Download Introduction to Economics

IB ECONOMICS
SECTION 1.0 THE FOUNDATIONS OF ECONOMICS
3.1 INTERNATIONAL TRADE: FREE TRADE
1.0 Adam Smith
Was a Scottish social philosopher
and a pioneer of political economy.
The Wealth of Nations, is considered
the first modern work of economics.
Smith is widely cited as the father of
modern economics and capitalism
and is still among the most influential
thinkers in the field of economics
today.
Smith expounded how rational selfinterest and competition can lead to
economic prosperity.
1.0 Adam Smith
Invisible hand
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In economics, the invisible hand, also known as invisible hand of
the market, is the term economists use to describe the selfregulating nature of the marketplace. This is a metaphor first
coined by the economist Adam Smith in The Theory of Moral
Sentiments.
For Smith, the invisible hand was created by the conjunction of the
forces of self-interest, competition, and supply and demand, which
he noted as being capable of allocating resources in society. This is
the founding justification for the Austrian laissez-faire economic
philosophy, but is also frequently seen in neoclassical and
Keynesian economics.
The central disagreement between economic ideologies is, in a
sense, a disagreement about how powerful the "invisible hand" is.
1.Explain that economics is a social science.
What is economics?
 Economics is the scientific study of the ownership, use, and exchange of scarce resources often shortened to the science of scarcity.
 Economics is regarded as a social science because it uses scientific methods to build
theories that can help explain the behavior of individuals, groups and organizations.
 Economics attempts to explain economic behavior, which arises when scarce resources
are exchanged.
 In terms of methodology, economists, like other social scientists, are not able to
undertake controlled experiments in the way that chemists and biologists are. Hence,
economists have to employ different methods, based primarily on observation and
deduction and the construction of abstract models.
Social science
The study of society and the way individuals interact within it.
Economics
The study of how society employs its finite resources in the attempt to satisfy infinite wants.
2. Outline the social scientific method.
Economists use scientific observation and deduction in their investigations. To achieve this they:
Describe and measure the exchanges they observe
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Economists describe changes in economic variables, and measure these changes over time.
Explain how interactions arise and create costs and benefits
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Economists try to explain the effects, or results, of economic transactions
Propose hypotheses, construct, and apply ‘models’ to test these hypotheses.
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Like all scientists, economists develop hypotheses to explain why economic behavior takes place,
and then construct models to test these hypotheses.
Gather data to put into the model
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Models must be tested against the real world, which means gathering statistical data about
real events. In this way, a model can be improved and revised when necessary.
Predict behavior based on these models.
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The ultimate goal of the economist is to predict future behavior. The ultimate value of an
economic model is that it can accurately predict the onset and the effect of an economic event.
The better the model is, the more useful it is in helping economists make predictions.
3. Explain the process of model building in economics.
The differences between physical science and social science lead to slightly
different structures of research. Although there is no ideal structure, a reasonable
approach to a problem in social science is the following:
1. Observe.
2. Define the problem.
3. Review the literature. (Become familiar with what others have observed.)
4. Observe some more.
5. Develop a theoretical framework and formulate a hypothesis.
6. Choose the research design.
7. Collect the necessary data.
8. Analyze the results.
9. Draw conclusions.
Using this outline as a rough guide, and recognizing that the specific project and
each specific social science determine the exact nature of the methodology to be
used, you have a reasonably good method of attack.
4. Explain that economists must use the ceteris paribus
assumption when developing economic models.
Ceteris Paribus
Latin for all other things being equal
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Since Economics is basically the study of society, we have to understand that there are
thousands of variables present, and to control each one of these variables is downright
impossible Thus we make everything else "ceteris paribus" in order to see the effect of
one aspect With all other factors or things remaining the same:
This means that we change one parameter at a time and watch how it influences the
variables
For example: if the government cuts income taxes in order to lead to an increase in
personal income, we would like to see whether consumption rises
If we hold everything else constant, we expect that most people will spend more
money when their income rises
However, if at the same time there was a jump in prices and interest rates, people might
not spend more money
This is why it is so important to isolate one change from another
In real life, of course, that is usually not possible and we have to make adjustments
5. Distinguish between positive and normative economics.
Positive and Normative Concepts
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Positive: Based on testable theories (e.g., a hike in interest rates leads to a
fall in aggregate demand can be proven using data)
Positive economics is based on theories which can be tested by looking at past
data
Positive statements concern what is, was or will be: assertions about the world
Normative: Based on opinion/norms
Uses words such as "should" (i.e., the government should make fixing
unemployment its number one priority)
Normative economics is based on opinion
Normative statements often include words such as ‘should’ or ought to’ and
involve value judgments about what is good and what is bad
Normative statements are not testable: 'ought we to be more concerned about
unemployment than about inflation?'
In democracies normative statements are often settled by voting
6. Distinguish between economic goods and free goods
Free Goods
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A good with no scarcity, that has unlimited supply and therefore no price
Free goods involve no opportunity cost such as fresh air and sunshine,
but they become economic goods if opportunity costs are involved in
such things as removing pollution from the air
A good which has no opportunity cost associated with its consumption
Economic Goods
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A good which is scarce and therefore has a possible opportunity cost and
could command a price
Consumption goods are purchased by consumers and consist of
