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 Suppose you had the chance to meet the Chief
Executive in a cocktail party. You were asked to express your opinion on minimum wage legislation in
Hong Kong.
 How do you express your views and convince him/her in five minutes?
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 Most students who take introductory economics leave the course without really having learned even the most important basic economic principles.
 Their ability to answer simple economic questions several months after leaving the course is not measurably different from that of people who never took a principles course.
*
* Hansen, W. L., M. K. Salemi, and J. J. Siegfried (2002) “Use it or lose it: teaching economic literacy,” American Economic Review
Proceedings), 92 (May): 463-72.
(Papers and
6

Start simple
Repetition and drill
Active learning
Have fun
“How much is this?”
7

Should there be 12 separate sections of Econ
101, with 25 students each?
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Or should there be only one section, with 300 students?
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What is the Optimal Class Size?
 To maximize learning without consideration of cost?
 How would considering costs change our answer?
 A personal tutorial course in economics might cost
$40,000
 A class of 300 students might cost $200/student
 Extreme case: a class of infinite students might cost less than $0.1/student
 What trade-offs must university administrators and students consider when choosing class size?
10

The Scarcity Principle
(also called no-free-lunch principle)
 Boundless wants cannot be satisfied with limited resources.
 Therefore, having more of one thing usually means having less of another.
 Because of scarcity we must make choices.
 Even Bill Gates (once valued as having US$100 billion) still faces scarcity
 There are only 24 hours
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Selling Seats Through An English Auction
 In the classroom, the teacher owns the seats. As usual, the teacher can assign seats. Here, we do it in the economics way -the teacher will sell seats through an English auction. In an
English auction, bidders cry out their bid for a good item until no one is willing to submit a higher bid. The highest bidder will get the item. This kind of auction has been used in Hong Kong’s land auction. There is no restriction on how many seats a student can buy or resale activity.
 Bidders suggest a seat for auction. A suggestion is also taken as minimum bid of HK$0.5. The minimum price of the seat is
HK$0.5. Each cry should be at a HK$0.5 or higher. When submitting a bid, raise your “number plate” and cry out the bid.
Students who do not get a seat will have to seat on the floor.
 The teacher will collect the money/ IOU and put it in a jar. The money collected will be used to fund class refreshments as determined by the class later.
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What are the alternatives to English auction?
 First come, first served;
 Teacher assigned;
 Class negotiation.
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Microeconomics
 The study of how people make choices under conditions of scarcity and of the results of those choices for society.
 In a market system, allocation of resources occur via the price system, incomes and preferences
14

Rationality assumption and The Incentive
Principle
 People have goals and try to fulfill them as best as they can.
 The Incentive Principle: An agent (person, firm or society) is more likely to take an action if its benefit rises, and less likely to take it if its cost rises.
Incentives matter in our analysis of behavior and in designing economic policies
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The Cost-Benefit Principle
 An individual (or a firm or a society) should take an action if, and only if, the extra benefits from taking the action are at least as great as the extra costs
Should I do activity x?
C(x) = the costs of doing x
B(x) = the benefits of doing x
If B(x) > C(x), do x; otherwise don't.
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Should we make the econ class larger?
 Benefit of making the class size larger = the reduction in cost per student = B(x)
 Cost of making the class size bigger = The amount people would be willing to pay to avoid the reduced quality of instruction = C(x)
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Some relevant costs:
 Faculty salary: $90,000 per course
 Per student faculty salary cost:
 1 section: $90,000/300 = $300
 12 sections: $90,000/25 = $3600
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Benefits and costs
 Benefit of increasing class size from 25 students to 300 students = ($3600 - $300) = $3300 = B(x)
 If you were currently in a class with 25 students, how much would you be willing to pay to avoid switching to one with 300 students? C(x)
 If C(x) < $3300, then it makes sense to offer the larger class.
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Optimal class size
 Observations
 The “best” class from an economic point of view will generally not be the same as the “best” size from the point of view of an educational psychologist.
 People will feel differently about the value of smaller classes.
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Optimal class size
 Who will opt for smaller classes:
 Those who value smaller classes more.
 Those who are less financially constrained.
 Observations:
 We have colleges of different class size.
 Colleges of smaller class size generally charge higher tuition fees.
 But colleges and universities may also be subsidized
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Example 1.1
Should I turn down my stereo?
 You have settled into a comfortable chair and are listening to your stereo when you realize that the next two tracks on the album are ones you dislike.
 If you had a programmable disc player or a remote control, you would have programmed them not to play.
 But you don't, and so you must decide whether to get up and turn the music down, or to stay put and wait it out.
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Example 1.1.
Should I turn down my stereo?
Suppose C(x) = $1.00 = the minimum amount it would take to get you out of your chair.
B(x) = the maximum you would be willing to pay someone to turn down the volume.
If B(x) > $1, then turn your stereo down by yourself
If B(x) < $1, then don't.
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The Cost-Benefit Principle
 An individual (or a firm, or a society) should take an action if, and only if, the extra benefits from taking the action are at least as great as the extra costs.
 Critics of the cost-benefit approach often object that people don’t really calculate costs and benefits when deciding what to do.
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People often behave
they were comparing the relevant costs and benefits.
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People often make bad decisions because they fail to compare the relevant costs and benefits.
26

