1.

0 Introduction to Economics Unit overview

Economics as a Social Science Introduction to

• Explain that Economics is a social science Economics Online:
• Outline the social scientific method. Scarcity
• Explain the process of model building in economics. Basic Economic Question
• Explain that economists must use the ceteris paribus assumption when developing economic models. Opportunity cost
• Distinguish between positive and normative economics. Trade-offs
• Examine the assumption of rational economic decision-making Production possibilities curve
Price Theory
Scarcity Circular Flow Model
• Explain that scarcity exists because factors of production are finite and wants are infinite. Factors of Production
• Explain that economics studies the ways in which resources are allocated to meet needs and wants.
Cost/Benefit Analysis
• Explain that the three basic economic questions that must be answered by any economic system are: “What
to produce?”, “How to produce?” and “For whom to produce?”
Incentives
Utility
Choice and Opportunity Cost Utility maximization
Comparative advantage
• Explain that as a result of scarcity, choices have to be made.
• Explain that when an economic choice is made, an alternative is always foregone. Specialization
• Explain that a production possibilities curve (production possibilities frontier) model may be used to show Economic systems
the concepts of scarcity, choice, opportunity cost and a situation of unemployed resources and inefficiency. Free Markets
Command economies
Central Themes Rational behavior
• The extent to which governments should intervene in the allocation of resources
• The threat to sustainability as a result of the current patterns of resource allocation Introduction to
• The extent to which the goal of economic efficiency may conflict with the goal of equity
• The distinction between economic growth and economic development.
Economics Glossary
1.0 Introduction to Economics What is Economics?

A Riddle to start off your course

• You may not know it yet, but you are beginning a science
class. Yes, Economics is a science, and just like other
sciences, it deals with a fundamental problem of nature.
• Think of Aerospace Engineering. This is a science that
struggles to overcome a basic problem of nature, that of
GRAVITY. Aerospace Engineers are scientists whose
research and life’s work is aimed at overcoming the
problem of gravity and putting man in space.
• Economists are also scientists whose work attempts to
overcome a basic problem of nature.
Your Riddle:
What is the basic problem of nature that the science
of Economic attempts to overcome?

Hint: It arises because of the limited nature of earth’s

natural resources!
1.0 Introduction to Economics Scarcity

Scarcity – the Basic Economic Problem

The problem that Economics, a social science, attempts to overcome is that of Scarcity.
Scarcity arises when something is
both limited in quantity yet desired
Some facts about scarcity
• Not all goods are scarce, but most are
• Some goods that humans consume are infinite, such as air
• Organize the following words under the correct category: Scarce or Not Scarce

Scarce (limited and desired) Not Scarce (not limited OR not desired)

Sewing machines factory workers Computers Swiss francs Happiness

Teachers
Dirt Worms Doctors
Apartments in Zurich Oxygen
Love Air Creativity
Nitrogen Football players
Murderers Diamonds
British Pounds HIV Water Clouds Mosquitos
1.0 Introduction to Economics Scarcity

What makes something scarce?

Here’s another riddle for you…
• Nobody needs diamonds, yet they are considered extremely valuable
• Everybody needs water, yet they are considered extremely cheap

Why Are Diamonds So Expensive? Why Is Water So Cheap?

This is known as the “diamond / water paradox”. The answer lies in the fact that economic
value is derived from scarcity Read more: The Diamond
• The more scarce an item, the more valueable it is Water Paradox
• The less scarce, the less value it has in society!
1.0 Introduction to Economics Scarcity

Free Goods and Economics Goods

Goods in Economics are those things we like to consume. They are called “goods” because
consuming them makes us feel good!
• Free goods are those things that we desire but that are not limited
• Economic goods are those that we desire but that ARE limited

Which of these goods are Free Goods and which are Economic Goods?
Haircuts Cars Toothbrushes T.V.S Movies Happiness
Shoes Vacations Friendship Hamburgers Love Jewelry
Education Air Fresh Water Public Sunshine Etc.
Transportation
Economics as a Social Science: Economics is the social science that studies the interactions of humans in
the commercial realm. Economists examine the way societies allocate their scarce resources towards
competing wants and needs and seek to develop systems that achieve certain objectives, including:
• Growth in humans’ standard of living over time
• Sustainable development
• Employment and stability
 Do you think
1.0 Introduction to Economics like an Economist?

