Comparative Advantage: Input vs. Output

Comp. output - lowest opportunity cost (you give up less)
Comp. input - least effort to make 1 

For Comparative Advantage Output Questions:

• The country that can produce the most, with similar resources as another country, has the absolute advantage.
• Make opportunity cost comparisons.
• The country with the lowest opportunity cost has the comparative advantage and will make that product.
• Each country will seek a trade that is BETTER than their own domestic opportunity cost.  If they can’t do better in trade than they could produce on their own, then they don’t trade.
• When each country trades, based on lowest opportunity cost, both can gain more in trade than they could produce domestically.  Therefore, they can “exceed” their own production frontiers.

For Comparative Advantage Input Questions:

• The country that can produce a set amount of something by using the least resources, land, or time, has the absolute advantage.
• Make opportunity cost comparisons by creating an “output” matrix first.  Do this by deciding for each product, what would be spent if a set unit was produced.
• The country with the lowest output opportunity cost will, again, have the comparative advantage.

Trick for determining per unit opportunity cost

• Output Question: "Other goes over"
• Input Question: "Other goes under"

Specialization and Trade (Comp. Advantage)

Specialization

Specialization occurs when individual (workers, firms, countries) focus on single tasks, enabling each to become more efficient and productive.

Law of Comparative Advantage: The entity with the lowest opportunity cost of producing an output should specialize in that output.

Division of Labor: The organization of production so that individual workers focus on specific tasks.

• takes advantage of individual preferences and natural abilities 
• allows for workers to gain experience 
• reduces the need to shift between different tasks 
• permits the introduction of labor-saving machinery

International Trade 

Key issues:

• Which country can produce the most?
• Which country is the most efficient?
• How is efficiency measured?
• How can trade based on efficiency lead to improvement for both trading partners?

Law of comparative advantage 

• The entity that has the lowest opportunity cost has comparative advantage.

• The entity that can produce more of a good or service than others with similar resources has absolute advantage.

• Each country will seek a trade that is BETTER than their own domestic opportunity cost.  

• If they can’t do better in trade than they could produce on their own, then they don’t trade.

• When each country trades, based on lowest opportunity cost, both can gain more in trade than they could produce domestically.  
• Therefore, they can “exceed” their own production frontiers.

Price Controls (Ceilings / Floors)

Price Ceiling: An imposed maximum price for a good or service. 

• If EP is considered too high. 
• Set below EP
• Supposed to help consumers
• Example: rent control 
• Results in shortage
• Other side effects? 

Price Floor: An imposed minimum price for a good or service. 

• If EP is too low considered too low. 
• Set above EP
• Supposed to help producers 
• Example: food price controls 
• results in surplus  

To keep it simple on your notes....
Price Ceilings = Shortages
Price Floors = Surpluses 

Market Forces: Supply and Demand

Supply and demand (graph)

• economic model of price determination.

(or) how markets determine prices, and how market determined prices result in an orderly, efficient allocation of productive resources
(the three questions)

Other things to remember

• transaction costs
• property rights
• scarcity (of information) 
• Planning

In the absence of any disturbances, the market price will always tend to the market equilibrium

 How does that work? 

Excess Quantity Supplied

• Surplus
• (P2) QS > QD
• Sellers compete with sellers
• forces prices down

Excess Quantity Demanded 

• Shortage 
• (P3): QD >  QS
• Buyers compete with buyers
• forces prices up 

Equilibrium

• Equilibrium Price 
• (or) market clearing price (P1Q1)
• no shortage, no surplus
• no market forces acting on the price 
• quantity supplied meets quantity demanded. 

Recall: The three questions

1. What gets produced? 
2. How is it produced? 
3. Who consumes what is produced?

Markets answer these questions.

• buyers and sellers have different views (Law of Demand, Law of Supply)
• finds equilibrium among the voluntary actions of all buyers and sellers in a market.