perishable goods such as fresh food, semi-durable goods such as
clothing, and durable goods such as cars
Capital goods also referred to as producer goods are simply capital
used in the production of consumer goods
7. Examine the assumption of rational economic
decision-making.
'Rational Choice Theory'
An economic principle that assumes that individuals always make prudent and
logical decisions that provide them with the greatest benefit or satisfaction and that
are in their highest self-interest.
Most mainstream economic assumptions and theories are based on rational choice
theory.
Systematic, step by step method in which 'hard' (quantitative) data obtained
through observation or mathematical (statistical) analysis or modeling is used for
making long-term decisions.
Steps in a rational decision making model
 Define the situation/decision to be made
 Identify the important criteria for the process and the result
 Consider all possible solutions
 Calculate the consequences of these solutions versus the likelihood of
satisfying the criteria
 Choose the best option
8. Explain that scarcity exists because factors of
production are finite and wants are infinite.
Scarcity is the fundamental economic problem of having seemingly unlimited
human wants in a world of limited resources.
It states that society has insufficient productive resources to fulfill all human wants
and needs.
A common misconception on scarcity is that an item has to be important for it to be
scarce. However, this is not true, for something to be scarce, it has to be hard to
obtain, hard to create, or both. Simply put, the production cost of something
determines if it is scarce or not.
For example, although air is more important to us than diamonds, it is cheaper
simply because the production cost of air is zero. Diamonds on the other hand have
a high production cost. They have to be found and processed, both which require a
lot of money.
Additionally, scarcity implies that not all of society's goals can be pursued at the
same time; trade-offs are made of one good against others.
9. Explain that economics studies the ways in which
resources are allocated to meet needs and wants.
Wants and needs
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All humans are born with basic needs, including the need to eat and drink, the need to keep warm,
and the need to be protected. These result in a sustained demand for food, drink, clothing, and
shelter.
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In addition, the human species has wants, which also have a strong influence on behavior. As
incomes rise the relative importance of wants increases in relation to needs.
Consumption
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The process of satisfying needs and wants is called consumption. The need and desire to consume
is, clearly, what drives individual economic actions and provides the motive for engaging in an
exchange of scarce resources. To be able to consume, individuals need to exchange their skill and
effort, or their enterprise, land or capital, for an income. They can then exchange this income for
the scarce products they need or want. Through exchange, consumption is satisfied by a process
called production.
Needs
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Something we MUST have in order to survive (e.g., water, food, housing)
Wants
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Something we desire (e.g., pens, computers, automobiles) We have unlimited wants and limited
resources
10. Explain that the three basic economic questions that must be answered by
any economic system are: “What to produce?”, “How to produce?” and “For whom
to produce?”
All societies face the economic problem, which is the problem of how to make the best use of limited, or
scarce, resources. The economic problem exists because, although the needs and wants of people are
endless, the resources available to satisfy needs and wants are limited.
Samuelson's three questions
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America’s first Nobel Prize winner for economics, the late Paul Samuelson, is often credited with
providing the first clear and simple explanation of the economic problem - namely, that in order to
solve the problem of scarcity all societies, no matter how big or small, developed or not, must
endeavor to answer three basic questions.
What to produce?
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Societies have to decide the best combination of goods and services to meet their needs. For
example, how many resources should be allocated to consumer goods, and many resources to
capital goods, or how many resources should go to schools, and how many to defense, and so on.
How to produce?
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Societies also have to decide the best combination of factors to create the desired output of goods
and services. For example, precisely how much land, labor, and capital should be used produce
consumer goods such as computers and motor cars.
For whom to produce?
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Finally, all societies need to decide who will get the output from the country’s economic activity, and
how much they will get. For example, who will get the computers and cars that have been
produced? This is often called the problem of distribution.
10. Explain that the three basic economic questions that must be answered by any
economic system are: “What to produce?”, “How to produce?” and “For whom to produce?”
11. Explain that as a result of scarcity, choices
have to be made.
Choice and opportunity cost
 Choice and opportunity cost are two fundamental concepts in economics. Given that
resources are limited, producers and consumers have to make choices between
competing alternatives. All economic decisions involve making choices. Individuals
must choose how best to use their skill and effort, firms must choose how best to use
their workers and machinery, and governments must choose how best to use taxpayer's
money.
 Making an economic choice creates a sacrifice because alternatives must be given up,
which results in the loss of benefit that the alternative would have provided. For
example, if an individual has $10 to spend, and if books are $10 each and
downloaded music tracks are $1 each, buying a book means the loss of the benefit that
would have been gained from the 10 downloaded tracks.
 The loss of the next best option represents the real sacrifice and is referred to as
opportunity cost. The opportunity cost of choosing the school is the loss of the factory,
and what could have been produced.
 It is necessary to appreciate that opportunity cost relates to the loss of the next best
alternative, and not just any alternative. The true cost of any decision is always the
closest option not chosen.
12. Explain that when an economic choice is
made, an alternative is always foregone.
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The opportunity cost of a choice is the value of the best alternative
forgone, in a situation in which a choice needs to be made between several
mutually exclusive alternatives given limited resources.
Assuming the best choice is made, it is the "cost" incurred by not enjoying