What do you already know about economics?

Take this true/false quiz to see what you already know about Economics!

1. - T F 1. Because it is desirable, sunshine is scarce.

2. Because it is limited, HIV is scarce.
2. - T F 3. Because water covers three-fourths of the earth's surface it cannot be
3. - T F considered scarce.
4. The main cost of going to college is tuition, room and board.
4. - T F 5. If public transportation fares are raised, everyone will take the trains
5. - T F anyway.
6. You always get what you pay for.
6. - T F 7. If someone makes an economic gain, someone else loses.
7. - T F 8. If one nation produces everything better than another nation, there is
8. - T F no economic reason for these two nations to trade.
9. A non-regulated monopoly tends to charge the highest possible price.
9. - T F 10. A business owner's decision to show more care for consumers is a
10. - T F decision to accept lower levels of profits.

Source: Adapted from NCEE's "AP Microeconomics" by John Morton

1.0 Introduction to Economics What is Economics?

What do Economists study?

The topics below are all some of the things you will study in your Economics course.
Follow the links to see some headlines from a blog relating to each of the topics
Some key topics from your Economics Course
Scarcity Cost/Benefit Analysis Environment Supply and Demand
Resources Utility maximization Perfect competition Trade
Trade-offs Price Theory Game Theory Markets
Opportunity cost Taxes Price discrimination Prices
Marginal analysis Market failure Income distribution Consumer behavior
Factors of Production Public goods Recession Firm behavior
Exchange Rates Financial markets Free Trade

Read the following blog post:

Microeconomics vs. Macroeconomics
1.0 Introduction to Economics What is Economics?

Economics is divided into two main fields of study

Microeconomics: Studies the behaviors of INDIVIDUALS within an economy: Consumers and
producers in particular markets. Examples of microeconomic topics:
• The Automobile market in Switzerland,
• the market for movie tickets in Zurich,
• the market for airline tickets between the US and Europe,
• the market for vacations to Spain,
• the market for international school teachers.

Macroeconomics: Studies the total effect on a nation's people of all the economic activity within that
nation. The four main concerns of macroeconomics are:
1. total output of a nation,
2. the average price level of a nation,
3. the level of employment (or unemployment) in the nation and
4. distribution of income in the nation
Examples of macroeconomic topics:
• Unemployment in Canada, inflation in Zimbabwe, economic growth in China, the gap between the
rich and the poor in America
1.0 Introduction to Economics What is Economics?

Microeconomics vs. Macroeconomics

The two main units in your economics course can be broken down into many smaller
topics. Some of them are identified below.

Microeconomics examines Macroeconomics examines

• Individual markets • National markets
• the behavior of firms (companies) and consumers • Total output and income of nations
• the allocation of land, labor and capital resources • Total supply and demand of the nation
• Supply and demand • Taxes and government spending
• The efficiency of markets • Interest rates and central banks
• Product markets • Unemployment and inflation
• Supply and Demand • Income distribution
• Profit maximization • Economics growth and development
• Utility maximization • International trade
• Competition
• Resource markets
• Market failure
1.0 Introduction to Economics What is Economics?

Fundamental Concepts
Weather we study micro or macro, there are some basic concepts that underly all fields of
Economics study
Economics is about the allocation of scarce resources among society’s various needs and
Scarcity: wants.
Economics is about the allocation of resources among society’s various needs and
Resources: wants.
Individuals and society as whole are constantly making choices involving tradeoff
between alternatives. Whether it’s what goods to consume, what goods to produce,
Tradeoffs: how to produce them, and so on.

Opportunity “The opportunity cost is the opportunity lost”.

Cost: In other words, every economic decision involves giving up something.
NOTHING IS FREE!!
1.0 Introduction to Economics What is Economics?

Read the following from “The Worldly

Philosophers” about the basic economic
problems faced by all societies
1.0 Introduction to Economics What is Economics?
1.0 Introduction to Economics What is Economics?

