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Baby Economics Some Tools and Terms… 1 Baby Economics Some Tools and Terms… 1

OVERVIEW n Refresh some of the topics learned in introductory economics courses n Identify OVERVIEW n Refresh some of the topics learned in introductory economics courses n Identify Specific tools required to examine Issues in International Economics (specifically trade) 2

2. 1) Important Terms and Tools • Economic Model • Demand Supply Relative (Real) 2. 1) Important Terms and Tools • Economic Model • Demand Supply Relative (Real) and Nominal Prices • Autarkyand Normative Analysis • Positive (“ No Trade”) • Production Possibilities Frontier (Curve) • Indifference Curve (IC) 3

2. 1) Important Terms and Tools • Consumer and Producer Surplus • Welfare 4 2. 1) Important Terms and Tools • Consumer and Producer Surplus • Welfare 4

WELFARE n International Economics affects the wellbeing of residents of any country. 5 WELFARE n International Economics affects the wellbeing of residents of any country. 5

WELFARE n Cross border exchange of goods and service, and financial assets are welfare WELFARE n Cross border exchange of goods and service, and financial assets are welfare improving because Provide access to goods and services that can’t be produced at home n Provide access to factors that are not available at home n Serve as a forum for transfer of technology n 6

WELFARE n when a country involves in international trade, there always some losers and WELFARE n when a country involves in international trade, there always some losers and some winners within a country. 7

WELFARE n Because International trade may affect the producers’ benefits (Producers’ Surplus) and consumers’ WELFARE n Because International trade may affect the producers’ benefits (Producers’ Surplus) and consumers’ benefits (Consumers’ Surplus) differently …. 8

WELFARE For Instance, n While consumers may gain from reduced prices, access to new WELFARE For Instance, n While consumers may gain from reduced prices, access to new products/services and quality, some producers may lose their profits and even driven out of markets…loss of jobs n Producers may also benefit from expanded opportunities (access to resources, transfer of a technology, …. ) 9

IMPROVING WELFARE Changes in Consumer Surplus + Changes in Producer Surplus Gains (+ Changes) IMPROVING WELFARE Changes in Consumer Surplus + Changes in Producer Surplus Gains (+ Changes) > Losses (- Changes) 10

Demand, Supply and Autarky Price P If a country engages in no international trade Demand, Supply and Autarky Price P If a country engages in no international trade Supply …. Autarky price Equilibrium Price Equilibrium Quantity Demand Quantity Q 11 Copyright© 2003 Southwestern/Thomson Learning

Autarky: Why? n The nation is closed to international trade (Political reasons…. ) n Autarky: Why? n The nation is closed to international trade (Political reasons…. ) n The country is self sufficient… Net changes in its welfare when it involves in international trade is ZERO n Thus decides to produce all what it consumes/ consumes all what it produces. . n 12

EXPORT Price Supply Surplus P 1 P 0 Demand 0 Qd Qs Quantity 13 EXPORT Price Supply Surplus P 1 P 0 Demand 0 Qd Qs Quantity 13 Copyright© 2003 Southwestern/Thomson Learning

IMPORT Price Supply P 0 P 1 Shortage Demand 0 Quantity supplied Quantity demanded IMPORT Price Supply P 0 P 1 Shortage Demand 0 Quantity supplied Quantity demanded 14 Copyright© 2003 Southwestern/Thomson Learning

Production Possibilities Frontier n A graph that shows alternative combination of two products that Production Possibilities Frontier n A graph that shows alternative combination of two products that can be produced from the available resources and technology 15

The Production Possibilities Frontier (PPF) Beer 70 A B C 40 Wine The Production Possibilities Frontier (PPF) Beer 70 A B C 40 Wine

Usually PPF has a Bowed Out shape Beer 70 A B 0 C 40 Usually PPF has a Bowed Out shape Beer 70 A B 0 C 40 Wine

