Principles 13

1
Principles 1-3

• People face trade-offs.
• The cost of something is what you give up to get
  it.
  
• Opportunity cost
• Rational People think at the margin.
• marginal benefit vs. marginal cost

2
Principles 4-6

• People respond to incentives.
• Mechanism design
• Trade can make everyone better off.
• Specialization
• Markets are usually a good way to organize
  economic activity.
  
• Decentralization

3
Principles 7-10

• Governments can sometimes improve market
  outcomes.
  
• Externality, coordination, etc.
• A countrys standard of living depends on its
  ability to produce goods and services.
  
• Prices rise when the government prints too much
  money.
  
• Society faces a short-run trade-off between
  inflation and unemployment.

4
Theory vs. Empirics

• One improves on the other.
• A good theory needs to be parsimonious and
  testable rather than complex and assertive.
  
• Empirics need to be constructed rather than
  accumulated.
  
• Theory guides where and how to look at.
• Empiric guides what to correct and find.

5
Example

• Accumulation of facts
• A king and a queen lived in a country.
• The queen died.
• The king died later.
• Hypotheses
• The king died, because he was so sad.
• The king died, because he was so excited.
• Empirics
• Check if the king was sad or happy.

6
Example (cond)

• If the king was sad (excited), the first (second)
  hypothesis is supported by the empirics.
  
• If the king was neither sad nor excited, a new
  hypothesis theory is needed.
  
• If supported, empiricists check if the hypothesis
  is generalizable.
  
• If so, the hypothesis becomes a theory.
• If not, the hypothesis needs to be modified or
  discarded.

7
Positive vs. Normative

• Positive economics answers what it is.
• Normative economics answers what it ought to
  be.
  

8
Pareto Optimality

• Pareto optimality An economic outcome is said to
  be Pareto optimal if it is impossible to make
  some individuals better off without making some
  others worse off.
• A minimal and uncontroversial test that any
  social optimal economic outcome should pass

9
When Normative Comes In?

• An economic outcome is not Pareto optimal.
• Value judgments are needed.
• Political problems, yet positive economics helps
  to resolve the problems.

10
Caveats

• The boundary is not clear-cut.
• A value judgment is already contained in the
  choice of questions, methodologies, and
  communication tools.

11
Production Possibilities Frontier

• What combination of goods can you produce per
  unit time?
  
• 24 hours are given to Adam and Eve.
• Adam can produce 10 apples or 20 bananas in 24
  hours.
  
• Eve can produce 6 apples or 18 bananas in 24
  hours.
  
• Some other combinations are possible.

12
Absolute Advantage

• The ability to produce a good using fewer inputs
  than another producer.
  
• Adam uses 2.4 hours to produce one apple.
• Eve uses 4 hours to produce one apple.
• Adam uses 1.2 hours to produce one banana.
• Eve uses 4/3 hours to produce one banana.
• Adam has an absolute advantage in producing both
  apples and bananas over Eve.

13
Comparative Advantage

• The ability to produce a good at a lower
  opportunity cost than another producer.
  
• Adams opportunity cost of an apple is 2
  bananas.
  
• Adams opportunity cost of a banana is 1/2
  apple.
  
• Eves opportunity cost of an apple is 3 bananas.
• Eves opportunity cost of a banana is 1/3 apple.

14
Comparative Advantage (cond)

• Adams opportunity cost of an apple is lower than
  Eves.
  
• Adam has a comparative advantage in producing
  apples.
  
• Eves opportunity cost of a banana is lower than
  Adams.
  
• Eve has a comparative advantage in producing
  bananas.
  

15
When to Trade?

• The price of one good should be between the
  opportunity costs of the traders of the good.
  
• Suppose the price of an apple is 2.5 banana.
• One trader has an incentive to buy.
• Even pays 0.5 fewer banana by buying.
• The other trader has an incentive to sell.
• Adam gets 0.5 more banana by selling.

16
When not to Trade

• The price of one good is beyond the opportunity
  cost of one of the traders of the good.
  
• Suppose the price of an apple is 1 banana.
• One trader has an incentive to buy.
• Eve pays 2 fewer bananas by buying.
• But the other trader does not have an incentive
  to sell.
  
• Adam loses 1 banana by selling.

17
Another Example

• 24 hours are given to Adam and Eve.
• Adam produces 12 desktops and 24 notebooks in 24
  hours.
  
• Eve produces 24 desktops and 6 notebooks in 24
  hours.
  
• Some other combinations are possible.

18
Absolute Advantage

• Adam produces 0.5 desktop and 1 notebook per
  hour.
  
• Adam has an absolute advantage in producing
  notebooks over Eve.
  
• Eve produces 1 desktop and 1/4 notebook per
  hour.
  
• Eve has an absolute advantage in producing
  desktops over Adam.

19
Comparative Advantage

• Adams opportunity cost of 1 desktop is 2
  notebooks.
  
• Adams opportunity cost of 1 notebook is 1/2
  desktop.
  
• Eves opportunity cost of 1 desktop is 1/4
  notebook.
  
• Eves opportunity cost of 1 notebook is 4
  desktops.

20
Comparative Advantage (cond)

• Adam has a comparative advantage in producing
  notebooks.
  
• Eve has a comparative advantage in producing
  desktops.
  
• In this case, the owner of the comparative
  advantage in producing one good is the same as
  the owner of the absolute advantage in producing
  the good.
• This happens when no one dominates the other in
  producing both goods.