Econ 102 Notes, App. B, Ch. 2.5

how trade expands the set of consumption opportunities

(farmer)

specialization

(def.) the organization of economic activity so that what each person (or region) consumes is not identical to what that person (or region) produces. An individual may specialize, for example, in law or medicine. A nation may specialize in the production of coffee, e-book readers, or digital cameras involves working at a relatively well-defined, limited endeavor, such as accounting or teaching. Most individuals do specialize. For example, you could replace a cracked smartphone screen if you wanted to. Typically, though, you take your smartphone to a repair shop and let a technician replace the screen. *You benefit by letting the technician specialize in replacing the screen and in doing other repairs on your smartphone* The specialist normally will get the job finished sooner than you could and has the proper equipment to make the job go more smoothly. *Specialization usually leads to greater productivity, not only for each individual but also for the nation*

graphing producer surplus

*Naturally, when producers receive the same per-unit price PB for each unit supplied at point B, producers sell QB units* Consequently, producers gain surplus values—all of the vertical distances between the level of the market clearing price and the supply curve—for each unit supplied, up to the total of QB units. *In Figure B-2 above, this is equivalent to the brown-shaded area above the supply curve but below the market clearing price* *This area is the total producer surplus,* = which is the difference between the total amount that producers actually receive for an item and the total amount that they would have been willing to accept for supplying that item. (total amount producers actually receive for an item - total amount of willingness to supply that item)

gains from trade within a price system

*The concepts of consumer surplus and producer surplus can be combined to measure the gains* realized by consumers and producers from engaging in voluntary exchange. - take a look at Figure B-3. The market demand and supply curves intersect at point E, and as you have learned, at this point, the equilibrium quantity is QE. At the market clearing price PE, this is both the quantity that consumers are willing to purchase and the quantity that producers are willing to supply. At point E, the demand and supply curves intersect at the equilibrium quantity QE and the market clearing price PE. *Total consumer surplus at the market clearing price is the blue-shaded area under the demand curve but above the market clearing price. Total producer surplus is the brown-shaded area below the market clearing price but above the supply curve* *The sum of consumer surplus and producer surplus at the market clearing price constitutes the total gain to society from voluntary exchange of the quantity QE at the market clearing price PE.* - *The sum of both areas is the total value of the gains from trade*—(the sum of consumer surplus and producer surplus)—*generated by the mutually beneficial voluntary exchange of the equilibrium quantity QE at the market clearing price PE* (consumer surplus + producer surplus = total value of the gains from trade)

trade among regions

Consider the United States. The Plains states have a comparative advantage in the production of grains and other agricultural goods. Relative to the Plains states, the states to the east tend to specialize in industrialized production, such as automobiles. Not surprisingly, grains are shipped from the Plains states to the eastern states, and automobiles are shipped in the reverse direction. *Such specialization and trade allow for higher incomes and standards of living* If both the Plains states and the eastern states were separate nations, the same analysis would still hold, but we would call it international trade Indeed, the European Union (EU) is comparable to the United States in area and population, but instead of one nation, the EU has 27. What U.S. residents call interstate trade, Europeans call international trade. - *There is no difference, however, in the economic results—both yield greater economic efficiency and higher average incomes*

comparative advantage and trade among nations

Most of our analysis of absolute advantage, comparative advantage, and specialization has dealt with individuals. Nevertheless, it is equally applicable to groups of people.

graphing consumer surplus

Of course, when consumers pay the same per-unit price PA for every unit of this product that they purchase at point A, they obtain QA units. Thus, consumers gain surplus values—all of the vertical distances between the demand curve and the level of the market clearing price—for each unit consumed, up to the total of QA units Graphically, this is equivalent to the blue-shaded area under the demand curve *but above the market clearing price* This entire (blue) area equals the *total consumer surplus*, which is the difference between the total amount that consumers would have been willing to pay for an item and the total amount that they actually pay.

