Chapter 2

Comparative Advantage:

The Basis of Exchange

(Economic Models)

Economics: Redefined

Economics is the subject that studies how decision-making entities allocate and utilize the limited resources to produce goods and services that best satisfy the various, unlimited, competing human desires.

Economics: Macro vs. Micro

Macroeconomics: – How does the economic system work?– When and why economic system does not work?– When do people become counterproductive?– Why are there ups and downs in the economy?– Why is the long run mainly a story of ups?

=> National economy, GDP, inflation, unemployment, international trade, exchange rate, etc.

Economics: Macro vs. Micro

Microeconomics: – The housing market in Shanghai– The price of Honda Accord in Guangzhou– The production quantity of peaches in Nanhui– The number of people hired producing milk

powder at Mengniu– The number of T-shirts I buy at Hang-Ten=> Individual decisions and interactions, individual

consumer behaviors, individual producer decisions on production and input requirements, single product market, single market structure, etc.

Microeconomics

Individual decisions about what to do and what not to do.

Decisions about production and consumption made by individual firms and consumers (market economy)

How individuals’ pursuit of self interest can lead to good results as a whole (the invisible hand)

Also in Microeconomics

Society’s goal: efficiency and equity Market usually leads to efficiency, but

not necessarily equity. There are times for market failures. When market fails, it calls for

government interventions. Proper “incentives” offered by

government interventions may help reach society’s goals.

Economics: a way of thinking and an analysis tool

Economics is not the body of concrete truth, but an engine for the discovery of concrete truth.

Economic Analysis

Positive analysis : – objective descriptions about what

things are (facts) Normative analysis:

– value judgments on what thingsshould be (opinions)

Positive vs. Normative

Positive:

objective descriptions

what things are

facts Minimum wage:

Shanghai-960

Beijing-800

Shanghai higher

Normative: value judgments

what things should be

opinions

Minimum wage causes higher unemployment, therefore it should be eliminated

Equilibrium Analysis

Equilibrium：– a situation in which economic forces

are balanced and in the absence of external influences the values of economic variables will not change

Example:Market equilibrium

Market forces: demand and supply Economic Variables: market price and

quantity of product exchanged Market equilibrium: a market price is

established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. – This price is often called the

equilibrium price or market clearing price and will tend not to change unless demand or supply change.

Static vs. Dynamic Analysis

Static analysis:

under what conditions the economic variables will reach equilibrium (ignoring the time factor and the process of getting to equilibrium)

equilibrium

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Static vs. Dynamic Analysis

Comparative static analysis:

what happens to the equilibrium and the values of the economic variables if some of the conditions change

Equilibrium price under D1 vs. equilibrium price under D2

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Static vs. Dynamic Analysis

Dynamic analysis: – the process analysis; – the interactive process and relationships among all

economic variables

Equilibrium price P1 – US companies bankrupt US income lowers US

consumption of Chinese products lowers Chinese exports decreases Chinese income lowers Chinese comsumption decreases Chinese companies investments decrease Chinese domestic D lower equilibrium price lower

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Economic Models

A model is a simplified representation of a real situation that is used to

better understand real-life situations.

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Economic model

Using functions to describe the inter relationships among economic variables

Word description, mathematics, graphs

Abstract: skip some of the non-vital factors and variables (assumptions)

Focus on certain relationships only (hypothesis)

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A Model

Definitions of variablesAssumptionsHypothesisForecastTest True: theory

False: 1. adjust hypothesis >forecast test

2. Give up

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Model Example: PPC

The production possibility curve

the trade-offs facing an economy that produces only two goods.

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PPC

Issue to investigate: how many of each product a country can produce

Variables: Product A, Product B – Define:

• Qa: (F) the quantity of fish produced by the economy

• Qb: (C) the quantity of coconut produced by the economy

* Can also be butter vs. gun, bread vs. dresses, etc.

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PPC

Assumptions:– only two goods produced

– only two kinds of resources, each of limited amount

– resources are used up with efficiency

– there is increasing opportunity costs

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PPC

Hypothesis: producing more of A would require reduction in production of B (the only way to produce more of A is to produce less of B -- trade off)

Forecast: when more of A is produced, production of B decreases (reason: less resources available)

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PPC

Test: real dataConclusion:

true: accept, realistic and helpful theory

(if not: why? Assumptions? Data? Methods? Retest?...)

The PPC

Increasing Opportunity Cost

Shift of the PPF: Economic Growth Economic growth results in an outward shift of the PPF because production possibilities are expanded.

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PPC: Key Points

Intersections with X-axis and Y-axis

Points inside, on, outside the curve

The bowed-out shapeShift of the curve

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Marginal Analysis

Trade off situations:

How much decisions (as vs. either-or) marginal analysis: comparing marginal

benefit to marginal cost Marginal Benefit: additional benefit related to

one more unit change

Marginal Cost: additional cost related to the same one more unit change

Example: Marginal Cost

Marginal Benefit

Net Gain

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Decision rule

if MB >= MC, DO IT!if MB < MC, FORGET IT!

Total net gain is maximized when marginal net gain = 0

or when MB=MC

The Goal:Maximization of Total Net Gain

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Math and Graph

Variables: Total Net Gain (G)Hours of mowing (H)

Assumptions: Hypothesis: G = f (H) (more hours, more

gain) Forecast:

1. gain from 4 hours is more than gain from 3 hours2. gain from 10 hours is more than gain from 9 hours

Test: 1. True; 2. False (correct hypothesis then forast and test again)

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Graph

Plotting: origin, X-axis, Y-axis, Variables: independent, dependent Relationships:

positive, negative;

linear, nonlinear;

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Slopes: Calculation

Linear: Change in Y / Change in X = Y / X △ △

Non-linear:– Arc method: connect to points on the

arc with a straight line, then calculate the slope of the straight line

– Point method:draw a tangent line at a point and calculate the slope of the tangent line

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Slopes: Meaning

slope > 0, positive relationship (upward sloping)

slope = 0, horizontal line

slope < 0, negative relationship (downward sloping)

slope = infinite, vertical line

constant slope: straight line

variable slope: curve

Maximum and Minimum of a curve: when point slope = 0