ECON 2103 (Spring 2020)

20 March, 2020 (Tutorial 2)

This week:
Review on Chapter 3 and 4
Discussion on Assignment 2

Chapter 3 Interdependence and the Gains from Trade

 Trade allows people to specialize in the production of goods for which they have a
comparative advantage and then trade for goods that other people produce.
 Total output rises because of specialization, and people can benefit through trade
 Absolute advantage: the ability to produce a good using fewer inputs than another
producer
 Comparative advantage: the ability to produce a good at a lower opportunity cost than
another producer
 Opportunity cost: whatever must be given up to obtain some item

Example:
 2 goods: Meat and Potatoes
 2 people: Frank and Ruby
 Both work 8 hours per day and use the time to grow potatoes, raise cattle, or both
 Production possibilities:
Time needed to make 1 ounce of
Meat Potatoes
Frank 60 min/oz 15 min/oz
Ruby 20 min/oz 10 min/oz

In 8 hours,
Meat Potatoes
Frank 8 oz 32 oz
Ruby 24 oz 48 oz

 Opportunity costs:
Frank: 1 oz of meat = 4 oz of potato, 1 oz of potato = 0.25 oz of meat
Ruby: 1 oz of meat = 2 oz of potato, 1 oz of potato = 0.5 oz of meat
 Ruby has absolute advantage in producing both meat and potatoes
 Frank has comparative advantage in potato  specializes in producing potato
 Ruby has comparative advantage in meat  specializes in producing meat

 Specialization, trade and gain from trade

(1) When there is no trade, Frank and Ruby spend half of their time in producing each good
(2) Frank and Ruby specialize according to their comparative advantage
(3) Trade after specialization (Suppose they trade at a rate of 1 oz of meat = 3 oz of potato,
Frank buys 5 oz of meat from Ruby)

 What is the gain from trade? (Production? Consumption?)

 What is the range of the exchange ratio that make trade possible?

1
 Ruby’s production
with trade Ruby’s consumption
with trade

B*
19

10 15

Meat (oz) Potato (oz)

No Trade
Frank 4 16
Ruby 12 24
Specialization
Frank 0 32
Ruby 24 0
After Trade
Frank 5 17
Ruby 19 15

2
Example:
In an hour, Sue can produce 40 caps or 4 jackets and Ted can produce 80 caps or 4 jackets.
(a) Calculate Sue’s opportunity cost of producing a cap.
(b) Calculate Ted’s opportunity cost of producing a cap.
(c) Who has a comparative advantage in producing caps and jackets?
(d) Suppose that before trade Sue produces 20 caps and 2 jackets and Ted produces 40
caps and 2 jackets. If Sue and Ted specialize in producing the good in which each of
them has a comparative advantage, and they trade 2 jackets for 30 caps, who gains
from specialization and trade?

(a) Sue
Opportunity cost of 1 cap = 1/10 jacket. Opportunity cost of 1 jacket = 10 caps
(b) Ted
Opportunity cost of 1 cap = 1/20 jacket. Opportunity cost of 1 jacket = 20 caps
(c) Ted has comparative advantage in producing caps
Sue has comparative advantage in producing jackets
(d) Both Sue and Ted gain from specialization and trade
Before trade Sue Ted
Caps 20 40
Jackets 2 2
Specialize Sue Ted
Caps 0 80
Jackets 4 0
Trade Sue Ted
Caps Buy 30 Sell 30
Jackets Sell 2 Buy 2
After trade Sue Ted
Caps 30 50
Jackets 2 2
Gain from trade Sue Ted
Caps +10 +10
Jackets +0 +0
Jackets Jackets

Sue’s PPF Ted’s PPF

4 B 4

2 A C 2 A C

Caps B Caps
20 30 40 40 50 80

3
Chapter 4 The Market Forces of Supply and Demand
 Market: a group of buyers and sellers of a particular good or service
 Competitive market: a market in which there are so many buyers and so many sellers
that each has a negligible impact on the market price

Demand
 Demand schedule: the entire relationship between the price of a good and the quantity
demanded. (Demand curve is negatively sloped)
 Quantity demanded: the amount of a good that buyers are willing and able to purchase.
 Law of demand: other things remaining the same, the higher the price of a good, the
lower is the quantity demanded.
 Market demand is the horizontal summation of individual demands
 Movement along the demand curve VS a shift in the demand curve
 Willing to pay, diminishing marginal value/ marginal benefit

Factors affecting demand (shift of demand curve)

(1) The prices of related goods
 Substitutes: a good can be used in place of another good. Example: Coke and Pepsi
 Complements: a good used together with another good. Example: DVD and DVD player

(2) Expected future prices and income

(3) Income
 Normal good: A good is a normal good if demand rises as income rises.
 Inferior good: A good is an inferior good if demand falls as income rises
(4) Population/ Number of buyers
(5) Preferences/ Tastes

Supply
 Supply schedule: the entire relationship between the price of a good and the quantity
supplied (supply curve is positively sloped)
 Quantity supplied: the amount of a good that sellers are willing and able to sell
 Law of supply: other things remaining constant, the higher the price of a good, the
greater is the quantity supply
 Market supply is the horizontal summation of individual supplies
 Movement along the supply curve VS a shift in the supply curve
 Increasing marginal cost of production

Factors affecting supply (shift of supply curve)

(1) Prices of factors of production/ input
(2) Expected future price
(3) Number of producers
(4) Technology

4
Market equilibrium and predicting changes in equilibrium

Surplus  The market equilibrium is determined by the

intersection of the demand and supply curve. It occurs
when the price balances the plans of buyers and
sellers

Shortage  Equilibrium price: the price at which the quantity

demanded equals the quantity supplied.
 Equilibrium quantity: the quantity bought and sold at
the equilibrium price.

 Price as a regulator and price adjustment

- If P >P*, there will be excess supply (QS > QD / surplus) and the price will fall.
- If P < P*, there will be excess demand (QS < QD / shortage) and the price will rise.

Change in demand, change in supply, change in demand and supply

 Why a market moves toward its equilibrium?
- Price adjusts when buying and selling plans do not match
 How would the equilibrium price and quantity be affected when there are changes in
demand and supply?

DD/ SS P Q
DD↑ P↑ Q↑
DD↓ P↓ Q↓
SS↑ P↓ Q↑
SS↓ P↑ Q↓
DD↑ and SS↑ P uncertain Q↑
DD↑ and SS↓ P↑ Q uncertain
DD↓ and SS↓ P uncertain Q↓
DD↓ and SS↑ P↓ Q uncertain