price controls and gains from trade

How do price controls affect gains from trade? Consider first the effects of imposing a ceiling price that is lower than the market clearing price. As you learned in an earlier chapter, the results are an increase in quantity demanded and a decrease in quantity supplied, so a shortage occurs. *Thus, consumers are able to purchase fewer units, and this means that consumer surplus may be lower than it would have been without the government's price ceiling* - Furthermore, because firms sell fewer units at the lower ceiling price, producer surplus definitely decreases. Thus, *the government's imposition of the price ceiling tends to reduce gains from trade* ///////////////////////////////////////// Now consider the effects of the establishment of a price floor above the market clearing price of a good. - The effects of imposing such a floor price are an increase in the quantity supplied and a decrease in the quantity demanded. (surplus) The smaller quantity demanded by consumers is the amount actually traded in the market. - Thus, consumers purchase fewer units of the good, resulting in a reduction in consumer surplus. In addition, firms sell fewer units, so producer surplus may decrease. Hence, *the establishment of a price floor also tends to reduce gains from trade*

absolute advantage vs comparative advantage

If all of these self-perceptions were really true, then you would have an absolute advantage in all of these endeavors. (based on flashcard #14) In other words, if you were to spend a given amount of time in any one of them, you could produce more than anyone else in the company Nonetheless, you would NOT spend your time doing these other activities. Why not? Because *your time advantage in undertaking the president's managerial duties is even greater*. = *Therefore, you would find yourself specializing in that particular task even though you have an absolute advantage in all these other tasks* - Indeed, absolute advantage is irrelevant in predicting how you will allocate your time. *Only comparative advantage, not absolute advantage, matters in determining how you will allocate your time*. Comparative advantage determines your choice because it involves the highest-valued alternative in a decision about time allocation.

the division of labor

In any firm that includes specialized human and nonhuman resources, there is a division of labor among those resources. *The best-known example comes from Adam Smith (1723-1790), who in The Wealth of Nations illustrated the benefits of a division of labor in the making of pins, as depicted in the following example*: - "One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper." Making pins this way allowed 10 workers without very much skill to make almost 48,000 pins "of a middling size" in a day. One worker, toiling alone, could have made perhaps 20 pins a day. Therefore, 10 workers could have produced 200. Division of labor allowed for an increase in the daily output of the pin factory from 200 to 48,000! (Smith did not attribute all of the gain to the division of labor but credited also the use of machinery and the fact that less time was spent shifting from task to task.) *What we are discussing here involves a division of the resource called labor into different uses of labor*. *The different uses of labor are organized in such a way as to increase the amount of output possible from the fixed resources available*. We can therefore talk about an organized division of labor within a firm leading to increased output.

Adam Smith

In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith performed a detailed analysis of trade and economic interdependence, which economists still adhere to today.

David Ricardo

In his 1816 book Principles of Political Economy and Taxation, *David Ricardo developed the principle of comparative advantage as we know it today*

CONSUMER surplus

Let's first examine how economists measure the benefits that consumers gain from engaging in market transactions in the price system We begin by assuming that consumers face a per-unit price of this item given by PA. Thus, the quantity demanded of this particular product is equal to QA at point A on the demand curve. If the per-unit price is PA, then at point A on the demand curve D, consumers desire to purchase QA units. To purchase Q1 units of this item, consumers would have been willing to pay the price P1 for the last unit purchased, but they have to pay only the per-unit price PA, so they gain a surplus equal to P1−PA for the last of the Q1 units purchased. Likewise, to buy the last of the Q2 units, consumers would have been willing to pay the price P2, so they gain the surplus equal to P2−PA for the last of the Q2 units purchased. *Summing these and all other surpluses that consumers receive from purchasing each of the QA units at the price PA, yields the total consumer surplus at this price, shown by the blue-shaded area*

international aspects of trade

Political problems that normally do not occur within a particular nation often arise between nations - For example, if California avocado growers develop a cheaper method of producing avocados than growers in southern Florida use, the Florida growers will lose out. They cannot do much about the situation except try to lower their own costs of production or improve their product. If avocado growers in Mexico, however, develop a cheaper method of producing avocados, both California and Florida growers can (and likely will) try to raise political barriers that will prevent Mexican avocado growers from freely selling their product in the United States. - U.S. avocado growers will use such arguments as "unfair" competition and loss of U.S. jobs. Certainly, avocado-growing jobs may decline in the United States, but there is no reason to believe that U.S. jobs will decline overall. Instead, former U.S. avocado workers will move into alternative employment—something that 1 million people do every week in the United States. If the argument of U.S. avocado growers had any validity, every time a region in the United States developed a better way to produce a product manufactured somewhere else in the country, U.S. employment would decline. *That has never happened and never will* *When nations specialize in an area of comparative advantage and then trade with the rest of the world, the average standard of living in the world rises* - *In effect, international trade allows the world to move from inside the global production possibilities curve toward the curve itself, thereby improving worldwide economic efficiency*. Thus, all countries that engage in trade can benefit from comparative advantage, just as regions in the United States benefit from interregional trade.

