AP Economics Intro

Second Objection: People, Firms, and Society Should Not Act This Way

1. The economics approach portrays people as self-interested. For some critics of this approach, even if self-interest is an accurate description of how people behave, these behaviors are not moral. Instead, the critics argue that people should be taught to care more deeply about others. 2. Second, self-interested behavior and profit-seeking can be labeled with other names, such as personal choice and freedom. 3. But, self-interested behavior can lead to positive social results. For example, when people work hard to make a living, they create economic output. Consumers who are looking for the best deals will encourage businesses to offer goods and services that meet their needs. 4. also, even people who focus on their own self-interest in the economic part of their life often set aside their own narrow self-interest in other parts of life.

absolute advantage

A country has an absolute advantage in producing a good over another country if it uses fewer resources to produce that good. Absolute advantage can be the result of a country's natural endowment. For example, extracting oil in Saudi Arabia is pretty much just a matter of "drilling a hole." The United States has some of the richest farmland in the world, making it easier to grow corn and wheat than in many other countries. Guatemala and Colombia have climates especially suited for growing coffee. Chile and Zambia have some of the world's richest copper mines.As some have argued, "geography is destiny." Chile will provide copper and Guatemala will produce coffee, and they will trade. Absolute advantage simply compares the productivity of a worker between countries

Benefits of International Trade

Ben Franklin: "No nation was ever ruined by trade." Many economists would express their attitudes toward international trade in an even more positive manner. The evidence that international trade confers overall benefits on economies is pretty strong. Trade has accompanied economic growth in the United States and around the world. There is no modern example of a country that has shut itself off from world trade and yet prospered. To understand the benefits of trade, or why we trade in the first place, we need to understand the concepts of comparative and absolute advantage.

Essential themes: Scarcity

Good and services are limited, so we can't have all that we desire.

Specialization

The U.S. Economy, after Specialization, Will Benefit If It: Exports no more than 60 bushels of corn Imports at least 20 barrels of oil The Saudi Arabian Economy, after Specialization, Will Benefit If It: Exports less than 60 barrels of oil Imports at least 10 bushels of corn The underlying reason why trade benefits both sides is rooted in the concept of opportunity cost. Recall that David Ricardo argued that if each country specializes in its comparative advantage, it will benefit from trade, and total global output will increase.

First Objection to Economics: People, Firms, and Society Do Not Act Like This

The economic approach to decision-making seems to require more information than most individuals possess and more careful decision-making than most individuals actually display

iPhone and Samsung as competitors and supplier

The iPhone is a global product. Apple does not manufacture the iPhone components, nor does it assemble them. The assembly is done by Foxconn Corporation, a Taiwanese company, at its factory in Sengzhen, China. But, Samsung, the electronics firm and competitor to Apple, actually supplies many of the parts that make up an iPhone—about 26%. That means, that Samsung is both the biggest supplier and biggest competitor for Apple. Why do these two firms work together to produce the iPhone? To understand the economic logic behind international trade, you have to accept, as these firms do, that trade is about mutually beneficial exchange. Samsung is one of the world's largest electronics parts suppliers. Apple lets Samsung focus on making the best parts, which allows Apple to concentrate on its strength—designing elegant products that are easy to use. If each company (and by extension each country) focuses on what it does best, there will be gains for all through trade.

Law of Diminishing Returns

The law of diminishing returns holds that as increments of additional resources are devoted to producing something, the marginal increase in output will become smaller and smaller. When government spends a certain amount more on reducing crime, for example, the original gains in reducing crime could be relatively large. But additional increases typically cause relatively smaller reductions in crime, and paying for enough police and security to reduce crime to nothing at all would be tremendously expensive. The curvature of the production possibilities frontier shows that as additional resources are added to education, moving from left to right along the horizontal axis, the original gains are fairly large, but gradually diminish. Similarly, as additional resources are added to healthcare, moving from bottom to top on the vertical axis, the original gains are fairly large, but again gradually diminish. In this way, the law of diminishing returns produces the outward-bending shape of the production possibilities frontier

Difference between budget constraint and PPF

There are two major differences between a budget constraint and a production possibilities frontier. The first is the fact that the budget constraint is a straight line. This is because its slope is given by the relative prices of the two goods. In contrast, the PPF has a curved shape because of the law of the diminishing returns. The second is the absence of specific numbers on the axes of the PPF. There are no specific numbers because we do not know the exact amount of resources this imaginary economy has, nor do we know how many resources it takes to produce healthcare and how many resources it takes to produce education.

What happens to the possibilities for trade if one country has an absolute advantage in everything?

This is typical for high-income countries that often have well-educated workers, technologically advanced equipment, and the most up-to-date production processes. These high-income countries can produce all products with fewer resources than a low-income country. If the high-income country is more productive across the board, will there still be gains from trade? Even when one country has an absolute advantage in all products, trade can still benefit both sides. This is because gains from trade come from specializing in one's comparative advantage Country Workers needed to produce 1,000 units — Shoes Refrigerators United States 4 workers 1 worker Mexico 5 workers 4 workers So, the comparative advantage of the United States, where its absolute productivity advantage is relatively greatest, lies with refrigerators, and Mexico's comparative advantage, where its absolute productivity disadvantage is least, is in the production of shoes.