Reading Discussion Questions

1. How is the struggle against scarcity a struggle for survival of man?

2. Is man by nature a social creature? How does man's nature pose a challenge to his survival? Discuss...

3. Discuss the benefits and dangers of the two ways societies organized economic activities throughout
most of human history
a. Tradition
b. command

4. Why was there no need for "economists" throughout most of human history?

5. "It was not at all obvious that with each man out only for his own gain, society could in fact endure. It
was by no means clear that all jobs of society - the dirty ones as well as the plush ones - would be done
if custom and command no longer ran the world. When society no longer obeyed one man's dictates,
who was to say where it would end?“ Evaluate the author's claim that the economic revolution was
"fundamentally more disturbing by far than the French, the American, or even the Russian Revolution."
1.0 Introduction to Economics The productive Resources

The Factors of Production

The production of all of the good we desire requires scarce resources. It is the allocation of
these resources between humans’ competing wants that Economics focuses on.
Land Labor Capital Entrepreneurship
Capital refers to the tools
and technologies that are This refers to the
used to produce the innovation and creativity
Labor refers to the applied in the production
Land resources are those goods and services we
human resources used in of goods and services.
things that are "gifts of desire. Since more and
the production of goods The physical scarcity of
nature". The soil in which better tools enhance the
and services. Labor is the land, labor and capital
we grow food, wood, production of all types of
human work, both
minerals such as copper goods and services, from does not apply to human
physical and intellectual, ingenuity, which itself is
and tin and resources cars to computers to
that contributes to the
such as oil, goal, gas and education to haircuts, yet a resource that goes into
production of goods and the production of out
uranium are scarce the amount of capital in
services economic output.
the world is limited,
capital is a scarce
resource.
 The Basic Economic
1.0 Introduction to Economics Questions

The Basic “Economic Problem”?

In a world of finite resources, the wants of man are virtually infinite. The basic Economic
Problem is how to allocate those limited, scarce resources between the unlimited wants of
man. This problem gives rise to three questions that any and all economic systems must
address. The Three Basic Econoimcs Questions are :

1. What should be produced? Given the resources with which society is endowed,
what combination of different goods and services should be produced?
2. How should things be produced? Should production use lots of labor, or should
lots of capital and technology be used?
3. Who should things be produced for? How should the output that society produces
be distributed? Should everyone keep what he or she makes, or should trade take
place? Should everyone be given equal amounts of the output, or should it be
every man for himself?

These are the three guiding questions of any Economic system

1.0 Introduction to Economics Introduction to Trade

Free Trade
The market system allocates society’s scarce resources through the free, voluntary exchanges
of individuals households and firms in the free market. These exchanges are broadly known
as “trade”. Trade ban exist between individuals, or between entire nations. Trade between
countries is called International Trade.
Trade is one of the concepts fundamental to the field of economics.
Voluntary exchanges between individuals and firms in resource and product markets involving the exchange
of goods, services, land, labor and capital is a type of trade.
International trade involves the exchange of resources, goods, services, assets (both real and financial)
across national boundaries.
Trade makes everyone better off, and leads to a more efficient allocation of society's scarce resources.

Adam Smith on Trade: "It is not from the benevolence of the butcher, the brewer, or the
baker, that we expect our dinner, but from their regard to their own interest. We address
ourselves, not to their humanity but to their self-love, and never talk to them of our
necessities but of their advantages" - Adam Smith "The Wealth of Nations"
1.0 Introduction to Economics Introduction to Trade

Adam Smith, the father of Modern Economics

• Lived 1723-1790
• Leading thinker of the Scottish Enlightenment
• Two great works: The Theory of Moral Sentiments (1759) and The
Wealth of Nations (1776)
Believed that humans acting in their own self-interest would lead to
benefits for society as a whole, since the pursuit of self-interest naturally
leads individuals to meet the wants and needs of those around them.

