Independent University, Bangladesh (IUB) Department of Economics ECN 201: Principles of Microeconomics

Sample Midterm Question Solution

1. Put the table in graphical form, i.e., in production possibility curves. Assume Bangladesh and the US each use half their resources in producing potatoes and half in producing laptops. Identify their absolute advantage and comparative advantages in potatoes and laptops. Which country will specialize in producing what goods? Country US Bangladesh Production of Potato 100 200 Production of Laptop 20 10

Answer: A country has absolute advantage over another country in producing a good if it can use fewer resources to produce that good. A country has comparative advantage over another country in producing a good if it can produce that good with lower opportunity cost: it gives up fewer of the other good to produce that good. laptop 20

10

100

200

potato

In this example, Bangladesh has both absolute and comparative advantage in potatoes and the US has both absolute and comparative advantage in laptops. Since they both have absolute advantage in different, each should specialize (completely) in their advantageous good, Bangladesh to potatoes and US to laptops. This allows both countries to improve their welfare (number of goods consumed) after trade.

2. Consider the American foreign exchange market for the Bangladeshi taka. a. Why does the demand for taka slope downward? b. Why does the supply of taka slope upward? c. Draw a graph illustrating a demand shift that causes the dollar to weaken. What could have caused this shift to occur? Explain. Answer: a. Demand slopes down because of the Law of Demand: as the takas price falls, Americans will buy more of it (i.e., they can afford more taka, which can in turn buy more Bangladeshi goods). The exchange rate is just the price of taka b. Supply follows a similar Law of Supply: a Law of Demand for dollars. As the price (exchange rate) goes up, people are more willing to sell on the market the taka can now buy more dollars, which can in turn buy more American goods. c. See the graph below. Correct labels are critical! The change implies in increase in the dollars-per-taka exchange rate. This change can be explained by either an increase in D (illustrated) or a decrease in S. They are shifted by similar features. For demand, this includes a positive shift in tastes for Bangladeshi goods, an increase in US wealth, or an increase in Bangladeshi interest rates. The opposite is true for a negative Supply shift.
E = $/tk S

E2 E1

D2 D1 taka