Key Principles of Economics: Understanding Decision-Making, Trade, and Market Dynamics

Posted on Jan 15, 2025 in Economy

CHAPTER 1: Ten Principles of Economics

Ninth Edition

In this Chapter

• What kinds of questions does economics address?
• What are the principles of how people make decisions?
• What are the principles of how people interact?
• What are the principles of how the economy as a whole works?

Ten Principles of Economics

Resources are scarce

• Scarcity: The limited nature of society’s resources
• Society has limited resources and cannot produce all the goods and services people wish to have.
• Economics
• The study of how society manages its scarce resources.

Ten Principles of Economics

Economists study:

• How people decide how much they work, what they buy, how much they save, and how they invest their savings
• How firms decide how much to produce and how many workers to hire
• How society decides how to divide its resources between national defense, consumer goods, protecting the environment, and other needs

How People Make Decisions

Principle 1: People face trade-offs

Principle 2: The cost of something is what you give up to get it

Principle 3: Rational people think at the margin

Principle 4: People respond to incentives

• Principle 1: People Face Trade-Offs

To get something that we like, we have to give up something else that we also like.

• Going to a party the night before an exam
• Less time for studying
• Having more money to buy stuff
• Working longer hours, less time for leisure
• Protecting the environment
• Resources could be used to produce consumer goods.
• Example 1A: Society faces trade-offs
• The more it spends on national defense (guns) to protect from foreign aggressors
• The less it can spend on consumer goods (butter) to raise its standard of living
• Pollution regulations: cleaner environment and improved health
• But at the cost of reducing the well-being of the firms’ owners, workers, and customers
• Example 1B: Society faces trade-offs
• Efficiency: Society gets the maximum benefits from its scarce resources.
• Equality: Prosperity is distributed uniformly among society’s members.

• Trade-off:
• To achieve greater equality, we could redistribute income from the wealthy to the poor.
• But this reduces the incentive to work and produce, shrinking the size of the economic “pie”.
• Principle 2: The Cost of Something Is What You Give Up to Get It
• Making decisions:
• Compare costs with benefits of alternatives
• Need to include opportunity costs
• Opportunity cost
• Whatever must be given up to obtain some item
• Example 2: Opportunity cost
• What is the opportunity cost of going to college for a year?
• Tuition, books, and fees
• NOT: room and board
• PLUS foregone earnings
• What is the opportunity cost of going to the movies?
• The price of the movie ticket
• PLUS the value of the time you spend in the theater
• Principle 3: Rational People Think at the Margin
• Rational people
• Systematically and purposefully do the best they can to achieve their objectives given the available opportunities
• Make decisions by evaluating costs and benefits of marginal changes
• Small incremental adjustments to a plan of action
• Active Learning 1: Thinking at the margin
• As the manager at the local Save-a-lot, you are thinking of hiring one more cashier that would increase sales revenues by $400 per week. The new cashier would earn $300 per week. Should you hire the new cashier? Why?

• You pay $12/month for access to Netflix, regardless of how many movies or TV shows you watch in a month. Should you watch one more movie (or episode)? Why?
• Active Learning 1: Answers, A
• Manager at the local Save-a-lot:
• Marginal benefit of hiring one more cashier:
• Sales would increase by $400 per week.
• Marginal cost of hiring one more cashier:
• The new cashier would earn $300.
• Decision: Because the marginal benefit exceeds the marginal cost, the manager should hire the additional cashier
• Active Learning 1: Answers B

B. Netflix:

• Marginal benefit of watching one more movie:
• The enjoyment you get from watching the movie
• Marginal cost of watching one more movie:
• Monetary cost = $0
• Opportunity cost of time
• Decision: If the marginal benefit exceeds the marginal cost, watch the movie.

• Principle 4: People Respond to Incentives
• Incentive
• Something that induces a person to act
• Can have unintended consequences
• People respond to incentives
• Because rational people make decisions by comparing costs and benefits
• An increase in the price of doughnuts:
• Consumers buy fewer doughnuts.
• Sellers produce more doughnuts.
• Example 3: Incentives

The government increases the gasoline tax by $1 per gallon.

