Unit 7 Review
1.
Use the following production possibilities schedule to answer parts (a) – (d).
East Production Possibilities
A
B C D
Bananas 24 16 8 0
Apples
0
4 8 12
West Production Possibilities
A
B C D
Bananas 45 30 15 0
Apples
0
5 10 15
(a) Who has the absolute advantage in the production of apples? Bananas?
West has the absolute advantage in both apples (15 > 12) and bananas (45 > 24)
(b) Who has the comparative advantage in the production of apples? Bananas?
East has the comparative advantage in apples (2 B vs. 3 B) and West has the comparative advantage in bananas
(1/3 A vs. 1/2 A).
(c) Who would export apples?
East would export apples because they hold the comparative advantage and thus should produce apples.
(d) What are the trade terms for 1 apple and for 1 banana?
East For a fair trade to take place, the terms of the trade for 1 apple should fall between the opportunity costs of
producing 1 apple - 1 apple for 2 to 3 bananas
Conversely, the terms of trade for 1 banana would be 1/3 to 1/2 apples
(e) If the trade terms were 1 apple for 1.5 bananas, would this be fair trade for both countries? Explain.
The optimal trade range for 1 banana is 1/3 - 1/2 apples while the optimal trade range for 1 apple is 2- 3 bananas.
This trade involves 1 apple and thus between 2 and 3 bananas should be given up for it to be fair. Because West
(the producers of bananas) is giving less than they are supposed to, they benefit while East is hurt by the trade
(receiving too few bananas for their apple.
2.
How does the law of comparative advantage increase global standard of living?
If nations specialize, they can more efficiently use their resources to maximize production. The law of comparative
advantage states that these countries should then trade for the other product which they are no longer producing.
This will benefit all participating countries because total output will increase and they will also have access to
products that otherwise might not have been unavailable to them.
3.
Explain the concept of outsourcing and what trade policy most typically creates the condition.
Outsourcing involves hiring labor and production outside of the country. Free trade policies support this because
businesses may find it cheaper to hire labor overseas and then ship the products back to the U.S. at a low cost due
to low (or no) tariffs. Protectionists use outsourcing as a chief criticism of free trade.
4.
The World Cup is hosted in Brazil. What effect will this have on the values of the U.S. dollar (USD) and the Brazilian real (BRL)?
BRL appreciates
5.
USD depreciates
Assume that the real interest rate in both the U.S. and the European Union equals 4.5%. Now assume that the real interest rate
in the U.S. falls to 3.75%. What effect will this have on the value of the USD and the EUR?
Financial investors will save their money in
countries with the lowest interest rates.
EUR appreciates
6.
USD depreciates
If the U.S. dollar depreciates relative to other countries, does the balance of trade move towards a deficit or a surplus? Explain.
A weaker USD means that foreigners will view U.S. products as comparatively cheaper. Thus U.S. exports will
begin to rise as foreigners buy more American goods. Exports are a credit (money flowing into the U.S.) to the U.S.
current account and thus a surplus will result.