Lecture 2: Basic Microeconomics I

Given to theGiven to theEMBA 8400 ClassEMBA 8400 Class

Classroom South #600Classroom South #600March 20, 2010March 20, 2010

Dr. Rajeev DhawanDr. Rajeev DhawanDirectorDirector

Chapter 3

Comparative Advantage & Trade

Positive vs. Normative Economics

Positive :– Descriptive statement ( is, was)– Refer to data– Examples of positive statements:

– GDP in the U.S. economy was about $7 trillion last year– The New York City rent control laws have created a shortage

of housing in the city Normative:

– Value judgment (ought to be, shall, will)– Examples of normative statements:

– Higher interest rates would be good for the U.S. economy in the next six months

– The U.S. government should be required to balance its budget every year

The classic tale of the farmer and the rancher…or a better example if you have one.

What should each produce? Why should they trade?

Production Possibilities Frontier

Potatoes (ounces)

4

16

8

32

A

0

Meat (ounces)

(a) The Farmer ’ s Production Possibilities Frontier

If there is no trade, the farmer chooses this production and consumption.

Production Possibilities Frontier

FARMER:32 oz. of Potatoes in 8 hours8 oz. of Meat in 8 hours

Potatoes (ounces)

12

24

B

0

Meat (ounces)

(b) The Rancher ’ s Production Possibilities Frontier

48

24 If there is no trade, the rancher chooses this production and consumption.

Production Possibilities Frontier

RANCHER:48 oz. of Potatoes in 8 hours24 oz. of Meat in 8 hour

Trade Example

Without trade:

““Farmer, my friend, have I got a deal for you! I know Farmer, my friend, have I got a deal for you! I know how to improve life for both of us. I think you should how to improve life for both of us. I think you should stop producing meat altogether and devote all your stop producing meat altogether and devote all your time to growing potatoes. According to my time to growing potatoes. According to my calculations, if you work 8 hours a day growing calculations, if you work 8 hours a day growing potatoes, you’ll produce 32 ounces of potatoes. potatoes, you’ll produce 32 ounces of potatoes.

Specialization & Trade

If you give me 15 of those 32 ounces, I’ll give you 5 If you give me 15 of those 32 ounces, I’ll give you 5 ounces of meat in return. In the end, you’ll get to eat ounces of meat in return. In the end, you’ll get to eat 17 ounces of potatoes and 5 ounces of meat every 17 ounces of potatoes and 5 ounces of meat every week, instead of the 16 ounces of potatoes and 4 week, instead of the 16 ounces of potatoes and 4 ounces of meat you now get. If you go along with my ounces of meat you now get. If you go along with my plan, you’ll have more of both foods.”plan, you’ll have more of both foods.”

How Trade Increases Consumption

Potatoes (ounces)

4

16

5

17

8

32

A

A*

0

Meat (ounces)

(a) The Farmer ’ s Production and Consumption

Farmer's production & consumption without trade

Farmer's consumption with trade

Farmer's production with trade

How Trade Increases Consumption

Potatoes (ounces)

12

24

13

27

B

0

Meat (ounces)

(b) The Rancher ’ s Production and Consumption

48

24

12

18

B*

Rancher's consumption with trade

Rancher's production with trade

Rancher's production and consumption without trade

Example Continued..

With trade:

Trade According to Comparative Advantage (CA) or Opportunity Cost (OC)

CA is OC of two products – whatever must be given up to obtain a product

The producer who has the smaller OC of producing a good has a CA in producing that good

– Rancher has CA in producing meat

– Farmer has CA in producing potatoes

Absolute Advantage: Rancher beats the farmer in producing both meat and potatoes

Let’s Calculate OC(Meat in terms of Potatoes)

Benefits of Trade

Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade.

Trade can benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage.

Better Answer to Tough Questions (p.6)by David Wessel

“What do you say to someone…who has lost his job to someone overseas who’s being paid a fraction of what that job paid here?”

Those of us who benefit from low-cost imports – or who have well-paid export jobs that wouldn’t exist if we don’t allow imports and outsourcing – must not ask those who lose jobs to go it alone.

If trade and technology make us richer, then we can afford to help pay for health insurance and protect pensions forced to bear the cost.

