macroeconomics week 2 (maclachlan, fall 04) 1 principles and policies i: macroeconomics chapter 2:...
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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?
Micro with macro implications.
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d) Should the minimum wage be raised?
Micro with macro implications.
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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.
7
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
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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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Production Possibilities without Trade
• Pakistan has a comparative advantage in producing textiles.
• Belgium has a comparative advantage in chocolate.
Production Possibilities without Trade
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
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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Production Possibilities without Trade
• 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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Production Possibilities without Trade
• 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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Production Possibilities without Trade
Production Possibilities without Trade
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
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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Production Possibilities without Trade
• 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.
Production Possibilities without Trade
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)
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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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Production Possibilities with Trade
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
Production Possibilities with Trade
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
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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Production Possibilities with Trade
• 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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Adjust for Undesired Market Results
• 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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Adjust for Undesired Market Results
• 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