Introduction to Macroeconomics

Principles of Economics
Thinking like an Economist
Interdependence and the gain from Trade

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 Principles of Economics
look for the answers to these questions:
•What kinds of questions does economics
address?
•What are the principles of how people make
decisions?
•What are the principles of how people interact?
•What are the principles of how the economy as
a whole works?

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 What Economics Is All About
• Scarcity: the limited nature of society’s
resources
• Economics: the study of how society manages
its scarce resources, e.g.
– how people decide what to buy,
how much to work, save, and spend
– how firms decide how much to produce,
how many workers to hire
– how society decides how to divide its resources
between national defense, consumer goods,
protecting the environment, and other needs
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The principles of
HOW PEOPLE
MAKE DECISIONS

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 PRINCIPLE #1:
People Face Tradeoffs
All decisions involve tradeoffs. Examples:
• Going to a party the night before your midterm
leaves less time for studying.
• Having more money to buy stuff requires working
longer hours, which leaves less time
for leisure.
• Protecting the environment requires resources
that could otherwise be used to produce
consumer goods.
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 PRINCIPLE #1:
People Face Tradeoffs
• Society faces an important tradeoff:
efficiency vs. equality
• Efficiency: when society gets the most from its
scarce resources
• Equality: when prosperity is distributed uniformly
among society’s members
• Tradeoff: To achieve greater equality,
could redistribute income from wealthy to poor.
But this reduces incentive to work and produce,
shrinks the size of the economic “pie.”
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 PRINCIPLE #2:
The Cost of Something Is
What You Give Up to Get It
• Making decisions requires comparing the costs
and benefits of alternative choices.
• The opportunity cost of any item is
whatever must be given up to obtain it.
• It is the relevant cost for decision making.

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 PRINCIPLE #2:
The Cost of Something Is
What You Give Up to Get It
Examples:
The opportunity cost of…
…going to college for a year is not just the tuition,
books, and fees, but also the foregone wages.
…seeing a movie is not just the price of the ticket,
but the value of the time you spend in the theater.

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 PRINCIPLE #3:
Rational People Think at the Margin

Rational people
– systematically and purposefully do the best they can
to achieve their objectives.
– make decisions by evaluating costs and benefits of
marginal changes, incremental adjustments to an
existing plan.

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 PRINCIPLE #3:
Rational People Think at the Margin
Examples:
• When a student considers whether to go to college
for an additional year, he compares the fees &
foregone wages to the extra income
he could earn with the extra year of education.
• When a manager considers whether to increase
output, she compares the cost of the needed labor
and materials to the extra revenue.

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 PRINCIPLE #4:
People Respond to Incentives
• Incentive: something that induces a person to
act, i.e. the prospect of a reward or
punishment.
• Rational people respond to incentives.
Examples:
– When gas prices rise, consumers buy more hybrid
cars and fewer gas guzzling SUVs.
– When cigarette taxes increase,
teen smoking falls.
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 ACTIVE LEARNING 1
Applying the principles

You are selling your 1996 Mustang. You have already

spent $1000 on repairs.
At the last minute, the transmission dies. You can pay
$600 to have it repaired, or sell the car “as is.”
In each of the following scenarios, should you have the
transmission repaired? Explain.
A. Blue book value (what you could get for the car) is
$6500 if transmission works, $5700 if it doesn’t
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t

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 ACTIVE LEARNING 1
Answers

Cost of fixing transmission = $600

A. Blue book value is $6500 if transmission works,
$5700 if it doesn’t
Benefit of fixing the transmission = $800
($6500 – 5700).
It’s worthwhile to have the transmission fixed.
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t
Benefit of fixing the transmission is only $500.
Paying $600 to fix transmission is not worthwhile.
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 ACTIVE LEARNING 1
Observations

• The $1000 you previously spent on repairs is

irrelevant. What matters is the cost and
benefit
of the marginal repair (the transmission).
• The change in incentives from scenario A
to scenario B caused your decision to change.

