IB ECONOMICS SECTION 1 0 THE FOUNDATIONS OF

IB ECONOMICS SECTION 1. 0 THE FOUNDATIONS OF ECONOMICS 3. 1 INTERNATIONAL TRADE: FREE TRADE

1. 0 Adam Smith Was a Scottish social philosopher and a pioneer of political economy. The Wealth of Nations, is considered the first modern work of economics. Smith is widely cited as the father of modern economics and capitalism and is still among the most influential thinkers in the field of economics today. Smith expounded how rational self-interest and competition can

1. 0 Adam Smith Invisible hand In economics, the invisible hand, also known as invisible hand of the market, is the term economists use to describe the self-regulating nature of the marketplace. This is a metaphor first coined by the economist Adam Smith in Theory of Moral Sentiments. For Smith, the invisible hand was created by the conjunction of the forces of self-interest, competition, and supply and demand, which he noted as being capable of allocating resources in society. This is the founding justification for the Austrian laissez-faire economic philosophy, but is also frequently seen in neoclassical and Keynesian economics. The central disagreement between economic ideologies is, in a sense, a disagreement about how powerful the "invisible hand" is.

1. Explain that economics is a social science. What is economics? Economics is the scientific study of the ownership, use, and exchange of scarce resources - often shortened to the science of scarcity. Economics is regarded as a social science because it uses scientific methods to build theories that can help explain the behavior of individuals, groups and organizations. Economics attempts to explain economic behavior, which arises when scarce resources are exchanged. In terms of methodology, economists, like other social scientists, are not able to undertake controlled experiments in the way that chemists and biologists are. Hence, economists have to employ different methods, based primarily on observation and deduction and the construction of abstract models. Social science The study of society and the way individuals interact within it. Economics The study of how society employs its finite resources in the attempt to satisfy infinite wants.

2. Outline the social scientific method. Economists use scientific observation and deduction in their investigations. To achieve this they: Describe and measure the exchanges they observe � Economists describe changes in economic variables, and measure these changes over time. Explain how interactions arise and create costs and benefits � Economists try to explain the effects, or results, of economic transactions Propose hypotheses, construct, and apply ‘models’ to test these hypotheses. � Like all scientists, economists develop hypotheses to explain why economic behavior takes place, and then construct models to test these hypotheses. Gather data to put into the model � Models must be tested against the real world, which means gathering statistical data about real events. In this way, a model can be improved and revised when necessary. Predict behavior based on these models. � The ultimate goal of the economist is to predict future behavior. The ultimate value of an economic model is that it can accurately predict the onset and the effect of an economic event. The better the model is, the more useful it is in helping economists make predictions.

3. Explain the process of model building in economics. The differences between physical science and social science lead to slightly different structures of research. Although there is no ideal structure, a reasonable approach to a problem in social science is the following: 1. Observe. 2. Define the problem. 3. Review the literature. (Become familiar with what others have observed. ) 4. Observe some more. 5. Develop a theoretical framework and formulate a hypothesis. 6. Choose the research design. 7. Collect the necessary data. 8. Analyze the results. 9. Draw conclusions. Using this outline as a rough guide, and recognizing that the specific project and each specific social science determine the exact nature of the methodology to be used, you have a reasonably good method of attack.

4. Explain that economists must use the ceteris paribus assumption when developing economic models. Ceteris Paribus Latin for all other things being equal Since Economics is basically the study of society, we have to understand that there are thousands of variables present, and to control each one of these variables is downright impossible Thus we make everything else "ceteris paribus" in order to see the effect of one aspect With all other factors or things remaining the same: This means that we change one parameter at a time and watch how it influences the variables For example: if the government cuts income taxes in order to lead to an increase in personal income, we would like to see whether consumption rises If we hold everything else constant, we expect that most people will spend more money when their income rises However, if at the same time there was a jump in prices and interest rates, people might not spend more money This is why it is so important to isolate one change from another In real life, of course, that is usually not possible and we have to make adjustments

5. Distinguish between positive and normative economics. Positive and Normative Concepts Positive: Based on testable theories (e. g. , a hike in interest rates leads to a fall in aggregate demand can be proven using data) Positive economics is based on theories which can be tested by looking at past data Positive statements concern what is, was or will be: assertions about the world Normative: Based on opinion/norms Uses words such as "should" (i. e. , the government should make fixing unemployment its number one priority) Normative economics is based on opinion Normative statements often include words such as ‘should’ or ought to’ and involve value judgments about what is good and what is bad Normative statements are not testable: 'ought we to be more concerned about unemployment than about inflation? ' In democracies normative statements are often settled by voting