Better Answer to Tough Questions (p.6)by David Wessel

That means pushing China and others to stop bending trade rules or manipulating currencies and pressing Europe and Japan to get their people spending so the U.S. Isn’t always the consumer of last resort. It means setting U.S. taxes so they cover government spending at least in good times, rewriting perverse tax laws that encourage companies to invest elsewhere and managing the unquenchable American thirst for health care without giving employers new excuses.

Discuss: wage insurance and role of education

Economic Focus – Trade Disputes (p.7)

Suppose the poor country, spurred by technical progress, improves productivity in the rich country’s export goods: think of China’s advances in semiconductors or India’s in financial services/ Then, says the theory, trade can turn entirely to the poor country's advantage. The improvement in productivity in the poor country can reduce the price of the rich country’s exports by enough to make it worse off, despite the increased availability or cheaper goods.

Europeans worried about American growth in the 1950’s for this reason, and Americans later worried about Japan.

Move of textile manufacturing to the American South may have caused net losses in the North. OR that Malaysia’s leap in rubber production may have had the same effect on Brazil . Might the new wave of outsourcing to poor countries be different, and make rich countries poorer?

Forrester Research claims that 3.4 million jobs will be outsourced by 2015, but considering that the American economy destroys 30 million jobs EACH YEAR and then creates slightly more, this dwarfs the effect of outsourcing.

Review of Last Week

10 Principles of Economics Sunk/Fixed costs Opportunity Cost and Comparative

Advantage Benefits of Trade Trade Debate

Article 2: Too Many Cars

Overcapacity is the biggest problem for any automobile company in the world GM buys Daewoo Motor, Fiat Auto, Saab Ford motor owns Mazda, Land Rover Daimler Chrysler is riding to rescue Mitsubishi Oldsmobile and Chrysler’s Plymouth, are the first major automobile

companies in 40 years

Why do ailing automobile companies who decry overcapacity keep ailing car companies?

• National pride plays a big role• More brands mean more dealerships mean more sales.• But this also means more costs and complexity in business operations.

In reality, overcapacity is not really a problem.One man’s overcapacity is other’s bargain.Thus, lower priced leases and generous rebates abound in today’s

car market.

Who REALLY Owns that Winery (p.8)by Terry McCarthy

Consolidation is the Norm

60% of U.S. wine is produced by the top five companies– Consolidation among distributors is squeezing out the

medium-sized producers, who make from 100,000 to 1 million cases a year

Market is not growing– Only 10% of adults drink 86% of the wine

Fixed Costs– Some wineries do not have enough volume to get a priority

from distributors

Chapter 5

Elasticity

Elasticity & Its Application Evaluating questions like-

– Banana Republic store manager/headquarters needs to decide on sale on jeans vs. sale on shirts

– Rain destroys strawberry crop, prices go . Does it benefit growers ?

– Why don’t you ever see sale or discounts on pure milk but see it on orange juice ?

These can be answered with the concept of elasticity (or responsiveness of buyers & sellers to changes in market conditions)

Elasticity

Price elasticity of demand: a measure of how much the quantity demanded of a good responds to a change in the price of that good

P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed

P ercen tag e ch an g e in p rice

Continued.. Two types of demand:

– Elastic – responds a lot e.g. luxury cars ( luxuries)– Inelastic – not much change e.g. milk, certain food

items, gasoline ( necessities) Preferences: Luxuries vs. Necessities Availability of close substitutes: Elastic

– Butter & margarine; cars, booze Time horizon:

– Gasoline – necessity in short run– Substitute long run (electric cars, walk, bike)

Elasticity

Inelastic Demand– Quantity demanded does not respond strongly

to price changes.– Price elasticity of demand is < one.

Elastic Demand– Quantity demanded responds strongly to

changes in price.– Price elasticity of demand is > one.

Demand Curves

Question: Can I tell from the graphical shape of the demand curve what kind of elasticity the curve has?

Answer: Yes, but not all the time.

Perfectly Inelastic Demand

Elasticity = 0

$5

4

Quantity

Demand

1000

1. Anincreasein price . . .

2. . . . leaves the quantity demanded unchanged.

Price

3. . . . revenue goes from $4 x 100 to $5 x 100

Inelastic Demand

Elasticity < 1

Quantity0

$5

90

Demand1. A 22%increasein price . . .

Price

2. . . . leads to an 11% decrease in quantity demanded.

