Consider a world with only two large) countries, North and South. Assume a Heckscher Ohlin model. There two goods [Fossil Fuels (F) and Manufactures (M)]. And there are two inputs: capital (K) and labour (L). Both inputs are fully mobile across sectors. Let w be the wage and r be the return to capital. Assume that Fossil Fuels is capital intensive in comparison with Manufacturing. The world relative price pe/pm is determined by world relative supply and demand. Suppose North exports F.

Now suppose that North imposes a carbon tax on the consumption of F. That is, producers of F get the world price pr but consumers in North also pay a tax t per unit of F purchased (whether it is produced locally or imported). So the net price to Home consumers of F changes to pr + t. Note also that the equilibrium world price pF will change as you will see in part (a) below. Assume pm stays fixed.

a. Use a relative supply and demand diagram with the world relative price of F (i.e. pF/p) on the vertical axis and world relative supply F/M on the horizontal axis.

(i) What happens to the world relative demand curve for F/M? Why?

(ii) What happens to the world relative supply curve for F/M? Why?

(iii) What happens to the world relative price of F (i.e. pF/pM)?

(iv) Do South's terms of trade improve or worsen? Why?

b. What happens to the real returns to capital and labour in the South? Explain why, using a diagram to help illustrate your results. If you cannot tell whether real returns to a factor go up or down, explain why.

c. What happens to the real returns to capital and labour in the North? Explain why, using a diagram to help illustrate your results. If you cannot tell whether real returns to a factor go up or down, explain why.

d.What happens to the output of F in the South? Suppose that carbon emissions are directly proportional to the output of F. Is this policy successful in reducing global carbon emissions.

d. Suppose a new government comes to power in North. One set of advisors recommends keeping the policy in place. Another set of advisors recommends changing the policy to a tax on production of F. That is, the tax on consumption would be eliminated, so consumers in both North and South pay the world price Pf. But instead Northern producers would pay a tax t per unit of output of F and so get pF-t for each unit they produce. You have to make a choice between these two options. Which would you choose and why?