Adam Smith on the mutual benefits of trade:

"Whoever offers to another a bargain of any kind, proposes to do this. Give me that which I want, and you shall
have this which you want, is the meaning of every such offer; and it is in this manner that we obtain from one
another the far greater part of those good offices which we stand in need of."
And on self-interest:
"Every man…is first and principally recommended to his own care; and every man is
certainly, in every respect, fitter and abler to take care of himself than of any other person."
1.0 Introduction to Economics
Model Building in Economics
A popular tool in the Economist’s kit is the economic model. Just like scientists in other fields,
economists use models to represent something from the real world.

A model of the solar system: Allows

astronomers to illustrate in a simplified model
the relationships between solar bodies.
A Circular Flow Model: Allows economists to
illustrate in a simplified model the relationships
between households and firms in a market
economy.

Ceteris Paribus: Like in other scientists, when using

economic models we must assume “all else equal”. This
allows us to observe how one variable in an economy
will affect another, without considering all the other
factors that may affect the variable in question.
1.0 Introduction to Economics
Positive and Normative Economics
Economists explore the world of facts and data, but also often draw conclusions or prescribe policies
based more on interpretation or even their own opinions. It is important to distinguish at all times
whether the focus of our studies is in the realm of positive or normative Economics
Positive economic statements: Each of the following statements above are statements of fact,
and each can be supported by evidence based on quantifiable observations of the world.
• Unemployment rose by 0.8 percent last quarter as 250,000 Americans lost their jobs in both the public and private
sectors.
• Rising pork prices have led to a surge in demand for chicken across China.
• Increased use of public transportation reduces congestion on city streets and lowers traffic fatality rates.
Normative economic statements: Each of the statements above are based on observable,
quantifiable variables, but each includes an element of opinion
• Unemployment rates are higher among less educated workers, therefore government should include education and job
training programs as a component of benefits for the nation's unemployed.
• Rising pork prices harm low income households whose incomes go primarily towards food, therefore, to slow the rise in
food prices, the Chinese government should enforce a maximum price scheme on the nation's pork industry.
• It is the government's obligation to provide public transportation options to the nation's people to relieve the negative
environmental and health effects of traffic congestion.
1.0 Introduction to Economics Opportunity Cost

Opportunity Cost
Perhaps the most fundamental concept to Economics, opportunity cost is what must be given up in
order to undertake any activity or economic exchange.
• Opportunity costs are not necessarily monetary, rather when you buy something, the opportunity
cost is what you could have done with the money you spent on that thing.
• Even non-monetary exchanges involve opportunity costs, as you may have done something different
with the time you chose to spend undertaking any activity in your life.

Examples of opportunity costs

• The opportunity cost of watching TV on a weeknight is the benefit you could have gotten
from studying.
• The opportunity cost of going to college is the income you could have earned by getting a job
out of high school
• The opportunity cost of starting your own business in the wages you give up by working for
another company
• The opportunity cost of using forest resources to build houses is the enjoyment people get
from having pristine forests.
1.0 Introduction to Economics The PPC

Opportunity Cost in the Production Possibilities Model

The tradeoff we face between the use of our scarce resources (or even time) can be modeled
in a simple Economic graph known as the Production Possibilities Curve (the PPC). Study the
graph below:
Tradeoffs in the PPC: Sarah faces two tradeoff. She
can either work or play with her limited amount of
time.
• The opportunity cost of an hour of work is an
hour of play
• As she goes from 3 hours of work to 7 hours of
work, she gives up 4 hours of play.
• She cannot spend 10 hours working AND 10
hours playing, so Sarah has to make CHOICES

This basic model can be used to illustrate the

economic challenges faced by individuals, firms,
states, countries or the entire world…
1.0 Introduction to Economics The PPC

Consider the hypothetical PPC for the

country of Italy
This model shows that Italy can produce:
• Either 7.5 million pizzas,
• OR 750 robots
• Note, however, that Italy can NOT produce 7.5 million
pizzas AND 750 robots

Italy faces a tradeoff in how to use its scarce resources of

land, labor and capital. As the country moves along its PPC
from point A to point D:
• It gives up more and more pizza to have more robots
• It gives up current consumption of food for production
of robots, which themselves are capital goods, and
therefore will assure that Italy’s economy will grow into
the future.
1.0 Introduction to Economics The PPC

