BU204-01: Unit 2 Seminar Tilahun Ayanou, PhD Thursday 8:00-9:00PM 3/29

Unit 1 Seminar: Recap 1.Basic Economic Principles Guide Economic Decision Making Process (Individual Choices) Scare resources and rational choices Opportunity costs Tradeoff: Marginal Costs and Marginal Benefits Comparison Rational People Respond to Incentives 2.Economic Principles Guide Economic Interactions Gains from Trade Markets move towards equilibrium Efficient use of resources to achieve national goals Markets lead to better economic efficiency when markets fail, government interventions improves welfare 3.Principles that underlie economy-wide interactions

Unit 1 Recap: Gains from Trade In a market economy: there are gains from trade since specialization increases output. – Tradeoffs occur based on opportunity costs. Principles Extended to chapters 2 and 5 – Interdependence of economic agents’ choices – Gains from trade based on opportunity costs

Unit 2 Seminar Agenda Chapter 2: Economic Models: Tradeoffs and Trade Also Refer to Chapter 2 Appendix: Graphs in Economics – Relevant throughout the course Chapter 5: International Trade Pages 117 – 127, and Pages 136 – 142.

Chapter 2 Economic Models: Tradeoffs and Trade o Simple Economic Models: Agents Interactions  Production Possibility Frontier (PPF): Tradeoffs  Circular Flow Diagram: Economic Agents Interdependence o Trade and Comparative Advantage o The difference between positive economics and normative economics

Models in Economics Almost all economics is based on models. A model is a simplified representation of a real economic situation that is used to better understand real-life economic conditions. The “other things equal” assumption means that all other relevant factors remain unchanged. “Ceteris Paribus”

2.1 Tradeoffs: The Production Possibility Frontier The production possibility frontier (PPF) illustrates the tradeoffs facing an economy that produces only two goods. PPF shows the maximum quantity of one good that can be produced for any given production of the other. Why do we face PPF? Resources at our disposal are scarce at a given period. Increase in the production of one good leads to the decrease in the production of another good.

The Production Possibility Frontier Quantity of Coconuts Production possibility frontier A B D C Feasible and efficient in production Not feasible PPF Quantity of fish Feasible but not efficient

A Simple Economic Model Assumptions: 1.A simple Economy that produces and trades two goods: Coconuts and fish 2.Two Island Castaways: Hank and Tom  Produce and consume both goods 3. Limited/Scarce Resource: Time  Should Hank and Tom strive for self-sufficiency or engage in trade based on opportunity costs?  Do they gain from Trade based on opportunity costs?

Production Possibilities for Two Castaways (Hank and Tom) Hank’s PPF Quantity of Coconuts Quantity of fish (a) Hank’s Production Possibilities Hank’s consumption without trade

Production Possibilities for Two Castaways (b) Tom’s Production Possibilities Tom’s consumption without trade Tom’s PPF Quantity of Coconuts Quantity of fish

Opportunity Cost from PPF Opportunity Cost is a Ratio (constant O.C.) O.C. coconuts=(# fish lost)/ (# coconuts gained) O.C. Fish= (#coconuts lost)/(# fish gained)

PPF of Hank Hank’s Maximum Production Coconuts: 20 or Fish: 10 O.C. Coconuts = 10/20 = ½ fish O.C. Fish = 20/10 =2 coconuts Hank’s Consumption without Trade:  8 Coconuts and 6 fish

PPF of Tom Tom’s Maximum Production: Coconuts :30 or Fish: 40 O.C. Fish =30/40= ¾ Coconuts O.C. Coconuts = 40/30 = 4/3 Fish Tom’s Consumption without Trade:  9 Coconuts and 28 fish

Tom and Hank’s Opportunity Costs Tom’s Opportunity Cost Hank’s Opportunity Cost One fish3/4 coconut2 coconuts One Coconut4/3 fish1/2 fish

Specialize and Trade  Both castaways are better off when they each specialize in what they are good at and trade.  It’s a good idea for Tom to catch fish for both of them, because his opportunity cost of fish in terms of coconuts not gathered is only 3/4 of a coconut, versus 2 coconuts for Hank.  Correspondingly, it’s a good idea for Hank to gather coconuts for the both of them since his O.C. is ½ fish vs. 4/3 fish for Tom.

