SLIDES
BY
CHAPTER
2
SOLINA LINDAHL
Economic Models:
Trade-offs and Trade
FOOD FOR THOUGHT….
SOME GOOD BLOGS AND OTHER SITES TO GET THE JUICES FLOWING:
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What you will
learn in this chapter
▪ Why models play a crucial role in economics
▪ Two simple but important models: the production
possibility frontier and comparative advantage
▪ The circular-flow diagram, a schematic representation
of the economy
▪ The difference between positive economics and
normative economics
▪ When economists agree and why they sometimes
disagree
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MODELS IN ECONOMICS
Model: a simplified representation of a real
situation that is used to better understand
real-life situations.
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“OTHER THINGS EQUAL”
Other things equal assumption: all other
relevant factors remain unchanged.
We try to treat economics
as close to a laboratory
science as possible—with
only one variable allowed
to change at a time.
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THE PRODUCTION POSSIBILITIES FRONTIER
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TRADE-OFFS: THE PPF
We can use the PPF model to answer questions
like:
How much can we produce?
What will it cost us to change our mix of
production?
Does it make sense to import the good
from somewhere else?
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TRADE-OFFS: THE PPF
All points under the curve are feasible (but not
efficient)…
And all points above the curve are not feasible.
All points on the curve are feasible and efficient.
Quantity of
Dreamliners
The PPF line
D
Production Possibilities
30
A
15
Small Jets
Dreamliners
30
15
9
0
0
20
28
40
B
9
C
20
28
40
Quantity of Small Jets
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OPPORTUNITY COST
Opportunity Cost: what must be given up in
order to get a good.
Production Possibilities
Small Jets
Dreamliners
30
15
9
0
0
20
28
40
EACH SMALL JET HAS AN OPPORTUNITY
COST OF ¾ OF A DREAMLINER.
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LEARN BY DOING: PRACTICE QUESTION
Suppose you are stranded on an island. Luckily,
this island is rich in clams and mangos. If you
devote all of your time to harvesting clams, you
can get 100 clams in a week. If you us all of
your time to collect mangos, you can find 200
mangos in a week.
Assume it is possible to collect fractional
amounts of both goods and draw a sketch of
your production possibility frontier for a week.
(Place mangos on the x-axis and clams on the
y-axis.)
Calculate the opportunity cost of each good.
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LEARN BY DOING: PRACTICE QUESTION
What is the opportunity cost of each
lamp?
a) ¼ of a sofa
b) 1 sofa
c) 4 sofas
d) 200 sofas
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LEARN BY DOING: PRACTICE QUESTION
With a partner, create your production
possibilities curve for the following two
activities: (a) drawing happy faces and (b)
drawing elephants:
1. Take turns timing each other for 30 seconds
and recording the following:
The maximum number of happy faces drawn
The maximum number of elephants drawn
2. Now construct your PPF with elephants on
the vertical axis and faces on the horizontal
axis.
3. Calculate your opportunity cost for each
good.
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INCREASING OPPORTUNITY COST
Quantity of
Dreamliners
Producing the first
20 small jets . . .
35
…requires giving up
5 Dreamliners
But producing
20 more small jets . . .
30
A
25
20
…requires giving up
25 more Dreamliners…
15
10
5
PPF
0
C
10
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5
W
O
50 Quantity of small jets
40
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ECONOMIC GROWTH
Quantity of
Dreamliners
THE ECONOMY CAN NOW
PRODUCE MORE OF
EVERYTHING.
35
E
30
A
25
20
15
10
5
Original
New
PPF
PPF
0
10
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25
2
0
30
1
5
40
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50
H
P
U
B
Quantity of small jets
L
I
S
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LEARN BY DOING: PRACTICE QUESTION
If you invent a clam rake that doubles your
clam production, what happens to your
opportunity cost?
Graph the effect of your new invention on
the original PPF.
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WHAT CAUSES ECONOMIC GROWTH?
Two possibilities:
1. An increase in factors of production:
resources used to produce goods and
services.
2. Better technology: the technical means
for producing goods and services.
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FACTORS OF PRODUCTION
1. Land includes natural resources, such
as mineral deposits, oil, natural gas,
water, and actual land acreage.
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FACTORS OF PRODUCTION
2. Labor is the mental and physical
abilities of the workforce.
