Chapter 5 Movement of Labor and Capita between countries

1. In the short-run specific-factors model, examine the impact on a small country following a
natural disaster that decreases its population. Assume that land is specific to agriculture, capital
is specific to manufacturing, and labor is free to move between the two sectors.

a. In a diagram similar to Figure 5-2, determine the impact of the decrease in the workforce
on the output of each industry and the equilibrium wage.

Answer: The following diagram depicts a decrease in population (labor) in the specific-factors
model. The origin for agriculture shifts inward by exactly the amount of the change in
population, carrying with it the curve representing the marginal product of labor in agriculture.
The new equilibrium is determined at the intersection of PM·MPLM and (PA ·MPLA)`, which
corresponds to a higher wage W‘. In manufacturing, the amount of labor decreases from 0ML to
0ML` and the amount of capital remains the same. As a result, the output of manufacturing
decreases. In agriculture, the amount of labor has decreased from 0AL to 0A’L‘ and the amount of
land remains the same. As a result, the output of agriculture also decreases.

b. What happens to the rentals on capital and land?

Answer: Because the quantity of labor in both industries decreases because of the natural disaster,
the marginal product of labor increases in both industries and the marginal products of the
industry-specific factors decrease.
2. How would your answer to Problem 1 change if instead we use the long-run model, with
shoes and computers produced using labor and capital? Determine the impact of the
decrease in the workforce on the output of each industry.

Answer: In the long-run model, a decrease in labor does not affect factor prices at all. Rather,
the output of shoes and computers adjusts: according to the Rybczynski theorem, the output of the
labor-intensive industry (shoes) decreases and the output of the capital-intensive industry
(computers) increases. This point can be illustrated graphically.
4. In the short-run specific-factors model, consider a decrease in the stock of land. For example,
suppose a natural disaster decreases the quantity of arable land used for planting crops.

a. Redraw panel (a) of Figure 5-11 starting from the initial equilibrium at point A.

b. What is the effect of this change in land on the quantity of labor in each industry and on
the equilibrium wage?
Answer: With less land per laborer in the agriculture sector, MPLA decreases. This is
represented by an inward shift in the wage curve for agriculture and leads to a new equilibrium at
point B. In the new equilibrium, wages are once again equalized across industries at W’<W,
manufacturing labor increases from 0ML to 0ML’, and agriculture labor decreases from 0AL to
0AL’.

c. What is the effect on the rental on land and the rental on capital?
Answer: In the manufacturing industry, the quantity of labor increases and the amount of capital
remains the same (i.e. L/K increases). Therefore, the marginal product of capital increases
because each unit of capital has more laborers working with it. As a result, the rental on capital,
PM·MPK, increases. In agriculture, the natural disaster decreases the stock of land, which
increases the marginal product of land. On the other hand, the movement of labor from agriculture
to manufacturing decreases the marginal product of land. Which one of these effects is stronger
(i.e. L↓/T↓ ??)? It is possible to answer this question by looking at the move from A to B in
steps. Consider the contraction in the marginal product of labor in agriculture from A to C: The
wage is held constant by (L``-L) workers leaving the agriculture industry. Because the wage has
not changed, neither has the labor/land ratio or the rental on land. Then, allowing workers to
migrate back into agriculture holding the amount of land fixed, going from C to B, the wage is
depressed to W` and the marginal product of land increases. Combining these steps, the land
rental, PA · MPT, increases from A to B.
Chapter 6 Increasing Returns to Scale and Monopolistic Competition

3. Starting from the long-run equilibrium without trade in the monopolistic competition model, as
illustrated in Figure 6-5, consider what happens when the Home country begins trading with
two other identical countries. Because the countries are all the same, the number of consumers
in the world is three times larger than in a single country, and the number of firms in the
world is three times larger than in a single country.

a. Compared with the no-trade equilibrium, how much does industry demand D increase?
How much does the number of firms (or product varieties) increase? Does the demand
curve D/NA still apply after the opening of trade? Explain why or why not.
Answer: Industry demand increases by three times, and the number of firms also increases by
three times. Compared with the no-trade equilibrium, the demand curve D/NA does not change
because both total quantity demanded and the number of firms tripled.

b. Does the d1 curve shift or pivot due to the opening of trade? Explain why or why not.
Answer: Because D/NA is unchanged, point A is still on the short-run demand curve facing each
firm (d2 in Figure 6-6). However, the demand curve faced by each firm becomes more elastic
due to the increase in the number of firms: d1 pivots to become flatter, like d2 in Figure 6-6.

c. Compare your answer to (b) with the case in which Home trades with only one other identical
country. Specifically, compare the elasticity of the demand curve d1 in the two cases.
Answer: In the case with three countries, Home consumers have more varieties to choose from
compared with the two-country case. For that reason, the demand curve facing each firm d1 is
flatter (more elastic) when there are more trading partners.

