UNIVERSITY OF OXFORD

Department of Economics
Undergraduate - Microeconomics

Last updated: September 17, 2014

Tutorial/Class 1: General Equilibrium

Sketch solutions

FOR USE BY TUTORS ONLY

DO NOT CIRCULATE, ESPECIALLY TO STUDENTS
Note: For each tutorial/class, a collection of questions related to the topic is provided. In
general there are too many questions for students to tackle in a single week. Tutors will decide
which of these questions their students should do in preparation for the tutorial or class.

Problems and Multipart Questions

1. A Pure Exchange Economy I
Consider a pure exchange economy with two consumption goods, 1 and 2, and two
consumers, a and b. Consumer a has an endowment of 10 units of good 1 (and none
of good 2), and preferences that are represented by the utility function:
ua (xa1 , xa2 ) = ln xa1 + ln xa2 ;
consumer b has an endowment of 10 units of good 2 (and none of good 1), and preferences that are represented by the utility function:
ub (xb1 , xb2 ) = ln xb1 + ln xb2 .
Normalise the price of good 1 to 1, and write p for the price of good 2.
(a) Draw this economy in an Edgeworth box, putting good 1 on the x-axis and good
2 on the y-axis. Identify the initial endowment. Sketch in a budget line and some
indifference curves for each consumer.
xb1

10

IC b
8
10
p

xa2

xb2

Budget Line
4

IC a
Initial Endowment

0
0

xa1

10

(b) Write down the budget constraints for the two consumers.
The value of consumer as endowment is 10 so her budget constraint is:
xa1 + p xa2 10 .
The value of consumer bs endowment is 10p so her budget constraint is:
xb1 + p xb2 10p .

(c) Write down the consumers constrained optimisation problems.

Consumer a chooses xa1 0 and xa2 0 to maximise
ua = ln xa1 + ln xa2

xa1 + p xa2 10 .

subject to

Consumer b chooses xb1 0 and xb2 0 to maximise

ub = ln xb1 + ln xb2

subject to

xb1 + p xb2 10p .

(d) Solve the consumers problems using Lagrangeans. Evaluate the consumers demand curves for goods 1 and 2. What does the Lagrange multiplier represent?
Local non-satiation.
Lagrangean for consumer a:
L = ln xa1 + ln xa2 + [10 xa1 p xa2 ] .
FOCs:

L
1
= a = 0,
a
x1
x1
L
1
= a p = 0 .
a
x2
x1

From these FOCs we have:

=

1
1
= a .
xa1
x2 p

Substitute in for xa1 = 10 p xa2 (budget line):

=

1
1
= a .
10 p xa2
x2 p

Re-arrange to obtain:
xa2 =

5
.
p

Substitute into budget line to obtain:

xa1 = 10 p
Same method for consumer b.

5
= 5.
p

Gives:
xb2 = 5 , xb1 = 5p .

The Lagrange multiplier is (as usual) the marginal utility of income - here, it
tells us how much utility would increase if the consumer had an additional unit
of the numeraire good 1.

(e) Write down two market clearing conditions.

The demand for x1 must equal the supply of x1 :
xa1 + xb1 = 10 .
The demand for x2 must equal the supply of x2 :
xa2 + xb2 = 10 .

(f) Hence find the Walrasian equilibrium relative price and allocation of this economy.
Sketch it in your diagram. Is the allocation efficient?
Substitute answer to part (d) into market clearing conditions from part (e):
5 + 5p = 10
5
+ 5 = 10 .
p
Hence the Walrasian equilibrium
is 1,

 relative price

and the allocations are xa1 , xa2 = (5, 5) and xb1 , xb2 = (5, 5).
xb1

10

Budget Line
8

Eq. Allocation

xa2

xb2

IC a
2

IC b
Initial Endowment

0
0

4 xa 6
1

10

The allocation is efficient because it exhausts the endowment and lies on the
contract curve.

2. A Pure Exchange Economy II

Consider a pure exchange economy with two goods, x and y, and two consumers, a
and b, that trade the goods. The preferences of consumer a are represented by the
utility function:
ua (xa , ya ) = xa + ln ya ,
and the preferences of consumer b are represented by the utility function:
ub (xb , yb ) = xb + ln yb .
(a) With the price of good x normalised to 1, calculate the Walrasian equilibrium
when consumer a has an endowment (4, 0) of (x, y) and consumer b has an endowment (0, 4).
Consumer a maximises xa + ln ya s.t.
Lagrangean:
FOCx :
FOCy :
CS:

L(xa , ya ) = xa + ln ya [xa + pya 4]

1 = 0, = 1
1/ya p = 0, ya = 1/p = 1/p
> 0 xa + pya = 4, xa + 1 = 4, xa = 3

Consumer b maximises xb + ln yb s.t.