the benefit that would be had by taking the second best choice available.
The New Oxford American Dictionary defines it as "the loss of potential gain
from other alternatives when one alternative is chosen".
Opportunity cost is a key concept in economics, and has been described as
expressing "the basic relationship between scarcity and choice".
The notion of opportunity cost plays a crucial part in ensuring that scarce
resources are used efficiently. Thus, opportunity costs are not restricted to
monetary or financial costs: the real cost of output forgone, lost time,
pleasure or any other benefit that provides utility should also be
considered opportunity costs.
Whereas, Tradeoffs: a range of alternatives
13. Describe the factors of production
Factors of production:
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Basic components or inputs which are required in the production of goods and services
Land:
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Gifts of nature, this includes everything on the land, under the land, above the land, or
in the sea (e.g., oil, water)
Labor:
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The human component hired to assist in producing a good or service. Simply the number
of hours of work put in by a person
Capital:
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Any man-made aid to production. It is physical plant, machinery, equipment and
buildings; it is not the money that you invest in the stock market
Entrepreneurship:
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Combines the other factors and takes risks recognizing the possibility of gain from
employing these factors in a specific way. An entrepreneur is the one who sees an
economic opportunity and mixes land, labor and capital together to produce a product
with economic value.
13. Describe the factors of production
Types of production
Production is undertaken by firms, also known as enterprises, or businesses. There are three
stages of production:
 Primary production, which involves the extraction of resources from the earth, such as
agriculture, fishing, and mining. Land and natural resources are the main resources used
in primary production.
 Secondary, which involves the manufacture of semi-finished and finished consumer
goods, such as computers, motor vehicles, and clothing. Labor and capital are the main
resources used in the secondary sector.
 Tertiary production involves the distribution of products and the creation of services,
such as road haulage, financial services, and healthcare. Human capital is usually the
most essential resource used in tertiary production.
 The tertiary sector is sometimes sub-divided into tertiary, quaternary and quandary
sectors. The quaternary sector of an economy includes the infrastructure of information
technology and knowledge that enables an economy to produce successfully.
 The quandary sector is defined at the not-for-profit aspect of the economic, political
and social infrastructure which supports economic activity, including universities, charities
and government activity. Sophisticated quaternary and quandary sectors are commonly
viewed as essential to economic development in a globalized economy.
1.0 Circular flow of income
The flow of income and
payments between economic
agents in an economy.
The key agents are
households and firms and
the circular flow shows how
money and resources moves
between them.
There may also be leakages
from the circular flow and
injections into it.
14. Explain that a production possibilities curve (production possibilities frontier)
model may be used to show the concepts of scarcity, choice, opportunity cost and
a situation of unemployed resources and inefficiency.
Production possibility frontiers
Opportunity cost can be illustrated by
using production possibility frontiers
(PPFs) which provide a simple, yet
powerful tool to illustrate the effects
of making an economic choice.
A PPF shows all the possible
combinations of two goods, or two
options available at one point in time.
A hypothetical economy, produces only
two goods - textbooks and
computers.
When it uses all of its resources, it can
produce five million computers and
fifty five million textbooks. In fact, it
can produce all the following
combinations of computers and books.
14. Explain that a production possibilities curve (production possibilities frontier)
model may be used to show the concepts of scarcity, choice, opportunity cost and
a situation of unemployed resources and inefficiency.
Interpreting PPFs
Firstly, we can describe the opportunity cost of
producing a given output of computers or textbooks.
For example, If we produces 3m computers; the
opportunity cost is 5m textbooks. This is the
difference between the maximum output of textbooks
that can be produced if no computers are produced
(which is 70m) and the number of textbooks that can
be produced if 3m computers are produced (which is
65m).
Similarly, the opportunity cost of producing 7m
computers is 31m textbooks - which is 70 - 39.
PPFs can also illustrate the opportunity cost of a
change in the quantity produced of one good.
For example, suppose we produce 3 million
computers and 65m textbooks. We can calculate the
opportunity cost if it decides to increase production
from 3 million computers to 7 million, shown on the
PPF as a movement from point A to point B.
14. Explain that a production possibilities curve (production possibilities frontier)
model may be used to show the concepts of scarcity, choice, opportunity cost and
a situation of unemployed resources and inefficiency.
Pareto efficiency
Any point on a PPF, such as points 'A' and 'B', is
said to be efficient and indicates that an
economy’s scarce resources are being fully
employed.
This is also called Pareto efficiency, after Italian
economist Vilfredo Pareto.
Any point inside the PPF, such as point 'X' is said
to be inefficient because output could be greater
from the economy’s existing resources.
Any point outside the PPF, such as point 'Z', is
impossible with the economy’s current scarce
resources, but it may be an objective for the
future.
Pareto efficiency can be looked at in another way
- when the only way to make someone better off
is to make someone else worse off.
In other words, Pareto efficiency means an
economy is operating at its full potential, and no
more output can be produced from its existing
resources.
14. Explain that a production possibilities curve (production possibilities frontier)
model may be used to show the concepts of scarcity, choice, opportunity cost and
a situation of unemployed resources and inefficiency.
Increasing opportunity cost
According to economic theory, successive increases in the
production of one good will lead to an increasing
sacrifice in terms of a reduction in the other good.
For example, as an economy tries to increase the
production of good X , such as cameras, it must sacrifice
more of the other good, Y, such as mobile phones.
This explains why the PPF is concave to the origin,
meaning its is bowed outwards.
For example, if an economy initially produces at A,
with 8m phones and 10m cameras (to 20m), and then
increases output of cameras by 10m, it must sacrifice
1m phones, and it moves to point B.
