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| Graphing Exercise: Comparative Advantage Why do nations trade? The principle of comparative advantage can help to explain how countries with different endowments of resources can, through specialization and exchange, enhance the economic conditions of their residents. If each country specializes in the production of the good in which it has a comparative advantage, trade will allow each country to consume greater amounts of all goods than would be possible without trade. Exploration: How can specialization and exchange improve the economic welfare of a country? Click here to view an interactive exercise. This will open a new browser window. Then answer the questions below. This exercise is from the website for Begg and Ward Economics for Business. If you have clicked on the link above and cannot see the interactive exercise, you may need to install a free Java plugin for you internet browser. Click here for the plugin. The graph shows the production possibilities for the United States and Brazil for two goods, coffee and wheat. The straight-line production possibilities curves (red for the U.S., blue for Brazil) assume that there are constant opportunity costs of production for the two goods, although these costs differ in the two countries. The different endowments of the two countries are also reflected in the graph: The U.S. can produce more total wheat than can Brazil while Brazil can produce more coffee. Prior to any trade, each country has opted to use half of their resources to produce each of the goods. Any gains from trade reported in the table are relative to these initial levels of production and consumption. To use the graph, click on any of the bold entries in the table and change their values. Entries in the first column determine how much specialization a country will undertake in coffee. Entries in the second column will automatically adjust to determine the production of wheat possible with that degree of specialization. Click on the amount of U.S. exports desired, either wheat or coffee. The terms of trade will determine the amount exchanged with Brazil. The terms of trade, shown by the green line on each graph, are initially set at 2 units of wheat for 2 units of coffee. To change the terms of trade, click on either of the boxes at the bottom of the graph and enter a new value. Clicking on the Opp. Costs box will reveal the domestic opportunity costs faced by each country; Reset will reset all values to their initial levels. 1. Which country is the lower opportunity cost producer of coffee? AnswerOpportunity costs are constant in this example, as illustrated by the straight-line production possibilities curves for each country. In the U.S., increasing coffee production from its current level of 80 units to a maximum 160 would cause wheat production to fall from its current level of 120 to zero. In other words, 80 additional units of coffee would cost 120 units of wheat; each unit of coffee costs 1½ units of wheat. In Brazil, increasing coffee production from its current level of 160 units to a maximum 320 would cause wheat production to fall from its current level of 40 to zero. In other words, 160 additional units of coffee would cost 40 units of wheat; each unit of coffee costs ¼ units of wheat. Verify this by clicking on the Opp. Cost button. Brazil is the lower opportunity cost producer of coffee. 2. Which country is the lower opportunity cost producer of wheat? AnswerIn the U.S., increasing wheat production from its current level of 120 units to a maximum 240 would cause coffee production to fall from its current level of 80 to zero. In other words, 120 additional units of wheat would cost 80 units of coffee; each unit of wheat costs 2/3 units of coffee. In Brazil, increasing wheat production from its current level of 40 units to a maximum 80 would cause coffee production to fall from its current level of 160 to zero. In other words, 400 additional units of wheat would cost 160 units of coffee; each unit of wheat costs 4 units of coffee. Verify this by clicking on the Opp. Cost button. The United States is the lower opportunity cost producer of wheat. 3. Suppose the U.S. wishes to consume 48 units more coffee than its current consumption of 80 units, which it could do by devoting 80% of its resources to coffee production. Which would be better, producing the extra coffee itself, or importing it from Brazil at the current 2 for 2 terms of trade? AnswerClick inside the U.S. % Resources in Coffee box and enter a value of 80. Wheat production falls by 72 units to 48 and coffee production increases by 48 units to 128. This reflects the domestic U.S. opportunity cost of coffee at 1½ units of wheat. Click Reset to restore initial production levels, then click in the Wheat Exports box and enter a value of 48. In the U.S., consumption of coffee increases by 48 while wheat consumption falls by only 48 rather than 72. Trade is a "cheaper" source of coffee for the U.S. Note also that Brazil is consuming at a point outside its production possibilities curve after this trade. 