1. Continuation of Lecture 2

2. Checking Out What do the stores have in common?
Supermarket Model -- gather all of your purchases into your cart and selecting which line (in front of store) to pay for purchases
Department Store Model -- pay for purchases in the ‘department’ where the goods are located
Snake Line Model -- Enter a single line and when at head of line go to first available clerk
What do the stores have in common?
Why do certain stores adopt one method and not the other?

3. 7) Resources should be used efficiently to achieve society’s goals
Efficiency -- the inability to improve one person’s well being without hurting someone else (Pareto Optimality)
If we are inefficient in our use of resources, we are wasting them. We could increase well-being (produce more) by reallocating them.
Why would you want to deny someone additional welfare if it didn’t hurt anyone else’s welfare?
This is a normative (value) statement in contrast to positive statements (statements of fact). What can economists say about other goals for society such as fairness or equity in the distribution of society’s wealth?

4. 8) Markets usually lead to efficiency
This statement is often taken to mean that society (a collective decision perhaps taken by government) should not interfere with individual choice. A positive statement leading to a normative conclusion.
But markets can fail to achieve an efficient result-- for example, congestion on the highways.

5. 9) When markets are not efficient, government intervention can lead to improvement in social welfare
Yet there isn’t a guarantee that governments will improve upon the market outcome. Rather they hold out the possibility to improve upon the efficiency of the outcomes of individual choice.
Important to remember -- it is not that individuals make ‘bad’ choices; rather the market has failed to coordinate their decisions

6. How is equity related to efficiency?
There is a tradeoff between equity and efficiency
As markets become more efficient, they are perceived as less equitable.
Markets generate inequality in earnings
Markets reward winners and punish losers
Losing firms exit from the market
In labor markets, the most able/talented are hired; others accept low wage jobs or are unemployed

7. Equity
What is equity?
Equity is a value judgment that means different things to different people
Equity in the distribution of income often means that income was earned fairly

8. Equity and Equality Equity is not the same thing as Equality
A equal distribution of income means that all units have exactly the same income.
Some people may define an equitable distribution of income as one in which all incomes are equal, but most Americans would not!!!
To most Americans, incomes in an equitable distribution of income would vary according to individuals contributions to the market.
Most Americans believe the story of the Little Red Hen represents equity!

9. Are markets moral?
If markets generate distributions of income that are unequal, are markets moral?
Markets are neither moral or immoral.
Markets are amoral.
They are simply the interactions among individuals
They move toward equilibrium and
They promise efficient use of resources.

10. Are markets moral, cont.
The issue of morality enters the discussion of markets in two ways:
Did the market participants behavior morally?
Was there a level playing field?
Did firms collude? Fix prices? Restrict supply?
Were individuals given equal opportunity to prepare themselves for market activity?

11. Are markets moral, cont.
2. How did society react to the situation of the losers?
Were the losers supported in ways consistent with their dignity as human beings? (alternate definition of equity)
Examine redistributive policies
Tax policies
Social insurance and public welfare

12. Is the market moral, cont.
Additional reading
Chapter 21, “Taxes, Social Insurance and Income Distribution”
Rebecca Blank and William McGurn, Is the Market Moral? A Dialogue on Religion, Economics, and Justice. The Brookings Institution, 2003.
National Conference of Catholic Bishops, Economic Justice for All: Pastoral Letter on Catholic Social Teaching and the US Economy, 1986.

13. Summary: Nine Principles
Resources are scarce
Every Choice has an Opportunity Cost
Choices are made at the margin
Individuals seek their self interest
There are gains from trade
Markets move toward equilibrium
Resources should be used efficiently
Markets usually lead to efficiency
When markets don’t achieve efficiency, government intervention can improve social welfare

14. Clicker Time We know that resources are being used efficiently when
Scarcity is no longer an issue.
An economy utilizes every opportunity to make people better off.
There are still gains from trade available.
We achieve equity.

15. Clicker Time, cont. 2. The concept of equity focuses on
How to produce the maximum possible output from a given amount of resources.
How governments can intervene to make markets work better.
The issue of fairness
The amount of physical plant and equipment an employer owns.

16. Clicker Time, cont.
3. Government intervention in a market can improve society’s welfare when
The market outcome is equitable.
The market fails to provide certain goods.
The market outcome is efficient.
We have exploited all opportunities to make people better off.

17. Trade-Offs and Trading
Lecture 3

18. In Lecture 3
Models
Trade-Offs (Production Possibility Frontiers and Opportunity Cost)
Implication for Trading and Production (Specialization and Comparative Advantage)

19. To Understand the Complex World, We Construct a Simplified Model
Models are abstractions of reality, capturing what is believed to be the important relationships
Expressed in words, graphs, or mathematical equations
Will imply a path of causation and relationship between variables
Holding Everything Else Constant

20. David Ricardo ( )
Credited with creation of the ideas of absolute and comparative advantage to understand trade
Examined taxation and government spending
Was successful in his own investing

21. Attendance
I am in class on August 31, 2006
a. Yes

22. What Can I Produce? I could produce only Wool (specialization in Wool)
I could produce only Wine (specialization in Wine)
Or combinations of both (efficient combinations)
Why is the production possibility frontier (PPF) bowed outward?
Wine
Wool
Not Feasible
Feasible but Inefficient