4

100

3. . . . revenue goes from $4 x 100 to $5 x 90

Unit Elastic Demand

Elasticity = 1

Quantity0

$5

80

1. A 22%increasein price . . .

Price

2. . . . leads to a 22% decrease in quantity demanded.

4

100

Demand

3. . . . revenue goes from $4 x 100 to $5 x 80

Elastic Demand

Elasticity > 1

Quantity0

$5

50

1. A 22%increasein price . . .

Price

2. . . . leads to a 67% decrease in quantity demanded.

4

100

Demand

3. . . . revenue goes from $4 x 100 to $5 x 50

Perfectly Elastic Demand

Elasticity = Infinity

Quantity0

Price

$4 Demand

2. At exactly $4,consumers willbuy any quantity.

1. At any priceabove $4, quantitydemanded is zero.

3. At a price below $4,quantity demanded is infinite.

Relationship Between Total Revenue (Sales) & Elasticity

Total Revenue = Price x Qty Sold = P x Qty If demand is elastic, then a price decrease

increases revenue If demand is inelastic, then a price increase

increases revenueExample class to contribute

Box Shows the 50% Drop of New Paying Customers for the May & August 2004 Conference Caused by the Latest Price Hike

Conference Date Attendance New Paying % of Total

Feb’ 01 72 6 8%

May’ 01 66 10 15%

Aug’ 01 101 31 31%

Nov’ 01 163 49 30%

Feb’ 02 189 28 15%

May’ 02 160 42 26%

Aug’ 02 195 62 32%

Nov’ 02 169 44 26%

Feb’ 03 260 55 21%

May’ 03 196 37 19%

Aug’ 03 220 43 20%

Nov’ 03 222 40 18%

Feb’ 04 238 48 20%

May’ 04 201 25 12%

Aug’ 04 211 23 11%

1st Price Hike

2nd Price Hike

Applications of Supply, Demand & Elasticity

Can good news for farmers be bad news for farmers?

Wheat is inelastic: Bumper crop bad news

Increase In Supply In Market For Wheat

Quantity ofWheat

0

Price ofWheat

3. . . . and a proportionately smallerincrease in quantity sold. As a result,revenue falls from $300 to $220.

Demand

S1 S2

2. . . . leadsto a large fallin price . . .

1. When demand is inelastic,an increase in supply . . .

2

110

$3

100

Better Answer to Tough Questions WSJ; by David Wessel

“What do you say to someone…who has lost his job to someone overseas who’s being paid a fraction of what that job paid here?”

Those of us who benefit from low-cost imports – or who have well-paid export jobs that wouldn’t exist if we don’t allow imports and outsourcing – must not ask those who lose jobs to go it alone.

If trade and technology make us richer, then we can afford to help pay for health insurance and protect pensions forced to bear the cost.

Better Answer to Tough Questions WSJ; by David Wessel

That means pushing China and others to stop bending trade rules or manipulating currencies and pressing Europe and Japan to get their people spending so the U.S. Isn’t always the consumer of last resort. It means setting U.S. taxes so they cover government spending at least in good times, rewriting perverse tax laws that encourage companies to invest elsewhere and managing the unquenchable American thirst for health care without giving employers new excuses.

Discuss: wage insurance and role of education

Market and Federal Govt. have given energy customers enough incentives to use natural gas. But, Oil and Gas Industry has got little encouragement to produce more.

Fed’s efforts to promote clean air and US energy independence meant surge in demand of Natural Gas.

Increase in oil prices has curtailed oil and gas exploration. Thus, there has been an increase in imports of natural gas, mainly from Canada. Net result is prices go from $2.17 to $8 per million BTUs

– Nation’s record long economic expansion – accompanying surge in energy consumption

– Cold winter weather over much of US (2001)

Article 2: Federal Policies, Industry Shifts Produced Natural-Gas Crunch

Cont. Article 2: Federal Policies….

Federal govt. ordered the pipeline companies to become “open access” carriers. The move lowered the prices, which was a boon to the customers but a nightmare for the producers

Marketers emerged as a new breed of middlemen that took more profits without boosting gas production. As a result of narrow margins, some producers were forced to close and others to consolidate.

– Seasonal Relief– Crackdown on Coal– Bankers Balk

  Drilling for natural gas exploration, prohibited by federal agencies.

Alaskan producers pushing for a pipeline to continental US, but it

will take another decade for that to materialize.