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ECON 425: INTERNATIONAL TRADE THEORY AND POLICY
ASSIGNMENT FOUR
Fall 2024
DUE TUESDAY, NOVEMBER 26, 2024, 11:59pm
COMPLETED ASSIGNMENTS MUST BE SUBMITTED THROUGH THE
ASSIGNMENTS TAB ON THE COURSE WEBSITE.
PLEASE SUBMIT YOUR ASSIGNMENT IN A PDF FILE.
Justify your answers for full credit.
Question One
Consider a Heckscher-Ohlin-Samuelson model of trade with two large countries: Home (H) and Foreign (F); two goods: electronics (E) and textiles (T) and two factors of production: high- skilled labour (S) and low-skilled labour (L). Country F is relatively abundant in low-skilled labour. Textile production uses low-skilled labour relatively intensively.
Let VE denote the ratio of low-skilled labour to high-skilled labour in electronics; VT denote the ratio of low-skilled labour to high-skilled labour in textiles; pE denote the price of electronics; pT denote the price of textiles; wS denote the high-skilled labour wage; and wL denote the low-skilled labour wage.
(1.A.) (15 points) For this economy we can use the analog of the relative labour (to capital) demand and supply diagrams we used in class which here would be relative low-skilled labour (to high-skilled labour) demand and supply diagrams. Use this type of diagram to demonstrate that this model is capable of predicting that moving from autarky to trade will increase the skill wage gap (wS /wL ) and, therefore, increase inequality, in some countries but will decrease the skill wage gap and, therefore, decrease inequality, in other countries. Provide economic intuition to explain why the skill wage gap increases in one of the countries.
(1.B.) (15 points) Suppose that large Country H imposes a unilateral ad-valorem tariff on its imports and fully distributes the tariff revenue to households in Country H. Assume that we have the “normal case” with regard to the effects of the tariff on goods’ price ratios. Assume that the imposition of the tariff has the same qualitative impact on aggregate welfare in Country H as it would if Country H were small. Draw a single PPF diagram for Country H which depicts the equilibrium output point, the equilibrium aggregate consumption point, and the aggregate indifference curve for three different scenarios: (i.) autarky, (ii.) free trade, and (iii.) tariff restricted trade. In your diagram, put electronics on the horizontal axis and textiles on the vertical axis.
Question Two
This question concerns the monopolistic competition model of trade with increasing returns to scale that we have studied. The question is partially designed to help students better understand the importance of increasing returns in production (through fixed costs) in affecting equilibrium variables and the gains from trade.
There are 3 identical large countries. In each country there is a single industry which produces different varieties of a good. The varieties are indexed by j and the total number of varieties produced in each country is denoted by N which is endogenous. Note that N does not need to be an integer. It is the same industry in all countries.
Each country has 490 households. All households have the same utility function is given by:
where dj is consumption of variety j and Nc is the number of varieties available to a household.
Each household has one unit of labour to supply and labour in the only factor of production The production technology is the same for every variety in every country and is given by:
where Qj is output of variety j , ℓj is labour input into the production of variety j, and α > 0 is the fixed cost parameter. There is free entry into production and every variety is produced by only one firm.
We know that equilibria will be characterized by symmetry across varieties so henceforth, we drop the j subscript.
(2.A.) (25 points) Complete Table 1 for the different autarky and trading scenarios and for the different values of α indicated in the table.
(2.B.) (15 points) For this question, use the results in Columns 1 and 2 of Table 1. Explain
Table 1: Monopolistic Competition Model: Autarky and Trade
how an increase in the fixed costs of production qualitatively affects d, Q, and Household Level Utility in autarky. Provide economic intuition for your findings.
(2.C.) (15 points) For this question, assume that α = 4 and use the results in Columns 1 and 3 of Table 1. Explain how your results demonstrate that there is a scale effect, an exit effect, and a pro-competitive effect of trade.
Let us define a measure of the gains from trade as the percentage difference in a household’s utility between autarky and trade:
(2.D.) (15 points) For this question, use the results from the last row of all of the columns of Table 1. Calculate the GFT in a country when α = 4 and when α = 16. Provide economic intuition to explain why the gains from trade are higher in one case than in the other.