Can cost-benefit analysis help you make better decisions?
Example 1.2
You are about to buy a $20 alarm clock at the campus store when a friend tells you that
Fortress has the same alarm clock on sale for $10.
Do you travel to
Fortress?
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Can cost-benefit analysis help you make better decisions?
Example 1.3. You are about to buy a $6510 laptop computer from the campus store when a friend tells you that Fortress has the same computer on sale for
$6500.
Do you travel to
Fortress?
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Example 1.2 and 1.3
you travel to Fortress?
 B(x) = benefit of traveling to Fortress
= $10 in both cases.
 C(x) = cost of traveling to Fortress
= the same amount in both cases.
 So your answer should be the same in both cases.
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Can cost-benefit analysis help you make better decisions?
Example 1.4. Choosing a public health program.
A rare disease will claim 600 lives if we do nothing. We must choose between the following two programs:
Program A: save 200 lives with certainty
Program B: save 600 lives with probability 1/3, and save zero lives with probability 2/3
Which program would you choose? A or B?
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Can cost-benefit analysis help you make better decisions?
Example 1.5. Choosing a public health program.
A rare disease will claim 600 lives if we do nothing. We must choose between the following two programs:
Program C: 400 people will die with certainty
Program D: 1/3 chance that no one will die, and 2/3 chance that all 600 will die
Which program would you choose? C or D?
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Example 1.4 vs. Example 1.5
 In Example 1.4, most people choose to save 200 lives with certainty (Program A).
 In Example 1.5, most people choose to save all 600 lives with prob. 1/3 (Program D).
 Yet the two pairs of programs are equivalent:
A=C and B=D
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Illusions
 If the list of alternatives among which we choose are the same in two cases, then the particular alternative we choose should also be the same in both cases.
 Yet people seem to prefer the safe alternative when the alternatives are framed as choices between different numbers of lives saved, and to prefer the risky alternative when the alternatives are framed as choices between different numbers of lives lost.
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Example 1.6. Losing a $100 bill
You have just arrived at the theater to buy your ticket and discover that you have lost a
$100 bill from your wallet.
Do you buy a ticket and see the play anyway?
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Example 1.7. A lost theater ticket.
You have just arrived at the theater and discover that you have lost the $100 ticket you purchased earlier that day.
Do you buy another ticket and see the play anyway?
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Example 1.6 vs. Example 1.7
 In both cases, you are $100 poorer than before.
 In both cases, the benefit of seeing the play is the same.
 In both cases, the additional cost you must incur to see the play is exactly $100.
 Since the relevant costs and benefits are the same in both cases, your decision should also be the same.
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Example 1.8. How much memory should your computer have?
Suppose that random access memory can be added to your computer at a cost of $0.50 per megabyte.
How many megabytes of memory should you purchase?
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Cost-benefit principle:
 Buy an additional megabyte if the marginal benefit of
RAM is at least as great as its marginal cost.
 Marginal benefit = added benefit from having 1 more unit.
 Marginal cost = added cost of having 1 more unit.
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Cost-benefit principle:
Dollars per megabyte
MB
Value of an additional megabyte
Cost of an additional megabyte
2.00
1.00
0.50
0.25
MC
Optimal amount of memory
1000 2000
Megabytes of memory
3000 4000
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Everyday Choices
"Should I do X?"
"How much X should I buy?"
"Should I buy an additional unit of X?"
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Some Common Pitfalls for Decision Makers
Pitfall 1: Measuring cost and benefits as proportions rather than absolute dollar amounts
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Example 1.9. Proportion vs. absolute
 Your employer has a travel discount voucher that can be redeemed on one of your next two business trips.
 You could use it to save $100 on a $2000 plane ticket to Tokyo; or you could save $90 on a $200 plane ticket to Chicago?
If your goal is to do what would be best for your company, for which trip should you use the coupon?
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Some Common Pitfalls for Decision Makers
Pitfall 2: Ignoring Opportunity Costs
 If doing activity x means not being able to do activity y, then the value to you of doing y is an opportunity
cost of doing x.
 Many people make bad decisions because they tend to ignore the value of such foregone opportunities.
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Pitfall 2: Ignoring Opportunity Costs
 It will almost always be instructive to translate questions like
"Should I do x?" into ones like
"Should I do x or y?"
 In the latter question, y is simply the most highly valued alternative to doing x.
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Example 1.10. Should I go skiing today?
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Example 1.10. Should I go skiing today?
 From experience you can confidently say that a day on the slopes is worth $50 to you.
 The charge for the day is $30 (which includes bus fare, lift ticket, and equipment).
 But this is not the only cost of going skiing. You must also take into account the value of the most attractive alternative you will forego by heading for the slopes.
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Example 1.10. Should I go skiing today?
 Suppose that if you don't go skiing, you will work at your new job as a research assistant for one of your professors.
 The job pays $40 dollars per day, and you like it just well enough to have been willing to do it for free.
 "Should I go skiing or stay and work as a research assistant?"
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Example 1.10. Should I go skiing today?
C(x) = cost of skiing plus value of forgone earnings
= $30 + $40
= $70
B(x) = $50 < C(x),
So don't go skiing.
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Willing to do it for free
 The fact that you liked your job just well enough to have been willing to do it for free is another way of saying that there are no psychic costs associated with doing it.
 This is important because it means that by the job you would not be escaping something unpleasant. not doing
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Many jobs, of course, are not pleasant.
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Example 1.11
Unwilling to do the job for less than $25/day
 Suppose instead that your job had been to scrape plates in the dining hall for the same pay, $40/day, and that the job was so unpleasant that you would be unwilling to do it for less than $25/day.
 Should you go skiing?
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I. One of the benefits of going skiing is not having to scrape plates.
 B(x) = $25 + $50 = $75
 C(x) is the same as before, namely the $30 ski charge plus the $40 opportunity cost of the lost earnings, or
$70.
 So now B(x) > C(x), which means you should go skiing.
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Some Common Pitfalls for Decision Makers
 Example 1.11 makes clear that there is a relationship between costs and benefits . reciprocal
 Not incurring a cost is the same as getting a benefit.
 By the same token, not getting a benefit is the same as incurring a cost.
Economic Surplus is the benefit of taking any action minus its cost
The goal of economic decision makers is to maximize their economic surplus.
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Example 1.12. Is it fair to charge interest when lending a friend some money?
 Suppose a friend lends you $10,000, and her primary concern in deciding whether to charge interest is to decide if it would be "fair" to do so.
 She could have put that same money in the bank, where it would have earned, say, 5 percent interest, or $500 each year.
 If she charges you $500 interest for each year the loan is out, she is merely recovering the opportunity cost of her money.
If she didn't charge you any interest, it would be the same as giving you a gift of $500/yr.
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Example 1.13. Is it fair to charge interest when lending a friend some money?
