Macroeconomics Week 2 (Maclachlan, Fall 04) 1 Principles and Policies I: Macroeconomics Chapter 2: Trade-offs and Government Policy

Macroeconomics Week 2 (Maclachlan, Fall 04)

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Principles and Policies I: Macroeconomics

Chapter 2: Trade-offs and Government Policy


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Prob. 1-3

Donor: gains $30,000, loses one of two kidneys and takes on risk associated with any surgery.

Recipient: loses $30,000, gains a working kidney.Both could be said to benefit if they undergo the

transaction voluntarily and with full knowledge.But such a transaction is illegal because of the view

that not everything should be for sale—a social force embodied in law through the political process.


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Prob. 1-5Micro or Macro?

a) Should the U.S. government use a policy of free trade with China to encourage China t advance human rights?

Micro with macro implications.


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b) Will the fact that more and more doctors are selling their practices to managed care networks increase the efficiency of medical providers.

Micro


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c) Should the current federal income tax structure be eliminated in favor of a flat tax?



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d) Should the minimum wage be raised?



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e) Should AT&T and Verizon both be allowed to build local phone networks?

Micro.


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f) Should commercial banks be required to provide loans in all areas of the territory from which they accept deposits?

Macro.


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Chapter Two Learning ObjectivesYou should be able to:

• Demonstrate opportunity cost with a PPC.

• Relate the concept of comparative advantage to the PPC.

• State the principle of increasing marginal cost.

• State how through comparative advantage and trade, production possibilities increase.

• State six roles of government.

• Compare the regulation of international markets to the regulation of domestic markets.

A Production Possibility Curve for a Society

Y

1098

6543210

.2Y

1X

A

X1 2 3 4 5 6 7 8 9

If the slope of the production curve is -2 at A, the

opportunity cost of 1X is 2Y.

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McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

A Production Possibilities Table and Curve (Graph with guns on horizontal axis.)

% of resources devoted toproduction of guns

Number of guns

% of resources devoted toproduction of butter

Pounds of butter Row

0 20 40 60 80

100

0 4 7 9 11 12

100 80 60 40 20 0

15 14 12 9 5 0

A B C D E F


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A Production Possibilities Table and Curve

AB

utte

r

Guns4 7 90

1 gun

5 pounds of butter

5

9

15

3 guns

2 pounds of butter

B

C

D

E

F

14

12

4 guns

1 pound of butter



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Increasing Marginal Opportunity Cost

• The principle of increasing marginal opportunity cost states that opportunity costs increase the more you concentrate on an activity.

• In order to get more of something, one must give up ever-increasing quantities of something else.


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Increasing Marginal Opportunity Cost

But

ter

Slope is flat at A. Low opportunity cost of

guns.

Slope is steep at B. High opportunity cost of guns.

Guns

B

A


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Adam Smith (1723-1790)

Critic of mercantilism.

Countries should specialize and trade.

Specialize where there’s an ABSOLUTE ADVANTAGE


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ABSOLUTE ADVANTAGE

A region has an absolute advantage if it takes fewer resources to produce a good there than elsewhere.

Coffee in Columbia.

Computer software in Silicon Valley.


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David Ricardo (1772-1823)

Theory of comparative advantage.

Even without an absolute advantage a region can trade to the benefit of all parties.


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The Benefits of Trade

• The argument for the benefits of trade underlies the general policy of laissez-faire.

– Laissez-faire – an economic policy of leaving coordination of individuals’ actions to the market.


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Production Possibilities without Trade

• Pakistan can produce 4,000 yards of textile per day or 1 ton of chocolate per day.

• Belgium can produce 1,000 yards of textile a day or 4 tons of chocolate per day.


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• Pakistan has a comparative advantage in producing textiles.

• Belgium has a comparative advantage in chocolate.


1 2 3 4 5

4

3

2

1

5

Chocolate (in tons)

Te

xtile

s(i

n th

ousa

nd

s o

f yar

ds)

Belgium

Pakistan



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• Pakistan has chosen to produce 2,000 yards of textiles and 0.5 tons of chocolate.

• Belgium has chosen to produce 500 yards of textile and 2 tons of chocolate.


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• Point A: The combination of textile and chocolate chosen by Pakistan.

• Point B: The combination of textile and chocolate chosen by Belgium.

• Point C: The joint combination without trade.


