Choice involves the loss of foregone alternatives. OPPORTUNITY COST is the highest valued alternative that must be sacrificed when one chooses. (Choosing between A and B, if you choose A the OPP COST of A is B).
Costs are always subjective and exist in the mind of the decision maker. Costs and benefits are highly individual, and can only really be evaluated with 100% accuracy by the decision maker. Costs being subjective allows trade to take place and re-allocates goods to the people who value them most highly.
Example - classified ads for used goods.
Cost usually has a MONETARY cost and a NON-MONETARY cost. Think of the TOTAL COST of getting a college degree. What is the largest cost of a B.A. degree?
Example - Greyhound bus to Miami for $50 each way. 2-3 days on the road each way is a non-monetary cost. Explains why Bill Gates/Oprah/Michael Jordan don't take the Greyhound bus - they have a very high OPP COST in terms of the next highest valued alternative. Their time is very expensive/valuable. Unemployed person, or a college student would be more likely to take the bus, they have a lower opp. cost in terms of the sacrificed alternatives. Their time is not worth as much.
Example: Round trip airline ticket costs $150 and a bus ticket costs $110. Bus - 10 hours, Airplane - 2 hours. Bus is 8 hours longer and $40 cheaper, or a savings of $5/hour. If the opp. cost of your time is less than $5, you should take the bus. If the opp. cost of your time is greater than $5, you should fly.
Example: Labor market.
The cost of hiring someone if the opp. cost of the next highest paying job available. If you want to hire a lawyer to teach or be a Univ. administrator, you will have to compensate them for the next highest valued alternative - private law practice. Variation in college professors' salaries reflect OPP COST.
Or, a Univ. professor can either teach during the summer or work doing consulting project. To do the consulting project, they have to be paid at least as much as summer teaching. Employers have to bid away workers from other employment opportunities.
Example - retirees watch more daytime TV than working professionals. Why? It is more costly for a stockbroker or real estate agent to take time away from work during the day to watch TV. Retirees have a low opp. cost.
Example - the opp. cost of taking time off from
studying to go to the movies is higher during exam time. Study time becomes
more valuable during exam time and recreation time is more costly. Choosing
recreation would be much more costly during exam time than the first week
of the semester.
TRADE CREATES VALUE
Voluntary Trade and exchange create economic value and
increase wealth and prosperity because:
1. Trade is WIN-WIN. What people gain in an exchange is worth more to them to what
they give up. Trade is a "positive sum" outcome. Not even zero sum
(+/-) or neg. sum game (-/-). In voluntary exchange, both parties are
made better off. WIN-WIN situation.
Grocery store example - $100 of worth of groceries.
2. Trade reallocates goods/service to those who value them most highly. Value/preferences are subjective, and differ among individuals. By trading, goods are redistributed from those who don't value them highly to those who do value them highly. Or stated differently, people who sell used goods value money more highly than the goods, and people who buy used goods value the goods more highly than they value the money. Think of the want ads or Ebay. Merchandise get redistributed more optimally through trade.
POINT: By channeling goods and resources toward those value them most highly, trade creates wealth for both trading partners (buyer and seller) regardless of the unit of analysis: individuals who trade benefit, as do organizations, corporations, states, trading blocs, nations, planets, etc.
TRANSACTION COSTS (trading frictions): The time,
effort, resources, and monetary cost to search out, negotiate and consummate
an exchange. Examples of transaction costs include commissions, fees, taxes,
tariffs, transportation costs, paperwork, contract negotiations, etc. for
Transaction costs are a potential barrier to trade if
the costs are HIGH, volume of trade may decrease (Ticketmaster). However,
efficient markets in a market economy will often organized to minimize transactions
costs and expand trade. Examples: mutual
funds, the Internet, Ebay, etc. see p. 31-32.
Example: you are looking for a job. Perhaps there
are ideal jobs available in Arizona or Alaska, but it may be hard for you
to find them. Transaction costs may prevent the ideal candidate getting
matched up with the ideal position.
"Friction-free capitalism" is an unreachable ideal, although we are moving towards it all the time, due to what???
POINT: Transaction costs (frictions) prevent all potentially valuable trades from taking place, explains some of the unemployment in the economy ("natural rate" of unemployment is estimated to be about 5-6%).
