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UNIT I – Basic Economic Concepts
 Chapters – Introduction, 1, and 2
Definition(?)
Other TEXT Examples
 Social science concerned with using scarce
resources to obtain the maximum satisfaction of
the unlimited material wants of society.
 The science that explains the choices we make
and how those choices change as we cope with
scarcity.
 The study of people producing and exchanging to
get the goods and services they want.
Definition(?)
Our working definition -SOCIAL SCIENCE CONCERNED WITH THE WAY SOCIETY
CHOOSES TO EMPLOY ITS LIMITED RESOURCES WHICH
HAVE ALTERNATIVE USES TO PRODUCE GOODS AND
SERVICES FOR PRESENT AND FUTURE CONSUMPTION.
Definition(?)
 “The study of mankind in
the ordinary business of
life.” -- Alfred Marshall
 Oikos / Nomos -- comes
from these two Greek
words for “one who
manages a household.”
 The science which makes common sense
difficult.
Economics – Social Science
 analyze human behavior, not physical science
(no atoms, electrons, moles, quantum theory)
Economic Analysis
 Many decisions -- economic underpinnings
 Framework of analysis -- economic way of
thinking
Economic Analysis
 Why study economics???
 Learning its tenents will
help you understand the world
Economic Analysis
Why study economics???
 Some questions to think about ...
 Why are apartments so hard to find in New York City?
 Why do airlines charge less for a round-trip ticket if the




