Trade, Tradeoffs, and Government Policy Chapter 2

Laugher Curve Q. How many Marxists does it take to screw in a light bulb? A. None. The bulb contains within itself the seeds of its own revolution.

Introduction An economic system has to solve three coordination problems: What, and how much, to produce. How to produce it. For whom to produce it.

Introduction All economic knowledge can be boiled down to a single phrase: There ain’t no such thing as a free lunch.

Introduction Every decision has an opportunity cost – the cost in foregone opportunities.

Introduction A production possibility curve is used to illustrate opportunity cost.

The Production Possibilities Model The production possibilities curve shows the trade-offs among choices we make.

The Production Possibility Table A production possibility table lists a choice's opportunity costs by summarizing what alternative outputs you can achieve with your inputs.

The Production Possibility Table Output – an output is simply a result of an activity. Input – an input is what you what you put into a production process to achieve an output.

The Production Possibility Curve for an Individual A production possibility curve measures the maximum combination of outputs that can be achieved from a given number of inputs. It slopes downward from left to right.

The Production Possibility Curve for an Individual Economics grade 100 88 70 46 40 58 66 78 94 98 History grade 20 hours of history 0 hours of economics E D C B 20 hours of economics 0 hours of history A Hours of study in history Grade in in economics 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 96 92 90 86 84 82 80 76 74 72 68 64 62 60 43 49 52 55 61 67 73 79 85 91 97 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Production Possibility Curve for an Individual The production possibility curve not only represents the opportunity cost concept, it also measures the opportunity cost.

The Production Possibility Curve for an Individual The production possibility curve demonstrates that: There is a limit to what you can achieve, given the existing institutions, resources, and technology. Every choice made has an opportunity cost—you can get more of something only by giving up something else.

A Production Possibility Curve for a Society The production possibility curve is generally bowed outward. Some resources are better suited for the production of some goods than others.

A Production Possibility Curve for a Society 10 9 8 6 5 4 3 2 1 . 2Y 1X A X 1 2 3 4 5 6 7 8 9 If the slope of the production curve is -2 at A, the opportunity cost of 1X is 2Y. 7 McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

A Production Possibility Curve for a Society Comparative advantage explains why opportunity costs increase as the consumption of a good increases. Some resources are better suited for the production of some goods than to the production of other goods.

A Production Possibilities Table and Curve % of resources devoted to production of guns Number of butter Pounds Row 20 40 60 80 100 4 7 9 1 12 15 14 5 A B C D E F McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

A Production Possibilities Table and Curve 4 guns 1 pound of butter 15 B 14 3 guns 2 pounds of butter C 12 D 9 Butter E 5 1 gun 5 pounds of butter F 4 7 9 11 12 Guns McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Increasing Marginal Opportunity Cost The principle of increasing marginal opportunity cost states that opportunity costs increase the more you concentrate on an activity. In order to get more of something, one must give up ever-increasing quantities of something else.

Increasing Marginal Opportunity Cost Butter Slope is flat at A. Low opportunity cost of guns. Slope is steep at B. High opportunity cost of guns. Guns B A

Efficiency In production, we’d like to have productive efficiency – achieving as much output as possible from a given amount of inputs or resources.

Efficiency Efficiency involves achieving a goal as cheaply as possible. Efficiency has meaning only in relation to a specified goal.

Efficiency Any point within the production possibility curve represents inefficiency. Inefficiency – getting less output from inputs which, if devoted to some other activity, would produce more output.

Efficiency Any point outside the production possibility curve represents something unattainable, given present resources and technology.

Efficiency and Inefficiency Guns 10 8 6 4 2 2 4 6 Butter C D A B Unattainable point, given available technology, resources and labor force Efficient points Inefficient point

Shifts in the Production Possibility Curve Society can produce more output if: Technology is improved. More resources are discovered. Economic institutions get better at fulfilling our wants.

Shifts in the Production Possibility Curve More output is represented by an outward shift in the production possibility curve.