If it now wishes to increase output of cameras by a
further 10m (to 30m) it must sacrifice 2m phones, rather
than 1m, and it moves to point C; hence, opportunity
cost increases the more a good is produced.
The gradient of the PPF gets steeper as more cameras
are produced, indicating a greater sacrifice in terms of
mobile phones foregone.
15. Distinguish between different rationing systems
Economic systems
There are two basic solutions to the economic
problem as described by Paul Samuelson, namely
free markets and central panning.
Free market economies
Markets enable mutually beneficial exchange
between producers and consumers, and systems
that rely on markets to solve the economic problem
are called market economies.
In a free market economy, resources are allocated
through the interaction of free and self-directed
market forces. This means that what to produce is
determined consumers, how to produce is
determined by producers, and who gets the
products depends upon the purchasing power of
consumers.
Market economies work by allowing the direct
interaction of consumers and producers who are
pursuing their own self-interest. The pursuit of selfinterest is at the heart of free market economics.
15. Distinguish between different rationing systems
Command economies
The second solution to the economic
problem is the allocation of scarce
resources by government, or an
agency appointed by the
government.
This method is referred to as central
planning, and economies that
exclusively use central planning are
called command economies.
In other words governments direct
or command resources to be used in
particular ways.
For example, governments can
force citizens to pay taxes and
decide how many roads or hospitals
are built.
15. Distinguish between different rationing systems
Mixed economies
There is a third type of economy involving a
combination of market forces and central
planning, called mixed economies.
Mixed economies may have a distinct
private sector, where resources are allocated
primarily by market forces.
Mixed economies may also have a distinct
public sector, where resources are allocated
mainly by government, such as defense,
police, and fire services.
In many sectors, resources are allocated by a
combination of markets and panning, such
as healthcare and, which have both public
and private provision.
In reality, all economies are mixed, though
there are wide variations in the amount of
mix and the balance between public and
private sectors.
16. Compare and contrast the advantages and
disadvantages of planned and free market economies
Command Economy
A market where the government or some central authority decides where to allocate resources
Advantages:
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The government can influence the distribution of income.
The government can determine which goods are supplied.
Disadvantages:
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In order to function well, requires an enormous amount of information which is difficult to
obtain.
No real incentive for individuals to be innovative. Goods are of poor quality since there
is a lack of profit motive.
May NOT lead to allocative efficiency or productive efficiency due to lack of
competition and profit motives.
Corruption - the government has the ability to abuse its absolute power.
The economy does not respond as well to supply and demand, firms are simply told to
produce a certain number of goods or services
16. Compare and contrast the advantages and
disadvantages of planned and free market economies
Free Market
The forces of supply and demand decide the economic questions and therefore where
to allocate resources
Advantages
 Resources allocated more efficiently by the price mechanism.
 The profit motive is a great incentive, and forces producers to reduce costs and
be innovative.
 With no imperfections, the free market maximizes community surplus.
 market system relies on a number of factors to ensure that it works efficiently.
 The profit motive - the incentive for a reward for enterprise
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Good levels of information being available to both producers and consumers
Price accurately reflecting the costs and benefits of consumption and production
The ease with which resources can move to different uses At the heart of the market system is
the profit motive.
16. Compare and contrast the advantages and
disadvantages of planned and free market economies
Free Market
Disadvantages:
 Instability
 Monopolies and corruption - The natural goal of all firms is to attain
monopoly, as this eliminates competition, eliminating the associated costs and
thus maximizing profit. If the market structure does not include limiting social
forces, financial forces will cause firms to externalize costs such as pollution to
gain monopoly.
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Market failures and imperfections occur because of public goods, merit
goods, externalities and lack of competitive markets.
The system of profits and losses is thought to be unfair, substantial
government intervention is needed to cope with income redistribution
problems.
The system is incapable of controlling pollution and producing
sustainable growth, planning has been introduced to correct for this
problem.
17. Define and give an example of a transition economy
A transition economy or transitional economy is an
economy which is changing from a centrally planned
economy to a free market.
Transition economies undergo economic liberalization,
where market forces set prices rather than a central planning
organization.
In addition to this trade barriers are removed, there is a
push to privatize state-owned businesses and resources, and
a financial sector is created to facilitate macroeconomic
stabilization and the movement of private capital.
The process has been applied in China, the former Soviet
Union and Communist bloc countries of Europe, and many
third world countries.
17. Define and give an example of a transition economy
Transition economies
A transition economy is one that is changing from central planning to free
markets. Since the collapse of communism in the late 1980s, countries of
the former Soviet Union, and its satellite states, including Poland, Hungary,
and Bulgaria, sought to embrace market capitalism and abandon central
planning. However, most of these transition economies have faced severe
short-term difficulties, and longer-term constraints on development.
 Rising unemployment
 Rising inflation
 Lack of entrepreneurship and skills
 Corruption
 Lack of infrastructure
 Lack of a sophisticated legal system
 Moral hazard
 Inequality
18. Explain that the economics course will focus on
several themes, which include:
a. the extent to which governments should intervene in
the allocation of resources
b. the threat to sustainability as a result of the current
patterns of resource allocation
c. the extent to which the goal of economic efficiency
may conflict with the goal of equity
d. the distinction between economic growth and
economic development.
a. the extent to which governments should intervene in the
allocation of resources
18.
MARKET FAILURES:
Imperfections in the exchange process between buyers and sellers that