traveler stays over a Saturday night?
Why is (put famous actor/actress here) paid so much to star in
TV/Film?
Why are living standards so meager in many African
countries?
Why do some countries have high rates of inflation while
others have stable prices?
Why are jobs easy to find in some years and hard to find in
others?
Economic Analysis
Why study economics???
 You will be an astute participant in the economy
 Many “life” decisions have economic
underpinnings
 Job, spending,
investing, decisions
w/in your career
Economic Analysis
Why study economics???
 You will understand potential limits of governmental
economic policy
 As a voter, you help choose the policies that guide the
allocation of society’s resources.
 Examples:
 What are the burdens associated with alternative forms of
taxation?
 What are the effects of free trade with other countries?
 What is the best way to protect the environment?
 How does the budget deficit effect the economy?
The Economic Problem: Making
Choices
 “The difficulty in life is the choice.”
George Moore, The Bending of the
Bough, Act IV
 Basic Terms
 Resources -- Things used to produce other things
to satisfy people’s wants
 Wants
-- What people would buy if their
incomes were unlimited
The Economic Problem: Making
Choices
-- Not all wants can be realized
 Why?
 Resources are limited
 Wants are unlimited
 Central economic idea:
Scarcity
The Economic Problem: Making
Choices
 Due to scarcity, people are forced into making
choices based on their limited resources
 Framework = economic way of thinking
-- To be scarce, the item:
 Must be limited
 Desirable
 Have a price
 Example:
 Scarcity not always about money
Economic Disciplines
 Two types:
 Microeconomics
 Decisions undertaken by individuals (or
households) / by firms
 Microscope -- focus on small elements of
economy
 New taxes on a specific industry or product
 Wages (up) by an effective union strike
Economic Disciplines
 Two types:
 Macroeconomics
 Behavior of the economy as a
whole
 Rate of inflation
 Economy wide unemployment
 Yearly growth in output of goods / services
in U.S.
People Behave Rationally
 Assumption:
 Individuals act as if motivated by self-interest,
respond predictably to gain
“
 ... it is not from the benevolence of the
butcher, the brewer, or the baker that
we expect our dinner, but from their
regard to their own interest.”
-Adam Smith An
Inquiry into the Nature and Causes of the Wealth
of Nations
People Behave Rationally
 Assumption:
 People will look out for their self-interest in a
rational manner
 Example:
 Explain the
anomaly
concerning the
makeup of U.S.
population.
People Behave Rationally
 Assumption:
 People do not intentionally make decisions that
leave them worse off
 Economics:
 Does not involve itself in thought processes
 Looks at what people actually do in life with
their limited resources
 Example:
 Why can’t you sometimes
teach an old dog new tricks?
People Behave Rationally
 Incentives
 Rewards for engaging in a particular activity
 One will react to incentives after making
rational choices involving balancing costs and
benefits
People Behave Rationally
 Self-interest
 Not always measured in the goal of attaining
more dollars and cents
 Self-interest goals may relate to:
 prestige
love
 helping others friendship
 power
creating works of art
 Example:
 How valuable is your gift giving?
 Charitable acts -- self-interest?
Unique Terms / Ideas
 Models, or Theories
 Simplified representations of the real world
 Used as basis for predictions or explanations
 Important:
no economic model complete
can not capture every detail
 Example:
 I35W, I35, I80, I15, I99, I55, I73, Southwest on Jamboree, Lt. on
San Joaquin Hills Rd., Lt. Big Canyon Rd., Rt. Burning Tree Rd.
 Focus on relevance to problem / omit what is
not
Unique Terms / Ideas
 Ceteris Paribus Assumption
 Assumption:
 Nothing changes except factor or factors being
studied
 “other things being equal”
 Example:
 Lower prices cause people to buy more. Other
factors beyond price influence buying decisions
 Income
Religious beliefs
 Season
Tastes
 Custom, etc.
Unique Terms / Ideas
 Positive Economics
 Analysis limited to making
either purely descriptive statements or
scientific predictions.
 No subjective or moral judgments.
 A statement of “what is”
 “If A, then B.”
Unique Terms / Ideas
 Normative Economics
 Analysis involving
value judgments
about economic
policies
 Relates to whether
things are good or
bad
 Statement of
“what ought to be”
Unique Terms / Ideas
 Positive and Normative Economics
 Example:
 Positive economic
statement:
 “If the price of gas
rises, people will buy less.”
 Normative economic statement:
 “So, we should not allow the price to go
up.”
 We have expressed a value judgment
Tools of Production
 Production
 Conversion of resources
to products -- used in
consumption
Tools of Production
 Five Factors of Production
1.
human
Land
(natural resource) encompasses non
gifts of nature
Example:
timber, water,
mineral deposits,
climate
Tools of Production
 Five Factors of Production
2.
Labor
Productive contributions of humans
activities
Involves both mental and physical
Example:
steelworkers,
teachers,
computer programmers
Tools of Production
 Five Factors of Production
3.
Physical capital
Manufactured resources
Includes: buildings, machines,
equipment,
improvements to land used
for
production
Example:
Bloomington, Indiana
Pizza oven, irrigation ditches, Best Buy
Campus
Tools of Production
 Five Factors of Production
4.
Human capital
Accumulated training / education
Whenever skills increase, human capital
improves
Tools of Production
 Five Factors of Production
5.
Entrepreneurship
Human resources -- perform functions of
raising capital, organizing, managing,
assembling other factors of production
Risk taker
Tools of Production
 Goods