 If someone chooses not to give you a gift, is that unfair?
 If not, it makes no more sense to say that recovering the opportunity cost of lending someone money is unfair.
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Example 1.13.
Why do banks pay interest in the first place?
 Suppose you owned a bank and someone deposited
$10,000 in it on January 1 without your having to pay him interest.
 You could then take the money and buy a productive asset, such as a row of trees.
 Suppose that each year trees grow at the rate of 6 percent annually, and that the price of a tree is proportional to the amount of lumber in it.
 At the end of the year you could then sell the trees for
$10,600, and have $600 more than before.
 But that same option was available to the person who put his money in your bank.
 Why should he give earned?
you the $600 he could have
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Example 1.14.
Why do banks pay interest in the first place?
 Why should he give earned?
you the $600 he could have
 He will be willing to let you use his money only if you compensate him for the opportunity cost of not using it himself.
 If you pay him 5 percent interest, he will get $500, which will probably be acceptable to him because he won't have to go to the trouble of tending the trees himself (or of lending the money to someone who will tend them).
 You get to keep the remaining $100 for taking care of that.
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Opportunity cost
 As simple as the opportunity cost concept is, it is one of the most important in microeconomics.
 The art in applying the concept correctly lies in being able to recognize the most valuable alternative that is sacrificed by the pursuit of a given activity.
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Marginal cost versus sunk cost
 Sunk costs are costs that have already been incurred and which cannot be recovered to any significant degree.
 Marginal cost is the additional cost required to make a successful bid.
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Some Common Pitfalls for Decision Makers
Pitfall 3: Failure To Ignore Sunk Costs
 An opportunity cost will often not seem like a relevant cost when in reality it is.
 Another pitfall in decision making is that sometimes an expenditure will seem like a relevant cost when in reality it is not.
 The only costs that should influence a decision about whether to take an action are those that we can avoid by not taking the action.
 Sunk cost is a cost that is beyond recovery moment a decision must be made at the
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Example 1.15: The Pizza Experiment
How much should you eat at an all-you-can-eat restaurant?
 A local pizza parlor offers an all-you-can-eat lunch for
US$3.
 You pay at the door, and then the waiter brings you as many slices of pizza as you like.
 The "waiter" selects half of the tables at random and gave everyone at those tables a US$3 refund before taking orders.
 If all diners are rational, will there be any difference in the average quantity of food consumed by these two groups?
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"Should I eat another slice of pizza?"
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"Should I eat another slice of pizza?"
 For both groups, C(x) is exactly zero.
 Because the refund group was chosen at random, B(x) should be the same for each group, on the average.
 People from both groups should keep eating until B(x) falls to zero.
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"Should I eat another slice of pizza?"
 So the two groups should eat the same amount of pizza, on the average.
 The US$3 admission fee is a sunk cost, and should have no influence on the amount of pizza one eats.
 In fact, however, the group that did not get the refund consumed substantially more pizza.
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Four Important Decision Pitfalls
Pitfall 4: Failure To Understand the Average-
Marginal Distinction
 Marginal Benefit: The increase in total benefit that results from carrying out one additional unit of an activity.
 Average Benefit: The total benefit of undertaking units of an activity divided by n.
n
 Marginal Cost: The increase in total cost that results from carrying out one additional unit of an activity.
 Average Cost: The total cost of undertaking of an activity divided by n.
n units
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Example 1.15. Should NASA expand the space shuttle program?
 NASA currently makes four launches per year.
 Should NASA expand the space shuttle program from four launches per year to five?
 Benefits
 Total of $24 billion
 Average of $6 billion/launch
 Costs
 Total of $20 billion
 Average of $5 billion/launch
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Example 1.14. Should NASA expand the space shuttle program?
# of Launches Total Cost Average Cost Marginal Cost
($ billion) ($ billion/launch) ($ billion/launch)
0
1
2
0
3
7
0
3
3.5
3 12 4
What is the optimal number of launches?
4 20 5
Assume: Average Benefit = Marginal
5
Benefit = $6 billion
32 6.4
5
8
3
4
12
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Example 1.15. Fishing boat allocation
 Suppose you own a fishing fleet consisting of a given number of boats, and can send your boats in whatever numbers you wish to either of two ends of an extremely wide lake, east or west.
Where should you send your boats?
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Example 1.15. Fishing boat allocation
 Under your current allocation of boats, the ones fishing at the east end return daily with 100 pounds of fish each, while those in the west return daily with 120 pounds each.
 The fish populations at each end of the lake are completely independent, and your current yields can be sustained indefinitely.
 Average Catch:
West End: 120 lbs/boat
East End: 100 lbs/boat
True or False: If you shift some of your boats from the east end to the west end, you will catch more fish.
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Example 1.16. Should you move one of your boats from the east end to the west end?
Currently two boats are sent to the east end and two to the west end.
Number of boats
1
2
3
4
Average output per boat
East end West end
100 lbs/boat
100 lbs/boat
100 lbs/boat
100 lbs/boat
130 lbs/boat
120 lbs/boat
110 lbs/boat
100 lbs/boat
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Example 1.16. Should you move one of your boats from the east end to the west end?
Number of boats
1
2
3
4
Average output per boat
East end West end
100 lbs/boat
100 lbs/boat
100 lbs/boat
130 lbs/boat
120 lbs/boat
110 lbs/boat
100 lbs/boat 100 lbs/boat
Number of boats
East end West end
2
3
2
1
1
4
0
3
0
4
Total output
440 lbs
430 lbs
430 lbs
400 lbs
400 lbs
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Example 1.16. Should you move one of your boats from the east end to the west end?
Number of boats
3
4
1
2
Average output per boat
East end West end
100 lbs/boat
100 lbs/boat
100 lbs/boat
100 lbs/boat
130 lbs/boat
120 lbs/boat
110 lbs/boat
100 lbs/boat
The n-th boat
1
2
3
4
Marginal output per boat
East end West end
100 lbs 130 lbs
100 lbs
100 lbs
100 lbs
110 lbs (= 240-130)
90 lbs (=330-240)
70 lbs (400-330)
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Rules for allocating resources
 The general rule for allocating a resource efficiently across different production activities is:
 Allocate each unit of the resource to the production activity where its marginal benefit is highest.
 For a resource that is perfectly divisible, and for activities for which the marginal product of the resource is not always higher in one than in the others, the rule is:
 Allocate the resource so that its marginal benefit is the same in every activity.
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Normative Economics vs. Positive Economics
 Normative Economic Principle
 One that says how people should behave
 Example: Cost-benefit principle
 Positive Economic Principle
 One that predicts how people will behave
 Example: The incentives matter principle
 A person (or a firm or society) is more likely to take an action if its benefit rises and less likely if its cost rises
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Economics: Micro and Macro
 Microeconomics
 The study of individual choice under scarcity and its implications for the behavior of prices and quantities in individual markets.
 Macroeconomics
 The study of the performance of national economies , and of the policies that governments use to try to improve that performance.
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Economic Naturalism
 Applications
 Use cost-benefit analysis to explain some pattern of events or behavior you have observed in your own environment
Start simple
Repetition and drill
Active learning – apply to real life phenomena
76

