SURVEY OF ECONOMIC THEORY

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SURVEY OF ECONOMIC THEORY

• LECTURE 3

Microsoft
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SURVEY OF ECONOMIC ANALYSIS

• LECTURE 3

VOLUNTARY EXCHANGE AT THE RUDIMENTARY LEVEL
Microsoft
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Quote from Adam Smith
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Basis of Free Exchange

• THIS division of labour, from which so many
  advantages are derived, is not originally the
  effect of any human wisdom, which foresees and
  intends that general opulence to which it gives
  occasion. It is the necessary, though very slow
  and gradual consequence of a certain propensity
  in human nature which has in view no such
  extensive utility the propensity to truck,
  barter, and exchange one thing for another.

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• Whether this propensity be one of those original
  principles in human nature of which no further
  account can be given or whether, as seems more
  probable, it be the necessary consequence of the
  faculties of reason and speech, it belongs not to
  our present subject to inquire.
• It is common to all people, and to be found in no
  other race of animals, which seem to know neither
  this nor any other species of contracts.
• Wealth of Nations, Adam Smith

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GAIN FROM TRADE OR EXCHANGE

• TRULY VOLUNTARY TRADE OR EXCHANGE BENEFITS
  EVERYONE INVOLVED.
• IN THE EXCHANGE PROCESS , PEOPLE REVEAL THEIR
  TRUE PREFERENCES BY WHAT THEY DO -- AN ACTION --
  NOT BY WHAT THEY SAY.
• Consumer Surplus difference between the price a
  consumer is willing to pay for a good or service
  and what she/he actually pays for it.
• Supplier Surplus difference between what a
  supplier (producer) would sell a good or service
  for and what he/she actually sells it for.

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• Each person driven by incentives results in
  benefits to all.
• Organizing force of exchange process. The
  exchange process is the organizing force.
• Invisible hand operates through the exchange
  process.
• Results in the efficient use of resources

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• Imagine that there are two goods in the world-
  meat and potatoes. And that there are two people
  in the world a cattle rancher and a farmer each
  of whom would like to eat meat and potatoes.
• The gains from trade are most obvious if the
  rancher can produce only meat and the farmer can
  produce only potatoes.
• In one scenario, the rancher and the farmer could
  choose to have nothing to do with each other in
  which case the rancher would eat only meat and
  the farmer would eat only potatoes.

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• Suppose more realistically that the potato farmer
  is able to raise cattle and produce meat but that
  he is not very good at it. Further suppose that
  the rancher can produce potatoes but not very
  productively. In this situation there is
  obviously an incentive for exchange.
• Exchange can take place even if one party is
  better at producing both goods.
• This is the basis of the law of comparative
  advantage.

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Production Possibilities
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• Suppose that the farmer and the rancher each work
  40 hours a week and can the devote this time to
  growing potatoes, raising cattle, or a
  combination of the two.
• The amount of time each person requires to
  produce one pound of each good is shown in the
  table on the next slide.

