Continuation of Lecture 2

1
Continuation of Lecture 2
2
Checking Out

• Supermarket Model -- gather all of your purchases
  into your cart and selecting which line (in front
  of store) to pay for purchases
• Department Store Model -- pay for purchases in
  the department where the goods are located
• Snake Line Model -- Enter a single line and when
  at head of line go to first available clerk
• What do the stores have in common?
• Why do certain stores adopt one method and not
  the other?

3
7) Resources should be used efficiently to
achieve societys goals

• Efficiency -- the inability to improve one
  persons well being without hurting someone else
  (Pareto Optimality)
• If we are inefficient in our use of resources, we
  are wasting them. We could increase well-being
  (produce more) by reallocating them.
• Why would you want to deny someone additional
  welfare if it didnt hurt anyone elses welfare?
• This is a normative (value) statement in contrast
  to positive statements (statements of fact).
  What can economists say about other goals for
  society such as fairness or equity in the
  distribution of societys wealth?

4
8) Markets usually lead to efficiency

• This statement is often taken to mean that
  society (a collective decision perhaps taken by
  government) should not interfere with individual
  choice. A positive statement leading to a
  normative conclusion.
• But markets can fail to achieve an efficient
  result-- for example, congestion on the highways.

5
9) When markets are not efficient, government
intervention can lead to improvement in social
welfare

• Yet there isnt a guarantee that governments will
  improve upon the market outcome. Rather they
  hold out the possibility to improve upon the
  efficiency of the outcomes of individual choice.
• Important to remember -- it is not that
  individuals make bad choices rather the market
  has failed to coordinate their decisions

6
How is equity related to efficiency?

• There is a tradeoff between equity and efficiency
• As markets become more efficient, they are
  perceived as less equitable.
• Markets generate inequality in earnings
• Markets reward winners and punish losers
• Losing firms exit from the market
• In labor markets, the most able/talented are
  hired others accept low wage jobs or are
  unemployed

7
Equity

• What is equity?
• Equity is a value judgment that means different
  things to different people
• Equity in the distribution of income often means
  that income was earned fairly

8
Equity and Equality

• Equity is not the same thing as Equality
• A equal distribution of income means that all
  units have exactly the same income.
• Some people may define an equitable distribution
  of income as one in which all incomes are equal,
  but most Americans would not!!!
• To most Americans, incomes in an equitable
  distribution of income would vary according to
  individuals contributions to the market.
• Most Americans believe the story of the Little
  Red Hen represents equity!

9
Are markets moral?

• If markets generate distributions of income that
  are unequal, are markets moral?
• Markets are neither moral or immoral.
• Markets are amoral.
• They are simply the interactions among
  individuals
• They move toward equilibrium and
• They promise efficient use of resources.

10
Are markets moral, cont.

• The issue of morality enters the discussion of
  markets in two ways
• Did the market participants behavior morally?
• Was there a level playing field?
• Did firms collude? Fix prices? Restrict supply?
• Were individuals given equal opportunity to
  prepare themselves for market activity?

11
Are markets moral, cont.

• 2. How did society react to the situation of the
  losers?
• Were the losers supported in ways consistent with
  their dignity as human beings? (alternate
  definition of equity)
• Examine redistributive policies
• Tax policies
• Social insurance and public welfare

12
Is the market moral, cont.

• Additional reading
• Chapter 21, Taxes, Social Insurance and Income
  Distribution
• Rebecca Blank and William McGurn, Is the Market
  Moral? A Dialogue on Religion, Economics, and
  Justice. The Brookings Institution, 2003.
• National Conference of Catholic Bishops, Economic
  Justice for All Pastoral Letter on Catholic
  Social Teaching and the US Economy, 1986.

13
Summary Nine Principles

1. Resources are scarce
2. Every Choice has an Opportunity Cost
3. Choices are made at the margin
4. Individuals seek their self interest
5. There are gains from trade
6. Markets move toward equilibrium
7. Resources should be used efficiently
8. Markets usually lead to efficiency
9. When markets dont achieve efficiency, government
   intervention can improve social welfare

14
Trade-Offs and Trading

• Lecture 3

15
In Lecture 3

• Models
• Trade-Offs (Production Possibility Frontiers and
  Opportunity Cost)
• Implication for Trading and Production
  (Specialization and Comparative Advantage)

16
To Understand the Complex World, We Construct a
Simplified Model

• Models are abstractions of reality, capturing
  what is believed to be the important
  relationships
• Expressed in words, graphs, or mathematical
  equations
• Will imply a path of causation and relationship
  between variables
• Holding Everything Else Constant

17
David Ricardo (1772-1823)

• Credited with creation of the ideas of absolute
  and comparative advantage to understand trade
• Examined taxation and government spending
• Was successful in his own investing

18
What Can I Produce?

• I could produce only Wool (specialization in
  Wool)
• I could produce only Wine (specialization in
  Wine)
• Or combinations of both (efficient combinations)
• Why is the production possibility frontier (PPF)
  bowed outward?