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The principles of
HOW PEOPLE
INTERACT

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 PRINCIPLE #5:
Trade Can Make Everyone Better Off
• Rather than being self-sufficient,
people can specialize in producing one good
or service and exchange it for other goods.
• Countries also benefit from trade and
specialization:
– Get a better price abroad for goods they produce
– Buy other goods more cheaply from abroad than
could be produced at home

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 PRINCIPLE #6:
Markets Are Usually A Good Way to
Organize Economic Activity
• Market: a group of buyers and sellers
(need not be in a single location)
• “Organize economic activity” means
determining
– what goods to produce
– how to produce them
– how much of each to produce
– who gets them
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 PRINCIPLE #6:
Markets Are Usually A Good Way to
Organize Economic Activity
• A market economy allocates resources through
the decentralized decisions of many
households and firms as they interact in
markets.
• Famous insight by Adam Smith in
The Wealth of Nations (1776):
Each of these households and firms
acts as if “led by an invisible hand”
to promote general economic well-being.
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 PRINCIPLE #6:
Markets Are Usually A Good Way to
Organize Economic Activity
• The invisible hand works through the price
system:
– The interaction of buyers and sellers
determines prices.
– Each price reflects the good’s value to buyers and
the cost of producing the good.
– Prices guide self-interested households and firms
to make decisions that, in many cases, maximize
society’s economic well-being.
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 PRINCIPLE #7:
Governments Can Sometimes
Improve Market Outcomes
• Important role for govt: enforce property
rights
(with police, courts)
• People are less inclined to work, produce,
invest, or purchase if large risk of their
property being stolen.

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 PRINCIPLE #7:
Governments Can Sometimes
Improve Market Outcomes

• Market failure: when the market fails to

allocate society’s resources efficiently
• Causes of market failure:
– Externalities, when the production or consumption
of a good affects bystanders (e.g. pollution)
– Market power, a single buyer or seller has substantial
influence on market price
(e.g. monopoly)
• Public policy may promote efficiency.
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 PRINCIPLE #7:
Governments Can Sometimes
Improve Market Outcomes
• Govt may alter market outcome to
promote equity.
• If the market’s distribution of economic well-
being is not desirable, tax or welfare policies
can change how the economic “pie” is divided.

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 ACTIVE LEARNING 2
Discussion Question

In each of the following situations, what is the

government’s role? Does the government’s
intervention improve the outcome?
a. Public schools for K-12
b. Workplace safety regulations
c. Public highways
d. Patent laws, which allow drug companies to
charge high prices for life-saving drugs

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The principles of
HOW THE
ECONOMY
AS A WHOLE
WORKS

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 PRINCIPLE #8:
A Country’s Standard of Living Depends on Its
Ability to Produce Goods & Services

• Huge variation in living standards across

countries and over time:
– Average income in rich countries is more than ten
times average income in poor countries.
– The U.S. standard of living today is about
eight times larger than 100 years ago.

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 PRINCIPLE #8:
A Country’s Standard of Living Depends on Its
Ability to Produce Goods & Services
• The most important determinant of living
standards: productivity, the amount of goods
and services produced per unit of labor.
• Productivity depends on the equipment, skills,
and technology available to workers.
• Other factors (e.g., labor unions, competition
from abroad) have far less impact on living
standards.
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 PRINCIPLE #9:
Prices Rise When the Government Prints Too
Much Money
• Inflation: increases in the general level of
prices.
• In the long run, inflation is almost always
caused by excessive growth in the quantity of
money, which causes the value of money to
fall.
• The faster the govt creates money,
the greater the inflation rate.
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 PRINCIPLE #10:
Society Faces a Short-run Tradeoff Between
Inflation and Unemployment
• In the short-run (1–2 years),
many economic policies push inflation and
unemployment in opposite directions.
• Other factors can make this tradeoff more or
less favorable, but the tradeoff is always
present.

