ECON1131 Study Guide - Midterm Guide: Economic Surplus, Demand Curve, Efficient-Market Hypothesis

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17 Feb 2017

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Production possibility frontier: the line on a graph that depicts the maximum productivity for two objects without one decreasing the efficiency of the other. Efficiency in production: not being able to produce any more of one object without producing less of the other. Comparative advantage: having a lower opportunity cost. If one country has a comparative advantage in something the other country has the advantage in the other. Absolute advantage: ability to generally produce more of a product or total output with the same resources. Efficiency in allocation: distributing the right products to the right places. Trade advantage: since countries have different comparative advantages trade is always beneficial so that countries can specialize and make more money. Circular flow model: major exchanges are shown as the flow of money, goods and services between different economic participants. Meant to illustrate how one participant"s spending impacts another"s.

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Discuss and explain the difference between the two.

The principle upon which Adam Smith first claimed that free trade benefits all countries. It holds that a country benefits from trade when it produces a particular good at a lower cost (in terms of labor input) than it costs to produce the good in any other country. By specializing the in the production and export of this good and importing goods whose production costs are higher than in other countries, the country can consume more of both goods. In trade theories, this principle was later replaced by the principle of comparative advantages.

Comparative Advantage is first fully stated by David Ricardo in the early nineteenth century, this concept holds that a country has a comparative advantage in a good if it can produce that good more cheaply than it can produce other goods. By specializing in the production of goods in which it holds a comparative advantage and importing the other goods, the country can consume more of all goods. In contrast to Adam Smith, therefore, this principle states that a country need not have an absolute advantage in any good to benefit from trade. The principle provides a powerful justification for liberal international trade by asserting that all countries benefit from such trade.

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The law of comparative advantage states that:

a. each country should specialize in producing the good with the lowest opportunity cost.

b. a country that is able to produce something using fewer resources than other countries would gain from specialization and trade.

c. international trade barriers slow the introduction of new goods and better technologies.

d. countries can gain from trade if production is subject to economies of scale.

e. countries must agree on how much of one good exchanges for another.

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Q2. (35 points) The following table shows the output of textile and auto one unit of labor can produce in the U.K. and the U.S.:

	Textiles	Autos
United Kingdom	16	4
United States	6	3

A)Which country has an absolute advantage in textiles and which country has an absolute advantage in autos?

B)What is the autarky price ratio of autos relative to textiles in each country?

C)Which country has a comparative advantage in textiles and which country has a comparative advantage in autos?

D)Which product should each country export?

E)Suppose the United States has 300 units of labor available. Construct the production-possibilities frontier (PPF) and identify the optimal autarky equilibrium (using an indifference curve) for the United States.

F)Suppose the international price is set at 1 auto:3 units of textile and the U.S. decides to completely specialize at producing the product in which it has a comparative advantage. How would the above graph change? Use the graph to show the gains from trade and the export and import quantities. For each unit of export good, how much does the U.S. gain (measured in terms of the other good)?

G)Discussion: At what level of international price ratio will all the benefits from trade accrue to the United States?

Your answer:

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ECON1131 Study Guide - Midterm Guide: Economic Surplus, Demand Curve, Efficient-Market Hypothesis

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