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.

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 underpinnings Job, spending, investing, decisions w/in your career

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 limited Desirable Have 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 economy New taxes on a specific industry or product Wages (up) by an effective union strike

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.

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

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

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

Incentives Rewards for engaging in a particular activity One will react to incentives after making rational choices involving balancing costs and benefits

Self-interest Not always measured in the goal of attaining more dollars and cents Self-interest goals may relate to: prestige love helping others friendship power 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 beliefs Season Tastes Custom, 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

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

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

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

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

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 allocated What? How? For Whom?

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.

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?

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?

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

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? Ask your students about the saying “The best things in life are free.” Ask them to name some of these things that supposedly are free. Ask them what “free” means in this context. The idea here is to get them to see that even things without an explicit monetary cost are not truly “free,” because they have an opportunity cost. For example, when you ask them to name the “best things” that are “free,” they will respond with answers like love, sitting at the top of a mountain you just climbed and enjoying an awesome view, or maybe witnessing the joy of a child who has just been given a new toy. In each case, there is no explicit monetary cost, but there’s an opportunity cost. For example, a day spent climbing a mountain represents a day of foregone wages. And the fact that the mountain offers the incredible view probably means that land has been set aside for a national park that might otherwise be used to produce industrial chemicals, or it might be used for a subdivision of million-dollar homes. With love, it’s less obvious, but if prodded enough, your students will be able to think of non-monetary costs associated with love. For example, you might not want to see the latest Ashton Kutcher film, you might think he’s the world’s worst actor. But your boyfriend/girlfriend/teenaged daughter or other loved one is DYING to see it, they are BEGGING you to take them. So you take them. That’s true love, don’t you think? And it’s certainly not free.

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: 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 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: Answers
Cost of fixing transmission = $600 A. Blue book value is $6500 if transmission works, $5700 if it doesn’t Benefit 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’t Benefit of fixing the transmission is only $500. Paying $600 to fix transmission is not worthwhile.

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.

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.

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 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.

Employment of labor hours
PPF Example Producing one computer requires 100 hours labor. Producing one ton of wheat requires 10 hours labor. E D C B A Wheat Computers Production Employment of labor hours 50,000 500 50,000 40,000 10,000 25,000 1,000 400 Suggestion: Show first row. Explain how we get the production numbers from the employment numbers. Then, show the rest of the employment numbers, and give students 3 minutes to compute the production numbers for each employment allocation. 2,500 250 4,000 100 5,000

E D C B A Point on graph Production Com-puters Wheat A 500 B 400 1,000
B 400 1,000 C 250 2,500 D 100 4,000 E 5,000 E D C B A

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? This exercise leads students to discover for themselves that points under the PPF are possible but inefficient, while points above it are not possible. If you wish to move quickly through this material, you can safely “hide” or delete this slide and the two that follow it (which provide the answers to the questions on this slide).

Point F: 100 computers, 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

Point G: 300 computers, 3500 tons wheat G Point G requires 65,000 hours of labor. Not possible because economy only has 50,000 hours.

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) 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
–1000 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. slope = = –10 100 Here, the “rise” is a negative number, because, as you move to the right, the line falls (meaning wheat output is reduced). Moving to the right involves shifting resources from the production of wheat (which causes wheat output to fall) to the production of computers (which causes computer production to rise). Producing an additional computer requires the resources that would otherwise produce 10 tons of wheat. 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
In which country is the opportunity cost of cloth lower? FRANCE ENGLAND 61

England, because its PPF is not as steep as France’s. FRANCE ENGLAND There are two ways to get the answer. The hard way is to compute the slope of both PPFs. The slope of France’s PPF equals -600/300 = -2, meaning that France must give up two units of wine to get an additional unit of cloth. The slope of England’s PPF = -200/300 = -2/3, meaning that England only must sacrifice 2/3 of a unit of wine to get an additional unit of cloth. Thus, the opportunity cost of cloth is lower in England than France. The question, however, does not ask for the numerical values of the opportunity cost of cloth in the two countries. It only asks which country has a lower opportunity cost of cloth. There is an easy way to determine the answer. Students must remember that the slope of the PPF equals the opportunity cost of the good measured on the horizontal axis. Then, students can simply “eyeball” the two PPFs to determine which is steepest. From the graphs show, it’s pretty easy to see that England’s PPF isn’t as steep, and therefore the opportunity cost of cloth is lower in England than in France. 62