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 SUMMARY

The principles of decision making are:

• People face tradeoffs.
• The cost of any action is measured in terms of
foregone opportunities.
• Rational people make decisions by comparing
marginal costs and marginal benefits.
• People respond to incentives.

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 SUMMARY

The principles of interactions among people are:

• Trade can be mutually beneficial.
• Markets are usually a good way of
coordinating trade.
• Govt can potentially improve market
outcomes if there is a market failure or if the
market outcome is inequitable.

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 SUMMARY

The principles of the economy as a whole are:

• Productivity is the ultimate source of living
standards.
• Money growth is the ultimate source of
inflation.
• Society faces a short-run tradeoff between
inflation and unemployment.

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 Thinking like an Economist,
look for the answers to these questions:
• What are economists’ two roles? How do they differ?
• What are models? How do economists use them?
• What are the elements of the Circular-Flow Diagram?
What concepts does the diagram illustrate?
• How is the Production Possibilities Frontier related
to opportunity cost? What other concepts does it
illustrate?
• What is the difference between microeconomics and
macroeconomics? Between positive and normative?
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 The Economist as Scientist
• Economists play two roles:
1. Scientists: try to explain the world
2. Policy advisors: try to improve it

• In the first, economists employ the

scientific method,
the dispassionate development and testing of
theories about how the world works.

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 Assumptions & Models
• Assumptions simplify the complex world,
make it easier to understand.
• Example: To study international trade,
assume two countries and two goods.
Unrealistic, but simple to learn and
gives useful insights about the real world.
• Model: a highly simplified representation of
a more complicated reality.
Economists use models to study economic issues.
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 Some Familiar Models

A road map

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 Some Familiar Models

A model of human
anatomy from high
school biology class

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 Some Familiar Models

A model airplane

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 Some Familiar Models
The model teeth at the
Don’t forget
dentist’s office to floss!

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Our First Model:
The Circular-Flow Diagram
• The Circular-Flow Diagram: a visual model of
the economy, shows how dollars flow through
markets among households and firms
• Two types of “actors”:
– households
– firms
• Two markets:
– the market for goods and services
– the market for “factors of production”
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 Factors of Production
• Factors of production: the resources the
economy uses to produce goods & services,
including
– labor
– land
– capital (buildings & machines used in production)

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FIGURE 1: The Circular-Flow Diagram

Households:
 Own the factors of production,
sell/rent them to firms for income
 Buy and consume goods & services

Firms Households

Firms:
 Buy/hire factors of production,

use them to produce goods

and services
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Sell goods & services Dr. S. Jain 41
FIGURE 1: The Circular-Flow Diagram

Revenue Spending
Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income
profit
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Our Second Model:
The Production Possibilities Frontier
• The Production Possibilities Frontier (PPF):
a graph that shows the combinations of
two goods the economy can possibly produce given
the available resources and the available technology
• Example:
– Two goods: computers and wheat
– One resource: labor (measured in hours)
– Economy has 50,000 labor hours per month available for
production.

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 PPF Example
• Producing one computer requires 100 hours labor.
• Producing one ton of wheat requires 10 hours labor.

Employment of
Production
labor hours
Computers Wheat Computers Wheat
A 50,000 0 500 0
B 40,000 10,000 400 1,000
C 25,000 25,000 250 2,500
D 10,000 40,000 100 4,000
E 0 50,000 0 5,000
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 PPF Example

Production
Point
on Com-
graph puters Wheat E

A 500 0 D
B 400 1,000
C
C 250 2,500
D 100 4,000 B
E 0 5,000 A

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 ACTIVE LEARNING 1
Points off the PPF

A. On the graph, find the point that represents

(100 computers, 3000 tons of wheat), label it F.
Would it be possible for the economy to produce this
combination of the two goods?
Why or why not?
B. Next, find the point that represents
(300 computers, 3500 tons of wheat), label it G.
Would it be possible for the economy to produce this
combination of the two goods?

