ECO2300H1 PS1

ECO2300H1F Problem Set 1

1) In terms of productivity, Ti represents the state of technology in country i and
describes the absolute advantage across the continuum of goods that it produces.
Note that a high Ti does not mean that a country will have the lowest unit cost in
all goods, but rather it implies higher average draws.
On the other hand, regulates heterogeneity across goods in countries relative efficiencies, and is therefore a measure of comparative advantage. Overall,
dictates the degree of randomness in the draws, where a higher implies a lower
dispersion of draws. Also (because the distribution is skewed to the right) a higher
does slightly increase the value of the average draw.

2) ci is the input cost in country i. Thus,

ci
zi (j)

is the cost of producing good j in

country i. By including the iceberg costs, we get the following expression for price:

pni (j) =

 c 
i
dni
zi (j)

(1)

3) Rearranging equation (1) and suppressing the index of goods j, gives zi =

ci dni p1
ni . Now from the Frechet distribution, we have that

Fi (zi ) = P r[Zi z] = eTi zi

The distribution of prices that country i offers country n is given by Gni (p) =
P r[Pni p] = 1 Fi (zi ). By using our expression for Fi (zi ) and substituting in
our expression for zi , it gives the following:

Gni (p) = 1 eTi zi

= 1 e[Ti (ci dni )

]p

(2)

4) Gni (p) is the distribution of prices that country i presents to country n. Gn (p)
is the CDF of prices of goods that consumers in n actually buy. This means that,
Gn (p) = P r[Pn p]. As the lowest price in a country n will be less than p in

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all cases except for when all countries charge more than p, then it means we can
rewrite Gn (p) as 1 where is the joint probability that all countries i charge a
price greater than p. By definition, Gni (p) is the probability that country i charges
a price less than p, and so 1 Gni (p) is the probability that country i charges a
N
Q
price greater than p. By independence, this means that
[1 Gni (p)] = . Thus,
i=1

we can rewrite Gn (p) as follows:

Gn (p) = 1

N
Y

[1 Gni (p)]

(3)

i=1

By substituting in the formula for Gni (p) from equation (2) it gives equation (4).
Gn (p) = 1 en p

(4)

where
n

N
X

Ti (ci dni )

(5)

i=1

5) From question 4, we defined n by equation (5), which was as follows:

N
X

Ti (ci dni )

i=1

This has four components. The summation means that we are summing across all
countries of the world (1 through to N ).
1) is the same as in question 1 and is discussed there.
2) Ti is the same as in question 1 and states the technology of different countries i.
3) ci was first discussed in question 2 and it is the input cost in country i.
4) dni is the iceberg transportation cost (which arises due to geographic barriers)
of delivering a unit of a good from i to n; these costs can be thought of as losing a
certain percentage of each good transported. The only reason countries face different prices is due to different iceberg costs. Note that when dni = 1 then there are
no transportation costs.

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6) The probability that country i is the supplier of a given good j to country n can
be written as

Z
ni = P r[Pni (j) min{Pns (j); s 6= i}] =
0

[1 Gns (p)]dGni (p)

(6)

s6=i

By differentiating equation (2) with respect to p we get the following:

dGni (p)
= Ti (ci dni ) e[Ti (ci dni ) ]p
dp

(7)

Notice that Gni (p) is bounded above by 1 and that Gni (p) 1 when p .
Further, Gni (p) 0 when p 0. Now by integration by substitution, equation
(6) becomes

Z
ni =
0

]p

N
Y

e[Ts (cs dns )

Ti (ci dni ) e[Ti (ci dni )

]p

dp

(8)

s6=i

Simplifying,
ni = Ti (ci dni )

= Ti (ci dni )

e[Ti (ci dni )

]p

dp

i=1

en p dp

7) We are given Pn1 =

R
0

Ti (ci dni )
n

(9)

p1 gn (p)dp. Also, Gn (p) =

gn (p) which means by

differentiating equation (4) with respect to p we get that

gn (p) =

dGn (p)
= p1 (n )en p
dp

(10)