Lagrangean:
FOCx :
FOCy :
CS:

xa + pya 4.

xb + pyb 4p.

L(xb , yb ) = xb + ln yb [xb + pyb 4p]

1 = 0, = 1
1/yb p = 0, yb = 1/p = 1/p
> 0 xb + pyb = 4p, xb + 1 = 4p, xb = 4p 1

Market clearing (good x):

Equilibrium:

xa + xb = 4 + 0, 3 + 4p 1 = 4, p = 1/2

p = 1/2, (xa , ya ) = (3, 2), (xb , yb ) = (1, 2)

(b) Now assume that consumer a has an endowment (0, 4) and consumer b has an
endowment (4, 0). What is the Walrasian equilibrium in this case?
Relabelling a for b and b for a:
equilibrium: p = 1/2, (xa , ya ) = (1, 2), (xb , yb ) = (3, 2)

(c) Illustrate your findings in an Edgeworth box, and clearly indicate all the Pareto
efficient allocations.

Slope of the indifference curve:

x + ln y = c 1 + (1/y)y 0 = 0 y 0 = y.

At (0, 1), for example, as indifference curve has a slope = 1 (flattish), but
bs has a slope = 3 (steep); therefore, no gains from trade.
Efficient allocations are:
xa = 4.
(xb = 4 xa , yb = 4 xb .)

ya = 2 (any x);

0 ya 2, xa = 0;

2 ya 4,

(d) Comment briefly.

With quasi-linear utility, any efficient outcome will entail the same allocation
of the non-linear good (provided initial wealth is high enough).

3. An Economy with Production I

[Exam 2012, Part A]

Consider an economy with one consumer, one firm (owned by the consumer), and two
types of good, x and y. The consumer owns the endowment of the economy, which
is 48 units of good x, and her utility function is u(x, y) = ln x + ln y. The firm can
transform good x into good y; if it uses X units of good x it produces Y = X 1/2 .
(a) Find the consumers MRS and the firms MRT.
The consumers MRS is y/x.

The firms MRT is 21 X 1/2 or 12 Y 1 .

(b) Show that an allocation in which she consumes x = 32 and y = 4 is efficient.

When 32 units of good x are consumed, the endowment of 48 is exhausted
by letting the firm use the remaining 16 to produce 4 units of good y.
In this case, MRS = 4/32 = 1/8, and MRT = 21 41 = 1/8.

(c) What relative price of good x is required for this allocation to be a competitive
equilibrium? Find the firms profits in this equilibrium, and verify that the consumers budget constraint (which includes her income from the firms profits) is
satisfied.
The price ratio must equal MRS so px /py = 1/8, say px = 1/8, py = 1.
The firm makes 4 from selling 4 units of good y but must pay 16/8 = 2 to obtain
the 16 units of good x. Its profit is therefore 2.
The consumer spends a total of 32px + 4py = 8 on the two goods.
Her income is the value of her endowment, 48px = 6, plus the firms profit, 2,
giving a total of 8.
budget constraint
xSo her PPF
BC
IC is indeed satisfied.
0
1
(d)2
3
4
5
6
The7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34

6.928
8.000
6.856
7.875
6.782 the
7.750
Illustrate
equilibrium
6.708
7.625
of the
economy.
6.633
7.500
6.557
7.375
6.481
7.250
ppf6.403
is y =7.125
(48 x)1/2 .
6.325
7.000
6.245
6.875
6.164
6.750
8
6.083
6.625
6.000
6.500
5.916
6.375
9.846
y5.831
6.250
9.143
5.745
6.125
8.533
4
5.657
6.000
8.000
5.568
5.875
7.529
5.477
5.750
7.111
5.385
5.625
6.737
5.292
5.500
6.400
0
5.196
5.375
6.095
0
16
5.099
5.250
5.818
5.000
5.125
5.565
4.899
5.000
5.333
4.796
4.875
5.120
4.690
4.750
4.923
4.583
4.625
4.741
4.472
4.500
4.571
4.359
4.375
4.414
4.243
4.250
4.267
4.123
4.125
4.129
4.000
4.000
4.000
3.873
3.875
3.879
3.742
3.750
3.765