Economic Naturalism
Observe things happening around us
Ask interesting questions
Provide plausible answers
77

Ask an interesting question
 Why do so many computer hardware manufacturers include more than $1,000 worth of “free” software with a computer selling for only slightly more than that?
78

Ask an interesting question
 Why don’t automobile manufacturers make cars without heaters?
79

Ask an interesting question
 Why do the keypad buttons on drive-up automatic teller machines have Braille dots?
80

Ask an interesting question ….
 Why are round-trip fares from Hawaii to the mainland US higher than the corresponding fares from the mainland US to
Hawaii?
81

Ask an interesting question ….
 Why is airline food so bad?
82

Ask an interesting question ….
 Why does a telecommunications equipment manufacturer offer “free” BMW sedans to employees with more than one year of service?
BMW lease price was
$9000/year.
Why not give employees
$9000/year in extra salary instead?
83

Ask an interesting question ….
Why are foreign films so good?
Criteria for choosing a film to see:
Is it by a well-known director?
Does it feature a favorite actor or actress?
Has it gotten rave reviews in the media?
Word of mouth?
The only foreign films with a chance to make it in the HK market are really good ones—those able to generate strong reviews and word of mouth.
84

End
85

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The Basis of Exchange
 Why do people exchange goods and services in the first place?
 Why is YAO Ming a top basketball player, Dr. WONG an instructor in a university, and Thomas FRIEDMAN a prominent writer?
87

Why not do everything on our own?
 Should Joe Jamail write his own will?
 Jamail is the most renowned trial lawyer in American
History
 He is listed 195 on the Forbes list of the 400 richest
Americans, with net assets over $1 billion.
 Should Ms. Sarah Liao do her own household chores?
 Secretary for the Environment, Transport and Works
(SETW) of the Hong Kong Special Administrative
Region Government
 She knows how to do household chores.
88

Why not do everything on our own?
Grow our own food…
89

Why not do everything on our own?
replace our own roofs…?
…paint our own houses…
90

Why not do everything on our own?
We can all have more of every good and service if we specialize in the activities at which we are efficient. relatively most
91

Example 2.1. Basis for exchange
 Paul is a house painter whose roof needs replacing. Ron is a roofer whose house needs painting.
 Although Paul is a painter, he also knows how to install roofing. Ron, for his part, knows how to paint houses.
 Should Paul roof his own house? Should Ron paint his own house?
Paul
Ron
92

Example 2.1. Basis for exchange
Time required by each to complete each type of job:
Paul
Ron
Painting
300 hrs
200 hrs
Roofing
400 hrs
100 hrs
Ron has an absolute advantage over Paul at both painting and roofing, which means that Ron takes fewer hours to perform each task than Paul does.
Should Ron do the roofing and painting jobs for both houses?
93

Example 2.1. Basis for exchange
Time required by each to complete each type of job:
Paul
Ron
Painting
300 hrs
200 hrs
Roofing
400 hrs
100 hrs
However, Paul has a comparative advantage over Ron at painting, which means that he is relatively more efficient at painting than Ron is .
94

Comparative advantage and opportunity cost
“To have a comparative advantage at a task”
(is the same as)
“To have a lower opportunity cost of performing it”
95

Example 2.1. Basis for exchange
Paul
Ron
Painting
300 hrs
200 hrs
Roofing
400 hrs
100 hrs
 For Paul, the opportunity cost of painting one house = the number of roofing jobs he could do in the same time.
 Paul takes 300 hours to paint a house, 400 hours to roof a house.
 So in the time it takes Paul to paint a house, he could complete .75 roofing jobs.
 So Paul’s opportunity cost of painting a house is .75 roofing jobs.
96

Example 2.1. Basis for exchange
Paul
Ron
Painting
300 hrs
200 hrs
Roofing
400 hrs
100 hrs
 For Ron, the opportunity cost of painting one house = the number of roofing jobs he could do in the same time.
 Ron takes 200 hours to paint a house, 100 hours to roof a house.
 So in the time it takes Ron to paint a house, he could complete 2 roofing jobs.
 So Ron’s opportunity cost of painting a house is 2 roofing jobs.
97

