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UNIT I – Basic Economic Concepts Chapters – Introduction, 1, and 2.

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1 UNIT I – Basic Economic Concepts Chapters – Introduction, 1, and 2

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.

3 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.

4 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.

5 Economics – Social Science analyze human behavior, not physical science (no atoms, electrons, moles, quantum theory)

6 Economic Analysis Many decisions -- economic underpinnings Framework of analysis -- economic way of thinking

7 Economic Analysis Why study economics??? Learning its tenents will help you understand the world

8 Economic Analysis Why study economics??? 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?

9 Economic Analysis Why study economics??? You will be an astute participant in the economy Many life decisions have economic underpinnings Job, spending, investing, decisions w/in your career

10 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 societys 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?

11 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 peoples wants Wants -- What people would buy if their incomes were unlimited

12 The Economic Problem: Making Choices Scarcity

13 The Economic Problem: Making Choices

14 Economic Disciplines Two types: Microeconomics Decisions undertaken by individuals (or households) / by firms Microscope -- focus on small elements of economy New taxes on a specific industry or product Wages (up) by an effective union strike

15 Economic Disciplines Two types: Macroeconomics Behavior of the economy as a whole Rate of inflation Economy wide unemployment Yearly growth in output of goods / services in U.S.

16 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

17 People Behave Rationally Assumption: People will look out for their self-interest in a rational manner Example: Explain the anomaly concerning the makeup of U.S. population.

18 People Behave Rationally Assumption: People do not intentionally make decisions that leave them worse off Economics: Does not involve itself in thought processes Looks at what people actually do in life with their limited resources Example: Why cant you sometimes teach an old dog new tricks?

19 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

20 People Behave Rationally Self-interest Not always measured in the goal of attaining more dollars and cents Self-interest goals may relate to: prestigelove helping othersfriendship powercreating works of art Example: How valuable is your gift giving? Charitable acts -- self-interest?

21 Unique Terms / Ideas

22 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 IncomeReligious beliefs SeasonTastes Custom, etc.

23 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.

24 Unique Terms / Ideas Normative Economics Analysis involving value judgments about economic policies Relates to whether things are good or bad Statement ofwhat ought to be

25 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

26 Tools of Production Production Conversion of resources to products -- used in consumption

27 Tools of Production Five Factors of Production 1.Land (natural resource) encompasses non human gifts of nature Example: timber, water, mineral deposits, climate

28 Tools of Production Five Factors of Production 2.Labor Productive contributions of humans Involves both mental and physical activitiesExample: steelworkers, teachers, computer programmers

29 Tools of Production Five Factors of Production 3.Physical capital Manufactured resources Includes: buildings, machines, equipment, improvements to land used for production Example: Pizza oven, irrigation ditches, Best Buy Campus Bloomington, Indiana

30 Tools of Production Five Factors of Production 4.Human capital Accumulated training / education Whenever skills increase, human capital improves

31 Tools of Production Five Factors of Production 5.Entrepreneurship Human resources -- perform functions of raising capital, organizing, managing, assembling other factors of production Risk taker

32 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

33 Tools of Production Service Mental / physical labor purchased by consumers Example: Sales, laundry, ski waxing, psychological counseling

34 Big Economic Questions Resource allocation By answering economic questions, scarce resources allocated What? How? For Whom?

35 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.

36 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?

37 Big Economic Questions For Whom??? One key task for any society is to decide who gets to eat the fruit of the economys 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?

38 Cost In 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

39 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?

40 Cost Explicit Cost Costs that must be paid Fixed costs Example: Rent, taxes, tuition

41 Cost Implicit Cost Not paid out of pocket so not explicitly calculated Opportunity cost of a decision

42 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 ofthat. Remember: People will only choose actions which will bring the greater benefits over costs.

43 Marginal (cost vs. benefit) Analysis

44 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

45 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.

46 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.