Economic Growth and the PPF
Economic growth shifts the PPF outward. With additional resources or an improvement in technology, the economy can produce more computers, more wheat, The PPF shows the tradeoff between the outputs of different goods at a given time, but the tradeoff can change over time. For example, over time, the economy might get more workers (or more factories or more land). Or, a more efficient technology might be invented. Both events – an increase in the economy’s resources or an improvement in technology – cause an expansion in the set of opportunities. That is, both allow the economy to produce more of one or both goods. This is a simple example of economic growth, an important subject that gets its own chapter in the macroeconomics portion of the textbook. In the example shown on this slide, economic growth causes a parallel outward shift of the PPF. Since the new PPF is parallel to the old one, the tradeoff between the two goods is the same. However, this need not always be the case. For example, if a new technology had more impact on the computer industry than on the wheat industry, then the horizontal (computer) intercept would increase more than the vertical (wheat) intercept, and the PPF would become flatter: the opportunity cost of computers would fall, because the technology has made them relatively cheaper (relative to wheat). Going into more detail here is probably beyond the scope of this chapter. or any combination in between.

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 Tater tots As the economy shifts resources from Tater tots to mountain bikes: PPF becomes steeper opp. cost of mountain bikes increases

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. At A, opp. cost of mtn bikes is low. Tater tots Here, we are using “workers” for the more general “resources,” to keep things simple and consistent with the previous examples. Mountain Bikes

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. At B, opp. cost of mtn bikes is high. Tater tots B Mountain Bikes

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 bow-shaped PPF is more realistic. However, the linear PPF is simpler to work with, and we can learn a lot about how the economy works using the linear PPF.

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

(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

(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

(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

(3) Market Competition Resource competition Sellers compete against other sellers by trying to make their resources more productive

(3) Market Competition Product competition Buyers compete against other buyers in product markets Example: auction

(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”

Households: own the factors of production, sell/rent them to firms for income buy and consume goods & services Firms Households This and the following two slides build the Circular-Flow Diagram, piece by piece.

Firms Households Firms: buy/hire factors of production, use them to produce goods and services sell goods & services

Firms Households Markets for Goods & Services
Revenue Spending G & S sold G & S bought Firms Households Wages, rent, profit Factors of production Income Labor, land, capital In this diagram, the green arrows represent flows of income/payments. The red arrows represent flows of goods & services (including services of the factors of production in the lower half of the diagram). To keep the graph simple, we have omitted the government, financial system, and foreign sector, as discussed on the next slide. Changing the animation on this slide: If you wish, you can easily change the order in which the markets and arrows appear. From the “Slide Show” drop-down menu, choose “Custom Animation…” Then, a box will appear (maybe along the right-hand-side of your PowerPoint window) that allows you to modify the order in which things appear (as well as other aspects of the animation). For further information, open PowerPoint help and search on “change the sequence of animations.” Markets for Factors of Production

HOW PEOPLE INTERACT An “economy” is just a group of people interacting with each other. Whether we’re talking about the U.S. economy, or the local economy, the term “economy” simply means a group of people interacting with each other. These interactions play a critical role in the allocation of society’s scarce resources. For example, the interaction of buyers and sellers determines the prices of goods and the amounts produced and sold. These interactions are an important part of what economists study.

hair gel from Roseville, MN
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. hair gel from Roseville, MN cell phone from Taiwan dress shirt from China coffee from Kenya

