Solve the following exercise: We are in the context of a 2*2*2 model: 1. Two countries (Fantasy Land & Realist Land*), 2. Two factors of production Capital (K) & Labor (L), 3. Two goods (Cars C & Bags B). The mix of labor and capital used varies across goods (i.e. there are different factor intensities across the two sectors). Both goods are produced with constant returns to scale i.e. with Fel.) being the production function it is true that -> Fc(aK, al)= aFc(K,L) for any a>0. The perfect competition hypothesis is also satisfied: workers get competitive wage and capital owners competitive rent, corresponding to the value of their marginal products. Cars' production is more capital-intensive than bags' production, see below. are = 20, capital (K) used to produce one bag (B) aL = 20, labor (L) used to produce one bag (B) akc = 30, capital (K) used to produce one car (C) aLc = 10, labor (K) used to produce one car (C) K = 60000, total amount of capital available for production in each country L = 40000, total amount of labor available for production in each country Suppose each country uses a fixed mix of capital and labor in each sector (no substitution of resources is allowed in the production of each good, this means that the production function is Kinked - combination of straight lines- not "round"): Constraint on capital, i.e. the capital used cannot exceed supply K = 60000: 20Qg + 30Qc 60000 Constraint on labor, ie the labor used cannot exceed labor supply L = 40000: 2008 + 10Qc 40000 Each economy must produce subject to both constraints - i.e., it must have enough capital and labour. Answer ALL five sub-points: a. (Up to 2 Point) Draw the Production possibility frontier (PPF) complying with both constraints. Clearly indicate the "kinked" line that satisfies both. b. (Up to 0.5 Point) Suppose that the internal relative price Ps/Pc are 2 (-Pe/Pc=-2), how much Qs and Qc will the economy produce (before trade)? c. (Up to 0.5 Point) Suppose that the internal relative price Po/Pc are 2/3 (-P./Pc=-2/3,) how much QB and Qg will the economy produce (before trade)? d. (Up to 1 Points) Suppose that the internal relative price Pe/Pc is strictly greater than 2/3 and smaller than 2 (for example Ps/Pc= 1), how much Os and Oc wilthe economy produce (before trade)? e. (Up to 2 Points) Opening up to trade. Finally, suppose that Fantasy land is relatively abundant in labor and Realist land* in capital: namely L/K> L*/ K*. Draw a graph for the relative supply (RS) and relative demand (RD) of the two goods (theoretical graph like in the slides, no numbers needed) where Ps/Pc is on the vertical axis and Qg/Qis on the horizontal axis. In the graphs there are two relative supply (RS & RS*) curves and only one relative demand (RD) of the world. Before trade occurs, which relative supply (RS) curve will be the lowest (ie. on the low right side of the graph) Fantasy RS or Realist* R$*? Why? What will trade imply to the relative prices P/Pc and relative quantities O/Qc in a hypothetical new equilibrium point? Show on the graph.