Assumptions about the PPC

• A point ON the PPC is attainable only if a nation achieves
full-employment of its productive resources
• The nation's resources are fixed in quantity
• The economy is closed, i.e. does not trade with other
countries
• Represents only one country's economy
Observations about points on or within the PPC
• Points ON the PPC are attainable, and desirable, since a
country producing on the line is achieving full employment
and efficiency
• Points inside the PPC (such as E) are attainable but
undesirable, because a nation producing here has
unemployment and is inefficient
• Points outside the PPC (such as F) are unattainable because
they are beyond what is presently possibble given the
country’s scarce resources. But such points are desirable
because they mean more output and consumption of both
goods.
1.0 Introduction to Economics The PPC

Straight –line versus curved PPCs

A PPC can be either straight (A) or bowed outwards from the
origin (B).
A straight line PPC (A)
• Indicates that the two goods require similar resources to produce
(like pizzas and calzones)
• The opportunity cost of one pizza is one calzone, so Italy always gives
up the same quantity of one good no mater where it is on its PPC

A bowed out PPC

• Indicates that the two goods require very different resources to
produce (like pizzas and robots)
• As Italy increases its output of one good, the oportunity cost (in
terms of the quantity of the other good that must be given up)
increases. (B)
The Law of Increasing Opportunity Cost:
As the output of one good increases, the opportunity
cost in terms of other goods tends to increase
1.0 Introduction to Economics The PPC

Key Concepts shown by the PPC

In addition to opportunity costs and tradeoffs, the PPC can be used to illustrate several other
key Economic concepts, including…
• Scarcity: Because of scarcity, society can only have
a certain amount of output
• Actual output: A country’s actual output is shown
by where it is currently producing on or within its
PPC
• Potential output: A point on the PPC shows the
potential output of a nation at a particular time
• Economic growth: An increase in the quantity or
the quality of a nation’s resources will shift its PPC
out, indicating the economy has grown
• Economic development: The composition of a
nation’s output will help determine whether the
standards of living of its people are improving over
time
 Economic Growth vs.
1.0 Introduction to Economics Economic Development

Economic Growth vs. Economic Development

Two of the key areas of study in economics are those of growth and development. Sometimes
these concepts are thought of as the same, but they are not.
Economic Growth: This refers to the increase in the total output of goods
and services by a nation over time.
• It is also sometimes defined as an increase in household income over
time.
• It is purely a monetary measure of the increases in the material well
being of a nation.
• On a PPC growth can be shown as an outward shift of the curve.

Economic Development: This refers to the improvement in peoples’

standard of living over time.
• Measured by improvements in health, education, equality, life
expectancy and so on
• Incorporate income as well, but is a much broader measure than growth
• On a PPC development can be shown by a movement towards the
production of goods that improve peoples’ lives
1.0 Introduction to Economics PPC Video Lesson

SCARCITY, OPPORTUNITY COST AND THE

PRODUCTION POSSIBILITIES CURVE
1.0 Introduction to Economics PPC Video Lesson

THE LAW OF INCREASING OPPORTUNITY

COST AND THE PPC MODEL
1.0 Introduction to Economics Opportunity Cost

Announcement:
All economics students will receive a FREE
LUNCH of pizza and soda compliments of
your Economics teacher this Friday!
1.0 Introduction to Economics Opportunity Cost

"There's No Such Thing As A Free Lunch!”

It is a popular saying among Economists that there is no such
thing as a free lunch:
• Everything in life has a cost associated with it.
• The free lunch your teacher offers you is not really free.
There are opportunity costs associated with giving up your
lunch break to eat with your teacher

If nothing in life is free, then why do we seem to be surrounded

by things that are FREE? Analyze each of the signs below and
determine whether you’re really getting anything for free.
1.0 Introduction to Economics Markets

Product and Resource Markets

In the market system, there exists an interdependence between all individuals.
• Households (that’s us) depend on the goods and services produced by business firms, and
the incomes they provide us, for our survival
• Business firms depend on households for the workers, the capital, the land resources they
need to produce the goods they hope to sell us and make profits on.
These exchanges all take place in one of two categories of market
present in all market economies
Product Markets Resource Markets