in a diagram

32

32
0
32
4
0
4
showing
the

1
2
3
4
5
6
7
8
9
10
11
12
PPF
13
14
15
16
x
17
18
19
20
21
22
23
24
25

production possibility frontier

IC

48
endowment

64

4. An Economy with Production II

Consider an economy with a single turnip farmer endowed with one unit of time
(available for work and leisure) and a field. The farmer has preferences represented
by the utility function:
u(t, l) = ln t + ln(1 l) ,
where t is the number of turnips consumed and l is labour supplied.
There is only one industry in this economy turnip production which requires
two inputs, labour and fields. Turnips are competitively produced with a production
function:
1
1
f (L, F ) = L 2 F 2 ,
where L is the total labour used and F is the total number of fields used.
Assume that all three markets in this economy (for turnips, labour, and fields) are
competitive. Normalise the turnip price to 1. Let w be the wage, and r the fields
rental price.
(a) Argue that the farmers budget constraint may be written t w l + r.
The farmer cannot spend more on turnips (t) than he earns from selling his labour
(w l) and renting his field (r).

(b) Hence find the farmers optimal demand for turnips and supply of labour in terms
of r and w. When is labour supply positive?
The farmer chooses t 0 and l 0 to maximise
u = ln t + ln(1 l)

subject to

t wl+r.

Local non-satiation.
Lagrangean:
L = ln t + ln(1 l) + [w l + r t] .
FOCs:

L
1
L
1
= = 0,
=
+ w = 0.
t
t
l
1l
From these FOCs we have:
1
1
= =
.
t
w(1 l)
Substitute in for t = w l + r (budget line):

1
1
=
.
wl+r
w(1 l)
Re-arrange to obtain the farmers labour supply curve:
l=

wr
.
2w

For the farmers turnip demand curve, substitute l into budget line to obtain:
wr
t=w
2w


+r =

r+w
.
2

Labour supply is positive when w > r.

(c) If the industry employs inputs L and F , what are costs?

Costs are C = w L + r F .

(d) Using a Lagrangean with multiplier , solve the cost-minimisation problem and
deduce the factor demand curves for labour and fields. Interpret .
The problem is to choose L 0 and F 0 to minimise
C = wL+rF

subject to

where T is the industrys output of turnips.

L2 F 2 = T ,
Lagrangean:
1

L = w L + r F + [T L 2 F 2 ] .
FOCs:

1
1
1
1
1 1
L
L
= w L 2 F 2 = 0 ,
= r L2 F2 = 0 .
L
2
F
2
Re-arrange the first FOC for w and multiply by L to obtain:

1 T
1 1 1
w L = L2 F 2 L = 2 .
2
w
Re-arrange the second FOC for r and multiply by F to obtain:
1 T
1 1 1
r F = L2 F 2 F = 2 .
2
r
1

Substitute in for L and F into L 2 F 2 = T (production function):

12 T
w

!1

21 T
r

!1
2

=T.

Re-arrange for :
1

= 2r 2 w 2 .
Use to eliminate from expressions for L and F .
The factor demand curve for labour is:


L=

2r 2 w 2

1
2

r
= T.
w

1
2

w
= T.
r

The factor demand curve for fields is:



F =

2r 2 w 2
r

The Lagrange multiplier is the shadow price of relaxing the constraint, here the
marginal cost of producing another turnip.

(e) Remember that the supply of fields is 1. Calculate turnip supply in terms of
Using three market clearing conditions, find the Walrasian equilibrium.
With the supply of fields fixed at 1, T =

r
w

1
2

r
.
w

Market clearing: The farmers consumption of turnips must equal the endowment (0)
plus the industrys net output of turnips:
r+w
=T.
2
The farmers consumption of leisure must equal the endowment (1) plus the
industrys net output of leisure:1
!
r
wr
1
= 1 + T .
2w
w
Finally, the farmers consumption of fields must equal the endowment (1) plus
the industrys net output of fields:
!

w
0=1+ T .
r

Substituting in for T =


Hence w =

3
2

and r =

r
w

r
w

1
2

, we have two equations and two unknowns:

1
2

r+w
2

and

wr
r
= .
2w
w

.
2 3

Substitute these factor prices into the factor demands to obtain the equilibrium
allocation.
The consumption bundle is (turnips, leisure, fields) =
The production plan is (turnips, leisure, fields) =

The equilibrium price vector is (1,

1 , 2 , 0
3 3

1 , 1 , 1
3
3

3
1
2 , 2 3 ).