• How do consumers respond?
• Drive smaller or more fuel-efficient cars
• Carpool
• Use public transportation
• Move closer to work
• How do businesses respond?
• Active Learning 2: Applying the principles

You are selling your black 1967 Chevy Impala. You have already spent $2,000 on repairs. At the last minute, the transmission dies. You can pay $1,400 to have it repaired or sell the car “as is.”

In each of the following scenarios, should you have the transmission repaired? Explain.

• Blue book value (what you could get for the car) is $14,500 if transmission works, $11,200 if it doesn’t.
• Blue book value is $12,300 if transmission works, $11,000 if it doesn’t.
• Active Learning 2: Answers

Cost of fixing the transmission = $1,400

A. Blue book value is $14,500 if transmission works, $11,200 if it doesn’t.

• Benefit of fixing transmission = $3,300

(= 14,500 – 11,200)

• Get the transmission fixed.

B. Blue book value is $12,300 if transmission works, $11,000 if it doesn’t.

• Benefit of fixing the transmission = $1,300

(= 12,300 – 11,000)

• Do not pay $1,400 to fix it.

How People Interact

Principle 5: Trade can make everyone better off.

Principle 6: Markets are usually a good way to organize economic activity.

Principle 7: Governments can sometimes improve market outcomes.

• Principle 5: Trade Can Make Everyone Better Off
• People benefit from trade:
• People can buy a greater variety of goods and services at a lower cost.
• Countries benefit from trade:
• Allows countries to specialize in what they do best
• Enjoy a greater variety of goods and services
• Principle 6: Markets Are Usually a Good Way to Organize Economic Activity – 1
• Market
• A group of buyers and sellers (need not be in a single location)
• “Organize economic activity” means determining
• What goods and services to produce
• How to produce these goods and services
• How to allocate them to their final user
• Principle 6: Markets Are Usually a Good Way to Organize Economic Activity – 2
• Market economy
• Allocates resources through the decentralized decisions of many firms and households as they interact in markets
• Proven remarkably successful in organizing economic activity to promote overall prosperity
• Principle 6: Markets Are Usually a Good Way to Organize Economic Activity – 3
• Prices:
• Determined by the interaction of buyers and sellers
• Reflect the good’s value to buyers
• Reflect the cost of producing the good
• Adam Smith’s “invisible hand”:
• Prices guide self-interested households and firms to make decisions that maximize society’s economic well-being.
• Types of Economic Systems
• Principle 7: Governments Can Sometimes Improve Market Outcomes – 1
• Government: enforce property rights
• Enforce rules and maintain institutions that are key to a market economy
• People are less inclined to work, produce, invest, or purchase if there is a large risk of their property being stolen.
• We rely on government-provided police and courts to enforce our rights over the things we produce.
• Principle 7: Governments Can Sometimes Improve Market Outcomes – 2
• Government: promote efficiency
• Avoid market failures: Market left on its own fails to allocate resources efficiently.
• Externality – source of market failure
• Production or consumption of a good affects bystanders (e.g. pollution).
• Market power – source of market failure
• A single buyer or seller has substantial influence on market price (e.g., monopoly).

• Principle 7: Governments Can Sometimes Improve Market Outcomes – 3
• Government: promote equality
• Avoid disparities in economic well-being
• Use tax or welfare policies to change how the economic “pie” is divided.
• To say that the government can improve market outcomes
• Does not mean that it always will
• Active Learning 3: The government

In each of the following situations, what is the government’s role?

Does the government’s intervention improve the outcome?

• Public schools for K-12
• Workplace safety regulations
• Public highways
• Patent laws, which allow drug companies to charge high prices for life-saving drugs

How the economy as a whole works

Principle 8: A country’s standard of living depends on its ability to produce goods and services.

Principle 9: Prices rise when the government prints too much money.

Principle 10: Society faces a short-run trade-off between inflation and unemployment.