Where households buy the goods and services Where business firms buy the productive
we desire from firms. Examples: resources they need to make their products:
• The market for private schools • The market for teachers
• The market for dental services • The market for dentists
• The market for airline travel • The market for pilots
• The market for football merchandise • The market for football players
1.0 Introduction to Economics Markets

In Resource Markets:
• Households supply productive resources (land, labor, capital)
• Firms buy productive resources from households. In exchange for their productive resource, firms
pay households:
 Wages: payment for labor
 Rent: payment for land
 Interest: payment for capital
 Profit: payment for entrepreneurship
• Firms seek to minimize their costs in the resource market
• Firms employ productive resources to make products, which they sell back to households in the
product market
In Product Markets:
• Consumers buy goods and services from firms
• Households use their money incomes earned in the resource market to buy goods and services
• Expenditures by households become revenues for firms
• Firms seek to maximize their profits
• Households seek to maximize their utility (happiness)
Notice the circular flow of money payments from one market to the other
 The Circular Flow
1.0 Introduction to Economics of Resources

The Circular Flow

Market economies are
characterized by a circular flow
of money, resources, and
products between households
and firms in resource and
product markets. Notice:
• Money earned by
households in the resource
market is spent on goods
and services in the product
market
• Money earned by firms in
the product market is spent
on resources from
households in the resource The incentives of Households: Maximize Utility
market. The incentive of Firms: Maximize Profits!
1.0 Introduction to Economics Resources

Resource Payments (Incomes for households)

In exchange for their land, labor, capital and entrepreneurship, households receive
payments. The payments for the four productive resources (which are costs for firms) ar…

Firms pay households RENT. Landowners have the option to use their land for their own use or to
For Land: Rent rent it to firms for their use. If the landowner uses his land for his own use, the opportunity cost
of doing so is the rent she could have earned by providing it to a firm.

Firms pay households WAGES. To employ workers, firms must pay workers money wages. If a
For Labor: Wages worker is self employed, the opportunity cost of self-employment is the wages he could have
earned working for another firm.

Firms pay households INTEREST. Most firms will take out loans to acquire capital equipment. The
money they borrow comes mostly from households' savings. Households put their money in
For Capital:
banks because they earn interest on it. Banks pay interest on loans, which becomes the payment
Interest to households. If a household chooses to spend its extra income rather than save it, the
opportunity cost of doing so is the interest it could earn in a bank.

Entrepreneurship: Households earn PROFIT for their entrepreneurial skills. An entrepreneur who takes a risk by
Profits putting his creative skills to the test in the market expects to earn a normal profit for his efforts.
 Circular Flow Model
1.0 Introduction to Economics Video Lesson

THE CIRCULAR FLOW MODEL OF A

MARKET ECONOMY
1.0 Introduction to Economics The Price Mechanism

The Price Mechanism

Prices are how resources are allocated between competing interests in a market economy. Without
tradition or command determining the allocation of resources, prices send the signals to producers and
consumers regarding what should be produced, how it should be produced, and for whom.
Examples of how prices allocate resources: Imagine a city with two types of street food, hot dogs and
kebabs. How would price assure that the right amount of these two foods is produced based on consumer
demand.
At present,
• The price of a hot dog is $2
• The price of a kebab is $3
Due to a report on the negative effects of hot dogs on health, consumers now demand more kebabs. How
will each of the two systems assure that the increased demand for kebabs is met?

Prices are signals from buyers to sellers!

As the demand for kebabs rises, they will become more scarce,
causing the price to rise. Sellers will realize there are more
profits in kebabs and hot dog vendors will switch to kebabs.
The price mechanism led to a reallocation of
resources!
1.0 Introduction to Economics The Price Mechanism

Prices as the Allocating mechanism in the market economy

Wow, we keep selling Yeah, and we better lower

out of brown bags, the price of black bags!
If only they'd make more
let's raise the price!
brown leather handbags!
Price of brown bags rises, other
colors must get cheaper to sell

More brown bags are

made available to buyers
1.0 Introduction to Economics The Price Mechanism Video

Commanding Heights - 1.3 & 1.4 Vienna and the Soviet Union
1.0 Introduction to Economics International Trade

Introduction to International Trade

The expansion of voluntary trade between nations has been a defining characteristic of the global
economic system since the second World War. But peoples’ view on trade were not always so liberal.

