UNIT I – Basic Economic Concepts

UNIT I – Basic Economic Concepts

Chapters – Introduction, 1, and 2

Definition(?) Other TEXT Examples Social science concerned with using scarce

resources to obtain the maximum satisfaction of the unlimited material wants of society.

The science that explains the choices we make and how those choices change as we cope with scarcity.

The study of people producing and exchanging to get the goods and services they want.

Definition(?)

Our working definition -- SOCIAL SCIENCE CONCERNED WITH THE WAY SOCIETY CHOOSES TO EMPLOY ITS LIMITED RESOURCES WHICH

HAVE ALTERNATIVE USES TO PRODUCE GOODS AND SERVICES FOR PRESENT AND FUTURE CONSUMPTION.

Definition(?) “The study of mankind in

the ordinary business of life.” -- Alfred Marshall

Oikos / Nomos -- comes from these two Greek words for “one who manages a household.”

The science which makes common sense difficult.

Economics – Social Science analyze human behavior, not physical science

(no atoms, electrons, moles, quantum theory)

Economic Analysis Many decisions -- economic underpinnings

Framework of analysis -- economic way of thinking

Economic Analysis Why study economics???

Learning its tenents will help you understand the world


Some questions to think about ... Why are apartments so hard to find in New York City? Why do airlines charge less for a round-trip ticket if the

traveler stays over a Saturday night? Why is (put famous actor/actress here) paid so much to star in

TV/Film? Why are living standards so meager in many African

countries? Why do some countries have high rates of inflation while

others have stable prices? Why are jobs easy to find in some years and hard to find in

others?


You will be an astute participant in the economy Many “life” decisions have economic

underpinningsJob, spending,

investing, decisions w/in your career

Economic Analysis Why study economics??? You will understand potential limits of governmental

economic policy

As a voter, you help choose the policies that guide the allocation of society’s resources. Examples:

What are the burdens associated with alternative forms of taxation?

What are the effects of free trade with other countries? What is the best way to protect the environment? How does the budget deficit effect the economy?

The Economic Problem: Making Choices

“The difficulty in life is the choice.” George Moore, The Bending of the Bough, Act IV

Basic Terms Resources -- Things used to produce other things

to satisfy people’s wants Wants -- What people would buy if their

incomes were unlimited


Problem -- Not all wants can be realized Why?

Resources are limited Wants are unlimited

Central economic idea:

Scarcity


Due to scarcity, people are forced into making choices based on their limited resources Framework = economic way of thinking Remember -- To be scarce, the item:

Must be limitedDesirableHave a price

Example: Scarcity not always about money

Economic Disciplines Two types:

Microeconomics Decisions undertaken by individuals (or

households) / by firms Microscope -- focus on small elements of

economyNew taxes on a specific industry or

productWages (up) by an effective union strike

Economic Disciplines Two types:

Macroeconomics Behavior of the economy as a

wholeRate of inflationEconomy wide unemploymentYearly growth in output of goods / services

in U.S.

People Behave Rationally Assumption:

Individuals act as if motivated by self-interest, respond predictably to gain“... it is not from the benevolence of the

butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”

-- Adam Smith An Inquiry into the Nature and Causes of the Wealth

of Nations


People will look out for their self-interest in a rational manner

Example: Explain the

anomaly concerning the makeup of U.S. population.


People do not intentionally make decisions that leave them worse off

Economics:Does not involve itself in thought processesLooks at what people actually do in life with

their limited resourcesExample:

Why can’t you sometimes teach an old dog new tricks?

People Behave Rationally Incentives

Rewards for engaging in a particular activity One will react to incentives after making

rational choices involving balancing costs and benefits

People Behave Rationally Self-interest

Not always measured in the goal of attaining more dollars and cents

Self-interest goals may relate to: prestige lovehelping others friendshippower creating works of art

Example:How valuable is your gift giving?Charitable acts -- self-interest?

Unique Terms / Ideas Models, or Theories

Simplified representations of the real world Used as basis for predictions or explanations Important:

- - no economic model complete - - - - can not capture every detail - -

Example: I35W, I35, I80, I15, I99, I55, I73, Southwest on Jamboree, Lt. on

San Joaquin Hills Rd., Lt. Big Canyon Rd., Rt. Burning Tree Rd.

