Chapter 2
Comparative
Advantage:
The Basis of Exchange
Economics: Redefined
Economics is the subject that studies
how decision-making entities
allocate and utilize the limited
resources to produce goods and
services that best satisfy the
various, unlimited, competing
human desires.
Economics: Macro vs. Micro
 Macroeconomics:
– How does the economic system work?
– When and why economic system does not work?
– When do people become counterproductive?
– Why are there ups and downs in the economy?
– Why is the long run mainly a story of ups?
=> National economy, GDP, inflation, unemployment,
international trade, exchange rate, etc.
Economics: Macro vs. Micro

Microeconomics:
–
–
–
–
The housing market in Shanghai
The price of Honda Accord in Guangzhou
The production quantity of peaches in Nanhui
The number of people hired producing milk
powder at Mengniu
– The number of T-shirts I buy at Hang-Ten
=> Individual decisions and interactions, individual
consumer behaviors, individual producer decisions
on production and input requirements, single
product market, single market structure, etc.
Microeconomics
Individual decisions about what to do
and what not to do.
 Decisions about production and
consumption made by individual firms
and consumers (market economy)
 How individuals’ pursuit of self interest
can lead to good results as a whole (the
invisible hand)

Also in Microeconomics
Society’s goal: efficiency and equity
 Market usually leads to efficiency, but
not necessarily equity.
 There are times for market failures.
 When market fails, it calls for
government interventions.
 Proper “incentives” offered by
government interventions may help
reach society’s goals.

Economics: a way of thinking and an
analysis tool
Economics is not the body of
concrete truth, but an engine
for the discovery of concrete
truth.
Economic Analysis

Positive analysis :
– objective descriptions about what things
are (facts)

Normative analysis:
– value judgments on what things
be (opinions)
should
Positive vs. Normative
Positive: what
objective things
descriptio are
ns
facts
Minimum wage:
Shanghai-960
Beijing-800
Shanghai higher
Normativ what
opinion Minimum wage
e: value
things s
causes higher
judgments should
unemployment,
be
therefore it should
be eliminated
Equilibrium Analysis
 Equilibrium：
– a situation in which economic forces
are balanced and in the absence of
external influences the values of
economic variables will not change
Example:
Market equilibrium


Market forces: demand and supply
Economic Variables: market price and
quantity of product exchanged
 Market equilibrium: a market price is
established through competition such that the
amount of goods or services sought by
buyers is equal to the amount of goods or
services produced by sellers.
– This price is often called the equilibrium
price or market clearing price and will tend
not to change unless demand or supply
change.
Static vs. Dynamic Analysis
 Static
analysis:
under what conditions the
economic variables will reach
equilibrium (ignoring the time factor
and the process of getting to
equilibrium)
 equilibrium
Static vs. Dynamic Analysis
 Comparative
static analysis:
what happens to the equilibrium
and the values of the economic
variables if some of the conditions
change
 Equilibrium price under D1 vs.
equilibrium price under D2
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Static vs. Dynamic Analysis

Dynamic analysis:
– the process analysis;
– the interactive process and relationships among
all economic variables

Equilibrium price P1
– US companies bankrupt  US income lowers 
US consumption of Chinese products lowers
Chinese exports decreases  Chinese income
lowers  Chinese comsumption decreases 
Chinese companies investments decrease 
Chinese domestic D lower  equilibrium price
lower
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Economic Models
A model is a simplified
representation of a real
situation that is used to
better understand real-life
situations.
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Economic model
 Using
functions to describe the
inter relationships among economic
variables
 Word description, mathematics,
graphs
 Abstract: skip some of the non-vital
factors and variables (assumptions)
 Focus on certain relationships only
(hypothesis)
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A Model
 Definitions
of variables
 Assumptions
 Hypothesis
 Forecast
 Test
True: theory
False: 1. adjust hypothesis >forecast test
2. Give up
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Model Example: PPC
The production possibility curve
the trade-offs facing an
economy that produces only
two goods.
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PPC
Issue to investigate: how many of each
product a country can produce
 Variables: Product A, Product B

– Define:
• Qa: (F) the quantity of fish produced by the
economy
• Qb: (C) the quantity of coconut produced by
the economy
* Can also be butter vs. gun, bread vs. dresses,
etc.
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PPC
 Assumptions:
– only two goods produced
– only two kinds of resources, each of
limited amount
– resources are used up with efficiency
– there is increasing opportunity costs
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PPC
 Hypothesis:
producing more of A
would require reduction in
production of B (the only way to
produce more of A is to produce
less of B -- trade off)
 Forecast: when more of A is
produced, production of B
decreases
(reason: less resources available)
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PPC
 Test:
real data
 Conclusion:
true: accept,
realistic and helpful
theory
(if not: why? Assumptions? Data?
Methods? Retest?...)
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The PPC
Increasing Opportunity Cost
Shift of the PPF: Economic Growth
Economic growth results
in an outward shift of the
PPF because production
possibilities are expanded.
PPC: Key Points
 Intersections
with X-axis and Y-
axis
 Points inside, on, outside the
curve
 The bowed-out shape
 Shift of the curve
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Marginal Analysis

Trade off situations:
How much decisions (as vs. either-or)

marginal analysis: comparing marginal
benefit to marginal cost

Marginal Benefit: additional benefit related to
one more unit change
Marginal Cost: additional cost related to the
same one more unit change
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Example: Marginal Cost
Marginal Benefit
Net Gain
Decision rule
if MB >= MC, DO IT!
if MB < MC, FORGET IT!
Total net gain is maximized when
marginal net gain = 0
or when MB=MC
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The Goal:
Maximization of Total Net Gain
Math and Graph

Variables:
Total Net Gain (G)
Hours of mowing (H)
 Assumptions:
 Hypothesis: G = f (H) (more hours, more
gain)
 Forecast:
1. gain from 4 hours is more than gain from 3 hours
2. gain from 10 hours is more than gain from 9 hours

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Test: 1. True; 2. False (correct hypothesis then
forast and test again)
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Graph
Plotting: origin, X-axis, Y-axis,
 Variables: independent, dependent
 Relationships:
positive, negative;
linear, nonlinear;

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Slopes: Calculation

Linear:
Change in Y / Change in X = △Y / △X

Non-linear:
– Arc method: connect to points on the
arc with a straight line, then calculate
the slope of the straight line
– Point method:draw a tangent line at a
point and calculate the slope of the
tangent line
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Slopes: Meaning
slope > 0, positive relationship (upward
sloping)
slope = 0, horizontal line
slope < 0, negative relationship (downward
sloping)
slope = infinite, vertical line
constant slope: straight line
variable slope: curve
Maximum and Minimum of a curve: when point
slope = 0
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