US President Lincoln once argued that…

To me that if we buy the rails from England, then we've got the rails and they've got the money. But if we
build the rails here, we've got our rails and we've got our money."
Author and political Economist Charles Wheelan paraphrased Lincoln’s view of trade in the following way:
"If I buy meat from the butcher, then I get the meat and he gets my money. But if I raise a cow in my
backyard for three years and slaughter it myself, then I've got the meat and I've got my money.“

What’s wrong with Lincoln’s logic?

Lincould probably would not argue against a family buying their meet from a butcher. What he does not
recognize is that what makes an economy thrive at the level of individual consumers can also help an
economy thrive at the international level. b
Key Questions about International Trade
Why do nations trade? What are the gains from trade between nations?
How does a nation determine what it should produce? What are the obstacles to free trade?
1.0 Introduction to Economics International Trade

Specialization based on Comparative Advantage

Because the world’s productive resources are not distributed evenly between nations, it does
not make sense that every nation tries to produce the same goods. Rather, nations tend to
specialize in goods for which their natural, human and capital resources are particularly
appropriate to produce. These may be…
Labor-intensive goods Land-intensive goods
Examples: Where? Examples: Where?
Textiles China Agricultural products North America
Low-skilled Latin America Minerals Russia
manufactured goods Low-wage countries Timber resources Australia
Capital-intensive goods
Examples: Where?
Airplanes Western Europe
Automobiles Japan
Microchips South Korea

What does your country specialize in the production of? Why?

1.0 Introduction to Economics International Trade

Specialization based on Comparative Advantage

What a particular nation should produce and trade is based on what the country has a
comparative advantage in the production of.
• Comparative Advantage: A country has a comparative advantage in production of a certain product
when it can produce that product at a lower relative opportunity cost than another country.
Production Possibilities Analysis: Consider two countries, South Korea and the United States.
How much do apples "cost“ each 39 PPC - USA PPC - Korea
country to produce?
• The US can produce either 39 apples
or 13 cell phones. 24

apples

apples
• 1 apple = 1/3 cell phone
• S. Korea can produce either 24 apples
or 12 cell phones.
• 1 apple = ½ cell phone
How much do cell phones “cost”?
• The US must give up 3 apples for
each cell phone it produces.
• S. Korea must give up only 2 apples 13 12
for each cell phone it produces. cell phones cell phones

The US has a comparative advantage in apples, South Korea in cell phones

1.0 Introduction to Economics International Trade

Specialization based on Comparative Advantage

Because the US has a lower opportunity cost for apples than S. Korea, and S. Korea has a lower
opportunity cost for cell phones than the US, these two countries can benefit from specializing and
trading with one another.
• United States: Specialize in apples -> trade Trading possibilities line 36 Trading possibilities line
apples for cell phones with Korea. Korea 39
USA Korea
should be willing to trade 1 apple for
anything up to, but not beyond, 1/2 cell 24

apples

apples
phone. Before trade, 1 apple could only be
get America 1/3 cell phone.
• The US has gained from trade.
• South Korea: Specialize in cell phones ->
trade cell phones for apples with the US.
The US should be willing to exchange up to 13 12
19.5
three apples for one cell phone. Before cell phones cell phones
trade, Korea could only get two apples for The red dashed lines represent the maximum amount of output the
each cell phone it gave up. two countries could hope to consume as a result of trade with one
• South Korea has gained from trade. another. This is the trading possibilities line. Trade allows each
nation to consumer beyond its own production possibilities.
1.0 Introduction to Economics International Trade

Specialization based on Comparative Advantage

Specialization is defined as “the use of the resources of an individual, a firm, a region, or a nation to
concentrate production on one or a small number of goods and services.“
• What a person, company or country should specialize in depends on the task for which it has the lowest
opportunity costs.
• Countries should specialize based on the products for which they have a comparative advantage

Terms of trade: Terms that are mutually beneficial to the two countries in trade. Where the trade leaves
both countries better off than they were originally.

