Economics 1B Lecture 2 S2011

Economics 1B Lecture 2 S2011 - 3/31/2011 Economics 1B...

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Unformatted text preview: 3/31/2011 Economics 1B Economics 1B UC Davis Professor Siegler Spring 2011 I. Absolute and Comparative Advantage Absolute advantage Absolute advantage A situation in which an individual, a firm, or a country is more efficient at producing a good or service in comparison to another individual, firm, or country. Comparative advantage The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost d d i t l t it t than its competitors. 2 1 3/31/2011 I. Absolute and Comparative Advantage The basis for specialization and exchange (trade) is f p g ( ) comparative advantage, not absolute advantage. Individuals, firms, and countries are better off if they specialize in producing goods and services for which they have a comparative advantage and obtain the other goods and services they need by trading. Even if a country is at an absolute disadvantage in the production of all goods and services, they can still benefit from specialization and exchange by producing goods and services for which they have a comparative advantage (for which they have lower opportunity costs). 3 II. Production Possibilities Curve A production possibilities curve (PPC) is a graph A production possibilities curve (PPC) is a graph that shows the combinations of two goods or services that an individual, firm, or economy can possibly produce given the available factors of production (resources) and the available production technology. 4 2 3/31/2011 II. Production Possibilities Curve Assumptions p Fixed Factors of Production (Resources) Natural Resources (N) surface and subsurface resources like land, oil, lakes, climate, and geography. Labor (L) the quantity of workers. Human capital (H) the knowledge and skills workers q g , g, p acquire through education, training, and experience. Physical Capital (K) the stock of equipment and structures that are used to produce other goods and services, examples include machines, buildings, equipment, roads, pencils, computers, and trucks. 5 II. Production Possibilities Curve Assumptions Fixed Technological Knowledge Society's understanding of the best ways to produce goods and services. The factors of production and technological knowledge are the exogenous variables, and the production possibilities of two goods and/or services are the possibilities of two goods and/or services are the endogenous variables. 6 3 3/31/2011 III. A Model of Specialization and Trade A Two Person, Two Good PPC Model A TwoPerson, TwoGood PPC Model We are starting with a twoperson, twogood, two market economy to illustrate the gains from specialization and trade. Although this is a very simple model, the benefits of specializing according to comparative advantage and exchange also hold for complex, modern economies. exchange also hold for complex modern economies 7 III. A Model of Specialization and Trade Assumptions Imagine a shipwreck in which there are only two survivors let's call them Kate and Hurley who wash up on opposite shores of a deserted island. Initially unaware of each other, each is forced to become completely selfsufficient, using the 12 hours of daylight to perform the two tasks necessary for of daylight to perform the two tasks necessary for survival: picking berries and catching fish. Assume that the production of berries and fish (the two goods) involves no specialization of resources implying that the PPC for each is a straight line. 8 4 3/31/2011 III. A Model of Specialization and Trade Assumptions Both Kate and Hurley are selfinterested and rational utility maximizers. Both Kate and Hurley derive utility or satisfaction from consuming goods, and more goods are preferred to fewer goods. 9 III. A Model of Specialization and Trade Time Requirements Picking a Quart of Berries Catching a Fish 1 hour 3 hours 3 hours Kate Hurley 1 hour 1.5 hours 1 5 hours 10 5 3/31/2011 III. A Model of Specialization and Trade Production and Consumption in Isolation (Autarky) p ( y) Kate: On one side of the island, Kate finds that it takes her 1 hour to pick 1 quart of berries or to catch 1 fish. Based on her tastes and preferences, Kate decides to spend 5 hours picking berries and 7 hours fishing, producing and consuming 5 quarts of berries and 7 fish. Hurley: One the other side of the island, Hurley, who is less adept at both tasks, requires 1.5 hours to pick a quart of l d b h k i 15h i k f berries and 3 hours to catch 1 fish. Hurley decides to spend 3 hours picking berries and 9 hours fishing, producing and consuming 2 quarts of berries and 3 fish. 11 Production and Consumption without Trade (Autarky) Kate s PPC Kate's PPC Fish 12 Kate's Production and Consumption Hurley's Production and Consumption Hurley s PPC Hurley's PPC Fish 7 4 3 5 12 Berries 2 8 Berries 12 6 3/31/2011 III. A Model of Specialization and Trade One day, Kate and Hurley find each other. The y, y question is how should they allocate production and consumption. Note that Kate has an absolute advantage in the production of both goods, since she can both pick a quart of berries and catch a fish in less time. However, if absolute advantage is the criterion for assigning work, then Kate should do both tasks. This, however, would leave Hurley doing nothing, which is certainly not in the pair's best interest. 