Comparative advantage metaphor of camping

To build an intuitive understanding of how comparative advantage can benefit all parties, set aside examples that involve national economies for a moment and consider the situation of a group of friends who decide to go camping together. The six friends have a wide range of skills and experiences, but one person in particular, Jethro, has done lots of camping before and is also a great athlete. Jethro has an absolute advantage in all aspects of camping: he is faster at carrying a backpack, gathering firewood, paddling a canoe, setting up tents, making a meal, and washing up. So here is the question: Because Jethro has an absolute productivity advantage in everything, should he do all the work? Of course not! Even if Jethro is willing to work like a mule while everyone else sits around, he, like most mortals, only has 24 hours in a day. If everyone sits around and waits for Jethro to do everything, not only will Jethro be an unhappy camper, but there will not be much output for his group of six friends to consume. The theory of comparative advantage suggests that everyone will benefit if they figure out their areas of comparative advantage—that is, the area of camping where their productivity disadvantage is least, compared to Jethro. For example, it may be that Jethro is 80% faster at building fires and cooking meals than anyone else, but only 20% faster at gathering firewood and 10% faster at setting up tents. In that case, Jethro should focus on building fires and making meals, and others should attend to the other tasks, each according to where their productivity disadvantage is smallest. If the campers coordinate their efforts according to comparative advantage, they can all gain.

Globalization

We live in a global marketplace. We are all linked by international trade, and the volume of that trade has grown dramatically in the last few decades. The food on your table might include fresh fruit from Chile, cheese from France, and bottled water from Scotland. Your wireless phone might have been made in Taiwan or Korea. The clothes you wear might be designed in Italy and manufactured in China. The toys you give to a child might have come from India. The car you drive might come from Japan, Germany, or Korea. This first wave of globalization crashed to a halt in the beginning of the twentieth century. World War I severed many economic connections. During the Great Depression of the 1930s, many nations misguidedly tried to fix their own economies by reducing foreign trade with others. World War II further hindered international trade. Global flows of goods and financial capital rebuilt themselves only slowly after World War II. It was not until the early 1980s that global economic forces again became as important, relative to the size of the world economy, as they were before World War I.

Comparative Advantage

When a country can produce a good at a lower opportunity cost than another country, we say that this country has a comparative advantage in that good Countries tend to have different opportunity costs of producing a specific good, either because of different climates, geography, technology or skills. Due to its climatic conditions, Brazil can produce a lot of sugar cane per acre but not much wheat. Conversely, the U.S. can produce a lot of wheat per acre, but not much sugar cane. Clearly, Brazil has a lower opportunity cost of producing sugar cane (in terms of wheat) than the U.S. The reverse is also true; the U.S. has a lower opportunity cost of producing wheat than Brazil. When countries engage in trade, they specialize in the production of the goods that they have comparative advantage in, and trade part of that production for goods they do not have comparative advantage in. Total production can increase if countries specialize in the goods they have comparative advantage in and trade some of their production for the remaining goods.

comparative advantage

a country has a comparative advantage when a good can be produced at a lower cost in terms of other goods. Another way of looking at this is that comparative advantage identifies the good for which the producer's absolute advantage is relatively larger, or where the producer's absolute productivity disadvantage is relatively smaller. The question each country or company should be asking when it trades is this: "What do we give up to produce this good?" (opportunity cost) For example, if Zambia focuses its resources on producing copper, its labor, land and financial resources cannot be used to produce other goods such as corn Country Oil Corn Saudi Arabia 100 or 25 United States 50 or 100 Opportunity cost Country Oil Corn Saudi Arabia ¼ 4 United States 2 ½ Since Saudi Arabia gives up the least to produce a barrel of oil, (14 < 2 in Table) it has a comparative advantage in oil production. The United States gives up the least to produce a bushel of corn, so it has a comparative advantage in corn production.

Production Possibility Frontier (PPF)

a diagram that shows the productively efficient combinations of two products that an economy can produce given the resources it has available. A production possibilities frontier defines the set of choices society faces for the combinations of goods and services it can produce given the resources available. The shape of the PPF is typically curved outward, rather than straight. Choices outside the PPF are unattainable and choices inside the PPF are wasteful. Over time, a growing economy will tend to shift the PPF outwards. Because society has limited resources (e.g., labor, land, capital, raw materials) at any point in time, there is a limit to the quantities of goods and services it can produce. Suppose a society desires two products, healthcare and education. This situation is illustrated by the production possibilities frontier This production possibilities frontier shows a tradeoff between devoting social resources to healthcare and devoting them to education. At A all resources go to healthcare and at B, most go to healthcare. At D most resources go to education, and at F, all go to education.

Normative Economics

describes how the world should be Another economist argues for extended unemployment compensation during the Great Depression because a rich country like the United States should take care of its less fortunate citizens—an example of normative analysis

Positive Economics

describes the world as it is For example, an economist could analyze a proposed subway system in a certain city. If the expected benefits exceed the costs, he concludes that the project is worth doing—an example of positive analysis.

Essential themes: Economic efficiency

getting the most benefit from scarce resources

Productive Efficiency

given the available inputs and technology, it is impossible to produce more of one good without decreasing the quantity that is produced of another good.

Invisible hand

idea that self-interested behavior by individuals can lead to positive social outcomes

Essential themes: Tradeoffs

it is necessary to give up some of one good to gain more of the other good.

Allocative efficiency

the particular mix of goods a society produces represents the combination that society most desires. How to determine what a society desires can be a controversial question, and is usually discussed in political science, sociology, and philosophy classes as well as in economics. At its most basic, allocative efficiency means producers supply the quantity of each product that consumers demand. Only one of the productively efficient choices will be the allocatively efficient choice for society as a whole.

David Ricardo

wrote a treatise called On the Principles of Political Economy and Taxation. In this treatise, Ricardo argued that specialization and free trade benefit all trading partners, even those that may be relatively inefficient. To see what he meant, we must be able to distinguish between absolute and comparative advantage.