Price signals are the means of coordination

• guide resources to their most productive uses
• provide information on relative scarcity
• high prices encourage consumers to find substitutes 
• also encourage producers to allocate more resources
• provide incentives (each actor behaves according to self-interest) 
• promotes general welfare
• Adam Smith's "Invisible Hand"

A few more notes on Market Exchanges

• voluntary (worth saying again)
• both sides expect to benefit 
• If we do not expect to benefit, we do not act 
• NOT a zero-sum game 
• markets reduce transaction costs
• (the costs of time and information in carrying out market exchanges) 
• therefore promoting exchange

supply

supply - different quantities that firms are willing and able to produce at different prices (other things staying constant) 

• Demand has to do 
• with consumers (demanders) 
• Supply has to do with producers (suppliers) 

Law of Supply: there is a direct relationship between price and quantity supplied.

So

• price increases, supply increases 
• price decreases, supply decreases

Two reasons why
1. Price as signal 

• Prices act as a signal for producers 
• If a good has a high price, existing firms have an incentive to produce more. 
• High prices will bring other producers into the market   
• Profit = total revenue - total cost 

2. Ability to produce

• Marginal cost increases when output increases 
• higher prices make producers more able to increase quantity supplied. 

 

Supply curve: Graph showing the quantities of a good supplied at at various prices during a given time period. (Other things remaining constant)

Change in Supply vs. Change in Quantity Supplied 

Movement along the curve: a change in Q supplied

• only thing that can affect it is price
• price never shifts the curve, it moves along the curve

Movement of the curve: change of supply 

• one of the six shifters of supply (change in any non-price determinant of supply) 

• 1. Production costs, how much a good costs to be produced
• raw materials, labor, etc. 

• 2. The technology used in production, and/or technological advances

• 3. The price of related goods

• other goods the firm could produce

• 4. Firms' expectations about future prices

• 5. Number of suppliers

• 6. Taxes and subsidies 

about the graph:

• Increase in supply: curve shifts to the right 
• Decrease in supply: curve shifts to the left

Demand

Demand Curve

• economic model of price determination in a market.
• Consumer demand and consumer wants are not the same thing

demand - different quantities that people are willing and able to buy at different prices in a given period of time. 

• prices provide information
• help answer the 5 questions

Consider the table below.

Hat-Tip: Darsey and Dr. Doyle

Demand Curves

• Price Axis (Y axis) 
• Quantity Axis (X axis) 

Law of Demand: inverse relationship b/t price and quantity demanded. (Demand curves slope down)

Three reasons why: 

• Substitution effect 
• Income Effect
• Decreasing Marginal Utility 

1. substitution effect

• substitute goods: goods which, as a result of changed conditions, may replace each other in use or consumption.

2. income effect

• changes in price affects purchasing power (real income)
• increase in price can decrease real income.
• decrease in price can increase real income. 

3. law of diminishing marginal utility 

Marginal Utility: The satisfaction you derive from an additional unit of a product. 

• (diminishing additional satisfaction)
• the first unit of consumption of a good or service yields more utility than the second and subsequent units. 
• (MU declines as consumption increases)

Change in Demand vs. Change in Quantity Demanded

PRICE CHANGE DOES NOT CHANGE DEMAND 

• DEMAND = "the relationship"
• PRICE changes QUANTITY DEMANDED
  

Movement along the curve: a change in Q demanded

• only thing that can affect it is price
• price never shifts the curve, it moves along the curve,

When the "RELATIONSHIP" changes, the curve moves. 

Movement of the curve: change of demand. 

• one of the five shifters of demand (change in any non-price determinant of demand)

1. Changes in consumer income
2. Changes in tastes and preferences
3. Changes in expectations
4. Changes in the prices of related goods
   (substitutes and complements)
5. Changes in Population size and composition

1. Changes in income

 Normal vs. Inferior Goods

Normal good

• income increase = demand increase   
• income decrease = demand decrease

Inferior Good

• income increase = demand decrease
• income decrease = demand increase

2. Changes in tastes and preferences 

• just what it sounds like
• perceptions of quality / value 

3. Changes in expectations

• expected future prices 
• future price increase = demand increase
• future price decrease = demand decrease
  

4. Changes in Related Goods
Substitutes: Products than can be used in place of each other.

• goods are substitutes if an increase in price for one shifts demand in the other.  

Compliments: Goods used in combination with other goods. 

