Economics 1 Principles of Economics

Economics 1Principles of EconomicsThinking Like an Economist(Chapter 2)

Dr. Patrick D. Convery1Look for the Answers to These Questions:What are economists two roles? How do they differ? What are models? How do economists use them?What are the elements of the Circular-Flow Diagram? What concepts does the diagram illustrate? How is the Production Possibilities Frontier related to opportunity cost? What other concepts does it illustrate?What is the difference between microeconomics and macroeconomics? Between positive and normative.2I. The Economist as a ScientistEconomists play two roles:1. Scientists: try to explain the world2. Policy advisors: try to improve itIn the first, economists employ the scientific method, the dispassionate development and testing of theories about how the world works. 3II. Assumptions & ModelsAssumptions simplify the complex world, make it easier to understand. Example: To study international trade, assume two countries and two goods. Unrealistic, but simple to learn and gives useful insights about the real world.Def: Model = a highly simplified representation of a more complicated reality. Economists use models to study economic issues. 4III. The Circular-Flow Diagram 1 of 4Def: The Circular-Flow Diagram = a visual model of the economy, shows how dollars flow through markets among households and firms.

Two types of actors: householdsfirms

Two markets:the market for goods and services the market for factors of production 5Money going in one direction and goods going in the other direction III. The Circular-Flow Diagram 2 of 4Def: Factors of production = the resources the economy uses to produce goods & services, includinglabor land capital (buildings and machines used in production)6III. The Circular-Flow Diagram 3 of 47Households:Own the factors of production, sell/rent them to firms for incomeBuy and consume goods & servicesHouseholdsFirms:Buy/hire factors of production, use them to produce goods and servicesSell goods & servicesFirmsIII. The Circular-Flow Diagram 4 of 4Markets for Factors of ProductionHouseholdsFirms IncomeWages, rent, profitFactors of productionLabor, land, capital Spendingbuy G & Ssell G & SRevenueMarkets for Goods & Services8IV. The Production Possibilities Frontier 1 of 13Def: 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 wheatOne resource: labor (measured in hours)Economy has 50,000 labor hours per month available for production.9International trade

Us and china Are pushing the fronteir out The pie is getting bigger so both sides benefit IV. The Production Possibilities Frontier 2 of 13Example: U.S. and JapanTwo 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 consumesif the country chooses to be self-sufficient.if it trades with the other country.10IV. The Production Possibilities Frontier3 of 13Example: 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. 11IV. The Production Possibilities FrontierProducing one computer requires 100 hours labor.Producing one ton of wheat requires 10 hours labor.5,00004,0001002,5002501,00040050,000040,00010,00025,00025,00010,00040,0000500050,000EDCBAWheatComputersWheatComputersProductionEmployment of labor hours12IV. The Production Possibilities Frontier 5 of 13Example: The U.S. PPF134,0001005,0002,0001,0003,0005002003004000ComputersWheat (tons)The U.S. has enough labor to produce 500 computers,or 5000 tons of wheat,or any combination along the PPF.Parameters such as gross domestic product

International trade between china and japanTrade doesnt need to be better forone side There doesnt need to be a winner or loser.

Japan had a compartive advantage in making computers.

IV. The Production Possibilities Frontier 6 of 13Example: The U.S. Without Trade144,0001005,0002,0001,0003,0005002003004000ComputersWheat (tons)Suppose the U.S. uses half its labor to produce each of the two goods. Then it will produce and consume250 computers and2500 tons of wheat.Note: Without trade, a country consumes what it produces. IV. The Production Possibilities Frontier 7 of 13Example: JapanJapan 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.15IV. The Production Possibilities Frontier 8 of 13Example: Japans PPF16ComputersWheat (tons)2,0001,0002000100300Japan has enough labor to produce 240 computers,or 1200 tons of wheat,or any combination along the PPF.IV. The Production Possibilities Frontier 9 of 13 Example: Japan Without Trade17ComputersWheat (tons) 2,0001,0002000100300Suppose Japan uses half its labor to produce each good. Then it will produce and consume120 computers and 600 tons of wheat.IV. The Production Possibilities Frontier 10 of 13Example: Consumption With and Without TradeWithout trade, U.S. consumers get 250 computers and 2500 tons wheat.Japanese consumers get 120 computersand 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. 18IV. The Production Possibilities Frontier 11 of 13Example: Consumption Under TradeSuppose 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 Japans PPF.194,0001005,0002,0001,0003,0005002003004000ComputersWheat (tons)2700270= amount consumed0110+ imported7000 exported3400160producedwheatcomputersIV. The Production Possibilities Frontier 12 of 13 U.S. Consumption With Trade20The red point again represents production.