• Principle 8: Country’s Standard of Living Depends on Its Ability to Produce Goods and Services – 1
• Huge variation in living standards across countries and over time
• 2017 average income:
• $60,000 in the U.S.; $6,000 in Nigeria
• Average income in rich countries
• Is more than ten times average income in poor countries
• The U.S. standard of living today
• Is about eight times greater than 100 years ago
• Principle 8: Country’s Standard of Living Depends on Its Ability to Produce Goods and Services – 2
• Productivity: most important determinant of living standards
• Quantity of goods and services produced from each unit of labor input
• Depends on the equipment, skills, and technology available to workers
• Other factors (e.g., labor unions, competition from abroad) have far less impact on living standards.

• Principle 9: Prices Rise When the Government Prints Too Much Money
• Inflation
• An increase in the overall level of prices in the economy
• In the long run
• Inflation is almost always caused by excessive growth in the quantity of money, which causes the value of money to fall
• The faster the government creates money, the greater the inflation rate
• Principle 10: Society Faces a Short-Run Trade-Off between Inflation and Unemployment
• Short-run trade-off between inflation and unemployment
• In the short-run, many economic policies push inflation and unemployment in opposite directions.
• Other factors can make this trade-off more or less favorable, but the trade-off is always present.

Think-Pair-Share

Your university decides to reduce the price of a parking permit on campus from $250 per semester to $10 per semester.

• The number of students desiring to park their cars on campus will _________.
• The amount of time it would take to find a parking place will ___________.
• Will the lower price of a parking permit necessarily lower the true cost of parking? (Hint: opportunity cost)
• Would the opportunity cost of parking be the same for students with no outside employment and students with jobs earning $15 per hour?

Chapter in a Nutshell

• Individual decision making:
• People face trade-offs among alternative goals.
• The cost of any action is measured in terms of forgone opportunities.
• Rational people make decisions by comparing marginal costs and marginal benefits.
• People change their behavior in response to the incentives they face.

Chapter in a Nutshell

• Interactions among people:
• Trade and interdependence can be mutually beneficial.
• Markets are usually a good way of coordinating economic activity among people.
• Governments can potentially improve market outcomes by remedying a market failure or by promoting greater economic equality.

Chapter in a Nutshell

• The economy as a whole:
• Productivity is the ultimate source of living standards.
• Growth in the quantity of money is the ultimate source of inflation.
• Society faces a short-run trade-off between inflation and unemployment.

CHAPTER 2: Thinking Like an Economist

N. Gregory Mankiw

Principles of Economics

Ninth Edition

In this Chapter

• What are economists’ two roles? How do they differ?
• What are models? How do economists use them?
• What are the elements of the Circular-Flow Diagram? What concepts does the diagram illustrate?
• How is the Production Possibilities Frontier related to opportunity cost? What other concepts does it illustrate?
• What is the difference between microeconomics and macroeconomics? Between positive and normative?

The Economist as a Scientist – 1

• Economists play two roles:
• Scientists: try to explain the world
• Policy advisors: try to improve it
• As scientists, economists employ the scientific method.
• Dispassionate development and testing of theories about how the world works
• Devise theories, collect data, and analyze these data to verify or refute their theories

The Economist as a Scientist – 2

• Economists make assumptions.
• Simplify the complex world and make it easier to understand. For example, to study international trade, assume only two countries producing two goods
• Economists use models to study economic issues.
• Simplified representation of a more complicated reality

The Circular-Flow Diagram

• Circular-flow diagram
• Visual model of the economy
• Shows how dollars flow through markets among households and firms
• Two decision makers
• Firms and households
• Interacting in two markets
• Market for goods and services
• Market for factors of production (inputs)

The circular flow – 1

The circular flow – 2

The circular flow – 3

The PPF

• Production possibilities frontier (PPF)
• A graph that shows various combinations of outputs that the economy can possibly produce, given the available factors of production and the available production technology.

• Example 1: The PPF
• Assume the following:
• A country produces only two goods: airplanes and soybeans.
• It has a fixed amount of resources (labor).
• And it has a fixed amount and quality of technology.
• The available resources and technology can be used to produce:
• Only soybeans (5,000 tons)
• Only airplanes (100 airplanes)
• Or a combination of soybeans and airplanes
• Example 1: The PPF and output combinations
• These are just a few of the possible production combinations.
• To increase the production of airplanes from 0 to 20, how many tons of soybeans do we have to give up?
• Example 1: Drawing the PPF
• Efficient: the economy is getting all it can from the scarce resources available – points on the PPF (A, B, C, D, E)
• Inefficient levels of production: points inside the PPF
• Not feasible: points outside the PPF
• Active Learning 1: Points off the PPF

Use the graph from the previous example.