47 A C T I V E L E A R N I N G 1: Exercise You 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 doesnt B. Blue book value is $6000 if transmission works, $5500 if it doesnt

48 A C T I V E L E A R N I N G 1: Answers Cost of fixing transmission = $600 A. Blue book value is $6500 if transmission works, $5700 if it doesnt Benefit of fixing the transmission = $800 ($6500 – 5700). Its worthwhile to have the transmission fixed. B. Blue book value is $6000 if transmission works, $5500 if it doesnt Benefit of fixing the transmission is only $500. Paying $600 to fix transmission is not worthwhile.

49 A C T I V E L E A R N I N G 1: Answers Observations: 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.

50 People Face Tradeoffs All 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.

51 People Face Tradeoffs Society faces an important tradeoff: efficiency vs. equity efficiency:getting the most out of scarce resources equity: distributing prosperity fairly among societys members Tradeoff: To increase equity, can redistribute income from the well-off to the poor.

52 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.

53 PPF Example Producing 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 25,000 10,00040,000 0500050,000 E D C B A WheatComputersWheatComputers Production Employment of labor hours

54 Point on graph Production Com- puters Wheat A5000 B4001,000 C2502,500 D1004,000 E05,000 A B C D E

55 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?

56 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

57 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

58 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

59 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.

60 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. –1000 100 slope = = –10 Here, the opportunity cost of a computer is 10 tons of wheat.

61 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? FRANCEENGLAND

62 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 Frances. FRANCEENGLAND

63 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.

64 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.

65 Why the PPF Might Be Bow-Shaped Mountain Bikes Tater tots As the economy shifts resources from Tater tots to mountain bikes: PPF becomes steeper opp. cost of mountain bikes increases

66 A Why the PPF Might Be Bow-Shaped At point A, most workers are producing Tater tots, even those that are better suited to building mountain bikes. So, you do not have to give up many Tater tots to get more bikes. Mountain Bikes Tater tots At A, opp. cost of mtn bikes is low.

67 B Why the PPF Might Be Bow-Shaped 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 Tater tots At B, opp. cost of mtn bikes is high.

68 Why the PPF Might Be Bow-Shaped 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

69 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.

70 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

71 The ISMS Pure, laissez faire, capitalism, or market private ownership of resources markets / prices coordinate and direct economic activity Governments role: protect private property establish legal framework

72 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.

73 The ISMS Socialism State owns major share of productive resources except labor usually involves redistribution of income varied degrees in practice Europe

74 The ISMS Mixed falls between extremes of pure capitalism and command economy Capitalism w/ government Important: Incentives matter

75 The ISMS Traditional Economy production methods, exchange, and distribution of income sanctioned by custom heredity and caste circumscribe economic roles

76 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

77 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

78 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

79 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

80 U.S. free enterprise system (3) Market Competition Resource competition Sellers compete against other sellers by trying to make their resources more productive

81 U.S. free enterprise system (3) Market Competition Product competition Buyers compete against other buyers in product markets Example: auction

82 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 firms total revenues and its total costs

83 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

84 The Circular-Flow Diagram Households: own the factors of production, sell/rent them to firms for income buy and consume goods & services Households: own the factors of production, sell/rent them to firms for income buy and consume goods & services Households Firms

85 The Circular-Flow Diagram Households Firms Firms: buy/hire factors of production, use them to produce goods and services sell goods & services Firms: buy/hire factors of production, use them to produce goods and services sell goods & services

86 Markets for Factors of Production Households Firms Income Wages, rent, profit Factors of production Labor, land, capital Spending G & S bought G & S sold Revenue Markets for Goods & Services

87 HOW PEOPLE INTERACT An economy is just a group of people interacting with each other.

88 Interdependence Every 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

89 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 produce buy other goods more cheaply from abroad than could be produced at home

90 SPECIALIZATION AND TRADE Comparative 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

91 Liz's opportunity cost of producing 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.

92 Joe's opportunity cost of producing 1 smoothie is 5 salads. Joe's opportunity cost of producing 1 salad is 1/5 smoothie. SPECIALIZATION AND TRADE 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.

93 SPECIALIZATION AND TRADE Lizs 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 JoeLiz can produce 20 smoothies and 20 salads an hour and Joe can produce only 5 smoothies and 5 salads an hour.

