Transcript Document

BU224-01: Unit 2 Seminar
Tilahun Ayanou, PhD
Wednesday 9:00-10:00PM (EST)
3/28
Unit 1 Seminar: Recap
1.
Basic Economic Principles Guide Economic Decision Making
Process (Individual Choices)
•
•
•
•
2.
Scare resources and rational choices
Opportunity costs
Tradeoff: Marginal Costs and Marginal Benefits Comparison
Rational People Respond to Incentives
Economic Principles Guide Economic Interactions
•
•
•
•
•
Gains from Trade
Markets move towards equilibrium
Efficient use of resources to achieve national goals
Markets lead to better economic efficiency
when markets fail, government interventions improves welfare
Unit 1 Recap: Gains from Trade
• In a market economy: there are gains from
trade since specialization increases output.
– Tradeoffs occur based on opportunity costs.
• Principles Extended to chapters 2
– Interdependence of economic agents’ choices
– Gains from trade based on opportunity costs
Unit 2 Seminar Agenda
Chapter 2: Economic Models: Tradeoffs and Trade
• Also Refer to Chapter 2 Appendix: Graphs in Economics
– Relevant throughout the course
Chapter 2
Economic Models: Tradeoffs and Trade
o Simple Economic Models: Agents Interactions
 Production Possibility Frontier (PPF): Tradeoffs
 Circular Flow Diagram: Economic Agents Interdependence
o Trade and Comparative Advantage
o The difference between positive economics and
normative economics
Models in Economics
• Almost all economics is based on models.
• A model is a simplified representation of a
real economic situation that is used to better
understand real-life economic conditions.
• The “other things equal” assumption
means that all other relevant factors remain
unchanged.
• “Ceteris Paribus”
2.1 Tradeoffs: The Production Possibility Frontier
• The production possibility frontier (PPF)
illustrates the tradeoffs facing an economy that
produces only two goods.
• PPF shows the maximum quantity of one good that can
be produced for any given production of the other.
• Why do we face PPF? Resources at our disposal
are scarce at a given period.
• Increase in the production of one good leads to the
decrease in the production of another good.
The Production Possibility Frontier
Quantity of Coconuts
D
30
Feasible and
efficient
in production
Not
feasible
A
15
9
Feasible
but
not efficient
B
C
Production possibility frontier
PPF
0
20
28
40
Quantity of fish
A Simple Economic Model
Assumptions:
1. A simple Economy that produces and trades two
goods: Coconuts and fish
2. Two Island Castaways: Hank and Tom
 Produce and consume both goods
3. Limited/Scarce Resource: Time
 Should Hank and Tom strive for self-sufficiency or
engage in trade based on opportunity costs?
 Do they gain from Trade based on opportunity costs?
Production Possibilities for Two Castaways (Hank and Tom)
(a) Hank’s Production Possibilities
Quantity of Coconuts
20
Hank’s consumption
without trade
8
Hank’s
PPF
0
6
10
Quantity of fish
Production Possibilities for Two Castaways
(b) Tom’s Production Possibilities
Quantity of Coconuts
30
Tom’s consumption
without trade
9
Tom’s
PPF
0
28
40
Quantity of fish
Opportunity Cost from PPF
• Opportunity Cost is a Ratio (constant O.C.)
O.C. coconuts=(# fish lost)/ (# coconuts gained)
O.C. Fish = (#coconuts lost)/(# fish gained)
PPF of Hank
Hank’s Maximum Production
• Coconuts: 20 or
• Fish: 10
O.C. Coconuts = 10/20 = ½ fish
O.C. Fish = 20/10 =2 coconuts
Hank’s Consumption without Trade:
 8 Coconuts and 6 fish
PPF of Tom
Tom’s Maximum Production:
• Coconuts :30 or
• Fish: 40
O.C. Fish =30/40= ¾ Coconuts
O.C. Coconuts = 40/30 = 4/3 Fish
Tom’s Consumption without Trade:
 9 Coconuts and 28 fish
Tom and Hank’s Opportunity Costs
Tom’s Opportunity Cost
Hank’s Opportunity Cost
One fish
3/4 coconut
2 coconuts
One Coconut
4/3 fish
1/2 fish
Specialize and Trade
 Both castaways are better off when they each
specialize in what they are good at and trade.
 It’s a good idea for Tom to catch fish for both of
them, because his opportunity cost of fish in
terms of coconuts not gathered is only 3/4 of a
coconut, versus 2 coconuts for Hank.
 Correspondingly, it’s a good idea for Hank to
gather coconuts for the both of them since his
O.C. is ½ fish vs. 4/3 fish for Tom.
Do the Castaways Gain from Trade?
Both Tom and Hank experience gains from trade:
 Tom’s consumption of fish increases by two, and
his consumption of coconuts increases by one.