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Production Possibilities
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Farmer has 40 hours
20 hours to produce 1 lb of meat
10 hours to produce 1 lb of potatoes
2 lbs of meat in 40 hours
4lbs of potatoes In 40 hours
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Farmer has 40 hours
20 hours to produce 1 lb of meat
10 hours to produce 1 lb of potatoes
2 lbs of meat in 40 hours
4lbs of potatoes In 40 hours
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Farmer has 40 hours
20 hours to produce 1 lb of meat
10 hours to produce 1 lb of potatoes
2 lbs of meat in 40 hours
4lbs of potatoes In 40 hours
Rancher has 40 hours
1 hour to produce 1 lb of meat
8 hours to produce 1 lb of potatoes
5lbs of potatoes In 40 hours
40 lbs of meat in 40 hours
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Farmer has 40 hours
20 hours to produce 1 lb of meat
10 hours to produce 1 lb of potatoes
2 lbs of meat in 40 hours
4lbs of potatoes In 40 hours
Rancher has 40 hours
1 hour to produce 1 lb of meat
8 hours to produce 1 lb of potatoes
5lbs of potatoes In 40 hours
40 lbs of meat in 40 hours
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Production Possibilities Functions of the Farmer
and the Rancher
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Farmers Production Possibilities Frontier
Meat lbs
2
A
1
0
2
4
Potatoes lbs
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Farmers Production Possibilities Frontier
Meat lbs
2
A
1
0
2
4
Potatoes lbs
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Ranchers Production Possibilities Frontier
Meat lbs
40
B
20
0
2.5
5
Potatoes lbs
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Ranchers Production Possibilities Frontier
Meat lbs
40
B
20
2.5
0
5
Potatoes lbs
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In the first diagram if the farmer devotes all
40 hours of his time to producing potatoes then
he can produce 4 lbs. of potatoes and no meat. If
he devotes all his time to producing meat he
produces 2 lbs. of meat and no potatoes. If the
farmer divides his time equally between the two
activities, spending 20 hours on each, he
produces 2 lbs. of potatoes and 1 lb. and of
meat. In the second diagram if the rancher
devotes all 40 hours of her time to producing
potatoes she can produce 5 lbs. of potatoes and
no meat. If she devotes all of her time to meat,
she can produce 40 lbs. of meat and no potatoes.
If the rancher divides her time equally, spending
20 hours on each activity, she produces 2.5 lbs.
of potatoes and 20 lbs. of meat. If the farmer
and the rancher chose to be self-sufficient,
rather than trade with each other, then each
consumes exactly what he or she produces. In
this case, The production possibilities frontier
is also the consumption possibilities frontier.
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Specialization and Trade

• Consider this conversation between the farmer and
  the rancher.
• Rancher

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Specialization and Trade

• Consider this conversation between the farmer and
  the rancher.
• Rancher farmer my friend have I got a deal for
  you. I know how to improve life for both of us.
• I think you should stop producing meat
  altogether and devote all your time to producing
  potatoes.According to my calculations, if you
  devote 40 hours a week growing potatoes you will
  produce 4 lbs. potatoes.

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• If you give me 1 pounds of those 4 lbs., I will
  give you 3 lbs. of meat in return. In the end,
  you will get to eat 3 lbs. of potatoes and 3 lbs.
  of meat every week, instead of the 2 lbs of
  potatoes and 1 lb of meat you now get. If you go
  along with my plan you will have more of both
  foods.
• Farmer

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• If you give me 1 pounds of those 4 lbs., I will
  give you 3 lbs. of meat in return. In the end,
  you will get to eat 3 lbs. of potatoes and 3 lbs.
  of meat every week, instead of the 2 lbs of
  potatoes and 1 lb of meat you now get. If you go
  along with my plan you will have more of both
  foods.
• Farmer That seems like a good deal to me. But I
  dont understand why youre offering it. If the
  deal is so good for me, it cant be good for you
  too. Can it?

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• Rancher

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• Rancher If I spend 24 hours a week raising
  cattle and 16 hours growing potatoes, I will
  produce 24 lbs. of meat and 2 lbs of potatoes.
  After I give you 3 lbs. of meat in exchange for 1
  lb of potatoes, I will have 21 lbs of meat and 3
  lbs. of potatoes. In the end, I will also get
  more of both foods than I have now.
• Farmer

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• Rancher If I spend 24 hours a week raising
  cattle and 16 hours growing potatoes, I will
  produce 24 lbs. of meat and 2 lbs of potatoes.
  After I give you 3 lbs. of meat in exchange for 1
  lb of potatoes, I will have 21 lbs of meat and 3
  lbs. of potatoes. In the end, I will also get
  more of both foods than I have now.
• Farmer I dont know. This sounds too good to
  be true.
• The following diagrams illustrate the production
  possibilities and consumption possibilities.

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Farmers Production Possibilities Frontier
Meat lbs
Farmers consumption with trade A point on the
consumption possibilities curve
A
3
2
Farmers consumption without trade
A
1
3
2
4
Potatoes lbs
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Ranchers Production Possibilities Frontier
Meat lbs
40
Ranchers consumption with trade A point on the
consumption possibilities curve
B
21
20
B
Ranchers consumption without trade
2.5
5
3
Potatoes lbs
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Absolute Advantage

• Economist use the term absolute advantage when
  comparing the productivity one person, firm, or
  nation to that of another. The producer that
  requires a smaller quantity of inputs to produce
  a good is said to have an absolute managing
  producing that good.