Example 2.1. Basis for exchange
 Paul’s opportunity cost of painting a house is .75 roofing jobs.
 Ron’s opportunity cost of painting a house is 2 roofing jobs.
 Paul thus has a comparative advantage at painting, because his opportunity cost of painting is lower than
Ron’s.
 Therefore it makes sense for Paul to do both painting jobs and leave both roofing jobs for Ron.
98

Example 2.1. Basis for exchange
Paul
Ron
Painting
300 hrs
200 hrs
Roofing
400 hrs
100 hrs
 If each person performed both tasks for himself, the total time spent would be 700 hours for Paul and 300 hours for Ron.
 By contrast, when each specializes in his comparative advantage, these totals fall to 600 for Paul and 200 for Ron, a savings of 100 hours each .
99

Principle of Comparative Advantage
 Everyone does best when each person (or country) concentrates on the activities in which he or she is relatively most efficient .
 “Concentrates on the activities in which he or she is relatively most efficient” means specialization .
 Specialization by comparative advantage provides the rationale for market exchange.
 It explains why each person does not devote 10 percent of her time to producing cars, 5 percent to growing food, 25 percent to building housing, 0.0001 percent to brain surgery….
 By performing only those tasks at which we are relatively most efficient, we can produce vastly more than if we each tried to be self-sufficient .
100

Caution!!
 Pay close attention to the form in which the productivity information is provided.
 Your goal in each case is to find each person’s opportunity cost of producing the good in question.
101

Example 2.2.
Arthur can milk a goat in 10 minutes and shear a sheep in 4 minutes. Ben can milk a goat in 6 minutes and shear a sheep in 3 minutes.
Which statement below is true?
a. Arthur has no comparative advantage. b. Ben should do both tasks because he has an absolute advantage in both.
c. Arthur has a comparative advantage in shearing sheep and Ben has a comparative advantage in milking goats.
d. Arthur has a comparative advantage in milking goats and Ben has a comparative advantage in shearing sheep.
e. None of the above statements is true.
102

Example 2.2.
Who has the comparative advantage of milking goats?
 Arthur can milk a goat in 10 minutes and shear a sheep in 4 minutes. Arthur’s opportunity cost of milking a goat is
 10/4 = 2.5 sheep shorn.
 Ben can milk a goat in 6 minutes and shear a sheep in 3 minutes.
Ben’s opportunity cost of milking a goat is
 6/3 = 2 sheep shorn.
 Who has a comparative advantage at milking goats?
 Ben, whose opportunity cost of milking a goat is lower.
103

Example 2.2.
Who has the comparative advantage of shearing sheep?
 Arthur can milk a goat in 10 minutes and shear a sheep in 4 minutes. Arthur’s opportunity cost of shearing a sheep is
 4/10 = 0.4 goats milked.
 Ben can milk a goat in 6 minutes and shear a sheep in 3 minutes.
Ben’s opportunity cost of shearing a sheep is
 3/6 = 0.5 goats milked.
 Who has a comparative advantage at shearing sheep?
 Arthur, whose opportunity cost of shearing a sheep is lower.
104

Example 2.2.
Arthur can milk a goat in 10 minutes and shear a sheep in 4 minutes. Ben can milk a goat in 6 minutes and shear a sheep in 3 minutes.
Which statement below is true?
a. Arthur has no comparative advantage. b. Ben should do both tasks because he has an absolute advantage in both.
c. Arthur has a comparative advantage in shearing sheep and Ben has a comparative advantage in milking goats.
d. Arthur has a comparative advantage in milking goats and Ben has a comparative advantage in shearing sheep.
e. None of the above statements is true.
105

Example 2.3.
Arthur can milk 10 goats per hour or shear 4 sheep per hour.
Ben can milk 6 goats per hour or shear 3 sheep per hour.
Which statement below is true?
a. Arthur has no comparative advantage. b. Ben should do both tasks because he has an absolute advantage in both.
c. Arthur has a comparative advantage in shearing sheep and Ben has a comparative advantage in milking goats.
d. Arthur has a comparative advantage in milking goats and Ben has a comparative advantage in shearing sheep.
e. None of the above statements is true.
106

Example 2.3.
Who has the comparative advantage of milking goats?
 Arthur can milk 10 goats per hour or shear 4 sheep per hour. So his opportunity cost of milking 1 goat is
 0.4 sheep shorn.
 Ben can milk 6 goats per hour or shear 3 sheep per hour. So his opportunity cost of milking 1 goat is
 0.5 sheep shorn.
 Who has a comparative advantage at milking goats?
 Arthur, whose opportunity cost of milking a goat is lower.
107

Example 2.3.
Who has the comparative advantage of shearing sheep?
 Arthur can milk 10 goats per hour or shear 4 sheep per hour. So his opportunity cost of shearing 1 sheep is
 2.5 goats milked.
 Ben can milk 6 goats per hour or shear 3 sheep per hour. So his opportunity cost of shearing 1 sheep is
 2 goats milked.
 Who has a comparative advantage at shearing sheep?
 Ben, whose opportunity cost of shearing sheep is lower.
108

Example 2.3.
Arthur can milk 10 goats per hour or shear 4 sheep per hour.
Ben can milk 6 goats per hour or shear 3 sheep per hour.
Which statement below is true?
a. Arthur has no comparative advantage. b. Ben should do both tasks because he has an absolute advantage in both.
c. Arthur has a comparative advantage in shearing sheep and Ben has a comparative advantage in milking goats.
d. Arthur has a comparative advantage in milking goats and Ben has a comparative advantage in shearing sheep.
e. None of the above statements is true.
109