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 ACTIVE LEARNING 1
Answers

 Point F:
100 computers,
3000 tons wheat
 Point F requires
40,000 hours
of labor. F
Possible but
not efficient:
could get more
of either good
w/o sacrificing
any of the other.
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 ACTIVE LEARNING 1
Answers

 Point G:
300 computers,
3500 tons wheat

 Point G requires
G
65,000 hours
of labor.
Not possible
because
economy
only has
50,000 hours.
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 The PPF: What We Know So Far
Points on the PPF (like A – E)
– possible
– efficient: all resources are fully utilized
Points under the PPF (like F)
– possible
– not efficient: some resources underutilized
(e.g., workers unemployed, factories idle)
Points above the PPF (like G)
– not possible
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 The PPF and Opportunity Cost
• Recall: The opportunity cost of an item
is what must be given up to obtain that item.
• Moving along a PPF involves shifting resources
(e.g., labor) from the production of one good to
the other.
• Society faces a tradeoff: Getting more of one
good requires sacrificing some of the other.
• The slope of the PPF tells you the opportunity
cost of one good in terms of the other.
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 The PPF and Opportunity Cost
The slope of a line
equals the
–1000
slope = = –10 “rise over the run,”
100
the amount the line
rises when you move
to the right by one
unit.

Here, the
opportunity cost of
a computer is
10 tons of wheat.

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 ACTIVE LEARNING 2
PPF and Opportunity Cost

In which country is the opportunity cost of cloth lower?

FRANCE ENGLAND

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 ACTIVE LEARNING 2
Answers

England, because its PPF is not as steep as France’s.

FRANCE ENGLAND

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 Economic Growth and the PPF
With additional
Economic
resources or an growth shifts
improvement in the PPF
technology, outward.
the economy can
produce more
computers,
more wheat,
or any combination
in between.

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 The Shape of the PPF
• The PPF could be a straight line or bow-shaped
• Depends on what happens to opportunity cost
as economy shifts resources from one industry
to the other.
– If opp. cost remains constant,
PPF is a straight line.
(In the previous example, opp. cost of a computer
was always 10 tons of wheat.)
– If opp. cost of a good rises as the economy
produces more of the good, PPF is bow-shaped.

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Why the PPF Might Be Bow-Shaped
As the economy

Beer
shifts resources
from beer to
mountain bikes:
 PPF becomes
steeper
 opp. cost of
mountain bikes
increases
Mountain
Bikes
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 Why the PPF Might Be Bow-Shaped
At A, opp. cost of
At point A,

Beer
A mtn bikes is low.
most workers are
producing beer,
even those who
are better suited
to building bikes.
So, do not have to
give up much beer
to get more bikes.

Mountain
Bikes
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 Why the PPF Might Be Bow-Shaped
At B, most workers are

Beer
At B, opp. cost
producing bikes. of mtn bikes
The few left in beer are is high.
the best brewers.
Producing more bikes B
would require shifting
some of the best
brewers away from
beer production,
causing a big drop in
beer output. Mountain
Bikes
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 Why the PPF Might Be Bow-Shaped

• So, PPF is bow-shaped when different workers

have different skills, different opportunity costs
of producing one good in terms of the other.
• The PPF would also be bow-shaped when there
is some other resource, or mix of resources
with varying opportunity costs
(E.g., different types of land suited for
different uses).

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 The PPF: A Summary
• The PPF shows all combinations of two goods
that an economy can possibly produce,
given its resources and technology.
• The PPF illustrates the concepts of
tradeoff and opportunity cost,
efficiency and inefficiency,
unemployment, and economic growth.
• A bow-shaped PPF illustrates the concept of
increasing opportunity cost.
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 Microeconomics and Macroeconomics

• Microeconomics is the study of how

households and firms make decisions and how
they interact in markets.
• Macroeconomics is the study of economy-wide
phenomena, including inflation,
unemployment, and economic growth.
• These two branches of economics are closely
intertwined, yet distinct—they address different
questions.
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 The Economist as Policy Advisor
• As scientists, economists make
positive statements,
which attempt to describe the world as it is.
• As policy advisors, economists make
normative statements,
which attempt to prescribe how the world should be.
• Positive statements can be confirmed or refuted,
normative statements cannot.
• Govt employs many economists for policy advice. E.g., the
U.S. President has a Council of Economic Advisors, which
the author of this textbook chaired from 2003 to 2005.

