Sketch and label a diagram to illustrate comparative advantage between Country X and Country Y on Figure 4.

Figure 4

Outline the reason why Country X should specialize in the production of apples and Country Y should specialize in the production of bananas.

Outline one reason why it might not be in a country’s best interests to specialize according to the principle of comparative advantage.

Calculate the change in expenditure on imported oranges as a result of the increase in demand.

Calculate the change in consumer surplus in Country Z as a result of the increase in demand for oranges.

Calculate the change in social (community) surplus as a result of the increase in demand for oranges.

State one administrative barrier that Country Z could use in order to restrict imports.

Explain two possible economic consequences for the eurozone if the euro appreciates.

Calculate the quantity of EU€ she will receive for her US$300 000.

Calculate, in US$, the loss made by Tanya as a result of these transactions.

Explain two reasons why a government might prefer a floating exchange rate system for its currency.

Award [1] for a sketch showing the PPC of Country Y above/further out than for Country X.

Award [1] for a sketch showing the PPC of Country X with a steeper gradient than for Country Y.

NB There is no set position for each of the curves. However, no marks may be awarded unless both curves are downward-sloping.

OFR applies.

Reasons may include:

• unemployment in industries where trading partners enjoy comparative advantage because workers are unable to move to those industries where there is a comparative advantage
• over-specialization resulting in vulnerability to changes in market conditions or as a barrier to economic development
• risk will be reduced by the avoidance of over-reliance on trading partners for essential products or resources which might compromise national security or diminish negotiating power
• specialization may make it difficult for the economy to diversify, thus maintaining the risk of vulnerability to market conditions
• safety and environmental standards may be compromised by low-quality imports
• specialization may not result in beneficial trade if export markets are protected by barriers to trade
• if demand conditions for the export good suffer a long-term decrease then the resulting deterioration of the country's terms of trade may harm the economy
• over-specialization may result in an economy continuing to produce a good with low income elasticity of demand, causing economic growth to be slow relative to other economies.

Any other reasonable response should be rewarded.

100 000 × 2 − 40 000 × 2

Any valid working is sufficient for [1].

NB Workings which measure market demand, rather than the demand for imports (so the calculation is 160 000 × 2 − 100 000 × 2 are not valid.

= $120 000

An answer of $120 000 or 120 000 without any working or with invalid working as exemplified above is sufficient for [1].

(0.5 × 160 000 × 1.6) − (0.5 × 100 000 × 1.0)

Any valid working is sufficient for [1] (eg correct calculation of either initial or final consumer surplus).

= $78 000

An answer of $78 000 or 78 000 without any working is sufficient for [1].

Change in producer surplus = 0

Change in community surplus = 78 000 + 0

Any valid working is sufficient for [1].

= $78 000

An answer of $78 000 or 78 000 without any working is sufficient for [1].

OFR applies.

Administrative barriers may include:

• requirements for packaging/labelling
• health/safety/inspection procedures
• changes in permitted specifications for a product
• increased bureaucracy.

Award [1] for stating one administrative barrier.

Any other reasonable response should be rewarded.

Consequences may include:

• a stronger currency may reduce the export competitiveness of the eurozone, thus worsening the current account balance/increasing imports and reducing exports
• a currency appreciation will reduce the domestic price of imports so cost of living will decrease and cost of imported raw materials will decrease, lowering production costs of domestic firms and reducing inflationary pressure
• a stronger currency may reduce export competitiveness, causing aggregate demand to decrease, thus reducing inflationary pressure
• a stronger currency may reduce the export competitiveness of the eurozone, causing aggregate demand to decrease, thus causing slower growth/higher unemployment
• the value of any foreign debt may be reduced as a smaller amount of euros will be needed to repay/service the debt (if denominated in foreign currency)
• foreign direct investment inflows may decrease as it becomes more expensive to purchase assets in the eurozone (also reward greater outflows of FDI or changes in flows of financial capital).

Any other reasonable response should be rewarded.

$\frac{300\hspace{0.17em}000}{1.2}$ = 250 000

An answer of 250 000 without any working is sufficient for [1].

The new exchange rate = €1 = US$1.20 × 0.9 = US$1.08

Any valid working is sufficient for [1].

€250 000 can be exchanged for 250 000 × 1.08 = US$270 000

Any valid working is sufficient for [1] (eg if an incorrectly calculated exchange rate is correctly applied to exchanging €250 000.

Loss = 270 000 − 300 000 = US$30 000

An answer of US$30 000 or 30 000 without any working is sufficient for [1].

OFR applies.

NB A simple but accurate calculation, such as “10% × 300 000 = $30 000, may be fully rewarded.

Reasons may include:

• a floating exchange rate system allows for independent monetary policy. Interest rates can be set in order to influence AD without fear of disrupting the (fixed) exchange rate
• the economy can use exchange rate policy to affect macroeconomic variables, such as the growth rate; inflation)
• if an economy has a current account deficit/surplus, the exchange rate will act as a self-regulating mechanism to restore the balance
• the central bank does not need to maintain foreign reserves: (involving an opportunity cost) to be able to intervene in the foreign exchange market.

Any other reasonable response should be rewarded.

Generally well-answered. Lower achieving responses drew intersecting PPCs or confused the relative gradients.

Candidates were invariably aware that each country should specialize in the product for which it has a lower opportunity cost, though quite a few implied or even stated that the “lower” opportunity cost referred to the other good (“for apples than bananas”), rather than the other country. However, they did not identify a positive consequence of such specialization.

Many candidates were able to explain a danger of over-specialization, while a minority focused on limitations of the model, such as transport costs or focus on a 2-country, 2-product model, which are limitations of the model rather than factors influencing the decision to specialize.

Most responses provided the correct answer of $120 000, although some focused on the total demand rather than the demand for imported oranges, so were awarded 1 mark only owing to invalid working.

Candidates commonly struggled to calculate the new consumer surplus. Some attempted to calculate via manipulation of the functions and were invariably unsuccessful.

Higher achieving responses identified that there would be no change in producer surplus, so the change in consumer surplus would be equal to the change in social surplus. Others successfully calculated the new social surplus. Lower achieving responses struggled to calculate, or even to recognise the term “social surplus”

The term “administrative barrier” appeared to be unfamiliar to many candidates. “Quotas” was the most common response.

The majority of candidates were able to explain the possible effect on exports, imports and thus the current balance. Lower achieving responses treated the effects on imports/exports as two separate points – but were awarded Level 1. Stronger responses referred to effects on aggregate demand (stated) and therefore on growth/unemployment. It was common for candidates to confuse the balance of trade with the terms of trade and to suggest that an appreciation might cause a depreciation, or even an increased demand for the currency.

Well-answered.

Many candidates were not able to calculate the new exchange rate correctly, but performed the rest of the calculation successfully.

Lower achieving responses simply described how a floating exchange rate works, and implied that this was an advantage, while others stated that it was “easier” or “cheaper” for the government if the exchange rate was allowed to float. Several views were expressed as to the likelihood of currency speculation. In contrast, many responses explained clearly the advantages regarding independence of demand-side policies and the removal of a requirement to hold significant reserves of foreign currency (bearing an opportunity cost) under a fixed exchange rate system.