6. Distinguish between economic goods and free goods Free Goods A good with no scarcity, that has unlimited supply and therefore no price Free goods involve no opportunity cost such as fresh air and sunshine, but they become economic goods if opportunity costs are involved in such things as removing pollution from the air A good which has no opportunity cost associated with its consumption Economic Goods A good which is scarce and therefore has a possible opportunity cost and could command a price Consumption goods are purchased by consumers and consist of perishable goods such as fresh food, semi-durable goods such as clothing, and durable goods such as cars Capital goods also referred to as producer goods are simply capital used in the production of consumer goods

7. Examine the assumption of rational economic decision-making. 'Rational Choice Theory' An economic principle that assumes that individuals always make prudent and logical decisions that provide them with the greatest benefit or satisfaction and that are in their highest self-interest. Most mainstream economic assumptions and theories are based on rational choice theory. Systematic, step by step method in which 'hard' (quantitative) data obtained through observation or mathematical (statistical) analysis or modeling is used for making long-term decisions. Steps in a rational decision making model Define the situation/decision to be made Identify the important criteria for the process and the result Consider all possible solutions Calculate the consequences of these solutions versus the likelihood of satisfying the criteria Choose the best option

8. Explain that scarcity exists because factors of production are finite and wants are infinite. Scarcity is the fundamental economic problem of having seemingly unlimited human wants in a world of limited resources. It states that society has insufficient productive resources to fulfill all human wants and needs. A common misconception on scarcity is that an item has to be important for it to be scarce. However, this is not true, for something to be scarce, it has to be hard to obtain, hard to create, or both. Simply put, the production cost of something determines if it is scarce or not. For example, although air is more important to us than diamonds, it is cheaper simply because the production cost of air is zero. Diamonds on the other hand have a high production cost. They have to be found and processed, both which require a lot of money. Additionally, scarcity implies that not all of society's goals can be pursued at the same time; trade-offs are made of one good against others.

9. Explain that economics studies the ways in which resources are allocated to meet needs and wants. Wants and needs All humans are born with basic needs, including the need to eat and drink, the need to keep warm, and the need to be protected. These result in a sustained demand for food, drink, clothing, and shelter. In addition, the human species has wants, which also have a strong influence on behavior. As incomes rise the relative importance of wants increases in relation to needs. Consumption The process of satisfying needs and wants is called consumption. The need and desire to consume is, clearly, what drives individual economic actions and provides the motive for engaging in an exchange of scarce resources. To be able to consume, individuals need to exchange their skill and effort, or their enterprise, land or capital, for an income. They can then exchange this income for the scarce products they need or want. Through exchange, consumption is satisfied by a process called production. Needs Something we MUST have in order to survive (e. g. , water, food, housing) Wants Something we desire (e. g. , pens, computers, automobiles) We have unlimited wants and limited resources

10. Explain that the three basic economic questions that must be answered by any economic system are: “What to produce? ”, “How to produce? ” and “For whom to produce? ” All societies face the economic problem, which is the problem of how to make the best use of limited, or scarce, resources. The economic problem exists because, although the needs and wants of people are endless, the resources available to satisfy needs and wants are limited. Samuelson's three questions America’s first Nobel Prize winner for economics, the late Paul Samuelson, is often credited with providing the first clear and simple explanation of the economic problem namely, that in order to solve the problem of scarcity all societies, no matter how big or small, developed or not, must endeavor to answer three basic questions. What to produce? Societies have to decide the best combination of goods and services to meet their needs. For example, how many resources should be allocated to consumer goods, and many resources to capital goods, or how many resources should go to schools, and how many to defense, and so on. How to produce? Societies also have to decide the best combination of factors to create the desired output of goods and services. For example, precisely how much land, labor, and capital should be used produce consumer goods such as computers and motor cars. For whom to produce? Finally, all societies need to decide who will get the output from the country’s economic activity, and how much they will get. For example, who will get the computers and cars that have been produced? This is often called the problem of distribution.

10. Explain that the three basic economic questions that must be answered by any economic system are: “What to produce? ”, “How to produce? ” and “For whom to produce? ”

11. Explain that as a result of scarcity, choices have to be made. Choice and opportunity cost are two fundamental concepts in economics. Given that resources are limited, producers and consumers have to make choices between competing alternatives. All economic decisions involve making choices. Individuals must choose how best to use their skill and effort, firms must choose how best to use their workers and machinery, and governments must choose how best to use taxpayer's money. Making an economic choice creates a sacrifice because alternatives must be given up, which results in the loss of benefit that the alternative would have provided. For example, if an individual has $10 to spend, and if books are $10 each and downloaded music tracks are $1 each, buying a book means the loss of the benefit that would have been gained from the 10 downloaded tracks. The loss of the next best option represents the real sacrifice and is referred to as opportunity cost. The opportunity cost of choosing the school is the loss of the factory, and what could have been produced. It is necessary to appreciate that opportunity cost relates to the loss of the next best alternative, and not just any alternative. The true cost of any decision is always the closest option not chosen.