 Physical objects that are produced
 Example:
 Bike, GI Joe with the Kung Fu Grip,
surfboard
 Capital goods
 Nonconsumerable goods
used to make other goods
Tools of Production
 Service
 Mental / physical labor purchased by
consumers
 Example:
 Sales, laundry,
ski waxing,
psychological
counseling
Big Economic Questions
 Resource allocation
 By answering economic questions, scarce
resources allocated
 What?
 How?
 For Whom?
Big Economic Questions
 What???
 A society must determine how much of each of
the many possible goods and services it will
make, and when they will be produced. Will we
produce frozen pizzas or shirts today? A few
high-quality shirts or many cheap shirts? Will
we use scarce resources to produce many
consumption goods (like frozen pizzas)? Or
will we produce fewer consumption goods and
more capital goods (like pizza-making
machines), which will boost production and
consumption tomorrow.
Big Economic Questions
 How???
 A society must determine who will do the
production with what resources, and what
production techniques they will use. Who
farms and who teaches? Is electricity
generated from oil, from coal, or from nuclear
power? With much air pollution or with little?
Big Economic Questions
 For Whom???
 One key task for any society is to decide who
gets to eat the fruit of the economy’s efforts.
Or, to put it formally, how is the national
product divided among different households?
Are many people poor or a few rich? Do high
incomes go to managers or workers or
landlords? Do the sick or elderly eat well, or
are they left to fend for themselves?
Cost
In economics, cost is always a forgone opportunity.
Opportunity cost
 best alternative given up in order to satisfy
wants
 Remember: opportunity cost is the next-
highest-ranked alternative, not all alternatives
Cost of Something is What You Give up to
Get It
Examples:
The opportunity cost of …
 … growing carrots for the gardener, is the
alternative crop that might have been grown instead
(potatoes, tomatoes, pumpkins, etc.).
 … seeing the latest Lincoln film is not just the price
of the ticket, but the value of the time you spend in
the AMC Rosedale theater.
Question: “The best things in life are free.” True?
Cost
Explicit Cost
 Costs that must be paid
 Fixed costs
 Example: Rent, taxes, tuition
Cost
Implicit Cost
 Not paid out of pocket so not explicitly
calculated
 Opportunity cost of a decision
Marginal (cost vs. benefit) Analysis
Marginal analysis
 Extra or additional benefits of a decision
Cost / Benefit analysis
 Decision making comes down to benefits vs. costs
 If I do a little more of “this” what is the cost of
“that.”
 Remember: People will only choose actions
which will bring the greater benefits over costs.
Marginal (cost vs. benefit) Analysis
Rational People THINK at the Margin
 A person is rational if she systematically and
purposefully does the best she can to achieve
her objectives.
 Many decisions are not “all or nothing,”
but involve marginal changes – incremental
adjustments to an existing plan.
 Evaluating the costs and benefits of marginal
changes is an important part of decision making
Rational People THINK at the Margin
Examples:
 A student considers whether to go to college
for an additional year, comparing the fees &
foregone wages to the extra income he could
earn with an extra year of education.
 A firm considers whether to increase output,
comparing the cost of the needed labor and
materials to the extra revenue.
People Respond to Incentives
 incentive: something that induces a person to act, i.e.
the prospect of a reward or punishment.
 Rational people respond to incentives because they
make decisions by comparing costs and benefits.
Examples:
 In response to higher gas prices, sales of “hybrid”
cars (e.g., Toyota Prius) rise.
 In response to higher cigarette taxes, teen smoking
falls.
A C T I V E L E A R N I N G 1:
Exercise
You are selling your 1996 Mustang. You have already
spent $1000 on repairs.
At the last minute, the transmission dies. You can pay
$600 to have it repaired, or sell the car “as is.”
In each of the following scenarios, should you have the
transmission repaired?
A. Blue book value is $6500 if transmission works,
$5700 if it doesn’t
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t
A C T I V E L E A R N I N G 1:
Answers
Cost of fixing transmission = $600
A. Blue book value is $6500 if transmission works,
$5700 if it doesn’t
Benefit of fixing the transmission = $800 ($6500 – 5700).
It’s worthwhile to have the transmission fixed.
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t
Benefit of fixing the transmission is only $500.
Paying $600 to fix transmission is not worthwhile.
A C T I V E L E A R N I N G 1:
Answers
Observations:
 The $1000 you previously spent on repairs is
irrelevant. What matters is the cost and benefit of the
marginal repair (the transmission).
 The change in incentives from scenario A to scenario B
caused your decision to change.
People Face Tradeoffs
All decisions involve tradeoffs. Examples:
 Going to a basketball game the night before your
economics exam leaves less time for studying.
 Having more money to buy stuff requires working
longer hours, which leaves less time for leisure.
 Protecting the environment requires resources that
might otherwise be used to produce consumer goods.
People Face Tradeoffs
 Society faces an important tradeoff:
efficiency vs. equity
 efficiency:
getting the most out of scarce
resources
 equity:
distributing prosperity fairly among
society’s members
 Tradeoff: To increase equity, can redistribute income
from the well-off to the poor.
The Production Possibilities Frontier
 The Production Possibilities Frontier (PPF):
A graph that shows the combinations of
two goods the economy can possibly produce given the
available resources and the available technology.
Example:



