Set02a-GainsRicardian2 - Econ 441 Problem Set 2 - Answers...

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Econ 441 Alan Deardorff Problem Set 2 - Answers Gains and Ricardian Page 1 of 11 Problem Set 2 - Answers Gains from Trade and the Ricardian Model 1. Use community indifference curves as your indicator of national welfare in order to evaluate the following claim: “An improvement in the terms of trade increases welfare only if the country increases its quantity of exports in response. If a country is unwilling or unable to increase exports when their price rises, then the price increase does it no good.” This is false, which we can illustrate as follows: In the figure, the relative price of X rises from p 1 to p 2 , causing production to move to the right, from P 1 to P 2 . With the indifference curves shown, consumption also moves to the right, from C 1 to C 2 , although this is not a necessary result. Indeed, as drawn, the consumption of good X rises by more than the production of X, so that exports of X fall. Nonetheless, the country moves to a higher indifference curve, indicating an improvement in welfare. The reason this is possible without an increase in exports is that, when the price of the exported good rises, the country can buy and enjoy a larger quantity of imports in exchange for its exports, even if it keeps the quantity of exports fixed or even reduces that quantity somewhat. (Here’s a question for you: Is it possible for the quantity of imports to fall in response to such an improvement of the terms of trade? And if so, does welfare still increase? I’ll leave that for you to ponder on your own.) 2. Consider an economy that does not produce goods, but is simply endowed with certain amounts of them, and in which the population consists of two groups: farmers who own only wheat and weavers who own only cloth. (Never mind that Y X p 1 p 2 P 1 P 2 C 2 C 1 U 1 U 2
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Econ 441 Alan Deardorff Problem Set 2 - Answers Gains and Ricardian Page 2 of 11 these people don’t actually farm and weave – the names are just for convenience.) There are equal numbers of people in both groups, and they all share identical homothetic preferences for consuming wheat and cloth. a. Draw the production possibility frontier for this economy, and illustrate the autarky equilibrium. It is not really production, of course, but the maximum quantities of the two goods available to the country, W and C , are now fixed. Since the country can consume these amounts or less, the PPF may be thought of as a rectangle with corner at C W , . The autarky equilibrium is then at that corner, and the autarky prices appear as the price line tangent to a community indifference curve at that point: b. Is it possible to say who is better off in autarky, the farmers or the weavers? On what does that depend? It is not possible to say who is better off in
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This note was uploaded on 04/15/2009 for the course ACCOUNTING BUSI0027 taught by Professor Guan during the Spring '09 term at HKU.

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Set02a-GainsRicardian2 - Econ 441 Problem Set 2 - Answers...

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