 Hank’s consumption of fish increases by four, and
his consumption of coconuts increases by two.
 Key Assumption: No Cheating
Quantity of Apples
(pounds)
Quantity of Oranges
(pounds)
A
1,000
0
B
900
400
C
700
600
D
500
700
E
300
750
F
0
825
What is the opportunity cost of increasing the annual
output of apples from 700 to 900 pounds?
Decrease production of orange from 600 to 400 pounds
= decrease of 200 pounds of oranges.
Quantity of coconuts
35
Increasing Opportunity Cost
…requires giving up
5 coconuts
Producing the first
20 fish . . .
But producing
20 more fish . . .
30
A
25
20
…requires giving up
25 more coconuts…
15
10
5
PPF
0
10
20
30
40
50
Quantity of fish
Economic Growth
Quantity of coconuts
The economy can now produce
more of everything.
35
E
Economic growth results in an
outward shift of the PPF because
production
30
A
25
Production is initially at point A (20 fi
and 25 coconuts),  it can move to
point E (25 fish and 30 coconuts).
possibilities are expanded.
20
15
10
5
Original
New
PPF
PPF
0
10
20
25
30
40
50
Quantity of fish
2.2 Comparative vs. Absolute Advantage
• An individual has a comparative advantage in
producing a good or service if the opportunity
cost of producing the good is lower for that
individual than for other people.
• Comparative advantage explains the
source of gains from trade between
individuals as well as between countries.
Absolute Advantage…
• An individual has an absolute advantage in an
activity if she or he can do it better than other people.
• Ex: Tom has absolute advantage in gathering
coconuts and catching fish.
• Maximum Production:
• Hank: 20 Coconuts or 10 Fish
• Tom: 40 Fish or 30 Coconuts
Tom also benefits from trade: comparative
advantage guides based on opportunity cost trade.
Comparative Advantage and Gains from Trade
(a) Tom’s Production and Consumption
Quantity of coconuts
30
(b) Hank’s Production and Consumption
Quantity of coconuts
Tom’s consumption
without trade
Hank’s production
with trade
Tom’s consumption
with trade
Tom’s production
with trade
10
9
20
Hank’s consumption
with trade
Hank’s consumption
without trade
10
8
Hank's
PPF
Tom's
PPF
0
2830
40 Quantity of fish
0
6 10
Quantity of fish
Comparative Advantage and International Trade
(a) The U.S. Production Possibilities Frontier
Quantity of aircraft
(b) Canadian Production Possibilities Frontier
Quantity of aircraft
3,000
Canadian production
with trade
U.S. consumption
without trade
U.S. consumption
with trade
1,500
Canadian
consumption
without trade
2,000
1,500
U.S.
production
with trade
1,000
Canadian
consumption
with trade
U.S.
PPF
0
1
2
3
Quantity of pork (millions of tons)
Canadian
PPF
0
0.5
1
1.5
Quantity of pork (millions of tons)
Comparative Advantage and International Trade
• Just like the example of Tom and Hank, the U.S. and
Canada can both achieve mutual gains from trade.
• If the U.S. concentrates on producing pork and
ships some of its output to Canada, while Canada
concentrates on aircraft and ships some of its
output to the U.S., both countries can consume
more than if they insisted on being self-sufficient.
2.3 Transactions: The Circular-Flow Diagram
• The circular-flow diagram is a model that
represents the transactions (interactions) in
an economy by flows around a circle.
• It represents transactions within the
economy as flows of goods, services, and
money between households and firms.
These transactions occur in markets for
goods and services and factor markets.
The Circular-Flow Diagram
Money
Households
Goods
and
services
Money
Factors
Factor Markets
Goods
and
services
Money
Factors
Firms
Money
Households
and firms pay
taxes and
receive
transfers.
Governments buy
goods and services
from firms.
Circular-Flow of Economic Activities
The economy works via interactions
among economic agents.
• Economy operates in a circular flow.
• Households’ economic decisions (choices)
affect the firms, and firms decisions (choices)
affect the households.
• Government’s economic policy instruments
affect both households and firms.
Economic Interactions…
• Firms sell goods and services that they
produce to households in markets for
goods and services.
• Firms buy the resources they need to
produce, i.e. factors of production, in factor
markets from households (labor).
• Factor markets: determine the economy’s
income distribution.
2.4 Positive and Normative Economics
• Positive economics is the branch of economic
analysis that describes the way the economy
actually works.
• Based on facts or data.
• Examples: the current unemployment rate in the
USA is 8.5%.
• USA has high labor productivity (output/labor)
• Africa has very low wage rates.
• USA has very high wage rates.
Normative Economics
• Normative economics makes prescriptions
about the way the economy should work.
• Personal Opinions (Value Judgments).
Example: We should reduce USA imports.
• Economists can determine correct answers for
positive questions, but typically not for
normative questions, which involve value
judgments.