Free Trade Example Sheet

The example I did in class is available online. I strongly recommend using this when doing your quiz .

This is the link

Note: I remind you on the example, but I will do so again. The example starts from scratch. That is, I give you hours work and then we see what each country (in the example person) can produce. Then I calculate the comparative advantage. On the quiz, however, I already give you the production possibilities. Then I ask you to calculate comparative advantage. Thus I have saved you a step and you can just go right towards solving for who has a comparative advantage in what.

Study Outline for Final

The Following Topics will appear on the final

Supply and Demand
Elasticity
Market Failure (not government failure though)
The 4 market models (PC, Monopoly, Monopolistic Competition, Oligopoly)
Free Trade (in the form of the take home quiz and multiple choice.

All the other topics will not be explicitly tested in multiple choice or part 2 problems. However, you should still have some familiarity with production theory in so much as it is used for the market models (so you can't ignore Marginal Cost, but I won't be asking you to calculate it).

Roger Clemens, Supply and Demand.

If you haven't heard, Roger Clemens has signed with the New York Yankees for a pro-rated $28mn dollars (it works out to about $6.5mn a month). Some may be asking, how is such a salary possible. A modified supply and demand graph can provide an easier answer.

Supply - The market for baseball pitchers is extremely small right now. Word on the street says that potential for a trade is extremely thin due to a lack of talent. About the only player left on the market of any quality is (well, was) Roger Clemens. Thus the supply curve for Clemens was completely inelastic, i.e. vertical. Changes in the price level would not effect the supply curve because there was simply no more talent that could be induced into player for a higher salary.

Demand - However, there was strong demand for a good pitcher. 3 teams were vying for another starting pitcher (The Yankees, Red Sox and Astros). The reaons were unrelated to price and more related to making the playoffs and out competing the competition. Therefore, the demand curve shifted right and the salary Roger Clemens could extract from the market shot up through the roof.

Conclusion: When something is in short supply and the demand for it is increasing, price will increase. It's just simple supply and demand.

Economist Bloggers attracting attention

Well, not me.

Quiz 8 - Spring 07

The Link to Quiz 8 -Spring 07 is here. I will post the answers tomorrow, but try the questions again on your own.

Update: The answers to the quiz are

1) D
2) B
3) C
4) D
5) c
6) a
7) C
8)B
9)C
10) B

May 16th

May 16th is the tentative date for the final. Mark your calendar

Diminishing Marginal Returns

This is a review of the law of Diminishing Marginal Returns. Wikipedia says that

"According to this relationship, in a production system with fixed and variable inputs (say factory size and labor), beyond some point, each additional unit of variable input yields less and less additional output."

What does this mean? Notice that the first part of the definition says "fixed and variable inputs." If you have both fixed and variable inputs you know that you are in the short run (in the long run, every input is variable.

Second, the law is saying that beyond some point, adding additional variable inputs yields less and less additional output. In the graph above the MPP (Marginal physical product, which is a fancy way of saying Marginal Product) curve is plotted. Notice that initially the MP curve is going up. Adding additional inputs (workers) yields more additional output. Say adding 1 worker adds 2 extra units of output. Then adding another adds 3 extra units.

However, the law states that beyond some point the MP curve will start to yield less and less additional output. So we go from 3 extra units to 2 if we higher another person and then to 1 if we decide to go even further.

What is happening here is that initially the workers are gaining from specialization, hence MP is increasing. Once that disappears, however, we are cramming more and more people to try and get additional output. Beyond some point, the extra output we get starts becoming less and less until adding another worker would actually start hurting output.

Remember the story of the Hot Dog stand. Initially, hiring additional workers boosted output at an increasing rate because one guy was able to focus on making the hot dogs and the other guy focused on handling the customers. However, as the firm kept adding workers the extra output started diminishing. Think about having 10 workers in one hot dog stand. Hiring the 11th might not do you much good as you already have 10 people there. So you don't get many more hot dogs for the added worker.

Finally, note that in the example above, I had a fixed cost: the hot dog stand. Since this is the short run, I cannot change hot dog stands. If demand is increasing, the only thing I can do in the short run is the higher more workers. In the long run this does not hold as I can always move to a bigger hot dog stand.