Focus on relevance to problem / omit what is not

Unique Terms / Ideas Ceteris Paribus Assumption

Assumption: Nothing changes except factor or factors being

studied “other things being equal”

Example:Lower prices cause people to buy more. Other

factors beyond price influence buying decisions Income Religious beliefsSeason TastesCustom, etc.

Unique Terms / Ideas Positive Economics

Analysis limited to making either purely descriptive statements or scientific predictions.No subjective or moral judgments.A statement of “what is”“If A, then B.”

Unique Terms / Ideas Normative Economics

Analysis involving value judgments about economic policies

Relates to whether things are good or bad

Statement of “what ought to be”

Unique Terms / Ideas Positive and Normative Economics

Example:Positive economic

statement:“If the price of gas

rises, people will buy less.” Normative economic statement:

“So, we should not allow the price to go up.”

We have expressed a value judgment

Tools of Production Production

Conversion of resources to products -- used in consumption

Tools of Production Five Factors of Production

1. Land

(natural resource) encompasses non human gifts of nature

Example:

timber, water, mineral deposits, climate


2. Labor

Productive contributions of humans

Involves both mental and physical activities Example:

steelworkers, teachers,

computer programmers


3. Physical capital

Manufactured resources

Includes: buildings, machines, equipment, improvements to land used for production

Example:

Pizza oven, irrigation ditches, Best Buy CampusBloomington, Indiana


4. Human capital

Accumulated training / education

Whenever skills increase, human capital improves


5. Entrepreneurship

Human resources -- perform functions of raising capital, organizing, managing,

assembling other factors of production

Risk taker

Tools of Production Goods

Physical objects that are produced Example:

Bike, GI Joe with the Kung Fu Grip, surfboard

Capital goods Nonconsumerable goods

used to make other goods

Tools of Production Service

Mental / physical labor purchased by consumers

Example:Sales, laundry,

ski waxing, psychological counseling

Big Economic Questions Resource allocation

By answering economic questions, scarce resources allocatedWhat?How? For Whom?

Big Economic Questions What???

A society must determine how much of each of the many possible goods and services it will make, and when they will be produced. Will we produce frozen pizzas or shirts today? A few high-quality shirts or many cheap shirts? Will we use scarce resources to produce many consumption goods (like frozen pizzas)? Or will we produce fewer consumption goods and more capital goods (like pizza-making machines), which will boost production and consumption tomorrow.

Big Economic Questions How???

A society must determine who will do the production with what resources, and what production techniques they will use. Who farms and who teaches? Is electricity generated from oil, from coal, or from nuclear power? With much air pollution or with little?

Big Economic Questions For Whom???

One key task for any society is to decide who gets to eat the fruit of the economy’s efforts. Or, to put it formally, how is the national product divided among different households? Are many people poor or a few rich? Do high incomes go to managers or workers or landlords? Do the sick or elderly eat well, or are they left to fend for themselves?

CostIn economics, cost is always a forgone opportunity.

Opportunity cost

best alternative given up in order to satisfy wants

Remember: opportunity cost is the next-highest- ranked alternative, not all alternatives

Cost of Something is What You Give up to Get It

Examples:The opportunity cost of …

… growing carrots for the gardener, is the alternative crop that might have been grown instead (potatoes, tomatoes, pumpkins, etc.).

… seeing the latest Lincoln film is not just the price of the ticket, but the value of the time you spend in the AMC Rosedale theater.

Question: “The best things in life are free.” True?

Cost

Explicit Cost

Costs that must be paid

Fixed costs Example: Rent, taxes, tuition

Cost

Implicit Cost

Not paid out of pocket so not explicitly calculated

Opportunity cost of a decision

Marginal (cost vs. benefit) Analysis

Marginal analysis Extra or additional benefits of a decision

Cost / Benefit analysis Decision making comes down to benefits vs.

costs If I do a little more of “this” what is the cost of

“that.” Remember: People will only choose actions

which will bring the greater benefits over costs.