Gains from Specialization and Trade: Specialization based on comparative advantage improves global
resource allocation. Each country would result in a larger global output with the same total inputs or world
resources and technology.

Specialization and trade based on comparative advantage increases the

productivity of a nation's resources and allows for greater total output
than would otherwise be possible.
1.0 Introduction to Economics International Trade

Specialization and Trade based on Production Possibilities Tables

The PPC provides a graphical means of displaying a nation’s potential output of two goods. The same
information can be shown in a table as well. These tables come in two types, Output and Input tables.
Output Table Input Table
Reading the table: Given a fixed amount of resources, Reading the table: In order to produce one ton of
Mexico and the USA can choose between the following output, Mexico and the USA must use the
alternatives. following amount of resources. (in acres of land)
Soybeans Avocados Soybeans Avocados

Mexico 15 60 Mexico 16 8

USA 30 90 USA 8 6

How to determine specialization and trade based on a table

1. Identify the opportunity costs of soybeans and avocados in Mexico and the USA
2. The countries should specialize in the one for which they have the lower opportunity cost.
3. Cross multiplication trick. (maximize output and minimize inputs)
1.0 Introduction to Economics International Trade

Specialization and Trade based on Production Possibilities Tables

Based on the tables below, Mexico has the comparative advantage in avocados and the US in soy beans. The
two countries should specialize and trade with one another based on these advantages.
Output Problem Input Problem
Soybeans Avocados Soybeans Avocados

Mexico 15 60 = 1800 Mexico 16 8 = 64

X X

USA 30 90 = 1350 USA 8 6 = 96

For an input problem, cross-multiply and then choose

For an output problem, simply cross multiply and
the combination that uses the least amount of
then choose the highest level of output.
inputs.
Output is maximized when the US specializes in Inputs are minimized when the US specializes in
soybeans and Mexico in avocados. soybeans and Mexico in avocados.
 1.0 Introduction to Economics International Trade

Absolute Advantage versus Comparative Advantage

Having put the data into a PPC, it is clear that the US is, in fact, better at producting BOTH avocados and
soybeans. The US has an absolute advantage in both goods
• Absolute Advantage: When a nation can produce a certain good more efficiently than another nation.
• How is this different from comparative advantage? Having an absolute advantage in a product, as the
US does in both soybeans and avocadoes, does not mean a country has a lower opportunity costs in
both products. The US should still only specialize in what it has a comparative advantage in.
Soybeans Avocados
30
USA Mexico 15 60
Soybeans

15 Mexico
USA 30 90

Soybeans Avocados
In US: 1s = 3a In US: 1a=1/3s
60 90 In Mexico: 1s=4a In Mexico: 1a=1/4s
Avocados
 International Trade
1.0 Introduction to Economics Video Lesson

DETERMINING COMPARATIVE ADVANTAGE USING PPCS –

WORKED SOLUTIONS TO AP FREE RESPONSE QUESTIONS
 Central Themes
1.0 Introduction to Economics in Economics

Other Key Themes in Economics

Having introduces several of the topics you will study in this course, we can now look at some of the major
themes that will underlie all sections of the course. These include:
• The role of government in the economy: In every unit of this course we will examine the appropriate
role of government in the market economy. There are some who argument government should never
interfere with the free functioning of markets; on the other hand, when market failures arise, the
government may be needed to improve the allocation of resources.
• Threats to sustainability of current economic trends: What threat do global warming, environmental
degredation, population growth and urbanization play to the ability of our economic systems to endure?
• The conflict between the pursuits of efficiency and equity: Sometimes the pursuit of wealth and
economic growth leaves some individuals behind. To what extent should economic policy be concerned
with income and wealth inequality? Is there a mechanism available for reducing inequality while at the
same time encouraging efficiency?
• The distinction between economic growth and economic development: The emerging market
economies of the world have achieve amazing economic growth for decades; but at what cost? Is
increasing income and output the only thing the market system is good for? Does getting richer assure
we will be happier, live longer and healthier lives, and live in a just society?

Each of these themes will guide us in our examination of Economics throughout the course