CH 1: Economics and

Economic Reasoning

What is Economics?

• Economics is the study of how human beings coordinate their wants and desires, given the decision-making mechanism, social customs, and political realities of the society

Microeconomics and Macroeconomics

• Economic theory is divided into two parts:

• Microeconomics is the study of individual choice, and how that choice is influenced by economic forces

• To use an analogy, we are looking at the individualtrees in the forest

Microeconomics

• Microeconomics studies such things as:

• The pricing policy of firms

• Household’s decisions on what to buy

• How markets allocate resources among alternative ends

Macroeconomics

• Macroeconomics is the study of the economy as a whole

• To use an analogy, we are looking at the forest as a whole

Macroeconomics

• Macroeconomics studies such things as:

• Inflation

• Unemployment

• Economic growth

The Factors of Production

• Economists classify resources into 4 categories:

• Land

• Natural resources

• The payment for land is rent

• Labor

• Human resources

• The payment for labor is wages

The Factors of Production

• Capital

• Tools, machines, & factories

• The payment for capital is interest

• Entrepreneurship

• Combines land, labor and capital in new ways in order to make profit

• The payment for entrepreneurship is profit

Scarcity

• Economics, simply put, is the study of scarcity

• Scarcity exists because individuals want more than can be produced

Needs vs. Wants

• Needs: necessities for survival

• Wants: goods and services consumed beyond what is necessary for survival

Deduction

• Deduction: a method of reasoning in which one deduces a theory based on a set of almost self-evident principles

• Starts with a general principle then becomes more specific to reach a conclusion

• Example: The price of a student ticket to the football game is $6. I am a student. I will pay $6 to go to the game.

Induction

• Induction: a method of reasoning in which one develops general principles by looking for patterns in the data

• Conclusion is based on specific examples

• Example: People with brown hair have high GPAs. John has brown hair. Therefore, John has a high GPA (this statement may or may not be true).

Marginal Cost and Marginal Benefit

• Marginal cost: the additional cost (above incurred costs)

• Marginal benefit: the additional benefit (above the current benefit)

Applying MC and MB

• Making a good economic decision involves following this rule:

• If the marginal benefit of doing something exceeds the marginal cost DO IT

• MB > MC Do it!

MC and MB

• If the marginal cost of doing something exceeds the marginal benefit DON’T DO IT

• MC > MB Don’t do it!

MC and MB Example

• The marginal cost of going on a date is $30 while the marginal benefit is $40. What should you do?

• Go on the date: MB ($40) exceeds MC ($30)

Opportunity Cost

• Opportunity cost: is the benefit forgone of the next-best alternative to the activity you have chosen

• Opportunity cost should always be less than the benefit of what you have chosen

• Opportunity cost is the basis of cost/benefit economic reasoning

Opportunity Cost

• What are some opportunity costs of college?

• Loss of income from working full time

• Items that could have been purchased with the money spent for tuition and books

Opportunity Cost Example

Study for Micro(In hours)

Final Exam Score (out of 100)

3 100

2 80

1 60

0 0

Study for Math(In hours)

Final Exam Score(out of 100)

0 0

1 50

2 65

3 80

Robert has three hours to study for two final exams. The tables indicate the anticipated scores based on the time studied for each exam.

Opportunity Cost Example

Study for Micro(In hours)

Final Exam Score (out of 100)

3 100

2 80

1 60

0 0

Study for Math(In hours)

Final Exam Score(out of 100)

0 0

1 50

2 65

3 90

a. Calculate the marginal benefit from studying a second hour of micro.20 percent (difference between one hour and two hours)

Opportunity Cost Example

Study for Micro(In hours)

Final Exam Score (out of 100)

3 100

2 80

1 60

0 0

Study for Math(In hours)

Final Exam Score(out of 100)

0 0

1 50

2 65

3 90

b. Robert studies one hour of Micro and two hours of Math. Calculate his gain from studying a second hour of math. 15 percent (Difference between one and two hours of studying math)

Opportunity Cost Example

Study for Micro(In hours)

Final Exam Score (out of 100)

3 100

2 80

1 60

0 0

Study for Math(In hours)

Final Exam Score(out of 100)

0 0

1 50

2 65

3 90

c. Calculate Robert’s opportunity cost of studying a second hour of math. 20 percent (can only study one hour for Micro; 80-60)

Opportunity Cost Example

Study for Micro(In hours)

Final Exam Score (out of 100)

3 100

2 80

1 60

0 0

Study for Math(In hours)

Final Exam Score(out of 100)