The industrys net output of leisure is (labour demand). For more explanation see lectures.

1.0

Budget Line

Turnips
0.8

Prod Function
0.6

Eq. Allocation
IC f armer
0.4

0.2

0.0
0.0

0.2

0.4

0.6

0.8

1.0

Labour

5. An Economy with Production III

Consider a small closed economy with two consumption goods, good 1 (meat) and
good 2 (berries). There are two types of agent, h and g, and they have the same
preferences over consumption, represented by the utility function:
u(x1 , x2 ) = ln x1 + ln x2 ,
but there are twice as many type-h agents as type-g agents.
The only factors of production are their labour: when a type-h agent chooses to spend
a fraction of his day producing meat and the rest producing berries then his output
is (y1h , y2h ) = (2, 2(1 )); a type-g agent is more productive when she chooses to
spend a fraction of her day producing meat and the rest producing berries then her
output is (y1g , y2g ) = (3, 12(1 )).
Normalise the price of one unit of berries (good 2) to 1, and let p be the price of one
unit of meat (good 1).
(a) What would the agents choose for and if p < 1?
What would the agents choose for and if p > 4?
Argue that those values of p cannot be part of an equilibrium.
The income of a type-h agent is 2 p+2(1) = 2+2(p1) and that of a type-g
agent is 3 p + 12(1 ) = 12 + 3(p 4).
If p < 1 then both types of agent would choose to produce only berries, and if
p > 4 then both types of agent would choose to produce only meat.
But with the stated preferences over consumption bundles, both meat and berries
must be produced in equilibrium.

10

Now, assume that 1 < p < 4. (Check later that these inequalities are strict.)
(b) Taking p as given, calculate what each agent will produce daily.
Imagine that the agents sell their output to the market at prices p and 1, producing income, and then decide on how much of each good they actually want to
consume, resulting in expenditure.
Calculate what each agent will demand.
Assume that 1 < p < 4.
Since p > 1, type-h agents will concentrate on hunting and produce 2 units of
meat only; since p < 4, type-g agents will concentrate on gathering and produce
12 units of berries only.
Each type-h agent will have an income of 2p, and each type-g agent will have
an income of 12. Individual demands will be:
1 2p
2 p
1 12
2 p =

xh1 =
xg1

= 1,

xh2 =

6/p,

xg2

1 2p
2 1
1 12
2 1

= p;
= 6.

(c) Remembering that there are twice as many type-h agents as type-g agents, find
the value of p that equates demand and supply in the meat market, and confirm
that 1 < p < 4.
Check that with this value of p, demand and supply are equated in the market
for berries.
Let there be n type-g agents and 2n type-h agents.
Total demand for meat is x1 = 2n xh1 + n xg1 = 2n + 6n/p.
Total supply of meat is y1 = 2n y1h + n y1g = 4n + 0.
The meat market clears when x1 = y1 , i.e. when 2n + 6n/p = 4n, so p = 3 (and
obviously 1 < 3 < 4).
Total supply of berries is y2 = 2n y2h + n y2g = 0 + 12n; total demand for berries
is x2 = 2n xh2 + n xg2 = 2np + 6n, and when p = 3 this equals total supply.

(d) Show that in this equilibrium, type-h agents each consume 1 unit of meat and 3
units of berries, whereas type-g agents each consume 2 units of meat and 6 units
of berries.
With p = 3, the demands from part (b) become xh = (1, 3), and xg = (2, 6).

The hunter-gatherers now have the possibility of opening up their economy to free
trade. In world markets, 1 unit of meat can be exchanged for 2 units of berries, and
the country would be a price-taker.
(e) Using world prices, calculate what each agent would produce daily. By considering
whether each type of agent would become better or worse off, what do you think
11

would be the likely outcome of a referendum on whether or not to open up the

economy?
If the hunter-gatherers open up their economy to free trade, they would use the
world prices of p = 2 for meat and 1 for berries.
As p > 1, hunters would continue to concentrate on hunting but they would be
worse off since the relative price of meat would fall.
As p < 4, gatherers would continue to concentrate on gathering and they would
be better off since the relative price of berries would rise.
Since there are twice as many hunters as gatherers, you might conclude that
the outcome of a referendum would be to reject opening up the economy.
(*) In the closed economy, ug = ln 2 + ln 6 = ln 12, and uh = ln 1 + ln 3 = ln 3.
When p = p, each gatherer could use 2 units of her berries to bribe two hunters
with 1 unit of berries each. She would then have an income of 10 (from her
remaining berries) and demand xg = (2 21 , 5), resulting in ug = ln 12 12 > ln 12. In
turn, each hunter would have an income of 4 (from his meat production) + 1
(from the bribe) and demand xh = (1 14 , 2 12 ), resulting in uh = ln 3 81 > ln 3. So
both types of agent would be made better off by voting to open up the economy,
and subsequently engaging in bribery.

