Quiz 37: Current Issues in Macro Theory and Policy

Business

(a) We are given the following information on the opportunity cost of producing baby formula and tuna fish for two countries: img Note that to find the opportunity cost of producing one can of tuna fish, we simply need to ask ourselves "How many can of baby formula must the country give up to produce one can of tuna " With that said, each country to specialize in the product that they have a lower opportunity cost in producing. This is what is meant by specialization through comparative advantage. We see that Country 1 has a lower opportunity cost in producing baby formula, since they only have to give uP2 cans of tuna to make 1 can of baby formula (compared with having to give up 4 cans of tuna for Country 2). Therefore, Country 1 should specialize in baby formula. Country 2, on the other hand, should specialize in tuna fish because they have a lower opportunity cost of producing one can of tuna fish than Country 1 does. For a term of trade to be acceptable to both nations, it needs to be between the minimum and maximum price of each good. The minimum price of a good is simply the smaller opportunity cost, and the maximum price of a good is simply the larger opportunity cost. For example, with baby formula, the minimum price iS2 cans of tuna and the maximum price if 4 cans of tuna, and for tuna fish, the minimum price is img cans of tuna and the maximum price is img cans of tuna. We see then that if the terms of trade are 1 can of baby formula for 2.5 cans of tuna fish, then that price for a baby formula is within the minimum and maximum price for baby formula, which are 2 and 4 cans of tuna, respectively. Therefore, both countries will be okay with this price. (b) We see that 1 can of baby formula for 1 can of tuna fish is outside of the 2 to 4 cans of tuna price range for baby formula. Therefore, this will not be a terms of trade that is acceptable. To see why, note that for Country 1, who is specializing in baby formula, is giving uP2 cans of tuna fish in producing one can of baby formula. Therefore, without any trade, the cost of producing one can of baby formula iS2 cans of tuna fish. Note that Country 1 will not want to trade if they can do better without trading. If Country 2 is asking Country 1 to give them one can of baby formula for 1 can of tuna, Country 1 actually does better if they didn't trade, since the cost of producing one can of baby formula iS2 cans of tuna fish, and if they traded, they will only get 1 can of tuna fish for something that they gave uP2 cans of tuna fish for. (c) We see that 1 can of baby formula for 5 can of tuna fish is outside of the 2 to 4 cans of tuna price range for baby formula. Therefore, this will not be a terms of trade that is acceptable. To see why, note that for Country 2, who is specializing in tuna fish, is then only getting img cans of baby formula for every can of tuna fish they trade. However, it cost Country 2 img cans of baby formula to make one can of tuna fish. Therefore, they will not gain in trading, and they will not accept the terms of trade.

Quantitatively, the importance of trade to the United States is more than it is to any other countries. The U.S. has the highest combined volume of exports and imports. It also is third in value of exports traded, after China and Germany. The United States' most important trading partner, in terms of numbers, is Canada. Almost 20 percent of exported goods from the U.S. were to Canada in 2009, anD15 percent of imported goods came from Canada that year as well. The U.S. has the largest trade deficit with China. A trade deficit occurs when the value of imports exceed the value of exports. In 2009, the U.S. had a $220 billion trade deficit with China.

Without trade, countries are forced to consume whatever they produce. When trade is allowed, countries have opportunities to increase their consumption more than what they are able to produce under autarky. In this way, there are gains from trade when it is free and is based on specialization of activities. In the given case, there are two regions, region U and region B , that have an opportunity to trade wheat and coffee with each other. When they trade using their respective comparative advantages, they ensure increased consumption possibilities. img This is shown in Figure 1. The two regions have given production possibilities curves (production possibilities frontier or PPF ). The trading possibilities line extends outside to their production possibilities curve suggesting that trade has increased their available consumption bundles. Now both regions have straight line production possibilities curves implying a constant slope. The slope of a production possibilities curve is the opportunity cost of producing one good in terms of the other. This opportunity cost is the amount of one good not produced or sacrificed when one more unit of the other is produced. Since, the slopes are constant, it suggests that the opportunity costs are also constant. Hence, img is correct.

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