Professor Chris Wimmer Oct 23 2007 Lecture 2 i.) Trade and Comparative Advantage ii.) Market Forces: Demand Professor Chris Wimmer Oct 23 2007

Production Possibilities In a set time frame with set resources the production possibility frontier shows options for production Lets draw one! All points on or inside the line are possible Where is the most desirable points? The straight line means you can substitute production for each good evenly along line!!!

Consumption possibilities before and after trade If a person does trade, their production possibility frontier is also their consumption frontier Let’s look at a trading example!

Absolute Advantage A producer that requires less inputs to produce a product has absolute advantage In the example we use with farmer A and B, time is the only input!

Comparative Advantage To find comparative advantage we go back to our concept of opportunity cost Let us find the opportunity costs in our silk and rice example It is impossible for someone to have comparative advantage in both traded goods in our example, unlike absolute advantage. Why? Because the opportunity cost of one good is the ‘inverse’ of the other good

Who has comparative advantage in what goods? The farmer A has comp adv in silk The farmer B has comp adv in rice Why? What does this mean for trade?

Gains for trade. Absolute or Comparative Advantage counts? It is in comparative advantage that we can gain from specialization and trade Each person should specialize in the product that they have comparative advantage  increase economy and benefits all involved in trade But for both people to benefit, the price of trade must be between both farmer’s opportunity costs for the good.

Our example Farmer A concentrates on silk producing 64 pounds. Add 24 from Farmer B and the economy now produces 88 pounds which is greater than before with 32 + 48 Farmer B concentrates on rice production producing 36 pounds for a total of 36 which is greater than with no specialization/trade at 32

How has opportunity cost changed with trade? Before farmer A had to give up 4 pounds of silk for 1 of rice  Now he gives only 3 pounds for a pound of rice (30 for 10) Before farmer B had to give up ½ a pound of rice for a pound of silk  Now he gives up 1/3 pound of rice for a pound of silk Both gain from trade!!!

Rule of gains from trade and comparative advantage Notice that the opportunity cost of both goods lies between the old opportunity costs of farmer A and B This has to be the case for both farmers to gain from trade!

Homework Read Chapter 3 Do Pg. 59  60 Q# 1, 2, 3, 4, 5 Pr. # 1, 2, 3, 4, 5, 6, 7, 8, 9

ii.) Market Forces: Demand What is a market?  a network of buyers and sellers for a product or good. The demand is made up of the buyers while the sellers decide on the supply. A competitive market has many buyers and sellers! Can one seller/buyer affect the price/quantity?

Perfectly Competitive Markets 1. Must have many buyers and sellers so individuals can not affect market price. 2. Goods being sold are identical *3. All buyers and sellers have perfect information about products *4. There are no transaction costs *5.There are no externalities

The Demand Curve The quantity demanded is the amount consumers are willing and able to buy at a certain price Quantity demanded is negatively related to price This is the Law of Demand Quantity demanded goes down as price goes up

Demand Schedule This shows the relationship between price and quantity on a chart. Lets create a demand schedule and then graph it on a demand curve!

Building market demand from individuals The market demand is the sum of all individuals in society who have a demand for a certain products This is holding all else constant except price Let’s do an example about chocolate bars (SL16,L2)

Reasons for Demand Shifts Income – if your income falls you would want less of a Normal Good and demand would fall What is an inferior good? Substitution – Goods that are very similar will affect each others demands Complements – goods that are complements will have a positive relationship!

(Continued) Tastes – When people change their tastes for something, demand shifts. Expectations – your demands today will change depending on your expectations for future Number of buyers – if the number of buyers increases, demand increases

The Supply Curve This curve represents the sellers desire to supply goods at each price level. Price and the supply curve are positively related Law of supply is that as price goes up, the supply of goods increases

Supply curve and market supply Building the market demand for supply is very similar to the example we did for demand so let’s look at the example in the book, pg. 73 Let’s also go through shifts in the supply curve

Reasons for shifts in the supply curve Input prices: this affects the cost of producing so also supply Technology: new technology may make production cheaper or faster Expectations: A firm must always think about future demands, prices, and costs Number of sellers: The more sellers, the greater the supply.

Supply and Demand: Equilibrium This is where we find price and quantity