ECON 100 Lecture 5 Monday, September 29

Announcements Course webpage https://ais.ku.edu.tr/course/25089/Default.html Class participation records are posted - Announcements section Problem set #1 is posted - Assignments section Problem sets (study questions) are an important resource for exam preparation. Problem sets will not be graded. Answers to Problem set #1 will be posted on course webpage later this week.

Problem Session announcement PSs start this week My apologies for last Friday’s confusion I will email you the day-time-room info for all three PSs. You can go to any of the three. Freedom of choice. But you don’t have to! No attendance will be taken at the PSs.

Class participation You are not allowed to switch section times! Must attend the section where you are registered. Your in-class exercise is your participation record. Return them to me at the end of the lecture.

A few words on Problem Set #1 To convince you that the PS questions are very easy, let’s do a more difficult question from PS #1. It is a multiple choice question.

Opportunity cost Mallory decides to spend three hours working overtime rather than watching a video with her friends. She earns $8 an hour. Her opportunity cost of working is the $24 she earns working. the $24 minus the enjoyment she would have received from watching the video. the enjoyment she would have received from watching the video. nothing, since she would have received less than $24 of enjoyment from the video. ANS: C

This is my favorite question. It is not a multiple choice question. The most you would be willing to pay for having a freshly washed car before going out on a date is $6. The smallest amount for which you would be willing to wash someone else's car is $3.50. You are going out this evening, and your car is dirty. As a rational person would you wash the car? ANS: Wash the car. Max WtP is B. WtP is $6. Min WtA (to wash a car yourselv) is C. This is $3.50. B > C so as a rational individual you choose to wash the car!

Now The lecture

Please turn off your phones.

A brief summary of nearly everything Economics assumes that people are rational. Rational people compare costs and benefits when they choose. The simple rule: “Do activity x if B(x) ≥ C(x)”

A brief summary of nearly everything “Do activity x if B(x) ≥ C(x)” Measuring the costs and benefits of an action is not always easy. People sometimes ignore costs that should be counted: Opportunity cost People sometimes count costs that should be ignored: Sunk cost

Brief summary … The assumption that people do activity x if B(x) ≥ C(x) means that if the costs or the benefits of an action change, rational people change their behavior. This is what economists mean when they say “people respond to incentives”.

Brief summary … When rational people decide on the level of an activity, they compare the additional benefits against additional costs, also called marginal benefit and marginal cost. Increase the level of the activity by a small amount if the additional benefit is greater than the additional cost.

Brief summary … This rule will make you stop at the level where approximately the additional benefit (marginal benefit, denoted MB) equals the additional cost (marginal cost, denoted MC) MB = MC

Why do we study economics? The purpose of studying economics is not to acquire a set of ready-made answers to economic questions, but to learn how to avoid being deceived by economists. Joan Robinson (1903 - 1983) was one of the great economists of the 20th century. http://http-server.carleton.ca/~karmstro/bios/Robinson.htm

Why are we studying these topics? A road map Economics is the study of how society manages its scarce resources. In most societies resources are allocated through the combined actions of millions of people and firms (through markets and the political process).

Road map What is economics and why these topics? We start with the study of how people make decisions: Some of the examples we used were Should I iron my shirt? Should I go to the Clapton concert?

Road map What is economics and why these topics? These are some of the important decisions people make How much education to have How much to work / when to retire Which goods/services to buy How much to save, Marry or remain single How many children to have

What is today’s lecture about? We will study how people interact with one another. Specialization, interdependence, and the gains from trade

What is next? We will examine how buyers and sellers of a good (or service) together determine the prices of goods and the quantity produced and consumed. We will study Demand Supply Competitive markets, the equilibrium in competitive markets

and after we have discussed these … We will have the first midterm exam.

Now

Interdependence and the Gains from Trade

We can be economically self-sufficient We can be economically self-sufficient. or We can specialize and trade with others, leading to economic interdependence.

