Exercise 1 De…ne what is meant by: Food industry is capital intensive.

Answer: For each factor price ratio wr , food industry uses capital more inten-
K
sively than the cloth industry ( Lff > K
Lc ):
c

Exercise 2 Suppose in a H-O model, cloth and food are produced with capital
and labor. Home is capital abundant and cloth production is capital intensive.
How would home relative output price of cloth behave as home opens up to in-
ternational trade? What can you say about the welfare change of home capital
owners and labor? Explain your answers.
Answer: Since home is capital abundant and cloth production is capital inten-
sive, the home relative supply curve fc as a function of ppfc is to the right of that
a
of foreign. This means home autarky relative price ppfc increases to trade
equilibrium relative price ppfc : As the relative price of c increases, according to
Stolper-Samuelson, capital at home - which is used intensively in the produc-
tion of c; bene…ts unambiguously and the welfare of labor at home decreases
unambiguously.

Exercise 3 Suppose that a country has two clusters of an industry. Both are
subject to external economies and monopolistically competitive. Explain why the
cluster with lower current cost tends to grow at the expense of the higher cost
cluster.
Answer: As the lower priced cluster takes demand away from the higher priced
cluster, average cost of the lower priced cluster come down and the average cost
of higher cluster increases due to external economies. Since in a monopolistic
competition equilibrium, price is equal to average cost, price di¤ erential of the
two cluster increases.

1 Firms in the Global Economy

1.1 Monopolistic Competition and the theory of intra-
industry trade
In Ricardian theory, di¤erences in technology of countries generate international
trade. In Heckscher-Ohlin model, di¤erences in endowments generate interna-
tional trade. Empirically, however, much of international trade is among similar
countries (such as USA and Canada) . Krugman and others try to complement
classical theory of international trade by introducing two elements in the con-
text of monopolistic competition: scale economy and love of variety. Here, scale
economy means that the average cost of a typical …rm in an industry declines
as its output rate increases. Love of variety means that consumers get higher
utility be having more variety to choose from. In Krugman’s model, as countries
integrate through international trade, each successful …rm get bigger servicing
bigger market and they become more e¢ cient by the increase of their size. The
number of …rms in each country in an industry falls in this process but the total
number of …rms remaining after integration is larger than the corresponding

1
previous number in any country. Since, in a monopolistic competition, each
…rm produces a di¤erentiated product, consumers get a more variety of choices
as a result. Consumers welfare increases through two channels: reduced price
supported by increased e¢ ciency of production and more variety of choices. We
describe a simpli…ed model of Krugman
First, a general relationship if demand function is given by q = p; where
1
; are positive, p = q: Then, revenue = R(q) = pq = q 1 q 2 . marginal
d 2 1
revenue = dq R(q) = q= q 1 q = p 1 q:

1.1.1 demand that a typical …rm in the industry faces:

q = S n1 b (p p) = Sn + Sbp Sbp: Here, S is the …xed amount demanded
for the whole industry, n is the number of …rms in the industry. p is the average
price in the industry. If a …rm charges p = p; the …rm gets typical share Sn : If a
…rm charges less,than (resp. more than) p; the demand for the …rm’s product
exceeds (resp. less than) Sn : From the general relationship derived in the above,
M R(q) = p 1 q = p Sb 1
q:

1.1.2 cost function of a typical …rm

c(q) = F +cq: Here, F is the …xed cost and c is the marginal cost. Then, average
cost = AC(q) = Fq + c:

1.1.3 Equilibrium conditions

1
(marginal revenue is equal to marginal cost) p Sb q = c. At equilibrium, every
S 1 1
…rm charges the same price so that q = n : Thus, p nb = c or p = bn +c
S F F
(PP): In equilibrium, q = n ; AC(q) = q + c = S n + c (CC). . Finally, at
the intersection of PP and CC curve, price is equal to the average cost, the
zero pro…t equilibrium condition in a monopolistic competition. Figure 8-4
depicts equilibrium with market size S and larger size S 0 : S does not enter
the expression for PP curve so PP curve does not change as market increases
from S to S 0 through international trade. CC curve shifts down, however, as
S increases to S 0 : In the new equilibrium, there are more …rms in the market
o¤ering more variety and consumers enjoy lower price as well.