Shifts in the Production Possibility Curve Neutral Technological Change Butter C D A B Guns

Shifts in the Production Possibility Curve Biased Technological Change Butter C B A Guns

Distribution and Production Efficiency The production possibilities curve focuses on productive efficiency and ignores distribution.

Distribution and Production Efficiency In our society, more is generally preferred to less and many policies have relatively small distributional effects.

Examples of Shifts in the Production Possibility Curve Test your understanding: A meteor hits the world and destroys half the earth’s natural resources. Nanotechnology is perfected that lowers the cost of manufactured goods.

Examples of Shifts in the Production Possibility Curve Test your understanding: A new technology is discovered that doubles the speed at which all goods can be produced. Global warming increases the cost of producing agricultural goods.

Examples of Shifts in the Production Possibility Curve

Trade and Comparative Advantage The production possibility curve is bowed because individuals specialize in the production of goods for which they have a comparative advantage and trade with others.

Trade and Comparative Advantage To produce on the production possibilities curve, individuals must produce those goods for which they have a comparative advantage.

Trade and Comparative Advantage Adam Smith argued that humankind’s proclivity to trade leads to individuals using their comparative advantage.

Markets, Specialization, and Growth The growth in per capita income in the past two millennia has been astonishing. This owes largely to the introduction of markets and democracy.

Markets, Specialization, and Growth Markets allow specialization, leading to trade and growth.

Markets, Specialization, and Growth As people are allowed to compete and specialize, they get better at what they do, develop new technologies, and the market grows ever larger.

Growth in the Past Two Millennia $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 2000 1500 1000 500 (in 1990 international dollars) Per capita income McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Benefits of Trade When people trade, both parties expect to benefit from the trade. Otherwise, why would they have traded in the first place?

The Benefits of Trade The argument for the benefits of trade underlies the general policy of laissez-faire. Laissez-faire – an economic policy of leaving coordination of individuals’ actions to the market.

Production Possibilities without Trade Pakistan can produce 4,000 yards of textile per day or 1 ton of chocolate per day. Belgium can produce 1,000 yards of textile a day or 4 tons of chocolate per day.

Production Possibilities without Trade Pakistan has a comparative advantage in producing textiles. Belgium has a comparative advantage in chocolate.

Production Possibilities without Trade 1 2 3 4 5 4 3 2 1 5 Chocolate (in tons) (in thousands of yards) Textiles Pakistan Belgium McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Production Possibilities without Trade Pakistan has chosen to produce 2,000 yards of textiles and 0.5 tons of chocolate. Belgium has chosen to produce 500 yards of textile and 2 tons of chocolate.

Production Possibilities without Trade Point A: The combination of textile and chocolate chosen by Pakistan. Point B: The combination of textile and chocolate chosen by Belgium. Point C: The joint combination without trade.

Production Possibilities without Trade

Production Possibilities without Trade 5 4 Pakistan (in thousands of yards) Textiles 3 C A 2 Belgium 1 B 1 2 3 4 5 Chocolate (in tons) McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Production Possibilities without Trade The two extreme combinations are both countries producing only textile (point D) and both producing only chocolate (point E). The combined production possibilities curve with no trade is drawn by connecting these two points.

Production Possibilities without Trade 5 4 Pakistan (in thousands of yards) Textiles 3 C Joint (no trade) A 2 Belgium 1 B E 1 2 3 4 5 Chocolate (in tons) McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Production Possibilities with Trade Point F: This is where each nation is focusing on that activity for which it has a comparative advantage. Pakistan produces 4,000 yards of textile. Belgium produces 4 tons of chocolate.

Production Possibilities with Trade

Production Possibilities with Trade Gains from trade D 5 Joint (with trade) F 4 (in thousands of yards) Textiles 3 C Joint (no trade) 2 1 E 1 2 3 4 5 Chocolate (in tons) McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Production Possibilities with Trade The combined PPC is bowed out because of Point F – comparative advantage and specialization.

