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Economics as a social Science
Applying the scientific method in economics
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Observation, Theory, and Testing
Assumptions and ceteris paribus
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Controls for other influences
Creating a “laboratory” environment to test hypotheses
Avoiding flaws in logical thinking
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Post hoc, ergo proptor hoc
Fallacy of Composition/Division
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The art of making models = making them
simple and effective
Spreadsheet and handouts
Example: Production Possibilities Frontier
(PPF)
-efficiency, tradeoffs, opportunity costs, law of
increasing costs, economic growth.
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Example: Circular Flow Model– what, how
and for whom questions.
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overall economy, role of economic agents,
output and income, product and factor
markets
 What?
- determined by consumer preferences
and dollar “votes”
 How? – competition requires firms to produce
at lowest possible costs “compete or be
obsolete”
 For Whom? – it depends on ownership of
resources and the prices that resources bring
 Efficiency versus equity revisited
 Voluntary
versus involuntary exchange
 An intuitive approach to gains in trade
 Using an economic model to demonstrate the
gains from trade
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All parties to a voluntary exchange must be
made better off. Trade is mutually beneficial.
Allows for specialization and division of labor
and reduces opportunity costs.
Increases interdependence
Promotes cooperation rather than conflict
Excerpt from Wealth of Nations (Fordham
University website)
 Self-sufficiency
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Pros: independence
Cons: loss of efficiency, variety in consumption
and production
 Trade
with Yakima?
 Trade with other states?
 Trade with other nations?
 Good
model building: prove the point and
make it simple
 Assumptions = things held true during the
analysis = simplification
 Assumptions can be changed later to explore
their implications
 Assumptions:
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Two individuals – rancher and a farmer
Two goods – meat and potatoes
Each work eight hours a day
Farmer takes 60min/oz meat and 15min/oz
potatoes
Rancher takes 20min/oz of meat and 10min/oz of
potatoes
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Absolute advantage
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Comparative advantage
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The rancher is more efficient than the farmer at
producing both meat and potatoes
The farmer is comparatively better at producing
potatoes than the rancher.
Comparative advantage and opportunity cost
The person with the lower opportunity cost has a
comparative advantage
◦ Someone always has a comparative advantage in the
production of a least one thing
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 How
much can be produced?
 Need to know:
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Total time divided by time/output = total output,
or
output/time multiplied by total time = total
output
Farmer (8 hours = 480/min)/ (60 min/oz
of meat) = 8 oz of meat
Rancher (480min/20min/oz of
meat)=24 oz of meat
Copyright © 2004 South-Western
(a) The Farmer ’s Production Possibilities Frontier
Meat (ounces)
If there is no trade,
the farmer chooses
this production and
consumption.
8
4
0
A
16
32
Potatoes (ounces)
Copyright©2003 Southwestern/Thomson Learning
(b) The Rancher ’s Production Possibilities Frontier
Meat (ounces)
24
If there is no trade,
the rancher chooses
this production and
consumption.
12
0
B
24
48
Potatoes (ounces)
Copyright©2003 Southwestern/Thomson Learning
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In math, slope = Δy/Δx but in this case meat is
on the y-axis and potatoes are on the x-axis, so
it become ΔM/ΔP
E.g. Rancher ΔM/ΔP = -24/48 =-1/2 , but it is
help to think of this as -1/2/1. Why? +1P → -½
M
E.g. Farmer ΔM/ΔP =- 8/32 =-1/4 , but it is help
to think of this as 1/4/1. Why? +1P → -1/4 M
To get 1 P the rancher gives up 1/2M and the
farmer gives up 1/4M
Slope = opportunity cost (an example of making
math meaningful to real world situations)
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Reverse directions
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Rancher to get 1M → -2P
Farmer to get 1M → -4P
Conclusions:
Rancher has a comparative advantage in producing
meat (1M costs 2P or 1P costs 1/2M)
◦ Farmer has a comparative advantage in producing
potatoes (1P costs 1/4M or 1M costs 4P)
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The rancher should specialize in producing meat
and the farmer should specialization in
producing potatoes.
 Marginal
versus Complete Approach
 Marginal adjustment
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Farmer -1M → +4P
Rancher +1M → -2P
Total
0M +2P, or
Rancher -1P → +1/2M
Farmer +1P → -1/4M
Total
0P +1/4M
 Either
way specializing and trading means either
more meat or potatoes
 Mankiw
explains gains a bit differently and
perhaps in a more complicated way
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Farmer only produces potatoes and rancher
produces a combination of meat and potatoes
Trade takes place with equal amounts for each
New totals lie outside the old PPF and represents
a point on a consumption possibilities frontier
Let’s see how he does it….
Copyright © 2004 South-Western
(b) The Rancher’s Production and Consumption
Meat (ounces)
Rancher's
production
with trade
24
Rancher's
consumption
with trade
18
13
B*
B
12
0
12
24 27
Rancher's
production and
consumption
without trade
48
Potatoes (ounces)
Copyright © 2004 South-Western
(a) The Farmer’s Production and Consumption
Meat (ounces)
8
Farmer's
consumption
with trade
A*
5
4
Farmer's
production and
consumption
without trade
A
Farmer's
production
with trade
0
32
16
Potatoes (ounces)
17
Copyright©2003 Southwestern/Thomson Learning
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The gains to each party are determined by the Terms of
Trade
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The terms of trade must fall between the two parties
opportunity costs (see spreadsheet)
Positive analysis = gains exist so efficiency improvements
can occur
Normative analysis = who should get the gains
Normative analysis involves value judgments and
therefore must be made by others
We will develop a model that measures the gains to
trade to consumers and producers later
 History
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of Trade
Tribal to feudal to modern times
Adam Smith (1776) and David Ricardo (1817)
 Protectionism
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The costs of not trading (e.g. Cost of
Protectionism)
Distributional impacts – transfers from
consumers to producers/workers
Political preference for protection – the
marginal costs to each consumer are small the
marginal benefits to producers/workers are
large
We will develop models to show the above
later
 Strategic
trade can be a tool to develop
certain industries
 China manipulates its exchange rate to
generate artificial terms of trade
 The U.S. gets inexpensive products and
the Chinese grow certain industries
 However, China finances its trade surplus
by lending to the U.S and/or acquiring
dollars or U.S. assets.