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Economic Thinking • Economics as a social Science • The scientific method – Observation, Theory, and Testing – Assumptions and ceteris paribus – Avoiding flaws in logical thinking • Ergo hoc post proper hoc • Fallacy of Composition/Division • Microeconomics vs. Macroeconomics Economics Models • The art of making: simple and effective • Example: circular flow – overall economy, role of economic agents, output and income, product and factor markets • Example: production possibilities frontier (PPF) -efficiency, tradeoffs, opportunity costs, economic growth, law of increasing costs Economics and Economists • • • • Positive versus normative Avoiding unintended consequences Scientist, advisor and citizen Scientific judgment, values, perception versus reality The Power of Trade • Voluntary versus involuntary exchange • An intuitive approach to gains in trade • Using an economic model to demonstrate the gains from trade Voluntary Exchange • All parties to a voluntary exchange must be made better off • Allow for specialization and division of labor • Increase interdependence • Promote cooperation rather than conflict An intuitive Approach to Gains From Trade • Self-sufficiency – Pros: independence – Cons: loss of efficiency, variety in consumption and production • Trade with Yakima? • Trade with other states? • Trade with other nations? Gains from Trade: An Economic Model • Good model building: prove the point and make it simple • Assumptions = things held true during the analysis = simplification • Assumptions can be changed later to explore their implications The Model • Assumptions: – – – – Two individuals – rancher and a farmer Two goods – meat and potatoes Each work eight hours a day Farmer takes 60min/oz meat and 15min/oz potatoes – Rancher takes 20min/oz of meat and 10min/oz of potatoes • Absolute advantage – Rancher than farmer is more efficient and producing both meat and potatoes • Comparative advantage – The farmer is comparatively better at producing potatoes than the rancher. • Comparative advantage and opportunity cost – The person with the lower opportunity cost has a comparative advantage – Someone always has a comparative advantage in the production of a least one thing PPF and Production in a Simple Economy • How much can be produced? • Need to know: – Total time divided by time/output = total output, or – output/time multiplied by total time = total output Table 1 The Production Opportunities of the Farmer and Rancher Farmer (8 hours = 480/min)/ (60 min/oz of meat) = 8 oz of meat Rancher (480min/20min/oz of meat)=24 oz of meat Copyright © 2004 South-Western Figure 1 The Production Possibilities Curve (a) The Farmer ’s Production Possibilities Frontier Meat (ounces) If there is no trade, the farmer chooses this production and consumption. 8 4 0 A 16 32 Potatoes (ounces) Copyright©2003 Southwestern/Thomson Learning Figure 1 The Production Possibilities Curve (b) The Rancher ’s Production Possibilities Frontier Meat (ounces) 24 If there is no trade, the rancher chooses this production and consumption. 12 0 B 24 48 Potatoes (ounces) Copyright©2003 Southwestern/Thomson Learning Slope of the PPF • In math, slope = Δy/Δx but in this case meat is on the y-axis and potatoes are on the x-axis, so it become ΔM/ΔP • E.g. Rancher ΔM/ΔP = -24/48 =-1/2 , but it is help to think of this as -1/2/1. Why? +1P → -½ M • E.g. Farmer ΔM/ΔP =- 8/32 =-1/4 , but it is help to think of this as 1/4/1. Why? +1P → -1/4 M • To get 1 P the rancher gives up 1/2M and the farmer gives up 1/4M • Slope = opportunity cost (an example of making math meaningful to real world situations) • Reverse directions – Rancher to get 1M → -2P – Farmer to get 1M → -4P • Conclusions: – Rancher has a comparative advantage in producing meat (1M costs 2P or 1P costs 1/2M) – Farmer has a comparative advantage in producing potatoes (1P costs 1/4M or 1M costs 1/4P) • The rancher should specialize in producing meat and the farmer should specialization in producing potatoes. Gains to Trade • Marginal versus Complete Approach • Marginal adjustment – – – – – – Farmer -1M → +4P Rancher +1M → -2P Total 0M +2P, or Rancher -1P → +1/2M Farmer +1P → -1/4M Total 0P +1/4M • Either way specializing and trading means either more meat or potatoes The Total Approach • Mankiw explains gains a bit differently and perhaps in a more complicated way – Farmer only produces potatoes and rancher produces a combination of meat and potatoes – Trade takes place with equal amounts for each – New totals lie outside the old PPF and represents a point on a consumption possibilities frontier – Let’s see how he does it…. Table 2 The Gains from Trade: A Summary Copyright © 2004 South-Western Figure 2 How Trade Expands the Set of Consumption Opportunities (b) The Rancher’s Production and Consumption Meat (ounces) Rancher's production with trade 24 Rancher's consumption with trade 18 13 B* B 12 0 12 24 27 Rancher's production and consumption without trade 48 Potatoes (ounces) Copyright © 2004 South-Western Figure 2 How Trade Expands the Set of Consumption Opportunities (a) The Farmer’s Production and Consumption Meat (ounces) 8 Farmer's