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“The Economic Way of Thinking” 11 th Edition. Chapter 2 Efficiency, Exchange, and Comparative Advantage. Chapter 2 Outline. Introduction Goods and Bads The Myth of Material Wealth Trade Creates Wealth Is it Worth It? Efficiency and Values

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the economic way of thinking 11 th edition

“The Economic Way of Thinking” 11th Edition

Chapter 2Efficiency, Exchange, and Comparative Advantage

chapter 2 outline
Chapter 2 Outline
  • Introduction
  • Goods and Bads
  • The Myth of Material Wealth
  • Trade Creates Wealth
  • Is it Worth It? Efficiency and Values
  • Recognizing Tradeoffs: Comparing Opportunity Costs of Production
  • The Gains from Specialization and Exchange
chapter 2 outline3
Chapter 2 Outline
  • Why Specialize?
  • From Individual Trade to International Trade and Back Again
  • Transactions Costs
  • Incentives to Reduce Transactions Costs: Middlemen
  • Middlemen Create Information
  • Markets as Discovery Processes
  • Appendix – Economic Growth
introduction
Introduction
  • This chapter explores these questions
    • Who profits from trading?
    • Does trade increase wealth?
    • Is trade productive?
    • What are production possibilities?
good and bads
Good and Bads

Something is Good if ……

more of it is preferred to less.

Something is Bad if …

less of it is preferred to more.

A Free Good can be acquired without sacrifice.

A Scarce Good requires sacrifice.

the myth of material wealth
The Myth of Material Wealth
  • Of what does wealth consist?
    • Wealth, in the economic way of thinking, is whatever people value.
    • Value is in the eyes of the chooser.
the myth of material wealth7
The Myth of Material Wealth
  • Economic growth consists not in increasing production of things, but increasing the production of wealth.
  • “Wealth = Material things” is not a valid claim. It blocks an understanding of such aspects of economic life like “specialization and exchange”
  • Specialization and trade are the heart of Adam Smith’s “Commercial Society”
trade creates wealth
Trade Creates Wealth
  • Questions:
    • What do we gain from trading?
    • Is it accurate to say that the two goods traded have equal value?
    • Does trade add value, wealth?
    • Is trading efficient?
trade creates wealth9

More of what

people want.

Involves exchange

of unequal values.

Trade Creates Wealth

Trade:

Voluntary

Exchange:

trade creates wealth10

Jack

Jim

Trade Creates Wealth

Question:

Does an exchange

of a ball for a

glove, between two

people,

affect wealth?

trade creates wealth11
Trade Creates Wealth
  • With trade each party trades a scarce and valuable good for a more valued good.
  • Any choice entails a “trade-off.”
  • The cost of obtaining anything is the value placed on whatever must be sacrificed in order to obtain it.
    • In economics that cost is referred to as the “opportunity cost.”
is it worth it efficiency and values
Is It Worth It?Efficiency and Values
  • Efficiency changes with valuations.
    • Efficiency compares the ratio of the value of the output to the value of the input.
  • Increased Efficiency
    • Leads to lower production costs
is it worth it efficiency and value
Is It Worth It?Efficiency and Value

The efficiency of any process

can change with changes

in valuation

recognizing tradeoffs comparing opportunity costs of production
Recognizing Tradeoffs:Comparing Opportunity Costs of Production

A “Production Possibilities Frontier” illustrates

maximum combinations of products that can be

produced using a given set of resources and talent.

Jones:

5 S = 10 L therefore

1 S = cost 2 L and

1 L = ½ S

Brown:

4 S = 3 L therefore

1 S = cost ¾ L and

1 L = 4/3 S

recognizing tradeoffs comparing opportunity costs of production15

Lager

Lager

Jones

Brown

10

3

4

5

Stout

Stout

Recognizing Tradeoffs:Comparing Opportunity Costs of Production

Production possibilities before Specialization and Trade

recognizing tradeoffs comparing opportunity costs of production16
Recognizing Tradeoffs:Comparing Opportunity Costs of Production
  • Who produces lager at a relatively lower cost?
    • Note that Jones is more efficient at producing both stout and lager.
    • If Jones produces only lager he can make 10 gallons but sacrifices the opportunity to make 5 gallons of stout. If he makes only stout he sacrifices the opportunity to make 10 gallons of lager.
    • If Brown produces only stout she can make 4 gallons but gives up the opportunity to make 3 gallons of lager. For every gallon of stout she sacrifices ¾ gallons of lager.
recognizing tradeoffs comparing opportunity costs of production17
Recognizing Tradeoffs:Comparing Opportunity Costs of Production

The tables show that Jones has a lower relative cost

producing lager, he only sacrifices ½ S for each

gallon of L, while Brown must forego 4/3 S for each

gallon of L.