Thus, by substituting equation (10) into our price index and simplifying we get
that
Pn1 =

p1 p1 (n )en p dp

ECO2300H1 PS1

p en p dp

= n

(11)

Now define t = n p so when we differentiate with respect to p we get that

dt
= n p1 n p1 dp = dt
dp

(12)

Furthermore, t = n p implies that

1

p = t n

(13)

Rearranging equation (11) gives

Z

n p1 p()(1) en p dp

(14)

By substituting equation (12) and (13) into (14) it gives

Pn1 =

[t n ]1 en tn dt

0
1

= n

et dt

(15)

Finally, rearranging this gives our final equation of

1
1

Pn1 = n

tx et dt

where
x=

8) Taking the (natural) logs of equation (9) we get the following:

 T (c d ) 
i i ni
ln(ni ) = ln
n

(16)

ECO2300H1 PS1

= ln(Ti c
]
i ) ln(n ) + ln[(dni )

= i + n ln(dni )

(17)

i = ln(Ti c
i )

(18)

N
X

n = ln
Ti0 (ci0 dni0 )

(19)

where

and
i0 =1

9) To try and proxy iceberg costs, the distance that the goods need to travel will
be used. In terms of the model this gives dni = dist
ni where is the elasticity of
trade costs with respect to distance. As a result, equation (9) is now written as
follows:
ni =

Ti c
i distni
n

(20)

By taking the logs to recover the gravity model

ln(ni ) =

 T c dist 
i i
ni
n

= ln(Ti c
i ) ln(n ) + ln[distni ]

= i + n ln(distni )

(21)

i = ln(Ti c
i )

(22)

n = ln(n )

(23)

where

and

Thus the estimated coefficient when we estimate by the gravity model will be
and this is not the elasticity of transport cost with respect to distance. Overall, we
can make the following three remarks.

ECO2300H1 PS1

1) is the elasticity of the proportion of goods that consumers in i endogenously

choose to purchase from n with respect to distance.
2) is the elasticity of the proportion of goods that consumers in i endogenously
choose to purchase from n with respect to trade costs.
3) is elasticity of trade costs with respect to distance.

In summary, the elasticity between distance and the proportion of goods that consumers in i endogenously choose to purchase from n is the composite parameter
which is the estimated coefficient on distance. Likewise, we interpret the estimated
coefficient on distance as the composite parameter . It is a reduced form combination of the elasticity of trade costs with respect to distance and the dispersion
of technology . Even if a percentage change in physical distance is large a small
will significantly decrease these effects due to countries having relatively the same
dispersion of technology and less opportunities for comparative advantage. This
parameter has remained close to constant over time, but this could be due to a
falling and a rising .

10) The exporter fixed effect tells us the sources competitiveness. It is a measure
of the state of technology in the source country, the input costs in the source country, and the heterogeneity across goods in countries relative efficiencies. If the state
of technology increases, the input costs decrease or the heterogeneity across goods
in countries relative efficiencies increases then the exporter fixed effects will increase.

11) See the .do file (Appendix) for the steps that were taken to set up the regression
and then run it. The value of the coefficient of distance is 1.662219 and if = 4
then the implied partial elasticity of transport costs with respect to distance is
1.662219/4 = 0.41555.
12) Again see the appendix for the .do file. The correlation of wi with Ti is 0.3753
and the correlation of ln(wi ) and ln(Ti ) is 0.9761. Therefore, current wages and
current technology parameter are only moderately correlated with each other, but

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changes in wages and changes in the technology parameter are highly correlated
with each other. This is illustrated in Figure 1.

Figure 1: Correlation between Wages and Productivity

13) The correlation of Ti with total factor productivity is 0.4240. The calculated
correlation is an estimate of the true value. This correlation is moderately strong
and this correlation is most likely biased downwards due to the Hall and Jones
paper being made 8 years prior. Countries state of technology could have changed
relative to the US during that time and this would weaken the correlation between
our data and their data. There also appears to be some outliers that are weakening
the correlation between our variables. This is illustrated in Figure 2.

ECO2300H1 PS1

Figure 2: Correlation between Ti and T F P (A)