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FACTORS OF PRODUCTION
3. Physical capital is manufactured items
used to produce other goods and services.
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ECONOMIC RESOURCES
4. Human capital is the educational
achievements and skills of the labor force
(which increase labor productivity).
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LEARN BY DOING: APPLICATION VIDEO
Check out how containerization shaped the
modern world. Click here or on the picture
below. Consider how the world’s PPF changed.
(5 minutes)
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COMPARATIVE ADVANTAGE AND GAINS
FROM TRADE
Theory of Comparative Advantage:
It makes sense to produce the things you’re
especially good at producing… and buy
everything else from others.
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ORIGIN OF THE IDEA
David Ricardo (1772–1823)
Argued against Corn Laws in British Parliament.
Corn Laws: high tariffs on
imported grain that protected
British landowners.
His theory of comparative
advantage is still the
ideological foundation for free
trade.
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COMPARATIVE ADVANTAGE AND GAINS
FROM TRADE
Suppose that there are just two goods,
computers and shirts, and one input, labor.
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COMPARATIVE ADVANTAGE
AND GAINS FROM TRADE
Assume that in Mexico, it takes 12 units of labor to
make one computer and 2 units of labor to
produce one shirt
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COMPARATIVE ADVANTAGE
AND GAINS FROM TRADE
Suppose that Mexico has 24 units of labor. It can
produce 2 computers and 0 shirts…
or 0 computers and 12 shirts
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COMPARATIVE ADVANTAGE
AND GAINS FROM TRADE
The PPF is about trade-offs.
If Mexico wants to produce more shirts, it must
produce fewer computers.
Each computer “costs” 12 workers,
who could produce 6 shirts.
So a computer “costs” 6 shirts in Mexico.
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COMPARATIVE ADVANTAGE
AND GAINS FROM TRADE
AND…
Each shirt “costs” 2 workers,
who could produce one-sixth of a computer.
So a shirt “costs” one-sixth of a computer in
Mexico.
1/6
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COMPARATIVE ADVANTAGE
AND GAINS FROM TRADE
Mexico’s Production Possibilities Frontier
Computers
6
Production Possibilities
Shirts
Computers
The PPF
5
2
1
0
4
3
0
6
12
The slope = the trade-off
(“cost”) of one good for the
other. (One-sixth of a
computer = 1 shirt: 1 shirt
“costs” 6 computers.)
2
1
2
C
O
4
P
Y
R
6
I
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8
T
2
0
10
1
5
Shirts
12
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LEARN BY DOING: PRACTICE QUESTION
Erin has a choice between two activities:
She can repair one transmission per hour or
she can repair two fuel injectors per hour.
What is the opportunity cost of repairing one
fuel injector?
a) 1 transmission
b) 0.5 transmission
c) 2 transmissions
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LEARN BY DOING: PRACTICE QUESTION
Deirdre can write either one more book
this year or five more articles this year.
What is the opportunity cost of writing
half of a book this year, in terms of
articles?
a) 0.2 article
b) 1 article
c) 2.5 articles
d) 10 articles
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COMPARATIVE ADVANTAGE AND GAINS
FROM TRADE
Enter the U.S. with its own production and
cost ratios.
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COMPARATIVE ADVANTAGE
AND GAINS FROM TRADE
Assume that in the United States, there are 24
units of labor, and it takes 1 unit of labor to
produce either good.
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COMPARATIVE ADVANTAGE
AND GAINS FROM TRADE
Each shirt “costs” 1 worker,
who could produce 1 computer.
So a shirt “costs” 1 computer in the United States.
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COMPARATIVE ADVANTAGE AND GAINS
FROM TRADE
Summary of costs: each country has a different
opportunity cost for each good.
Take a look at the opportunity costs for computers:
Would there be a benefit to trade?
If so, who should produce what?
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COMPARATIVE ADVANTAGE AND GAINS
FROM TRADE
A country has a comparative advantage in
producing goods for which it has the lowest
opportunity cost.
The U.S. has the comparative advantage in (is the
lower-cost producer of) computers: Each computer
costs 1 shirt. (Mexico = 6 shirts.)
Mexico has the comparative advantage in (is the
lower-cost producer of) shirts: Each shirt costs onesixth of a computer. (United States = 1 computer.)