I don’t know much about the tariff I don’t know much about the tariff. But I know this much, Abraham Lincoln is supposed to have said: “When we buy manufactured goods abroad, we get the goods and the foreigner gets the money. When we buy the manufactured goods at home, we get both the goods and the money.” quoted in Dani Rodrik, Symposium on Globalization in Perspective: An Introduction, Journal of Economic Perspectives; Fall 1998 pages 3-8.

Abraham Lincoln (1809 –1865), is the 16th President of the United States. He served from March 1861 until his assassination. He led the country through a great constitutional, military and moral crisis—the American Civil War—preserving the Union while ending slavery and promoting economic and financial modernization.

We will use a simple economic model to… Talk about “Interdependence and the Gains from Trade”. This model was first introduced in David Ricardo’s book “Principles of Political Economy and Taxation”, published in 1817.

Suppose that country A (Advancedland) is more productive than country B (Backwardland) in every economic activity. Can both countries still benefit from trade? David Ricardo's “law of comparative advantage” showed that the answer is yes.

Principles of Political Economy and Taxation, 1817 David Ricardo was one of the most influential of the classical economists, along with Adam Smith. He is credited with systematizing economics. He was also a member of Parliament, businessman, financier and speculator. He amassed a considerable personal fortune.

David Ricardo's theory of Comparative Advantage is one of the very few statements in economics which is perfectly simple without being perfectly obvious. Paul Samuelson

Paul Samuelson (1915 –2009) won the Nobel Prize in Economics in 1970 Paul Samuelson (1915 –2009) won the Nobel Prize in Economics in 1970. The Nobel committee said that… Prof. Samuelson "has done more than any other contemporary economist to raise the level of scientific analysis in economic theory". Samuelson is often called the "Father of Modern Economics", and considered by many to be the "foremost academic economist of the 20th century".

Interdependence and the Gains from Trade Imagine a world with two goods, fish and bread; and two countries: Poorland and Richland Each country is populated by a single individual.

Technology and resource constraints Labor is the only scarce resource needed for production. Each person has 30 hours (per week) that can be allocated to fish or bread production.

Production technology The richlander can produce 1 fish in 1 hour and 1 (loaf of) bread in 1.5 hours. The poorlander can produce 1 fish in 3 hours and 1 (loaf of) bread in 2 hours.

Let’s draw The Production Possibilities Frontier graph for each country Bread Fish

The Production Possibilities (Frontier) is... a graph that shows the combinations of goods the economy can produce given the available resources (labor force, capital goods) and the existing technology.

Quantity of computers produced What are the combinations of goods the country can produce given the available resources and existing technology? 3,000  D C 2,200 600 A 700 2,000 Production Possibilities Frontier 1,000 300 B  1,000 Quantity of cars produced

The PPF for our simple economies: All combinations of the two goods (fish and bread) the country can produce given the available resources (30 hours of labor) and existing technology. Richland: 1 fish in 1 hour; 1 bread in 1.5 hours. Poorland: 1 fish in 3 hours; 1 bread in 2 hours.

Draw The Production Possibilities Frontier graph for each country ID last digit 0, 2, 4, 6, 8 draw the PPF for Richland. ID last digit 1, 3, 5, 7,9 draw the PPF for Poorland. Bread Fish

Help Find the max fish production (0 bread production) point Find the max bread production (0 fish production) point Find a third combination that uses 30 hours to produce a positive amount of both: for example labor time is divided equally between fish and bread. Try to draw these three combinations to scale Then you will get the shape of the PPF.

Draw The Production Possibilities Frontier graph for each country ID last digit 0, 2, 4, 6, 8 draw the PPF for Richland. ID last digit 1, 3, 5, 7,9 draw the PPF for Poorland. Bread Richland 1 fish in 1 h; 1 bread in 1.5 h. Poorland 1 fish in 3 h; 1 bread in 2 h. Fish

Poorland, Production Possibilities (She has 30 hours, can produce 1 fish in 3 hours and 1 bread in 2 hours) Bread 15 Slope: rise/run = ‒ 15/10 = ‒1.5 A 7.5 Fish 5 10

Richland, Production Possibilities (She has 30 hours, can produce 1 fish in 1 hour and 1 bread in 1.5 hours) 20 Bread Fish 30

Consumption Preferences (tercihler) Each person eats fish and bread as fixed-proportions sandwiches that are made with 1 fish and 1 loaf of bread. Any leftover fish or bread is useless. Fractional sandwiches are OK! Not very realistic, but easy to describe and easy to work with!