Allocative and Productive efficiency in PC

This is related to my previous post on perfect competition.

Remember the definition of both allocative and productive efficiency.

Allocative efficiency is when P = MC. Wikipedia has a definition available here. Productive efficiency is when ATC is minimized. Wikipedia has a definition of productive efficiency here. But I want to explain how we get there in perfect competition. What I want to get across is that Allocative and productive efficiency flows from the very assumptions of Perfect Competition

1) The individual firm cannot influence price because it is a very small player in a very big market. Thus its demand curve is flat. (perfectly elastic)
a) Since its demand curve is flat, it can only have one Price.
b) Since it only has one price, its Marginal Revenue Curve (MR) will also be flat. Further it is the same as its demand curve. Why? Because the demand curve is flat (say price = $5). It will not go lower nor higher than $5 due to the explanation I offered in the previous post. Since it is at $5, each additional unit sold will bring in $5 of marginal revenue. Think about it. If I sell one good rather than 0 I earn $5 instead of 0. Thus my marginal revenue is $5. If I sell 2 instead of 1 I earn $10 instead of $5. So my marginal revenue for 2 goods is 10-5 = 5. Get it?

2) The firm should produce until Marginal Revenue = Marginal Cost. No more or no less (see previous post.)
a) If this is the case, then the firm will produce until Marginal Cost = $5. Why? Because if Marginal Cost is $4 dollars then the firm SHOULD produce more because Marginal Revenue is $5. By producing the good the firm banks an extra $1 in profit. So you see that the firm has to produce until Marginal Cost = $5.

So now we can see why we have allocative efficiency. The very definition of allocative efficiency is that P = MC. In a perfectly competitive environment, the firm produces until MR=MC. Since we have PC, MR = P (look at graph above). Thus, we have achieved allocative efficiency. The market is producing the right goods for the right people at the right price.

3) In perfect Competition, the ATC will be minimized.
Note that this is the definition of productive efficiency (ATC minimized). Why is this the case in perfect competition? Well, if a firm is not producing at the lowest possible unit cost (ATC = $5), another firm will enter the market and undercut them. The firm goes out of business. In other words, competition ensures that every single firm in the industry produces at the least possible ATC per unit. In other words, if Firm A and Firm B are in the same industry--and that industry is perfectly competitive---you only need to find one ATC. If you found one you've found them all. If Firm A's ATC is $5, then Firm B's is $5 as well.

Read on if you want the policy implications of this. (What is below will not be a multiple choice or part 2 problem on the test, but reading it may help illuminate the above).

What I have described above is the best possible outcome for markets. Under the assumptions of perfect competition, we have achieved what is called "pareto efficiency."

That fancy and scary name is really a technical way of saying the following. If a situation exists where I can make one person better off without making anyone else worse off, we a pareto efficient opportunity. Steven Landsburg in his book "The Armchair Economist" gave an example in nature to illustrate this concept. Say you have a flock of birds. The female birds in the flock are attracted to male birds that have "large tails" (you students of Freud are left to make the connection). However, large tails hurt a birds flight as they increase wind resistance. How can we make a pareto efficient outcome out of this. Well, what we can do is take all the male birds and cut their tales off by 2 inches. Therefore, every single bird in the flock has a smaller tale but the ones with the big tales still have a their relatively large tail in comparison with the other birds intact. Every bird can now fly faster and we did not have to disadvantage any of the birds in the process.

This is what perfect competition does with regards to allocative and productive efficiency. The market has created a situation where the most efficient allocation and production of resources has occurred. Nothing can be done to improve efficiency without harming someone at the expense of someone else. Perfect competition has consumers trying to maximize their utility and producers trying to maximize their profits. Market forces ensure that we reach an equilibrium where we maximize the gains to everyone.

The relationship b/w TC, ATC and MC

Let's say that if we don't produce anything, a firm still has to pay $100 in rent. The firms total costs are the sum of its fixed costs ($100) plus its variable costs ($0) (Q0). So total costs are $100.

Now let's say the firm wants produce one unit. The cost of this unit will be $10. With 1 unit(Q), the costs will be the sum of its fixed costs ($100) plus its variable costs ($10). So the total costs are $110 (100+10).

