c: Suppose that the US consumes mostly wine while the rest of the worldconsumes mostly food. Would there be a secondary burden of foreign aid givenby the US to the ROW? Could the US reduce this secondary burden by givingits aid in barrels of wine? Why/Why not?3: This question asks you to think of how trade can result in gains due toincreasing competition and variety. You do not need to do any algebra. Justdraw the graphs needed.Suppose there two countries of equal size, i.e., both have the same numberof people, S. There are n symmetric rms. Each individual has demand forthe output of a representative rm denoted by q(p; P; n) where p is the rmsprice, P is the overall average price in the market, and n is the number ofrms. q(p; P; n) is decreasing in p, increasing in P and decreasing in n. With Sindividuals, the demand for a rm is thus Sq(p; P; n): Let c be marginal cost andF be the xed cost of production. Firms behave monopolistically competitivelyand choose p to maximize prots taking P and n as given. Assume all rms aresymmetric so that in equilibrium p = P and that rms enter till price equalsaverage cost, i.e., prots are 0.a: Depict the prot maximizing price charged by a representative rm forgiven P and n. You do not need to do any algebra. Just to draw demand andthe prot maximizing price.b: Show that the maximized prots of the rm are higher when its costs fall.(Hint: variable prots are also the sum of the di¤erence in marginal cost andmarginal revenue over units produced)c: As n rises, what happens to the prot maximizing price? What is theintuition? Call this relation the PP curve.d: Does an increase (or decrease) in S shift the PP curve? Why?2e: As n rises, what happens to output per rm in symmetric equilibrium andtherefore to average cost? What is the economic intuition here? Call this curveCC:f: Does an increase in S shift CC? Why?g: Depict the equilibrium n and p without and with trade where trade is justa doubling of S?h: Explain what the e¤ects of trade are on prices, variety and welfare.