Sources of Comparative Advantage
 Individual
 Inborn talent
 Education
 Training
 Experience
 National Level



Natural resources
Cultural
Institutions
 Non-economic
 Adoption of a language
 Institutions
What can we do to change our comparative advantage?
110

Economic Naturalist
 Televisions and videocassette recorders were developed and first produced in the U.S.
 Why did the U.S. fail to retain its lead in these markets?
111

The Production Possibilities Curve
 A graph that describes the maximum amount of one good that can be produced for every possible level of production of the other good.
112

Example 2.4
 Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of food.
 If Chris is the only person in the economy, describe the economy's
production possibilities curve.
Shelter (sq yd/wk)
6
4
2
0
4 8
Food (lb/wk)
12
113

Example 2.4
Shelter (sq yd/wk)
6
4
2
0
4 8
Food (lb/wk)
12
Production Possibilities Curve:
All combinations of shelter and food that can be produced with Chris’s labor.
The absolute value of the slope of the production possibility curve is 6/12 =
1/2.
For Chris, this means that the opportunity cost of an additional pound of food each week is 1/2 sq yd/wk of shelter.
114

Example 2.4
A, B, C, D Attainable and efficient
E Attainable but inefficient
F Unattainable
Shelter (sq yd/wk)
6
A
4
C
2
0
F
E D
4 8
Food (lb/wk)
12
B
115

Example 2.5
 Dana can produce 4 sq yd/wk of shelter and 4 lb/wk of food. If
Dana is the only one in the economy, describe the economy's production possibilities curve.
Shelter (sq yd/wk)
4
Production Possibilities Curve:
All combinations of shelter and food that can be produced with Dana’s labor.
2
2 4
Food (lb/wk)
For Dana, the opportunity cost of an additional pound of food each week is 1 sq yd/wk of shelter.
116

Production Possibilities in a Two-Person
Economy
 For Chris, the opportunity cost of an additional pound of food each week is 1/2 sq yd/wk of shelter.
 For Dana, the opportunity cost of an additional pound of food each week is 1 sq yd/wk of shelter.
 Thus, Chris has a comparative advantage in producing food, because the opportunity cost of producing food is only half as large as it is for Dana.
 By the same token, Dana has a comparative advantage producing shelter.
117

Example 2.6
 Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of food. Dana can produce 4 sq yd/wk of shelter and 4 lb/wk of food. If Chris and Dana are the only two people in the economy, describe the economy's production possibilities curve.
Shelter (sq yd/wk)
Food (lb/wk)
118

Example 2.6
 Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of food. Dana can produce 4 sq yd/wk of shelter and 4 lb/wk of food. If Chris and Dana are the only two people in the economy, describe the economy's production possibilities curve.
Shelter (sq yd/wk)
Food (lb/wk)
119

Example 2.6
 Chris can produce 6 sq yd/wk of shelter or 12 lb/wk of food. Dana can produce 4 sq yd/wk of shelter and 4 lb/wk of food. If Chris and Dana are the only two people in the economy, describe the economy's production possibilities curve.
Shelter (sq yd/wk)
Food (lb/wk)
120

Example 2.7
Dana and Chris, a married couple, have decided to consume, jointly,
6 sq yd/wk of shelter and 8 lb/wk of food. How should they divide the task of producing these quantities?
Shelter (sq yd/wk)
10
Dana works full time making shelter; Chris works 1/3 week on shelter, 2/3 week on food.
6
4
8 12 16
Food (lb/wk)
121

Example 2.7
Shelter (sq yd/wk)
10
Dana works full time making shelter; Chris works
1/3 week on shelter, 2/3 week on food.
6
4
8
Food (lb/wk)
12 16
 Dana has a comparative advantage in producing shelter, but even if she spends all his time producing shelter, she can make only 4 sq yd/wk.
 So Chris will have to produce the additional 2 sq yd/wk for them to achieve the desired 6 sq yd/wk.
 Since Chris is capable of producing 6 sq yd/wk of shelter on his own, it will take him only 1/3 of a week to produce 2 sq yd.
 This leaves 2/3 of a week for him to produce food, which is exactly how much time he needs to produce the desired 8 lb/wk.
122

The Principle of Increasing Opportunity Cost
(Also called “The Low-Hanging-Fruit Principle”)
 In expanding the production of any good, first employ those resources with the lowest opportunity cost, and only afterward turn to resources with higher opportunity costs.
123

Example 2.8
 Chris and Dana are now joined by George, whose production-possibilities curve is shown below. What is the production-possibilities curve for the new economy consisting of Chris, Dana, and George?
Shelter (sq y ds/wk)
2
George' s production possibility curve
1
Food
(lbs/wk)
124

Production Possibilities Curve with three persons
12
Shelter
(sq yd/wk)
Production P ossibilities Curve:
All com binations of shelter and food that can be produced with the labor of Chris, Dana and George.
6
2
12 16 17
Food (lb/wk)
Opportunity cost of producing 1 pound per week of food
George's = 2 sq yds/wk of shelter.
Chris's = 1/2 sq yd/wk of shelter
Dana's = 1 sq yd/wk of shelter
125

6
4
2
Example 2.9
 If the economy consisting of Chris, Dana, and George is to produce 14 lbs/wk of food and 4 sq yds/wk of shelter, how should each person's work time be allocated?
12
Shelter
(sq yd/wk)
Chris: 0 sq yds/wk of shelter, 12 lbs/wk of food.
Dana: 2 sq yds/wk of shelter, 2 lbs/wk of food.
George: 2 sq yds/wk of shelter, 0 lbs/wk of food.
production point
12 14 16 17
Food (lb/wk)
126

The Production Possibilities Curve for an
Economy with Many Workers
Food (lbs/wk)
Clothing (garments/wk)
Produce the initial units of clothing using the resources that are relatively most efficient at clothing production, and only then turn to those that are relatively less efficient at clothing production.
127