Now let's say you are asked to find out how much "extra" this one unit costs. If you get this question, you are being asked to calculate the Marginal Cost of the unit. Thus the "extra" cost is simply the total cost at one unit (Q1) minus the total costs with 0 unit(Q0). So the marginal cost is 110-100 = 10. 10 is your marginal cost of the first unit produced.

Now lets say that I want the average total cost if you produce one unit. This is even easier because all you have to do is take the total cost and divide it by the number of units you produce. For Q1, it is simply $110/1 = $110.

Now do this same calculation for the second unit produced(Q2). The variable costs for 2 units is $15. Calculate both the total cost, marginal cost and the Average total cost at this level.

I have the answer's below (shade it to see).

Total Cost = $115. Marginal Cost = $5. Average Total Cost = $57.5

E-mail me if you still have questions.

How do we correct for a Monopoly?

Another question some students had problems with is in how to correct for monopolies. First, the problem with monopoly is that we are both allocatively inefficient (P>MC ) and productively inefficient (ATC is not minimized). There are two ways we can correct for this

1) We can make the monopolist "behave" like a firm in perfect competition. That is, we can force the monopolist to set P = MC. Notice that if P=MC then we are now allocatively efficient. However, there are two problems that arise with this

a) It is often hard to estimate a firm’s Marginal Cost Curve

b) Sometimes by forcing it to behave like a perfect Competitor (P=MC), you are actually causing the firm to lose money. In the graph above, setting P=MC means that the firm loses money because P
2) To correct for this, we can adopt an alternative solution. We simply set P=ATC. If P=ATC, there is still some allocative inefficiency (on the graph above, P is still > than MC). But it is a step in the right direction.

Perfect Competition Review

I noticed that some people were confused as to why Q is the optimal level of output. Essentially any other output level (Q) is sub optimal. Why?

Well if the firm produces below Q (to the left) than you have a situation where MR>MC. That is, producing more units produces more marginal revenue than it does marginal costs. Hence the firm can increase its profits simply by producing more at the product price (P). If you look at the graph and draw a line up you will notice that the MR curve (the red line) is greater than the MC point (where the line cross the Nike Swoosh).

On the other hand, if you produce more units than the Q shown then MC>MR. Each extra unit produced costs more than the marginal revenue it is bringing in. Thus profits are decreasing if the firm starts producing more.

So in conclusion, there is no better point than Q (where MR=MC). That is where the firm is maximizing profits.

Note, however, that in perfect competition there is only normal profits. There are no economic profits because P=ATC. If you want permanent economic profits than P>ATC, you will most likely have to look at a monopoly model.

Free Trade discussion

Again, this is for after Test 2 but a number of economics blogs have been discussing free trade theory. Greg Mankiw has two posts on Free trade theory here and here.

Greg mentions The Ricardian Trade Model and the H-O model. The latter model is beyond the scope of this class, but since both are based on the principle of comparative advantage you can get the basic idea behind all free trade models by studying this counter-intuitive principle.

In economics, the theory of comparative advantage explains why it can be beneficial for two parties (countries, regions, individuals and so on) to trade if one has a lower relative cost of producing some good. What matters is not the absolute cost of production but the opportunity cost, which measures how much production of one good is reduced to produce one more unit of the other good

Essentially what comparative advantage allows countries to do is eliminate production inefficiences, increasing the total amount of output. The posts above discuss the distributions of benefits of free trade. Essentially there will always be winners and losers, but the winners gains will outweigh the losers losses.

Kinked Demand Curve

This is for after Test 2. But when we pick up our discussion of Oligopoly we will be looking at the Kinked Demand Curve. The empirical fact that the kinked demand curve is trying to explain is why do prices in Oligopolies tend to remain constant?

Basically we are assuming that there are two elasticities. At higher prices (low quantity) the curve is relatively elastic. This means that an increase in P will lower TR (because other firms will not follow suit with a price hike). Thus prices do not tend to rise. However, at lower prices we have a relatively inelastic demand curve. This means that if prices fall below a certain point TR does not increase.