Two goods:
computers and wheat
One resource:
labor (measured in hours)
Economy has 50,000 labor hours per month
available for production.
PPF Example
Producing one computer requires 100 hours labor.
Producing one ton of wheat requires 10 hours labor.
Employment of
labor hours
Production
Computers
Wheat
Computers
Wheat
A
50,000
0
500
0
B
40,000
10,000
400
1,000
C
25,000
25,000
250
2,500
D
10,000
40,000
100
4,000
E
0
50,000
0
5,000
Production
Wheat
Point
(tons)
on
Comgraph puters Wheat 6,000
A
500
0
B
400
1,000
C
250
2,500
D
100
4,000
E
0
5,000
E
5,000
D
4,000
C
3,000
2,000
B
1,000
A
0
0
100 200 300 400 500 600
Computers
A C T I V E L E A R N I N G 2:
Points on the PPF
A. On the graph, find the point that represents
(100 computers, 3000 tons of wheat), label it F.
Would it be possible for the economy to produce this
combination of the two goods?
Why or why not?
B. Next, find the point that represents
(300 computers, 3500 tons of wheat), label it G.
Would it be possible for the economy to produce this
combination of the two goods?
A C T I V E L E A R N I N G 2:
Answers
Wheat
 Point F:
100 computers,
3000 tons wheat
 Point F requires
40,000 hours
of labor.
Possible but
not efficient: could
get more
of either good
w/o sacrificing any
of the other.
(tons)
6,000
5,000
4,000
3,000
F
2,000
1,000
0
0
100 200 300 400 500 600
Computers
A C T I V E L E A R N I N G 2:
Answers
Wheat
 Point G:
300 computers,
3500 tons wheat
 Point G requires
65,000 hours
of labor.
Not possible
because economy
only has
50,000 hours.
(tons)
6,000
5,000
4,000
G
3,000
2,000
1,000
0
0
100 200 300 400 500 600
Computers
The PPF: What We Know So Far
 Points on the PPF (like A – E)
 possible
 efficient: all resources are fully utilized
 Points under the PPF (like F)
 possible
 not efficient: some resources underutilized
(e.g., workers unemployed, factories idle)
 Points above the PPF (like G)
 not possible
The PPF and Opportunity Cost
 Recall: The opportunity cost of an item
is what must be given up to obtain that item.
 Moving along a PPF involves shifting resources (e.g.,
labor) from the production of one good to the other.
 Society faces a tradeoff: Getting more of one good
requires sacrificing some of the other.
 The slope of the PPF tells you the opportunity cost
of one good in terms of the other.
The PPF and Opportunity Cost
Wheat
(tons)
6,000
5,000
4,000
3,000
2,000
1,000
slope =
–1000
= –10
100
The slope of a line
equals the “rise
over the run” –
the amount the line
rises when you
move to the right
by one unit.
Here, the
opportunity cost of a
0
computer is
0 100 200 300 400 500 600
Computers 10 tons of wheat.
A C T I V E L E A R N I N G 3:
PPF and Opportunity Cost
In which country is the opportunity cost of cloth lower?
FRANCE
ENGLAND
Wine
Wine
600
600
500
500
400
400
300
300
200
200
100
100
0
0
0
100 200 300 400
Cloth
0
100
200
300
400
Cloth
61
A C T I V E L E A R N I N G 3:
Answers
England, because its PPF is not as steep as France’s.
FRANCE
ENGLAND
Wine
Wine
600
600
500
500
400
400
300
300
200
200
100
100
0
0
0
100 200 300 400
Cloth
0
100
200
300
400
Cloth
62
Economic Growth and the PPF
With additional
resources or an
improvement in
technology,
the economy can
produce more
computers,
more wheat,
or any combination in
between.
Wheat
(tons)
6,000
Economic
growth shifts
the PPF
outward.
5,000
4,000
3,000
2,000
1,000
0
0
100 200 300 400 500 600
Computers
The Shape of the PPF
 The PPF could be a straight line, or bow-shaped
 Depends on what happens to opportunity cost
as economy shifts resources from one industry
to the other.
 If opp. cost remains constant, PPF is a straight line.
(In the previous example, opp. cost of a computer
was always 10 tons of wheat.)
 If opp. cost of a good rises as the economy produces
more of the good, PPF is bow-shaped.
As the economy
shifts resources
from Tater tots to
mountain bikes:
Tater
tots
Why the PPF Might Be Bow-Shaped
 PPF becomes
steeper
 opp. cost of
mountain bikes
increases
Mountain
Bikes
At point A,
most workers are
producing Tater
tots, even those
that are better
suited to building
mountain bikes.
So, you do not have
to give up many
Tater tots to get
more bikes.
Tater
tots
Why the PPF Might Be Bow-Shaped
A
At A, opp. cost of
mtn bikes is low.
Mountain
Bikes
At B, most workers
are producing bikes.
The few left in “tot”
production are the
best workers.
Producing more
bikes would require
shifting some of the
best workers away
from “tot” production,
which would cause a
big drop in “tot”
output.
Tater
tots
Why the PPF Might Be Bow-Shaped
At B, opp. cost
of mtn bikes
is high.
B
Mountain
Bikes
Why the PPF Might Be Bow-Shaped
 So, PPF is bow-shaped when different workers have
different skills, different opportunity costs of
producing one good in terms of the other.
 The PPF would also be bow-shaped when there is
some other resource, or mix of resources with
varying opportunity costs.
 E.g., different types of land suited for
different uses
The PPF: A Summary
 The PPF shows all combinations of two goods
that an economy can possibly produce, given its
resources and technology.
 A bow-shaped PPF illustrates the concept of
increasing opportunity cost.
 The PPF illustrates the concepts of tradeoff and
opportunity cost.
The “ISMS”
Economic system
 institutional means through which resources are used to
satisfy human wants
 Historically:
industrially advanced economies of the world differed
essentially in two ways:
 ownership of means of production
 method of coordinating / directing economic activity
The “ISMS”
Pure, laissez faire, capitalism, or market
 private ownership of resources
 markets / prices coordinate and direct economic
activity
 Government’s role:


protect private property
establish legal framework
The “ISMS”
Command economy or communism
 public ownership of virtually all property resources
 economic decisions completed through central planning
 Example:


The former Soviet Union is the 74-year experiment in trying
to run an economy without using the price, or market
system.
One of the great failures of the 20th Century.
The “ISMS”
Socialism
 State owns major share of productive resources except
labor
 usually involves redistribution of income
 varied degrees in practice

Europe
The “ISMS”
Mixed
 falls between extremes of pure capitalism and
command economy
 Capitalism w/ government
 Important:

Incentives matter
The “ISMS”
Traditional Economy
 production methods, exchange, and distribution of
income sanctioned by custom
 heredity and caste circumscribe economic roles
U.S. free enterprise system
3 Elements
 (1) Private Property


protected by U.S.
Constitution
gives owners incentive to use
their resources efficiently as
possible
U.S. free enterprise system
(2) Price System
 voluntary exchanges establish prices for goods,
services, and resources
 provide information and incentives
 information source
 Consumers -- prices serve as a guide
 Businesses -- prices indicate the value consumers
place on the good/service
U.S. free enterprise system
(2) Price System
 voluntary exchanges establish prices for goods,
services, and resources
 provide information and incentives
 Incentives
 increasing prices encourage businesses to increase
production
Remember:
 incentives and the desire for more money cannot explain
all of our behaviors
U.S. free enterprise system
(3) Market Competition
 Resource competition

Buyers

compete against one another in markets for
productive resources
Example:
 resources such as skilled workers, oil deposits, complex
machinery
U.S. free enterprise system
(3) Market Competition
 Resource competition

Sellers

compete against other sellers by trying to make their
resources more productive
U.S. free enterprise system
(3) Market Competition
 Product competition

Buyers

compete against other buyers in product markets
Example:
 auction
U.S. free enterprise system
(3) Market Competition
 Product competition