Do the Castaways Gain from Trade? Both Tom and Hank experience gains from trade:  Tom’s consumption of fish increases by two, and his consumption of coconuts increases by one.  Hank’s consumption of fish increases by four, and his consumption of coconuts increases by two.  Key Assumption: No Cheating

Quantity of Apples Quantity of Oranges (pounds) (pounds) A 1,000 0 B C D E F What is the opportunity cost of increasing the annual output of apples from 700 to 900 pounds? Decrease production of orange from 600 to 400 pounds = decrease of 200 pounds of oranges.

2.2 Comparative vs. Absolute Advantage An individual has a comparative advantage in producing a good or service if the opportunity cost of producing the good is lower for that individual than for other people. Comparative advantage explains the source of gains from trade between individuals as well as between countries.

Absolute Advantage… An individual has an absolute advantage in an activity if she or he can do it better than other people. Ex: Tom has absolute advantage in gathering coconuts and catching fish. Maximum Production: Hank: 20 Coconuts or 10 Fish Tom: 40 Fish or 30 Coconuts Tom also benefits from trade: comparative advantage guides based on opportunity cost trade.

2.3 Transactions: The Circular-Flow Diagram The circular-flow diagram is a model that represents the transactions (interactions) in an economy by flows around a circle. It represents transactions within the economy as flows of goods, services, and money between households and firms. These transactions occur in markets for goods and services and factor markets.

The Circular-Flow Diagram Money Factors Goods and services Factors Households Firms Markets for goods and services Factor Markets Goods and services Money

Households and firms pay taxes and receive transfers. Governments buy goods and services from firms.

Circular-Flow of Economic Activities The economy works via interactions among economic agents. Economy operates in a circular flow. Households’ economic decisions (choices) affect the firms, and firms decisions (choices) affect the households. Government’s economic policy instruments affect both households and firms.

Economic Interactions… Firms sell goods and services that they produce to households in markets for goods and services. Firms buy the resources they need to produce, i.e. factors of production, in factor markets from households (labor). Factor markets: determine the economy’s income distribution.

2.4 Positive and Normative Economics Positive economics is the branch of economic analysis that describes the way the economy actually works. Based on facts or data. Examples: the current unemployment rate in the USA is 8.5%. USA has high labor productivity (output/labor) Africa has very low wage rates. USA has very high wage rates.

Normative Economics Normative economics makes prescriptions about the way the economy should work. Personal Opinions (Value Judgments). Example: We should reduce USA imports. Economists can determine correct answers for positive questions, but typically not for normative questions, which involve value judgments.

Chapter 5: International Trade  How comparative advantage leads to mutually beneficial international trade.  The sources of international comparative advantages.  Why governments often engage in trade protection to shelter domestic industries from imports and how international trade agreements counteract this.

The Growing Importance of International Trade (b) Imports and Exports for Different Countries, 2005 Belgium 90% Percent of GDP (a) U.S. Imports and Exports Year 18% Percent of GDP Imports Exports Mexico France Germany Canada U.S.

Exports and Imports Exporting industries produce goods and services that are sold abroad. Import-competing industries produce goods and services that are also imported. International trade tends to increase the demand for factors that are abundant in our country compared with other countries, and to decrease the demand for factors that are scarce in our country compared with other countries. As a result, the prices of abundant factors tend to rise, and the prices of scarce factors tend to fall as international trade grows.

5.1 Production Possibilities and Comparative Advantage A country has a comparative advantage in producing a good or service if the opportunity cost of producing the good or service is lower for that country than for other countries.

The Gains from International Trade The Ricardian model of international trade: trade between two countries makes both countries better off than they would be in autarky. – there are gains from trade. Specialization has the effect of increasing total world production of both goods and that each country can consume more of both goods than it did under autarky. Autarky (closed economy) is a situation in which a country do not trade with other countries.