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Absolute Advantage
Meat lbs
40
Rancher
2
Farmer
4
5
Potatoes lbs
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Opportunity Cost and Comparative Advantage

• Economist use the term comparative advantage when
  describing the opportunity costs of two
  producers.
• The producer who has the smaller opportunity cost
  of producing a good is said to have a comparative
  advantage in producing that good.

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• In our example, the farmer has a lower
  opportunity cost of producing potatoes than the
  rancher ( 0.5 lbs. versus 8 lbs. of meat). The
  rancher has a lower opportunity cost of producing
  meat than the farmer ( 1/8 lbs. versus 2 lbs. of
  potatoes). Thus the farmer has a comparative
  advantage in growing potatoes, and the rancher
  has a comparative advantage in producing meat.
• The table in the next slide illustrates the
  opportunity cost.

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Opportunity Cost
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Opportunity Cost
Potatoes are Relatively Cheap
Meat is Relatively Cheap
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• "What is prudence in the conduct of every
  private family, can scarce be folly in that of a
  great kingdom. If a foreign country can supply
  us with a commodity cheaper than we ourselves can
  make it, better buy it of them with some part of
  the produce of our own industry, employed in a
  way in which we have some advantage. The general
  industry of the country, being always in
  proportion to the capital which employs it, will
  not therby be diminished... but only left to find
  out the way in which it can be employed with the
  greatest advantage.
• (Adam Smith, The Wealth of Nations, Book IV2,
  Modern Library edition)

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LAW OF COMPARATIVE ADVANTAGE

• Individuals and countries tend to specialize in
  producing those goods in which they are
  relatively, not absolutely, more efficient.
• Trade can benefit everyone in society because it
  allows people to specialize in activities in
  which they have a comparative.

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Advantages and Disadvantages of Specialization
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Adam Smiths Pin Factory

• To take an example, therefore, from a very
  trifling manufacture but one in which the
  division of labour has been very often taken
  notice of, the trade of the pin-maker a person
  not educated to this business (which the division
  of labour has rendered a distinct trade), nor
  acquainted with the use of the machinery employed
  in it (to the invention of which the same
  division of labour has probably given occasion),
  could scarce, perhaps, with his utmost industry,
  make one pin in a day, and certainly could not
  make twenty. But in the way in which this
  business is now carried on, not only the whole
  work is a peculiar trade, but it is divided into
  a number of branches, of which the greater part
  are likewise peculiar trades. One person draws
  out the wire, another straights 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 and the important business
  of making a pin is, in this manner, divided into
  about

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• eighteen distinct operations, which, in some
  manufactories, are all performed by distinct
  hands, though in others the same person will
  sometimes perform two or three of them. I have
  seen a small manufactory of this kind where ten
  people only were employed, and where some of them
  consequently performed two or three distinct
  operations. But though they were very poor, and
  therefore but indifferently accommodated with the
  necessary machinery, they could, when they
  exerted themselves, make among them about twelve
  pounds of pins in a day. There are in a pound
  upwards of four thousand pins of a middling size.
  Those ten persons, therefore, could make among
  them upwards of forty-eight thousand pins in a
  day. Each person, therefore, making a tenth part
  of forty-eight thousand pins, might be considered
  as making four thousand eight hundred pins in a
  day. But if they had all wrought separately and
  independently, and without any of them having
  been educated to this peculiar business, they
  certainly could not each of them have made
  twenty, perhaps not one pin in a day that is,
  certainly, not the two hundred and fortieth,
  perhaps not the four thousand eight hundredth
  part of what they are at present capable of
  performing, in consequence of a proper division
  and combination of their different operations.

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WHY SPECIALIZATION INCREASES PRODUCTIVITY

• Avoids time wasted in switching between tasks in
  the production process.
• Repetition improves worker skills --worker
  productivity.
• Creates a fertile environment for inventions.

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LIMITS OF SPECIALIZATION

• Specialization is limited by the extent of the
  market.
• Repetition may lead to bored/unproductive workers
• Cross-fertilization between different jobs may
  result in new ideas and innovations.
• Specialization in a high-technology society can
  be risky for individual workers Life-long
  learning concept.