Marginal (cost vs. benefit) Analysis

Rational People THINK at the Margin

A person is rational if she systematically and purposefully does the best she can to achieve her objectives.

Many decisions are not “all or nothing,” but involve marginal changes – incremental adjustments to an existing plan.

Evaluating the costs and benefits of marginal changes is an important part of decision making

Rational People THINK at the Margin

Examples: A student considers whether to go to college

for an additional year, comparing the fees & foregone wages to the extra income he could earn with an extra year of education.

A firm considers whether to increase output, comparing the cost of the needed labor and materials to the extra revenue.

People Respond to Incentives

incentive: something that induces a person to act, i.e. the prospect of a reward or punishment.

Rational people respond to incentives because they make decisions by comparing costs and benefits. Examples: In response to higher gas prices, sales of “hybrid”

cars (e.g., Toyota Prius) rise. In response to higher cigarette taxes, teen smoking

falls.

A C T I V E L E A R N I N G 1: ExerciseYou are selling your 1996 Mustang. You have already spent $1000 on repairs. At the last minute, the transmission dies. You can pay $600 to have it repaired, or sell the car “as is.” In each of the following scenarios, should you have the transmission repaired?A. Blue book value is $6500 if transmission works,

$5700 if it doesn’t

B. Blue book value is $6000 if transmission works, $5500 if it doesn’t

A C T I V E L E A R N I N G 1: AnswersCost of fixing transmission = $600

A. Blue book value is $6500 if transmission works, $5700 if it doesn’tBenefit of fixing the transmission = $800 ($6500 – 5700). It’s worthwhile to have the transmission fixed.

B. Blue book value is $6000 if transmission works, $5500 if it doesn’tBenefit of fixing the transmission is only $500.Paying $600 to fix transmission is not worthwhile.

A C T I V E L E A R N I N G 1: AnswersObservations:

The $1000 you previously spent on repairs is irrelevant. What matters is the cost and benefit of the marginal repair (the transmission).

The change in incentives from scenario A to scenario B caused your decision to change.

People Face TradeoffsAll decisions involve tradeoffs. Examples:

Going to a basketball game the night before your economics exam leaves less time for studying.

Having more money to buy stuff requires working longer hours, which leaves less time for leisure.

Protecting the environment requires resources that might otherwise be used to produce consumer goods.

People Face Tradeoffs Society faces an important tradeoff:

efficiency vs. equity efficiency: getting the most out of scarce

resources equity: distributing prosperity fairly among

society’s members Tradeoff: To increase equity, can redistribute income

from the well-off to the poor.

The Production Possibilities Frontier The Production Possibilities Frontier (PPF):

A graph that shows the combinations of two goods the economy can possibly produce given the available resources and the available technology.

Example: Two goods: computers and wheat One resource: labor (measured in hours) Economy has 50,000 labor hours per month

available for production.

PPF ExampleProducing one computer requires 100 hours labor.Producing one ton of wheat requires 10 hours labor.

5,0000

4,000100

2,500250

1,000400

50,0000

40,00010,000

25,00025,000

10,00040,000

0500050,000

E

D

C

B

A

WheatComputersWheatComputers

ProductionEmployment of labor hours

Point on

graph

Production

Com-puters Wheat

A 500 0

B 400 1,000

C 250 2,500

D 100 4,000

E 0 5,000A

B

C

D

E

A C T I V E L E A R N I N G 2: Points on the PPF

A. On the graph, find the point that represents (100 computers, 3000 tons of wheat), label it F. Would it be possible for the economy to produce this combination of the two goods?Why or why not?

B. Next, find the point that represents (300 computers, 3500 tons of wheat), label it G. Would it be possible for the economy to produce this combination of the two goods?

A C T I V E L E A R N I N G 2: Answers Point F:

100 computers, 3000 tons wheat

Point F requires 40,000 hours of labor. Possible but not efficient: could get more of either good w/o sacrificing any of the other.

F

A C T I V E L E A R N I N G 2: Answers Point G:

300 computers, 3500 tons wheat

Point G requires 65,000 hours of labor. Not possible because economy only has 50,000 hours.