Economic Growth:
An Outward Shift in the Economy’s PPC
Coffee
(1000s of lb/day)
New PPC
Factors Shifting the PPC
1. Increases in productive resources
(i.e. labor or capital)
2. Improvements in knowledge and technology
Original PPC
Nuts
(1000s of lb/day)
128

Factors That Shift The Economy’s Production
Possibilities Curve
 Increasing Productive Resources
 Investment in new factories and equipment
 Population growth
 Improvements in knowledge and technology
 Increasing education
 Gains from specialization
129

How much does specialization matter?
130

Example 2.10.
How much does specialization matter? (I)
 George and Tom are mechanics.
 Tom can replace 15 clutches per day or 10 sets of brakes, i.e., the opportunity cost of replacing a pair of brakes is 1.5 clutches;
 George can replace 10 clutches per day or 15 sets of brakes, i.e., the opportunity cost of replacing a pair of brakes is 2/3 clutches.
 At their garage, the number of brake replacements performed each day is the same as the number of clutch replacements.
 How much more can they accomplish if they specialize than if each performed an equal number of brake and clutch replacements?
131

Example 2.10.
How much does specialization matter? (I)
 If he doesn’t specialize, George can replace only 6 clutches per day and 6 sets of brakes.
Clutch replacements per day
10
6
0
6
George
George’s production possibilities curve:
C = 10 - (2/3) B
Want equal number of both types of jobs: C = B
15
Brake replacements per day
So write C = 10 – (2/3)C and solve for C = 6.
132

Example 2.10.
How much does specialization matter? (I)
If Tom doesn’t specialize, he too can produce 6 jobs of each type per day.
Clutch replacements per day
15
Tom
Tom’s production possibilities curve:
C = 15 - (3/2) B
6
Want equal number of both types of jobs: C = B
So write C = 15 – (3/2)C and solve for C = 6.
0
6 10
Brake replacements per day
133

Example 2.10.
How much does specialization matter? (I)
 By specializing, they can replace 15 clutches per day
(Tom) and 15 sets of brakes (George).
Clutch replacements/day
25
15
15 25
Brake replacements/day
134

Example 2.10.
How much does specialization matter? (I)
 So if neither George nor Tom specializes, the two can produce a total of only 12 jobs of each type per day, .
 If they specialize, they can produce a total of 15 jobs per day.
 A 25% increase in output isn’t bad,
 but cannot explain why industrialized countries produce so much more than developing countries.
135

Example 2.11.
How much does specialization matter? (II)
 George and Tom are mechanics. Tom can replace 30 clutches per day or 6 sets of brakes, i.e., the opportunity cost of replacing a pair of brakes is 5 clutches.
 George can replace 6 clutches per day or 30 sets of brakes, i.e., the opportunity cost of replacing a pair of brakes is 0.2 clutches.
 At their garage, the number of brake replacements performed each day is the same as the number of clutch replacements.
 Note that the difference in opportunity cost (5 vs. 0.2) is larger than that in Example 2.10 (3/2 vs. 2/3).
 How much more can they accomplish if they specialize than if each performed an equal number of brake and clutch replacements?
136

Clutch replacements per day
36
30
Example 2.11.
How much does specialization matter? (II)
By specializing, they can replace 30 clutches per day (Tom) and 30 sets of brakes (George)
0 30 36
Brake replacements per day
137

Example 2.11.
How much does specialization matter? (II)
If they don’t specialize, each can replace only
5 clutches per day and
5 sets of brakes, for a total of 10 daily replacements of each type.
Clutch replacements per day
6
5
0
George
5
Brake replacements per day
30
Clutch replacements per day
30
Tom
5
0 5 6
Brake replacements per day
138

Example 2.11.
How much does specialization matter? (II)
 By specializing, they can replace 30 clutches per day
(Tom) and 30 sets of brakes (George), i.e., 30 daily replacement of each type .
 If they don’t specialize, each can replace only 5 clutches per day and 5 sets of brakes, for a total of 10 daily replacements of each type .
 The gain in output is three fold.
The gains from specialization are larger when differences in opportunity cost are larger, and when individuals enjoy absolute advantage in their respective specialties.
139

Gains from specialization will often be far more spectacular!
 Division of labor according to talent and temperament
 Learning by doing
 Specialized capital equipment
140

Specialization can further shift comparative advantage
Service manufacturing
141

Adam Smith on specialization:
142

Adam Smith on specialization:
“One man draws out the wire, another straightens it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations... I have seen a small manufactory of this kind where only ten men were employed... [who] could, when they exerted themselves, make among them about twelve pounds of pins in a day. There are in a pound upwards of four thousand pins of middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day...”
143

Too much specialization?
 Specialization boosts productivity, but it also entails costs.
 Variety is one of the first casualties.
144

“[A]ll means for the development of production ... mutilate the laborer into a fragment of a man, degrade him to the level of an appendage of a machine, destroy every remnant of charm in his work and turn it into hated toil..”
145

Example 2.12.
Which job should Jane choose?
 Suppose Jane is a factory worker who must choose between two jobs:
1.
$1000/wk, little variety, or
2.
$800/wk, high variety.
 If Jane values the additional variety offered by the second job at $400 per week, which job should she choose?
Although the first job pays $200 more than the second, the second is actually worth more to Jane because its additional variety is worth $400, or $200 more than necessary to compensate for its lower salary. Therefore,
Jane should choose the second job .
146

Example 2.13. Why does excessive specialization create profit opportunities?
 Suppose Jane is forced to move to the more specialized firm at a salary of $1000 per week when her original employer dies.
 Explain how a new firm could lure her away from this job and make additional profit for itself in the process.
 Her original employer was breaking even by paying Jane $800 per week.
 She would be indifferent between working at the more specialized job at a salary of $1000 and working at the less specialized job at a salary of $600.
 So a new firm could offer her $700 per week for the less specialized job.
 She would accept and the new firm would earn a profit of at least
$100 per week.
147

