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) 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

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) B 0 Meat (ounces) (b) The Rancher’s Production and Consumption 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) 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

Markets: The power of Demand and Supply Competitive Markets –identical or homogeneous goods –many sellers and buyers –perfect Information –free entry and exit Non-Competitive Markets –Monopoly – one seller –Oligopoly – few sellers –Monopolistically Competitive – differentiated products

Demand The demand curve –Price and the quantity demanded Rational behavior –Utility maximization (MB=MC all over again) Income and substitution effects –Demand schedule –Individual demand curve –Market demand curve

Catherine’s Demand Schedule

Figure 1 Catherine’s Demand Schedule and Demand Curve Copyright © 2004 South-Western Price of Ice-Cream Cone Quantity of Ice-Cream Cones $ A decrease in price increases quantity of cones demanded.

The demand function –Income –Price of related goods Complements Substitutes –Tastes –Expectations –Number of Buyers

Movement along and shifts of the demand curve –Curve versus function –Schedules –Graphs

Figure 3 Shifts in the Demand Curve Copyright©2003 Southwestern/Thomson Learning Price of Ice-Cream Cone Quantity of Ice-Cream Cones Increase in demand Decrease in demand Demand curve,D 3 Demand curve,D 1 Demand curve,D 2 0

Supply Price and the quantity supplied –Rational behavior an the profit motive –Law of diminishing returns Supply schedule Individual supply curve Market supply curve

Ben’s Supply Schedule

Figure 5 Ben’s Supply Schedule and Supply Curve Copyright©2003 Southwestern/Thomson Learning Price of Ice-Cream Cone Quantity of Ice-Cream Cones $ An increase in price increases quantity of cones supplied.

The supply function –Input prices –technology –expectations –number of sellers

Figure 7 Shifts in the Supply Curve Copyright©2003 Southwestern/Thomson Learning Price of Ice-Cream Cone Quantity of Ice-Cream Cones 0 Increase in supply Decrease in supply Supply curve,S 3 curve, Supply S 1 curve,S 2

Market Equilibrium Equilibrium price and quantity = market clearing price and quantity Disequilibrium prices and quantities –Shortage –Surplus Comparative static analysis: changes in equilibrium prices and quantities Shifts in curves versus movement along revisited Changes in demand and supply

Figure 8 The Equilibrium of Supply and Demand Copyright©2003 Southwestern/Thomson Learning Price of Ice-Cream Cone Quantity of Ice-Cream Cones 13 Equilibrium quantity Equilibrium price Equilibrium Supply Demand $2.00

Figure 9 Markets Not in Equilibrium Copyright©2003 Southwestern/Thomson Learning Price of Ice-Cream Cone 0 Supply Demand (a) Excess Supply Quantity demanded Quantity supplied Surplus Quantity of Ice-Cream Cones 4 $

Figure 8 The Equilibrium of Supply and Demand Copyright©2003 Southwestern/Thomson Learning Price of Ice-Cream Cone Quantity of Ice-Cream Cones 13 Equilibrium quantity Equilibrium price Equilibrium Supply Demand $2.00

Figure 9 Markets Not in Equilibrium Copyright©2003 Southwestern/Thomson Learning Price of Ice-Cream Cone 0 Supply Demand (a) Excess Supply Quantity demanded Quantity supplied Surplus Quantity of Ice-Cream Cones 4 $

Figure 9 Markets Not in Equilibrium Copyright©2003 Southwestern/Thomson Learning Price of Ice-Cream Cone 0 Quantity of Ice-Cream Cones Supply Demand (b) Excess Demand Quantity supplied Quantity demanded $ Shortage

Figure 10 How an Increase in Demand Affects the Equilibrium Copyright©2003 Southwestern/Thomson Learning Price of Ice-Cream Cone 0 Quantity of Ice-Cream Cones Supply Initial equilibrium D D 3....and a higher quantity sold resulting in a higher price Hot weather increases the demand for ice cream New equilibrium $

Figure 11 How a Decrease in Supply Affects the Equilibrium Copyright©2003 Southwestern/Thomson Learning Price of Ice-Cream Cone 0 Quantity of Ice-Cream Cones Demand New equilibrium Initial equilibrium S1S1 S2S resulting in a higher price of ice cream An increase in the price of sugar reduces the supply of ice cream and a lower quantity sold $2.50 4

The Invisible Hand Economic Agents are motivated by self-interest –consumers by utility maximization –Producers by profit maximization Market prices as signals for resource allocation and coordinate consumer and producer behavior Market or the Price System and Efficiency