13 III. A Model of Specialization and Trade Kate and Hurley, having read David Ricardo s (1817) Kate and Hurley, having read David Ricardo's (1817) book, On the Principles of Political Economy and Taxation, recognize the importance of comparative advantage. To determine who has comparative advantage in which good, they need to find out who has the lower opportunity cost of producing each good. t it t f d i h d 14 7 3/31/2011 III. A Model of Specialization and Trade For Kate, the opportunity cost of 1 fish is 1 quart of pp y q berries (1F = 1B). For Hurley, the opportunity cost of 1 b i (1F 1B) F H l h i f1 fish is 2 quarts of berries (1F = 2B). Therefore, Kate has a comparative advantage in fishing since she has a lower opportunity cost. For Hurley, the opportunity cost of 1 quart of berries is 0.5 fish (1B = 0.5F). For Kate, the opportunity cost of 1 quart of berries is 1 fish (1B = 1F). Therefore, Hurley has a comparative advantage in picking berries. a comparative advantage in picking berries Therefore, Kate should specialize in fishing, catching 12 fish, and Hurley should specialize in picking berries, picking 8 quarts of berries. 15 III. A Model of Specialization and Trade If Kate and Hurley specialize according to their If Kate and Hurley specialize according to their comparative advantages, Kate spends all of her time fishing and catches 12 fish, while Hurley spends all of his time picking berries and picks 8 quarts of berries. While total island production has increased due to specialization, trade allows each to be made better i li ti t d ll ht b d b tt off compared to the selfsufficient outcome. 16 8 3/31/2011 III. A Model of Specialization and Trade The Price of Trade (Terms of Trade) The Price of Trade (Terms of Trade) While the principle of comparative advantage establishes that there are gains from specialization and trade, it leaves open a couple of related questions: What determines the price at which trade takes place? How are the gains from trade shared between the trading pa e partners? For both parties to gain from trade, the price at which they trade must lie between the two opportunity costs. 17 III. A Model of Specialization and Trade The Price of Trade Let's look at the price of fish: For Kate, the producer, the opportunity cost of 1 fish is 1 quart of berries (1F=1B). For Hurley, the buyer of fish, the opportunity cost of 1 fish is 2 quarts of berries (1F=2B). Any price of a fish between 1 quart of berries and 2 quarts is berries is mutually beneficial. quarts is berries is mutually beneficial Suppose that they agree on a price of 1 fish equals 1.5 quarts of berries (1F=1.5B). Suppose that Kate sells 4 fish to Hurley, and receives 6 quarts of berries in exchange from Hurley. 18 9 3/31/2011 Production and Consumption with Specialization and Trade Kate s PPC Kate's PPC Fish 12 Kate's Production with Specialization Kate's Consumption with Specialization and Trade Hurley's Consumption with Specialization and Trade Hurley s PPC Hurley's PPC Fish 8 7 4 3 Hurley's Production with Specialization 5 6 12 Berries 2 8 Berries 19 A Summary of the Gains from Trade Kate Fish Production and Consumption without trade (autarky) Production with pe ia i a io specialization Consumption with trade Gains from trade (increased consumption) 7 Berries 5 3 Hurley y Fish Berries 2 12 8 1 0 6 1 0 4 1 8 2 0 20 10 3/31/2011 IV. The Pitfalls of the 50/50 Marriage Many "modern" couples believe that spouses should y p p share all tasks equally. Each should contribute toward half of the dishes, half of the laundry, half of the childcare, half of the income, etc. The 50/50 marriage ignores the importance of specialization based on comparative advantage. Couples can get more done in the same amount of time, or get the same amount done in less time, if they apply or get the same amount done in less time if they apply the theory of comparative advantage instead. See Spousonomics: Using Economics to Master Love, Marriage, and Dirty Dishes, by Paula Szuchman and Jenny Anderson, Random House, 2011. 