There are two countries, Home and Foreign, and they produce cars and bananas. Cars are produced using capital and labor, and bananas produced using land and labor. Under the closed-economy equilibrium, Pcar/Pbanana > Pcar*/Pbanana*; i.e. the relative price of cars is lower in Foreign than in Home.

(1). Draw a picture to show the Home country’s closed-economy equilibrium.   

(2). Show the Home country’s free trade equilibrium in your picture above.  

For the questions below, assume that as the Home country moves from closed economy to free trade, the price of cars drops by 10% and the price of bananas remains unchanged.

(3). Draw a picture to illustrate the equilibrium in the Home country’s labor market. Then show how w, Lcars and Lbananas change as the Home country goes from closed economy to free trade. (4 points)

The following are T/F questions, and describe the change in the Home country in the movement from closed economy to free trade. Please explain why they are T/F. Hint: You may want to use your answers in (1)-(3).

(4) MPLcars increases because labor employment in the cars industry increases.

(5) The opportunity cost of bananas increases.

(6) The capital owners have lower purchasing power for cars.

(7) The workers have lower purchasing power for cars.

(8) The rental rate of land decreases by less than 10%.

(9) The rental rate of capital decreases by more than 10%.

(10) Wage decreases by less than 10%.

(11) Capital employment in the cars industry decreases.

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