solutionproblemset4nov07

# solutionproblemset4nov07 - L. Karp November 25, 2007...

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L. Karp November 25, 2007 Solution to Problem Set 4 Some of the f gures that are needed to provide "graphical proofs" appear rather complicated, making the arguments appear di cult. This apparent complication is a disadvante of graphical arguments, relative to mathematical arguments. For the latter, the sequential nature of the proof is apparent: one thing comes before another. In contrast, with a graph, "everything appears a tthesamet ime" . Onewaytoov e rcometh i sd i culty is to use lots of graphs, so that the reader can see the development of the argument. I have tried to do that, but there is no substitute for "thinking with a pencil". As you read the text of the argument, you should draw the f gure, and compare your drawings with the ones in the answer key. Case I (Constraint on food consumption) a) Under free trade the equilibrium consumption of food is F T >F so the constraint is violated. (Figure 1) b) The optimal policy is a consumption tax/subsidy. The domestic con- sumer price equals slope of the tangent to indi f erence curve at point A, f gure 2, denoted p d . The ad valorem consumption tax on food, t, solves p d = p w 1+ t . You can write the tax in terms of the slopes of lines p d and p w .T h e f rst best consumption tax/subsidy leads to consumption at A and utility U 1 . Imposition of the constraint leads to a lower level of utility compared to free trade: there are points on the balance of payments constraint, above point A, that result in higher utility. (The indi f erence curve U 1 is not tangent to the BOP line.) Note that the consumption tax does not alter the production point nor the BOP constraint. c and d) First consider the production policy. I’ve drawn the constraint as the dashed line at F in f gure 3. If a production tax/subsidy is used, the consumer price equals the world price, so consumption must be on IEP ( p w ) . This fact, and the fact that the constraint is binding, means that consump- tion must occur at point

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f rst best policy. Production must be at point C , in order to satisfy the BOP equilibrium. Note that growth cannot alter the consumption point (which is uniquely determined by the IEP curve and the constraint) so growth neither increases nor decreases welfare. Growth can change the production point (e.g. growth may result in production shifting away from point C); growth cannot shift the consumption point along the line at F when a production policy is used. Therefore, growth cannot be immiserizing if a production policy is used - but neither can it lead to an increase in welfare. Now consider the trade policy. Note that point A gives the highest feasi-
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## This note was uploaded on 08/01/2008 for the course ARE 201 taught by Professor Karp during the Fall '07 term at Berkeley.

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solutionproblemset4nov07 - L. Karp November 25, 2007...

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