**Terms of Trade**

**(Absolute & Comparative Advantage)**

**(A) Who has the absolute advantage in producing donuts? Explain.**

**(B) Who has the comparative advantage in producing donuts? Explain.**

John can either produce 200 donuts or 100 cupcakes. If he makes 200 donuts he gives up 100 cupcakes (100/200 = .5 or 1/2). Said in a different way, for every donut John makes he gives up 1/2 of a cupcake or for every cupcake he makes he gives up 2 donuts. (200/100 = 2)

Erica, on the other hand, can either make 150 donuts or 50 cupcakes. If she makes 150 donuts she gives up 50 cupcakes (50/150 = .333... or 1/3). Said in a different way, for every donut Erica makes she gives up a 1/3 of a cupcake or for every cupcake she makes she gives up 3 donuts. (150/50 = 3)

As Erica's opportunity cost of producing 1 donut is 1/3 of a cupcake, which is less than John's opportunity cost which is 1/2 of a cupcake for every donut he makes.

**Erica gives up less cupcakes by producing donuts than John does. She is more efficient.**

Remember that

**comparative advantage**is about who gives up less than the other person, as**lower opportunity cost is the key.**

**(C) Assume that John and Erica decide to specialise according to their comparative advantages and that one cupcake is exchanged for four donuts.**

If John and Erica specialise then Erica would make the donuts and John would make cupcakes.

**(i) Indicate wether or not specialisation and trade would be beneficial to John.**

Before specialisation John could make a cupcake or two donuts, said another way, if John makes two donuts he gives up a cupcake. After trade and specialisation John can trade a cupcake for 4 donuts. He would be better off.

**(ii**

**) Indicate wether or not specialisation and trade would be beneficial to Erica.**

Before specialisation Erica could make a donut and give up 1/3 of a cupcake. Said another way, Erica could make a cupcake and give up 3 donuts. After trade and specialisation Erica would have to give up 4 donuts for 1 cupcake.

**This would not be beneficial for Erica.**

**(D) Assume that Erica discovers a new cupcake production technique that will increase her daily production of cupcakes only. Using donuts on the horizontal axis, draw a correctly labeled production possibility curve for Erica, before and after the technology change in cupcake production.**

Understand, that Erica's production of donuts will not increase but her ability to produce more cupcakes with the same resources will increase.