0 0

1 50

2 65

3 90

d. Robert wants to maximize the sum of his final exam scores for Micro and math. How many hours should he study for each exam? Two hours for Micro and one hour for math (sum of scores is 130; highest of all combinations)

CH 2: The PPC and

Trade

The Production Possibilities Model

• A production possibility table shows the opportunity cost of each choice by summarizing what alternative outputs you can achieve with your inputs

• An output is a result of an activity

• An input is what you put into the production process to achieve an output

Guns Butter

0 10

1 15

2 0

The Production Possibilities Model

• A production possibility curve (PPC) is a curve measuring the maximum combination of outputs that can be obtained from a given number of inputs

• It is a graphical representation of the opportunity cost concept that uses two goods

Production Possibilities Curve

• The PPC is based on these assumptions:

• Resources are fixed

• All resources are fully employed (used)

• Only two things can be produced

• Technology is fixed

Graphing the PPC

• PPC runs between extremes of producing only one item or the other

• Data is plotted on a graph; the lines connected between the points is the PPC

• Shows maximum number of one item relative to other item

• PPC shows the opportunity cost of each choice

• More of one product means less of the other: tradeoff

Graphing the PPC

• Commonly, a PPC is depicted with two goods: guns and butter

• Guns represents military goods

• Butter represents consumer goods

PPC: Efficient and Inefficient Points

• An efficient point is any point along the curve

• Productive efficiency is achieving as much output as possible from a given amount of inputs or resources

PPC: Efficient and Inefficient Points

• An inefficient point any point inside the curve

• This means resources are being underutilized or not being used efficiently

• An unattainable point is one beyond the curve

• It cannot currently be achieved unless there is an increase in technology or additional resources become available

Draw the Graph: PPC Showing Efficient and Inefficient Points

• A: Point of efficiency (anywhere on the curve)

• B: Point of inefficiency (underproducing or underutilization of resources

• C: Unattainable (beyond the curve)

Butter

Guns

•

• B

• C

A

Why is the PPC a Curve?

• Law of increasing opportunity costs

• As production switches from one product to another, more resources are needed to increase production of second product

• Reasons for increasing cost of making more of one product

• Need new resources, machines, or factories

• Must retrain workers

Why can the PPC also be a straight line?

The PPC can be a straight line to represent a constant opportunity cost

Butter

Guns

A

B

Opportunity Cost and Tradeoff

• What is the difference between opportunity cost and tradeoff?

• Tradeoff: to produce more guns, you have to produce less butter

• Opportunity cost: the specific number of butter you give up to produce more guns

Butter

Guns

•

• B

A

Shifting the PPC

An increase in technology or an increase in resources

Technological increase for one good

Guns

ButterMore guns and butter can be produced

Guns

ButterMore guns can be produced based on better technology

Comparative Advantage• We cannot produce everything efficiently

• A resource has comparative advantage if it has the ability to be better suited to the production of one good than another; it can be produced at the lowest opportunity cost

• Countries should specialize in the good that is “cheaper” for them to produce (lower opportunity cost) and trade for goods that they have a higher opportunity cost to produce

Comparative Advantage

• According to Adam Smith, the market guides us like an invisible hand to produce goods in which we have a comparative advantage

The Benefits from Trade

Chocolate (tons)

Textiles (yds)

Without trade, each country can only consume those

combinations of goods along their PPCs

• When people freely enter into trade, both parties can be expected to benefit from trade

5,000

4,000

3,000

2,000

1,000

2 3 4 51

Belgium

Pakistan

The Benefits from Trade

Chocolate (tons)

Textiles (yds) If each country specializes according to comparative advantage and trades,

they can consume beyond their PPCs5,000

4,000

3,000

2,000

1,000

2 3 4 51

Belgium

Pakistan

Absolute and Comparative Advantage

• Absolute Advantage: the producer that can produce the most output

• Comparative Advantage: the producer with the lowest opportunity cost

Determining Comparative Advantage: The Output Method

Output Questions:

• OOO=Output: Other goes Over

Determining Comparative Advantage The Output Method

• Mexico can produce 60 avocados if it uses its entire labor force. Or, Mexico can produce 15 soybeans if it uses its entire labor force.

• The U.S. can produce 90 avocados if it uses its entire labor force. Or, the U.S. can produce 30 soybeans if it uses its entire labor force.