Trade un-tethers consumption from production. The light blue point represents consumption. Notice that the consumption point is above the PPF. Without trade, it would not be possible to consume this combination of the two goods!

In a sense, international trade is like technological progress: it allows society to produce quantities of goods that would otherwise not be possible. ComputersWheat (tons)2,0001,0002000100300700130= amount consumed7000+ imported0110 exported0240producedwheatcomputers21IV. The Production Possibilities Frontier 13 of 13Japans Consumption With TradeAgain, the light blue point representing consumption is above the PPF. Without trade, it would not be possible to consume this combination of the goods. Trade Makes Both Countries Better Off20027002500Wheat20270250ComputersGains from tradeConsumption with tradeConsumption without tradeU.S.100700600Wheat10130120ComputersGains from tradeConsumption with tradeConsumption without tradeJapan22These tables summarize the gains from trade for both countries. V. Where Do These Gains Come From?1 of 2Def: Absolute Advantage = The ability to produce a good using fewer inputs than another producer. The U.S. has an absolute advantage in 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. 23V. Where Do These Gains Come From? 2 of 2Which 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!24So why does Japan specialize in computers? Why do both countries gain from trade?VI. Two Measures of the Cost of a GoodTwo 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. 25VII. Opportunity Cost and Comparative Advantage 1 of 2Def: 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 opportunity cost of a computer in each country. 26VII. Opportunity Cost and Comparative Advantage 2 of 2The opportunity cost of a computer is10 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. Lesson: Absolute advantage is not necessary for comparative advantage!27VIII. Comparative Advantage and TradeGains from trade arise from comparative advantage (differences in opportunity costs).

When each country specializes in the good(s) in which it has a comparative advantage, total production in all countries is higher, the worlds economic pie is bigger, and all countries can gain from trade. 28IX. The PPF and Opportunity CostThe slope of a line equals the rise over the run, the amount the line rises when you move to the right by one unit.1000100slope == 10Here, the opportunity cost of a computer is 10 tons of wheat.29Here, the rise is a negative number, because as you move to the right, the line falls (meaning wheat output is reduced).

Moving to the right involves shifting resources from the production of wheat (which causes wheat output to fall) to the production of computers (which causes computer production to rise). Producing an additional computer requires the resources that would otherwise produce 10 tons of wheat. Q: In which country is the opportunity cost of cloth lower?FRANCEENGLANDExample30A: England, because its PPF is not as steep as Frances.FRANCEENGLANDExample31There are two ways to get the answer. The hard way is to compute the slope of both PPFs. The slope of Frances PPF equals -600/300 = -2, meaning that France must give up two units of wine to get an additional unit of cloth. The slope of Englands PPF = -200/300 = -2/3, meaning that England only must sacrifice 2/3 of a unit of wine to get an additional unit of cloth. Thus, the opportunity cost of cloth is lower in England than France.

The question, however, does not ask for the numerical values of the opportunity cost of cloth in the two countries. It only asks which country has a lower opportunity cost of cloth.

There is an easy way to determine the answer. Remember that the slope of the PPF equals the opportunity cost of the good measured on the horizontal axis. Therefore, you can simply eyeball the two PPFs to determine which is steepest. From what the graphs show, its pretty easy to see that Englands PPF isnt as steep, and therefore the opportunity cost of cloth is lower in England than in Frane.X. Economic Growth and the PPFWith additional resources or an improvement in technology, the economy can produce more computers,more wheat, or any combination in between. Economic growth shifts the PPF outward.32The PPF shows the tradeoff between the outputs of different goods at a given time, but the tradeoff can change over time.