12. Explain that when an economic choice is made, an alternative is always foregone. The opportunity cost of a choice is the value of the best alternative forgone, in a situation in which a choice needs to be made between several mutually exclusive alternatives given limited resources. Assuming the best choice is made, it is the "cost" incurred by not enjoying the benefit that would be had by taking the second best choice available. The New Oxford American Dictionary defines it as "the loss of potential gain from other alternatives when one alternative is chosen". Opportunity cost is a key concept in economics, and has been described as expressing "the basic relationship between scarcity and choice". The notion of opportunity cost plays a crucial part in ensuring that scarce resources are used efficiently. Thus, opportunity costs are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered opportunity costs.

13. Describe the factors of production Factors of production: Basic components or inputs which are required in the production of goods and services Land: Gifts of nature, this includes everything on the land, under the land, above the land, or in the sea (e. g. , oil, water) Labor: The human component hired to assist in producing a good or service. Simply the number of hours of work put in by a person Capital: Any man-made aid to production. It is physical plant, machinery, equipment and buildings; it is not the money that you invest in the stock market Entrepreneurship: Combines the other factors and takes risks recognizing the possibility of gain from employing these factors in a specific way. An entrepreneur is the one who sees an economic opportunity and mixes land, labor and capital together to produce a product with economic value.

13. Describe the factors of production Types of production Production is undertaken by firms, also known as enterprises, or businesses. There are three stages of production: Primary production, which involves the extraction of resources from the earth, such as agriculture, fishing, and mining. Land natural resources are the main resources used in primary production. Secondary, which involves the manufacture of semi-finished and finished consumer goods, such as computers, motor vehicles, and clothing. Labor and capital are the main resources used in the secondary sector. Tertiary production involves the distribution of products and the creation of services, such as road haulage, financial services, and healthcare. Human capital is usually the most essential resource used in tertiary production. The tertiary sector is sometimes sub-divided into tertiary, quaternary and quandary sectors. The quaternary sector of an economy includes the infrastructure of information technology and knowledge that enables an economy to produce successfully. The quandary sector is defined at the not-for-profit aspect of the economic, political and social infrastructure which supports economic activity, including universities, charities and government activity. Sophisticated quaternary and quandary sectors are commonly viewed as essential to economic development in a globalized economy.

1. 0 Circular flow of income The flow of income and payments between economic agents in an economy. The key agents are households and firms and the circular flow shows how money and resources moves between them. There may also be leakages from the circular flow and injections into it.

14. Explain that a production possibilities curve (production possibilities frontier) model may be used to show the concepts of scarcity, choice, opportunity cost and a situation of unemployed resources and inefficiency. Production possibility frontiers Opportunity cost can be illustrated by using production possibility frontiers (PPFs) which provide a simple, yet powerful tool to illustrate the effects of making an economic choice. A PPF shows all the possible combinations of two goods, or two options available at one point in time. A hypothetical economy, produces only two goods - textbooks and computers. When it uses all of its resources, it can produce five million computers and fifty five million textbooks. In fact, it can produce all the

14. Explain that a production possibilities curve (production possibilities frontier) model may be used to show the concepts of scarcity, choice, opportunity cost and a situation of unemployed resources and inefficiency. Interpreting PPFs Firstly, we can describe the opportunity cost of producing a given output of computers or textbooks. For example, If we produces 3 m computers; the opportunity cost is 5 m textbooks. This is the difference between the maximum output of textbooks that can be produced if no computers are produced (which is 70 m) and the number of textbooks that can be produced if 3 m computers are produced (which is 65 m). Similarly, the opportunity cost of producing 7 m computers is 31 m textbooks - which is 70 - 39. PPFs can also illustrate the opportunity cost of a change in the quantity produced of one good. For example, suppose we produce 3 million computers and 65 m textbooks. We can calculate the opportunity cost if it decides to increase production from 3 million computers to 7 million, shown on the PPF as a movement from point A to point B.

14. Explain that a production possibilities curve (production possibilities frontier) model may be used to show the concepts of scarcity, choice, opportunity cost and a situation of unemployed resources and inefficiency. Pareto efficiency Any point on a PPF, such as points 'A' and 'B', is said to be efficient and indicates that an economy’s scarce resources are being fully employed. This is also called Pareto efficiency, after Italian economist Vilfredo Pareto. Any point inside the PPF, such as point 'X' is said to be inefficient because output could be greater from the economy’s existing resources. Any point outside the PPF, such as point 'Z', is impossible with the economy’s current scarce resources, but it may be an objective for the future. Pareto efficiency can be looked at in another way - when the only way to make someone better off is to make someone else worse off. In other words, Pareto efficiency means an economy is operating at its full potential, and no more output can be produced from its existing resources.