prevent markets from efficiently allocating scarce resources.
Market failures come in several varieties -- public goods, market control,
externalities, imperfect information and inequality in the distribution of
income.
Market efficiency is achieved if the value of goods produced is equal to
the value of foregone production.
Markets fail when this efficiency condition is not achieved. Such failures
can only be corrected by government intervention.
While market failures can be corrected, in principle, only through some sort
of government action, government intervention does not guarantee a
solution nor an efficient allocation of resources.
The reason is that governments are also imperfect. Governments have their
own set of inefficiencies.
18. b. the threat to sustainability as a result of the current
patterns of resource allocation
The Sustainability Transition
The global sustainability challenge facing us is simply stated: it combines an empirical
assessment and a normative claim.
The evidence-based assessment, as shared by numerous scientists, is that current societynature interactions are not sustainable – they are negatively affecting both vital ecological
systems and human welfare in ways that threaten irreversible, long-term damage (UNEP
2007).
Attached to this empirical claim is the normative position of sustainable development; that
societal development paths should meet fundamental human needs, within and between
generations, while maintaining the planet’s life-support system and conserving living
resources.
It is broadly a social democratic understanding, which states that a durable commitment to
poverty eradication, delivered through inclusive governance structures and more equitable
economic growth, must run alongside measures to reverse the continuing degradation of the
global environment.
In other words, that which is to be ‘sustained’ is human development for all alongside
necessary ecosystem services.
18. c. the extent to which the goal of economic efficiency may
conflict with the goal of equity
The issues between efficiency and equity have always
been a contentious political debate. The goal of equity
conflicts with the goal of efficency.
Efficiency means that society is getting the most it can
from its scarce resources. A more efficient society can
produce more with the same amount of resources.
Equity means that the resources are distributed fairly
among the individuals.
We can view efficiency as the size of a pie, and equity
being how evenly the pie is being divided.
18. d. the distinction between economic growth and economic
development.
Economic growth
An increase in real GDP or an increase in the quantity of resources
 Gross Domestic Product (GDP) is often used to measure
economic growth
Economic development
A qualitative measure of a country's standard of living which takes
into account numerous factors such as education and health
 The Human Development Index (HDI) is normally used to
measure a country's economic development
Sustainable development
The rate at which a country can develop without compromising the
needs of future generations
3.1 International trade: Free trade
Free trade is a policy by which a government does not discriminate against
imports or interfere with exports.
Under a free trade policy, prices emerge from supply and demand, and
are the sole determinant of resource allocation.
Globalization
Is the process of international integration arising from the interchange of
world views, products, ideas, and other aspects of culture. Advances in
transportation, telecommunications and infrastructure, are major factors in
its development.
Foreign Direct Investment
Investment made by a foreign company in the economy of another country.
Multinational Corporations (MNCs)
An organization that manufactures and markets products in many different
countries and has a multinational stock ownership and multinational
management.
Free trade implies the following features:
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Trade of goods without taxes (including tariffs) or other
trade barriers (e.g., quotas on imports or subsidies for
producers)
Trade in services without taxes or other trade barriers
The absence of "trade-distorting" policies (such as taxes,
subsidies, regulations, or laws) that give some firms,
households, or factors of production an advantage over
others
Free access to markets
Free access to market information
Inability of firms to distort markets through governmentimposed monopoly or oligopoly power
19. Explain that gains from trade include lower prices for consumers, greater choice for
consumers, and the ability of producers to benefit from economies of scale, the ability to
acquire needed resources, a more efficient allocation of resources, increased competition,
and a source of foreign exchange.
Why do countries trade? Exploring the gains from trade
Trade is the exchange of goods and services between
countries. When the conditions are right trade brings benefits
to all countries involved and can be a powerful driver for
sustained growth and rising living standards.
One way of expressing the gains from trade in goods and
services between countries is to distinguish between the static
gains from trade (i.e. improvements in allocative and
productive efficiency) and the dynamic gains (the gains in
welfare that occur over time from improved product quality,
increased choice and a faster pace of innovative behavior).
Video: Gains from trade
Refers to net benefits to
agents from allowing an
increase in voluntary
trading with each other.
In technical terms, it is the
increase of consumer
surplus plus producer
surplus from liberalizing
trade.
19. Explain that gains from trade include lower prices for consumers, greater choice for
consumers, and the ability of producers to benefit from economies of scale, the ability
to acquire needed resources, a more efficient allocation of resources, increased
competition, and a source of foreign exchange.
Some of the gains from free trade are outlined below:
 Welfare gains: Economists who support the liberalization of trade
believe that trade is a ‘positive-sum game’ – all counties engaged in
trade and exchange stand to gain.
 Economies of scale – trade allows firms to exploit scale economies by
operating leading to lower average costs of production that can be
passed onto consumers.
 Competition / market contestability – trade promotes increased
competition particularly for those domestic monopolies that would
otherwise face little real competition.
 Dynamic efficiency gains from innovation - trade enhances consumer
choice and stimulates product and process innovations
 Access to new technology- trade, like investment, is also an important
mechanism by which countries can have access to new technologies.
 Rising living standards and a reduction in poverty - trade can be a
powerful force in reducing poverty and raising living standards.
19. Explain that gains from trade include lower prices for consumers, greater choice for
consumers, and the ability of producers to benefit from economies of scale, the ability to
acquire needed resources, a more efficient allocation of resources, increased
competition, and a source of foreign exchange.
The advantages of trade