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1 2 3 4 5

4

3

2

1

5

Chocolate (in tons)

Te

xtile

s(i

n th

ousa

nd

s o

f yar

ds)

Belgium

Pakistan

A

B

C



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• The two extreme combinations are both countries producing only textile (point D) and both producing only chocolate (point E).

• The combined production possibilities curve with no trade is drawn by connecting these two points.


1 2 3 4 5

4

3

2

1

5

Chocolate (in tons)

Te

xtile

s(i

n th

ousa

nd

s o

f yar

ds)

Belgium

Pakistan

A

B

C

D

E

Joint (no trade)



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Production Possibilities with Trade

• Point F: This is where each nation is focusing on that activity for which it has a comparative advantage.– Pakistan produces 4,000 yards of textile.– Belgium produces 4 tons of chocolate.


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Combined Production Possibilities

No Trade Specializing and Trade

Gains to Trade

Fabric 2,500 yards 4,000 yards 1,500 yards

Chocolate 2.5 Tons 4 tons 1.5 Tons


1 2 3 4 5

4

3

2

1

5

Chocolate (in tons)

Te

xtile

s(i

n th

ousa

nd

s o

f yar

ds)

C

D

E

Joint (no trade)

Joint (with trade)Gains from trade

F



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• The combined PPC is bowed out because of Point F – comparative advantage and specialization.


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The Roles of Government in a Market

• Provide a stable institutional framework.

• Promote effective and workable competition.

• Correct for externalities.

• Ensure economic stability and growth.

• Provide public goods.

• Adjust for undesired market results.


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Provide a Stable Set of Institutions and Rules

• Government can create a stable environment and enforce contracts through its legal system.

• Economic growth is difficult when government does not provide a stable environment.


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Promote Effective and Workable Competition

• Government promotes competition and protect against monopolies. – Monopoly power is the ability of individuals or

firms currently in business to prevent other individuals or firms from entering the same kind of business


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Promote Effective and Workable Competition

• Monopoly power gives existing firms or individuals the power to raise prices.

• Market participants often insist on open competition except when it comes to themselves.


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Correct for Externalities

• An externality is the effect of a decision on a third party not taken into account by the decision maker.


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Positive Externalities

Beneficial third party effects.


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Ensure Economic Stability and Growth

• Macroeconomic externalities are externalities that affect the levels of unemployment, inflation, and growth in the economy as a whole.


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Public Goods & Common Resources


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Figure 1 Four Types of Goods

Copyright © 2004 South-Western

Rival?

Yes

Yes

• Ice-cream cones• Clothing• Congested toll roads

• Fire protection• Cable TV• Uncongested toll roads

No

Private Goods Natural Monopolies

No

Excludable?

• Fish in the ocean• The environment• Congested nontoll roads

• Tornado siren• National defense• Uncongested nontoll roads

Common Resources Public Goods


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Provide for Public Goods

• Government steps in to provide public goods and requires that everyone pays for them, thereby reducing the free rider problem.


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Adjust for Undesired Market Results

• A progressive tax is one whose rates increase as a person's income increases.

• A regressive tax is one whose effect decrease as income rises.


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• A proportional tax is one whose rates are constant at all income levels, regardless of the taxpayer's total annual income.


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• Demerit goods or activities are things government believes are bad for you, although you may like them.

• Merit goods and activities are things the government believes are good for you, although you may not like them.


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Market Failures and Government Failures

• Government is always failing in one way or another.

• Real-world policy makers are left with the choice of selecting that which is least bad – market failure or government failure.


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Regulating Markets Internationally

• There is no central world government.

• Some countries have voluntarily restricted their ability to restrict trade.


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Regulating Markets Internationally

• Governments have been unable to come up with an effective means of dealing with environmental issues.


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Problem 2-2

Japan US

cloth wheat cloth wheat

1000 0 500 0

800 100 400 200

600 200 300 400

400 300 200 600

200 400 100 800

0 500 0 1000


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Japan

1000 bolts of cloth : 500 tons of wheat

1 bolt of cloth : 0.5 tons of wheat

1 ton of wheat: 2 bolts of cloth

_______________________

US

500 bolts of cloth : 1000 tons of wheat

1 bolt of cloth: 2 tons of wheat

1 ton of wheat: 0.5 bolt of cloth


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Problem 2-3

US Japan

Toyota Chevrolet Toyota Chevrolet

$8,000 $6,000 ¥1,000,000 ¥500,000

Documents

Macroeconomics Week 2 (Maclachlan, Fall 04) 1 Principles and Policies I: Macroeconomics Chapter 2: Trade-offs and Government Policy