14. Explain that a production possibilities curve (production possibilities frontier) model may be used to show the concepts of scarcity, choice, opportunity cost and a situation of unemployed resources and inefficiency. Increasing opportunity cost According to economic theory, successive increases in the production of one good will lead to an increasing sacrifice in terms of a reduction in the other good. For example, as an economy tries to increase the production of good X , such as cameras, it must sacrifice more of the other good, Y, such as mobile phones. This explains why the PPF is concave to the origin, meaning its is bowed outwards. For example, if an economy initially produces at A, with 8 m phones and 10 m cameras (to 20 m), and then increases output of cameras by 10 m, it must sacrifice 1 m phones, and it moves to point B. If it now wishes to increase output of cameras by a further 10 m (to 30 m) it must sacrifice 2 m phones, rather than 1 m, and it moves to point C; hence, opportunity cost increases the more a good is produced. The gradient of the PPF gets steeper as more cameras are produced, indicating a greater sacrifice in terms of mobile phones foregone.

15. Distinguish between different rationing systems Economic systems There are two basic solutions to the economic problem as described by Paul Samuelson, namely free markets and central panning. Free market economies Markets enable mutually beneficial exchange between producers and consumers, and systems that rely on markets to solve the economic problem are called market economies. In a free market economy, resources are allocated through the interaction of free and self-directed market forces. This means that what to produce is determined consumers, how to produce is determined by producers, and who gets the products depends upon the purchasing power of consumers. Market economies work by allowing the direct interaction of consumers and producers who are pursuing their own self-interest. The pursuit of self-interest is at the heart of free market economics.

15. Distinguish between different rationing systems Command economies The second solution to the economic problem is the allocation of scarce resources by government, or an agency appointed by the government. This method is referred to as central planning, and economies that exclusively use central planning are called command economies. In other words governments direct or command resources to be used in particular ways. For example, governments can force citizens to pay taxes and decide how many roads or hospitals are built.

15. Distinguish between different rationing systems Mixed economies There is a third type of economy involving a combination of market forces and central planning, called mixed economies. Mixed economies may have a distinct private sector, where resources are allocated primarily by market forces. Mixed economies may also have a distinct public sector, where resources are allocated mainly by government, such as defense, police, and fire services. In many sectors, resources are allocated by a combination of markets and panning, such as healthcare and, which have both public and private provision. In reality, all economies are mixed, though there are wide variations in the amount of mix and the balance between public and private sectors.

16. Compare and contrast the advantages and disadvantages of planned and free market economies Command Economy A market where the government or some central authority decides where to allocate resources Advantages: The government can influence the distribution of income. The government can determine which goods are supplied. Disadvantages: In order to function well, requires an enormous amount of information which is difficult to obtain. No real incentive for individuals to be innovative. Goods are of poor quality since there is a lack of profit motive. May NOT lead to allocative efficiency or productive efficiency due to lack of competition and profit motives. Corruption - the government has the ability to abuse its absolute power. The economy does not respond as well to supply and demand, firms are simply told to produce a certain number of goods or services

16. Compare and contrast the advantages and disadvantages of planned and free market economies Free Market The forces of supply and demand decide the economic questions and therefore where to allocate resources Advantages Resources allocated more efficiently by the price mechanism. The profit motive is a great incentive, and forces producers to reduce costs and be innovative. With no imperfections, the free market maximizes community surplus. market system relies on a number of factors to ensure that it works efficiently. The profit motive - the incentive for a reward for enterprise � � � Good levels of information being available to both producers and consumers Price accurately reflecting the costs and benefits of consumption and production The ease with which resources can move to different uses At the heart of the market system is the profit motive.

16. Compare and contrast the advantages and disadvantages of planned and free market economies Free Market Disadvantages: Instability Monopolies and corruption - The natural goal of all firms is to attain monopoly, as this eliminates competition, eliminating the associated costs and thus maximizing profit. If the market structure does not include limiting social forces, financial forces will cause firms to externalize costs such as pollution to gain monopoly. Market failures and imperfections occur because of public goods, merit goods, externalities and lack of competitive markets. The system of profits and losses is thought to be unfair, substantial government intervention is needed to cope with income redistribution problems. The system is incapable of controlling pollution and producing sustainable growth, planning has been introduced to correct for this problem.

17. Define and give an example of a transition economy A transition economy or transitional economy is an economy which is changing from a centrally planned economy to a free market. Transition economies undergo economic liberalization, where market forces set prices rather than a central planning organization. In addition to this trade barriers are removed, there is a push to privatize state-owned businesses and resources, and a financial sector is created to facilitate macroeconomic stabilization and the movement of private capital. The process has been applied in China, the former Soviet Union and Communist bloc countries of Europe, and many third world countries.

