Chapter 2 Prices, Costs, and the Gains from Trade

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Chapter 2 Prices, Costs, and the Gains from
Trade

• Why do people trade?
• Different Tastes
• Different Abilities Focus of Chapter
• Theory of Comparative Advantage
• First review concepts of prices and cost

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Absolute versus Relative Prices

• No money in world, people still trade
• Simply exchange goods
• Absolute prices
• The number of dollars that can be exchanged for a
  specified quantity of a given good
• Relative prices
• The quantity of some other good that can be
  exchanged for a specified quantity of a good

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EXHIBIT 2.1 Absolute and Relative Price Changes
in a World with Two Goods
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Focus of Microeconomics

• Study relative prices
• Absolute price change not same as a relative
  price change
• Relative price usually relative to some
  representative basket of goods or services
• Dollar refers to a basket of goods or services
  and not a piece of green paper

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Relative Price Changes

• Inflation
• An ongoing rise in the average level of absolute
  prices
• Price of one good risen relative to all other
  goods
• Relative price changes do not cause absolute
  price changes

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Quality of Oranges

• Relative price of oranges higher in New York than
  in Florida
• New Yorkers buy fewer oranges than they would at
  the Florida price
• Once decide to consume
• New Yorker faces lower relative price than the
  Floridian does for a choosing a good orange
  rather than a bad orange

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Costs, Efficiency, and the Gains from Trade

• Everyone can benefit
• when activities are carried out at
• the lowest possible cost

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Costs and Efficiency

• Cost
• Foregone opportunity
• Term opportunity cost misleading
• Totality of all opportunities that the activity
  requires you forgo
• Ex. The electrician and the carpenter

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EXHIBIT 2.2 The Electrician and the Carpenter
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Comparative Advantage

• Ability to perform a given task at a lower cost
• More efficient
• Specialization and gains from trade
• Everyone in society made better off
• People specialize in the area where most
  efficient
• Trade for the goods want to have

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Why People Trade

• Different tastes
• Different abilities
• Pays to be different
• Any difference is an opportunity for mutual gain
• The more different you are, the more gains to be
  had
• International Trade small countries gain the most

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Trade Without Differences

• David Ricardo
• 19th century economist
• First recognize importance of comparative
  advantage
• Analyze consequences for mutually beneficial
  trade
• Adam Smith
• 18th century economist
• Described another way trade benefit all parties
• Increased productivity through specialization

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Whats Next

• Thorough study of tastes
• Incorporate tastes into study of market behavior