 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

 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? - 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 revisi  ted

 Voluntary versus involuntary exchange  An intuitive approach to gains in trade  Using an economic model to demonstrate the gains from trade

 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) Excerpt from Wealth of Nations (Fordham University website)

 Self-sufficiency ◦ Pros: independence ◦ Cons: loss of efficiency, variety in consumption and production  Trade with Yakima?  Trade with other states?  Trade with other nations?

 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

 Assumptions: ◦ Two individuals – rancher and a farmer ◦ Two goods – meat and potatoes ◦ Each work eight hours a day ◦ Farmer takes 60min/oz meat and 15min/oz potatoes ◦ Rancher takes 20min/oz of meat and 10min/oz of potatoes

 Absolute advantage ◦ Rancher than farmer is more efficient and 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

 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

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

Potatoes (ounces) 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

Potatoes (ounces) B 0 Meat (ounces) (b) The Rancher’s Production Possibilities Frontier If there is no trade, the rancher chooses this production and consumption.

 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.

 Marginal versus Complete Approach  Marginal adjustment ◦ Farmer -1M → +4P ◦ Rancher +1M → -2P ◦ Total 0M +2P, or ◦ Rancher -1P → +1/2M ◦ Farmer +1P → -1/4M ◦ Total 0P +1/4M  Either way specializing and trading means either more meat or potatoes

 Mankiw explains gains a bit differently and perhaps in a more complicated way ◦ Farmer 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….

Copyright © 2004 South-Western

Potatoes (ounces) B 0 Meat (ounces) (b) The Rancher’s Production and Consumption B* Rancher's consumption with trade Rancher's production with trade Rancher's production and consumption without trade

Copyright©2003 Southwestern/Thomson Learning Potatoes (ounces) 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

 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 Trade ◦ Tribal to feudal to modern times ◦ Adam Smith (1776) and David Ricardo (1817)  Protectionism ◦ The costs of not trading (e.g. Cost of Protectionism)Cost of Protectionism ◦ Distributional impacts – transfers from consumers to producers/workers ◦ Political 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 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.