1. Principles and Policies I: Macroeconomics
Chapter 2: Trade-offs and Government Policy
Macroeconomics Week 2 (Maclachlan, Fall 04)

2. Macroeconomics Week 2 (Maclachlan, Fall 04)
Prob. 1-3
Donor: gains $30,000, loses one of two kidneys and takes on risk associated with any surgery.
Recipient: loses $30,000, gains a working kidney.
Both could be said to benefit if they undergo the transaction voluntarily and with full knowledge.
But such a transaction is illegal because of the view that not everything should be for sale—a social force embodied in law through the political process.
Macroeconomics Week 2 (Maclachlan, Fall 04)

3. Macroeconomics Week 2 (Maclachlan, Fall 04)
Prob. 1-5 Micro or Macro?
a) Should the U.S. government use a policy of free trade with China to encourage China t advance human rights?
Micro with macro implications.
Macroeconomics Week 2 (Maclachlan, Fall 04)

4. Macroeconomics Week 2 (Maclachlan, Fall 04)
b) Will the fact that more and more doctors are selling their practices to managed care networks increase the efficiency of medical providers.
Micro
Macroeconomics Week 2 (Maclachlan, Fall 04)

5. Macroeconomics Week 2 (Maclachlan, Fall 04)
c) Should the current federal income tax structure be eliminated in favor of a flat tax?
Micro with macro implications.
Macroeconomics Week 2 (Maclachlan, Fall 04)

6. Macroeconomics Week 2 (Maclachlan, Fall 04)
d) Should the minimum wage be raised?
Micro with macro implications.
Macroeconomics Week 2 (Maclachlan, Fall 04)

7. Macroeconomics Week 2 (Maclachlan, Fall 04)
e) Should AT&T and Verizon both be allowed to build local phone networks?
Micro.
Macroeconomics Week 2 (Maclachlan, Fall 04)

8. Macroeconomics Week 2 (Maclachlan, Fall 04)
f) Should commercial banks be required to provide loans in all areas of the territory from which they accept deposits?
Macro.
Macroeconomics Week 2 (Maclachlan, Fall 04)

9. Chapter Two Learning Objectives You should be able to:
Demonstrate opportunity cost with a PPC.
Relate the concept of comparative advantage to the PPC.
State the principle of increasing marginal cost.
State how through comparative advantage and trade, production possibilities increase.
State six roles of government.
Compare the regulation of international markets to the regulation of domestic markets.
Macroeconomics Week 2 (Maclachlan, Fall 04)

10. A Production Possibility Curve for a Society10 9 8 6 5 4 3 2 1 . 2Y 1X A X
If the slope of the production curve is -2 at A, the opportunity cost
of 1X is 2Y. 7
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

11. A Production Possibilities Table and Curve (Graph with guns on horizontal axis.)
% of resources
devoted to
production
of guns
Number
of butter
Pounds
Row 20 40 60 80
100 4 7 9 1 12 15 14 5 A B C D E F
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

12. A Production Possibilities Table and Curve
4 guns
1 pound of butter 15 B 14
3 guns
2 pounds of butter C 12 D 9
Butter E 5
1 gun
5 pounds of butter F 4 7 9 11 12
Guns
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

13. Increasing Marginal Opportunity Cost
The principle of increasing marginal opportunity cost states that opportunity costs increase the more you concentrate on an activity.
In order to get more of something, one must give up ever-increasing quantities of something else.
Macroeconomics Week 2 (Maclachlan, Fall 04)

14. Increasing Marginal Opportunity Cost
Butter
Slope is flat at A. Low opportunity cost of guns.
Slope is steep at B. High opportunity cost of guns.
Guns B A
Macroeconomics Week 2 (Maclachlan, Fall 04)

15. Macroeconomics Week 2 (Maclachlan, Fall 04)
Adam Smith ( )
Critic of mercantilism.
Countries should specialize and trade.
Specialize where there’s an ABSOLUTE ADVANTAGE
Macroeconomics Week 2 (Maclachlan, Fall 04)