G

The PPF: What We Know So Far

Points on the PPF (like A – E) possible efficient: all resources are fully utilized

Points under the PPF (like F) possible not efficient: some resources underutilized

(e.g., workers unemployed, factories idle)

Points above the PPF (like G) not possible

The PPF and Opportunity Cost

Recall: The opportunity cost of an item is what must be given up to obtain that item.

Moving along a PPF involves shifting resources (e.g., labor) from the production of one good to the other.

Society faces a tradeoff: Getting more of one good requires sacrificing some of the other.

The slope of the PPF tells you the opportunity cost of one good in terms of the other.

The PPF and Opportunity Cost

The slope of a line equals the “rise over the run” – the amount the line rises when you move to the right by one unit.

–1000100slope = = –10

Here, the opportunity cost of a computer is 10 tons of wheat.

A C T I V E L E A R N I N G 3: PPF and Opportunity Cost

61

In which country is the opportunity cost of cloth lower?

FRANCE ENGLAND

A C T I V E L E A R N I N G 3: Answers

62

England, because its PPF is not as steep as France’s.

FRANCE ENGLAND

Economic Growth and the PPF

With additional resources or an improvement in technology, the economy can produce more computers,

more wheat,

or any combination in between.

Economic growth shifts the PPF outward.

The Shape of the PPF The PPF could be a straight line, or bow-shaped Depends on what happens to opportunity cost

as economy shifts resources from one industry to the other. If opp. cost remains constant, PPF is a straight line.

(In the previous example, opp. cost of a computer was always 10 tons of wheat.)

If opp. cost of a good rises as the economy produces more of the good, PPF is bow-shaped.

Why the PPF Might Be Bow-Shaped

Mountain Bikes

Tate

r tot

s

As the economy shifts resources from Tater tots to mountain bikes: PPF becomes

steeper opp. cost of

mountain bikes increases

A


At point A, most workers are producing Tater tots, even those that are better suited to buildingmountain bikes.So, you do not have to give up many Tater tots to get more bikes. Mountain

Bikes

Tate

r to

ts At A, opp. cost of mtn bikes is low.

B


At B, most workers are producing bikes. The few left in “tot” production are the best workers.Producing more bikes would require shifting some of the best workers away from “tot” production, which would cause a big drop in “tot” output.

Mountain Bikes

Tate

r to

ts At B, opp. cost of mtn bikes is high.


So, PPF is bow-shaped when different workers have different skills, different opportunity costs of producing one good in terms of the other.

The PPF would also be bow-shaped when there is some other resource, or mix of resources with varying opportunity costs. E.g., different types of land suited for

different uses

The PPF: A Summary The PPF shows all combinations of two goods

that an economy can possibly produce, given its resources and technology.

A bow-shaped PPF illustrates the concept of increasing opportunity cost.

The PPF illustrates the concepts of tradeoff and opportunity cost.

The “ISMS”Economic system

institutional means through which resources are used to satisfy human wants

Historically:industrially advanced economies of the world differed

essentially in two ways: ownership of means of production method of coordinating / directing economic activity

The “ISMS”Pure, laissez faire, capitalism, or market

private ownership of resources

markets / prices coordinate and direct economic activity

Government’s role: protect private property establish legal framework

The “ISMS”Command economy or communism

public ownership of virtually all property resources

economic decisions completed through central planning

Example: The former Soviet Union is the 74-year experiment in trying

to run an economy without using the price, or market system.

One of the great failures of the 20th Century.

The “ISMS”Socialism

State owns major share of productive resources except labor

usually involves redistribution of income

varied degrees in practice Europe

The “ISMS”Mixed

falls between extremes of pure capitalism and command economy

Capitalism w/ government

Important: Incentives matter

The “ISMS”Traditional Economy

production methods, exchange, and distribution of income sanctioned by custom

heredity and caste circumscribe economic roles

U.S. free enterprise system 3 Elements(1) Private Property

protected by U.S. Constitution

gives owners incentive to use their resources efficiently as possible

U.S. free enterprise system (2) Price System voluntary exchanges establish prices for goods,

services, and resources

provide information and incentives information source

Consumers -- prices serve as a guide Businesses -- prices indicate the value consumers