U.S. Textile Production and Trade Two hundred yeas ago, the U.S had a comparative advantage in textile production. Now, countries with cheaper labor, such as Bangladesh have the comparative advantage in textile production.

U.S. Textile Production and Trade The gains from trade show up as higher pay for workers in Bangladesh and lower-priced cloth for U.S. consumers.

Regulating Trade: Institutions, Government, and Trade Government provides the institutional framework that facilitates trade. Government regulates markets, preventing trades that are harmful and encouraging trades that are helpful.

The Roles of Government in a Market Provide a stable institutional framework. Promote effective and workable competition. Correct for externalities. Ensure economic stability and growth. Provide public goods. Adjust for undesired market results.

Provide a Stable Set of Institutions and Rules Government can create a stable environment and enforce contracts through its legal system. Economic growth is difficult when government does not provide a stable environment.

Promote Effective and Workable Competition Government promotes competition and protect against monopolies. Monopoly power is the ability of individuals or firms currently in business to prevent other individuals or firms from entering the same kind of business

Promote Effective and Workable Competition Monopoly power gives existing firms or individuals the power to raise prices. Market participants often insist on open competition except when it comes to themselves.

Correct for Externalities An externality is the effect of a decision on a third party not taken into account by the decision maker. Unless they are required to do so, parties to any exchange are unlikely to take into account any externality.

Correct for Externalities The externality may be positive in which case society benefits even more than the two parties – an example is education.

Correct for Externalities The externality may be negative in which case society as a whole benefits less than the two parties – an example is pollution.

Correct for Externalities When there are externalities, there is a potential role for government to adjust the market result.

Correct for Externalities Government may not effectively assume that role. Government generally can only act within its borders. Politics and vested interests may prevent government from acting.

Ensure Economic Stability and Growth Most Americans look to the government to deal with macroeconomic externalities.

Ensure Economic Stability and Growth Macroeconomic externalities are externalities that affect the levels of unemployment, inflation, and growth in the economy as a whole.

Provide for Public Goods A public good is a good that if supplied to one person must be supplied to all whose consumption by one individual does not prevent its consumption by other individuals

Provide for Public Goods In contrast, a private good is one that, when consumed by one individual, cannot be consumed by another individual.

Provide for Public Goods A free rider is a person who participates in something without having to pay for it.

Provide for Public Goods Government steps in to provide public goods and requires that everyone pays for them, thereby reducing the free rider problem.

Adjust for Undesired Market Results A controversial role for government is to make markets fairer. Determining what is fair is a difficult philosophical question.

Adjust for Undesired Market Results For example, in trying to be fair, which type of tax should the government use?

Adjust for Undesired Market Results A progressive tax is one whose rates increase as a person's income increases. A regressive tax is one whose effect decrease as income rises.

Adjust for Undesired Market Results A proportional tax is one whose rates are constant at all income levels, regardless of the taxpayer's total annual income.

Adjust for Undesired Market Results Another controversial role for government involves deciding what is best for people independently of their desires.

Adjust for Undesired Market Results Should government prohibit demerit goods and activities?

Adjust for Undesired Market Results Demerit goods or activities are things government believes are bad for you, although you may like them. Merit goods and activities are things the government believes are good for you, although you may not like them.

Market Failures and Government Failures Market failures are the reason why government intervenes.

Market Failures and Government Failures Market failures are situations in which the market does not lead to a desired result. Government failures are situations where the government intervenes and makes things worse.

Market Failures and Government Failures Government is always failing in one way or another. Real-world policy makers are left with the choice of selecting that which is least bad – market failure or government failure.

Regulating Markets Internationally There is no central world government. Some countries have voluntarily restricted their ability to restrict trade.

Regulating Markets Internationally Governments have been unable to come up with an effective means of dealing with environmental issues.

The Production Possibilities Model and Government Policy Models are important because they structure the debate about regulating the market.

Conclusion The production possibilities curve represents the tough choices society makes. Seemingly free lunches often involve significant hidden costs.

The Economic Organization Of Society End of Chapter 2