6. The Specific Factors and Ricardian Trade Models

Consider an economy which is endowed with L units of a single factor of production,
labour, and can produce two goods with production functions y1 = a1 L1 , and y2 =
a2 L2 . Derive the economys production possibility frontier. Derive the supply curves
for goods 1 and 2 as a function of the goods price ratio, p1 /p2 . What is the autarky
goods price ratio?
This country can trade with another with endowment L and technology y1 = a1 L1 ,
and y2 = a2 L2 . For what configuration of parameters a1 , a2 , a1 , and a2 does country 1
export good 1? Interpret your result.
Supply curve for good 1 - see diagram below.
Autarky goods price ratio: (p1 /p2 )Aut = a2 /a1 .
Country 1 will export good 1 if the relative price of good 1 is lower under autarky,
i.e. if a2 /a1 < a2 /a1 .

12

y1

a1 L

p1/p2
a2/a1

What is the world supply curve of good 1, and what determines the world equilibrium
goods price ratio?
See diagram. Equilibrium price (and pattern of specialisation) depends on the level
of demand for good 1. Three alternative demand curves are shown; the price ratio
is bounded between the autarky price ratios.
y1

a1L+a1 L*

a1L

p1/p2
*
*
a2 /a1

a2/a1

13

7. Specific Factors Model

A small open economy produces two goods, 1 and 2, at output levels yi , i = 1, 2.
Output prices are set on world markets and denoted p1 , p2 . The economy is endowed
with quantities L of labour and K of capital. Capital is used in sector 2 only, and
labour is used in both sectors, Li denoting the use of labour in sector i = 1, 2. The
wage rate and the capital rental rate are w and r. The production function for good
1 is y1 = L1 , and good 2 has production function y2 = K 1 L2 , 0 < < 1.
(a) What is the value marginal product of labour in each sector? What is the equilibrium wage rate?
Sector 1:

V M P L1 = p1 .

Sector 2:

V M P L2 = p2

K
L2

1

Wage w = p1

(b) What is the equilibrium allocation of labour between sectors (expressed as a

function of goods prices and endowments)?
w = p1 = p2

K
L2

1

L2 = K


p2 1/(1)
p1

(c) Derive the economys supply curves of each good. What is the effect of a change
in endowments on production of each good?
y2 = K


p2 /(1)
,
p1

y1 = L K


p2 1/(1)
p1

(d) If there is a second economy, identical in all respects except endowments, what is
the pattern of trade between these economies?
Directly from (iii)

(e) What is the effect of an increase in p1 on wages, nominal and real? On the return
to capital? What is the effect of a decrease in p2 on real factor prices?
Equiproportionate, dw/w = dp/p, so (weakly) better off regardless of
1/(1)

/(1)

consumption bundle. r = (1 )p2

-- increases more than
p1
proportionately with p2 , decreases with p1 . Change in p2 is trick question;
only relative prices matter for real changes.

(f) Express the value of total output and the total value of factor incomes as functions
of goods prices and endowments. Comment on your results.
They are the same:

1/(1)

GN P = GN I = p1 L + (1 )Kp2

p1

/(1)

(g) Comment on the relationship of this model with (a) the Heckscher-Ohlin model
of trade and (b) the specific-factors model.
Borderline between the two models. Both factors are freely mobile as in HO but
one sector happens not to use any. It is therefore as if capital is specific
to sector 2. Rybczynski theorem applies -- but without amplification.

14

8. The 2 2 Production Model and the 2 2 2 Trade Model

Country A has two industries, each employing capital and labour to produce output,
with constant-returns-to-scale production functions:
1/3

2/3

2/3

y 1 = K1 L 1

1/3

y2 = K2 L2

Factor and product markets are competitive; the prices of the two products are p1 and
p2 , and the prices of labour and capital are w and r.
(a) By solving the cost minimisation problem for a firm in industry 1 producing an
amount of output y1 , show that:
K1
L1

the optimal capital-labour ratio in industry 1 is:

and the marginal cost of y1 is:
K2
L2

and hence similarly:

2w
,
r

M C1 =

M C2 =

w
2/3

w
1/3

2/3 

1/3 

r
1/3

r
2/3

w
2r
1/3

2/3

Which good is more labour intensive?