Which combination is more preferable? A = 6 fish 5 bread B = 8 fish 4 bread C = 5 fish 8 bread D = 6 fish 6 bread

We will start with the NO TRADE SITUATION Self-sufficiency (autarchy) What will each individual (country) produce? What will each individual (country) consume? Since there is no trade, consumption = production!

Report Card - Richlander - NO TRADE In Session 1, where I cannot trade with others, I chose to produce ____________ units of fish and _______________ units of bread, and consume ______________ sandwiches. (This has to be the minimum of these two quantities.) Richland: 1 fish in 1 hour; 1 bread in 1.5 hours. Poorland: 1 fish in 3 hours; 1 bread in 2 hours.

Let’s hear your answers

The official view Producing unequal number of fish and bread is inefficient. Richlander needs 2.5 hours for a sandwich: 1 h for fish 1.5 h for bread. In 30 hours she can produce 30/2.5 = 12 sandwiches (12 fish, 12 bread). Poorlander needs 5 hours for a sandwich: 3 h for fish 2 h for bread. In 30 hours she can produce 30/5 = 6 sandwiches (6 fish, 6 bread).

NO TRADE (self-sufficiency) Goal: eat as many sandwiches as possible. Richlander: produces 12 fish and 12 bread, eats 12 sandwiches (12 h) (18 h) Poorlander: produces 6 fish and 6 bread, eats 6 sandwiches (18 h) (12 h) +___________________ 18 sandwiches jj Richland: 1 fish in 1 hour; 1 bread in 1.5 hours. Poorland: 1 fish in 3 hours; 1 bread in 2 hours.

This part is difficult but you can do it! Specialization and gains from trade

Pair up! Poorlanders! Find yourselves a Richlander to trade Richlanders! Find yourselves a Poorlander to trade

Report Card - Richlander - WITH TRADE Name of the trading partner _______________ In Session 2 where I can trade with others, I chose to produce ________ units of fish and ________ units of bread. In my trade with the other country I sell/buy ________ units of fish and sell/buy ________units of bread. After I trade, I have ________ units of fish and ________ units of bread, and I consume ________ sandwiches. Richland: 1 fish in 1 hour; 1 bread in 1.5 hours. Poorland: 1 fish in 3 hours; 1 bread in 2 hours.

SPECIALIZATION and TRADE Each country/person will have more sandwiches to eat! With specialization, the total production of the two individuals can be (will be) more than 18 sandwiches.

Specialization and Trade Some practical questions: Who will specialize in which good? What will be the degree of specialization? Complete? (produce only one good) Partial? (produce a large quantity of one good (more than you will consume) and a small quantity of the other good.

Gains from trade After trade each individual should have more sandwiches than they could have without trade. Otherwise the individual who has fewer sandwiches with trade (than with self-sufficiency) will not agree to trade.

Each individual will specialize in producing the good she is more suited to produce.

There is no short-cut/magic formula. Think as a team! Let’s start working. There is no short-cut/magic formula. You need to try a few options before you can find a good enough answer.

Report Card - Richlander - WITH TRADE Name of the trading partner _______________ In Session 2 where I can trade with others, I chose to produce ________ units of fish and ________ units of bread. In my trade with the other country I sell/buy ________ units of fish and sell/buy ________units of bread. After I trade, I have ________ units of fish and ________ units of bread, and I consume ________ sandwiches. Richland: 1 fish in 1 hour; 1 bread in 1.5 hours. Poorland: 1 fish in 3 hours; 1 bread in 2 hours.