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

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 Comparative advantage and absolute advantage are concepts that give students trouble. It flies in the face of intuition to say that even though someone has the ability to produce something using fewer resources than someone else, nonetheless, it still pays for the two to trade. It is an especially difficult concept to grasp when you up the ante by saying that the same would still be true even if that person enjoyed an absolute advantage in everything over their trading partner! This might be a good opportunity to use a very concrete example that students should be able to compute right in the classroom. Lay out the following scenario: Assume Suzie, a computer consultant, is very good at repairing computers and also happens to be a very good house painter. In fact, she is so good that it turns out she is more productive at both things than her neighbor, Bob, who happens to paint houses for a living. To the right is a table that shows the amount of time it takes for Suzie and Bob to perform each of the two activities. In addition, let’s assume that Suzie and Bob earn $100 per computer repaired and Bob and Suzie earn $960 per house painted. Ask the students to compute the opportunity cost for Suzie and Bob repairing a computer and painting a house. The new table to the right contains the opportu54 nity costs. (To calculate these numbers, take Suzie’s opportunity cost of painting a house. In the 30 hours it takes her to paint a house, she could have repaired 15 computers, so the opportunity cost is 15 computers times $100 each.) It reveals that Suzie has the lower opportunity cost of repairing computers and Bob has the lower opportunity cost of painting houses. What this example demonstrates so powerfully is that a person can have an absolute disadvantage in everything, as is the case for Bob, but still manage to have a comparative advantage in an activity. Point out to students that this logic applies between individuals and also across cities, states, and nations

Liz's Smoothie Bar In an hour, Liz can produce either 40 smoothies or 40 salads. Liz's opportunity cost of producing 1 smoothie is 1 salad. Liz's opportunity cost of producing 1 salad is 1 smoothie. Each hour, Liz produces 20 smoothies and 20 salads.

Joe's Smoothie Bar In an hour, Joe can produce either 6 smoothies or 30 salads. Joe's opportunity cost of producing 1 smoothie is 5 salads. Joe's opportunity cost of producing 1 salad is 1/5 smoothie. 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.

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. 96

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.

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. Joe produces 30 salads at point B on his PPF. 2. Liz produces 35 smoothies and 5 salads at point B on her PPF.

Joe and Liz trade salads and smoothies at a price of 2 salads per smoothie. Joe sells 20 salads and buys 10 smoothies from Liz. Liz sells 10 smoothies and buys 5 salads from Joe. 3. Both consume at point C, which is outside their PPFs.

Another Trade Example Two countries: the U.S. and Japan
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 The lessons illustrated by this international trade example also apply to trade between two individual producers. Note that this chapter in the textbook does the reverse: It develops the lessons in the context of an example involving two individual producers, and then states that the lessons also apply to international trade. So, between this PowerPoint and the textbook chapter, students will see the same concepts and lessons developed in two different but entirely consistent approaches and examples. The example in this PowerPoint is highly contrived and unrealistic in order to illustrate complex concepts as simply as possible. The example has some qualities that make it especially valuable: * The two goods are fundamentally different (one is agricultural, the other manufactured), which makes gains from trade based on comparative advantage very likely. An example using more similar goods, say laptop computers and MP3 players, would not be appropriate for this chapter because it would more likely give rise to inter-industry trade, and the gains would likely arise from a source other than comparative advantage (probably increasing returns to scale). * In the example here, it turns out that the U.S. has an absolute advantage in both goods, yet both countries gain from trade. Students see, therefore, that comparative advantage, not absolute advantage, is what’s necessary for trade to be mutually beneficial. * In the real world, one often sees gains from trade based on comparative advantage occurring between countries that are very different – such as between rich industrialized countries and poor developing countries. This example shows that trade based on comparative advantage can also occur between countries that are at similar levels of industrialization and income. (Of course, the U.S. and Japan are very different; but they are far more similar than are the U.S. and, say, Botswana or Cameroon.)

Production Possibilities in the U.S.
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. In a few moments, students will be asked to derive Japan’s PPF. Warning them of this now may increase their attention, because they will have to follow the same steps that you are about to show them in your derivation of the U.S. PPF on the next slide.

The U.S. PPF The U.S. has enough labor to produce 500 computers,
4,000 100 5,000 2,000 1,000 3,000 500 200 300 400 Computers Wheat (tons) The U.S. has enough labor to produce 500 computers, or 5000 tons of wheat, or any combination along the PPF. Deriving the intercepts, or endpoints of the PPF: The U.S. has 50,000 labor hours. It takes 100 hours to produce a computer. If the U.S. uses all its labor to produce computers, then it will produce 50,000/100 = 500 computers. Hence, the horizontal intercept is (500 computers, 0 wheat). It takes 10 hours to produce a ton of wheat. If the U.S. uses all its labor to produce wheat, then it will produce 50,000/10 = 5000 tons of wheat. Hence, the vertical intercept is (0 computers, 5000 tons of wheat). The PPF is the straight line that connects the two endpoints.

