the following information regarding consumers valuation and cost of

| November 24, 2016

1.Consider two countries (Home and Foreign) that can potentially produce 3 different goods (A, B, C) using only labor with the following labor requirements (hours required to produce one unit of the good):

A B C

Home 15 10 34

Foreign 5 2 17

Assume free trade is possible with no transportation or other costs. If the wage rate in the Home country is 25% of the wage in the Foreign country… :

which goods will be produced in the Home country?

Which goods will be produced in the Foreign country?

Show how you get the result.

2.Consider the following information regarding consumers valuation and cost of

production of a good. The first table shows you how much consumers value different units of the good (the maximum price they would pay for the first unit, for a second unit, etc.):

Value 12 11 10 9 8 7 6 5 4 3 2 1

Unit 1 2 3 4 5 6 7 8 9 10 11 12

So the first unit has a value of 12 (some consumer is willing to pay up to 12 for that

unit), the second unit has a value of 11, etc.. Consumers will buy all the units that give them a value greater than or equal to the price they pay: for example, at a price P=10, 3 units will be consumed. Consumers surplusis the value they get minus the price they

pay: for example, at a price of 10, consumers get a surplus of 2 from the first unit, 1

from the second unit, 0 from the third unit consumed (we assume that in case of

indifference, when the surplus of a unit is 0, they still buy it).

The second table shows the marginal cost for domestic firms of producing each

additional unit (the minimum price at which they would supply the first unit, the

second, etc.):

Cost 1 2 3 4 5 6 7 8 9 10 11 12

Unit 1 2 3 4 5 6 7 8 9 10 11 12

So the first unit has a cost of production of 1 (some producer is willing to supply it at a

price of at least 1), the second unit has a cost of production of 2, etc.. Assuming perfect

competition, domestic producers will supply all the units they can produce at a cost

lower than or equal to the price they can get: for example, at a price P=10, 10 units will

be supplied. Producers surplusis the price they get minus the cost of production: for

example, at a price of 10, producers get a surplus of 9 from the first unit, 8 from the

second unit, etc. (0 from the 10th unit, but we assume that in case of indifference, when

the surplus of a unit is 0, they still supply it).

Suppose the country is a small open economy (so it does not affect the world price) and

under free trade any quantity of the good can be imported at a price P0= 3.

a) With free trade at the world price P0= 3,

how many units will be consumed in the country?

How much will be domestically produced?

How much will be imported?

b) Suppose now the government imposes a tariff t= 2 on each imported unit.

What will be the price of the good in the country?

How many units will be consumed?

How much will be domestically produced? How much will be imported?

c) The tariff will generate gains and losses.

Where do the gains and losses come from?

Who gains and who loses?

Explain in a few words whether the net welfare effect for the country as a whole is positive or negative.

d) Try to estimate the net aggregate welfare effect in the following way.

Consider first the units that were already bought from domestic producers before:

how does the tariff affects consumers and producers surplus?

what is the net welfare effect for those units?

Consider next the units that are still imported:

how does the tariff affects consumers and government surplus?

what is the net welfare effect for those units?

Consider finally the other units that before were imported but now are either bought from domestic producers or not consumed anymore:

how does the tariff affects consumers and producers surplus?

what is the net welfare effect for those units?

So putting together these three steps, how much is the net aggregate welfare gain or loss from the tariff?

3.Consider a country under a flexible exchange rate system. The economy is currently

producing at its naturallevel of output, corresponding to a situation of equilibrium in

the labor market (where the real wage that firms are willing to pay, given their costs and market power, is equal to the real wage that workers require, given their alternatives and their bargaining power, to supply the current amount of labor). The authorities are worried, though, about the unemployment rate, which is relatively high, and are considering possible measures to stimulate the economy and increase employment.

Suppose the central bank adopts a more expansionary monetary policy and consider the short-run effects of that policy:

a) What would happen to interest rates?

How would that affect the exchange rate?

b) How would the changes in interest rates and the exchange rate affect the aggregate

demand and its components (consumption, investment, government purchases, net

exports)?

– How would that affect employment?

b) Would the effects discussed above be persistent beyond the short-run?

In other words,what else would happen in the medium-run as a consequence of those changes and

How would that affect the state of the economy (in particular employment)?

d) Consider the same situation of the previous example, but this time thinking of a

country maintaining a fixed exchange rate with another major currency (and the country being small enough so that it does not affect the economy of the other countries).

How would the answers to the same questions (a-b-c) about the effects of monetary

policy differ?

Would an expansionary fiscal policy help in getting the desired effects on

employment?

e) If we think more in a medium-long run horizon, what kind of policies could help in

making employment persistently higher?

– Try to suggest at least two or three different types of measures that would have a permanent positive effect on employment.

– Comment very briefly on how they would affect per capita real income and what

difference (if any) would it make to have a fixed rather than a flexible exchange rate.

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