• Let’s write this in a chart format

Determining Comparative Advantage The Output Method

1. Which country has an absolute advantage in producing avocados? Explain.

• U.S.: it produces more avocados than Mexico (90 vs. 60)

Avocados Soybeans

Mexico 60 15

U.S. 90 30

Determining Comparative Advantage The Output Method

2. Which country has an absolute advantage in producing soybeans? Explain.

• U.S.: it produces more soybeans than Mexico (30 vs. 15)

Avocados Soybeans

Mexico 60 15

U.S. 90 30

Determining Comparative Advantage The Output Method

3. Which country has a comparative advantage in producing avocados? Explain.

• Mexico; it can produce them at a lower opportunity cost, 1/4 soybean for Mexico vs. 1/3 soybean for the U.S.

Avocados Soybeans

Mexico 60 1A=1/4S 15 1S=4A

U.S. 90 1A=1/3S 30 1S=3A

Determining Comparative Advantage The Output Method

4. Which country has a comparative advantage in producing soybeans? Explain.

• The U.S.; it can produce them at a lower opportunity cost; 3 avocados for the U.S. vs. 4 for Mexico.

Avocados Soybeans

Mexico 60 1A=1/4S 15 1S=4A

U.S. 90 1A=1/3S 30 1S=3A

Terms of Trade

Terms of trade refers to trade that is mutually beneficially to both countries.

• The U.S. has a comparative advantage in soybeans. It would specialize in soybeans if it could get more than 3 avocados through trade.

• Mexico has a comparative advantage in avocados. It would specialize in avocados if it could get one soybean for less than 4 avocados through trade.

Avocados Soybeans

Mexico 60 1A=1/4S 15 1S=4A

U.S. 90 1A=1/3S 30 1S=3A

Terms of Trade

What would be an acceptable term of trade for soybeans?• Anywhere between 3 and 4 avocados

• 1 soybean for 3.5 avocados: this would allow the U.S. to get 3.5 avocados from Mexico by sending 1 soybean to Mexico.

• This would allow Mexico to obtain 1 ton of soybeans for 3.5 avocados, a lower opportunity cost (on their own they would have to give up 4 avocados to produce 1 soybean).

Avocados Soybeans

Mexico 60 1A=1/4S 15 1S=4A

U.S. 90 1A=1/3S 30 1S=3A

Determining Comparative Advantage: The Input Method

Input Questions

• IOU= Input: Other goes Under

• Usually the amount of hours (or labor) to produce something

Determining Comparative Advantage: The Input Method

1. Which country has an absolute advantage in producing cars? Explain.

• Mexico; it can produce 4 cars while the U.S. can produce 2

Car (in hours) Machines (in hours)

Mexico 4 2

U.S. 2 6

Determining Comparative Advantage: The Input Method

2. Which country has an absolute advantage in producing machines?

• The U.S.; it can produce 6 machines while Mexico can produce 2

Car (in hours) Machines (in hours)

Mexico 4 2

U.S. 2 6

Determining Comparative Advantage: The Input Method

3. Which country has a comparative advantage in producing cars? Explain.

• The U.S. has a comparative advantage in cars because it can produce them with a lower opportunity cost (1/3 machine for the U.S. vs. 2 machines for Mexico).

Car (in hours) Machines (in hours)

Mexico 4 1C=2M 2 1M=1/2C

U.S. 2 1C=1/3M 6 1M=3C

Determining Comparative Advantage: The Input Method

4. Which country has a comparative advantage in producing machines?

• Mexico has a comparative advantage in machines because it can produce them with a lower opportunity cost (1/2 car for Mexico vs. 3 cars for the U.S.).

Car (in hours) Machines (in hours)

Mexico 4 1C=2M 2 1M=1/2C

U.S. 2 1C=1/3M 6 1M=3C

Terms of Trade

5. What would be terms of trade for machines?

• Anywhere between ½ car and 3 cars.

• Mexico has the comparative advantage in machines. It would specialize in machines if it could get more than ½ car through trade.

• The U.S. has the comparative advantage in cars. It would specialize in cars if it could get one machine for less than 3 cars through trade.

Car (in hours) Machines (in hours)

Mexico 4 1C=2M 2 1M=1/2C

U.S. 2 1C=1/3M 6 1M=3C

Outsourcing and Comparative Advantage

• Outsourcing: relocating production once done in the U.S. to foreign countries

• Why do countries do this?

• Due to comparative advantage; producing the good in another country may make it less expensive for a company to produce that good

Chapter Summary

• The production possibility curve embodies the opportunity cost concept

• Increasing marginal opportunity cost exists

• Trade allows people to use their comparative advantage and shifts out society’s combined production possibility curve

• Efficient, inefficient and unattainable points on the PPC

• Through specialization and trade, countries can increase consumption

Chapter Summary • The typical outward bow of the PPC is the result of

comparative advantage and trade

• Because many goods are cheaper to produce in foreign countries, production of goods formerly in the U.S. is being outsourced