Some Tools of Economic Analysis

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Some Tools of Economic Analysis

• Chapter 2

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Remember the Economic Problem

• Economics examines how people use their scarce
  resources to satisfy their unlimited wants
  
• Scarce resource
• Not freely available ? its price exceeds zero
• Resources are
• Inputs
• Factors of production
• Used to produce goods and services

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Choice involves Opportunity Cost

• Opportunity cost of a chosen activity is the
  value of the next best alternative that is
  forgone
  
• Similar to opportunity LOST
• Focuses on the alternatives associated with
  making choices
  
• Opportunity cost is subjective
• Only the individual making the choice can select
  the most attractive alternative
  
• Its different for everyone
• Chooser seldom knows the actual value of the
  road not taken

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Whats Your Opportunity Cost of Sitting in this
Class?

• What have you forgone to be here?
• Wages
• Possibly a different class
• Time spent with family or friends
• Free time
• Sleep
• The value of each alternative is different.
• Two individuals can place a different value on
  each.

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Time and Information

• Rational choice does not mean that individuals
  exhaustively calculate the value of ALL possible
  alternatives
  
• Acquiring information about alternatives is
  costly and time consuming ? people usually make
  choices based on limited or even incorrect
  information ? some choices may turn out to be
  poor ones

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Opportunity Cost

• Time is the ultimate constraint
• By pursuing one activity, we cannot at the same
  time do something else ? each activity undertaken
  has an opportunity cost
  
• May vary with circumstances
• Depends on the value of the alternatives
• Monetary cost
• May be a reasonable approximation but we cant
  omit the time involved which may be substantial
  for some activities

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Opportunity Cost Question to Consider

• Georgia Techs Calvin Johnson enters the NFL
  Draft in his junior yearIf he plays pro ball, he
  doesnt finish his degree.
  
• What are his opportunity costs of
• Joining the draft?
• Finishing his senior year and then going into the
  draft?
  
• Finishing his senior year and getting a job as an
  engineer?
  
• Johnson's contract with Detroit is worth 64
  million, with 27.2 million fully guaranteeddid
  he make the right decision?

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Sunk Cost and Choice

• Sunk cost
• A cost that has already been incurred
• Cannot be recovered regardless of further
  actions
  
• Economic decision makers should consider only
  those costs that are affected by the choice ?
  already incurred sunk costs should be irrelevant
  in making choices

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Sunk Cost and Choice Example

• Suppose you bought a non-refundable,
  non-transferable airline ticket and hotel
  accommodations to Jamaica for your spring break.
  
• Further suppose that you won a contest that never
  anticipated winning. The prize is an all expense
  paid vacation to Hawaii to be used on the same
  week (also, non-transferable).
• Your alternatives are 1) go to Jamaica or 2) go
  to Hawaiibut you paid for Jamaica already.
  
• What do you do???
• You choose the one that you want to do more,
  regardless of the forgone cost.

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Using some of what we have learned to make
decisions

• Deciding who produces what involves choices.
• In our economy, how do we determine who will dig
  a ditch versus who will be a surgeon?

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Law of Comparative Advantage

• The Law of Comparative Advantage states that the
  individual with the lower opportunity cost of
  producing a particular output should specialize
  in producing that output
• Absolute advantage means being able to produce a
  product using fewer resources than other
  producers requirewhile comparative advantage
  focuses on producing where opportunity costs are
  lower

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Law of Comparative AdvantageThe simple example
1

• Bill and Ted both attend UWG, live together and
  have two tasks they have to dowash loads of
  dishes and wash loads of clothes. They dedicate
  1 hour per week to get-r-done.
• In that hour
• Bill can wash 12 loads of clothes OR 2 loads of
  dishes.
  
• Ted can wash 6 loads of clothes OR 4 loads of
  dishes.
  
• Bills opp. cost of a load of clothes is (2/12
  or) 1/6th of a load of dishes.
  
• Teds opp. cost of clothes is (4/6 or) 2/3rds of
  a load of dishes.
  
• Bill has a lower opp. cost of clothes, so he does
  the laundry.
  
• If they specialize and trade (Billclothes,
  Teddishes) they can do 12 loads of laundry and 4
  loads of dishes in an hour.
  
• Bill could end up with 6C and 2D (better than
  6C1D), Ted could end up with 6C and 2D (better
  than 6C0D). They are BOTH better off.
  

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Law of Comparative AdvantageThe example 2
(absolute advantage)

• Ted graduates, and Bill picks up Ned as a
  roommate, but Ned is slooooooooow at everything.
  