19
A Word About Slopes

• Let Y f(X) denoted by the red line
• From the initial point (Xo,Yo)
• Consider a change in X ?X and consequently a
  change in Y ?Y
• The ratio ?Y/?X is the slope of the blue line
  drawn through the two points (Arc Method)
• For small (marginal) changes in X, the slope of
  the line tangent to the function represents the
  slope of the function (Point Method)

Y
X
20
Opportunity Cost

• The slope of the PPF tells us how much Wine we
  would have to give up to get more Wool --
  Opportunity Cost of Wool
• Assume we are producing small amounts of Wool
  (W0). The slope of the red tangency tells us the
  Opportunity Cost of Wool (how much Wine we have
  to give up). The relatively flat slope indicates
  small sacrifices of wine are required to obtain
  additional units of wool.
• Now assume we have produced more Wool (W1). The
  relatively tangency line tells us that larger
  amounts of wine must be sacrificed to obtain more
  wool than W1.
• The Opportunity Cost of Wool in terms of Wine has
  risen as we move along the PPF from A to B
• The bowing out of the PPF reflects increasing
  opportunity costs

Slope?Wine/?Wool
A
B
W0
W1
21
Alternative PPFs
Wine
Increasing Opportunity Costs
Wool
22
Economic Growth
Why would the PPF shift outward? -- more
resources land, labor, capital, and human
capital -- technological progress
23
Production and Consumption

• Assume that there are Constant Opportunity Costs
  in Wool and Wine Production in two Countries
• Britain is currently producing both wool and wine
  without trade (current production levels are
  marked)
• Consider a potential trading partners PPF,
  Portugal and their current production (neither
  country has an absolute advantage)
• Will trade between Britain and Portugal improve
  the well being in both countries?

24
Specialization and Trading

• Assume Britain decides to specialize in Wool and
  use some of their surplus wool to purchase wine
  from Portugal -- is this possible?
• If Portugal reduces its wool production by the
  same amount that Britain has increased
• Will the gain in their wine production exceed the
  loss in wine production in Britain?
• If Portugal trades their increased wine
  production for Britains increased wool
  production then Portugal continues to be able to
  consume exactly what it did prior to the
  specialization and trading but Britain can
  increase its wine consumption and still consume
  the same amount of wool -- they are better off.

25
Efficiency

• While Portugal has not gain, Britain has and so
  there has been a gain in efficiency. On this
  figure, how can we show wine and wool consumption
  that would represent both countries being made
  better off?
• Draw quadrants through each countries initial
  consumption points
• The areas in the northeast quadrants represent
  where both countries would be better off
• Less aggressive trading terms with Portugal would
  allow both countries to be made better off.
• Why do these trading patterns emerge (Portugal
  trades wine for wool)? Countries specialize in
  activities they have a comparative advantage --
  relatively lower opportunity cost of producing.

26
Adjustment Costs

• What is happening in both Britain and Portugal?
• In Britain, workers who used to work in the
  vineyards are working in wool. In Portugal,
  workers in the woolen industry will migrate to
  the vineyards.
• Is there a cost to this adjustment? There is a
  one time adjustment costs as workers have to find
  employment in other sectors of the economy but
  the benefits of trade are on going. How can a
  democratic society make these adjustments and
  impose these costs on some in order to reap the
  gains?

27
Additional Reading

• In handouts folder on web site, read the New York
  Times op-ed by Senator Schumer and Paul Craig
  Roberts and the speech by Ben Bernanke (Chair of
  the Fed) on globalization

28
The Story over Time

• Woolen manufacturing is more likely to benefit
  from technical progress compared to wine
  production
• Consequently the PPF of the country specializing
  in wool will shift out faster than the country
  specializing in wine
• Britain became wealthier while Portugal became
  relatively poorer

29
Trade and Specialization

• As individuals and countries specialize, they
  will trade for goods and services they do not
  produce. Consequently they will become dependent
  upon others for their consumption. Is this good
  or bad for countries? Can they trust each other?

30
On the Homefront

• In 1950, women made less in the paid market but
  were more productive in home production. What
  would the PPFs for males and females look like?
  Does this suggest that women would specialize in
  home production while males went to work? What
  gave women their comparative advantage?
• Over the last decades of the 1900s,
  discrimination against women in the labor force
  lessened (let us assume that our couple would
  earn the same amount if they devoted their entire
  time to market work). Would women stop cleaning
  homes?
• While women would have an absolute advantage over
  men, we would expect men to continue to devote
  themselves exclusively to market work (not to
  engage in home production). Women may engage in
  more market work using the extra income to hire
  someone to clean the home or do two shifts (at
  the home and at the office). Sharing the home
  production is not consistent with the theory of
  comparative advantage and specialization.

31
Assignment for Next Lecture

• Do Homework 2 on Homework Assignment by
  Wednesday at 5 pm
• Read Chapter 3
• Topics Next Time
• Concept of Demand and Supply