place on the good/service

U.S. free enterprise system (2) Price System voluntary exchanges establish prices for goods,

services, and resources

provide information and incentives Incentives

increasing prices encourage businesses to increase production

Remember:

incentives and the desire for more money cannot explain all of our behaviors

U.S. free enterprise system (3) Market Competition Resource competition

Buyers compete against one another in markets for

productive resources

Example:

resources such as skilled workers, oil deposits, complex machinery

U.S. free enterprise system (3) Market Competition Resource competition

Sellers compete against other sellers by trying to make their

resources more productive

U.S. free enterprise system (3) Market Competition Product competition

Buyers compete against other buyers in product markets

Example:

auction

U.S. free enterprise system (3) Market Competition Product competition

Sellers compete against sellers by trying to offer goods /

services buyers want at prices they are willing to pay winners in this competition earn profit

Note:

Profit is the difference between a firm’s total revenues and its total costs

The Circular-Flow Diagram Circular-Flow Diagram: A visual model of the economy,

shows how dollars flow through markets among households and firms.

Includes two types of “actors”: households firms

Includes two markets: the market for goods and services the market for “factors of production”

The Circular-Flow DiagramHouseholds: own the factors of production, sell/rent them to firms

for income buy and consume goods & services

HouseholdsFirms

The Circular-Flow Diagram

HouseholdsFirms

Firms: buy/hire factors of production,

use them to produce goods and services

sell goods & services

Markets for Factors of Production

HouseholdsFirms

IncomeWages, rent, profit

Factors of production

Labor, land, capital

Spending

G & S bought

G & S sold

Revenue Markets for Goods & Services

HOW PEOPLE INTERACT

An “economy” is just a group of people interacting with each other.

InterdependenceEvery day you rely on

many people from around the world,

most of whom you do not know,

to provide you with the goods and services

you enjoy.coffee from

Kenya

dress shirt from China

cell phone from Taiwan

hair gel from Roseville, MN

Trade Can Make Everyone Better Off Rather than being self-sufficient, people can

specialize in producing one good or service and exchange it for other goods.

Countries also benefit from trade & specialization:get a better price abroad for goods they producebuy other goods more cheaply from abroad than

could be produced at home

SPECIALIZATION AND TRADEComparative Advantage

ability of a person to perform an activity or produce a good or service at a lower opportunity cost than someone else

Example:Joe and Liz operate smoothie bars and produce

smoothies and salads

Liz's opportunity cost ofproducing 1 smoothie is 1 salad.

Liz's opportunity cost of producing 1 salad is 1 smoothie.

SPECIALIZATION AND TRADE

Liz's Smoothie Bar

In an hour, Liz can produce either 40 smoothies or 40 salads.

Each hour, Liz produces 20 smoothies and 20 salads.

Joe's opportunity cost ofproducing 1 smoothie is 5 salads.

Joe's opportunity cost ofproducing 1 salad is 1/5 smoothie.


Joe's Smoothie Bar

In an hour, Joe can produce either 6 smoothies or 30 salads.

Each hour, Joe's produces 5 smoothies and 5 salads.


Liz’s Absolute Advantage Absolute advantage

When one person is more productive than another person in several or even all activities.

Liz is four times as productive as Joe—Liz can produce 20 smoothies and 20 salads an hour and Joe can produce only 5 smoothies and 5 salads an hour.


Liz’s Comparative Advantage Liz’s opportunity cost of a smoothie is 1 salad. Joe’s opportunity cost of a smoothie is 5 salads. Liz’s opportunity cost of a smoothie is less than

Joe’s, so Liz has a comparative advantage in producing smoothies.


Joe’s Comparative Advantage Joe’s opportunity cost of a salad is 1/5 smoothie. Liz’s opportunity cost of a salad is 1 smoothie. Joe’s opportunity cost of a salad is less than Liz’s, so

Joe has a comparative advantage in producing salads.

SPECIALIZATION AND TRADEAchieving Gains from Trade

Liz and Joe produce more of the good in which they have a comparative advantage:

Liz produces 35 smoothies and 5 salads.Joe produces 30 salads.