MIDDLEMAN AS COST REDUCER
Middleman as a cost reducer - Middlemen bring together buyers and sellers, create a market and typically reduce overall transaction costs. For a fee, middlemen reduce transaction costs.
Example: Banks, Real estate agents, Prop. mgmt.
agencies, Automobile dealers, Stock brokers, Mutual Funds, Grocers, Auto
dealers, Shopping Malls, Want Ads, Jewelry district
in NYC, Yellow Pages, Ebay, etc.
IMPORTANCE OF PROPERTY RIGHTS
Important concept in economics: The right to exclusive use and control of a resource, good or service.
Who owns the Washington Monument?
Private Property Rights involves:
1. Exclusive control of property or resource.
2. Legal protection of private property by rule of law.
3. Transferable rights - you can sell, rent, trade, give away, privately owned property, etc.
ALL Goods, resources, assets, property have to be either owned privately or publicly.
Strong Difference in incentives based on who owns property.
"Tragedy of the commons" - If everybody owns a resource, no one has a strong incentive to take care of it.
Examples: Buffalos, elephants, commonly owned bicycles
at Berry College, grazing land, etc.
Incentives under private ownership:
1. Private owners gain by using their resources in ways that benefit others and bear the cost of ignoring the wishes of others. In other words, private owners have a strong incentive to pay attention to what other people want. You can be selfish or abuse your property, but you will pay the cost.
Example - you own a house and you are concerned about resale value. You are going to do some decorating. You can paint the walls purple and put up wall paper with dogs playing cards and pave the front yard, but it would be very bad for resale value, because it is not what other people want. So in your decisions for redecorating and remodeling, you are forced to be concerned about other peoples' tastes. If not, you pay the price of being selfish because the resale value of your property will decrease. General rule for maximizing resale value: neutral colors.
2. Private owners have strong incentives to take good care of their property. Example: you own a car and you will trade it in or sell it in three years. You have a strong incentive to change the oil and maintain the vehicle. Private owners are good stewards, they have strong incentive to take good care of their property. Example: Berry Bikes on page 35-36.
3. Private owners have an incentive to conserve property for the future. Example: private owner of a house, building, land or other real estate, and future generations. Owner is forced to be concerned with future owners to enhance value of property, and will make repairs that will last longer than they plan to live their. Example: planting trees that will last for hundreds of years, putting on a new roof that will last for 30 years. Adding a garage or swimming pool that will last for many years...... Your personal wealth is tied to the value of your own property, so you have a strong incentive to maintain its value, which increases its value for future owners.
4. With private property rights, the private owner can be held accountable for damage to others caused by the misuse of property. Example: factory that pollutes the water, driving your car while intoxicated, not shoveling your sidewalk creating unsafe conditions, etc.
MAIN POINT: Private property rights provide powerful incentives for good stewardship, that are not present for common property ("tragedy of the commons").
Example: About 1% of the land in Russia is privately farmed. That 1% of the farm land produces about 40% of the produce grown in Russia.
Example: Water rights. Pollution - who to sue in Cuba, Soviet Union or N. Korea for pollution?
Example: Animals and endangered species, see p.
PRODUCTION POSSIBILITIES CURVE
We now look at our first economic model - the Production Possibility Curve (PPC). It gives us insight into several of the econ. guideposts we have talked about. It shows graphically the fact that resources are limited - universe of scarcity.
Example - we start with a student and graph their PPC for grades. Limited amount of study time - 10 hours per week. Allocated between. study for Econ and English. Given the limited study time and the ability of the student, the PPC on p. 39 shows the expected grade outcomes from different allocations of study time. If Susan spends 5 hours per week on both Eng. and Econ, she can get a B in both classes, Point T (B, B). If she spends more time on Econ, she could get an A, but would only get a D in Eng., point S (A,D). If she spends more time on Eng., she can get an A, but would only get a D in Econ, Point U (D, A).
How could Susan try to get better grades in both classes????? (Shift out the PPC.)
