Understanding the Business Cycle

Business Cycle

• Economic activity experiences recurring periods of increase and decrease.
• Expansions and contractions are other terms to describe this activity.
• The economic cycle consists of recession, trough, expansion, and peak stages.

The Four Stages of the Economic Cycle

• Recession is characterized by a decline in GDP for two consecutive quarters, slowing the economy.
• Recession includes decreased consumer purchasing, increased unemployment, and business contraction or closure.
• Trough is the bottom of the cycle where production and unemployment are at their lowest.
• Trough indicates the economy is completing the recession and turning towards prosperity; a deep trough is called a depression.
• Expansion occurs when the economy starts to grow, employment increases, wages, production, and profits expand and new businesses arise with strong investment.
• Peak is the top of the business cycle, marking the end of expansion; the economy stops expanding and begins contracting.
• These stages repeat over time, creating the cyclical pattern of economies.

Economic Indicators

• Used to measure the economy's performance.
• Leading indicators adjust before the economy changes occur.
• Leading indicators help investors, businesses, and the government to act on potential changes, such as housing and retail sales.
• Lagging indicators adjust after the economy experiences a change and includes the employment rate.
• Coincident indicators move in conjunction with the business cycle, such as international trade or real wages.

Absolute Advantage

• Refers to a country's capability to produce a product more efficiently.
• Absolute advantage results in manufacturing more products using the same amount of resources.
• Absolute advantage is due to better technology, labor, or higher quality resources used.
• Zambia has an absolute advantage in making copper.
• Canada has an absolute advantage in making forest products.

Absolute Advantage Example

• If Canada can produce 1,000 apples with half of its resources and the United States can produce 1,400 oranges with half of its resources if each country specializes.
• Canada makes 2,000 apple by using all of its resources on apples, and the United States makes 2,800 oranges by using all of its resources on oranges.

Opportunity Cost

• Opportunity cost is defined as the value of the next-best alternative that a person gives up.
• Opportunity cost is not the value of all possible alternatives.
• As an example, the opportunity cost of a student who spends three hours and $20 at the movies the night before an exam, or a farmer who chooses to plant wheat
• Or a commuter takes the train to work instead of driving, costing 70 minutes instead of 40.

Opportunity Cost Example

• Canada has an absolute advantage in producing apples, whereas the U.S. has an absolute advantage in producing oranges.
• If Canada specializes in apples it gives up 600 oranges.
• If the U.S. specializes in oranges, it gives up 800 apples.

Comparative Advantage

• Comparative advantage occurs when a country can produce a good at a lower opportunity cost than another country.
• Comparative advantage is the basis for specialization and trade.
• Countries do not have to have an absolute advantage to engage in trade: they only need a comparative advantage.
• Assume that United States has an absolute advantage in producing both apples and oranges and they both spend an equal amount of time producing different products.

Comparative Advantage Example

• In Canada, 1,000 apples equals 500 oranges, so one apple costs 0.5 oranges.
• In the U.S., 1,200 apples equals 800 oranges, so one apple costs 0.667 oranges.
• The opportunity cost of giving up oranges to produce apples is lower in Canada, so Canada should only produce apples.

Comparative Advantage Example

• In Canada, 1,000 apples equals 500 oranges, so one orange costs 2 apples.
• In the U.S., 1,200 apples equals 800 oranges, so one orange costs 1.5 apples.
• The opportunity cost of giving up apples to produce oranges is lower in the U.S., so the U.S. should only produce oranges.
• Even if the United States can produce more apples and oranges, Canada has a comparative advantage in producing apples because it has a lower opportunity cost.

Comparative Advantage Continued

• Canada focuses on apples and the United States focuses on oranges, the level of production increases.
• If United States specializes and focuses on producing oranges they can produce 1,600 oranges.
• If Canada specializes and focuses on producing apples they can produce 2,000 apples
• Production in both countries can be adjusted so no apples are lost (back to original level of 2200 apples). 200 apples = 200 *.667 oranges = 133 oranges lost (to make 200 apples, the countries would give up 133 oranges). 1600 oranges – 133 oranges = 1,467 oranges.