Important Tools of the Economist

  1. Opportunity Cost

    Definition: The Opportunity cost of consuming a good is the value one places on the next best alternative.

    1. Since goods are not free (they are scarce), something must be given up in order to obtain an economic good.
    2. Cost is subjective
      1. Explicit Cost: The monetary payment one makes for a particular good.
      2. Implicit Cost: The opportunity cost associated with using goods you already own. These usually don't include monetary payments.
      3. Cost can never be completely measured by someone other than the decision-maker because only the decision-maker can value what he or she is giving up.

        Example: The cost of attending Econ 2023

        Explicit Costs:

        Tuition $300

        Books 45 Supplies 40

        Transportation 70

        Antidepressant 45

        Sub-Total $500

        Implicit Costs:

        Time (150 hrs) $1500 Assuming $10/hr.

        Travel ( 15 Hrs.) $150

        Stress $100

        Sub-Total $1750

        Total Costs: $2250

    3. Cost involves the comparison of Alternatives!
    4. Changes in the value of alternatives change cost and in turn affect decision-making.
      1. Poor people, kids, elderly tend to take the bus rather than fly.
      2. Retiree's tend to watch a lot of TV
      3. Study Time increases at Final Exam Time

  2. Trade Creates Value
Since people value alternatives differently, trading (without production) can create value. Merely rearranging existing goods can make everyone better off!

  1. Trade is voluntary.
  2. People exchange things they value less for other things they value more.
  3. Trade usually involves Transaction Cost.

    Definition: Transaction cost is the time, effort, and other resources needed to search out, negotiate, and carry out an exchange of goods or services.

  4. Middlemen specialize in reducing transaction costs. Reducing transaction costs creates value.

    It is wrong to assume that a particular good or service has value just because it exists. The microwave oven on the department store shelf is worth more than the one in a warehouse. By getting it to a place where the customer can easily see it and buy it, the distributor has added value to the product.

  1. Property Rights

    Definition: Property Right: The right to use, control and obtain the benefits associated with a particular good.

    Private Property Right: Exists when the property right is:

    1. Exclusively held by one owner.
    2. Transferable to someone else as the owners wishes.

    1. Private property owners gain by using their property in ways that benefit themselves and others; they lose by ignoring the wishes of others.
    2. Private owners have strong incentives to care for their property.
    3. Private property owners have strong incentives to conserve for the future.
    4. Private owners who negligently use their property can be held accountable for that misuse.

      Production Possibilities

Definition: The production possibilities curve reveals the mazimum amount of any two (or more) products that can be produced from a fixed set of resources.
  1. Assumptions
    1. Fixed amount of resources are available for use.
    2. Those resources are used fully and efficiently.
    3. A specific state of technical knowedge (technology).

      The production possibilities curve indicates the rate at which one good can be traded off to produce another good.

  2. Increasing Production Possibilities
    1. Increasing the economy's resource base increases production possibilities.
    2. Advancements in technology increase production possibilities.
    3. Working more and working harder increase production possibilities.
  1. Comparative Advantage

    Definition: The Law of Comparative Advantage - This economic principle suggests that individuals, firms, regions, states, countries or other economic units can gain by specializing in the production of goods that they produce cheaply (as low opportunity cost producer) and trading for those goods for which they are the high opportunity cost producer.

    1. Applies to individuals as well as nations
    2. When opportunity costs differ, potential gains from specialization and trade exist
      1. Joint or total output of the individuals increases. Both individuals will be able to consume more of both goods.
      2. The gains from specializing and trading can be had even by individuals with and absolute comparative disadvantage. Even though the lawyer can type faster than the secretary, it is more productive to let the secretary type and the lawyer practice law.
    3. Economizing behavior requires that goods be produced by the low opportunity cost producer.
      1. Maximizes total output
      2. Minimizes or conserves the use of resources
      3. Leads maximization of "Social Welfare" in competitive economies.

        Numerical Example:

        Consider the production of two goods in two regions of a country. The following is a table which tells us how much of the two goods these regions can produce with their 3available resources.

        Slavia Italia
        Food Beer Food Beer
        0 8 0 32
        2 6 2 24
        4 4 4 16
        6 2 6 8
        8 0 8 0

        Comparative Advantage - The producer that produces the good with relatively low opportunity cost has a comparative advantage in the production of that good. Low Cost Producers have comparative advantage.

        Steps to take in solving comparative advantage problems

        Step 1: You must determine the opportunity cost of producing 1 more unit of each good in each region.

        Opportunity cost of Producing 1 more unit of Food:

        In Slavia, 2 additional units of food cost 2 units of Beer. Or, 1 more food costs 1 more beer.

        In Italia producing 2 more units of food causes production of Beer to fall by 8 units. Hence the cost of 1 more food is 4 units of Beer.

        Slavia gives up less beer per unit of food production, so they have comparative advantage in producing Food.

        Step 2: As long as opportunity costs differ between the two regions, one will be the relatively low cost producer of one good; the other will have comparative advantage in the other good.

        Opportunity cost of Producing 1 more unit of Beer:

        In Slavia, 2 additional units of Beer cost 2 units of Food. Or, 1 more Beer costs 1 more Food.

        In Italia producing 8 more units of Beer causes production of Food to fall by 2 units. Hence the cost of 1 more Beer is 2/8=1/4 units of Food.

        Italia gives up less Food per unit of Beer production, so they have comparative advantage in producing Beer.

        Slavia is low cost producer of Food: Italia is the low cost producer of Beer

        Joint output of Beer and Food can be maximized if the two regions specialize.

        Step 3: Terms of trade describe the range of "prices" at which trade will be mutually beneficial. Compare the opportunity costs from step 2 to determine these.

        Terms of trade:

        Slavia makes food and demands at least 1 beer for each food it sells. Of course, they would like to get more.

        Italia makes Beer and demands at least 1 food for each 4 beers it sells. They will accept no less.

        So, the acceptable terms of trade will be somewhere between

        1 Food for 4 Beers and 1 Food and 1 Beer.

        Examples:

        1. Cuba has a comparative advantage over the US in production of Sugar
        2. Florida has a comparative advantage over Kansas in the production of Oranges
        3. Secretary has a comparative advantage in typing over the lawyer

  2. Specialization under the Law of Comparative Advantage
The law of comparative advantage and the specialization that it encourages is the primary source of our modern standard of living. It simply means that if we want to accomplish a task with the least effort, each of us should specialize in that task that we do best, relatively speaking.
  1. Specialization and mutual dependence are directly related.

    The costs associated with mutual dependence must be weighed against the benefits of specialization.

  2. Overspeicalization leads to worker alienation and decreased worker satisfaction (which in turn leads to lower productivity).