PPC applied to entire simple economy - 2 good economy - Food and Clothing. Page 40. There is a limited amount of resources - land, labor and capital. If all resources are devoted to Clothing, then Amount S (all clothing) can be produced. If all resources to Food, amount T can be produced (all food). A, B, C are other possible combinations of both Food and Clothing. (S and T are corner solutions)
Point D is attainable, but is inefficient. Example: Epidemic or Plague, or War. Points outside the PPC are unattainable given the current resources available.
PPC could be flat or concave. If flat it means that resources can be easily and costlessly shifted from F to C or vice-versa. Example: farmer growing corn or soybeans.
In most cases, it would be realistic to assume that as resources starting getting shifted from one production process to the other, it becomes increasing costly to shift resources. Reason: labor, land and capital is not equally suited to both production. Intuition: as cloth workers get shifted to food, they are less and less able to produce food. Same for land and capital (machinery). Therefore, there is an increasing cost of production as resources get shifted, and this is reflected in a concave PPC.
Economy can operate at full production (max. output) in
SR as long as
1) Resources are fixed
2) Resources are used efficiently/full employment and
3) Level of technology is constant.
How to get MORE output over time? How to INCREASE productivity? Shift OUT the PPC?
1. An increase in the economy's resources - discovery of oil, minerals. Investment in capital formation and capital equipment - machines, buildings, property, plant and equipment, and human capital! Increasing the stock of capital equipment (machinery, computers, vehicles, etc.) increases current and future production.
See graph page 41 - High Investment (Panel a) vs Low Investment (Panel b) economies.
2. Advances in technology - Industrial Revolution, Machine Age, Information Age. Computers, etc. Bar Codes, word processing, etc. Inventions/Innovation/Entrepreneurs lead to increases in output/productivity, by expanding our economy's production possibilities.
Example: development of corporate law in 1800s reduced the cost of forming large companies, for example by providing limited liability to owners, and helped the Industrial Revolution which involved large, mass production type firms. We went from small craft guilds to large companies.
Example - 18th century, patent law was developed. Intellectual property rights were established - copyrights (music), patents, trademarks, formulas, etc. Led to an increase in production.
Problem: China has not always followed our copyright laws - Bootleg tape/CDs
Problem: Poland - no way to record a mortgage or bankruptcy.
Problem: Peru - took 5 years to transfer title of car. 90% of the land is untitled.
Problem: Russia after collapse of communism. Highly-educated
workforce and abundant natural resources, but weak legal structure and lack
of property rights has prevented prosperity from developing rapidly (see p.
4. Working more hours could lead to an increase in
production. We face a labor/leisure tradeoff
as an individual or as a household. We determine the number of hours
of labor that we supply as a household. Marginal Income tax rates can affect
our work effort. Or increasing labor force
- more women are now working, more two-earner households. We have some control
over how many hours we work we supply: one job or two jobs?, part-time vs.
full-time work, overtime or not?, one spouse or two spouses working?, etc.
POINT: The more labor and less leisure we supply
as individuals and households, the more output in the economy.
TRADE, OUTPUT AND LIVING STANDARDS
Trade leads to more output through specialization and
division of labor, large-scale production and improved products and production
Gains from Specialization and Division of Labor
Division of labor and specialization allow us to produce much more as a society compared to each household being self-sufficient. Imagine if each family grew its own food, made their own clothes, chopped wood, made bread, made soap, milked cows, raised cattle, chickens, pigs, etc. for meat, built their own house, etc.
Adam Smith example on page 43 about pin-making. Smith compared pin output when one person produced a pin from start to finish, vs. separating the various tasks associated with pin-making and implementing specialization. Workers now specialized in just one phase of pin-making. Specialization resulted in output of 4800 pins/worker/day vs. 20 per day working alone. Pin output increased by 240x by division of labor and specialization.
Why does specialization lead to inc. output?
Important Insight about Trade: Comparative advantage increases output.
Law of comparative advantage - (David Ricardo, early 1800s) states that individuals, firms, regions, nations, planets can gain (increase total output) by specialization in what they are efficient at (low opp. cost of production), and trading for goods for which they are inefficient (high opp. cost of production) at producing. Even if a country has an Absolute Advantage (more efficient at everything), they will still benefit from trade because of Comparative (relative) Advantage in certain products.
Example on p. 44-45: Andrea is a lawyer who charges
$100/hour for legal work. Andrea is also a very fast typist (120 wpm).