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 ACTIVE LEARNING 3
Identifying positive vs. normative

Which of these statements are “positive” and which are

“normative”? How can you tell the difference?
a. Prices rise when the government increases the
quantity of money.
b. The government should print less money.
c. A tax cut is needed to stimulate the economy.
d. An increase in the price of burritos will cause an
increase in consumer demand for music
downloads.

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 ACTIVE LEARNING 3
Answers

a. Prices rise when the government increases the

quantity of money.
Positive – describes a relationship, could use
data to confirm or refute.

b. The government should print less money.

Normative – this is a value judgment, cannot be
confirmed or refuted.

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 ACTIVE LEARNING 3
Answers

c. A tax cut is needed to stimulate the economy.

Normative – another value judgment.

d. An increase in the price of burritos will cause an

increase in consumer demand for music
downloads.
Positive – describes a relationship.
Note that a statement need not be true to be
positive.

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 Why Economists Disagree
• Economists often give conflicting policy advice.
• They sometimes disagree about the validity of
alternative positive theories about the world.
• They may have different values and, therefore,
different normative views about what policy
should try to accomplish.
• Yet, there are many propositions about which
most economists agree.

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 Propositions about Which Most
Economists Agree (and % who agree)
• A ceiling on rents reduces the quantity and quality of
housing available. (93%)
• Tariffs and import quotas usually reduce general
economic welfare. (93%)
• The United States should not restrict employers from
outsourcing work to foreign countries. (90%)
• The United States should eliminate agriculture
subsidies. (85%)

continued…

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 Propositions about Which Most
Economists Agree (and % agreeing)
• The gap between Social Security funds and expenditures
will become unsustainably large
within the next fifty years if current policies remain
unchanged. (85%)
• A large federal budget deficit has an adverse effect on the
economy. (83%)
• A minimum wage increases unemployment among young
and unskilled workers. (79%)
• Effluent taxes and marketable pollution permits represent
a better approach to pollution control
than imposition of pollution ceilings. (78%)
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 SUMMARY

• As scientists, economists try to explain the world using

models with appropriate assumptions.
• Two simple models are the Circular-Flow Diagram and
the Production Possibilities Frontier.
• Microeconomics studies the behavior of consumers and
firms, and their interactions in markets.
Macroeconomics studies the economy as a whole.
• As policy advisers, economists offer advice on how to
improve the world.

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 Interdependence and the gain from Trade,
look for the answers to these questions:
• Why do people—and nations—choose to be
economically interdependent?
• How can trade make everyone better off?
• What is absolute advantage?
What is comparative advantage?
How are these concepts similar?
How are they different?

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 Interdependence
Every day hair gel from
you rely on Cleveland, OH
many people
from around cell phone
the world, from Taiwan
most of whom
you’ve never met, dress shirt
to provide you from China
with the goods
and services coffee from
you enjoy. Kenya

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 Interdependence
• One of the Ten Principles from Chapter 1:
Trade can make everyone better off.
• We now learn why people—and nations—
choose to be interdependent,
and how they can gain from trade.

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 Our Example
• Two countries: the U.S. and Japan
• Two goods: computers and wheat
• One resource: labor, measured in hours
• We will look at how much of both goods
each country produces and consumes
– if the country chooses to be self-sufficient
– if it trades with the other country

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 Production Possibilities in the U.S.
• The U.S. has 50,000 hours of labor
available for production, per month.
• Producing one computer
requires 100 hours of labor.
• Producing one ton of wheat
requires 10 hours of labor.