comparative advantage

Specialization occurs because different individuals experience different costs when they engage in the same activities. Some individuals can accurately solve mathematical problems at lower cost than others who might try to solve the same problems. Thus, those who solve math problems at lower cost sacrifice production of fewer alternative items. Some people can develop more high-quality iPad applications than others while giving up less production of other items, such as clean houses and neatly manicured yards. (def.) the ability to produce a good or service at a lower opportunity cost than other producers is the ability to perform an activity at a lower opportunity cost. You have a comparative advantage in one activity whenever you have a lower opportunity cost of performing that activity. *Comparative advantage is always a relative concept* You may be able to change the oil in your car. You might even be able to change it faster than the local mechanic. But if the opportunity cost you face by changing the oil exceeds the mechanic's opportunity cost, the mechanic has a comparative advantage in changing the oil. The mechanic faces a lower opportunity cost for that activity. You may be convinced that everybody can do more of everything than you can during the same period of time and using the same resources. In this extreme situation, do you still have a comparative advantage? The answer is yes. You do not have to be a mathematical genius to figure this out. The market tells you so very clearly by offering you the highest income for the job for which you have a comparative advantage. Stated differently, to find your comparative advantage, simply find the job that maximizes your income.

absolute advantage

Suppose you are the president of a firm and are convinced that you have the ability to do every job in that company faster than everyone else who works there. You might be able to enter data into a spreadsheet program faster than any of the other employees, file documents in order in a file cabinet faster than any of the file clerks, and wash windows faster than any of the window washers. Furthermore, you are able to manage the firm more effectively in less time than any other individual in the company.

naval economics: production possibilities for weapons and ships

The Navy must utilize a fixed set of available resources to produce ships and weapons. Thus, as shown in Figure 2-6, the Navy confronts a production possibilities curve denoted PPC1. Along this curve, it currently produces a specific combination of ships and weapons, such as point A. Initially, the U.S. Navy produces the current combination of ships, S1 and W1, at point A on the production possibilities curve PPC1. After adopting a new technology for producing weapons, the production possibilities curve PPC2 is applicable. - Its altered slope indicates that the opportunity cost of producing weapons, in terms of forgone production of ships, has decreased. At point B on this new PPC, the Navy can now produce more ships than at point A while maintaining the same production of weapons. At point A, the Navy cannot feasibly produce any more than S1 ships if it continues to produce W1 weapons. This fact poses a problem for the Navy, which desires to expand production of ships while continuing to produce the same number of weapons. Clearly, at point A in Figure 2-6, the Navy cannot, using unchanged resources, increase ship production beyond S1 while still producing W1 weapons unless it finds a way to expand its production possibilities.

a weapons technology is moving the Navy's PPC (production possibilities curve)

The Navy recently has found a way to try to satisfy its goal by replacing its traditional missiles technology with a new weapons-system technology. *This new technology for propelling explosive force onto a target is called a rail gun system*, which functions much like ship-borne cannons of the nineteenth century that fired inert cannonballs. Indeed, rail-gun projectiles typically weigh as little as 25 pounds—about the same as a nineteenth-century cannonball. The difference is that rail guns propel projectiles at seven times the speed of sound. The force created by the impacts of these high-speed projectiles at target locations can be just as damaging as the forces generated by missiles. - The expense for a typical rail-gun projectile, however, is about 97 percent less than for a missile. This fact implies that the Navy no longer has to give up production of as many ships in order to produce additional weapons. *As shown in Figure 2-6, adopting the new weapons technology has altered the slope of the PPC in such a way that fewer ships must be given up to produce additional weapons* The Navy can now produce at a point B on the new curve PPC2. *At point B, the Navy can produce as many weapons, W1, as it could at point A* At the now-feasible point B on PPC2, though, the Navy can produce a larger number of ships, S2. *Hence, by employing its rail-gun technology, the Navy can expand its fleet of ships while continuing to produce the SAME number of weapons as before*

understanding comparative advantage vs. absolute advantage

The coaches of sports teams often have to determine the comparative advantage of an individual player who has an absolute advantage in every aspect of the sport in question. Babe Ruth, who could hit more home runs and pitch more strikeouts per game than other players on the Boston Red Sox, was a pitcher on that professional baseball team. After Ruth was traded to the New York Yankees, the owner and the manager decided to make him an outfielder, even though he could also pitch more strikeouts per game than other Yankees. They wanted "The Babe" to concentrate on his hitting because a home-run king would bring in more paying fans than a good pitcher would. Babe Ruth had an absolute advantage in both aspects of the game of baseball, but his comparative advantage was clearly in hitting homers rather than in practicing and developing his pitching game.