Comparative Advantage and the Production Possibility Frontier (a) U.S. Production Possibility Frontier(b) Vietnamese Production Possibility Frontier 0 2,000 1,000 Quantity of shrimp (tons) Quantity of computers 1, PPF US C Slope = –2 U.S. production and consumption in autarky 0 1, Quantity of computers 2,0001,000 PPF V C V Vietnamese production and consumption in autarky Slope = –0.5 Quantity of shrimp (tons)

USA’s and Vietnam’s Opportunity Costs USA specializes in Computers and Vietnam Specializes in Catching Shrimps USA’s Opportunity Cost Vietnam’s Opportunity Cost One Computer 1/2 ton Shrimp2 tons of shrimps One ton Shrimp 2 computers1/2 ton Shrimp

Production and Consumption Under Autarky (a) United StatesProductionConsumption Quantity of shrimp (tons)500 Quantity of computers1,000 (b) VietnamProductionConsumption Quantity of shrimp (tons)1,000 Quantity of computers500 (c) World (United States and Vietnam)ProductionConsumption Quantity of shrimp (tons)1,500 Quantity of computers1,500

The Gains from International Trade 0 2,000 1,000 1,250 Quantity of computers 1, PPF US C US Q 0 1, Quantity of shrimps (tons) 2,0001,0001,250 Q C C’ V PPF C’ US U.S. production and consumption in autarky U.S. consumption with trade U.S. production with trade Vietnamese production with trade Vietnamese consumption with trade Vietnamese production and consumption in autarky (a) U.S. Production and Consumption(b) Vietnamese Production and Consumption Quantity of computers V V V

Production and Consumption after Specialization and Trade (a) United StatesProductionConsumption Quantity of shrimp (tons)0750 Quantity of computers2,0001,250 (b) VietnamProductionConsumption Quantity of shrimp (tons)2,0001,250 Quantity of computers0750 (c) World (United States and Vietnam)ProductionConsumption Quantity of shrimp (tons)2,000 Quantity of computers2,000

5.2 Sources of Comparative Advantage The main sources of comparative advantage are: International differences in climate Differences in technology Factor endowments – Goods differ in their factor intensity, and countries tend to export goods that are intensive in the factors they have in abundance. – The factor intensity of production of a good is a measure of which factor is used in relatively greater quantities than other factors in production. Examples: labor-intensive products: Textile products » Capital-intensive products: oil production & refining

5.3 Effects of Trade Protection An economy has free trade when the government does not attempt either to reduce or to increase the levels of exports and imports that occur naturally due to supply and demand. Policies that limit imports are known as trade protection. Most economists advocate free trade. But many governments engage in trade protection of import-competing industries.

Protectionist Policies The two most common protectionist policies are tariffs and import quotas. In rare instances, governments subsidize export industries. A tariff is a tax levied on imports. – It raises the domestic price above the world price, leading to a fall in trade and total consumption but a rise in domestic production. An import quota is a legal limit on the quantity of a good that can be imported.

The Political Economy of Trade Protection Arguments for Trade Protection – national security – job creation – the infant industry argument Both exports and imports create jobs but exports generally tend to create more jobs. Infant (new) industries may need protection from imports until they grow to be competitive.

5.4 International Trade Agreements and the World Trade Organization To further trade liberalization, countries engage in international trade agreements. International trade agreements are treaties in which a country promises to engage in less trade protection against the exports of other countries in return for a promise by other countries to do the same for its own exports.

Some trade agreements are for only a small number of countries, such as the North American Free Trade Agreement (NAFTA) which is among the United States, Canada and Mexico. The European Union (EU) is a customs union among 27 European countries. The World Trade Organization (WTO) is a multinational organization that seeks to negotiate global trade agreements as well as adjudicate trade disputes between member countries.

5.5 New Challenges to Globalization Two concerns shared by economists:  Worries about the effects of globalization on inequality. (Efficiency vs. Equity Tradeoffs)  Worries that new developments, in particular the growth in offshore outsourcing, are increasing economic insecurity, especially jobs. Growing Inequality and Growth Pattern Income and Wealth Concentration at the Top. » Also growing fast for the top income group only. Income Stagnation or Decline for the Majority. » Unsustainable and may Lead to Instability. =The End=