17. Define and give an example of a transition economy Transition economies A transition economy is one that is changing from central planning to free markets. Since the collapse of communism in the late 1980 s, countries of the former Soviet Union, and its satellite states, including Poland, Hungary, and Bulgaria, sought to embrace market capitalism and abandon central planning. However, most of these transition economies have faced severe short-term difficulties, and longer-term constraints on development. Rising unemployment Rising inflation Lack of entrepreneurship and skills Corruption Lack of infrastructure Lack of a sophisticated legal system Moral hazard Inequality

18. Explain that the economics course will focus on several themes, which include: a. the extent to which governments should intervene in the allocation of resources b. the threat to sustainability as a result of the current patterns of resource allocation c. the extent to which the goal of economic efficiency may conflict with the goal of equity d. the distinction between economic growth and economic development.

a. the extent to which governments should intervene in the allocation of resources 18. MARKET FAILURES: Imperfections in the exchange process between buyers and sellers that prevent markets from efficiently allocating scarce resources. Market failures come in several varieties -- public goods, market control, externalities, imperfect information and inequality in the distribution of income. Market efficiency is achieved if the value of goods produced is equal to the value of foregone production. Markets fail when this efficiency condition is not achieved. Such failures can only be corrected by government intervention. While market failures can be corrected, in principle, only through some sort of government action, government intervention does not guarantee a solution nor an efficient allocation of resources. The reason is that governments are also imperfect. Governments have their own set of inefficiencies.

18. b. the threat to sustainability as a result of the current patterns of resource allocation The Sustainability Transition The global sustainability challenge facing us is simply stated: it combines an empirical assessment and a normative claim. The evidence-based assessment, as shared by numerous scientists, is that current society-nature interactions are not sustainable – they are negatively affecting both vital ecological systems and human welfare in ways that threaten irreversible, longterm damage (UNEP 2007). Attached to this empirical claim is the normative position of sustainable development; that societal development paths should meet fundamental human needs, within and between generations, while maintaining the planet’s life-support system and conserving living resources. It is broadly a social democratic understanding, which states that a durable commitment to poverty eradication, delivered through inclusive governance structures and more equitable economic growth, must run alongside measures to reverse the continuing degradation of the global environment. In other words, that which is to be ‘sustained’ is human development for all alongside necessary ecosystem services.

18. c. the extent to which the goal of economic efficiency may conflict with the goal of equity The issues between efficiency and equity have always been a contentious political debate. The goal of equity conflicts with the goal of efficency. Efficiency means that society is getting the most it can from its scarce resources. A more efficient society can produce more with the same amount of resources. Equity means that the resources are distributed fairly among the individuals. We can view efficiency as the size of a pie, and equity being how evenly the pie is being divided.

18. d. the distinction between economic growth and economic development. Economic growth An increase in real GDP or an increase in the quantity of resources Gross Domestic Product (GDP) is often used to measure economic growth Economic development A qualitative measure of a country's standard of living which takes into account numerous factors such as education and health The Human Development Index (HDI) is normally used to measure a country's economic development Sustainable development The rate at which a country can develop without compromising the needs of future generations

3. 1 International trade: Free trade is a policy by which a government does not discriminate against imports or interfere with exports. Under a free trade policy, prices emerge from supply and demand, and are the sole determinant of resource allocation. Globalization Is the process of international integration arising from the interchange of world views, products, ideas, and other aspects of culture. Advances in transportation, telecommunications and infrastructure, are major factors in its development. Foreign Direct Investment made by a foreign company in the economy of another country. Multinational Corporations (MNCs) An organization that manufactures and markets products in many different countries and has a multinational stock ownership and multinational management.

Free trade implies the following features: Trade of goods without taxes (including tariffs) or other trade barriers (e. g. , quotas on imports or subsidies for producers) Trade in services without taxes or other trade barriers The absence of "trade-distorting" policies (such as taxes, subsidies, regulations, or laws) that give some firms, households, or factors of production an advantage over others Free access to market information Inability of firms to distort markets through government-imposed monopoly or oligopoly power

19. Explain that gains from trade include lower prices for consumers, greater choice for consumers, and the ability of producers to benefit from economies of scale, the ability to acquire needed resources, a more efficient allocation of resources, increased competition, and a source of foreign exchange. Why do countries trade? Exploring the gains from trade Trade is the exchange of goods and services between countries. When the conditions are right trade brings benefits to all countries involved and can be a powerful driver for sustained growth and rising living standards. One way of expressing the gains from trade in goods and services between countries is to distinguish between the static gains from trade (i. e. improvements in allocative and productive efficiency) and the dynamic gains (the gains in welfare that occur over time from improved product quality,

Video: Gains from trade Refers to net benefits to agents from allowing an increase in voluntary trading with each other. In technical terms, it is the increase of consumer surplus producer surplus from liberalizing trade.