Example 2.13. Why does excessive specialization create profit opportunities?
1.
Because people are willing to pay for variety in their jobs, firms that are willing to provide jobs with greater variety may be able to earn additional profit.
2.
The emergence of firms to offer jobs of variety benefits also the workers.
3.
Additional economic surplus is resulted.
148

Efficiency of specialization and variety
 A situation is efficient if it results in the largest possible economic surplus.
 A situation is inefficient if it fails to achieve the largest possible economic surplus.
 Specialization brings additional output.
 People like more output and also variety in their jobs.
 There is a trade-off between output and variety.
 Too much specialization could be inefficient.
149

The Efficiency Principle
Efficiency is a good thing, because when the economic pie is larger, everyone can have a larger slice.
150

Specialization vs. variety
 Why don’t people just choose the level of simplicity that seems to work best for them?
 Possible answers:
 Spending is tempting.
 Hard to cut back when others don’t.
Bottom line: Life entails compromise. Specialization may be unpleasant, but those who don’t specialize at all must accept low wages or work extremely long hours.
We can expect to meet life’s financial obligations in the shortest time— thereby freeing up more time to do whatever else we wish—if we concentrate at least a significant proportion of our efforts on those tasks for which we have a comparative advantage.
151

Comparative Advantage and International Trade
 The same logic that leads the individuals in an economy to specialize and exchange goods with one another also leads nations to specialize and trade among themselves.
 As with individuals, each trading partner can benefit from exchange, even though one may be more productive than the other in absolute terms.
152

Example 2.14. How does international trade expand domestic consumption possibilities?
 Elizabeth and Dennis are the only two workers in
Islandia, a small island nation, and their production possibilities curve is as shown.
Bananas
(lb/day)
120
100
E
In a closed economy, consumption possibilities = production possibilities
100 120
Tea
(lb/day)
153

Example 2.14. How does international trade expand domestic consumption possibilities?
 In the world market, tea can be purchased or sold at a price of $2 per pound and bananas can be bought or sold at a price of $1 per pound.
 How does the opportunity to trade in the world markets for bananas and tea affect consumption opportunities in
Islandia?
154

Example 2.14. How does international trade expand domestic consumption possibilities?
 If Islandians specialized at the point E and sold all their produce in the world market, they would earn
 $200 +$100 = $300 per day.
Bananas
(lb/day)
120
100
E
100 120
Tea
(lb/day)
155

Example 2.14. How does international trade expand domestic consumption possibilities?
They could buy as many 300 pounds of bananas per day (point
F) or as many as 150 pounds per day of tea
(point G). Islandia could also consume any combination of tea and bananas on the line FG.
Bananas
(lb/day)
300
F
1x300 + 2x0 = 300
120
100
1x150 + 2x75 = 300
E
1x100 + 2x100 = 300
In a open economy, consumption possibilities > production possibilities
1x0 + 2x150 = 300
G
100
120
150
Tea
(lb/day
156

Example 2.15. How does international trade expand domestic consumption possibilities?
 In the world market, tea can be purchased or sold at a price of $20 per pound and bananas can be bought or sold at a price of $10 per pound.
 How does the opportunity to trade in the world markets for bananas and tea affect consumption opportunities in
Islandia?
157

Example 2.15. How does international trade expand domestic consumption possibilities?
 If Islandians specialized at the point E and sold all their produce in the world market, they would earn
 $2000 +$1000 = $3000 per day.
Bananas
(lb/day)
120
100
E
Although their income is
10 times as large as before, so are the prices of all goods.
The relative prices has not changed.
100 120
Tea
(lb/day)
158

Example 2.15. How does international trade expand domestic consumption possibilities?
The relative price has not changed. So the menu of consumption possibilities is unchanged.
Bananas
(lb/day)
300
F
They could buy as many 300 pounds of bananas per day
(point F) or as many as 150 pounds per day of tea (point
G). Islandia could also consume any combination of tea and bananas on the line
FG.
120
100
E
G
100
120
150
Tea
(lb/day
159

Example 2.16. How does international trade expand domestic consumption possibilities?
 Same as the preceding example, except now the prices of both tea and bananas are $2 per pound.
 If Islandians again specialized at the point E and sold all their produce in the world market, they would earn $200
+$200 = $400 per day.
Bananas
(lb/day)
120
100
E
100 120
Tea
(lb/day)
160

Example 2.16. How does international trade expand domestic consumption possibilities?
 They could buy as many
200 pounds of bananas per day (point F) or as many as 200 pounds per day of tea (point G).
Bananas
(lb/day)
200 F
 Islandia could also consume any combination of tea and bananas on the line FG.
120
100
E
Relative price has changed. So, is the consumption possibilities.
100
120
G
200
Tea
(lb/day)
161

True or false:
 There is no way the United States can gain by trading with a nation whose workers are less productive than theirs, in absolute terms, for every production process.
False.
Each country can gain by specializing in the products for which it is relatively more efficient, then exporting those products and importing the products for which it is relatively less efficient.
162

Factors That Shift The Economy’s Production
Possibilities Curve
 Why Have Countries Like Nepal Been So Slow to
Specialize?
 Low population density
 Isolation
 Factors that may limit specialization in other countries
 Laws
 Customs
163

Economic Naturalist
 If trade between nations is so beneficial, why are freetrade agreements so controversial?
164

Alan Blinder
"... one true test of whether a person is an economist is how devoutly he or she lives by the principle of comparative advantage."
--Central Banking in Theory and Practice (1998, p.1) http://en.wikipedia.org/wiki/Alan_Blinder
165

End
166