• Would it be possible for the economy to produce the following combinations of the two goods?
• Point F: 80 airplanes and 4,000 tons of soybeans
• Point G: 30 airplanes and 2,500 tons of soybeans
• Active Learning 1: Answers

Point F (80 airplanes, 4,000 tons of soybeans): Not possible

Point G (30 airplanes, 2,500 tons of soybeans): Possible but not efficient (can produce more)

• The PPF: What We Know So Far
• Points on the PPF (like A – E): efficient
• Efficient: all resources are fully utilized
• Points under the PPF (like G): possible
• Not efficient: some resources are underutilized (e.g., workers unemployed, factories idle)
• Points above the PPF (like F)
• Not possible

Moving Along the PPF

• Moving along a PPF
• Involves shifting resources from the production of one good to the other
• Society faces a tradeoff.
• Getting more of one good requires sacrificing some of the other.
• The slope of the PPF
• The opportunity cost of one good in terms of the other

• Example 2: The PPF and opportunity cost

To produce the first 1,000 tons of soybeans: give up 20 airplanes

• Opportunity cost of 1 airplane = ______
• Opportunity cost of 1 ton of soybeans = _______

Economic growth and the PPF

• With additional resources or an improvement in technology, the economy can produce:

The Shape of the PPF

• Shape of the PPF
• Straight line: constant opportunity cost
• Previous example: the opportunity cost of 1 airplane is 50 tons of soybeans
• Bowed outward: increasing opportunity cost
• As more units of a good are produced, we need to give up increasing amounts of the other good produced.

Why the PPF might be bowed outward – 1

• As the economy shifts resources from beer to mountain bikes:

Why the PPF might be bowed outward – 2

• At point A, most workers are producing beer, even those who are better suited to building bikes.
• At B, most workers are producing bikes. The few left in beer production are the best brewers.

Why the PPF Might Be Bowed Outward

• The PPF is bowed outward when:
• Different workers have different skills
• There are different opportunity costs of producing one good in terms of the other
• There is some other resource, or mix of resources, with varying opportunity costs
• E.g., different types of land suited for different uses

Micro- and Macroeconomics

• Microeconomics
• The study of how households and firms make decisions and how they interact in markets
• Macroeconomics
• The study of economy-wide phenomena, including inflation, unemployment, and economic growth

The Economist as Policy Adviser

• Positive statements: descriptive
• Attempt to describe the world as it is
• Confirm or refute by examining evidence: “Minimum-wage laws cause unemployment.”
• Normative statements: prescriptive
• Attempt to prescribe how the world should be: “The government should raise the minimum wage.”
• Active Learning 2: Positive or normative?

Which of these statements are “positive” and which are “normative”? How can you tell the difference?

• Prices rise when the government increases the quantity of money.
• The government should print less money.
• A tax cut is needed to stimulate the economy.
• An increase in the price of burritos will cause an increase in consumer demand for movie streaming.
• Active Learning 2: Answers
• Prices rise when the government increases the quantity of money. Positive—describes a relationship, could use data to confirm or refute.
• The government should print less money. Normative—this is a value judgment; cannot be confirmed or refuted.
• A tax cut is needed to stimulate the economy. Normative—another value judgment.
• An increase in the price of burritos will cause an increase in consumer demand for movie streaming. Positive—describes a relationship.

Note: A statement need not be true to be positive.

Economists in Washington – 1

• Council of Economic Advisers
• Advises the president
• Writes the annual Economic Report of the President
• Office of Management and Budget
• Helps formulate spending plans and regulatory policies
• Department of the Treasury
• Designs tax policy

Economists in Washington – 2

• Department of Labor
• Analyzes data on workers and those looking for work
• Formulates labor-market policies
• Economists at the Department of Justice
• Enforce the nation’s antitrust laws
• Congressional Budget Office
• Helps the Congress
• The Federal Reserve
• Sets monetary policy

Why Economists’ Advice Is Not Always Followed

• The president receives advice from:
• Economists
• Communication advisers
• Press advisers
• Legislative affairs advisers
• Political advisers
• The president makes the decision.

