Download Scientific Method, Models, and Gains to Trade

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