Terms of Trade Cheat Sheet

Terms of Trade Cheat Sheet

Terms of Trade (Absolute & Comparative Advantage)

Terms of Trade (Macro)

(Absolute & Comparative Advantage)

(This is an output problem therefore cross multiply (Over).

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

If we look at the chart above we see that John can produce 200 donuts and Erica can produce 150. Therefore John has an absolute advantage in the production of donuts.

(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.

(Equal Amounts of Resources = Output/Over Problem)

(If they give you a graph draw a chart, if you get a chart draw a graph)

Make a chart and cross multiply (over)

(A) Calculate the opportunity cost of a bicycle in Artland.

Look at the chart - Understand that you only make two goods, so your opportunity cost is what you give up of the other good. In this instance the opportunity cost of a bicycle is how many hats you give up for one bicycle.

Art land gives up 2 hats for 1 bicycle.

(B) If the two countries specialise and trade which country will import bicycles. Explain.

OK, so this is the college board trying to be very tricky. 

If Art should produce Bicycles as it only gives up 2 hats for each bicycle it makes then Art should produce Bicycles and import hats.

Since, Ray will produce hats as its opportunity cost is lowest for bicycles, it will import bicycles.

(C) If the term of trade are 5 hats for 1 bicycle, would trade be advantage for

 (i) Artland

(ii) Rayland

Understand what is happening - Artland is making bicycles and Rayland is making hats, if the terms of trade are 5 hats for 1 bicycle and Artland is making bicycles then they would give up one bike and get 5 hats. Pretty Good!!! - - - But, Rayland is making hats and the terms are trade are 5 hats for 1 bicycle - right now Rayland can give up 4 hats to get a bicycle. If they accept these terms of trade they will be giving up 1 extra hat for a bicycle.

(D) If production in Artland triples, which country has the comparative advantage in hats?

If the production capabilities triple in one country for both goods then the ratios remain the same

300/1200 = .25 or

900/3600 = .25

(Using Equal Amounts of Resources = Output/Over Problem)

Take a moment to see what is going on.
The coloured circles show who has the lowest opportunity cost in that column.

Understand that the opportunity cost of having something is the good being given up.

So, to have 1 unit of cloth an amount of food must be given up

to have 1 unit of food an amount of good must be given up

(A) 

(i) Calculate the opportunity cost of producing a unit of cloth in Newland.

Understand that the opportunity cost of 1 unit of cloth is the mount of food that must be given up.

2/10 = .2 or 20% or 1/5

In essence, Newline must give up producing 1/5 of a unit of food to produce 1 unit of cloth

(ii) Calculate the opportunity cost of producing a unit of food in Beeline.

1/10 = .1 or 10% or 1/10

Beeline, to produce 1 unit of food must give up 10 units of cloth.

(B) 

(i) Which nation has the comparative advantage in cloth production.

Do the cross multiplying (over) and then evaluate in the cloth column who has the lowest opportunity cost. In essence, who will give up less resources in producing this good.

Beeland only gives up .1 or 1/10th of a unit of food to create (1) unit of cloth

(ii) Which nation has the comparative advantage in food production.

Cross multiply, and then look at the food column and see who has the lowest opportunity cost. Who can produce a unit of food and give up the least resources.

Newland,  only gives up (5) units of cloth to produce (1) unit of food.

(C) Now assume that the productivity of Beeland's workers triple (for each good).

(i) Which country has the comparative advantage in food production? (ii) Explain.

(Have Equal Amounts of Resources = Output/over)

(IF they give you a graph, make a chart)

(A) Which country has an absolute advantage in the production of tractors? Explain.

You must know what an absolute advantage is...

Since, using the same amount of resources tells us that this is an output problem 

(inputs are fixed and the output is variable)

Each country uses the same resources, who produces more has absolute advantage

Tractors - Xanadu using the same resources has an output (production) of 40 > 10

(B) Which country has a comparative advantage in the production of cars? Using the concept of opportunity cost. Explain.

(To get comparative advantage you must compare, do the math)

(C) If the two countries specialise and trade with each other, which country will import cars? Explain.

Understand, that if Atlantis has the comparative advantage in producing cars so it will produce cars domestically.

Xanadu has the comparative advantage in producing tractors, so it will produce tractors and import cars.

(D) If the terms of trade are one car for one tractor, explain how Atlantis will benefit.

I'm Atlantis and I have 3 cars but I want a tractor. Jed comes up to me and says he has a tractor to sell but its gonna cost me 3 cars. Now Jung Sub shows up and he has a tractor to sell me and he only wants 1 car. By trading with Jung Sub instead of Jed I've gained/not lost 2 cars.

I'm Xanadu, I have tractors and I want to purchase a car. Chris offers to sell me a car but she wants 2 tractors. (Don't be a bitch Chris!) Instead, Jamie comes along and offers me a car for only 1 tractor. I win and save myself the cost of 1 tractor by trading with Jamie.

(Using Equal Amounts of Resources = Output/over)

(A) Which country has an absolute advantage in the production of machines? Explain.

Look at the graph, using equal resources Luna can produce 40 machines to Ashna's 10. (40>10)

 (B) Which country has an absolute advantage in the production of food? Explain.

Look at the graph, using equal resources, Luna can produce 40 units of food to Ashna's 30.

(C) Which country has a comparative advantage in the production of machines? Explain.

To find comparative advantage you must compare, do the math with a chart.

(D) With trade between these two countries which will import food. Explain.

Looking at the chart we see that Luna has the lowest opportunity cost in making machines and therefore should make machines. Therefore if Luna is making machines they must be importing food.

(Understand that turning this around might be closer to what they want but I'd be willing to bet they would accept any explanation as long as it is correct.)

(E) Give an example of a terms of trade acceptable to both countries.

2012 Macro Multiple Choice (Balance of Payments)

2012 Macro Multiple Choice (Balance of Payments)

Cheat Sheet here.

Answer - (B)

Surplus = Exports > Imports