Why Economists Disagree

• Economists often give conflicting policy advice:
• Can disagree about the validity of alternative positive theories about the world
• May have different values and, therefore, different normative views about what policy should try to accomplish

Yet, there are many propositions about which most economists agree.

Ask the Experts

• Ticket Resale
• “Laws that limit the resale of tickets for entertainment and sports events make potential audience members for those events worse off on average.”

Propositions about which most economists agree – 1

• A ceiling on rents reduces the quantity and quality of housing available. (93%)
• Tariffs and import quotas usually reduce general economic welfare. (93%)
• The United States should not restrict employers from outsourcing work to foreign countries. (90%)
• The United States should eliminate agricultural subsidies. (85%)
• Local and state governments should eliminate subsidies to professional sports franchises. (85%)

Propositions about which most economists agree – 2

• Cash payments increase the welfare of recipients to a greater degree than do transfers in-kind of equal cash value. (84%)
• A large federal budget deficit has an adverse effect on the economy. (83%)
• The United States should not ban genetically modified crops. (82%)
• A minimum wage increases unemployment among young and unskilled workers. (79%)
• Government subsidies on ethanol in the United States should be reduced or eliminated. (78%)

Think-Pair-Share – 1

You are watching PBS NewsHour. The first focus segment is a discussion of the pros and cons of free trade. For balance, there are two economists present—one in support of free trade and one opposed.

Your roommate says, “Those economists have no idea what’s going on. They can’t agree on anything. One says free trade makes us rich. The other says it will drive us into poverty. If the experts don’t know, how is the average person ever going to know whether free trade is best?”

Think-Pair-Share – 2

• Can you give your roommate any insight into why economists might disagree on this issue?
• Suppose you discover that 93 percent of economists believe that free trade is generally best (which is the greatest agreement on any single issue). Could you now give a more precise answer as to why economists might disagree on this issue?
• What if you later discovered that the economist opposed to free trade worked for a labor union. Would that help you explain why there appears to be a difference of opinion on this issue?

Chapter in a Nutshell

• Economists are scientists.
• Make appropriate assumptions and build simplified models
• Use the circular-flow diagram and the production possibilities frontier
• Microeconomists study decision making by households and firms and their interactions in the marketplace.
• Macroeconomists study the forces and trends that affect the economy as a whole.

Chapter in a Nutshell

• A positive statement is an assertion about how the world is.
• A normative statement is an assertion about how the world ought to be.
• As policy advisers, economists make normative statements.
• Economists sometimes offer conflicting advice.
• Differences in scientific judgments
• Differences in values

CHAPTER 3: Interdependence and the Gains from Trade

N. Gregory Mankiw

Principles of Economics

Ninth Edition

In this Chapter

• Why do people – and nations – choose to be economically interdependent?
• How can trade make everyone better off?
• What is absolute advantage?
• What is comparative advantage?
• How are these concepts similar?
• How are they different?

Ask the Experts

• Trade between China and the United States–1
• “Trade with China makes most Americans better off because, among other advantages, they can buy goods that are made or assembled more cheaply in China.”

Interdependence

• Interdependence
• Rely on many people from around the world, most of whom you’ve never met
• To provide you with the goods and services you enjoy
• “Trade can make everyone better off”
• One of the Ten Principles from Chapter 1
• We now learn why people – and nations – choose to be interdependent
• And how they can gain from trade

• Our example
• Assumptions:
• Two countries: the U.S. and Japan
• Two goods: airplanes and soybeans
• One resource: labor, measured in hours
• We want to determine how much of both goods each country produces and consumes:
• If the country chooses to be self-sufficient
• If it trades with the other country
• Example 1: The U.S.
• The U.S. economy has 50,000 labor hours per month available for production
• Produces only two goods: airplanes and soybeans
• To produce 1 airplane requires 500 labor hours
• To produce 1 ton of soybeans requires 10 labor hours

• Example 1: Building the PPF
• Example 1: The U.S. PPF

The U.S. has enough labor to produce :

• 100 airplanes,
• OR 5,000 tons of soybeans,
• OR any combination along the PPF.

