Chapter 2 Prices, Costs and the Gains from Trade

1. Chapter 2 Prices, Costs and the Gains from Trade

2. Overview In this chapter we want to 1) understand the meaning of the microeconomic term price, and 2) Understand why differences in cost can lead to beneficial trade for all.

3. section 2.1 absolute price The number of dollars necessary to purchase a unit of product is called the absolute price of the product. As an example, say in 1990: bread: $1/loaf Wine: $2/bottle Note that we put the price of bread as a fraction and read the fraction as “dollars per unit.”

4. sec. 2.1 a basic math calculation Let’s do a basic math calculation of the form absolute price of y absolute price of x . From the previous screen make bread = y and wine = x. The calculation is ($1/loaf) ($1/loaf) times(bottle/$2) ($2/bottle) =((1/2) bottle)/loaf

5. sec. 2.1 relative price Before we saw the absolute price of a product is how many dollars one must give up per unit of the product. The calculation we made allows us to see how many units of another product we must give up to get a unit of the product in question. This is the notion of relative price. The number of units of product x you must give up to purchase 1 unit of product y is called the relative price of y. absolute price of y = relative price of y absolute price of x .

6. sec. 2.1 example absolute price 1990 1995 bread $2/loaf $2/loaf wine $4/bottle $8/bottle relative prices bread (1/2)bottle/loaf (1/4)bottle/loaf wine 2 loaves/bottle 4 loaves/bottle In this example the absolute price of bread stayed the same and the absolute price of wine doubled. BUT, the relative price of bread fell while the relative price of wine increased.

7. Sec. 2.1 Rules Rule: In microeconomics, the single word price means relative price and one good’s value should be stated in terms of the other good. Qualification to the rule: We can still use dollars to measure relative price of good y - bread in our example - provided the dollar or absolute price of good x does not change. We simply must remember that the dollars in which we express the price of good y are really just stand-ins for good x. Note: good x may actually be a whole basket of goods and so we compare good y to the basket.

8. sec. 2.2 cost All costs in economics represent forgone opportunities. Example: Say you go to the Orange Bowl to watch the big game. What is the cost to go to the game? $1,000 you could sell ticket for on the street before game 500 hotel room 250 airline tickets 300 lost wages $2,050 Wait, you say. You already paid $50 for the ticket! Well, then the ticket cost $50 out of your pocket plus the additional $950 you could put back in your pocket if you didn’t go to the game.

9. sec. 2.2 cost Remember cost is what you forgo when you undertake an activity. Example: We will look at some data about how much time it takes two people to do a “standard” amount of work. The numbers presented do not really represent cost because we don’t have forgone opportunities, but we can get there from the data given. Job Electrician Carpenter rewiring 10 hours 20 hours paneling 15 hours 18 hours

10. sec. 2.2 cost Note for the electrician 10 hours/rewiring job 15 hours/paneling job = 2/3 paneling jobs rewiring job

11. sec. 2.2 cost and comparative advantage In terms of cost Job Electrician Carpenter rewiring 2/3 paneling 10/9 paneling paneling 3/2 rewiring 9/10 rewiring Now the electrician does the rewiring job cheaper than the carpenter - the electrician only gives up 2/3 of a paneling job as opposed to 10/9 of a paneling job. We say the electrician 1) has a comparative advantage, or 2) is more efficient at rewiring relative to the carpenter.

12. sec. 2.2 terms of trade Note the carpenter has a comparative advantage in paneling. Terms of trade Say the carpenter and the electrician each have a paneling and a rewiring job to get accomplished. If they don’t work together the electrician will work 25 hours and the carpenter 38 hours(from original table). If we look at the table of costs we note that 1 rewiring takes either 2/3 paneling or 10/9 of a paneling job. If the two decide between them that 1 rewiring job trades for more than 2/3 of a paneling job, but less than 10/9 of a job, then both can benefit from trade.

13. sec. 2.2 terms of trade Say the two decide 1 rewiring job can be traded for 1 paneling job. 1 rewiring = 1 paneling is called the terms of trade.

14. sec. 2.2 benefits from trade Now with trade the electrician will have to work 10 hour on one rewiring + 10 hours on the rewiring if he trades for the 1 paneling. He works for a total of only 20 hours instead of the 25 before the trade occurred. The carpenter reduces his hours from 38 to 36, a similar benefit. Conclusion: Everyone in society can be made better off if each specializes in the area where each is most efficient and then trades for the goods each wants - provided agreeable terms of trade can be negotiated.

15. sec 2.2 another solution Note: electrician went from 25 to 20 hours carpenter went from 38 to 36 hours. It seems the electrician benefited more. This is based on the terms of trade used in the example. We said the terms of trade must be, for 1 rewiring job, between 2/3 and 10/9 of a paneling job. Say they agree the terms of trade will be 1 rewiring = 7/9 paneling. electrician would work 10 + 10 + (2/9)(15) = 23 and 1/3 hours. Carpenter works 18 + (7/9)(18) = 32 hours.

16. sec 2.2 middleman Note that the benefits on the previous screen can be achieved because of differences in costs of production between the two people. What is a middleman? Someone between the producer or manufacturer of a good and the final consumer. The middleman provides a useful service by reducing the time it takes producers and consumers to get what they want. Retails stores are a good example of middlemen. Why don’t we have a large sporting goods store in Wayne? Can’t find reasonable terms of trade?