Economic Thinking

• Economics as a social Science• The scientific method

– Observation, Theory, and Testing– Assumptions and ceteris paribus– Avoiding flaws in logical thinking

• Ergo hoc post proper hoc• Fallacy of Composition/Division

• Microeconomics vs. Macroeconomics

Economics Models

• The art of making: simple and effective

• Example: circular flow– overall economy, role of economic agents,

output and income, product and factor markets

• Example: production possibilities frontier (PPF) -efficiency, tradeoffs, opportunity costs,

economic growth, law of increasing costs

Economics and Economists

• Positive versus normative

• Avoiding unintended consequences

• Scientist, advisor and citizen

• Scientific judgment, values, perception versus reality

The Power of Trade

• Voluntary versus involuntary exchange

• An intuitive approach to gains in trade

• Using an economic model to demonstrate the gains from trade

Voluntary Exchange

• All parties to a voluntary exchange must be made better off

• Allow for specialization and division of labor

• Increase interdependence

• Promote cooperation rather than conflict

An intuitive Approach to Gains From Trade

• Self-sufficiency – Pros: independence– Cons: loss of efficiency, variety in consumption

and production

• Trade with Yakima?

• Trade with other states?

• Trade with other nations?

Gains from Trade: An Economic Model

• Good model building: prove the point and make it simple

• Assumptions = things held true during the analysis = simplification

• Assumptions can be changed later to explore their implications

The Model

• Assumptions:– Two individuals – rancher and a farmer– Two goods – meat and potatoes– Each work eight hours a day– Farmer takes 60min/oz meat and 15min/oz

potatoes– Rancher takes 20min/oz of meat and 10min/oz

of potatoes

• Absolute advantage– Rancher than farmer is more efficient and producing both meat and

potatoes

• Comparative advantage– The farmer is comparatively better at producing potatoes than the

rancher.

• Comparative advantage and opportunity cost– The person with the lower opportunity cost has a comparative

advantage– Someone always has a comparative advantage in the production of

a least one thing

PPF and Production in a Simple Economy

• How much can be produced?

• Need to know:– Total time divided by time/output = total

output, or– output/time multiplied by total time = total

output

Table 1 The Production Opportunities of the Farmer and Rancher

Copyright © 2004 South-Western

Farmer (8 hours = 480/min)/ (60 min/oz of meat) = 8 oz of meat

Rancher (480min/20min/oz of meat)=24 oz of meat

Figure 1 The Production Possibilities Curve

Potatoes (ounces)

4

16

8

32

A

0

Meat (ounces)

(a) The Farmer’ s Production Possibilities Frontier

If there is no trade, the farmer chooses this production and consumption.

Copyright©2003 Southwestern/Thomson Learning

Figure 1 The Production Possibilities Curve

Copyright©2003 Southwestern/Thomson Learning

Potatoes (ounces)

12

24

B

0

Meat (ounces)

(b) The Rancher ’s Production Possibilities Frontier

48

24

If there is no trade, the rancher chooses this production and consumption.

Slope of the PPF• In math, slope = Δy/Δx but in this case meat is on

the y-axis and potatoes are on the x-axis, so it become ΔM/ΔP

• E.g. Rancher ΔM/ΔP = -24/48 =-1/2 , but it is help to think of this as -1/2/1. Why? +1P → -½ M

• E.g. Farmer ΔM/ΔP =- 8/32 =-1/4 , but it is help to think of this as 1/4/1. Why? +1P → -1/4 M

• To get 1 P the rancher gives up 1/2M and the farmer gives up 1/4M

• Slope = opportunity cost (an example of making math meaningful to real world situations)

• Reverse directions– Rancher to get 1M → -2P– Farmer to get 1M → -4P

• Conclusions:– Rancher has a comparative advantage in producing meat (1M

costs 2P or 1P costs 1/2M)– Farmer has a comparative advantage in producing potatoes

(1P costs 1/4M or 1M costs 4P)

• The rancher should specialize in producing meat and the farmer should specialization in producing potatoes.

Gains to Trade• Marginal versus Complete Approach• Marginal adjustment

– Farmer -1M → +4P– Rancher +1M → -2P– Total 0M +2P, or– Rancher -1P → +1/2M– Farmer +1P → -1/4M– Total 0P +1/4M

• Either way specializing and trading means either more meat or potatoes

The Total Approach

• Mankiw explains gains a bit differently and perhaps in a more complicated way– Farmer only produces potatoes and rancher

produces a combination of meat and potatoes– Trade takes place with equal amounts for each– New totals lie outside the old PPF and

represents a point on a consumption possibilities frontier

– Let’s see how he does it….

Table 2 The Gains from Trade: A Summary

Copyright © 2004 South-Western

Figure 2 How Trade Expands the Set of Consumption Opportunities

Copyright © 2004 South-Western

Potatoes (ounces)

12

24

13

27

B

0

Meat (ounces)

(b) The Rancher’s Production and Consumption

48

24

12

18

B*

Rancher's consumption with trade

Rancher's production with trade

Rancher's production and consumption without trade

Figure 2 How Trade Expands the Set of Consumption Opportunities

Copyright©2003 Southwestern/Thomson Learning

Potatoes (ounces)

4

16

5

17

8

32

A

A*

0

Meat (ounces)

(a) The Farmer’ s Production and Consumption

Farmer's production and consumption without trade

Farmer's consumption with trade

Farmer's production with trade

Distribution of Gains to Trade

• Voluntary exchange results in gains to trade, but who gets the gains?

• Positive analysis = gains exist so efficiency improvements can occur

• Normative analysis = who should get the gains• Normative analysis involves value judgments and

therefore must be made by others

History of Trade

• Tribal to feudal times• Adam Smith (1776) and David Ricardo (1817)• The costs of not trading (e.g. lamb example)• Distribution impacts: consumers win but some

producers and workers lose• The cost of protectionism• http://www.dallasfed.org/fed/annual/2002/ar02f.html• http://www.economist.com/displaystory.cfm?

story_id=1059489