d. Illustrate the long-run equilibrium with trade and compare it with the long-run equilibrium
when Home trades with only one other identical country.
Answer: The long-run equilibrium with trade occurs where the demand curve facing the firm is
tangent to the average cost curve, to the right of the long-run equilibrium without trade (due to
the exit of firms from the industry). Because the demand curve facing each firm with trade (d3)
is flatter when there are three countries compared with two, it will end up further down the
average cost curve in Figure 6-7. Therefore, firms will produce a greater quantity, at lower
average cost, than the in the two-country case.
4. Starting from the long-run trade equilibrium in the monopolistic competition model, as
illustrated in Figure 6-7, consider what happens when industry demand D increases. For
instance, suppose that this is the market for cars and lower gasoline prices generate higher
demand D.

a. Redraw Figure 6-7 for the Home market and show the shift in the D/NT curve and the new
short-run equilibrium.

Answer: The increase in demand shifts the D/NT curve to the right, dragging along the
curves d3 and mr3. Each firm produces Q4 at a price of P4 attempting to earn monopoly
profits at point D, and when all firms do so they move along the new D/NT curve to point E.

b. From the new short-run equilibrium, is there exit or entry of firms, and why?

Answer: In the short-run with trade, monopoly profits are positive because price exceeds
average cost. As a result, firms enter the industry and NT increases.

c. Describe where the new long-run equilibrium occurs, and explain what has happened to the
number of firms and the prices they charge.

Answer: In the long-run with trade, firm entry makes d4 more elastic until it is tangent to the
average cost curve. At that point, monopoly profits are zero and firms no longer enter the
industry. Relative to the short-run equilibrium in (b), the number of firms increases and price
decreases.
Chapter 7 Offshoring of Goods and Service

2. Consider an offshoring model in which Home’s high-skilled labor has a higher relative
wage than Foreign’s high-skilled labor and in which the costs of capital and trade are
uniform across production activities.

a. Will Home’s offshored production activities be high or low on the value chain for a given
product? That is, will Home offshore production activities that are skilled and labor-
intensive, or low-skilled-labor-intensive? Explain.

Answer: The high relative wage of Home high-skilled labor makes high skilled-labor-intensive
activities more expensive at Home relative to Foreign. Equivalently, the low relative wage of
low-skilled labor makes low-skilled-labor intensive activities less expensive at Home relative to
Foreign. As a result, Home will undertake production activities lower on the value chain while
offshoring higher value activities to Foreign.

b. Suppose that Home uniformly increases its tariff level, effectively increasing the cost of
importing all goods and services from abroad. How does this affect the slicing of the value
chain?

Answer: A uniform increase in the tariff level causes fewer activities to be offshored. The slicing
of the value chain reflects this increased cost as a rightward shift; Home expands the set of
activities that it does at Home to include incrementally high-value activities, whereas the set of
high-value offshored activities shrinks.

c. Draw relative labor supply and demand diagrams for Home and Foreign showing the effect
of this change. What happens to the relative wage in each country?

Answer: An expansion in the set of production activities done at Home (to include
higher-value ones) increases the average skill intensity of Home production. This increases
the relative demand for high-skilled labor at Home. Similarly, because Foreign ceases to do
its least skill-intensive activities, the average skill-intensity in Foreign increases and hence
the relative demand for high-skilled labor increases. See the following figure.
3. Consider a U.S. firm’s production of automobiles, including research and development and
component production.

a. Starting from a no-trade equilibrium in a PPF diagram, illustrate the gains from offshoring
if the United States has comparative advantage in component production.

Answer: See the following figure, where the offshoring equilibrium is B and C. Since the
United States has comparative advantage in component production, the world relative price of
components is higher and correspondingly steeper in the figure. Production will shift to point
B, and by exporting components and importing R&D along the world price line, the U.S. firm ends
up at point C. Production of the final good at point C is Y1, which exceeds the production Y0 in
the no-trade equilibrium. Thus the U.S. firm enjoys greater gains from offshoring when the output
of automobiles increases from Y0 to Y1.

b. Now suppose that advances in engineering abroad decrease the relative price of research
and development. Illustrate this change on your diagram and state the implications for
production in the United States.

Answer: See the following figure, where the new equilibrium is B` and C`. A lower R&D price
will shift the world price line further down along the PPF curve and the new tangency is B’.
Given this higher world relative price of components, the United States is able to produce even
more automobiles at Y2 level.
c. Does the U.S. firm gain from advances in research and development abroad? Explain why
or why not.

Answer: Because the United States imports R&D and exports components, a decrease in the
relative price of R&D abroad represents an improvement in the U.S. terms of trade; as a result,
U.S. output increases to Y2 so there are gains for the United States.