4. At the current terms of trade, how might specialization allow residents in the U.S. to consume more coffee without giving up any wheat? AnswerClick Reset to establish initial production levels in each country. Since the U.S. is the lowest opportunity cost producer of wheat, the U.S. should specialize in wheat production. Click inside the U.S. % Resources in Coffee box and enter zero. Wheat production increases by 120 units while coffee production falls by 80. Next, click in the Wheat Exports box and enter 120 to restore wheat consumption to its previous level. At the 2 for 2 terms of trade, the U.S. imports 120 units of coffee - 40 more than it had prior to trade with Brazil. However, although Brazil has substantially more wheat than it had before, it has less coffee, a trade it may not be willing to make. 5. Experiment on your own. How is it possible for both Brazil and the U.S. to be unambiguously better off after trade? AnswerAs with the U.S. and wheat, Brazil should specialize in the production of coffee. Click inside the Brazil % Resources in Coffee box and enter 100. Likewise, set U.S. coffee resources at zero to reflect U.S. specialization in wheat. Click in the Wheat Exports box and enter 100 to return U.S. consumption of wheat to a level 20 units higher than its pre-trade levels. Comparing U.S. coffee production to its pre-trade levels, it is now 20 units higher. U.S. consumption of both goods is improved. Compared to its pre-trade position, Brazil is consuming an extra 60 units of coffee and an extra 60 units of wheat. Both countries are consuming more of both goods, an unambiguous improvement. 6. Experiment on your own. What are the limits on the terms of trade that will allow both countries to be better off through trade? AnswerClick Reset to establish the initial pre-trade position, then click in the % Resources in Coffee boxes and set the U.S. to 0 and Brazil to 100, reflecting complete specialization according to comparative advantage. In order for trade to be mutually advantageous, both countries’ terms of trade line (the green line) must lie outside the production possibilities curve. For the United States, the limits are 2 coffee = 3 wheat (the same as the U.S. opportunity cost of coffee). For Brazil, the limits are 8 coffee = 2 wheat (the same as the Brazilian opportunity cost of wheat). Graphing Exercise: Foreign Exchange MarketEuropean exporters wish to be paid for their goods and services in euros, yet the buyers in foreign countries possess their own local currencies, not euros. Likewise, European importers must pay in foreign currencies but possess only euros. A market for foreign exchange allows European importers - demanding the foreign currency - and foreign importers - supplying the foreign currency - to make an exchange. Exploration: What factors cause the exchange rate to change?Click here to view an interactive exercise. This will open a new browser window. Then answer the questions below. This exercise is from the website for Begg and Ward Economics for Business. If you have clicked on the link above and cannot see the interactive exercise, you may need to install a free Java plugin for you internet browser. Click here for the plugin. Consider the market for British pounds shown in the graph. The price is measured in the number of euros required to purchase one British pound. Currently, the market is in equilibrium - neither surplus nor shortage. Using the interactive graph, you can illustrate the impacts of changes in exports or imports on the market for foreign exchange. Click on the label of the appropriate curve and drag it to a new location to shift either demand or supply; click on the New Equilibrium to observe the market adjustments necessary to restore equilibrium. 1. Suppose European citizens wish to import more goods from Britain. Will the pound appreciate or depreciate relative to the euro? AnswerAn increase in desired imports will require European citizens to acquire more pounds: the demand for pounds will increase. Drag the demand curve to the right and click on the New Equilibrium button. The excess demand for pounds causes the euro price of pounds to increase - the pound appreciates (the euro depreciates). The rising value of the pound causes European goods to be cheaper (in pound terms) to the British. Although the supply curve does not move, the quantity of pounds supplied increases as British importers purchase more of the now relatively cheaper European goods. 2. Alternatively, suppose British citizens wish to import more goods from the EU. Will the pound appreciate or depreciate relative to the euro? AnswerA desire by Britons to acquire more EU goods will cause them to bring pounds to the market where they may be exchanged for the euros required by European exporters. That is, the supply of pounds will increase. To observe the effect on the pound market, drag the supply curve to the right and click on the New Equilibrium button. The excess supply of pounds causes the euro price of pounds to fall - the pound depreciates (the euro appreciates.) The falling value of the pound causes British goods to be cheaper (in euro terms) to European citizens. Although the demand curve does not move, the quantity of pounds demanded increases as European citizens buy more of the now less expensive British goods. |