TRADE PRACTICE PROBLEM

Fall 2014

Assume that the world consists of two countries, Freedonia and Sylvania, and each country
produces two goods, apples and bananas. In Freedonia, maximum apple production is 50 and
maximum banana production is 200. In Sylvania, the maximum production of apples and
bananas is 250 and 500, respectively. In both countries opportunity cost is constant.
a. Graph Freedonia and Sylvanias production possibility curves.
b. For algebra practice, find the equations of the 2 production possibility curves. You dont
need to derive the equations to do the rest of the problem. However, if you cant derive
the equations it means that you should spend some time reviewing your algebra.
c. What is the maximum amount of bananas Freedonia can produce if they make 10 apples?
d. Is 100 apples and 350 bananas a point on Sylvanias PPC?
e. Which country has a comparative advantage in producing bananas? Why?
f. Which country has a comparative advantage in making apples? Why?
g. Construct a numerical example in which Freedonia and Sylvania each completely
specialize in the production of one good, and are made better off by trading and
exchanging with each other.
___________________________________________________________________

Freedonia
a.

Sylvania

B
200

B
Opp cost:
4B for 1A
A for 1B

Opp. Cost:
2B for 1A
A for 1B
500

50

250 A

The absolute value of the slope for Freedonia is 4 and for Sylvania its 2.
If you graphed A on the vertical axis and B on the horizontal axis then the slopes would have
been and .

b. Freedonia: B = 200 4A

Sylvania:

B = 500 2A

If you had A on the vertical axis the equations would be:

Freedonia A= 50 B
Sylvania A= 250 -B
c. 160 Bananas
Freedonia has to give up 4B to make 1A. For 10A they have to give up 40B.
Starting on the vertical axis, B has to be reduced from 200 to 160.
You could also get the answer by working with the equation of the PPC.
B = 200 4A
Plugging in:
B = 200 4 (10) = 160
d. No, its not a point on the PPC.
Starting out at 500 B, Sylvania has to give up 2B for each A. To obtain 100A it has to give up
200 B. Giving up 200 B would take it down to 300 B. Therefore, 100A and 300B is a point on
the PPC. 100A and 350B is outside of the PPC.
Alternatively, using Sylvanias PPC:
B = 500 2A
B = 500 2 (100) = 300
100 A, corresponds to 300 B, not 350.
e. Freedonia has a comparative advantage in making bananas.
Comparative advantage is defined as having a lower opportunity cost. <
f. Sylvania has a comparative advantage in making apples.
Comparative advantage is defined as having a lower opportunity cost. 2<4
g. Each country specializes in the item for which it has a comparative advantage. Freedonia will
make only Bananas and Sylvania will only make apples. Any terms of trade between 2 and 4 B
for 1A will make both countries better off. Suppose they agree on 3B for 1A. Any number you
choose between 2 and 4 is correct.
At the start, before trade, well assume that Freedonia produces and consumes 140B and 15A.
This starting point is completely arbitrary. Since there is no trade yet, the amount produced
equals the amount consumed. Check and youll see that 140B, 15A is a point on the PPC of
Freedonia. With trade, Freedonia will only produce bananas. That means they will produce
200B and zero A. Suppose they export 60 B to Sylvania.
That leaves Freedonia with a consumption of 140 B. At the terms of trade of 3 to 1 they will
import 20 A.
Freedonia Consumption:
No trade: 140B and 15A

With trade: 140B and 20 A

Sylvania produces only A (250 apples) and exports 20 A. This leaves Sylvania with 230 A to
consume. In the absence of trade they could make 2B for every A they give up. This would give
them 40 A. Instead, with trade they are able to import 60 B.
Sylvania consumption:
No Trade: 230A and 40B
With trade: 230A and 60B
The terms of trade could be any number between 2 and 4. The only reason I chose 3 as the terms
of trade is because it is easy to work with. If I had chosen 2.674 it would be correct but I would
have to get out a calculator to do the arithmetic.
Also, remember that there is no reason I had to choose 60 as the amount Freedonia exports. I
wanted a number easily divisible by 4 so I could quickly figure out how much A it could
consume in the absence of trade.
Freedonia and Sylvania are able to get outside their PPCs by specializing in the good for which
they have a comparative advantage. The average income of each country has increased. That
doesnt mean everyone is better off. However, since the average income has increased the
potential exists for everyone to be better off.
In a trade theory course the next step would be to make the model more realistic by introducing
factors such as increasing opportunity costs, transportation costs, consumer preferences, etc. In
most cases, the conclusion would remain the sametrading among nations allows you to get
outside the PPC.