• In an hour
• Bill can wash 12 loads of clothes OR 2 loads of
  dishes.
  
• Ned can wash 2 loads of clothes OR 1 load of
  dishes.
  
• Note Bill has an absolute advantage in both.
  But, what about their opportunity costs????
  
• Bills opp. cost of a load of clothes is 1/6th of
  a load of dishes per load of clothes.
  
• Neds opp. cost of clothes is ½ a load of
  dishes.
  
• Bill still has a lower opp. Cost of clothes, so
  he does the laundry.
  
• Now, they can combine for 12C and 1D.
• If they trade and Bill gets 10C and 1/2D (better
  than 9C and 1/2D), Ned gets 2C and 1/2D (better
  than 1C and 1/2D), they are still better off than
  if they both worked separately and not traded.

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• The only time the two room mates are NOT made
  better off by specializing is if they both have
  the same opportunity costs for each activity.
  
• Ex.
• Bill 12C and 2D
• Fred 6C and 1D
• Both have an opp. Cost of doing clothes of 1/6th
  of a load of dishesneither has a comparative
  advantage.
  

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Why is the Law of Comparative Advantage
important???

• The same principles that apply to individuals
  applies to
  
• Companies
• States
• Regions
• Countries

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Law of Comparative Advantage

• Comparative advantage between nations exists
  because of
  
• Climate
• Workforce skills
• Natural resources
• Capital stock
• Resources will be allocated more efficiently when
  production and trade conform to the law of
  comparative advantage

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Specialization and Exchange

• Barter
• System of exchange in which products are traded
  directly for other products
  
• Works best in simply economies with little
  specialization and few goods
  
• In advanced economies with specialization, money
  plays an important role in facilitating exchange
  
• Money serves as a medium of exchange because it
  is the one thing that everyone is willing to
  accept in return for all goods and services

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Specialization and Exchange

• Specialization and comparative advantage imply
• Most people consume little of what they produce
• Produce little of what they consume
• Thus, they exchange what they produce for money
  which is in turn exchanged for other goods and
  services
  
• THIS ALLOWS FOR

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Division of Labor

• Division of labor means that each worker
  specializes in separate tasks ? the group can
  produce more
  
• How is this increase in productivity possible?
• First, tasks can be assigned according to
  individual preferences and abilities according to
  comparative advantage
  
• Second, workers who perform the same task again
  and again gets better at it
  
• Third, there is no time lost in moving from task
  to task
  
• Fourth, specialization of labor allows for the
  introduction of specialized machines ? each
  worker becomes more productive

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Production Possibilities Frontier

• Focus is on how much an economy can produce with
  the resources available ? What are the economys
  production capabilities?
  
• Simplifying assumptions
• Two broad classes of products consumer goods
  and capital goods
  
• Production during a given time period one year
• Resources available are fixed in both quantity
  and quality during the time period
  
• The available technology does not change (in the
  short term)

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Production Possibilities Frontier

• Identifies the various possible combinations of
  the two types of goods that can be produced when
  all available resources are employed fully and
  efficiently
• No change increases the production of one good
  without decreasing the production of the other
  good
  
• Involves getting the maximum possible output from
  available resources

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Exhibit 1 The Economys PPF
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The Economys PPF

• Points A and F amount of consumer goods and
  capital goods that can be produced per year if
  all resources are used efficiently
  
• Points between A and F other possible
  combinations of the two goods produced when all
  resources are efficiently employed
  
• Points inside the curve, I, combinations that
  do not employ resources efficiently or fully
  
• Point C yields more consumer goods and no fewer
  capital goods than I, while point E yields more
  capital goods and no fewer consumer goods than I,
  and all points between C and E yield more of both
  goods
• Points outside the PPF, such as U, unattainable
  combinations ? PPF serves as the frontier between
  unattainable and attainable combinations.

A
B
48
C
U
D
I
E
F
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Movements along the PPF

• Law of Increasing Costs
• Dictates the bowed-out shape of the PPF
• When the economy uses all resources efficiently,
  each additional increment of one good requires
  the economy to sacrifice successively larger and
  larger increments of the other good
• Happens because resources drawn away from
  consumer goods are those that are increasingly
  better suited to producing consumer goods. I.e.,
  the resources better suited to capital production
  move first ?
• First 10 million units of capital goods have an
  opportunity cost of only 2 million units of
  consumer goods while
  
• Final 10 million (points E to F) have an
  opportunity cost of 20 million units of consumer
  goods

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Factors that can Shift the PPF

• Changes in Resource Availability
• Increases / Improvements in Quality ? rightward
  shift
  