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COMPARATIVE ADVANTAGE AND GAINS
FROM TRADE
(a) U.S. Production Possibilities
(b) Brazilian Production Possibilities
Quantity of
large jets
Quantity of
large jets
30
U.S. consumption
without trade
Brazilian consumption
without trade
18
10
8
U.S.
PPF
16
0
Brazilian
PPF
40
0
Quantity of small jets
6
30
Quantity of small jets
Since each country has a different opportunity cost, it makes
sense to specialize and trade…
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COMPARATIVE ADVANTAGE AND GAINS
FROM TRADE
(a) U.S. Production Possibilities
Quantity of
large jets
(b) Brazilian Production Possibilities
Quantity of
large jets
If the U.S. specializes
in large jets…
30
And Brazil
specializes in small
jets…
U.S. consumption
without trade
Brazilian consumption
without trade
18
10
8
U.S.
PPF
16
0
Brazilian
PPF
40
0
Quantity of small jets
6
30
Quantity of small jets
More airplanes will be produced with the same resources
(up from 26 (18 + 8) to 30 large jets and up from 22 (16+6) to
30 small jets).
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COMPARATIVE ADVANTAGE AND GAINS
FROM TRADE Both countries gain.
(a) U.S. Production Possibilities
Quantity of
large jets
(b) Brazilian Production Possibilities
Then the U.S. will send
some large jets to Brazil
in return for small jets…
30
U.S. consumption
without trade
20
18
And Brazil will send
some small jets to the
U.S. in return for large
jets…
Quantity of
large jets
U.S. consumption
with trade
Both are happy with 1
large jet trading for 2
small jets.
10
Brazilian consumption
without trade
Brazilian consumption
with trade
8
U.S.
PPF
16 20
0
Brazilian
PPF
6 10
40
0
Quantity of small jets
30
Quantity of small jets
Both countries will be happy to export their goods for any
price ABOVE their cost of production and import for any
price BELOW their cost of production.
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COMPARATIVE ADVANTAGE VS.
ABSOLUTE ADVANTAGE
Absolute advantage: a country can produce more output
per worker than other countries.
(a) U.S. Production Possibilities
Quantity of
large jets
(b) Brazilian Production Possibilities
Quantity of
large jets
U.S. has the absolute
advantage in BOTH
large and small jets.
30
10
U.S.
PPF
0
Brazilian
PPF
40
0
Quantity of small jets
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Quantity of small jets
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Don’t confuse absolute with comparative
advantage.
Just because the United States can
produce more of both goods doesn’t
mean we’re better off without trade.
Pay attention to opportunity costs:
If it’s cheaper for Brazil to produce small
jets than it is for the United States, the
United States will want to import small
jets from Brazil.
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C
OPYRIGHT
2015 W
ORTH
P
UBLISHERS
LEARN BY DOING: PRACTICE QUESTION
If Texia specializes in food, it can produce 1,000 units
of food and 0 units of clothing this year. If it
specializes in clothing, it can produce 500 units of
clothing and 0 units of food. This year Urbania can
produce either 500 units of food and 0 units of
clothing or 200 units of clothing and 0 units of food.
(assume linear production possibility frontiers)
_______has the absolute advantage in the production
of clothing and ________has the absolute advantage
in the production of food.
a) Texia; Texia
b) Texia; Urbania
c) Urbania; Texia
d) Urbania; Urbania
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LEARN BY DOING: PRACTICE QUESTION
If Texia specializes in food, it can produce 1,000 units
of food and 0 units of clothing this year. If it
specializes in clothing, it can produce 500 units of
clothing and 0 units of food. This year Urbania can
produce either 500 units of food and 0 units of
clothing or 200 units of clothing and 0 units of food.
(assume linear production possibility frontiers)
_______has the comparative advantage in the
production of clothing and ________has the
comparative advantage in the production of food.
a) Texia; Texia
b) Texia; Urbania
c) Urbania; Texia
d) Urbania; Urbania
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LEARN BY DOING: PRACTICE QUESTION
If a country specializes according to its own
comparative advantage and then trades with
other nations:
a) it will operate at a point inside its
production possibilities frontier.
b) it can consume at a higher level than the
domestic production possibilities frontier.
c) its production possibilities frontier will shift
or rotate inward.
d) it can consume at the same level as the
domestic production possibilities frontier.
