Week 2 Flashcards
(18 cards)
Gains from Trade
What are gains from trade?
refer to the net benefits to all economic agents from entering in voluntary trading
When are gains from trade possible?
Diversity in the population, differences in taste for goods in question and differences in skills and production technology.
How should an economy allocate productive resources?
Production of a good X should be allocated to agents (people, firms countries) with the lowest opportunity cost first and the highest opportunity last.
Production Possibilities
The concept of opportunity cost for an economy can be depicted by the production possibilities frontier
assumptions for the model- resources (land, labour, capital) are fixed, two and only two goods are produced and production technology is fixed. Additionally the output of these 2 goods can be changed by moving the fixed number of workers.
The Production Possibility Frontier (PPF) depicts the maximum combination of the output of 2 goods, with all resources being efficiently used. We can use this model to calculate opportunity cost using the formula loss/gain.
The curve reflects the law of diminishing marginal returns to production. Diminishing marginal returns means that each input adds less to output than the previous input adds.
In other words, as you shift resources from producing one good to another, you end up using resources that are less suitable and therefore less productive.
Production Possibility and International Trade
France has the comparative and absolute advantage in wine.
UK has the comparative and absolute advantage in beer.
If both countries engage in open and free trade, they increase the size of the economic pie
Shifting out the PPF
One way of shifting out the PPF curve is through technological change, which simply improves productivity. If there was technological change that only improved the production of one good, and not the other than the opportunity cost of producing the good that hasnβt experienced technological change rises (the slope becomes steeper)
Another way is through improving education, as workers that are highly skilled are more productive compared to those workers who are less educated, more resources can be produced. When comparing the output of high skilled services (engineering, finance) compared to low skilled services (manufacturing), when there is an improvement in education the opportunity cost of producing more lower skilled services rises. As a result, due to education improving in Western Countries the number of jobs done in manufacturing has declined rapidly.
Definition of a Market
A market is a means of transferring goods and services from one person (agent) to another.
In markets:
Exchange is reciprocated (both parties receive and give up something).
Exchange is voluntary.
There is competition (many sellers and many buyers).
Markets can be formal (online, open air market) and informal (markets in prisons, drug markets)
Definition of Price
A price for good X in terms of resource Y is the amount of Y that must be exchanged for a unit of X.
In a barter economy X and Y would both be goods and services. We will consider economies with fiat currency, where Y is money, prices will be given in terms of the amount of money.
Definitions of Supply and Demand Schedules and Equilibrium Price.
A demand schedule is the quantity of a good that buyers wish to purchase at every conceivable price.
A supply schedule is the quantity of a good that sellers wish to sell at every conceivable price.
An equilibrium price is the price at which the demand and supply schedules intersectβquantity supplied is equal to quantity demand. We say, at this price the market clears.
Demand Curve
A graphical representation of the demand schedule in price and quantity space.
The demand curve depicts a ceteris paribus relationship: the change in quantity demanded when price changes holding everything else constant.
The law of demand: as the price of a good increases, ceteris paribus, the quantity demanded decreases.
There are many other determinants of demand, which we assume to be constant.
Tastes/preferences
Number and price of substitute goods
Number and price of complementary goods
Income
Distribution of income
Expectations and beliefs.
All of these variables we treat as being exogenous (i.e. our model of demand does not explain any of these)
Demand Equation
Market demand can be represented as a function using simple equation
ππ· = π β πP
a- quantity intercept (constant)
b- price intercept (constant)
P- price
Demand can also be represented by much more complex functions:
ππ· = π β ππ + ππ + βππ β πππ
π=population income
ππ =price of substitute good
ππ=price of complement good
We will stick with the simplest specification.
Movements Along and Shifts in the Demand
Curve
Changes in price lead to a movement along the demand curve. Changes in price cause a βchange in quantity demandedβ.
Changes in any other determinant of demand lead to a shift in the demand curve. If demand shifts we say there is a βchange in demandβ.
Increase in demand β shift to the right
Decrease in demand β shift to the left
Positive shift in the demand curve. Demand increases at every price. Possible causes:
* Tastes shift towards the good.
* Rise in the price of substitute goods.
* Fall in the price of commentary goods.
* Incomes rise
Supply Curve
Supply curve: a graphical representation of the supply schedule in price and quantity space.
The supply curve depicts a ceteris paribus relationship: the change in quantity supplied when price changes holding everything else constant. Again, quantity (π) is on the horizontal axis and price (π) is on the vertical access.
The supply curve depicts the effect of price on supply.
There are other determinants of supply, which we assume to be constant (along the curve).
* Costs of production.
* Profitability of alternative products.
* Profitability of goods in joint supply.
* Nature (i.e. weather patterns)
* Objectives of the producers.
* Expectations of the producers.
All of these variables we treat as being exogenous (i.e. our model of supply does not explain any of these).
Supply functions can be represented using simple equation:
ππ = π + ππ
The supply function can also be made more complex. For now we stay with the simple specification.
Movements Along and Shifts in the Supply
Curve
Like with demand, we want to distinguish between movements along and shifts in the supply curve.
Changes in price lead to a movement along the supply curve.
Changes in price cause a βchange in quantity supplied.β
Changes in any other determinant of supply lead to a shift in the supply curve.
If supply shifts we say there is a βchange in supplyβ.
Increase in supply β shift to the right.
Decrease in supply β shift to the left.
Assumptions for Market Equilibrium
Large number of sellers and a large number of buyers in the market.
Everyone in the market is a price taker.
No one buyer/seller can influence the equilibrium price.
All goods sold in the market are identical (e.g. no variation in quality.)
Buyers and sellers have perfect information about all available options
(This is a competitive market)
Equilibrium Represented Mathematically
Mathematically, an equilibrium is described by the following three equations:
ππ· = π β ππ The demand schedule.
ππ = π + ππ The supply schedule.
ππ = ππ·. The market clearing condition.
Comparative Statics
Comparative statics are the analysis of how a change in an exogenous variable (a demand/supply shifter) in our model changes the equilibrium
Exogenous Demand Shifters
A shift in the demand curve mathematically means that the parameter π changes from the equation ππ· = π β πP
Exogenous demand shifters may include:
Tastes/preferences
Number and price of substitute goods
Number and price of complementary goods
Income
Distribution of income
Expectations and beliefs
Pattern of answering a question on this-
Increase in demand.
There is a shortage in supply at price π1.
Buyers express a higher willingness to pay, sellers start to raise their prices.
We move along the curves π·2 and π1 to the new equilibrium
Exogenous Supply Shifters
A shift in the demand curve mathematically means that the parameter π changes from the equation ππ = π + πP
Exogenous supply shifters may include:
Costs of production.
Profitability of alternative products.
Profitability of goods in joint supply.
Nature (i.e. weather patterns)
Objectives of the producers.
Expectations of the producers
Pattern of answering a question on this-
Decrease in supply.
There is a supply shortage at the price π1
We move from an initial equilibrium at A to a new equilibrium at C