Sellers


compete against sellers by trying to offer goods /
services buyers want at prices they are willing to pay
winners in this competition earn profit
Note:
 Profit is the difference between a firm’s total revenues and
its total costs
The Circular-Flow Diagram
 Circular-Flow Diagram: A visual model of the economy,
shows how dollars flow through markets among households
and firms.
 Includes two types of “actors”:
 households
 firms
 Includes two markets:
 the market for goods and services
 the market for “factors of production”
The Circular-Flow Diagram
Households:
 own the factors of production, sell/rent them to firms
for income
 buy and consume goods & services
Firms
Households
The Circular-Flow Diagram
Firms
Firms:
 buy/hire factors of production,
use them to produce goods
and services
 sell goods & services
Households
Revenue
G&S
sold
Markets for
Goods &
Services
Firms
Factors of
production
Wages, rent,
profit
Spending
G&S
bought
Households
Markets for
Factors of
Production
Labor, land,
capital
Income
HOW PEOPLE INTERACT
An “economy” is just a
group of people
interacting with
each other.
Interdependence
Every day
you rely on
many people
from around
the world,
most of whom
you do not know,
to provide you
with the goods
and services
you enjoy.
hair gel from
Roseville, MN
cell phone
from Taiwan
dress shirt
from China
coffee from
Kenya
Trade Can Make Everyone Better Off
 Rather than being self-sufficient, people can
specialize in producing one good or service
and exchange it for other goods.
 Countries also benefit from trade & specialization:
 get a better price abroad for goods they produce
 buy other goods more cheaply from abroad than
could be produced at home
SPECIALIZATION AND TRADE
Comparative Advantage
 ability of a person to perform an activity or produce
a good or service at a lower opportunity cost than
someone else
Example:
 Joe and Liz operate smoothie bars and
produce smoothies and salads
SPECIALIZATION AND TRADE
Liz's Smoothie Bar
In an hour, Liz can produce either
40 smoothies or 40 salads.
Liz's opportunity cost of
producing 1 smoothie is 1 salad.
Liz's opportunity cost of producing
1 salad is 1 smoothie.
Each hour, Liz produces 20
smoothies and 20 salads.
SPECIALIZATION AND TRADE
Joe's Smoothie Bar
In an hour, Joe can produce
either 6 smoothies or 30 salads.
Joe's opportunity cost of
producing 1 smoothie is 5 salads.
Joe's opportunity cost of
producing 1 salad is 1/5 smoothie.
Each hour, Joe's produces 5
smoothies and 5 salads.
SPECIALIZATION AND TRADE
Liz’s Absolute Advantage
 Absolute advantage
 When one person is more productive than
another person in several or even all activities.
 Liz is four times as productive as Joe—Liz can
produce 20 smoothies and 20 salads an hour and
Joe can produce only 5 smoothies and 5 salads
an hour.
SPECIALIZATION AND TRADE
Liz’s Comparative Advantage
 Liz’s opportunity cost of a smoothie is 1 salad.
 Joe’s opportunity cost of a smoothie is 5 salads.
 Liz’s opportunity cost of a smoothie is less than
Joe’s, so Liz has a comparative advantage in
producing smoothies.
SPECIALIZATION AND TRADE
Joe’s Comparative Advantage
 Joe’s opportunity cost of a salad is 1/5 smoothie.
 Liz’s opportunity cost of a salad is 1 smoothie.
 Joe’s opportunity cost of a salad is less than Liz’s,
so Joe has a comparative advantage in producing
salads.
SPECIALIZATION AND TRADE
Joe’s Comparative Advantage
 Joe’s opportunity cost of a salad is 1/5 smoothie.
 Liz’s opportunity cost of a salad is 1 smoothie.
 Joe’s opportunity cost of a salad is less than Liz’s,
so Joe has a comparative advantage in producing
salads.
SPECIALIZATION AND TRADE
Achieving Gains from Trade
Liz and Joe produce more
of the good in which they
have a comparative
advantage:
Liz produces 35
smoothies and 5 salads.
Joe produces 30 salads.
SPECIALIZATION AND TRADE
Liz and Joe trade:
 Liz sells Joe 10 smoothies
and buys 20 salads.
 Joe sells Liz 20 salads and
buys 10 smoothies.
After trade:
Liz has 25 smoothies and
25 salads.
Joe has 10 smoothies
and 10 salads.
SPECIALIZATION
AND TRADE
Gains from trade:
 Liz gains 5 smoothies and 5
salads an hour—she
originally produced 20
smoothies and 20 salads.
 Joe gains 5 smoothies and 5
salads an hour—he originally
produced 5 smoothies and 5
salads.
The next slide illustrates the
gains from trade.
SPECIALIZATION AND
TRADE
1. Joe and Liz each
produce at point A on
their PPFs.
Joe has a comparative
advantage in producing
salads.
Liz has a comparative
advantage in producing
smoothies.
SPECIALIZATION AND
TRADE
Joe and Liz produce more
of the good in which they
have a comparative
advantage.
2. Joe produces 30
salads at point B on his
PPF.
2. Liz produces 35
smoothies and 5 salads
at point B on her PPF.
SPECIALIZATION AND
TRADE
Joe and Liz trade salads
and smoothies at a price of
2 salads per smoothie.
Joe sells 20 salads and
buys 10 smoothies from Liz.
Liz sells 10 smoothies and
buys 5 salads from Joe.
3. Both consume at point C,
which is outside their PPFs.
Another Trade Example
Two countries:
the U.S. and Japan
Two goods:
computers and wheat
One resource:
labor, measured in hours
 We will look at how much of both goods
each country produces and consumes