The FOCs for the cost minimisation problem with production function y = K a L1a
are:
 1a
 a
L
K
r = a
and w = (1 a)
K
L
where is the Lagrange multiplier on the output constraint.
Taking the ratio of these we obtain

w
r

1a
a

K
L,

and substituting a = 1/3 and

a = 2/3 gives the optimal capital-labour ratios in the two industries:

K2
w
2w
2r and L2 = r .

K1
L1

Substituting the optimal K/L back into one of the FOCs and solving for gives
the marginal costs:
Hence M C1 =

w
2/3

MC =

2/3 

r
1/3

1/3

w
1a

1a

r a
a .

and M C2 =

w
1/3

1/3 

r
2/3

2/3

Good 1 is more labour intensive -- it has a lower capital-labour ratio for given
w and r.

(b) The country has an endowment of 160 units of capital, and 200 units of labour.
Use the optimal capital-labour ratios above to determine how much capital and
labour will be used in each industry, as functions of the factor price ratio. Illustrate the factor market equilibrium in an Edgeworth box for the case when
w/r = 1. How would the output of the two industries change if the endowment
of labour decreased?
The resource constraints are K1 + K2 = 160 and L1 + L2 = 200;
these can be combined with the K/L ratios above:
eliminating K1 and K2 : 12 wr L1 + 2 wr L2 = 160;
eliminating L2 : wr L21 + wr 2(200 L1 ) = 160;




L1 = 23 400 160 wr , L2 = 23 160 wr 100 ;




and K1 = 13 400 wr 160 , K2 = 34 160 100 wr .

15

When w/r = 1:

L1 = 160, L2 = 40, K1 = K2 = 80.

In the Edgeworth box with K and L on the vertical and horizontal axes
respectively, and industry 1 at the bottom left, the equilibrium occurs at the
intersection of the two lines representing the optimal K/L ratios. When the
endowment of labour decreases the right hand edge of the box moves to the left;
the equilibrium has lower output of good 1 (less of both factors employed), and
higher output of good 2 (more of both factors). This is the standard Rybczynski
diagram (see lectures).

(c) Use the conditions that price equals marginal cost in both industries to show
that there is a one-to-one relationship between relative factor prices and relative
product prices:
!3
w
p1
=
.
r
p2
How does the wage change if demand for product 1 increases? Explain this result
intuitively.
Taking the ratio of the expressions for marginal costs:
p1
M C1
=
=
p2
M C2

w
r

1/3

=
r

p1
p2

3

The relative wage rises if the demand for product 1 increases. An increase in
relative demand for product 1 raises the demand for the factor used intensively
in its production.

(d) How do your results relate to the Stolper-Samuelson and Rybczynski Theorems?
(c) is Stolper-Samuelson; (b) is Rybczynski.

There is a second country, B, identical to A except that it has a smaller endowment

of labour. Consumers in the two countries have identical preferences: the relative
demand for the two goods, yy21 , is a function only of the relative prices, pp12 .
(e) Initially both countries are both in autarkic (no trade) equilibrium. Suppose
that product prices in country A (determined by consumer demand) are equal:
p1 /p2 = 1. What can you say about relative product prices and relative factor
prices in country B?
Suppose p1 /p2 = 1 in country B as well. The countries have the same relative
demand for good 1. But from (c), w/r = 1 in both countries, and from (b), since
country B has a lower endowment of labour, its relative supply of good 1 would
be lower. So the relative price of good 1 must rise in country B: in autarkic
equilibrium p1 /p2 > 1 in country B.

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(f) Now suppose that the countries can trade freely with each other. Describe what
happens to relative product and factor prices in the two countries. Which goods
will be imported and exported by country A? What happens in country A to
employment and output in the two industries?
In a free-trade equilibrium the relative price must be the same in the two
countries; so it rises in country A and falls in country B. Country A moves both
labour and capital into industry 1, but the demand for labour increases more than
the demand for capital. The relative factor price w/r rises. Country A produces
more of good 1, and exports some of it; it imports good 2. In Country B the
opposite happens. The relative factor price is equalised across the two countries
(from (c)). A ppf diagram could be used to illustrate.

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