• If two goods are compliments, a decrease in the price of one increases demand for the other. 

5. Changes in Population size and composition

• more people = more demand
• less people = less demand
• different people  = different demands

About the Graph:

• Increase in demand: curve shifts to the right 
• Decrease in demand: curve shifts to the left 

Market Interaction / Circular Flow

Circular Flow Diagram 

• model which describes the reciprocal circulation of income between producers and consumers.
• (the flow of resources, products, and income)
• (theory that all parts of the economy are connected)
• macro / micro theory 

Parts of the model (simple)

• Firms (businesses)  
• Households (individual consumers) 
• Resource Markets 
• Product Markets 
• Government

more complex models include: financial markets, import and export markets, etc.

Market: means by which buyers and 
sellers carry out exchange

From our reading....
How do you think this model would 
look if it showed government?

Economic Systems

economic system: the set of mechanisms and institutions that resolve economic questions for an economy.

Five questions every system must answer:

• What goods and services will be produced?
• How will the goods and services be produced?
• Who will get the goods and services?

• How will the system accommodate change?
• How will the system promote progress?  

What sets economic systems apart:

1. Who owns the productive resources? 
2. What decision-making process is used to allocate resources and production?
3. What incentives guide economic decision makers?  

Command System
An economic system in which all resources are government-owned and production is coordinated by central plan of the government

• state ownership of all resources 
• central planners drive economic activity 
• no competition

What answers questions: the state

• consumers get low priority, capital goods high priority 
• little freedom of choice 
• planning is inefficient 
• resources can be wasted by the state 
• damage to environment 
• no functioning price system 

Examples of the command system
-Soviet Union 
-Cuba
-North Korea 

Market System

System characterized by private ownership of the means of production and the use of markets and prices to direct market activity. 

• private ownership the means of production (private property)
• free, competitive markets
• price drives economic activity
• “invisible hand” (Adam Smith) 

(Ref: I, Pencil, price coordination)

What answers questions: 
the market (market exchange)

Another way of saying that would be "People answer the questions..."

• specialization
• division of labor
• trade 

"It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest."

-Adam Smith, An Inquiry into the Nature & Causes of the Wealth of Nations, 1776

Limited role of government:

• maintain rule of law
• protect property rights

Big Points for Market and Mixed

• Efficiency: guides resources into production of goods and services most wanted. 
• Incentives: Hard work, skill acquisition, innovation = higher standard of living.
• Freedom: coordination without coercion.

(But won't it be chaotic without the state to promote the general welfare?)

A few words on Efficiency

• evaluative term
• ratio of value of output to the value of input.
• objective, but must consider the values of those involved.
• efficiency can change with changes in valuations
• (what we value determines what we consider efficient or inefficient)
• One way of determining value is through relative prices     

 

Productive Efficiency: occurs when a firm produces at the lowest possible cost per unit.

• firms that supply at the lowest cost preform best
• do it cheapest (least amount of resources) 
• competition with other firms makes this essential

Allocative Efficiency: Occurs when a firm produces the output most valued by consumers.

• competition makes it necessary for firms to produce what people will buy
• where marginal cost = marginal benefit
• unit produced is worth as much or more than anything else that could be produced with similar resources 

Mixed Economy

An economic system that mixes central planning with competitive markets

• competitive markets
• gov’t. regulates market activity

What answers questions: the state and the market

• "cronyism" 
• firm or person colludes with government officials to create unfair legislation and/or regulations which give them forced benefits they could not have otherwise obtained voluntarily.

Transitional Economy
An economic system in the process of shifting from central to competitive markets

• converting state-owned enterprises into private enterprises (privatization) 
• trying to become more competitive

What answers the questions: The market and the government

• competitive markets 
• strong temptation for gov to intervene 
• problem of selling off gov. owned firms

Hungary, Mongolia, two dozen other countries

Traditional Economy 
An economic system shaped largely by custom or religion

• family, religion, or custom play roles in organizing and coordinating economic activity 
• had job your father did
• typical where you see subsistence agriculture

What answers the questions: Tradition, family, religion

• limiting to people 
• coercion

Examples:
early societies, 
Caste system in India, 
“third world” countries