19. Explain that gains from trade include lower prices for consumers, greater choice for consumers, and the ability of producers to benefit from economies of scale, the ability to acquire needed resources, a more efficient allocation of resources, increased competition, and a source of foreign exchange. Some of the gains from free trade are outlined below: Welfare gains: Economists who support the liberalization of trade believe that trade is a ‘positive-sum game’ – all counties engaged in trade and exchange stand to gain. Economies of scale – trade allows firms to exploit scale economies by operating leading to lower average costs of production that can be passed onto consumers. Competition / market contestability – trade promotes increased competition particularly for those domestic monopolies that would otherwise face little real competition. Dynamic efficiency gains from innovation - trade enhances consumer choice and stimulates product and process innovations Access to new technology- trade, like investment, is also an important mechanism by which countries can have access to new technologies. Rising living standards and a reduction in poverty - trade can

19. Explain that gains from trade include lower prices for consumers, greater choice for consumers, and the ability of producers to benefit from economies of scale, the ability to acquire needed resources, a more efficient allocation of resources, increased competition, and a source of foreign exchange. The advantages of trade The exploitation of a country's comparative advantage, which means that trade encourages a country to specialize in producing only those goods and services which it can produce more effectively and efficiently, and at the lowest opportunity cost. Producing a narrow range of goods and services for the domestic and export market means that a country can produce in at higher volumes, which provides further cost benefits in terms of economies of scale. Trade increases competition and lowers world prices, which provides benefits to consumers by raising the purchasing power of their own income, and leads a rise in consumer surplus. Trade also breaks down domestic monopolies, which face competition from more efficient foreign firms. The quality of goods and services is likely to increases as competition encourages innovation, design and the application of new technologies. Trade will also encourage the transfer of technology between countries. Trade is also likely to increase employment, given that employment is closely related to production. Trade means that more will be employed in the export sector and, through the multiplier process, more jobs will be created across the whole economy.

19. Explain that gains from trade include lower prices for consumers, greater choice for consumers, and the ability of producers to benefit from economies of scale, the ability to acquire needed resources, a more efficient allocation of resources, increased competition, and a source of foreign exchange. The disadvantages of trade Trade can lead to over-specialization, with workers at risk of losing their jobs should world demand fall or when goods for domestic consumption can be produced more cheaply abroad. Jobs lost through such changes cause severe structural unemployment. Certain industries do not get a chance to grow because they face competition from more established foreign firms, such as new infant industries which may find it difficult to establish themselves. Local producers, who may supply a unique product tailored to meet the needs of the domestic market, may suffer because cheaper imports may destroy their market. Over time, the diversity of output in an economy may diminish as local producers leave the market.

20. Explain theory of absolute advantage. An absolute advantage exists if a person, country, business, government, or some other entity can produce more output using fewer inputs than a comparable entity. An absolute production advantage arises because of technological or technical superiority. That is, the producer is able to produce more with less. Note that an absolute advantage depends on the physical quantities of the inputs used and is not based on the cost of those inputs. It might be that fewer inputs are used, but that those inputs have a greater opportunity

21. Explain, using a diagram, the gains from trade arising from a country’s absolute advantage in the production of a good. Country A has an absolute advantage in the production of both maize and wheat. At all points its production possibility curve lies to the right of that of Country B has an absolute disadvantage. Due to abundance of raw materials or more productively efficient production techniques, Country A is able to produce more wheat and more maize that Country B. Perhaps common sense tells us that Country A should produce both goods and export surpluses and Country B neither. However, when comparative advantage is considered a different story emerges.

22. Explain theory of comparative advantage The ability to produce one good at a relatively lower opportunity cost than other goods, especially compared to production in another country. Every person or country has a comparative advantage in production of at least one good or service, even with relatively limited production technology. The law of comparative advantage states that every nation has a production activity that incurs a lower opportunity cost than that of another nation, which means that trade between the two nations can be beneficial to both if each specializes in the production of a good with lower

23. Describe the sources of comparative advantage, including the differences between countries in factor endowments and the levels of technology. Resource endowment plays a large role in countries comparative advantage. A country that possesses most of the farmable land in a region is likely to have a comparative advantage in agriculture. Other counties with little natural resources or land, but have highly skilled workforces can provide services to the world. What factors determine whether a country should specialize in their resources depend on two factors. First, the relative abundance of the resource and second, the value of the good produced from the

24. Draw a diagram to show comparative advantage.

24. Draw a diagram to show comparative advantage.

25. Calculate opportunity costs from a set of data in order to identify comparative advantage. Comparative Advantage Matrix: Output model First, we compare the output possibility for each product and each country, if each produced only that one good. The most output in comparison to the other country determines absolute advantage. To find out who has a comparative advantage, we need to calculate the domestic opportunity costs in each country for each good. Opportunity Cost of X for Country A = Output Y / Output X Opportunity Cost of Y for Country A = Output X / Output Y Opportunity Cost of X for Country B = Output Y /

25. Calculate opportunity costs from a set of data in order to identify comparative advantage. Next, to determine which country has the lowest opportunity cost of production, we make a comparison across the market for each product. (Opportunity Cost of X for Country A) VS (Opportunity Cost of X for Country B ) The country with the lowest opportunity cost has the comparative advantage. This should be the good for which this country specialize in production. This will maximize production between the two countries. Each country can sell the good at some price between or equal to their own opportunity cost and that of the other country. This is called the

