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Chapter 2

Chapter 2. Comparative Advantage: The Basis of Exchange ( Economic Models ). Economics: Redefined.

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Chapter 2

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  1. Chapter 2 Comparative Advantage: The Basis of Exchange (Economic Models)

  2. Economics: Redefined Economics is the subject that studies how decision-making entities allocate and utilize the limited resources to produce goods and services that best satisfy the various, unlimited, competing human desires.

  3. Economics: Macro vs. Micro • Macroeconomics: • How does the economic system work? • When and why economic system does not work? • When do people become counterproductive? • Why are there ups and downs in the economy? • Why is the long run mainly a story of ups? => National economy, GDP, inflation, unemployment, international trade, exchange rate, etc.

  4. Economics: Macro vs. Micro • Microeconomics: • The housing market in Shanghai • The price of Honda Accord in Guangzhou • The production quantity of peaches in Nanhui • The number of people hired producing milk powder at Mengniu • The number of T-shirts I buy at Hang-Ten => Individual decisions and interactions, individual consumer behaviors, individual producer decisions on production and input requirements, single product market, single market structure, etc.

  5. Microeconomics • Individual decisions about what to do and what not to do. • Decisions about production and consumption made by individual firms and consumers (market economy) • How individuals’ pursuit of self interest can lead to good results as a whole (the invisible hand)

  6. Also in Microeconomics • Society’s goal: efficiency and equity • Market usually leads to efficiency, but not necessarily equity. • There are times for market failures. • When market fails, it calls for government interventions. • Proper “incentives” offered by government interventions may help reach society’s goals.

  7. Economics: a way of thinking and an analysis tool Economics is not the body of concrete truth, but an engine for the discovery of concrete truth.

  8. Economic Analysis • Positive analysis : • objective descriptions about what things are (facts) • Normative analysis: • value judgments on what things should be (opinions)

  9. Positive vs. Normative

  10. Equilibrium Analysis • Equilibrium： • a situation in which economic forces are balanced and in the absence of external influences the values of economic variables will not change

  11. Example:Market equilibrium • Market forces: demand and supply • Economic Variables: market price and quantity of product exchanged • Market equilibrium: a market price is established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. • This price is often called the equilibrium price or market clearing price and will tend not to change unless demand or supply change.

  12. Static vs. Dynamic Analysis • Static analysis: under what conditions the economic variables will reach equilibrium (ignoring the time factor and the process of getting to equilibrium) • equilibrium

  13. Static vs. Dynamic Analysis • Comparative static analysis: what happens to the equilibrium and the values of the economic variables if some of the conditions change • Equilibrium price under D1 vs. equilibrium price under D2

  14. Static vs. Dynamic Analysis • Dynamic analysis: • the process analysis; • the interactive process and relationships among all economic variables • Equilibrium price P1 • US companies bankrupt  US income lowers  US consumption of Chinese products lowers Chinese exports decreases  Chinese income lowers  Chinese comsumption decreases  Chinese companies investments decrease  Chinese domestic D lower  equilibrium price lower

  15. Economic Models A modelis a simplified representation of a real situation that is used to better understand real-life situations.

  16. Economic model • Using functions to describe the inter relationships among economic variables • Word description, mathematics, graphs • Abstract: skip some of the non-vital factors and variables (assumptions) • Focus on certain relationships only (hypothesis)

  17. A Model • Definitions of variables • Assumptions • Hypothesis • Forecast • Test True: theory False: 1. adjust hypothesis >forecast test 2. Give up

  18. Model Example: PPC The production possibility curve the trade-offs facing an economy that produces only two goods.

  19. PPC • Issue to investigate: how many of each product a country can produce • Variables: Product A, Product B • Define: • Qa: (F) the quantity of fish produced by the economy • Qb: (C) the quantity of coconut produced by the economy * Can also be butter vs. gun, bread vs. dresses, etc.

  20. PPC • Assumptions: • only two goods produced • only two kinds of resources, each of limited amount • resources are used up with efficiency • there is increasing opportunity costs

  21. PPC • Hypothesis: producing more of A would require reduction in production of B (the only way to produce more of A is to produce less of B -- trade off) • Forecast: when more of A is produced, production of B decreases (reason: less resources available)

  22. PPC • Test: real data • Conclusion: true: accept, realistic and helpful theory (if not: why? Assumptions? Data? Methods? Retest?...)

  23. The PPC

  24. Increasing Opportunity Cost

  25. Shift of the PPF: Economic Growth Economic growth results in an outward shift of the PPF because production possibilities are expanded.

  26. PPC: Key Points • Intersections with X-axis and Y-axis • Points inside, on, outside the curve • The bowed-out shape • Shift of the curve

  27. Marginal Analysis • Trade off situations: How much decisions (as vs. either-or) • marginal analysis: comparing marginal benefit to marginal cost • Marginal Benefit: additional benefit related to one more unit change Marginal Cost: additional cost related to the same one more unit change

  28. Example: Marginal Cost

  29. Marginal Benefit

  30. Net Gain

  31. Decision rule if MB >= MC, DO IT! if MB < MC, FORGET IT! Total net gain is maximized when marginal net gain = 0 or when MB=MC

  32. The Goal:Maximization of Total Net Gain

  33. Math and Graph • Variables: Total Net Gain (G) Hours of mowing (H) • Assumptions: • Hypothesis: G = f (H) (more hours, more gain) • Forecast: • gain from 4 hours is more than gain from 3 hours • gain from 10 hours is more than gain from 9 hours • Test: 1. True; 2. False (correct hypothesis then forast and test again)

  34. Graph • Plotting: origin, X-axis, Y-axis, • Variables: independent, dependent • Relationships: positive, negative; linear, nonlinear;

  35. Slopes: Calculation • Linear: Change in Y / Change in X = △Y / △X • Non-linear: • Arc method: connect to points on the arc with a straight line, then calculate the slope of the straight line • Point method:draw a tangent line at a point and calculate the slope of the tangent line

  36. Slopes: Meaning slope > 0, positive relationship (upward sloping) slope = 0, horizontal line slope < 0, negative relationship (downward sloping) slope = infinite, vertical line constant slope: straight line variable slope: curve Maximum and Minimum of a curve: when point slope = 0

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