Andrea considers hiring a typist who can type 60 wpm to prepare some legal
documents for $15/hour. Andrea has an absolute advantage in both typing
(2x as efficient) and legal services compared to a typist (100x as efficient?).
Should Andrea do her own typing? NO, based on the law of comparative
advantage, Andrea should specialize in legal work and hire a typist.
Why? Andrea can type a set of legal documents in 20 hours and the typist would take 40 hours. However, Andrea has a very high OPPORTUNITY COST of typing the documents, $2000 of foregone legal income. The cost of having the typist would only be $600. Even though Andrea is a better typist, her comparative advantage is in law, and she should hire the typist and concentrate on law. By specializing according to her comparative advantage in legal work and hiring a word processor, Andrea's output and income will increase.
Example: cars produced in Michigan, oranges produced in Florida. We are better off specializing and trading compared to Michigan trying to produce both cars and oranges, and Florida trying to produce cars and oranges. National output is increased by specialization and trade among the 50 states.
Example: coffee and Colombia. World output is increased by specialization and trade among countries.
2. Gains from Mass Production Methods
Trade increases prosperity and wealth by allowing firms
to take advantage of economies of scale, economies of scope (across product
lines), and the efficiencies of large-scale production. Having access
to world markets allows U.S. and foreign firms to achieve possible economies
of scale that are not possible in the home (domestic market). Examples;
jet airplane production, airlines, automakers, piano makers, farmers, movies,
computers, electronics, etc.
3. Gains from Innovation
Trade stimulates development and dissemination of innovation,
invention, new technologies, production methods. Reasons: a) intense
economic competition breeds competence and b) cross-germination of ideas and
approaches among different countries, cultures, ideas, perspectives, etc.
Difficult to exaggerate the gains from trade due to Specialization, Division of Labor, Comparative Advantage, Mass Production, Innovation. Our high standard of living is a result of these conditions. Allows us to escape the limits of household production and take advantage of other people's talents and gifts. "Ultimate Resource."
Low standard of living of third world countries can be explained by their failure to take advantage of Specialization, Division of Labor and Trade - production is still largely by households. Agricultural, rural economies.
Specialization and trade create mutual dependence. Trading
partners become mutually dependent, which creates international cooperation.
War interrupts trade. "When goods can't cross boundaries, armies will."
IS THE SIZE OF THE ECONOMIC PIE FIXED? NO!
Due to economic progress and advances in technology, the economic
pie grows every year by approximately 3% in the U.S. economy. Economy
doubles every 24 years, or by 8x during one's lifetime!! That kind of
economic growth is fairly recent, last 200 years of fewer. Standard
of living 12th vs. 13th century?
Quote from T. Sowell (Outstanding Economist on p. 30),
p.46: "The cavemen had the same natural resources at their disposal as we
have today, and the difference between their standard of living and ours is
a difference between the knowledge they could bring to bear on those resources
and the knowledge used today." All of the natural resources required
to build a jet airplane or a computer existed at the time of the caveman.
Note: If Bill Gates or Oprah is hugely successful it doesn't
mean that the economic pie is smaller for you or me! Remember that trade
is WIN-WIN! Positive sum outcome!
THREE ECONOMIC QUESTION FOR AN ECONOMY/SOCIETY
1. VOICE - The ability to communicate information (wants, desires, likes, dislikes, complaints, suggestions, etc.) to decision makers in the Private sector and the Public Sector.
How do we as consumers transmit information to producers?
To politicians? Bureaucrats? By voting in a democracy.
How do producers communicate information about the cost of production to consumers?
The market as a "virtual voting booth." We vote with our dollars every day.
2. EXIT - The ability to withdraw from an economic relationship. Very direct and effective method of communicating information/preferences in the market. "Vote with your feet." What if you don't like Wal-Mart as a customer/shareholder/bondholder/employee? Exit strategy/option is very effective in the market economy, imposes a very strict discipline on firms and forces firms to operate efficiently and serve consumers.
Political arena, exit option is more limited. What if you don't like the service at the Post Office, Dept. of Motor Vehicles? What if you don't like taxes in MI as a taxpayer or business? What if you didn't like living in the Soviet Union? Or in Cuba today?
Questions 1-4, 8, 12-14