Liz and Joe trade: Liz sells Joe 10 smoothies

and buys 20 salads. Joe sells Liz 20 salads and

buys 10 smoothies.

After trade:Liz has 25 smoothies and 25 salads.Joe has 10 smoothies and 10 salads.


Gains from trade: Liz gains 5 smoothies and 5

salads an hour—she originally produced 20 smoothies and 20 salads.

Joe gains 5 smoothies and 5 salads an hour—he originally produced 5 smoothies and 5 salads.

The next slide illustrates the gains from trade.

1. Joe and Liz each produce at point A on their PPFs.

Joe has a comparative advantage in producing salads.


Liz has a comparative advantage in producing smoothies.

Joe and Liz produce more of the good in which they have a comparative advantage.

2. Liz produces 35 smoothies and 5 salads at point B on her PPF.


2. Joe produces 30 salads at point B on his PPF.

Joe and Liz trade salads and smoothies at a price of 2 salads per smoothie.

Liz sells 10 smoothies and buys 5 salads from Joe.


Joe sells 20 salads and buys 10 smoothies from Liz.

3. Both consume at point C, which is outside their PPFs.

Another Trade Example

Two countries: the U.S. and Japan

Two goods: computers and wheat

One resource: labor, measured in hours We will look at how much of both goods

each country produces and consumes if the country chooses to be self-sufficient if it trades with the other country

Production Possibilities in the U.S.

The U.S. has 50,000 hours of labor available for production, per month. Producing one computer

requires 100 hours of labor. Producing one ton of wheat

requires 10 hours of labor.

4,000

100

5,000

2,000

1,000

3,000

500200 300 4000 Computers

Wheat (tons)

The U.S. PPFThe U.S. has enough labor to produce 500 computers,or 5000 tons of wheat,or any combination along the PPF.

4,000

100

5,000

2,000

1,000

3,000

500200 300 4000 Computers

Wheat (tons)

The U.S. Without Trade

Suppose the U.S. uses half its labor to produce each of the two goods.

Then it will produce and consume250 computers and

2500 tons of wheat.

A C T I V E L E A R N I N G 4: Derive Japan’s PPF

Japan has 30,000 hours of labor available for production, per month.

Producing one computer requires 125 hours of labor.

Producing one ton of wheat requires 25 hours of labor.

Use the following information to draw Japan’s PPF.

Your graph should measure computers on the horizontal axis.

Computers

Wheat (tons)

2,000

1,000

2000

100 300

Japan’s PPFJapan has enough labor to produce 240 computers,or 1200 tons of wheat,or any combination along the PPF.

Japan Without Trade

Computers

Wheat (tons)

2,000

1,000

2000

100 300

Suppose Japan uses half its labor to produce each of the two goods.

Then it will produce and consume120 computers and

600 tons of wheat.

Consumption With and Without Trade

Without trade, U.S. consumers get 250 computers

and 2500 tons wheat. Japanese consumers get 120 computers

and 600 tons wheat.

We will compare consumption without trade to consumption with trade.

First, we need to see how much of each good is produced and traded by the two countries.

A C T I V E L E A R N I N G 5: Production under trade1. Suppose the U.S. produces 3400 tons of wheat.

How many computers would the U.S. be able to produce with its remaining labor? Draw the point representing this combination of computers and wheat on the U.S. PPF.

2. Suppose Japan produces 240 computers. How many tons of wheat would Japan be able to produce with its remaining labor? Draw this point on Japan’s PPF.

4,000

100

5,000

2,000

1,000

3,000

500200 300 4000 Computers

Wheat (tons)

U.S. Production With Trade

Producing 3400 tons of wheat requires 34,000 labor hours.

The remaining 16,000 labor hours are used to produce 160 computers.

Japan’s Production With TradeProducing 240 computers requires all of Japan’s 30,000 labor hours.

Computers

Wheat (tons)

2,000

1,000

2000

100 300

So, Japan would produce 0 tons of wheat.

International Trade

Exports: goods produced domestically and sold abroad

Imports: goods produced abroad and sold domestically

A C T I V E L E A R N I N G 6: Consumption under trade

How much of each good is consumed in the U.S.? Plot this combination on the U.S. PPF.