consumption with trade A* 5 4 Farmer's production and consumption without trade A Farmer's production with trade 0 32 16 Potatoes (ounces) 17 Copyright©2003 Southwestern/Thomson Learning Distribution of Gains to Trade • Voluntary exchange results in gains to trade, but who gets the gains? • Positive analysis = gains exist so efficiency improvements can occur • Normative analysis = who should get the gains • Normative analysis involves value judgments and therefore must be made by others History of Trade • Tribal to feudal times • Adam Smith (1776) and David Ricardo (1817) • The costs of not trading (e.g. lamb example) • Distribution impacts: consumers win but some producers and workers lose • The cost of protectionism Markets: The power of Demand and Supply • Competitive Markets – – – – identical or homogeneous goods many sellers and buyers perfect Information free entry and exit • Non-Competitive Markets – Monopoly – one seller – Oligopoly – few sellers – Monopolistically Competitive – differentiated products Demand • The demand curve – Price and the quantity demanded • Rational behavior – Utility maximization (MB=MC all over again) • Income and substitution effects – Demand schedule – Individual demand curve – Market demand curve Catherine’s Demand Schedule Figure 1 Catherine’s Demand Schedule and Demand Curve Price of Ice-Cream Cone $3.00 2.50 1. A decrease in price ... 2.00 1.50 1.00 0.50 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones 2. ... increases quantity of cones demanded. Copyright © 2004 South-Western • The demand function – Income – Price of related goods • Complements • Substitutes – Tastes – Expectations – Number of Buyers • Movement along and shifts of the demand curve – Curve versus function – Schedules – Graphs Figure 3 Shifts in the Demand Curve Price of Ice-Cream Cone Increase in demand Decrease in demand Demand curve, D2 Demand curve, D1 Demand curve, D3 0 Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning Supply • Price and the quantity supplied – Rational behavior an the profit motive – Law of diminishing returns • Supply schedule • Individual supply curve • Market supply curve Ben’s Supply Schedule Figure 5 Ben’s Supply Schedule and Supply Curve Price of Ice-Cream Cone $3.00 1. An increase in price ... 2.50 2.00 1.50 1.00 0.50 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of Ice-Cream Cones 2. ... increases quantity of cones supplied. Copyright©2003 Southwestern/Thomson Learning • The supply function – – – – Input prices technology expectations number of sellers Figure 7 Shifts in the Supply Curve Price of Ice-Cream Cone Supply curve, S3 Decrease in supply Supply curve, S1 Supply curve, S2 Increase in supply 0 Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning Market Equilibrium • Equilibrium price and quantity = market clearing price and quantity • Disequilibrium prices and quantities – Shortage – Surplus • Comparative static analysis: changes in equilibrium prices and quantities • Shifts in curves versus movement along revisited • Changes in demand and supply Figure 8 The Equilibrium of Supply and Demand Price of Ice-Cream Cone Supply Equilibrium Equilibrium price $2.00 Equilibrium quantity 0 1 2 3 4 5 6 7 8 Demand 9 10 11 12 13 Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning Figure 9 Markets Not in Equilibrium (a) Excess Supply Price of Ice-Cream Cone Supply Surplus $2.50 2.00 Demand 0 4 Quantity demanded 7 10 Quantity supplied Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning Figure 8 The Equilibrium of Supply and Demand Price of Ice-Cream Cone Supply Equilibrium Equilibrium price $2.00 Equilibrium quantity 0 1 2 3 4 5 6 7 8 Demand 9 10 11 12 13 Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning Figure 9 Markets Not in Equilibrium (a) Excess Supply Price of Ice-Cream Cone Supply Surplus $2.50 2.00 Demand 0 4 Quantity demanded 7 10 Quantity supplied Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning Figure 9 Markets Not in Equilibrium (b) Excess Demand Price of Ice-Cream Cone Supply $2.00 1.50 Shortage Demand 0 4 Quantity supplied 7 10 Quantity of Quantity Ice-Cream demanded Cones Copyright©2003 Southwestern/Thomson Learning Figure 10 How an Increase in Demand Affects the Equilibrium Price of Ice-Cream Cone 1. Hot weather increases the demand for ice cream . . . Supply New equilibrium $2.50 2.00 2. . . . resulting in a higher price . . . Initial equilibrium D D 0 7 3. . . . and a higher quantity sold. 10 Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning Figure 11 How a Decrease in Supply Affects the Equilibrium Price of Ice-Cream Cone S2 1. An increase in the price of sugar reduces the supply of ice cream. . . S1 New equilibrium $2.50 Initial equilibrium 2.00 2. . . . resulting in a higher price of ice cream . . . Demand 0 4 7 3. . . . and a lower quantity sold. Quantity of Ice-Cream Cones Copyright©2003 Southwestern/Thomson Learning The Invisible Hand • Economic Agents are motivated by self-interest – consumers by utility maximization – Producers by profit maximization • Market prices as signals for resource allocation and coordinate consumer and producer behavior • Market or the Price System and Efficiency