16. Macroeconomics Week 2 (Maclachlan, Fall 04)
ABSOLUTE ADVANTAGE
A region has an absolute advantage if it takes fewer resources to produce a good there than elsewhere.
Coffee in Columbia.
Computer software in Silicon Valley.
Macroeconomics Week 2 (Maclachlan, Fall 04)

17. Macroeconomics Week 2 (Maclachlan, Fall 04)
David Ricardo ( )
Theory of comparative advantage.
Even without an absolute advantage a region can trade to the benefit of all parties.
Macroeconomics Week 2 (Maclachlan, Fall 04)

18. Macroeconomics Week 2 (Maclachlan, Fall 04)
The Benefits of Trade
The argument for the benefits of trade underlies the general policy of laissez-faire.
Laissez-faire – an economic policy of leaving coordination of individuals’ actions to the market.
Macroeconomics Week 2 (Maclachlan, Fall 04)

19. Production Possibilities without Trade
Pakistan can produce 4,000 yards of textile per day or 1 ton of chocolate per day.
Belgium can produce 1,000 yards of textile a day or 4 tons of chocolate per day.
Macroeconomics Week 2 (Maclachlan, Fall 04)

20. Production Possibilities without Trade
Pakistan has a comparative advantage in producing textiles.
Belgium has a comparative advantage in chocolate.
Macroeconomics Week 2 (Maclachlan, Fall 04)

21. Production Possibilities without Trade 4 3 2 1 5
Chocolate (in tons)
(in thousands of yards)
Textiles
Pakistan
Belgium
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

22. Production Possibilities without Trade
Pakistan has chosen to produce 2,000 yards of textiles and 0.5 tons of chocolate.
Belgium has chosen to produce 500 yards of textile and 2 tons of chocolate.
Macroeconomics Week 2 (Maclachlan, Fall 04)

23. Production Possibilities without Trade
Point A: The combination of textile and chocolate chosen by Pakistan.
Point B: The combination of textile and chocolate chosen by Belgium.
Point C: The joint combination without trade.
Macroeconomics Week 2 (Maclachlan, Fall 04)

24. Production Possibilities without Trade
Macroeconomics Week 2 (Maclachlan, Fall 04)

25. Production Possibilities without Trade5 4
Pakistan
(in thousands of yards)
Textiles 3 C A 2
Belgium 1 B
Chocolate (in tons)
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

26. Production Possibilities without Trade
The two extreme combinations are both countries producing only textile (point D) and both producing only chocolate (point E).
The combined production possibilities curve with no trade is drawn by connecting these two points.
Macroeconomics Week 2 (Maclachlan, Fall 04)

27. Production Possibilities without Trade5 4
Pakistan
(in thousands of yards)
Textiles 3 C
Joint (no trade) A 2
Belgium 1 B E
Chocolate (in tons)
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

28. Production Possibilities with Trade
Point F: This is where each nation is focusing on that activity for which it has a comparative advantage.
Pakistan produces 4,000 yards of textile.
Belgium produces 4 tons of chocolate.
Macroeconomics Week 2 (Maclachlan, Fall 04)

29. Production Possibilities with Trade
Macroeconomics Week 2 (Maclachlan, Fall 04)

30. Production Possibilities with Trade
Gains from trade D 5
Joint (with trade) F 4
(in thousands of yards)
Textiles 3 C
Joint (no trade) 2 1 E
Chocolate (in tons)
McGraw-Hill/Irwin
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

31. Production Possibilities with Trade
The combined PPC is bowed out because of Point F – comparative advantage and specialization.
Macroeconomics Week 2 (Maclachlan, Fall 04)

32. The Roles of Government in a Market
Provide a stable institutional framework.
Promote effective and workable competition.
Correct for externalities.
Ensure economic stability and growth.
Provide public goods.
Adjust for undesired market results.
Macroeconomics Week 2 (Maclachlan, Fall 04)

33. Provide a Stable Set of Institutions and Rules
Government can create a stable environment and enforce contracts through its legal system.
Economic growth is difficult when government does not provide a stable environment.
Macroeconomics Week 2 (Maclachlan, Fall 04)

