Economic Issues Economics is the study of how society allocates its scarce resources among competing demand to improve human welfare. Scarcity exists because human wants exceed the resources available to satisfy them. Scarcity implies that choices must be made and economics is the study of those choices. Specifically, economics studies how societies answer the following questions: –What will be produced? –How it will be produced? –For whom will it be produced?

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 – Correlation does not equal causation Fallacy of Composition/Division Microeconomics vs. Macroeconomics

Economics and Economists Positive versus normative Avoiding unintended consequences Scientist, advisor and citizen Scientific judgment, values, perception versus reality

Economics Models and Issues an Introduction The art of making models = making them simple and effective Example: circular flow – what, how and for whom questions. –overall economy, role of economic agents, output and income, product and factor markets Example: production possibilities frontier (PPF) -efficiency, tradeoffs, opportunity costs, law of increasing costs, economic growth.

Figure 1 The Circular Flow Copyright © 2004 South-Western Spending Goods and services bought Revenue Goods and services sold Labor, land, and capital Income = Flow of inputs and outputs = Flow of dollars Factors of production Wages, rent, and profit FIRMS Produce and sell goods and services Hire and use factors of production Buy and consume goods and services Own and sell factors of production HOUSEHOLDS Households sell Firms buy MARKETS FOR FACTORS OF PRODUCTION Firms sell Households buy MARKETS FOR GOODS AND SERVICES

Figure 8 Illustrating Constant Opportunity Cost Production Possibilities Frontier Pizza Soda Opportunity Cost of going from 0 units of Pizza to 1 unit of pizza Opportunity Cost of going from 1 unit of Pizza to 2 units of pizza Opportunity Cost of going from 2 units of Pizza to 3 units of pizza

Figure 7 Illustrating Increasing Opportunity Cost Production Possibilities Frontier Pizza Soda Opportunity Cost of going from 0 units of Pizza to 1 unit of pizza Opportunity Cost of going from 1 unit of Pizza to 2 units of pizza Opportunity Cost of going from 2 units of Pizza to 3 units of pizza

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) 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) B 0 Meat (ounces) (b) The Rancher’s Production Possibilities Frontier 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 1/4P) 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

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

NAFTA, GATT, and the WTO NAFTA: North American Free Trade Agreement –An agreement between the United States, Canada and Mexico to have substantially free trade. (Some tariffs and quotas are permissible under certain circumstances.) GATT: General Agreement on Tariffs and Trade –A multi-nation agreement specifying conditions under which tariffs, quotas and non-tariff barriers are permissible. WTO: World Trade Organization –An organization designed to settle trade disputes.

The Benefits of Free Trade Free trade makes each trading partner better off than it would have been without trade. Countries export goods to other nations because the producing country can make the good at a lower opportunity cost than the importing country.

Why Do We Need Trade Agreements? It is logical to ask “if trade is so good why do we need an agreement to engage in it?” The answer is that a country can make itself better off by engaging in Strategic Trade Policies designed to get more of the benefits from trade in a country than would exist under free trade. Countries that do this increase the gains from trade to themselves but it is less than the losses to everyone else.

Example of Strategic Trade Boeing vs. AIRBUS –Boeing had significant market power in the production of airliners prior to the existence of AIRBUS. –Britain and France gave AIRBUS protection against Boeing’s exports to European airlines. –In doing so they might have made themselves better off. Boeing was worse off by more than AIRBUS (and the European consumer and taxpayer) were made better off.

What Trade Agreements Prevent (or discourage) Tariffs –A tax on imports. Quotas –A limit on imports. Non-tariff barriers –A regulatory means of limiting imports.

Alphabet Soup: NAFTA North American Free Trade Agreement Creates a (relatively) free trade zone in North America. Includes Canada, Mexico and the United States. Passage –Envisioned by President Reagan in the 1980’s. –Negotiated by President Bush (G.H.W.) in the late 1980s and early 1990s. –Enacted by President Clinton.

Alphabet Soup: GATT General Agreement on Tariffs and Trade Came into existence shortly after WWII –Uruguay Round set the latest rules A world agreement between more than 100 nations. NOT a free trade agreement –It sets conditions under which tariffs, quotas and non-tariff barriers are acceptable.

Alphabet Soup: WTO World Trade Organization Set up with GATT but had little power until the Uruguay Round of GATT. Serves as a “court” where countries can argue who is in the right in a trade dispute. Has no enforcement authority.

The Battle in Seattle (and other similar protests) December of 1999 riots broke out in the streets of Seattle with protestors voicing displeasure at –NAFTA –WTO –Globalization –The effect of trade on American jobs. –The effect of trade on the environment, worker safety and child labor standards.

Are Trade Agreements Working? The effects of these agreements are often overstated because trade was increasing before they were enacted. Trade agreements have (in isolation from the trend) increased trade somewhat, but have not had the –Dramatically positive impacts envisioned by free-trade advocates. –Dramatically negative impacts envisioned by detractors of globalization.

The Politics of Free Trade There are winners and losers from freer trade. –The winners have tended to be people who are educated and highly skilled. –The losers have tended to be people in manufacturing who have little education. –Cost of Saving a Job l

More Politics of Free Trade Free trade’s winners are harder to identify that its losers. –A person who loses a job when the plant they work for moves to a different country can easily identify themselves as a loser in free trade. –People who are hired because of an increase in exports may not see the reason. –People who are hired because of higher national incomes usually do not attribute their hiring to free trade policies.

The Bottom Line Trade increases the GDP of the trading countries. Trade can hurt key constituencies with political power. Because the gains to the winners of free trade more then offset the losses to the losers, economists generally view free trade agreements as good. Economists suggest that the losers from free trade agreements (unemployed workers) can (and should) be compensated with retraining opportunities. The implementing legislation of NAFTA provides for this.