intro to econ part.2

Chapter 2Efficiency,

Exchange, and Comparative Advantage

Outline

• Goods and Bads• The Myth of Material Wealth• Trade Creates Wealth• Is It Worth It? Efficiency and Values• Recognizing Trade-Offs: Comparing

Opportunity Costs of Production• The Gains from Specialization and Exchange

Outline - continued

• Why Specialize?• From Individual Trade to International

Trade, and Back Again• Transactions Costs• Incentives to Reduce Transactions

Costs: Middlemen• Markets as Discovery Processes• The Big Picture: First Thoughts on

Economic Growth

Introduction

• This chapter explores these questions:– Who profits from trading?– Is trade productive?– What are production possibilities?– What is wealth?– What is economic growth?

Good and Bads

• A commodity is a good if more of it is preferred to less

• A commodity is a bad if less of it is preferred to more

• A free good can be acquired without sacrifice

• A scarce good requires sacrifice

The Myth of Material Wealth

• Of what does wealth consist?

– wealth, in the economic way of thinking, is whatever people value

– value is in the eye of the chooser

Trade Creates Wealth

• The myth of material wealth: economic growth consists not in increasing output of things, but increasing the generation of wealth

• “wealth equals material things” is not a valid claim, as it omits key aspects of economic life like “specialization” and “exchange” in Adam Smith’s commercial society

• Questions:– What do we gain from trading?– Is it accurate to say that the two goods

traded have equal value?– Does trade add value, wealth?– Is trading efficient?

TradeInvolves exchange to gain more of what people value

Voluntary exchange

Involves exchangeof unequally valued goods

example:does

exchange of a ball for a

glove, between two

people, affect wealth?

• With trade each party trades a less valued good for a more valued good

every choice entails a trade-off

• The cost of obtaining a good is the value placed on whatever is sacrificed to buy it

referred to as the opportunity cost

Is It Worth It? Efficiency and Values

• Efficiency changes with valuations– efficiency compares the ratio of the value

of the output to the value of the input• Increased efficiency

leads to lower production costs

Is It Worth It? Efficiency and Values

Efficiency =value of output

value of input

The efficiency of any processcan change with changes

in valuation

Recognizing Trade-Offs: Comparing Opportunity Costs of Production

A Production Possibilities Frontier illustrates maximum combinations of products that can beproduced using a given set of resources and talent

Jones:5 S = 10 L therefore1 S = cost 2 L and 1 L = ½ S

Brown:4 S = 3 L therefore1 S = cost ¾ L and 1 L = 4/3 S

Production possibilities before specialization and tradeProduction possibilities before specialization and trade

• Who produces lager at a relatively lower cost?

– if Jones produces only lager he can make 10 gallons but sacrifices the opportunity to make 5 gallons of stout … if he makes only stout he sacrifices the opportunity to make 10 gallons of lager

– if Brown produces only stout she can make 4 gallons but gives up the opportunity to make 3 gallons of lager … for every gallon of stout she sacrifices ¾ gallons of lager

• Note that Jones can produce more of both stout (S) and lager(L)

Table 2–1

Recognizing tradeoffs: comparing opportunity costs of production

The tables show that Jones has a lower relative costproducing lager, he only sacrifices ½ S for each gallon of L, while Brown must forego 4/3 S for eachgallon of L.

Jones:5 S= 10 L therefore1 S = cost 2 L and 1 L = ½ S

Brown:4 S= 3 L therefore1 S = cost ¾ L and 1 L = 4/3 S

• Who produces lager at a relatively lower cost?– The least cost producer of a product has a

comparative advantage over other producers, due to lower opportunity cost

– The tables show that Jones has a comparative advantage in L, while Brown has a comparative advantage in S

The Gains from Specialization and Exchange

If Brown and Jonesagree to trade one for one

in the product of theircomparative advantage:

Jones can enjoy 7 lager and 3

stout …Brown can enjoy

3 lager and 1 stout

The Gains from Specialization and Trade

• At full production: Jones produces 10 Lager and Brown produces 4 Stout

• They trade 1 for 1: 3 Lagers for 3 Stouts • Jones now has 7L & 3S Brown has 1S & 3L

Both have more from specializing and trading

The Gains from Specialization and Exchange

Both can now consumemore than they could

individually produce

Wealth has been increasedfor both through

specializationand trade

Gains from specialization and exchangeProduction possibilities after specialization and tradeProduction possibilities after specialization and trade

Figure 2–1 Simple production possibilities frontiers

Why Specialize?

• Specialization is a synonym for “following one’s comparative advantage”– Producers specialize so that they can expand

their possibilities (wealth) by trading for something that is more costly to produce on their own

– This is referred to as the “Law of Comparative Advantage”

From Individual to International Trade, and Back Again

• Specialization and exchange occur between cities, regions and across political borders

• Each group pay for its imports with their exports

• The same idea applies at an individual level

Transaction Costs

• Transaction costs are costs of arranging contracts and agreements – trades in general among interested parties

Incentives to Reduce Transaction Costs: Middlemen

• Middlemen help interested parties find one another

e.g., stockbrokers, wholesalers, job placement agencies, realtors

• Middlemen’s comparative advantage is to generate quality information at a low cost

• They lower the hurdles that can impede exchange

Markets as Discovery Processes

• To enhance wealth, people pursue their comparative advantage

• Comparative advantage is discovered through market exchanges of property rights

• In doing so, people continuously coordinate the processes of cooperative interaction that comprise the economy

Explaining Economic Growth

• Adam Smith determined that wealth came from huge increases in production which resulted in the division of labor

• Economic growth is a consequence of the evolution of commercial society– Everyone specializes – Everyone exchanges

Encouraging Specialization and Exchange

• Market specialization / Division of labor– creates the conditions for economic

growth• Rule of law / Private property rights

– allows freedom of exchange– provides incentives to specialize in

activities of comparative advantage

Once Over Lightly

• exchange of property rights• a good – more preferred to less• free goods versus scarce goods• opportunity cost• wealth = whatever people value• comparative advantage

Once Over Lightly

• Middlemen• comparative advantage• market specialization• division of labor• trade between nations

intro to econ part.2

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