For example, over time, the economy might get more workers (or more factories or more land). Or, a more efficient technology might be invented. Both eventsan increase in the economys resources or an improvement in technologycause an expansion in the set of opportunities. That is, both allow the economy to produce more of one or both goods. XI. The Shape of the PPFThe PPF could be a straight line or bow-shaped.It depends on what happens to the opportunity cost as the economy shifts resources from one industry to the other.If the opportunity cost remains constant, the PPF is a straight line. (In the previous example, the opp. cost of a computer was always 10 tons of wheat.)If the opportunity cost of a good rises as more of the good is produced, PPF is bow-shaped. 33XII. Why the PPF Might Be Bow-ShapedMountain BikesBeerAs the economy shifts resources from beer to mountain bikes:PPF becomes steeper.opp. cost of mountain bikes increases. 34XII. Why the PPF Might Be Bow-ShapedAt point A, most workers are producing beer, even those who are better suited to building bikes.So, we do not have to give up much beer to get more bikes.AMountain BikesBeerAt A, opp. cost of mtn bikes is low.35Here, we are using workers for the more general resources, to keep things simple and consistent with the previous examples. XII. Why the PPF Might Be Bow-ShapedAt B, most workers are producing bikes. The few left in beer are the best brewers.Producing more bikes would require shifting some of the best brewers away from beer production, causing a big drop in beer output. BMountain BikesBeerAt B, opp. cost of mtn bikes is high.36XII. Why the PPF Might Be Bow-ShapedIn short, 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).37The bow-shaped PPF is more realistic. However, the linear PPF is simpler to work with, and we can learn a lot about how the economy works using the linear PPF. In Chapter 3, we will use a linear PPF to show how trade can make two countries (or two individuals) better off. PPF SummaryThe PPF shows all combinations of two goods that an economy can possibly produce, given its resources and technology. The PPF illustrates the concepts of tradeoff and opportunity cost, efficiency and inefficiency, unemployment, and economic growth.A bow-shaped PPF illustrates the concept of increasing opportunity cost.38XIII. The Economist as Policy AdvisorAs scientists, economists make positive statements, which attempt to describe the world as it is. As policy advisors, economists make normative statements, which attempt to prescribe how the world should be. Positive statements can be confirmed or refuted, normative statements cannot. The Government employs many economists for policy advice. E.g., the U.S. President has a Council of Economic Advisors, which the author of this textbook chaired from 2003 to 2005. 39Positive statement you can verifyIt has thats true or not true

Normative Personal opinion Cant prove or disapprove

ExampleWhich of these statements are positive and which are normative? How can you tell the difference?a. Prices rise when the government increases the quantity of money. b. The government should print less money. c. A tax cut is needed to stimulate the economy. d. An increase in the price of burritos will cause an increase in consumer demand for music downloads.40Examplea.Prices rise when the government increases the quantity of money. Positive describes a relationship, could use data to confirm or refute.b.The government should print less money. Normative this is a value judgment, cannot be confirmed or refuted.41Examplec.A tax cut is needed to stimulate the economy. Normative another value judgment.d.An increase in the price of burritos will cause an increase in consumer demand for music downloads.Positive describes a relationship. Note that a statement need not be true to be positive.42XIV. Why Economists DisagreeEconomists often give conflicting policy advice. They sometimes disagree about the validity of alternative positive theories about the world. They may have different values and, therefore, different normative views about what policy should try to accomplish. Yet, there are many propositions about which most economists agree. 43XV. Propositions about Which Most Economists Agree (and % who agree) 1 of 2A ceiling on rents reduces the quantity and quality of housing available. (93%)Tariffs and import quotas usually reduce general economic welfare. (93%)The United States should not restrict employers from outsourcing work to foreign countries. (90%)The United States should eliminate agriculture subsidies. (85%)continued44XV. Propositions about Which Most Economists Agree (and % agreeing) 2 of 2The gap between Social Security funds and expenditures will become unsustainably large within the next fifty years if current policies remain unchanged. (85%)A large federal budget deficit has an adverse effect on the economy. (83%)A minimum wage increases unemployment among young and unskilled workers. (79%)Effluent taxes and marketable pollution permits represent a better approach to pollution control than imposition of pollution ceilings. (78%)45SummaryAs scientists, economists try to explain the world using models with appropriate assumptions. Two simple models are the Circular-Flow Diagram and the Production Possibilities Frontier. Microeconomics studies the behavior of consumers and firms, and their interactions in markets. Macroeconomics studies the economy as a whole. As policy advisers, economists offer advice on how to improve the world. 46