• Example 1: The U.S. without trade

Suppose the U.S. uses half its labor to produce each of the two goods.

• The U.S. production and consumption would be: 50 airplanes and 2,500 tons of soybeans
• Active Learning 1: Derive Japan’s PPF

Use the following information to draw Japan’s PPF:

• Japan has 30,000 labor hours per month available for production
• Produces only two goods: airplanes and soybeans
• To produce 1 airplane requires 625 labor hours
• To produce 1 ton of soybeans requires 25 labor hours
• Your graph should measure soybeans (tons) on the horizontal axis.
• Active Learning 1: Answers

Japan has enough labor to produce :

• 48 airplanes,
• OR 1,200 tons of soybeans,
• OR any combination along the PPF.

• Active Learning 1: Japan without trade

Suppose Japan uses half its labor to produce each of the two goods.

• Japan’s production and consumption would be: 24 airplanes and 600 tons of soybeans
• Consumption with and without trade
• Without trade:
• U.S. consumers get 50 airplanes and 2,500 tons of soybeans
• Japanese consumers get 24 airplanes and 600 tons soybeans
• Comparison: consumption without trade vs. consumption with trade
• We need to see how much of each good is produced and traded by the two countries
• Active Learning 2: Production under trade

We continue Example 1 and Active Learning 1, but this time the two countries will choose different production points.

• U.S. produces 3,500 tons of soybeans. How many airplanes can the U.S. produce with the remaining resources? Draw this point on the PPF.
• Japan produces 48 airplanes. How many tons of soybeans can Japan produce with the remaining resources? Draw this point on the PPF.
• Active Learning 2A: U.S. production with trade

Producing 3,500 tons of soybeans requires 3,500 * 10 = 35,000 labor hours.

• The remaining (50,000 – 35,000) = 15,000 labor hours are used to produce 15,000 / 500 = 30 airplanes.

• Active Learning 2B: Japan’s production with trade

Producing 48 airplanes requires all of Japan’s resources: 48 * 625 = 30,000 labor hours.

• So, Japan would produce 0 tons of soybeans.

• Exports and Imports
• Imports
• Goods produced abroad and sold domestically
• Exports
• Goods produced domestically and sold abroad
• Active Learning 3: Consumption under trade

We continue Active Learning 2, but this time the two countries will be able to trade: 22

airplanes for 880 tons of soybeans.

• The U.S. exports 880 tons of soybeans and imports 22 airplanes. How much of each good is consumed in the U.S.?  Plot this combination on the U.S. PPF.
• Japan exports 22 airplanes and imports 880 tons of soybeans. How much of each good is consumed in Japan?  Plot this combination on Japan’s PPF.
• Active Learning 3A: U.S. consumption with trade
• Active Learning 3B: Japan’s consumption with trade
• Trade makes both countries better off
• Where Do These Gains Come From?
• Absolute advantage: 
• The ability to produce a good using fewer inputs than another producer 
• In our example:
• Absolute advantage in soybeans: the U.S.
• Producing 1 ton of soybeans  uses 10 labor hours in the U.S. vs. 25 in Japan
• Absolute advantage in airplanes: the U.S.
• Producing one airplane requires 625 labor hours in Japan, but only 500 in the U.S.

• Where Do These Gains Come From?

The U.S. has an absolute advantage in both goods!