Production Possibilities Frontier n Illustrates Several Concepts n Attainable/Unattainable levels n Efficient Production and Production Possibilities Frontier n Illustrates Several Concepts n Attainable/Unattainable levels n Efficient Production and Slack Production Levels n Tradeoffs/Opportunity n Economic Cost Growth 18

The Constant-Opportunity Cost Production Possibilities Frontier (PPF) Beer Output levels outside PPF are unattainable The Constant-Opportunity Cost Production Possibilities Frontier (PPF) Beer Output levels outside PPF are unattainable given the current technology and resources 70 55 A D 40 B C 25 E 0 10 20 30 40 Wine 19

Fig. 1. 3. The Production Possibilities Frontier (PPF) Beer Output levels within PPF indicate Fig. 1. 3. The Production Possibilities Frontier (PPF) Beer Output levels within PPF indicate the presence of unused (unemployed/slack) resources and thus are inefficient 70 55 40 A E B C 25 E 0 10 20 30 40 Wine 20

Fig. 1. 3. The Production Possibilities Frontier (PPF) Beer A movement from A to Fig. 1. 3. The Production Possibilities Frontier (PPF) Beer A movement from A to B on PPF shows the opportunity Cost of producing 10 more units Wine= 15 units of Beer 70 55 A 40 B C 25 E 0 10 20 30 40 Wine 21

Economic Growth Beer An Outward shift in PPF indicates Economic Growth 3, 000 A Economic Growth Beer An Outward shift in PPF indicates Economic Growth 3, 000 A 0 1, 000 2000 Wine 22

2. 2. Basic Assumptions … 1. Economic Agents Exhibit Rational Behavior Are goal oriented 2. 2. Basic Assumptions … 1. Economic Agents Exhibit Rational Behavior Are goal oriented n Choose to use the available resources in such a way that it gives them the maximum possible satisfaction. n 23

2. 2. Basic Assumptions … 2. There is No Money Illusion n Production and 2. 2. Basic Assumptions … 2. There is No Money Illusion n Production and consumption decisions are not based on changes only in some prices… 24

2. 2. Basic Assumptions … 2. There is No Money Illusion n Production and 2. 2. Basic Assumptions … 2. There is No Money Illusion n Production and consumption decisions are based on changes in Real (relative) NOT Nominal prices. 25

2. 2. Basic Assumptions … 3. Often times there are only 2 countries, 2 2. 2. Basic Assumptions … 3. Often times there are only 2 countries, 2 commodities, and 2 factors (2 X 2 X 2) n Convenience (2 dimensional graphs, such as PPF, IC…) 26

2. 2. Basic Assumptions … 4. Factor endowments & technologies are fixed. The supply 2. 2. Basic Assumptions … 4. Factor endowments & technologies are fixed. The supply of factors and technology in each country is fixed n Allows us to draw PPF and trace the growth path of a nation n 27

PPF (Production) Beer PPF Wine 28 PPF (Production) Beer PPF Wine 28

PPF Beer 6 A B A bowed out shape of the PPF shows an PPF Beer 6 A B A bowed out shape of the PPF shows an increasing Opportunity Cost ΔB=1 C 5 ΔB=2 3 D ΔB=3 0 1 2 3 4 E Wine 29

PPF Beer 12 Result from a neutral technical progress 6 C 5 3 0 PPF Beer 12 Result from a neutral technical progress 6 C 5 3 0 1 2 3 4 8 Wine 30

PPF Beer 12 A non-neutral technical progress 6 C 5 3 0 1 2 PPF Beer 12 A non-neutral technical progress 6 C 5 3 0 1 2 3 4 Wine 31

PPF Beer A non-neutral technical progress 6 5 C 3 0 1 2 3 PPF Beer A non-neutral technical progress 6 5 C 3 0 1 2 3 4 8 Wine 32

2. 2. Basic Assumptions … 5. Markets are Perfectly Competitive n Market prices reflect 2. 2. Basic Assumptions … 5. Markets are Perfectly Competitive n Market prices reflect the true social (opportunity) costs of production. n …P=MC; No Intervention; trade unions have no impact on wages… 33