• Decreases /Reductions in Quality ? leftward
  shift
  
• Increases in the Capital Stock
• Increases ? rightward shift
• Decreases ? leftward shift
• Technological Change
• Employs available resources more efficiently

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Exhibit 2a Shifts in the Economys PPF

• All of the following would lead to a rightward
  shift in the PPF from A to A
  
• Increase in the size or health of the labor
  force
  
• Improvement in the skills of the labor force
• Increases in the amount of capital
• Decreases in any of the above factors would shift
  the PPF from A' to A ? shift to the left
  
• The parallel shift implies the change that
  occurred affected the production of both goods
  equally

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Exhibit 2b Shifts in the Economys PPF

• A leftward shift from A to A" could be caused by
  any of the following
  
• Decrease in the size or health of the labor
  force
  
• Decline in the skills of the labor force
• Decreases in the amount of capital
• The parallel shift implies the change that
  occurred affected the production of both goods
  equally

• What might cause this???

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Exhibit 2c Shifts in the Economys PPF

• Increase in resources or technological change
  that benefits consumer goods would rotate the PPF
  outward from the horizontal axis, from A to A'

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Exhibit 2d Shifts in the Economys PPF

• Increase in resources or technological advance
  that benefits capital goods would rotate the PPF
  outward from the vertical axis, F to F'

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Lessons of PPF

• Efficiency ? PPF represents the combinations of
  output that are possible, given the economys
  resources and technology
  
• Scarcity ? Given the stock of resources and
  technology, the economy can produce only so much
  
• Economic Growth ? Rightward shift or rotation of
  PPF
  
• Economic Contraction or Decline ? Leftward shift
  or rotation of PPF
  
• Choice ? There is typically many efficient
  combination from which to choose (on the PPF)

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Three Questions

• How an economy selects the most preferred
  combination will depend on the decision-making
  rules employed
  
• Regardless of how decisions are made, each
  economy must answer three fundamental questions
  
• What goods and services will be produced?
• How will they will be produced?
• For whom will they be produced?

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Economic System

• Economic System is a set of mechanisms and
  institutions that resolve the what, how, and for
  whom questions
  
• Criteria used to distinguish among economic
  systems
  
• Who owns the resources
• What decision-making process is used to allocate
  resources and products
  
• What type of incentives guide the economic
  decision makers

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Pure Capitalism

• Rules of the Game
• Private ownership of all resources
• Coordination of economic activity based on price
  signals generated in free, unrestricted markets
  
• Owners have property rights to use their
  resources and are free to supply those resources
  to the highest bidder
  
• Voluntary buying and selling
• Market prices guide resources to their most
  productive uses and channel goods and services to
  consumers who value them most
  
• Laissez-faire let people do as they choose
  without government intervention

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Pure Capitalism

• Markets
• Transmit information about relative scarcity of
  goods and services
  
• Provide individual incentives
• Distribute income among resource supplies
• Adam Smiths invisible hand although each
  individual pursues his or her self-interest, the
  invisible hand of markets promotes the general
  welfare
• The PERFECT SYSTEM, RIGHT?!

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Flaws in Capitalism

• No central authority to protect property rights,
  enforce contracts, or ensure that rules of the
  game are followed (who do we have to do that
  job?)
• People with no resources to sell could/will
  starve
  
• Some producers may try to monopolize by
  eliminating competition (is this good?)
  
• Production or consumption of some goods generates
  byproducts pollution that affect people not
  involved in the market transaction
  
• Public goods, such as national defense, will not
  be produced by private firms because they cannot
  prevent non-payers from enjoying the benefits of
  public goods

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Pure Command System, (a.k.a. Command and Control)

• Resources are directed and production is
  coordinated not by markets buy by the command,
  or central plan, of government
  
• Public or communal ownership of property
• Central plans spell out answers to three questions

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Flaws of Command System

• Running an economy is so complicated that some
  resources are used inefficiently
  
• Because nobody owns resources, people have less
  incentive to employ them in their highest valued
  use
  
• Central plans may reflect more the preferences of
  central planners than those of society
  
• Since government is responsible for all
  production, the variety of products tends to be
  more limited than in a market economy
  
• Each individual has less personal freedom in
  making economic choices
  
• YOU CANT VOTE WITH YOUR

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Mixed / Transitional Economies

• Economic systems have grown more alike over time
• Role of government increasing in market economies
  and role of markets increasing in command
  economies
  
• United States represents a mixed system
  government directly accounts for about one-third
  of all economic activity
  
• Government also regulates the private sector in a
  variety of ways
  
• Some economies based on custom or religion