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 The U.S. PPF
Wheat
(tons) The U.S. has enough labor to
5,000 produce 500 computers,
or 5000 tons of wheat,
4,000
or any combination along the
3,000 PPF.

2,000

1,000

Computers
0
100 200 300 400 500

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 The U.S. Without Trade
Wheat
(tons)
Suppose the U.S. uses half its labor to
5,000
produce each of the two goods.
4,000 Then it will produce and consume
250 computers and
3,000 2500 tons of wheat.

2,000

1,000

Computers
0
100 200 300 400 500

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 ACTIVE LEARNING 1
Derive Japan’s PPF

Use the following information to draw Japan’s

PPF.
– Japan has 30,000 hours of labor available for
production, per month.
– Producing one computer requires 125 hours of
labor.
– Producing one ton of wheat requires 25 hours of
labor.
Your graph should measure computers on the
horizontal axis.
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 Japan’s PPF

Wheat
(tons)
Japan has enough labor to
produce 240 computers,
2,000 or 1200 tons of wheat,
or any combination along
the PPF.
1,000

0 Computers
100 200 300
2/24/18 Dr. S. Jain 78
 Japan Without Trade

Wheat
(tons) Suppose Japan uses half its labor to
produce each good.
2,000 Then it will produce and consume
120 computers and
600 tons of wheat.
1,000

0 Computers
100 200 300
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 Consumption With and Without Trade

• Without trade,
– U.S. consumers get 250 computers
and 2500 tons wheat.
– Japanese consumers get 120 computers
and 600 tons wheat.
• We will compare consumption without trade to
consumption with trade.
• First, we need to see how much of each good is
produced and traded by the two countries.

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 ACTIVE LEARNING 2
Production under trade

1. Suppose the U.S. produces 3400 tons of

wheat. How many computers would the U.S.
be able to produce with its remaining labor?
Draw the point representing this combination
of computers and wheat on the U.S. PPF.
2. Suppose Japan produces 240 computers.
How many tons of wheat would Japan be able
to produce with its remaining labor? Draw
this point on Japan’s PPF.
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 U.S. Production With Trade
Wheat
(tons)
5,000 Producing 3400 tons of wheat
requires 34,000 labor hours.
4,000
The remaining 16,000
3,000 labor hours are used to
produce 160 computers.
2,000

1,000

Computers
0
100 200 300 400 500

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 Japan’s Production With Trade

Wheat Producing 240 computers

(tons) requires all of Japan’s 30,000
labor hours.
2,000
So, Japan would produce
0 tons of wheat.

1,000

0 Computers
100 200 300
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 Exports & Imports
• Exports:
goods produced domestically and sold abroad
To export means to sell domestically produced
goods abroad.
• Imports:
goods produced abroad and sold domestically
To import means to purchase goods produced
in other countries.

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 ACTIVE LEARNING 3
Consumption under trade

Suppose the U.S. exports 700 tons of wheat to

Japan, and imports 110 computers from Japan.
(So, Japan imports 700 tons wheat and exports
110 computers.)
– How much of each good is consumed in the U.S.?
Plot this combination on the U.S. PPF.
– How much of each good is consumed in Japan? Plot
this combination on Japan’s PPF.

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 U.S. Consumption With Trade
Wheat
(tons) computers wheat
5,000 produced 160 3400
+ imported 110 0
4,000 – exported 0 700
= amount
3,000 270 2700
consumed
2,000

1,000

Computers
0
100 200 300 400 500

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 Japan’s Consumption With Trade

computers wheat
Wheat produced 240 0
(tons)
+ imported 0 700
2,000 – exported 110 0
= amount
130 700
consumed

1,000

0 Computers
100 200 300
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 Trade Makes Both Countries Better Off
U.S.
consumption consumption gains from
without trade with trade trade
computers 250 270 20
wheat 2500 2700 200
Japan
consumption consumption gains from
without trade with trade trade
computers 120 130 10
wheat 600 700 100
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 Where Do These Gains Come From?
• Absolute advantage: the ability to produce a
good using fewer inputs than another producer
• The U.S. has an absolute advantage in wheat:
producing a ton of wheat uses 10 labor hours
in the U.S. vs. 25 in Japan.
• If each country has an absolute advantage
in one good and specializes in that good,
then both countries can gain from trade.

