# Answers to Problem Set 2

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```					                    Economics 433: Advanced International Trade

Prof. Andrés Rodríguez-Clare

Spring, 2007

Problem Set 2

Please print this problem set out and work directly on it. If necessary, you may attach

extra sheets. Be sure to show your work on all questions that require a numerical

response.

Name __________________________________________________________________
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QUESTION 1

Consider the specific factors model. Imagine that the price of Agriculture falls by 5% and
the price of Manufacturing increases by 10%.

a) What happens to the wage paid to people working in Agriculture? What happens to the
wage paid to people working in Manufacturing?

Think first of the fall in the price of agriculture. We know from the diagram where
we determine the equilibrium wage and allocation of labor (figs 3.5 and 3.6) that the
wage decreases and labor moves from agriculture to manufacturing. Similarly, an
increase in the price of manufacturing leads to a reallocation of workers from
agriculture to manufacturing and an increase in the wage. The net effect on the
wage is ambiguous (could go up or down, depending on the shape of the curves), but
it is the same in agriculture and manufacturing, because there is a single wage.

b) What happens to the wage, the rental price of land, and the rental price of capital in
terms of Agriculture? What about in terms of Manufacturing?

The decline in the number of workers in agriculture means an increase in MPL A,
hence an increase in the wage in terms of agriculture, whereas there is a decline in
MPTA, hence a decline in the rental price of land in terms of agriculture. Similarly,
there is an decrease in MPLM and an increase in MPKM, hence a decline in the wage
in terms of manufacturing and an increase in the rental price of capital in terms of
manufacturing. Since the relative price of agriculture falls, then this establishes that
the real rental price of land falls (in terms of both goods), whereas the opposite
happens for capital. For labor the result is ambiguous (increase in terms of
agriculture, decrease in terms of manufacturing).

c) Summarize all the previous information by establishing how the proportional changes
in the wage, the rental price of land, the rental price of capital, and the price of both
goods relate to each other.

This is done as follows:

RT PA           W  PM          R K
     5%  0,       10 % 
RT   PA          W  PM             RK

Note: since we don’t know whether the wage falls or increases, then the middle part
of the above expression establishes this ambiguity.

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QUESTION 2

Evo Morales, the new president of Bolivia, has stated that Bolivia will allow cultivation
of Coca but penalize the production and trade of cocaine. He argues that there are many
uses of coca leaves besides cocaine. To explore this issue, let’s imagine first a
hypothetical situation where coca cultivation and cocaine production and exports are
allowed in Bolivia, and now imagine that a ban on cocaine production and exports is
imposed and effectively enforced. (Note: to answer this question, you need to think hard
about how to “map it” into the specific factors model we discussed in class.)

a) What would be the likely effect of this on farmers whose land is devoted to coca
cultivation?

* Farmers will lose. The fall in the production and export of cocaine implies a
reduction in the demand for coca, which lowers the domestic price and the real
returns to the owners of the specific factor used in its production, i.e. the coca
farmers.

b) What would be the effect of a loser enforcement (i.e., some cocaine is produced
and exported rather than zero under full enforcement) of the cocaine production
and export ban?

* Farmers gain because the loser enforcement means an increase demand and a
higher price for coca, increasing the returns on land and earnings for coca growers.

c) What would be the effect of an effective policy of discovering alternative and
legal uses of coca leaves?

* This policy will reduce losses to farmers due to increase in the demand for coca
leaves from other legal sectors of the economy.

d) U.S. drug policy is supposed to complement forced eradication (i.e., the stick)
with the promotion of alternative crops that are profitable for farmers (i.e., the
carrot). Explain how the carrot and the stick together can induce farmers to reduce
coca cultivation.

* Forced eradication increases the cost of planting coca for farmers (for example,
because that coca plants are destroyed). Promotion of alternative crops increases
profits from alternative crops. If profits from alternative crops are higher than from
planting coca, farmers will switch from coca to alternative crops and it will lead to
reduction in coca cultivation. Thus, the “carrot” of alternative crop promotion
together with the stick of forced eradication pushes farmers to drop coca cultivation
in favor of alternative activities with their land.

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QUESTION 3

Starting from the equilibrium in the specific factors model, suppose that the price of
agriculture PA falls by 20 %, while the price of manufactures PM does not change at
all.
1) Draw a picture (similar to one in Figure 3.6) to show what happens to the wage.

2) Draw a picture (similar to one in Figure 3.4) to show what happens to the output
of manufacturing and agriculture.

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3) What happens with the wage in terms of agriculture and in terms of
manufactures? Explain.

4) Assume that percentage decrease in the wage is equal to 10%. Find changes in the
rental on capital and the rental on land if the manufacturing and agriculture
industries have the following payments to labor, capital and land:

Manufacturing Industry                             Agriculture
WL M  50                                      WL A  30

RK K  20                                      RT T  30

5) Who gains and loses from a decrease in the price of agriculture? Does the whole
economy gains from this? Explain.

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QUESTION 4

China is clearly a country with an enormous comparative advantage in Manufacturing
relative to Agriculture. Explore the implications of China’s reforms (i.e., China moving
from Autarky to Free Trade) on land-owners in the United States. You don’t need to use
graphs, but be sure to describe and explain all the necessary steps from this event to its
impact on US land-owners.

China’s reforms imply that now China will be trading with the rest of the world.
Since China has a CA in manufacturing, this will increase the worldwide supply of
manufacturing and increase the worldwide demand for agriculture. The implication
is an increase in the international relative price of agriculture.

We know that this leads to a reallocation of labor from manufacturing to
agriculture in the U.S.. From there onwards, the analysis is as in question      1, and
in particular we know that the real rental price of land in the U.S. will increase.

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