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LEARN BY DOING: PRACTICE QUESTION
Write down, then discuss with a partner:
What do you think? Would the U.S.
economy be better off if we did not
import so much clothing from China?
List the groups who you think would
gain and the groups who would lose if
Chinese clothing imports were
restricted.
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LEARN BY DOING: PRACTICE QUESTION
Suppose that in Australia, it takes 2 hours to harvest 10
bushels of apples and 4 hours to harvest 10 bushels of
tomatoes. Suppose a worker in Brazil can harvest 10
bushels of apples in 4 hours or 10 bushels of tomatoes
in 5 hours. Which of these statements is TRUE?
a) Brazil has a comparative advantage in producing
tomatoes.
b) Brazil has a comparative advantage in producing
apples.
c) Brazil has an absolute advantage in producing
both goods.
d) In trade between these two countries, Australia
would gain and Brazil would lose.
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TRANSACTIONS: THE CIRCULAR-FLOW
DIAGRAM
Production and trade in an economy can be represented
by the circular-flow diagram:
Money
Money
Goods
and
service
s
Factors
Trade in physical
things such as
goods, services,
labor, and raw
materials flows in
one direction…
…and the
money that
pays for these
physical things
flows in the
opposite
direction.
Goods and
services
Factors
Money
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LEARN BY DOING: PRACTICE QUESTION
With a partner, trace the following
events through the circular flow:
(a) the introduction of a new
technology that boosts productivity
(b) the decision of consumers to save
more money
(c) an increase in government
spending
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LEARN BY DOING: PRACTICE QUESTION
An increase in household spending
leads to an increase in jobs in the
economy.
a) True
b) False
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USING MODELS: POSITIVE VERSUS
NORMATIVE ECONOMICS
Positive economics is the branch of
economic analysis that describes the way
the economy actually works.
Normative economics makes prescriptions
about the way the economy should work.
Positive economics is about description;
normative economics is about prescription.
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LEARN BY DOING: PRACTICE QUESTION
Label each of the following statements as
normative (a) or positive (b):
1. More than 60% of women are in the labor
market.
2. Rent control laws should be implemented
because they help to achieve equity or
fairness in housing.
3. Society should take measures to end gun
violence.
4. People who smoke pass on increased medical
costs to the whole society.
5. Single mothers are more than twice as likely as
married mothers to be in poverty.
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LEARN BY DOING: PRACTICE QUESTION
Label each of the following statements as
normative (a) or positive (b):
1. More than 60% of women are in the labor
market. POSITIVE
2. Rent control laws should be implemented
because they help to achieve equity or
fairness in housing. NORMATIVE
3. Society should take measures to end gun
violence. NORMATIVE
4. People who smoke pass on increased medical
costs to the whole society. POSITIVE
5. Single mothers are more than twice as likely as
married mothers to be in poverty. POSITIVE
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USING MODELS: WHEN AND WHY
ECONOMISTS DISAGREE
Media coverage tends to exaggerate the real
differences in views among economists.
Economics is often tied up in politics.
Powerful interest groups find and promote
economists who profess supportive opinions.
Economic modeling requires simplifying
assumptions.
Two economists can legitimately disagree about
which simplifications are appropriate.
In most cases such disputes are eventually
resolved.
But it can take a long time before research settles
important
disputes.
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SLIDES
BY
CHAPTER
1
SOLINA LINDAHL
First Principles
FOOD FOR THOUGHT….
SOME GOOD BLOGS AND OTHER SITES TO GET THE JUICES FLOWING:
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What you will
learn in this chapter
▪ A set of principles for understanding
the economics of how individuals
make choices
▪ A set of principles for understanding
how economies work through the
interaction of individual choices
▪ A set of principles for understanding
economy-wide interactions
To
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CHOICE: THE HEART OF ECONOMICS.
She must choose. And her choice affects others.
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INDIVIDUAL CHOICE: THE PRINCIPLES
1. Choices are necessary because
resources are scarce.
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RESOURCES AND SCARCITY
Resource: anything that can be used to
produce something else.
Scarce: in short supply; a resource is scarce
when there is not enough of the resource
available to satisfy all the various ways a
society wants to use it.
ECONOMICS: The study of the best
allocation of limited resources to
satisfy the unlimited wants of humans.