The exploitation of a country's comparative advantage, which means that trade
encourages a country to specialize in producing only those goods and services which it
can produce more effectively and efficiently, and at the lowest opportunity cost.
Producing a narrow range of goods and services for the domestic and export market
means that a country can produce in at higher volumes, which provides further cost
benefits in terms of economies of scale.
Trade increases competition and lowers world prices, which provides benefits to
consumers by raising the purchasing power of their own income, and leads a rise in
consumer surplus.
Trade also breaks down domestic monopolies, which face competition from more
efficient foreign firms.
The quality of goods and services is likely to increases as competition encourages
innovation, design and the application of new technologies. Trade will also encourage
the transfer of technology between countries.
Trade is also likely to increase employment, given that employment is closely related to
production. Trade means that more will be employed in the export sector and, through
the multiplier process, more jobs will be created across the whole economy.
19. Explain that gains from trade include lower prices for consumers, greater choice for consumers,
and the ability of producers to benefit from economies of scale, the ability to acquire needed
resources, a more efficient allocation of resources, increased competition, and a source of foreign
exchange.
The disadvantages of trade
 Trade can lead to over-specialization, with workers at risk of
losing their jobs should world demand fall or when goods for
domestic consumption can be produced more cheaply abroad.
Jobs lost through such changes cause severe structural
unemployment.
 Certain industries do not get a chance to grow because they face
competition from more established foreign firms, such as new
infant industries which may find it difficult to establish
themselves.
 Local producers, who may supply a unique product tailored to
meet the needs of the domestic market, may suffer because
cheaper imports may destroy their market. Over time, the
diversity of output in an economy may diminish as local producers
leave the market.
20. Explain the theory of absolute advantage.
An absolute advantage exists if a person, country,
business, government, or some other entity can produce
more output using fewer inputs than a comparable entity.
An absolute production advantage arises because of
technological or technical superiority. That is, the
producer is able to produce more with less. Note that an
absolute advantage depends on the physical quantities
of the inputs used and is not based on the cost of those
inputs. It might be that fewer inputs are used, but that
those inputs have a greater opportunity cost.
21. Explain, using a diagram, the gains from trade arising from a
country’s absolute advantage in the production of a good.
Country A has an absolute
advantage in the production of both
maize and wheat. At all points its
production possibility curve lies to the
right of that of Country B. Country B
has an absolute disadvantage. Due
to abundance of raw materials or
more productively efficient
production techniques, Country A is
able to produce more wheat and
more maize that Country B. Perhaps
common sense tells us that Country A
should produce both goods and
export surpluses and Country B
neither. However, when comparative
advantage is considered a different
story emerges.
22. Explain the theory of comparative advantage
The ability to produce one good at a relatively lower
opportunity cost than other goods, especially compared
to production in another country. Every person or country
has a comparative advantage in production of at least
one good or service, even with relatively limited
production technology.
The law of comparative advantage states that every
nation has a production activity that incurs a lower
opportunity cost than that of another nation, which
means that trade between the two nations can be
beneficial to both if each specializes in the production
of a good with lower relative opportunity cost.
23. Describe the sources of comparative advantage, including the
differences between countries in factor endowments and the levels of
technology.
Resource endowment plays a large role in countries
comparative advantage. A country that possesses most
of the farmable land in a region is likely to have a
comparative advantage in agriculture. Other counties
with little natural resources or land, but have highly
skilled workforces can provide services to the world.
What factors determine whether a country should
specialize in their resources depend on two factors. First,
the relative abundance of the resource and second, the
value of the good produced from the resource to the
world market.
24. Draw a diagram to show comparative advantage.
24. Draw a diagram to show comparative advantage.
25. Calculate opportunity costs from a set of data in order to
identify comparative advantage.
Comparative Advantage Matrix: Output model
 First, we compare the output possibility for each product and
each country, if each produced only that one good.
 The most output in comparison to the other country determines
absolute advantage.
 To find out who has a comparative advantage, we need to
calculate the domestic opportunity costs in each country for
each good.
Opportunity Cost of X for Country A = Output Y / Output X
Opportunity Cost of Y for Country A = Output X / Output Y
Opportunity Cost of X for Country B = Output Y / Output X
Opportunity Cost of Y for Country B = Output X / Output Y
25. Calculate opportunity costs from a set of data in
order to identify comparative advantage.