94 SPECIALIZATION AND TRADE Lizs Comparative Advantage Lizs opportunity cost of a smoothie is 1 salad. Joes opportunity cost of a smoothie is 5 salads. Lizs opportunity cost of a smoothie is less than Joes, so Liz has a comparative advantage in producing smoothies.

95 SPECIALIZATION AND TRADE Joes Comparative Advantage Joes opportunity cost of a salad is 1/5 smoothie. Lizs opportunity cost of a salad is 1 smoothie. Joes opportunity cost of a salad is less than Lizs, so Joe has a comparative advantage in producing salads.

96 SPECIALIZATION AND TRADE Joes Comparative Advantage Joes opportunity cost of a salad is 1/5 smoothie. Lizs opportunity cost of a salad is 1 smoothie. Joes opportunity cost of a salad is less than Lizs, so Joe has a comparative advantage in producing salads.

97 SPECIALIZATION AND TRADE Achieving 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.

98 SPECIALIZATION AND TRADE 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.

99 SPECIALIZATION AND TRADE Gains from trade: Liz gains 5 smoothies and 5 salads an hourshe originally produced 20 smoothies and 20 salads. Joe gains 5 smoothies and 5 salads an hourhe originally produced 5 smoothies and 5 salads. The next slide illustrates the gains from trade.

100

101 1.Joe and Liz each produce at point A on their PPFs. Joe has a comparative advantage in producing salads. SPECIALIZATION AND TRADE Liz has a comparative advantage in producing smoothies.

102 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. SPECIALIZATION AND TRADE 2. Joe produces 30 salads at point B on his PPF.

103 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. SPECIALIZATION AND TRADE Joe sells 20 salads and buys 10 smoothies from Liz. 3. Both consume at point C, which is outside their PPFs.

104

105 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

106 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.

107 4,000 100 5,000 2,000 1,000 3,000 500200 300400 0 Computers Wheat (tons) The U.S. PPF The U.S. has enough labor to produce 500 computers, or 5000 tons of wheat, or any combination along the PPF.

108 4,000 100 5,000 2,000 1,000 3,000 500200 300400 0 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 consume 250 computers and 2500 tons of wheat.

109 A C T I V E L E A R N I N G 4 : Derive Japans 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 Japans PPF. Your graph should measure computers on the horizontal axis.

110 Computers Wheat (tons) 2,000 1,000 200 0 100 300 Japans PPF Japan has enough labor to produce 240 computers, or 1200 tons of wheat, or any combination along the PPF.

111 Japan Without Trade Computers Wheat (tons) 2,000 1,000 200 0 100 300 Suppose Japan uses half its labor to produce each of the two goods. Then it will produce and consume 120 computers and 600 tons of wheat.

112 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.

113 A C T I V E L E A R N I N G 5 : Production under trade 1. 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 Japans PPF.

114 4,000 100 5,000 2,000 1,000 3,000 500200 300400 0 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.

115 Japans Production With Trade Producing 240 computers requires all of Japans 30,000 labor hours. Computers Wheat (tons) 2,000 1,000 200 0 100 300 So, Japan would produce 0 tons of wheat.

116 International Trade Exports: goods produced domestically and sold abroad Imports: goods produced abroad and sold domestically

117 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 Japans 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.)

118 U.S. Consumption With Trade 4,000 100 5,000 2,000 1,000 3,000 500200 300400 0 Computers Wheat (tons) computerswheat produced1603400 + imported1100 – exported0700 = amount consumed 2702700

119 Japans Consumption With Trade Computers Wheat (tons) 2,000 1,000 200 0 100 300 computerswheat produced2400 + imported0700 – exported1100 = amount consumed 130700

120 Trade Makes Both Countries Better Off U.S. consumption without trade consumption with trade gains from trade computers25027020 wheat2,5002,700200 Japan consumption without trade consumption with trade gains from trade computers12013010 wheat600700100

121 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.

122 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?

123 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.

124 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.

125 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!)

126 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 worlds 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.

127 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 hours Brazil producing one pound coffee requires 1 hour producing one bottle wine requires 5 hours Which country has an absolute advantage in the production of coffee? Which country has a comparative advantage in the production of wine?

128 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: Argentinas 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. Brazils opp. cost of wine is five pounds of coffee.

129 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.


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