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Econ 323 International Economics, Winter 2024

Assignment 2 (70 points, 10% of course grade)

This assignment is designed to help you understand the Heckscher-Ohlin (H-O) model and the Krugman model.

Q1. (44 points) Suppose all the standard assumptions of the Heckscher-Ohlin (H-O) Model hold in a hypothetical world. In this world,  there are two economies: A and B. Both economies produce computers and shoes using only skilled workers and unskilled workers with identical constant return to scale production technology (that is not Leontief type. You can ignore the information in this parenthesis if you have no idea what’s Leontief production technology.)

The production of computers is skilled-worker intensive and the production of shoes is unskilled-worker intensive. Country A has 20 million skilled workers and 10 million unskilled workers. Country B has 15 million skilled workers and 5 million unskilled workers.

For all the graphs you draw for Q1, always put “shoes” on the horizontal axis and “computers” on the vertical axis.

1) (4 points) Which country is the skill abundant country? Explain your answer.

2) (6 points) Draw the PPF of country A and country B on the same graph. Clearly label the PPFs and explain your graph with factor abundance and factor intensity.

3) (2 points) In the autarky equilibrium, which country has a lower relative price for computers in terms of shoes? Which country will export computers in the free trade equilibrium?

4) (9 points) Are there gains from trade for country A and country B? Demonstrate your answer with graphs. Clearly label relative prices of goods and indifference curves in both the autarky and free trade equilibrium for full credits.  

5)  (4 points) Suppose you are a skilled worker in country A. Write down your budget constraint (BC). Draw the change in your BC when country A moves from autarky to free trade. Are you better off in the free trade equilibrium?

6) (4 points) Suppose you are an unskilled worker in country A. Write down your budget constraint (BC). Draw the change in your BC when country A moves from autarky to free trade. Are you better off in the free trade equilibrium?

7) (4 points) Suppose you are a skilled worker in country B. Write down your budget constraint (BC). Draw the change in your BC when country B moves from autarky to free trade. Are you better off in the free trade equilibrium?

8) (4 points) Suppose you are an unskilled worker in country B. Write down your budget constraint (BC). Draw the change in your BC when country A moves from autarky to free trade. Are you better off in the free trade equilibrium?

9) (3 points) Is free trade a Pareto improvement compared to autarky in the H-O model? Why or why not?

10) (4 points) Suppose that nothing else changes in this hypothetical world from now to 10 years later except that in country A, 5 million unskilled workers receive more education (and training) and become skilled workers. How would country A and B trade 10 years later? Explain your answer.

Q2. (26 points) Suppose that industry X satisfies all the assumptions of the Krugman Model. Assume that each firm produces one variety. Each variety is symmetric in production and to consumers. The production of each variety needs 50,000 USD as the fixed cost and 5 dollars as marginal cost. The relationship between price (P) and the number of firms (n) is determined by P = n/40 +5. In this hypothetical world, there are two countries: country A and country B. Country A has a demand of 500,000 and country B has a demand of 1,500,000.

1) (4 points) Derive the average cost (AC) of a representative firm as a function of the quantity produced by the firm (Q).  Plot the function on a graph with “Q” on the horizontal axis and “AC” on the vertical axis.

2) (4 points) Suppose that there is a free trade agreement between country A and country B. Derive the average cost (AC) of a representative firm as a function of the number of firms (n). Plot the function on a graph with “n” on the horizontal axis and “AC” on the vertical axis.

3) (6 points) Suppose that there is a free trade agreement between country A and country B. Find the equilibrium number of varieties, the price of each variety for consumers, the average cost of each variety, and the quantity produced by each firm in this integrated market.

4) (6 points) Suppose that the free trade agreement between country A and country B breaks down and both countries impose prohibitive tariff rates (they no longer trade with each other in this industry). Find the equilibrium number of varieties, the price of each variety for consumers, the average cost of each variety, and the quantity produced by each firm in country A.

5) (3 points) How is a typical consumer in country A affected by the breakdown of the free trade agreement between country A and country B? Explain your answer with numbers.

6) (3 points) For a firm that exists before and after the breakdown of the free trade agreement between country A and country B, how is the profit of this firm affected by the breakdown? Explain your answer with numbers.