25. Calculate opportunity costs from a set of data in order to identify comparative advantage. Comparative Advantage Matrix: Input model Now, we compare the Input possibility for each product and each country, if each produced only that one good. The least input in comparison to the other country determines absolute advantage. To find out who has a comparative advantage, we need to calculate the domestic opportunity costs in each country for each good. Opportunity Cost of X for Country A = Input X / Input Y Opportunity Cost of Y for Country A = Input Y / Input X Opportunity Cost of X for Country B = Input X /

25. Calculate opportunity costs from a set of data in order to identify comparative advantage. Next, to determine which country has the lowest opportunity cost of production, we make a comparison across the market for each product. (Opportunity Cost of X for Country A) VS (Opportunity Cost of X for Country B ) The country with the lowest opportunity cost has the comparative advantage. This should be the good for which this country specialize in production. This will maximize production between the two countries. Each country can sell the good at some price between or equal to their own opportunity cost and that of the other country. This is called the

25. Calculate opportunity costs from a set of data in order to identify comparative advantage. Comparative advantage Using all its resources, country A can produce 30 m cars or 6 m trucks, and country B can produce 35 m cars or 21 m trucks. In this case, country B has the absolute advantage in producing both products, but it has a comparative advantage in trucks because it is relatively better at producing them. Country B is 3. 5 times better at trucks, and only 1. 17 times

25. Calculate opportunity costs from a set of data in order to identify comparative advantage. However, the greatest advantage - and the widest gap - lies with truck production, hence Country B should specialize in producing trucks, leaving Country A to produce cars. Economic theory suggests that, if countries apply the principle of comparative advantage, combined output will be increased in comparison with the output that would be produced if the two countries tried to become self-sufficient and allocate resources towards production of both goods. Taking this example, if countries A and B allocate resources evenly to both goods combined output is: Cars = 15 + 15 = 30; Trucks = 12 + 3 = 15, therefore

25. Calculate opportunity costs from a set of data in order to identify comparative advantage. Opportunity cost ratios It is being able to produce goods by using fewer resources, at a lower opportunity cost, that gives countries a comparative advantage. The gradient of a PPF reflects the opportunity cost of production. Increasing the production of one good means that less of another can be produced. The gradient reflects the lost output of Y as a result of increasing the output of X. Having a comparative advantage in X, Country A sacrifices less of Y than Country B. In terms of two countries producing two goods, different PPF gradients mean different opportunity costs ratios, and hence specialization and trade will increase world output. Only when the gradients are different will a country have a comparative advantage, and only then will trade be beneficial. Identical PPFs If PPF gradients are identical, then no country has a comparative advantage, and opportunity cost ratios are identical. In this case, international trade does not confer any advantage.

26. Draw a diagram to illustrate comparative advantage from a set of data.

26. Draw a diagram to illustrate comparative advantage from a set of data.

Terms of Trade TOT: The rate at which goods are traded, either between individuals or between nations. It is the quantity of one good exchanged per unit of another good. The terms of trade is essentially the price. But the price is stated in terms of the quantity of another good. Like any market price, the terms of trade is based on what the buyers are willing to pay and what the sellers are willing to accept. The terms of trade between any two countries is based on the relative opportunity cost in each country. In the real world, the terms of trade between two countries is adjusted for transit cost. That is, the "buying" or importing nation pays a slightly higher price that the "selling" or exporting receives, with the difference used to pay transit cost.

Terms of Trade A country’s terms of trade measures a country's export prices in relation to its import prices, and is expressed as: TOT = Index of export prices / Index of import prices x 100 When the terms of trade rise above 100 they are said to be improving and when they fall below 100 they are said to be worsening. If a country’s TOT improves, it means that for every unit of exports sold it can buy more units of imported goods. A worsening TOT indicates that a country has to export more to purchase a given quantity of imports.

World price and comparative advantage World price: The price of a good that prevails in the world market for that good. The effects of free international trade can be shown by comparing the domestic price of a good without trade and the world price of the good. If a country has a comparative advantage, the domestic price will be below the world price, and the country will be an exporter of the good. If the country has a comparative disadvantage, the domestic price will be higher than the world price, and the country will be an importer of the good.

International Trade in an Exporting Country World price of good Z > domestic price of good Z. � Domestic producers increase production as the price moves up to the world price. � Domestic consumers decrease consumption as the price moves up to the world price. � The excess supply (surplus) will be exported to willing buyers in another country. The analysis of an exporting country yields two conclusions: � Domestic producers of the good are better off, and domestic consumers of the good are worse off. � Trade raises the economic well-being of the nation as a whole because the gains of producers exceed the losses of consumers.

