1. (Specific Factors Model) Cruztopia is a small open economy which produces clothing and food (clothing with capital (K) and labor (LC); food with land (T) and labor (LF)). Capitalandlandarefixedfactorswhilelaborcanmovebetweensectors(LC+LF=L). The production technology in each sector demonstrates constant returns to scale with diminishing returns of marginal product of each factor and factor complementarity. Consumers in this economy exhibit homothetic preferences.

(a) Characterize an autarky equilibrium for Cruztopia.

(b) Graphically represent the autarky equilibrium with quantity of production in

clothingQCon the x-axis and quantity of production in foodQFon the y-axis.PT

Cruztopia opens up to free trade and observes a relative world priceC. Let usPF

further assume that the relative world price is higher than in the autarky relative price,

PTPA

C>C.PFPF

1

(c) How does the equilibrium production and consumption change with trade? Show on the graph how openness to trade affects consumers' utility. Again, put quantity of production in clothingQCon the x-axis and quantity of production in foodQFon the y-axis.

1. (d)How does the change in production affect factor allocations?
2. (e)Examine the changes in real returns for the workers in each sectorw,w, the

PCPF

real returns for the capital owners in the clothing sectorr,r, and the real

PCPF

rental rate of land in the food sectort,t. What are the key assumptions

PCPF

on the production technology that drive the change in each result?

Policy makers are considering the imposition of a 10% tariff on food. This tariff would raise the price of food in the country by 10% and would not affect the price of clothing.

1. (f)What is the effect of this tariff on the world relative price?
2. (g)Who benefits from the tariff policy compared to free trade? Again, examine the
3. changes in real returns for the workers in each sectorw,w, the real returns

PCPF

for the capital owners in the clothing sectorr,r, and the real rental rate ofPCPF

landinthefoodsectort,t.PCPF

Let us consider again, Cruztopia under autarky and further assume that the economy acquires additional land.

1. (h)Show on a graph how the autarky equilibrium production and consumption would change compared to part (b).Hint: There is no change in the autarky price!
2. (i)Examine the changes in real returns for the workers in each sectorw,w, the

PCPF

real returns for the capital owners in the clothing sectorr,r, and the realPCPF

rental rate of land in the food sectort,t.PCPF

2. (Heckscher-Ohlin Model) There are two economies, Home and Foreign producing 2 goods, furniture (F) and cosmetics (C), using capital (K) and labor (L). Furni- ture production is relatively more capital intensive than the production of cosmetics. The production functions for both goods satisfy the assumptions of constant returns to scale and diminishing returns to a single factor. Both economies share the same production technologies and consumers in all countries have identical homothetic pref- erences. Home has 600 units of capital and 400 units of labor while Foreign is endowed with 100 units of capital and 300 units of labor. Both factors can move freely across sectors. The world economy is currently under autarky.

(a) Characterize an autarky equilibrium for Home. (b) Which country is relatively more labor-abundant?

2

(c) Draw a possible PPF for Home and a separate one for Foreign. Put quantity of

production in clothingQCon the x-axis and quantity of production in clothing

QFon the y-axis. What are the possible production and consumption points

in each country under autarky? Compare the two autarky price ratios at Home

PC

PF

PC.

and in Foreign

(d) What happens to the relative price of cosmeticsPCin the Home country when

PF

PF

1. (e)With free trade, towards which sector will capital be re-allocated? Will this re-
2. allocation of capital induce any further movements of labor across sectors?
3. (f)Compare the welfare levels (real income) of workers and capital owners with the welfare levels (real income) in autarky. You do not need to prove this result just state it, referencing any result covered in class.