ECONOMIC THINKING

Economics as a social Science Applying the scientific method in

economics◦ Observation, Theory, and Testing◦ Assumptions and ceteris paribus

Controls for other influences Creating a “laboratory” environment to test hypotheses

◦ Avoiding flaws in logical thinking Post hoc, ergo proptor hoc Fallacy of Composition/Division

ECONOMICS MODELS AND ISSUESAN INTRODUCTION

The art of making models = making them simple and effective

Spreadsheet and handouts Example: Production Possibilities

Frontier (PPF) -efficiency, tradeoffs, opportunity costs, law

of increasing costs, economic growth. Example: Circular Flow Model– what,

how and for whom questions.◦ overall economy, role of economic agents,

output and income, product and factor markets

WHAT, HOW AND FOR WHOM What? - determined by consumer

preferences and dollar “votes” How? – competition requires firms to

produce at lowest possible costs “compete or be obsolete”

For Whom? – it depends on ownership of resources and the prices that resources bring

Efficiency versus equity revisited

THE POWER OF TRADE Voluntary versus involuntary exchange An intuitive approach to gains in trade Using an economic model to

demonstrate the gains from trade

VOLUNTARY EXCHANGE All parties to a voluntary exchange must

be made better off. Trade is mutually beneficial.

Allows for specialization and division of labor and reduces opportunity costs.

Increases interdependence Promotes cooperation rather than conflict Excerpt from Wealth of Nations (Fordham

University website)

AN INTUITIVE APPROACH TO GAINS FROM TRADE Self-sufficiency

Pros: independenceCons: loss of efficiency, variety in

consumption and production Trade with Yakima? Trade with other states? Trade with other nations?

GAINS FROM TRADE: AN ECONOMIC MODEL Good model building: prove the point

and make it simple Assumptions = things held true during

the analysis = simplification Assumptions can be changed later to

explore their implications

THE MODEL Assumptions:

Two individuals – rancher and a farmerTwo goods – meat and potatoesEach work eight hours a dayFarmer takes 60min/oz meat and 15min/oz

potatoesRancher takes 20min/oz of meat and

10min/oz of potatoes

Absolute advantage◦ The rancher is more efficient than the farmer at

producing both meat and potatoes Comparative advantage

◦ The farmer is comparatively better at producing potatoes than the rancher.

Comparative advantage and opportunity cost◦ The person with the lower opportunity cost has a

comparative advantage◦ Someone always has a comparative advantage in the

production of a least one thing

PPF AND PRODUCTION IN A SIMPLE ECONOMY How much can be produced? Need to know:

Total time divided by time/output = total output, or

output/time multiplied by total time = total output

TABLE 1 THE PRODUCTION OPPORTUNITIES OF THE FARMER AND RANCHER

Copyright © 2004 South-Western

Farmer (8 hours = 480/min)/ (60 min/oz of meat) = 8 oz of meat

Rancher (480min/20min/oz of meat)=24 oz of meat

FIGURE 1 THE PRODUCTION POSSIBILITIES CURVE

Potatoes (ounces)

4

16

8

32

A

0

Meat (ounces)

(a) The Farmer’ s Production Possibilities Frontier

If there is no trade, the farmer chooses this production and consumption.

Copyright©2003 Southwestern/Thomson Learning

FIGURE 1 THE PRODUCTION POSSIBILITIES CURVE

Copyright©2003 Southwestern/Thomson Learning

Potatoes (ounces)

12

24

B

0

Meat (ounces)

(b) The Rancher ’s Production Possibilities Frontier

48

24

If there is no trade, the rancher chooses this production and consumption.

SLOPE OF THE PPF In math, slope = Δy/Δx but in this case meat

is on the y-axis and potatoes are on the x-axis, so it become ΔM/ΔP

E.g. Rancher ΔM/ΔP = -24/48 =-1/2 , but it is help to think of this as -1/2/1. Why? +1P → -½ M

E.g. Farmer ΔM/ΔP =- 8/32 =-1/4 , but it is help to think of this as 1/4/1. Why? +1P → -1/4 M

To get 1 P the rancher gives up 1/2M and the farmer gives up 1/4M

Slope = opportunity cost (an example of making math meaningful to real world situations)

Reverse directions◦ Rancher to get 1M → -2P◦ Farmer to get 1M → -4P

Conclusions:◦ Rancher has a comparative advantage in producing

meat (1M costs 2P or 1P costs 1/2M)◦ Farmer has a comparative advantage in producing

potatoes (1P costs 1/4M or 1M costs 4P) The rancher should specialize in producing

meat and the farmer should specialization in producing potatoes.

GAINS TO TRADE Marginal versus Complete Approach Marginal adjustment

Farmer -1M → +4PRancher +1M → -2PTotal 0M +2P, orRancher -1P → +1/2MFarmer +1P → -1/4MTotal 0P +1/4M

Either way specializing and trading means either more meat or potatoes

THE TOTAL APPROACH Mankiw explains gains a bit differently

and perhaps in a more complicated wayFarmer only produces potatoes and rancher

produces a combination of meat and potatoes

Trade takes place with equal amounts for each

New totals lie outside the old PPF and represents a point on a consumption possibilities frontier

Let’s see how he does it….

TABLE 2 THE GAINS FROM TRADE: A SUMMARY

Copyright © 2004 South-Western

FIGURE 2 HOW TRADE EXPANDS THE SET OF CONSUMPTION OPPORTUNITIES

Copyright © 2004 South-Western

Potatoes (ounces)

12

24

13

27

B

0

Meat (ounces)

(b) The Rancher’s Production and Consumption

48

24

12

18

B*

Rancher's consumption with trade

Rancher's production with trade

Rancher's production and consumption without trade

FIGURE 2 HOW TRADE EXPANDS THE SET OF CONSUMPTION OPPORTUNITIES

Copyright©2003 Southwestern/Thomson Learning

Potatoes (ounces)

4

16

5

17

8

32

A

A*

0

Meat (ounces)

(a) The Farmer’ s Production and Consumption

Farmer's production and consumption without trade

Farmer's consumption with trade

Farmer's production with trade

DISTRIBUTION OF GAINS TO TRADE

The gains to each party are determined by the Terms of Trade◦ The terms of trade must fall between the two parties opportunity

costs (see spreadsheet) Positive analysis = gains exist so efficiency

improvements can occur Normative analysis = who should get the gains Normative analysis involves value judgments and

therefore must be made by others We will develop a model that measures the gains to

trade to consumers and producers later

History of TradeTribal to feudal to modern timesAdam Smith (1776) and David Ricardo (1817)

ProtectionismThe costs of not trading (e.g.

Cost of Protectionism)Distributional impacts – transfers from

consumers to producers/workersPolitical preference for protection – the

marginal costs to each consumer are small the marginal benefits to producers/workers are large

We will develop models to show the above later

STRATEGIC TRADE Strategic trade can be a tool to

develop certain industries China manipulates its exchange rate

to generate artificial terms of trade The U.S. gets inexpensive products

and the Chinese grow certain industries

However, China finances its trade surplus by lending to the U.S and/or acquiring dollars or U.S. assets.