Figure 3 How Free Trade Affects Welfare in an Exporting Country Price of Steel Price after trade Consumer surplus before trade Exports A B Price before trade World price D C Producer surplus before trade 0 Domestic supply Domestic demand Quantity of Steel Copyright © 2004 South-Western

A Country That Exports Soybeans Without trade, CS = A + B PS = C Total surplus =A+B+C With trade, CS = A PS = B + C + D Total surplus =A+B+C+D Soybeans P $6 $4 S exports A B C D gains from trade D Q

International Trade in an Importing Country World price of good T < domestic price of good T. � Domestic producers decrease production as the price moves down to the world price. � Domestic consumers increase consumption as the price moves down to the world price. � The excess demand (shortage) will be satisfied by imports from willing sellers in another country. The analysis of an importing country yields two conclusions � Domestic producers of the good are worse off, and domestic consumers of the good are better off. � Trade raises the economic well-being of the nation as a whole because the gains of consumers exceed the losses of producers.

Figure 5 How Free Trade Affects Welfare in an Importing Country Price of Steel Consumer surplus after trade Domestic supply A Price before trade Price after trade 0 B C D Imports Producer surplus after trade World price Domestic demand Quantity of Steel Copyright © 2004 South-Western

World price and comparative advantage

The Welfare Effects of Trade

Summary: The Welfare Effects of Trade PD < PW PD > PW direction of trade exports imports consumer surplus falls rises producer surplus rises falls total surplus rises Whether a good is imported or exported, trade creates winners and losers. But the gains exceed the losses.

27. Discuss the real-world relevance and limitations of theory of comparative advantage, considering factors including the assumptions on which it rests, and the costs and benefits of specialization (a full discussion must take into account arguments in favor and against free trade and protection). Relative prices and exchange rates are not taken into account in the simple theory of comparative advantage. For example if the price of X rises relative to Y, the benefit of increasing output of X increases. Comparative advantage is not a static concept - it may change over time. For example, nonrenewable resources can slowly run out, increasing the costs of production, and reducing the gains from trade. Many countries strive for food security, meaning that even if they should specialize in non-food products, they still prefer to keep a minimum level of food production. Finally, the principle of comparative advantage is derived from a simple two good/two country model. The real world is far more complex, with countries exporting and importing many different goods and services. However, the principle of comparative advantage clearly does ‘shape’ the pattern of world trade, although most countries do try to spread their risks by diversifying into a range of goods and services, even when they do not have a clear comparative

27. Discuss the real-world relevance and limitations of theory of comparative advantage, considering factors including the assumptions on which it rests, and the costs and benefits of specialization (a full discussion must take into account arguments in favor and against free trade and protection). It may overstate the benefits of specialization by ignoring a number of costs. These costs include transport costs and any external costs associated with trade, such as air and sea pollution. (Resource depletion) The theory also assumes perfect mobility of factors without any diminishing returns. The reality may be very different. Output from factor inputs is likely to be subject to diminishing returns. This will make the PPF for each country non-linear and bowed outwards. If this is the case, complete specialization might not generate the level of benefits that would be derived from linear PPFs. In other words, there is an increasing opportunity cost associated with increasing specialization. For example, it may be that the maximum output of cars produced by country A is only 20 million (compared with 30), and the maximum output of trucks produced by country B might only be 16 million instead of 21 million. Hence, the combined output from trade might only be 46 million units (instead of the 51 million units initially predicted). Complete specialization might create structural unemployment

1. 0 Basic Definitions Utility The satisfaction gained from the consumption of a good or service Most people are assumed to be motivated by rational desires Most people derive enjoyment or utility from the goods and services they consume, and most understand that the first amount of enjoyment from consuming a good is often the highest As more and more is consumed, the level of enjoyment starts to decrease This is referred to as the concept of diminishing marginal utility The demand curve slopes downward because of the law of diminishing marginal utility (extra happiness) The marginal utility is the enjoyment received from the next unit of whatever is being consumed, and it diminishes as more is consumed Most people try to maximize total utility or enjoyment by consuming more than one good: as the marginal utility from consuming one good starts to fall from consuming more, you switch to another good where the marginal utility is higher (e. g. , we do not just eat one food such as hamburger, we get more enjoyment from mixing it with other foods such as salad, potatoes and vegetables) The marginal utility gained from buying an extra ice cream decreases with every ice cream we buy at a fixed price

1. 0 Basic Definitions Explicit costs are opportunity costs that Implicit costs are by contrast, the involve direct monetary payment by producers. The opportunity cost of the factors of production not already owned by a producer is the price that the producer has to pay for them. For instance, a firm spends $100 on electrical power consumed, the opportunity cost is $100. The firm has sacrificed $100, which could have been spent on other factors of production. opportunity costs that involve only factors of production that a producer already owns. They are equivalent to what the factors could earn for the firm in alternative uses, either operated within the firm or rent