Next, to determine which country has the lowest
opportunity cost of production, we make a
comparison across the market for each product.
(Opportunity Cost of X for Country A) VS (Opportunity Cost of X for Country B )


The country with the lowest opportunity cost has the
comparative advantage. This should be the good for
which this country specialize in production. This will
maximize production between the two countries.
Each country can sell the good at some price between
or equal to their own opportunity cost and that of the
other country. This is called the Terms of Trade.
25. Calculate opportunity costs from a set of data in
order to identify comparative advantage.
Comparative Advantage Matrix:
Input model
 Now, we compare the Input possibility for each product
and each country, if each produced only that one good.
 The least input in comparison to the other country
determines absolute advantage.
 To find out who has a comparative advantage, we need
to calculate the domestic opportunity costs in each country
for each good.
Opportunity Cost of X for Country A = Input X / Input Y
Opportunity Cost of Y for Country A = Input Y / Input X
Opportunity Cost of X for Country B = Input X / Input Y
Opportunity Cost of Y for Country B = Input Y / Input X
25. Calculate opportunity costs from a set of data in
order to identify comparative advantage.

Next, to determine which country has the lowest
opportunity cost of production, we make a
comparison across the market for each product.
(Opportunity Cost of X for Country A) VS (Opportunity Cost of X for Country B )


The country with the lowest opportunity cost has the
comparative advantage. This should be the good for
which this country specialize in production. This will
maximize production between the two countries.
Each country can sell the good at some price between
or equal to their own opportunity cost and that of the
other country. This is called the Terms of Trade.
25. Calculate opportunity costs from a set of
data in order to identify comparative advantage.
Comparative advantage
Using all its resources, country A
can produce 30m cars or 6m
trucks, and country B can produce
35m cars or 21m trucks.
In this case, country B has the
absolute advantage in producing
both products, but it has a
comparative advantage in trucks
because it is relatively better at
producing them. Country B is 3.5
times better at trucks, and only
1.17 times better at cars.
25. Calculate opportunity costs from a set of
data in order to identify comparative advantage.
However, the greatest advantage - and the widest gap lies with truck production, hence Country B should specialize
in producing trucks, leaving Country A to produce cars.
Economic theory suggests that, if countries apply the
principle of comparative advantage, combined output will
be increased in comparison with the output that would be
produced if the two countries tried to become self-sufficient
and allocate resources towards production of both goods.
Taking this example, if countries A and B allocate resources
evenly to both goods combined output is: Cars = 15 + 15 =
30; Trucks = 12 + 3 = 15, therefore world output is 45 m
units.
25. Calculate opportunity costs from a set of data in
order to identify comparative advantage.
Opportunity cost ratios
It is being able to produce goods by using fewer resources, at a lower
opportunity cost, that gives countries a comparative advantage.
The gradient of a PPF reflects the opportunity cost of production. Increasing
the production of one good means that less of another can be produced. The
gradient reflects the lost output of Y as a result of increasing the output of X.
Having a comparative advantage in X, Country A sacrifices less of Y than
Country B. In terms of two countries producing two goods, different PPF
gradients mean different opportunity costs ratios, and hence specialization
and trade will increase world output.
Only when the gradients are different will a country have a comparative
advantage, and only then will trade be beneficial.
Identical PPFs
If PPF gradients are identical, then no country has a comparative advantage,
and opportunity cost ratios are identical. In this case, international trade
does not confer any advantage.
26. Draw a diagram to illustrate comparative
advantage from a set of data.
26. Draw a diagram to illustrate
comparative advantage from a set of data.
Terms of Trade
TOT: The rate at which goods are traded, either between
individuals or between nations. It is the quantity of one good
exchanged per unit of another good. The terms of trade is
essentially the price. But the price is stated in terms of the
quantity of another good. Like any market price, the terms
of trade is based on what the buyers are willing to pay and
what the sellers are willing to accept. The terms of trade
between any two countries is based on the relative
opportunity cost in each country.
In the real world, the terms of trade between two countries
is adjusted for transit cost. That is, the "buying" or importing
nation pays a slightly higher price that the "selling" or
exporting receives, with the difference used to pay transit
cost.
Terms of Trade
A country’s terms of trade measures a country's export
prices in relation to its import prices, and is expressed as:
TOT = Index of export prices / Index of import prices x 100
When the terms of trade rise above 100 they are said to
be improving and when they fall below 100 they are
said to be worsening.
If a country’s TOT improves, it means that for every unit
of exports sold it can buy more units of imported goods.
A worsening TOT indicates that a country has to export
more to purchase a given quantity of imports.
World price and comparative advantage
World price: The price of a good that prevails in the world
market for that good.
The effects of free international trade can be shown by
comparing the domestic price of a good without trade and
the world price of the good.


If a country has a comparative advantage, the
domestic price will be below the world price, and
the country will be an exporter of the good.
If the country has a comparative disadvantage,
the domestic price will be higher than the world
price, and the country will be an importer of the
good.
International Trade in an Exporting Country


World price of good Z > domestic price of good Z.
 Domestic producers increase production as the price
moves up to the world price.
 Domestic consumers decrease consumption as the price
moves up to the world price.
 The excess supply (surplus) will be exported to willing
buyers in another country.
The analysis of an exporting country yields two
conclusions:
 Domestic producers of the good are better off, and
domestic consumers of the good are worse off.
 Trade raises the economic well-being of the nation as a
whole because the gains of producers exceed the losses
of consumers.
Figure 3 How Free Trade Affects Welfare in an Exporting Country
Price
of Steel
Consumer surplus
before trade
Price
after
trade
Exports
A
B
Price
before
trade
World
price
D
C
Producer surplus
before trade
0
Domestic
supply
Domestic
demand
Quantity
of Steel
Copyright © 2004 South-Western
A Country That Exports Soybeans
Without trade,
CS = A + B
PS = C
Total surplus
=A+B+C
With trade,
CS = A
PS = B + C + D
Total surplus
=A+B+C+D
Soybeans
P
S
exports
A
$6
B
$4
C
D
gains
from trade
D
Q
International Trade in an Importing Country

