I. Consider a standard Heckscher-Ohlin model of trade between the United States and the European Union, in which the only resources are capital (K) and labor (L), and the only goods are chemicals (C) and electronics (E), both produced under perfect competition, with constant returns to scale, diminishing marginal returns, identical technologies, and identical preferences, and no transportation costs. The US is relatively capital abundant, and chemical production is relatively capital-intensive.
1. Use an Edgeworth allocation box, with chemical production in the southwest origin and labor on the horizontal axis, to show that unless the isoquants are tangent – and explain what this means in economic terms – that any allocation is not Pareto optimal.
2. In the Edgeworth allocation box, show how the movement from autarky to free trade affects the allocation of capital and labor in the long run between sectors, and how this affects both the wage-rental rate and the capital-labor ratios in each sector.
3. In the above Edgeworth allocation box, show that if labor moves is mobile but capital is not then the resulting allocation is not Pareto Optimal in the long run.
4. Use an Edgeworth distribution box, with the United States’ PPF in the southwest origin and the quantity of chemicals on the horizontal axis, to show how Pareto optimal distributions require that relative marginal costs equal relative prices equal relative marginal utilities, not just within a country but across countries.
II. Does international trade cause faster economic growth and higher per-capita incomes, is it the other was around, or is there no significant correlation? Review the journal articles . What are the main arguments for and against the causal connection between international trade, per-capita income, and economic growth? What does the research on the actual evidence, e.g., the meta-analysis by Lewer & van den Berg, prove or imply?
III. Consider the labor allocation problem for the specific factors model in the medium run. Assume that PC = $120, PE = $60, MPLC = 500 – LC/10, MPLE = 400 – LE/20, and LC + LE = 4000 persons per week.
1. Solve for the allocation of labor which would equate WC = WE, solve for the equilibrium weekly wage rate, and show your results on a labor allocation diagram.
2. Using the area method for the labor allocation graph, solve for the total gross profits (i.e., returns to capital) in each sector. Check your answers by solving for output of each (taking the integral of the MPL), multiply by price to get revenue, and subtract total wages to get profit.
3. Suppose that PC falls by half, to $60. Show this on your diagram.
4. Assume that in the very short-run, after PC falls, labor is immobile. How will wages change in each sector?
5. Assume instead that wages are sticky in the very short-run, after PC falls. What will happen to employment in each sector? What will be the temporary unemployment rate, as a percentage of the total labor endowment?
6. Now assume that nominal wages are flexible and labor is mobile. Solve for the new labor allocation after PC falls, and then solve for the new equilibrium wage rate, and the new amounts of total gross profits in each sector. By what percentage did each change, and how does this compare to the change in PC?
