Economics 58
Fall 2010
Solutions to Problem Set 8
1.
2.
a.
Contract curve is straight line with slope of 2. The only price ratio in
equilibrium is 3 to 4 (pc to ph).
b.
40h, 80c is on C.C. Jones will have 60h and 120c.
c.
60h, 80c is not on C.C. Equilibrium will be between 40h, 80c (for Smith)
and 48h, 96c (for Smith), as Jones will not accept any trades that make
him worse off. UJ = 4(40) + 3(120) = 520. This intersects the contract
curve at 520 = 4(h) + 3(2h), h = 52, c = 104.
d.
Smith grabs everything; trading ends up at OJ on C.C.
a. World price ratio determines location on PPF. This position in Edgeworth
Box determines tangent slope of the isoquants which determines relative price of
capital and labor. If production functions are the same everywhere, this
construction will be the same everywhere. So relative factor prices will be equal.
b. An increase in the price of the capital intensive good will increase its
production. This will reduce the capital labor ratio in both goods because of the
shape of the contract curve in the Edgeworth Box. A lower k/l in both industries
implies that the ratio of the return to capital to that of labor will rise.
c. Initially, the given world price will determine the capital labor ratio in both
industries. That will not be changed by an increase in capital. But with more
capital and a constant capital labor ratio, output of the capital intensive good must
rise and that of the labor intensive good must fall.