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INDIVIDUAL CHOICE: THE PRINCIPLES
2. The true cost of something is its
opportunity cost.
Opportunity cost: what you must give up in
order to get something.
Mark Zuckerberg understood
the concept of opportunity
cost—and dropped out of
Harvard.
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INDIVIDUAL CHOICE: THE PRINCIPLES
3. “How much” is a decision at the margin.
Trade-off: comparison of the costs and the
benefits of doing something.
Each bite of the candy bar has costs and
benefits.
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INDIVIDUAL CHOICE: THE PRINCIPLES
Marginal decision: decision made at the
margin of an activity about whether to do
a bit more or a bit less of that activity.
Marginal analysis: the study of marginal
decisions.
Incentive: anything that offers rewards to
people who change their behavior.
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LEARN BY DOING: DISCUSS
New York City Mayor Michael Bloomberg
proposed a ban on the sale of any sugary
beverage over 16 ounces in any of the city's
restaurants, delis, movie theaters, and street
carts.
“Obesity is a nationwide problem, and all
over the United States, public health
officials are wringing their hands saying,
‘Oh, this is terrible.’ New York City is not
about wringing your hands; it’s about doing
something. I think that’s what the public
wants the mayor to do,” Bloomberg told
The New York Times in making his proposal.
Discuss: Do you agree that soda should be
taxed or banned? Why or why not?
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INDIVIDUAL CHOICE: THE PRINCIPLES
4. People usually respond to incentives,
exploiting opportunities to make
themselves better off.
In the United States, restaurant
customers have the option of
adding a tip to the restaurant bill.
In much of Europe a tip is added
automatically.
Where would you expect
waiters to be more attentive?
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LEARN BY DOING: BUSINESS CASE
CAN YOU SPOT THE
PROBLEM WITH THIS
INCENTIVE SYSTEM?
A juvenile prison in
Pennsylvania offered judges
bribes the more young
people they sent to jail.
One teen was jailed for a
Facebook page that was
critical of her high-school
principal.
Both judges pleaded guilty
to accepting $2.6 million in
bribes.
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INTERACTION AND INDIVIDUAL CHOICE
5. There are gains from trade.
Trade allows us all to consume more than we
otherwise could.
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INTERACTION AND INDIVIDUAL CHOICE
Specialization: the situation in which each person
specializes in the task that he or she is good at
performing.
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INTERACTION AND INDIVIDUAL CHOICE
6. Markets move toward equilibrium.
Equilibrium: an economic situation in which
no individual would be better off doing
something different.
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LEARN BY DOING: APPLICATION VIDEO
For a look at a real-world equilibrium, click
the picture below to see the Aalsmeer Dutch
Tulip auction in action. (3 minutes)
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LEARN BY DOING: BUSINESS CASE
Lane speeds reach
equilibrium quickly
as people respond to
incentives.
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INTERACTION AND INDIVIDUAL CHOICE
7. Resources should be used efficiently
to achieve society’s goals.
Efficient: taking all opportunities to make
some people better off without making
other people worse off.
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INTERACTION AND INDIVIDUAL CHOICE
Equity trumps efficiency
in disabled parking
space offerings.
Equity: a condition in which
everyone gets his or her “fair
share.”
(There are many definitions of
equity.)
EQUITY AND EFFICIENCY
ARE OFTEN AT ODDS.
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INTERACTION AND INDIVIDUAL CHOICE
8. Markets usually lead to efficiency.
People normally take opportunities for mutual gain.
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INTERACTION AND INDIVIDUAL CHOICE
9. When markets don’t achieve efficiency,
government intervention can improve
society’s welfare.
Sometimes markets fail and need
correction.
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ECONOMY-WIDE INTERACTIONS
10. One person’s spending is another
person’s income.
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ECONOMY-WIDE INTERACTIONS
During recessions, a drop in business spending
leads to:
Less income,
less spending…
…and further drops in business spending,
layoffs, and rising unemployment.
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ECONOMY-WIDE INTERACTIONS
11. Overall spending sometimes gets out of
line with the economy’s productive
capacity.
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ECONOMY-WIDE INTERACTIONS
12. Government policies can change
spending.
The U.S. government funded the WPA and provided
almost 8 million jobs between 1935 and 1943.
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