23. A Word About Slopes Y Let Y = f(X) denoted by the red line
From the initial point (Xo,Yo)
Consider a change in X = X and consequently a change in Y = Y
The ratio Y/X is the slope of the blue line drawn through the two points (Arc Method)
For small (marginal) changes in X, the slope of the line tangent to the function represents the slope of the function (Point Method) Xo Yo Y X X

24. Opportunity Cost A B W0 W1 Slope=Wine/Wool
The slope of the PPF tells us how much Wine we would have to give up to get more Wool -- Opportunity Cost of Wool
Assume we are producing small amounts of Wool (W0). The slope of the red tangency tells us the Opportunity Cost of Wool (how much Wine we have to give up). The relatively flat slope indicates small sacrifices of wine are required to obtain additional units of wool.
Now assume we have produced more Wool (W1). The relatively tangency line tells us that larger amounts of wine must be sacrificed to obtain more wool than W1.
The Opportunity Cost of Wool in terms of Wine has risen as we move along the PPF from A to B
The bowing out of the PPF reflects increasing opportunity costs
Slope=Wine/Wool
Wine
Wool A B W0 W1

25. Alternative PPFs Wine Increasing Opportunity Costs
Constant Opportunity Costs
Decreasing Opportunity Costs
Wool

26. Economic Growth Wine Initial PPF Wool Why would the PPF shift outward?
-- more resources: land, labor, capital, and human capital
-- technological progress

27. Production and Consumption
Assume that there are Constant Opportunity Costs in Wool and Wine Production in two Countries
Britain is currently producing both wool and wine without trade (current production levels are marked)
Consider a potential trading partner’s PPF, Portugal and their current production (neither country has an absolute advantage)
Wine
Wool

28. Specialization and Trading
Assume Britain decides to specialize in wool and use some of their surplus wool to purchase wine from Portugal.
Also assume that Portugal decides to specialize in the production of wine and use some of its extra wine to purchase wool from Britain.
Will trade between Britain and Portugal improve the well being in both countries?
Wine
Wool

29. Efficiency
On this figure, how can we show wine and wool consumption that would represent both countries being made better off?
Draw quadrants through each countries initial consumption points
The areas in the ‘northeast’ quadrants represent where both countries would be better off
Wine
Wool

30. Specialization and Trading
Assume that specializing in wine production reduces Portugal’s woolen production by the same amount that Britain has increased its production of wool.
Will the gain in Portugal’s wine production exceed the loss in wine production in Britain?
Yes, because Portugal has a higher opportunity cost in the production of wool--it sacrifices more wine for each additional unit of wool. Conversely, the amount of wine that Portugal gains per unit of wool foregone is greater than the wine that Britain sacrifices to produce another unit of wool.
Wine
Wool

31. Efficiency
If Portugal trades their all of the increase in their wine production for Britain’s increased wool production, Portugal continues to be able to consume exactly what it did prior to the specialization and trading.
In contrast, Britain can increase its wine consumption and still consume the same amount of wool -- they are better off.
Less aggressive trading terms with Portugal would allow both countries to be made better off.
Wine
Wool

32. Adjustment Costs
What is happening to workers in both Britain and Portugal?
In Britain, workers who used to work in the vineyards are working in wool. In Portugal, workers in the woolen industry will migrate to the vineyards.
2. Is there a cost to this adjustment?
There is a one time adjustment costs as workers have to find employment in other sectors of the economy but the benefits of trade are on going.
3. Who benefits from the trade?
4. How can a democratic society make these adjustments and impose these costs on some in order to reap the gains?

33. Additional Reading
In handouts folder on web site, read the New York Times op-ed by Senator Schumer and Paul Craig Roberts and the speech by Ben Bernanke (Chair of the Fed) on globalization

34. The Story over Time
Woolen manufacturing is more likely to benefit from technical progress compared to wine production
Consequently the PPF of the country specializing in wool will shift out faster than the country specializing in wine
Britain became wealthier while Portugal became relatively poorer

35. Trade and Specialization
As individuals and countries specialize, they will trade for goods and services they do not produce. Consequently they will become dependent upon others for their consumption.
Is this good or bad for countries? Can they trust each other?

36. On the Homefront Market Production (Income)
Home Production
Market Production (Income)
In 1950, women made less than men in the paid market but were more productive in home production. What would the PPFs for males and females look like? Does this suggest that women would specialize in home production while males went to work?
Over the last decades of the 1900s, discrimination against women in the labor force lessened (let us assume that our couple would earn the same amount if they devoted their entire time to market work). Would women stop cleaning homes?
While women would have an absolute advantage over men, we would expect men to continue to devote themselves exclusively to market work (not to engage in home production). Women may engage in more market work using the extra income to hire someone to clean the home or do two shifts (at the home and at the office). Sharing the home production is not consistent with the theory of comparative advantage and specialization.
Male
Female (today)
Female (1950)

37. Clicker Time
4. Specialization and trade are beneficial to two countries
Provided their opportunity costs of production are not the same for all goods they produce.
When each country specializes in producing the good that it can produce at the lowest opportunity cost
Even when one country can absolutely produce more than the other country.
All of the above.

38. Assignment for Next Lecture
Do Homework 2 on ‘Homework Assignment’ by Wednesday at 5 pm
Read Chapter 3
Topics Next Time
Concept of Demand and Supply