34. Promote Effective and Workable Competition
Government promotes competition and protect against monopolies.
Monopoly power is the ability of individuals or firms currently in business to prevent other individuals or firms from entering the same kind of business
Macroeconomics Week 2 (Maclachlan, Fall 04)

35. Promote Effective and Workable Competition
Monopoly power gives existing firms or individuals the power to raise prices.
Market participants often insist on open competition except when it comes to themselves.
Macroeconomics Week 2 (Maclachlan, Fall 04)

36. Correct for Externalities
An externality is the effect of a decision on a third party not taken into account by the decision maker.
Macroeconomics Week 2 (Maclachlan, Fall 04)

37. Positive Externalities
Beneficial third party effects.
Macroeconomics Week 2 (Maclachlan, Fall 04)

38. Ensure Economic Stability and Growth
Macroeconomic externalities are externalities that affect the levels of unemployment, inflation, and growth in the economy as a whole.
Macroeconomics Week 2 (Maclachlan, Fall 04)

39. Public Goods & Common Resources
Macroeconomics Week 2 (Maclachlan, Fall 04)

40. Figure 1 Four Types of Goods
Rival?
Yes No
Private Goods
Natural Monopolies •
Ice-cream cones
Clothing
Congested toll roads •
Fire protection
Cable TV
Uncongested toll roads
Yes
Excludable?
Common Resources
Public Goods •
Fish in the ocean
The environment
Congested nontoll roads •
Tornado siren
National defense
Uncongested nontoll roads No
Macroeconomics Week 2 (Maclachlan, Fall 04)
Copyright © South-Western

41. Provide for Public Goods
Government steps in to provide public goods and requires that everyone pays for them, thereby reducing the free rider problem.
Macroeconomics Week 2 (Maclachlan, Fall 04)

42. Adjust for Undesired Market Results
A progressive tax is one whose rates increase as a person's income increases.
A regressive tax is one whose effect decrease as income rises.
Macroeconomics Week 2 (Maclachlan, Fall 04)

43. Adjust for Undesired Market Results
A proportional tax is one whose rates are constant at all income levels, regardless of the taxpayer's total annual income.
Macroeconomics Week 2 (Maclachlan, Fall 04)

44. Adjust for Undesired Market Results
Demerit goods or activities are things government believes are bad for you, although you may like them.
Merit goods and activities are things the government believes are good for you, although you may not like them.
Macroeconomics Week 2 (Maclachlan, Fall 04)

45. Market Failures and Government Failures
Government is always failing in one way or another.
Real-world policy makers are left with the choice of selecting that which is least bad – market failure or government failure.
Macroeconomics Week 2 (Maclachlan, Fall 04)

46. Regulating Markets Internationally
There is no central world government.
Some countries have voluntarily restricted their ability to restrict trade.
Macroeconomics Week 2 (Maclachlan, Fall 04)

47. Regulating Markets Internationally
Governments have been unable to come up with an effective means of dealing with environmental issues.
Macroeconomics Week 2 (Maclachlan, Fall 04)

48. Macroeconomics Week 2 (Maclachlan, Fall 04)
Problem 2-2
Japan US
cloth
wheat
1000
500
800
100
400
200
600
300
Macroeconomics Week 2 (Maclachlan, Fall 04)

49. Macroeconomics Week 2 (Maclachlan, Fall 04)
Japan
1000 bolts of cloth : 500 tons of wheat
1 bolt of cloth : 0.5 tons of wheat
1 ton of wheat: 2 bolts of cloth
_______________________ US
500 bolts of cloth : 1000 tons of wheat
1 bolt of cloth: 2 tons of wheat
1 ton of wheat: 0.5 bolt of cloth
Macroeconomics Week 2 (Maclachlan, Fall 04)

50. Macroeconomics Week 2 (Maclachlan, Fall 04)
Problem 2-3 US
Japan
Toyota
Chevrolet
$8,000
$6,000
¥1,000,000
¥500,000
Macroeconomics Week 2 (Maclachlan, Fall 04)