How much of each good is consumed in Japan? Plot this combination on Japan’s PPF.

Suppose the U.S. exports 700 tons of wheat to Japan, and imports 110 computers from Japan.(So, Japan imports 700 tons wheat and exports 110 computers.)

U.S. Consumption With Trade

4,000

100

5,000

2,000

1,000

3,000

500200 300 4000 Computers

Wheat (tons) computers wheat

produced 160 3400+ imported 110 0– exported 0 700= amount consumed 270 2700

Japan’s Consumption With Trade

Computers

Wheat (tons)

2,000

1,000

2000

100 300

computers wheatproduced 240 0+ imported 0 700– exported 110 0= amount consumed 130 700

Trade Makes Both Countries Better Off

U.S.consumption without trade

consumption with trade

gains from trade

computers 250 270 20

wheat 2,500 2,700 200

Japanconsumption without trade

consumption with trade

gains from trade

computers 120 130 10

wheat 600 700 100

Where Do These Gains Come From?

Absolute advantage: the ability to produce a good using fewer inputs than another producer

The U.S. has an absolute advantage in the production of wheat: producing a ton of wheat uses 10 labor hours

in the U.S. vs. 25 in Japan.

If each country has an absolute advantage in one good and specializes in that good, then both countries can gain from trade.

Where Do These Gains Come From?

Which country has an absolute advantage in computers?

Producing one computer requires 125 labor hours in Japan, but only 100 in the U.S.

The U.S. has an absolute advantage in both goods!

So why does Japan specialize in computers? Why do both countries gain from trade?

Two Measures of the Cost of a Good

Two countries can gain from trade when each specializes in the good it produces at lowest cost.

Absolute advantage measures the cost of a good in terms of the inputs required to produce it.

Recall: Another measure of cost is opportunity cost.

In our example, the opportunity cost of a computer is the amount of wheat that could be produced using the labor needed to produce one computer.

Opportunity Cost and Comparative Advantage

Comparative advantage: the ability to produce a good at a lower opportunity cost than another producer

Which country has the comparative advantage in computers?

To answer this, must determine the opp. cost of a computer in each country.

Opportunity Cost and Comparative Advantage

The opp. cost of a computer is 10 tons of wheat in the U.S., because producing one

computer requires 100 labor hours, which instead could produce 10 tons of wheat.

5 tons of wheat in Japan, because producing one computer requires 125 labor hours, which instead could produce 5 tons of wheat.

So, Japan has a comparative advantage in computers. (Absolute advantage is not necessary for comparative advantage!)

Comparative Advantage and Trade

Differences in opportunity cost and comparative advantage create the gains from trade.

When each country specializes in the good(s) in which it has a comparative advantage, total production in all countries is higher, the world’s “economic pie” is bigger, and all countries can gain from trade.

The same applies to individual producers (like a farmer and a rancher) specializing in different goods and trading with each other.

A C T I V E L E A R N I N G 7: Absolute & comparative advantage

Argentina and Brazil each have 10,000 hours of labor per month, and the following technologies:Argentina producing one pound coffee requires 2 hours producing one bottle wine requires 4 hoursBrazil producing one pound coffee requires 1 hour producing one bottle wine requires 5 hoursWhich country has an absolute advantage in the production of coffee? Which country has a comparative advantage in the production of wine?

A C T I V E L E A R N I N G 7: Answers

Brazil has an absolute advantage in coffee: Producing a pound of coffee requires only one

labor-hour in Brazil, but two in Argentina.

Argentina has a comparative advantage in wine: Argentina’s opp. cost of wine is two pounds of coffee, because

the four labor-hours required to produce a bottle of wine could instead produce two pounds of coffee.

Brazil’s opp. cost of wine is five pounds of coffee.

Unanswered Questions….

We made a lot of assumptions about the quantities of each good that each country produces, trades, and consumes, and the price at which the countries trade wheat for computers.

In the real world, these quantities and prices would be determined by the preferences of consumers and the technology and resources in both countries.

We will begin to study this in Unit III. For now, though, our goal was only to see that trade,

indeed, can make everyone better off.

UNIT I – Basic Economic Concepts

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