Solution

We agreed that Mrs. Poorlander specializes in bread production and Mrs. Richlander specializes in fish. That means; Mrs. P will produce bread for her own consumption and also to sell to Mrs. R (in exchange of fish) Mrs. R will produce fish for her own consumption and also to sell to Mrs. P (in exchange of bread)

Specialization: How much? Partial or complete? Complete specialization by both is not optimal. Mrs. Richlander produces 30 fish, Mrs. Poorlander produces 15 loaves of bread. This is not a good resource allocation if your goal is to eat maximum number of sandwiches. Mrs. Richlander: 1 fish in 1 hour and 1 bread in 1.5 hours. Mts. Poorlander: 1 fish in 3 hours and 1 bread in 2 hours.

Specialization: Use this method Let P produce bread and R produce fish one unit at a time, so that at each step the number of breads equals the number of fish, until one of them uses up all her 30 hours. This will be P, at that point you have 15 units of bread and 15 units of fish. R has still 15 hours free time. Let R produce 1 fish and 1 bread until she uses up all her remaining 15 hours. You will have an additional 15/2.5 = 6 fish and bread. Mrs. Richlander: 1 fish in 1 hour and 1 bread in 1.5 hours. Mts. Poorlander: 1 fish in 3 hours and 1 bread in 2 hours.

Specialization The “best” resource allocation with specialization: Mrs. Poorlander completely specializes in bread: She produces 15 breads. Mrs. Richlander mostly produces fish: 21 fish (in 21 hours), and also some bread: 6 loaves of bread (in 9 hours). This is partial specialization. They have 21 loaves of bread and 21 fish.

Dividing the gains from trade Specialization and division of labor gives them 3 more sandwiches. How will they divide up the gains from trade? After trade each individual should have at least the consumption level she could have without trade. Otherwise the individual who has fewer sandwiches with trade than with self-sufficiency will not agree to specialization and trade.

Dividing the gains from trade I didn’t explain that part very well on Monday. Therefore, many people gave 11 of these 21 sandwiches to one individual and the remaining 10 to the other. (equality, fairness) This is certainly great for Mrs. P. but not acceptable to Mrs. R. She wants at least 12 sandwiches to agree to specialization. But this point is less important. The important point is that with specialization and division of labor we “create” 3 extra sandwiches even though Mrs. P. and Mrs. R. work the same total number of hours and the technology they use is the same old technology!

Dividing the gains from trade Equal sharing of gains from trade Mrs. Poorlander “sells” 7.5 units of bread to Mrs. Richlander and “buys” 7.5 units of fish, so that she can make 7.5 sandwiches. This is 1.5 more than she had in the no trade situation. Mrs. Richlander “sells” 7.5 fish to Mrs. Poorlander and “buys” 7.5 units of bread from her. After trade, Mrs. Richlander can make 13.5 sandwiches. This is 1.5 more than the no trade situation.

Poorland, Production Possibilities (She has 30 hours, can produce 1 fish in 3 hours and 1 bread in 2 hours) Bread 15 D 7.5 A 6 7.5 Fish 6 10

Richland, Production Possibilities (She has 30 hours, can produce 1 fish in 1 hour and 1 bread in 1.5 hours) Bread 20 D 13.5 A 12 12 13,5 Fish 30

Dividing the gains from trade Specialization and division of labor “creates” 3 more sandwiches. All gains go to Poorlander Mrs. Poorlander “sells” 6 units of bread to Mrs. Richlander and “buys” 9 units of fish. After this trade, Mrs. Poorlander can make 9 sandwiches. This is 3 more than she had in the no trade situation. Mrs. Richlander “sells” 9 units of fish to Mrs. Poorlander and “buys” 6 units of bread from her. After this trade, Mrs. Richlander can make 12 sandwiches. This is the same as the no trade situation.

Which agreement is most likely? Equal division of the gains from trade? All gains go to Mrs. P? All gains go to Mrs. R? We don’t know the answer to that!