Yet firms do tend to match price decreases because they do not want to lose market share to the competition. Thus, if prices do start to fall, they tend to fall very quickly. We call this a "price war" in economics and there have been examples in the past. This article, on the price war between Burger King and McDonald's, is an excellent example of this. I have also heard about price wars between Cereal Brands and, of course, the current price war among HDTV's, which have come down substantially in price. The price war between McDonald's and Burger is interesting in that the prices came down on a day by day basis.

Sports Economics Continued

My old Economics professor has a post on when baseball players "peak."

Let’s start with a pop quiz: At what age does the average big-league ballplayer reach his peak?
If you said 27, you are an unusually conscientious student of sports and, quite likely, a devotee of the great Bill James, one of the founding fathers of sabermetrics and a consultant to the Red Sox.
You’re also wrong.

Wizard Economics

This paper discusses the economy that exists in the Harry Potter Books. The most interesting conclusion (which would make a good extra credit assignment) was this.


This implies that the factors of production (physical capital, human capital and
labor force) and the technology which could potentially drive economic growth remain
unchanged in the Potterian economy. As a consequence, the wizards’ economy remains
in a steady state without growth.

In the real world the economy grows and has been for hundreds of years. But in our fiction we keep things stagnant...interesting.

Marginal Revolution has a post on JK Rowlings earnings, tying it into inequality.

May be 10 minutes late to class today

I may be 10 minutes late to class today, although I should be able to make it on time. However, I am providing a fair heads up so don't leave class if I am a few minutes late.

Quiz Reminder

The links for the two quizzes due on Wed are Quiz 6 and Quiz 7 on production theory and perfect competition, respectively.

We will also be having a 10 question multiple choice quiz as preparation for the text, which will be the following Wed.

Sports Economics Post

There are a couple of interesting articles on sports economics up.

The first is an article interview with JC Bradbury, a sports economist who wrote the book The Baseball Economist. The free link is here. His Baseball blog is here.

This is the aspect I find most intriguing.

Are the final standings a product of pure financial determinism, or do small cities have a fighting chance?

JCB: While it is true that the big-market Yankees have been one of the most successful franchises and the small-market Brewers one of the worst in recent baseball history, these teams differ in more than just the sizes of their fan bases. Over a 10-year span from 1995–2004, I calculate that every 1.6 million residents of a city translates into one additional win for the team in that market. Given the disparity in market sizes between New York and Milwaukee, the Yankees were expected to win about 11 more games a season than the Brewers. That is not chump change; however, the actual disparity between these franchises was a whopping 26 games. Market size explained a minority of the difference (about 40 percent) between these organizations, which means that a majority of the blame must be placed somewhere else: the ineptitude and skill displayed by the front offices of these teams.

In itself this is an interesting point. But I wonder, just how good is league parity to begin. Football, America's most popular sport, has league parity. But has league parity done the NBA any good? ESPN.com argues no.

On the flip side, when the Lakers, Celtics, Sixers and Pistons were battling for control of the 1980s, did anyone care that the Clips, Cavaliers, Warriors and Kings were dreadful? Was it a coincidence that the NBA peaked from 1987 to 1993, with a lopsided league of quality teams and crummy teams? Call it the 600/400 Rule: More teams finishing above .600 (50 wins or more) and under .400 (50 losses or more) makes for a more entertaining league.

It seems that a few questions need to be asked

1) Has the NFL benefited from league parity? Was the league less popular in the early 90's when Dallas and San Fran dominated?
2) Are different sports different? That is, does league parity work for some leagues (NFL), but not for others (NBA).
3) Would increasing parity in baseball improve the sports popularity given that you would have to weaken teams in areas where baseball is extremely popular (New York, Boston)?

These would be good topics for an extra credit assignment.

Prediction Markets and American Idol

In a followup post on American Idol, if you are interested in forecasing who will be knocked off from week to week, trade sports has an interesting betting market here . They were right last week with Gina and this week they are predicting Lakisha by a large margin.

Prediction markets have tended to be more right than either polls or expert opinions. Why? Because they are functioning like an efficient market, where price reflects all known information. There are other markets (such as for US President, weather, economic data and sports) that are worth taking a look at.

Supply Side Economics Continued

Economist Brad Delong has a good follow up post on Supply Economics Here

This debate is a relatively good summary of the debates on different macroeconomic outlooks.