Steven Landsburg,

University of Rochester

Chapter 2 Prices, Costs, and the Gains from

Trade

Copyright ©2005 by Thomson South-Western, a part of the Thomson Corporation. All rights reserved.

Introduction

• Why do people trade?– Different Tastes– Different Abilities: Focus of Chapter

• Theory of Comparative Advantage

• First review concepts of prices and cost

Absolute versus Relative Prices

• No money in world, people still trade– Simply exchange goods

• Absolute prices– The number of dollars that can be exchanged

for a specified quantity of a given good

• Relative prices– The quantity of some other good that can be

exchanged for a specified quantity of a good

Focus of Microeconomics

• Study relative prices

• Absolute price change not same as a relative price change

• Relative price usually relative to some representative basket of goods or services

• Dollar refers to a basket of goods or services and not a piece of green paper

Relative Price Changes

• Inflation– An ongoing rise in the average level of

absolute prices– Price of one good risen relative to all other

goods

• Relative price changes do not cause absolute price changes

Quality of Oranges

• Relative price of oranges higher in New York than in Florida

• New Yorkers buy fewer oranges than they would at the Florida price

• Once decide to consume– New Yorker faces lower relative price than the

Floridian does for a choosing a good orange rather than a bad orange

Costs, Efficiency, and the Gains from Trade

Everyone can benefit

when activities are carried out at

the lowest possible cost

Costs and Efficiency

• Cost– Foregone opportunity– Term opportunity cost misleading– Totality of all opportunities that the activity

requires you forgo

• Ex. The electrician and the carpenter

EXHIBIT 2.2 The Electrician and the Carpenter

Comparative Advantage

• Ability to perform a given task at a lower cost• More efficient• Specialization and gains from trade

– Everyone in society made better off– People specialize in the area where most efficient– Trade for the goods want to have

• Ex. Small towns• Ex. No shoes, no shirts• Ex. The Middleman

Why People Trade

• Different tastes

• Different abilities

• Pays to be different– Any difference is an opportunity for mutual

gain– The more different you are, the more gains to

be had– International Trade: small countries gain the

most

Trade Without Differences

• David Ricardo– 19th century economist– First recognize importance of comparative advantage– Analyze consequences for mutually beneficial trade

• Adam Smith– 18th century economist– Described another way trade benefit all parties– Increased productivity through specialization

What’s Next

• Thorough study of tastes

• Incorporate tastes into study of market behavior