21 Question 2.1 In Mexico, the opportunity cost of one bushel of bananas is: b h l fb A. bushel of oranges B. 1 bushel of oranges C. 2 bushels of oranges D. 5 bushels of oranges E. None of the above Correct answer: B 22 Bushels Per Acre Mexico Oranges 200 160 120 80 40 0 Bananas 0 40 80 120 160 200 Guatemala Oranges 50 40 30 20 10 0 Bananas 0 20 40 60 80 100 11 3/31/2011 Question 2.2 Guatemala has: A. a comparative advantage in orange production. B. an absolute advantage in orange production. C. an absolute advantage in banana production. D. a comparative advantage p g in banana production. Correct answer: D 23 Bushels Per Acre Mexico Oranges 200 160 120 80 40 0 Bananas 0 40 80 120 160 200 Guatemala Oranges 50 40 30 20 10 0 Bananas 0 20 40 60 80 100 Question 2.3 Guatemala should specialize in and export ________, and Mexico d should specialize in and export ________. A. oranges; oranges B. bananas; bananas C. bananas; oranges C b D. oranges; bananas Correct answer: C Bushels Per Acre Mexico Oranges 200 160 120 80 40 0 Bananas 0 40 80 120 160 200 Guatemala Oranges 50 40 30 20 10 0 Bananas 0 20 40 60 80 100 24 12 3/31/2011 Question 2.4 Before specialization, Mexico produces 160 bushels of oranges and 40 bushels of bananas, and Guatemala ba a a a d Guate ala produces 30 bushels of oranges and 40 bushels of bananas. After specialization, the total increase in banana production is: A. 10 bushels of bananas. B. 15 bushels of bananas. C. 20 bushels of bananas. b h l fb D. 40 bushels of bananas. Correct answer: C Bushels Per Acre Mexico Oranges O 200 160 120 80 40 0 Bananas 0 40 80 120 160 200 Guatemala Oranges O 50 40 30 20 10 0 Bananas 0 20 40 60 80 100 25 Question 2.5 For both countries to benefit from trade, the terms of trade must be terms of trade must be between ________ bushel(s) of oranges to bushel(s) of bananas. A. 1:0.5 and 1:4 B. 1:1.5 and 1:0.5 C. 1:1 and 1:0.5 D. 1:1 and 1:2 Correct answer: D Bushels Per Acre Mexico Oranges 200 160 120 80 40 0 Bananas 0 40 80 120 160 200 Guatemala Oranges 50 40 30 20 10 0 Bananas 0 20 40 60 80 100 26 13 3/31/2011 V. A PPC for an Entire Economy Unlike our simple example of two people and two goods, p p p p g , a PPC for an entire economy usually displays increasing marginal opportunity costs because the factors of production (resources) are specialized. For example, consider an economy producing two goods: pills and food with fixed factors of production and fixed technological knowledge. g g 27 V. A PPC for the Entire Economy Pills Point E is currently unattainable E A B D C But it could be in the future with more resources or technology The movement from A to B to C (and vice versa) represents increasing marginal opportunity costs. 400 350 300 200 Inefficient 0 250 350 450 500 Food 28 14 3/31/2011 VI. International Trade Compared to the nineteenth century, the volume of Compared to the nineteenth century, the volume of international trade relative to the size of the economy is much larger today. There are two primary reasons for the growth of international trade: (1) large reductions in transportation and communications costs, and (2) large reductions in trade barriers imposed by l d ti i t d b i i db governments. 29 World Exports as a Percent of GDP 30 15 3/31/2011 VI. International Trade Why has internal and external trade grown so y g rapidly? Reason 1: Costs of transportation and communication are dramatically lower. The cost of air travel fell from 87 cents per mile in 1930 to 9.5 cents per mile in 2000. The cost of a 3minute call from New York to London fell from $315 in 1930 to 24 cents in 2002 to virtually nothing today. E mail and the Internet have reduced communication costs even mail and the Internet have reduced communication costs even further. With lower transportation and communication costs, there are more opportunities for specialization and exchange. Adam Smith in The Wealth of Nations said that "the division of labor is limited by the extent of the market." 31 VI. International Trade Reason 2: Government restrictions on trade have Reason 2: Government restrictions on trade have fallen. Canada, Mexico, and the United States have agreed to integrate their economies into a free trade area (NAFTA). Formerly closed economies in Eastern Europe, Russia, and China have now joined the world trading system. The twenty seven sovereign member states of the European The twentyseven sovereign member states of the European Union have reduced internal and external trade barriers (tariffs, quotas, etc.). 32 16 3/31/2011 VII. Sources of Comparative Advantage HeckscherOhlin Trade Theory predicts that a country yp y will specialize in and export goods and services that use its relatively abundant factors of production intensively. The U.S. is relatively abundant in skilled labor, agricultural land, and capital, so it exports goods and services like: Pharmaceuticals and Chemicals Pharmaceuticals and Chemicals Information Technology and Computers Agricultural Products Specialized Machinery Financial and Insurance Services 33 17 ...
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This note was uploaded on 02/07/2012 for the course ECON 1b taught by Professor Sheffrin during the Spring '07 term at UC Davis.

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