World price of good T < domestic price of good T.
Domestic producers decrease production as the price moves
down to the world price.
 Domestic consumers increase consumption as the price moves
down to the world price.
 The excess demand (shortage) will be satisfied by imports
from willing sellers in another country.


The analysis of an importing country yields two
conclusions
Domestic producers of the good are worse off, and
domestic consumers of the good are better off.
 Trade raises the economic well-being of the nation as a whole
because the gains of consumers exceed the losses of
producers.

Figure 5 How Free Trade Affects Welfare in an Importing Country
Price
of Steel
Consumer surplus
after trade
Domestic
supply
A
Price
before trade
Price
after trade
0
B
C
D
Imports
Producer surplus
after trade
World
price
Domestic
demand
Quantity
of Steel
Copyright © 2004 South-Western
World price and comparative advantage
The Welfare Effects of Trade
Summary: The Welfare Effects of Trade
PD < PW
PD > PW
direction of trade
exports
imports
consumer surplus
falls
rises
producer surplus
rises
falls
total surplus
rises
rises
Whether a good is imported or exported,
trade creates winners and losers.
But the gains exceed the losses.
27. Discuss the real-world relevance and limitations of the theory of comparative advantage,
considering factors including the assumptions on which it rests, and the costs and benefits of
specialization (a full discussion must take into account arguments in favor and against free trade
and protection).





Relative prices and exchange rates are not taken into account in the
simple theory of comparative advantage. For example if the price of X
rises relative to Y, the benefit of increasing output of X increases.
Comparative advantage is not a static concept - it may change over
time. For example, nonrenewable resources can slowly run out, increasing
the costs of production, and reducing the gains from trade.
Many countries strive for food security, meaning that even if they should
specialize in non-food products, they still prefer to keep a minimum level
of food production.
Finally, the principle of comparative advantage is derived from a simple
two good/two country model. The real world is far more complex, with
countries exporting and importing many different goods and services.
However, the principle of comparative advantage clearly does ‘shape’
the pattern of world trade, although most countries do try to spread their
risks by diversifying into a range of goods and services, even when
they do not have a clear comparative advantage.
27. Discuss the real-world relevance and limitations of the theory of comparative advantage,
considering factors including the assumptions on which it rests, and the costs and benefits of
specialization (a full discussion must take into account arguments in favor and against free trade
and protection).




It may overstate the benefits of specialization by ignoring a number of
costs. These costs include transport costs and any external costs
associated with trade, such as air and sea pollution. (Resource depletion)
The theory also assumes perfect mobility of factors without any
diminishing returns. The reality may be very different. Output from factor
inputs is likely to be subject to diminishing returns. This will make the PPF
for each country non-linear and bowed outwards.
If this is the case, complete specialization might not generate the level of
benefits that would be derived from linear PPFs. In other words, there is
an increasing opportunity cost associated with increasing
specialization. For example, it may be that the maximum output of cars
produced by country A is only 20 million (compared with 30), and the
maximum output of trucks produced by country B might only be 16 million
instead of 21 million. Hence, the combined output from trade might only
be 46 million units (instead of the 51 million units initially predicted).
Complete specialization might create structural unemployment as some
workers cannot transfer from one sector to another.
1.0 Basic Definitions
Utility
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The satisfaction gained from the consumption of a good or service
Most people are assumed to be motivated by rational desires
Most people derive enjoyment or utility from the goods and services they consume, and most
understand that the first amount of enjoyment from consuming a good is often the highest
As more and more is consumed, the level of enjoyment starts to decrease
This is referred to as the concept of diminishing marginal utility
The demand curve slopes downward because of the law of diminishing marginal utility (extra
happiness)
The marginal utility is the enjoyment received from the next unit of whatever is being consumed, and
it diminishes as more is consumed
Most people try to maximize total utility or enjoyment by consuming more than one good: as the
marginal utility from consuming one good starts to fall from consuming more, you switch to another
good where the marginal utility is higher (e.g., we do not just eat one food such as hamburger, we
get more enjoyment from mixing it with other foods such as salad, potatoes and vegetables)
The marginal utility gained from buying an extra ice cream decreases with every ice cream we buy
at a fixed price
1.0 Basic Definitions

Explicit costs are opportunity costs that involve
direct monetary payment by producers. The opportunity cost
of the factors of production not already owned by a
producer is the price that the producer has to pay for them.
For instance, a firm spends $100 on electrical power
consumed, the opportunity cost is $100. The firm has
sacrificed $100, which could have been spent on other
factors of production.

Implicit costs are by contrast, the opportunity costs
that involve only factors of production that a producer
already owns. They are equivalent to what the factors could
earn for the firm in alternative uses, either operated within
the firm or rent out to other firms.