2. 2. Basic Assumptions … 6. Factors are perfectly mobile within industries Guarantees that 2. 2. Basic Assumptions … 6. Factors are perfectly mobile within industries Guarantees that resources earn the same payments in every production sector… n Can move to sectors where returns are higher…price equalization. . n 34

2. 2. Basic Assumptions … 6. Preferences can be represented by indifference curves (IC) 2. 2. Basic Assumptions … 6. Preferences can be represented by indifference curves (IC) 35

Definition and Properties of ICs 36 Definition and Properties of ICs 36

Definition n Indifference curves are graphs that reflect the consumption preferences of individuals n Definition n Indifference curves are graphs that reflect the consumption preferences of individuals n Locus of bundles of goods that yield the same level of satisfaction 37

IC (Consumption) Beer Different combination of two goods that give a consumer the same IC (Consumption) Beer Different combination of two goods that give a consumer the same (equal) level of satisfaction 24 A 14 C E 4 2 6 10 Wine 38

IC (Consumption) Beer Bundles of Beer and Wine ( A, C, or E) gives IC (Consumption) Beer Bundles of Beer and Wine ( A, C, or E) gives a consumer equal (the same) level of satisfaction (utility) 24 A C 14 E 4 2 6 10 Wine 39

IC (Consumption) Beer Budget Line (Price Line): A line that shows the different combination IC (Consumption) Beer Budget Line (Price Line): A line that shows the different combination of two goods that a consumer can buy given his budget 24 A B 4 10 Wine 40

IC (Consumption) Beer The Tangency between IC and budget line shows utility max point IC (Consumption) Beer The Tangency between IC and budget line shows utility max point 24 A B 4 10 Wine 41

Properties 1. Are Down ward slopping (Trade-offs) 42 Properties 1. Are Down ward slopping (Trade-offs) 42

Properties Are Down ward slopping Indicate that both goods are (Trade-offs) If one bundle Properties Are Down ward slopping Indicate that both goods are (Trade-offs) If one bundle (E) has lessto the consumer…. “truly” goods of one good (Beer), Beer 1. it must have more of another good (A) to be equally pleasing as the other bundle (E). 24 A 14 C E 4 2 6 10 Wine 43

Properties 2. Convex to the Origin (Bowed In) 44 Properties 2. Convex to the Origin (Bowed In) 44

2. Convex to the Origin…(Variety) Beer Indicate that consumers are willing to give up 2. Convex to the Origin…(Variety) Beer Indicate that consumers are willing to give up less and less quantities of one good (Beer) for increased consumption of another good (Wine) 24 A 14 C E 4 2 6 10 Wine 45

Properties 3. Infinitely many ICs… 4. (Ranking) 46 Properties 3. Infinitely many ICs… 4. (Ranking) 46

3. Infinitely many ICs… Beer Consumers can describe their feelings regarding any conceivable consumption 3. Infinitely many ICs… Beer Consumers can describe their feelings regarding any conceivable consumption bundles… and right hand side An indifference curve on the upper of another indifference curve shows higher level of satisfaction. . 24 A 14 C E 4 2 6 10 Wine 47

IC (Consumption) Beer Higher utility with the same budget 24 A C B 4 IC (Consumption) Beer Higher utility with the same budget 24 A C B 4 10 Wine 48

Properties 4. Two Indifference curves never Intersect (Consistency) 49 Properties 4. Two Indifference curves never Intersect (Consistency) 49

4. Two ICs never intersect… Beer Violates the rationality Assumption 24 A 14 C 4. Two ICs never intersect… Beer Violates the rationality Assumption 24 A 14 C 4 E 2 6 Wine 50

Why PPF and IC? 51 Why PPF and IC? 51

Production and Consumption (Using PPF and IC) Beer D A C IC(2) B IC(1) Production and Consumption (Using PPF and IC) Beer D A C IC(2) B IC(1) PPF Wine 52