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 Where Do These Gains Come From?

• Which country has an absolute advantage in

computers?
• Producing one computer requires
125 labor hours in Japan,
but only 100 in the U.S.
• The U.S. has an absolute advantage in both
goods!
So why does
does Japan
Japan specialize
specialize in
in computers?
computers? Why do
both
both countries
countries gain from trade?
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 Two Measures of the Cost of a Good
• Two countries can gain from trade when each
specializes in the good it produces at lowest cost.
• Absolute advantage measures the cost of a good in
terms of the inputs required to produce it.
• Recall:
Another measure of cost is opportunity cost.
• In our example, the opportunity cost of a computer is
the amount of wheat that could be produced using the
labor needed to produce one computer.

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 Opportunity Cost and
Comparative Advantage
• Comparative advantage: the ability to
produce
a good at a lower opportunity cost than
another producer
• Which country has the comparative advantage
in computers?
• To answer this, must determine the
opportunity cost of a computer in each
country.
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 Opportunity Cost and
Comparative Advantage
• The opportunity cost of a computer is
– 10 tons of wheat in the U.S., because producing one
computer requires 100 labor hours,
which instead could produce 10 tons of wheat.
– 5 tons of wheat in Japan, because producing one
computer requires 125 labor hours,
which instead could produce 5 tons of wheat.
• So, Japan has a comparative advantage in
computers. Lesson: Absolute advantage is not
necessary for comparative advantage!
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 Comparative Advantage and Trade
• Gains from trade arise from comparative advantage
(differences in opportunity costs).
• When each country specializes in the good(s)
in which it has a comparative advantage,
total production in all countries is higher,
the world’s “economic pie” is bigger,
and all countries can gain from trade.
• The same applies to individual producers
(like the farmer and the rancher) specializing
in different goods and trading with each other.
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 ACTIVE LEARNING 4
Absolute and comparative advantage

Argentina and Brazil each have 10,000 hours of labor per

month.
In Argentina,
– producing one pound coffee requires 2 hours
– producing one bottle wine requires 4 hours
In Brazil,
– producing one pound coffee requires 1 hour
– producing one bottle wine requires 5 hours
Which country has an absolute advantage in the
production of coffee? Which country has a comparative
advantage in the production of wine?
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 ACTIVE LEARNING 4
Answers

Brazil has an absolute advantage in coffee:

– Producing a pound of coffee requires only one
labor-hour in Brazil, but two in Argentina.
Argentina has a comparative advantage in wine:
– Argentina’s opp. cost of wine is two pounds of
coffee, because the four labor-hours required
to produce a bottle of wine could instead produce
two pounds of coffee.
– Brazil’s opp. cost of wine is five pounds of coffee.

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 Unanswered Questions…
• We made a lot of assumptions about the quantities of
each good that each country produces, trades, and
consumes, and the price at which the countries trade
wheat for computers.
• In the real world, these quantities and prices would be
determined by the preferences of consumers and the
technology and resources in both countries.
• We will begin to study this in the next chapter.
• For now, though, our goal was merely to see how trade
can make everyone better off.

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 SUMMARY

• Interdependence and trade allow everyone to enjoy a

greater quantity and variety of goods & services.
• Comparative advantage means being able to produce a
good at a lower opportunity cost. Absolute advantage
means being able to produce a good with fewer inputs.

• When people—or countries—specialize in the goods in

which they have a comparative advantage, the
economic “pie” grows and trade can make everyone
better off.

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