hw02 - Homework #2: Answers Text questions: 1. The home...

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Homework #2: Answers Text questions: 1. The home country in Figure 3.3 responds to the trading opportunities shown by line 2 by increasing production of clothing for export (from E to A ) and actually reducing the quantity of clothing consumed. Show why: a. For a country in which production cannot change (e.g. the home country in figure 2.3), trade must result in a drop in consumption of the good exported. With fixed production, any amount of trade must reduce the quantity consumed of one of the goods (of course the quantity of the other must rise). This follows from the condition that expenditure = income (i.e. balanced trade): the exports used to pay for the imports will reduce the quantity of the export good available for consumption. b. If production can respond to new world prices, the quantity of cloting consumed at home could rise. With both goods normal in consumption, as income increases (as it must when production responds to world prices) the consumption of both goods increase. Thus, for a sufficiently large increase in income, the quantity of clothing consumed will rise. c. In figure 3.3 reduction in clothing consumption results in an increase in well-being, compared with taking advantage of trade to consume more of both commodities. Because substitution in consumption is assumed to be possible, when prices change consumers prefer an alternative bundle of goods (i.e. MRS p ). By trading, they are able
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y y x x F C F C = - = 20 1 2 2 . to achieve a more preferred consumption bundle. Even if adjustment of production permits increased consumption of both goods (i.e. in the area defined to the NE of the right angle centered on E ), this will only occur if tastes pick out such a point. In the figure above, at F , they do not. Note that, in the diagram, every indifference curve consistent through consumption points in the region defined by the right angle centered on E must be lower than the indifference curve through B (not shown). 2. Some consumers have quite rigid taste patterns. Suppose the indifference curves for a community are strictly right-angled, and the corner of each ever-higher indifference curve lies on a ray from the origin. To be precise, suppose that whatever the prices prevailing in the market, two units of food are demanded for each unit of clothing demanded. Furthermore, suppose the transformation schedule shows considerable flexibility in production, so much so that it is a downward sloping straight line, with a vertical food intercept of 20 units and a horizontal clothing intercept of 40 units. a. If the country cannot engage in trade, how much of each commodity does it consume and produce? We can answer this problem by solving the system of equations consisting of the income- expansion line and the PPF for the point where y F = x F and y C = x C : This will yield, y F = x F = 16 and y C = x C = 8.
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y y x x F C F C = - = 40 2 . b.
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hw02 - Homework #2: Answers Text questions: 1. The home...

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