Steven Landsburg, University of Rochester Chapter 2 Prices, Costs, and the Gains from Trade Copyright ©2005 by Thomson South-Western, a part of the Thomson Corporation. All rights reserved.

Landsburg, Price Theory and Applications, 6 th edition Introduction Why do people trade? –Different Tastes –Different Abilities: Focus of Chapter Theory of Comparative Advantage First review concepts of prices and cost

Landsburg, Price Theory and Applications, 6 th edition Absolute versus Relative Prices No money in world, people still trade –Simply exchange goods Absolute prices –The number of dollars that can be exchanged for a specified quantity of a given good Relative prices –The quantity of some other good that can be exchanged for a specified quantity of a good

Landsburg, Price Theory and Applications, 6 th edition Focus of Microeconomics Study relative prices Absolute price change not same as a relative price change Relative price usually relative to some representative basket of goods or services Dollar refers to a basket of goods or services and not a piece of green paper

Landsburg, Price Theory and Applications, 6 th edition Relative Price Changes Inflation –An ongoing rise in the average level of absolute prices –Price of one good risen relative to all other goods Relative price changes do not cause absolute price changes

Landsburg, Price Theory and Applications, 6 th edition Quality of Oranges Relative price of oranges higher in New York than in Florida New Yorkers buy fewer oranges than they would at the Florida price Once decide to consume –New Yorker faces lower relative price than the Floridian does for a choosing a good orange rather than a bad orange

Landsburg, Price Theory and Applications, 6 th edition Costs, Efficiency, and the Gains from Trade Everyone can benefit when activities are carried out at the lowest possible cost

Landsburg, Price Theory and Applications, 6 th edition Costs and Efficiency Cost –Foregone opportunity –Term opportunity cost misleading –Totality of all opportunities that the activity requires you forgo Ex. The electrician and the carpenter

Landsburg, Price Theory and Applications, 6 th edition EXHIBIT 2.2The Electrician and the Carpenter

Landsburg, Price Theory and Applications, 6 th edition Comparative Advantage Ability to perform a given task at a lower cost More efficient Specialization and gains from trade –Everyone in society made better off –People specialize in the area where most efficient –Trade for the goods want to have Ex. Small towns Ex. No shoes, no shirts Ex. The Middleman

Landsburg, Price Theory and Applications, 6 th edition Why People Trade Different tastes Different abilities Pays to be different –Any difference is an opportunity for mutual gain –The more different you are, the more gains to be had –International Trade: small countries gain the most

Landsburg, Price Theory and Applications, 6 th edition Trade Without Differences David Ricardo –19 th century economist –First recognize importance of comparative advantage –Analyze consequences for mutually beneficial trade Adam Smith –18 th century economist –Described another way trade benefit all parties –Increased productivity through specialization

Landsburg, Price Theory and Applications, 6 th edition What’s Next Thorough study of tastes Incorporate tastes into study of market behavior