Jones:

5 S= 10 L therefore

1 S = cost 2 L and

1 L = ½ S

Brown:

4 S= 3 L therefore

1 S = cost ¾ L and

1 L = 4/3 S

recognizing tradeoffs comparing opportunity costs of production18
Recognizing Tradeoffs:Comparing Opportunity Costs of Production

The tables show that Brown has a lower relative cost

producing lager, she only sacrifices ¾ L for each

gallon of S, while Jones must forego 2 L for each

gallon of S.

Jones:

5 S= 10 L therefore

1 S = cost 2 L and

1 L = ½ S

Brown:

4 S= 3 L therefore

1 S = cost ¾ L and

1 L = 4/3 S

recognizing tradeoffs comparing opportunity costs of production19
Recognizing Tradeoffs:Comparing Opportunity Costs of Production
  • Who produces lager at a relatively lower cost?
    • The least cost producer of a product has a comparative advantage over other producers. Least cost producers have a lower opportunity cost.
    • The tables show that Jones has a comparative advantage in brewing lager, while Brown has a comparative advantage in stout production.
the gains from specialization and exchange
The Gains from Specialization and Exchange

If Brown and Jones

agree to trade one for one

in the product of their

comparative advantage:

Both can now consume more than they could individually

produce.

Jones can enjoy

7 lager and 3 stout

Brown can enjoy

3 lager and 1 stout.

the gains from specialization and exchange21
The Gains from Specialization and Exchange

If Brown and Jones

agree to trade one for one

in the production of their

comparative advantage:

Wealth has been increased

for both through specialization

and trade.

Both can now consume

more than they could

individually

produce.

Jones can enjoy

7 lager and 3 stout

Brown can enjoy

3 lager and 1 stout.

the gains from specialization and exchange22

Lager

Lager

Brown

Jones

10

3

1

3

4

5

Stout

Stout

The Gains from Specialization and Exchange

Production Possibilities after specialization and trade

why specialize
Why Specialize?
  • Specialization is a synonym for “Following one’s comparative advantage.”
  • People specialize so that they can increase their wealth.
  • Specialization allows producers to expand their possibilities (wealth) by trading for something that is more costly to produce on their own.
  • The phenomenon is referred to as the “Law of Comparative Advantage” in Economics.
individual to international trade and back again
Individual to International Trade and Back Again
  • The terms of trade at the individual level are the exchange rates at the international level.
    • People pay for their imports with their exports.
  • Specialization and exchange occur between individuals, regions, and across political borders.
transaction costs
Transaction Costs
  • Transaction costs are costs of arranging contracts and agreements – trades in general among interested parties.
transaction costs middlemen
Transaction Costs: Middlemen
  • Middlemen help interested parties find one another.
    • Stockbrokers, wholesalers, job placement agencies, etc.
  • They create more desirable options for us.
middlemen create information
Middlemen Create Information
  • Middlemen generate high quality information at a low cost which is their comparative advantage.
  • They are specialists in organizing markets.
  • They lower the hurdles that will impede exchange.
markets as discovery processes
Markets as Discovery Processes
  • In the real world people pursue their comparative advantages by choosing the most attractive option.
  • Comparative advantages are discovered thru real market exchanges of property rights.
  • In doing so people continuously coordinate these processes of cooperative interaction and mutual accommodation that comprise the economy.
appendix economic growth
Appendix: Economic Growth
  • Adam Smith determined that wealth came from huge increases in production which resulted in the division of labor.
  • Economic growth is a consequence of the evolution of commercial society…
    • Everyone specializes and
    • Lives by exchanges
appendix the evolution of rules that encourage specialization and exchange
Appendix: The Evolution of Rules That Encourage Specialization and Exchange
  • Market Specialization / Division of Labor
    • Creates the conditions for economic growth
  • The Rule of Law – Private Property Rights
    • Allows freedom of exchange
    • Provides incentives to specialize in activities of comparative advantage
once over lightly
Once Over Lightly
  • Exchange of Property Rights
  • A Good – more preferred to less
  • Free Good...Scarce Good
  • Opportunity Cost
  • Wealth = Value
  • Comparative Advantage
once over lightly32
Once Over Lightly
  • Information and the Middlemen
  • Middlemen and Comparative Advantage
  • Market Specialization
  • Division of Labor
  • Wealth and Nations
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