International Economics - ECOI 31253
Problem Set 2 - Note
Definition of Autarky Equilibrium
It is an allocation of consumption, production and labor employment
{xi (v), xi (c), q i (c), q i (v), li (c), li (v)}i=E,P and a set of prices {pi (v), pi (c), wi }i=E,P , such that:
• Consumers maximize utility given prices
• Producers maximize profits given prices
• Equilibrium profits are zero: pi (c)q i (c) = wi li (c); pi (v)q i (v) = wi li (v)
• Labor market and goods market clear: li (c) + li (v) = li ; xi (c) = q i (c), xi (v) = q i (v)
Computing Autarky Equilibrium
1. Determine prices from numeraire and opportunity cost
2. Find quantity consumed and produced using:
a) Write down the PPF of country i
b) Use the utility maximization condition and combine it with the goods market clearing
condition. Plug the result back in the PPF and get the quantities needed (N.B under
autarky the goods market equilibrium condition is xi (k) = q i (k), k = c, v)
3. Get the labor allocation using technology and the result from point 2
4. Get wages from the zero-profit condition.
Definition of Free Trade Equilibrium
It is an allocation of consumption, production and labor employment
{xi (v), xi (c), q i (c), q i (v), li (c), li (v)}i=E,P and a set of prices {p(v), p(c), wi }i=E,P , such that (no-
tice that prices are now equal across countries):
• Use relative supply and relative demand graph to get the relative price and the pattern of
specialization
• Producers maximize profits given prices
• Equilibrium profits are zero: pi (c)q i (c) = wi li (c); pi (v)q i (v) = wi li (v)
• Labor market and goods market clear: li (c) + li (v) = li ; xE (c) + xP (c) = q E (c) + q P (c),
xE (v) + xP (v) = q E (v) + q P (v)
Computing Free Trade Equilibrium
1. Use relative supply and relative demand graph to get the relative price and the pattern of
specialization
2. Find quantity produced using the pattern of specialization. If a country fully specializes
you get the quantities directly from technology and labor endowment. If a country does
not fully specialize you do as before:
1
a) Write down the PPF of country i
b) Use the utility maximization condition and combine it with the goods market clearing
condition. Plug the result back in the PPF and get the quantities needed (N.B under
free trade the goods market equilibrium condition is xE (k) + xP (k) = q E (k) + q P (k),
k = c, v)
3. Get the labor allocation using technology and the result from point 2
4. Get wages from the zero-profit condition.
5. Get the quantity consumed from the countrys budget constraint
Wage and Welfare Comparison
For wage comparison, remember to write down the nominal wage and the real wage in terms of
both goods. For welfare comparison plug the expenditures X i (k) into the utility function.