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Issues About Efficiency and Equity of the
Exchange Process

• Asymmetrical information
• Distribution of gains from an exchange
• Interference with the exchange process and gain
  from trade

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COMPARATIVE ADVANTAGE ANOTHER EXAMPLE
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COMPARATIVE COST OF PRODUCING COMPUTERS AND WHEAT

• U.S.
  JAPAN
• LABOR REQUIRED
• FOR 1 COMPUTERS 100
  120
• LABOR REQUIRED
• FOR 1 UNIT WHEAT 5
  8
• RELATIVE TIME TO
• PRODUCE A COMPUTER (100/5) 20x
  (120/8) 15x

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COMPARATIVE COST OF PRODUCING COMPUTERS AND WHEAT

• U.S.
  JAPAN
• LABOR REQUIRED
• FOR COMPUTERS 100
  120
• LABOR REQUIRED
• FOR WHEAT
  5 8
• RELATIVE TIME TO
• PRODUCE A COMPUTER (100/5) 20x
  (120/8) 15x

WHEAT PRICE OF A COMPUTER IN U.S.
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COMPARATIVE COST OF PRODUCING COMPUTERS AND WHEAT

• U.S.
  JAPAN
• LABOR REQUIRED
• FOR COMPUTERS 100
  120
• LABOR REQUIRED
• FOR WHEAT
  5 8
• RELATIVE TIME TO
• PRODUCE A COMPUTER (100/5) 20x
  (120/8) 15x

WHEAT PRICE OF A COMPUTER IN U.S.
WHEAT PRICE OF A COMPUTER IN JAPAN
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EXAMPLE ASSUME A TOTAL OF 240,000 HOURS TO
PRODUCE COMPUTERS AND WHEAT FOR BOTH COUNTRIES

• U.S.
  JAPAN
• LABOR TO LABOR TO LABOR TO
  LABOR TO
• WHEAT COMPUTERS WHEAT
  COMPUTERS
• 120,000 120,000
  120,000 120,000
• (24,000) (1200)
  (15,000) (1000)

COMBINED OUTPUT WHEAT
39,000 COMPUTERS 2,200
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EXAMPLE ASSUME A TOTAL OF 240,000 HOURS TO
PRODUCE COMPUTERS AND WHEAT FOR BOTH COUNTRIES

• U.S.
  JAPAN
• LABOR TO LABOR TO LABOR TO
  LABOR TO
• WHEAT COMPUTERS WHEAT
  COMPUTERS
• 200,000 40,000
  20,000 220,000
• (40,000) (400)
  (2500) (1833)

COMBINED OUTPUT WHEAT
42,500 COMPUTERS 2233
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DIAGRAMMATIC PRESENTATION

United States
Japan
WHEAT
WHEAT
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30
15
40
2.5
24
1200
1833
400
2400
2000
1000
COMPUTERS
COMPUTERS
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DIAGRAMMATIC PRESENTATION
SLOPE ??WHEAT /?? COMPUTER
-16,000 / 800 -20x
80,000 LABOR HOURS

WHEAT
WHEAT
48
30
15
40
2.5
24
1200
1833
400
2400
2000
1000
COMPUTERS
COMPUTERS
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DIAGRAMMATIC PRESENTATION
SLOPE ??WHEAT /?? COMPUTER
-12,500 / 833 -15x

WHEAT
WHEAT
48
30
15
40
2.5
24
1200
1833
400
2400
2000
1000
COMPUTERS
COMPUTERS
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WHAT DETERMINES COMPARATIVE ADVANTAGE

• Natural endowments --geographical determination
• Acquired endowments
• Higher savings rates
• Devoting resources to
• Education
• Capital accumulation
• Superior knowledge
• Specialization

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PERCEIVED COSTS OF INTERNATIONAL INTERDEPENDENCES

• Loss of domestic jobs
• Vulnerability
• Unfair trade -- dumping / monopoly
• Indebtness -- interest burden
• Weak countries hurt trade

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Example from the History of Economic Thought
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David Ricardo on Comparative Advantage
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• David Ricardo, working in the early part of the
  19th century, realized that absolute advantage
  was a limited case of a more general theory. He
  considered the following example. It can be seen
  that Portugal can produce both wheat and wine
  more cheaply than England (i.e., it has an
  absolute advantage in both commodities). What
  David Ricardo saw was that it could still be
  mutually beneficial for both countries to
  specialize and trade.