absolute advantage

The comparison among producers of a good according to their productivity - absolute advantage Describes the productivity of one person, firm, or nation compared to that of another. *The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good*

Willingness to pay

The demand curve also tells us the price that consumers are willing to pay for a unit of output at various possible quantities. For instance, if consumers buy Q1 units of this good, they will be willing to pay a price equal to P1 for the last unit purchased. If they have to pay only the price PA for each unit they buy, however, consumers gain an amount equal to P1−PA for the last of the units Q1 purchased. This benefit to consumers equals the vertical distance between the demand curve and the level of the market clearing price. - *Economists call this vertical distance a surplus value to consumers from being able to consume the last of the Q1 units at the lower, market clearing price* Likewise, if consumers purchase Q2 units of this good, they will be willing to pay a price equal to P2 for the last unit. Nevertheless, because they have to pay only the price PA for each unit purchased, consumers gain an amount equal to P2−PA. Hence, this is the surplus associated with the last of the Q2 units that consumers buy.

Willingness to sell

The market supply curve tells us the quantities that all producers are willing to sell at each possible price. At the same time, the supply curve also indicates the price that producers are willing to accept to sell a unit of output at various possible quantities. For example, if producers sell Q3 units of this good, they will be willing to accept a price equal to P3 for the last unit sold. If they receive the price PB for each unit they supply, however, producers gain an amount equal to PB−P3 for the last of the Q3 units sold. This benefit to producers equals the vertical distance between the supply curve and the market clearing price, which is a surplus value from being able to provide the last of the Q3 units at the higher, market clearing price. Similarly, if producers supply Q4 units of this good, they will be willing to accept a price equal to P4 for the last unit. Producers actually receive the price PB for each unit supplied, however, so they gain an amount equal to PB−P4. Hence, this is the surplus gained from supplying the last of the Q4 units.

PRODUCER surplus

To consider how economists measure the benefits to producers from supplying goods and services in exchange, look at Figure B-2, which displays a market supply curve, S. - Let's begin by assuming that suppliers face a per-unit price of this item given by PB - Thus, the quantity supplied of this particular product is equal to QB at point B on the supply curve. If the per-unit price is PB, then at point B on the supply curve S, producers are willing to supply QB units. To sell Q3 units of this item, producers would have been willing to receive the price P3 for the last unit sold, but instead they accept the higher per-unit price PB, so they gain a surplus equal to PB−P3 for the last of the Q3 units sold. Similarly, producers would have been willing to accept P4 to provide Q4 units, so they gain the surplus equal to PB−P4 for the last of the Q4 units sold. - *Summing these and all other surpluses that producers receive from supplying each of the QB units at the price PB yields the total producer surplus at this price, shown by the brown-shaded area*

scarcity, self-interest, and specialization

To repeat, for the purposes of our analyses we assume that individuals are rational in that they will do what is in their own self-interest. - They will not consciously carry out actions that will make them worse off. In this chapter, you learned that scarcity requires people to make choices. We assume that they make choices based on their self-interest. When people make choices, they attempt to maximize benefits net of opportunity cost. = In so doing, individuals choose their comparative advantage and end up specializing.

differences in costs of production

Two ways to measure differences in costs of production: 1. The number of hours required to produce a unit of output (for example, one pound of potatoes). 2. The opportunity cost of sacrificing one good for another.

patterns of production and trade

are based upon differences in opportunity costs.

comparative advantage and differences in opportunity costs

are the basis for specialized production and trade. Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade.

consumer surplus

is the buyer's willingness to pay for a good minus the amount the buyer actually pays for it. It measures the benefit that buyers receive from a good as the buyers themselves perceive it.

interdependence

occurs because people are better off when they specialize and trade with others.

how trade expands the set of consumption opportunities (contd.)

rancher

consumer surplus (def.)

the difference b/w the total amount that consumers would have been willing to pay for an item and the total amount that they actually pay (total amount of consumer willingness - actual total amount of pay)

producer surplus

the difference b/w the total amount that producers actually receive for an item and the total amount that they would have been willing to accept for supplying that item

division of labor

the segregation of resources into different specific tasks. For instance, one automobile worker puts on bumpers, another doors, and so on

gains from trade

the sum of consumer surplus and producer surplus