prelim03 - Question (prelim 2003): Consider a small...

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Question (prelim 2003): Consider a small two-sector (food and cloth) economy with constant returns to scale in each sector and two factors of production, (capital and labor). The economy exports cloth (the capital-intensive good) and is incompletely specialized. The world relative price of cloth is p. (Food is the numeraire.) There are no distortions in the economy, prior to the imposition of taxes. a) Using indifference curves to represent social welfare, compare the effect on aggregate social welfare and on the level of exports of the following two polices: (i) a small production tax on cloth and (ii) an export tax of the same magnitude. Under both policies, the tax revenue is given to consumers in a lump sum transfer. b) Now compare the effect of the two policies on the real return to capital and the real return to labor. c) Are the aggregate welfare effects described in part (a) consistent with the individual welfare effects (for owners of capital and labor) described in part (b)? Explain. Answer: A minimal pass requires doing (a) correctly. Students who get (a) and most of part (b) get a “good”. If they get all of parts (b) and (c) they rate an “excellent”. a) Draw a production possibility frontier. Both policies cause the producer’s relative price of cloth to fall, say to level p’<p (since the export tax and the production tax have the same magnitude). Either tax causes production to move to a point such as A, where the tangent to the production possibility curve is equal to the domestic producer price of cloth, p’. The balance of payment constraint is shown as the dashed line with slope p, through point A. Under the production tax, the consumption point is at the intersection of the balance of payment constraint and the income expansion path (IEP) associated with price p (since consumers continue to face the fixed world prices). The consumption point is shown as B. The indifference curve through B is tangent to the balance of payments constraint. Under the export tax, the domestic consumer and producer relative price of
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prelim03 - Question (prelim 2003): Consider a small...

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