if the country chooses to be self-sufficient

if it trades with the other country
Production Possibilities in the U.S.
 The U.S. has 50,000 hours of labor
available for production, per month.

Producing one computer
requires 100 hours of labor.

Producing one ton of wheat
requires 10 hours of labor.
The U.S. PPF
Wheat
(tons)
The U.S. has enough labor
to produce 500 computers,
or 5000 tons of wheat,
or any combination along
the PPF.
5,000
4,000
3,000
2,000
1,000
0
Computers
100
200 300 400
500
The U.S. Without Trade
Wheat
(tons)
Suppose the U.S. uses half its labor
to produce each of the two goods.
5,000
Then it will produce and consume
250 computers and
2500 tons of wheat.
4,000
3,000
2,000
1,000
0
Computers
100
200 300 400
500
A C T I V E L E A R N I N G 4:
Derive Japan’s PPF
Use the following information to draw Japan’s PPF.
 Japan has 30,000 hours of labor
available for production, per month.
 Producing one computer
requires 125 hours of labor.
 Producing one ton of wheat
requires 25 hours of labor.
Your graph should measure computers on the
horizontal axis.
Japan’s PPF
Wheat
(tons)
Japan has enough labor to
produce 240 computers,
or 1200 tons of wheat,
or any combination
along the PPF.
2,000
1,000
0
Computers
100
200
300
Japan Without Trade
Wheat
(tons)
2,000
Suppose Japan uses half its labor to
produce each of the two goods.
Then it will produce and consume
120 computers and
600 tons of wheat.
1,000
0
Computers
100
200
300
Consumption With and Without Trade
 Without trade,
 U.S. consumers get 250 computers
and 2500 tons wheat.
 Japanese consumers get 120 computers
and 600 tons wheat.
 We will compare consumption without trade to
consumption with trade.
 First, we need to see how much of each good is
produced and traded by the two countries.
A C T I V E L E A R N I N G 5:
Production under trade
1.
Suppose the U.S. produces 3400 tons of wheat.
How many computers would the U.S. be able to
produce with its remaining labor? Draw the
point representing this combination of
computers and wheat on the U.S. PPF.
2. Suppose Japan produces 240 computers.
How many tons of wheat would Japan be able
to produce with its remaining labor? Draw this
point on Japan’s PPF.
U.S. Production With Trade
Wheat
(tons)
Producing 3400 tons of wheat
requires 34,000 labor hours.
5,000
4,000
The remaining 16,000
labor hours are used to
produce 160 computers.
3,000
2,000
1,000
0
Computers
100
200 300 400
500
Japan’s Production With Trade
Wheat
(tons)
Producing 240 computers
requires all of Japan’s
30,000 labor hours.
2,000
So, Japan would produce
0 tons of wheat.
1,000
0
Computers
100
200
300
International Trade
 Exports:
goods produced domestically and sold abroad
 Imports:
goods produced abroad and sold domestically
A C T I V E L E A R N I N G 6:
Consumption under trade
Suppose the U.S. exports 700 tons of wheat to
Japan, and imports 110 computers from Japan.
(So, Japan imports 700 tons wheat and exports
110 computers.)
 How much of each good is consumed in the U.S.? Plot
this combination on the U.S. PPF.
 How much of each good is consumed in Japan? Plot
this combination on Japan’s PPF.
U.S. Consumption With Trade
Wheat
(tons)
produced
+ imported
5,000
computers
160
wheat
3400
110
0
4,000
– exported
0
700
3,000
= amount
consumed
270
2700
2,000
1,000
0
Computers
100
200 300 400
500
Japan’s Consumption With Trade
Wheat
(tons)
produced
+ imported
– exported
= amount
consumed
2,000
computers
240
0
110
wheat
0
700
0
130
700
1,000
0
Computers
100
200
300
Trade Makes Both Countries Better Off
U.S.
consumption
without trade
consumption gains from
with trade
trade
computers
250
270
20
wheat
2,500
2,700
200
Japan
consumption
without trade
consumption gains from
with trade
trade
computers
120
130
10
wheat
600
700
100
Where Do These Gains Come From?
Absolute advantage: the ability to produce a good using
fewer inputs than another producer
 The U.S. has an absolute advantage in the production
of wheat:

producing a ton of wheat uses 10 labor hours
in the U.S. vs. 25 in Japan.
 If each country has an absolute advantage
in one good and specializes in that good,
then both countries can gain from trade.
Where Do These Gains Come From?
 Which country has an absolute advantage in
computers?
 Producing one computer requires
125 labor hours in Japan,
but only 100 in the U.S.
 The U.S. has an absolute advantage in both goods!
So why does Japan specialize in computers?
Why do both countries gain from trade?
Two Measures of the Cost of a Good
 Two countries can gain from trade when each
specializes in the good it produces at lowest cost.
 Absolute advantage measures the cost of a good
in terms of the inputs required to produce it.
 Recall: Another measure of cost is
opportunity cost.
In our example, the opportunity cost of a computer
is the amount of wheat that could be produced
using the labor needed to produce one computer.
Opportunity Cost
and Comparative Advantage
Comparative advantage: the ability to produce
a good at a lower opportunity cost than another
producer
 Which country has the comparative advantage in
computers?
 To answer this, must determine the opp. cost of
a computer in each country.
Opportunity Cost
and Comparative Advantage
 The opp. cost of a computer is

10 tons of wheat in the U.S., because producing one
computer requires 100 labor hours,
which instead could produce 10 tons of wheat.

5 tons of wheat in Japan, because producing one
computer requires 125 labor hours,
which instead could produce 5 tons of wheat.
 So, Japan has a comparative advantage in computers.
(Absolute advantage is not necessary for comparative
advantage!)
Comparative Advantage and Trade
 Differences in opportunity cost and comparative
advantage create the gains from trade.
 When each country specializes in the good(s)
in which it has a comparative advantage,
total production in all countries is higher,
the world’s “economic pie” is bigger,
and all countries can gain from trade.
 The same applies to individual producers
(like a farmer and a rancher) specializing
in different goods and trading with each other.
A C T I V E L E A R N I N G 7:
Absolute & comparative advantage
Argentina and Brazil each have 10,000 hours of labor
per month, and the following technologies:
Argentina
 producing one pound coffee requires 2 hours
 producing one bottle wine requires 4 hours
Brazil
 producing one pound coffee requires 1 hour
 producing one bottle wine requires 5 hours
Which country has an absolute advantage in the
production of coffee? Which country has a
comparative advantage in the production of wine?
A C T I V E L E A R N I N G 7:
Answers
Brazil has an absolute advantage in coffee:
 Producing a pound of coffee requires only one
labor-hour in Brazil, but two in Argentina.
Argentina has a comparative advantage in wine:
 Argentina’s opp. cost of wine is two pounds of coffee,
because the four labor-hours required to produce a bottle of
wine could instead produce two pounds of coffee.
 Brazil’s opp. cost of wine is five pounds of coffee.
Unanswered Questions….
 We made a lot of assumptions about the quantities of
each good that each country produces, trades, and
consumes, and the price at which the countries trade
wheat for computers.
 In the real world, these quantities and prices would be
determined by the preferences of consumers and the
technology and resources in both countries.
 We will begin to study this in Unit III.
 For now, though, our goal was only to see that trade,
indeed, can make everyone better off.