The U.S. Without Trade 4,000 100 5,000 2,000 1,000 3,000 500 200 300 400 Computers Wheat (tons) 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. Of course, the U.S. could choose a different point. The actual choice will depend on the preferences of society. It’s important to note that, without trade, a country consumes what it produces.

A C T I V E L E A R N I N G 4: Derive Japan’s PPF
Use the following information to draw 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. ** Using this information to draw Japan’s PPF requires a calculator (or the ability to do long division). ** If your students have a “gutted handout” of these slides, have them draw their PPF on the axes provided on the following slide. This activity should take only 3 minutes of class time. It’s good practice & review for students, and helps break up the lecture. Your graph should measure computers on the horizontal axis.

Japan’s PPF Japan has enough labor to produce 240 computers,
Japan’s PPF Computers Wheat (tons) 2,000 1,000 200 100 300 Japan has enough labor to produce 240 computers, or 1200 tons of wheat, or any combination along the PPF. Horizontal intercept: (30,000 labor-hours)/(125 hours per computer) = 240 computers. Vertical intercept: (30,000 labor-hours)/(25 hours per ton of wheat) = 1200 tons of wheat.

Japan Without Trade Computers Wheat (tons) 2,000 1,000 200 100 300 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.

Consumption With and Without Trade
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 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 Japan’s PPF. Give your students a few minutes to solve these problems before showing the answers on the next slides. This will break up the lecture, get the students involved, and give them practice with “word problems.” It is not necessary that all students finish both problems before moving on. It’s fine if most finish the first, and a few finish the second. Note that most students will need a calculator to solve these problems.

U.S. Production With Trade
Computers Wheat (tons) 4,000 100 5,000 2,000 1,000 3,000 500 200 300 400 Producing 3400 tons of wheat requires 34,000 labor hours. The remaining 16,000 labor hours are used to produce 160 computers. Point out to students that the red dot represents the combination (160 computers, 3400 tons of wheat). We will assume that this is the combination the U.S. produces in the scenario in which the U.S. trades.

Japan’s Production With Trade
Japan’s Production With Trade Computers Wheat (tons) 2,000 1,000 200 100 300 Producing 240 computers requires all of Japan’s 30,000 labor hours. So, Japan would produce 0 tons of wheat. The red dot represents the combination (240 computers, 0 tons wheat). We will assume this is the combination that Japan produces. Point out that, just because Japan is not producing any wheat does not mean that Japan’s consumers must all go on the Atkins diet (which shuns bread and other foods made from wheat). When trade is allowed, Japan can trade some of its computers for wheat produced in another country.

International Trade Exports: goods produced domestically and sold abroad Imports: goods produced abroad and sold domestically You might want to see if your students can figure out that consumption is the difference between the amount produced and the amount traded. Giving them a hint might be helpful.

A C T I V E L E A R N I N G 6: Consumption under trade
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.) 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. Some students need help figuring out that consumption of a good is the difference between the amount produced and the amount exported.

U.S. Consumption With Trade
Computers Wheat (tons) computers wheat produced 160 3400 + imported 110 – exported 700 = amount consumed 270 2700 4,000 100 5,000 2,000 1,000 3,000 500 200 300 400

Japan’s Consumption With Trade
computers wheat produced 240 + imported 700 – exported 110 = amount consumed 130 Computers Wheat (tons) 2,000 1,000 200 100 300

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 Japan consumption without trade consumption with trade gains from trade computers 120 130 10 wheat 600 700 100

Where Do These Gains Come From?
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. The last bullet point states that gains from trade will arise if each country has an absolute advantage in something. We will see next, though, that absolute advantage is not required for both countries to gain from trade.

Where Do These Gains Come From?
Where Do These Gains Come From? Which country has an absolute advantage in computers? Producing one computer requires 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 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
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. This definition of comparative advantage is new to the 4th edition. The definition from the 3rd edition read “the comparison among producers of a good according to their opportunity cost.” The new definition is more precise.

Opportunity Cost and Comparative Advantage
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
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 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?

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….
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. The second bullet point mentions technology and resources. In our example, the technology is how many labor-hours are required to produce each good. The resources are simply the quantity of labor-hours available in each country. In the following chapter (supply & demand), students will begin their study of how prices and quantities are determined.

UNIT I – Basic Economic Concepts

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