• So why does Japan specialize in airplanes? 
• Why do both countries gain from trade?
• Two countries can gain from trade
• When each specializes in the good it produces at lowest cost
• Two Measures of the Cost of a Good
• Absolute advantage
• Measures the cost of a good in terms of the inputs required to produce it
• Another measure of cost: opportunity cost
• The opportunity cost of an airplane = amount of soybeans that could be produced using the labor needed to produce one airplane

• Comparative Advantage
• Comparative advantage
• The ability to produce a good at a lower opportunity cost than another producer
• Principle of comparative advantage
• Each good should be produced by the individual that has the smaller opportunity cost of producing that good

Specialize according to comparative advantage

• EXAMPLE 2: Comparative advantage
• The U.S.: produce 1 airplane using 500 labor hours; produce 1 ton of soybeans using 10 labor hours
• Japan: produce 1 airplane using 625 labor hours; produce 1 ton of soybeans using 25 labor hours
• For each country, calculate the opportunity cost of producing each good.
• Which country has comparative advantage in the production of soybeans?
• Which country has comparative advantage in the production of airplanes?
• EXAMPLE 2A: Calculating opportunity costs
• The U.S. :
• Produce 1 airplane using 500 labor hours, but using the 500 labor hours to produce soybeans would have produced 500/10 = 50 tons of soybeans (TS)
• Opportunity cost of 1 airplane = 50 TS
• Opportunity cost of 1 TS = 0.02 airplanes
• Japan:
• Opportunity cost of 1 airplane = 25 TS
• Opportunity cost of 1 TS = 0.04 airplanes
• EXAMPLE 2B, C: Comparative advantage
• Comparative advantage in airplanes: Japan
• Because Japan only has to give up 25 tons of soybeans (less than the 50 for U.S.)
• Comparative advantage in soybeans: the U.S.
• Because the U.S. has the lowest opportunity cost of producing soybeans
• Comparative Advantage and Trade
• Gains from trade
• Arise from comparative advantage (differences in opportunity costs)
• When each country specializes in the good(s) in which it has a comparative advantage
• Total production in all countries is higher
• The world’s “economic pie” is bigger
• All countries can gain from trade 
• The Price of the Trade
• The price of trade
• Must lie between their opportunity costs
• In our example: 22 airplanes were traded for 880 tons of soybeans
• So, the price of trade is 1 airplane for 40 tons of soybeans
• Greater than Japan’s opportunity cost  of 1 airplane (25 tons of soybeans )
• Lower than U.S. opportunity cost of 1 airplane (50 tons of soybeans)

• Active Learning 4: Argentina and Brazil

Argentina, 10,000 hours of labor/month:

• producing 1 lb. coffee requires 2 hours;
• producing 1 bottle wine requires 4 hours

Brazil, 10,000 hours of labor/month:

• producing 1 lb. coffee requires 1 hour
• producing 1 bottle wine requires 5 hours
• Which country has an absolute advantage in the production of coffee? 
• Which country has a comparative advantage in the production of wine?
• Active Learning 4: Answers
• Absolute advantage in the production of coffee?
• Fewer resources to produce 1 lb. of coffee
• Brazil: (1 labor-hour in Brazil, but 2 in Argentina)
• Which country has a comparative advantage in the production of wine?
• Producing wine at the lowest opportunity cost
• Argentina’s opportunity cost of wine= 2 lb. coffee
• Brazil’s opportunity cost of wine= 5 lb. coffee
• ASK THE EXPERTS
• Trade between China and the United States
• “Some Americans who work in the production of competing goods, such as clothing and furniture, are made worse off by trade with China.”

• THINK-PAIR-SHARE

                  You are watching an election debate on television. A candidate says, “We need to stop the flow of foreign steel into our country. If we place a tariff on imports of steel, our domestic steel produc­tion will rise and the United States will be better off.” 

• Will the U.S. be better off if we limit steel imports? Explain.
• Will anyone in the U.S. be better off if we limit steel imports? Explain.
• In the real world, does every person in the country gain when restrictions on imports are reduced? Explain.
• CHAPTER IN A NUTSHELL
• Interdependence and trade are desirable
• Allow everyone to enjoy a greater quantity and variety of goods and services
• Comparative advantage: being able to produce a good at a lower opportunity cost
• Absolute advantage: being able to produce a good with fewer inputs
• The gains from trade are based on comparative advantage, not absolute advantage
• CHAPTER IN A NUTSHELL
• Trade makes everyone better off:
• It allows people to specialize in those activities in which they have a comparative advantage
• The principle of comparative advantage applies to countries as well as to people
• Economists use the principle of comparative advantage to advocate free trade among countries