Opportunity Cost and Comparative Advantage PDF

Opportunity Cost and Comparative Advantage Tara Shankar Shaw IIT Bombay, Mumbai July 28, 2024 Cronology TSS Opportunity Cost and Comparative Advantage Origin Economy comes from the Greek work ”Oikonomia” where oikos...

Opportunity Cost and Comparative Advantage Tara Shankar Shaw IIT Bombay, Mumbai July 28, 2024 Cronology TSS Opportunity Cost and Comparative Advantage Origin Economy comes from the Greek work ”Oikonomia” where oikos mean ”house” and nomos means ”law” Oikonomia means household management or rules according to which household or business are best run. Ref: Kurz(2013) TSS Opportunity Cost and Comparative Advantage Definition of Economics-Adam Smith (1723-1790) ”Economics as a science of wealth which studies the process of production, consumption and accumulation of wealth.” Wealth: Sum of all goods and services which command value in exchange Price-System Criticism: ã Too narrow emphasizes ”wealth-hunting” ã No role of choice and scarcity Wealth of Nation Theory of Moral Sentiments TSS Opportunity Cost and Comparative Advantage Definition of Economics-Alfred Marshal (1842-1924) ”Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well-being ” It is a social science Material part of welfare Criticism: ã Welfare is not measurable ã Makes is normative Principles of Economics Economics of Industry TSS Opportunity Cost and Comparative Advantage Definition of Economics-Lionel Robbins (1898-1984) ”Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.” Unlimited want and scarce resources Focus in Optimization Positive science Criticism: ã Downplayed it as social science ã Ignores human welfare ã Ignores normative aspect Essay on the Nature and Significance of Economic Science TSS Opportunity Cost and Comparative Advantage Definition of Economics ”Economics is a science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world. It is compelled to be this, because, unlike the typical natural science, the material to which it is applied is, in too many respects, not homogeneous through time. The object of a model is to segregate the semi-permanent or relatively constant factors from those which are transitory or fluctuating so as to develop a logical way of thinking about the latter, and of understanding the time sequences to which they give rise in particular cases.” Correspondence with Roy Harrod 4-07-1938 TSS Opportunity Cost and Comparative Advantage Definition of Economics-P.A. Samuelson (1915-2009) ”Economics is the study of how men and society choose, with or without the use of money, to employ scarce productive resources which could have alternative uses, to produce various commodities over time, and distribute them for consumption, now and in the near future, among various people and groups in society ” TSS Opportunity Cost and Comparative Advantage Definition Economics is the science of making choices. Modern economics is a science of rational choice or decision-making under conditions of scarcity. TSS Opportunity Cost and Comparative Advantage Is Economics Science? ã 16th century philosopher Francis Bacon who coined the term science Science is the pursuit of knowledge and understanding of the natural and social world following a systematic methodology based on evidence. Science Council, 2009 ã Scientific investigation: Systematic method of probing for an answer through scientific method ã Scientific Method: A method of investigation in which a problem is identified, relevant data are gathered, a hypothesis is formulated, and the hypothesis is empirically tested. ã Economics as social science can at best predict aggregative behaviour but not individual behavious ã Economics is more akin to ”Engineering” where the quest is to find solution to specific problem rather than a general solution TSS Opportunity Cost and Comparative Advantage Models 1-Circular Flow Diagram Model simplifies reality to improve understanding TSS Opportunity Cost and Comparative Advantage Models 1-PPF Model simplifies reality to improve understanding TSS Opportunity Cost and Comparative Advantage Role of Economists ã Individuals are rational or bounded rational ã Given that economic agents are rational economist study incentives Incentive is something that motives an agent to take an action. It can involve either satisfying cultural norm or financial rewards or punishment Incentives changes due to culture, time, space A general universal solution are not possible ã Economist observe a phenomena → Defines the problem → Studies the incentive structure (Develop Models) → Make hypothesis; Collects data → Test the hypothesis. ã Examples: ã The incentive structure can be manipulated by price-system determined from a market TSS Opportunity Cost and Comparative Advantage Role of Economists-Examples A youtube video lecture by—Robert Litian https://www.youtube.com/watch?v=4SkoG9FWP4w Does incentive always work? Unintended consequence of reform: https://www.youtube.com/watch?v=xzdeZdg6nxo ã Micreconomcis and Macroeconomics ã Positive and Normative TSS Opportunity Cost and Comparative Advantage Principle of Economics-1 ã People face trade-offs Efficiency and Equalty trade-off ã Cost of something is what you give up to get it ã Rational People always think at margin ã People responds to incentive ã Trade can make everyone better off ã Market are efficient way to organize economic activity Market Economy: an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services TSS Opportunity Cost and Comparative Advantage Principle of Economics-2 ã Governments can sometimes improve market outcomes Market Failure Externality Market Power ã A Country’s Standard of Living Depends on Its Ability to Produce Goods and Services ã Prices Rise When the Government Prints Too Much Money ã Society Faces a Short-Run Trade-off between Inflation and Unemployment TSS Opportunity Cost and Comparative Advantage Firms Firms Firm is an organisation that combines various factors of production to produce goods and services. Firms directs the resources to achieve stated goal of the enterprise Direct the effort of others Purchase Inputs Making Decision Role of Exchange Scarcity of resources Exercise of Choices Specialization and Mutual Exchange of Goods and Services TSS Opportunity Cost and Comparative Advantage Firms Firms Firm is an organisation that combines various factors of production to produce goods and services. Firms directs the resources to achieve stated goal of the enterprise Direct the effort of others Purchase Inputs Making Decision Role of Exchange Scarcity of resources Exercise of Choices Specialization and Mutual Exchange of Goods and Services TSS Opportunity Cost and Comparative Advantage Exchange and Trade Trade is beneficial between individuals. Trade is beneficial even between countries that have large disparity between resource and income. This can be achieved by individual or international specialization Barack Obama: Feb 23 2012 ”It provides tax break for moving jobs ad profits overseas and hits companies that choose to stay in America with one of the highest tax rate in the World...” Patrick Buchanan: Feb 14 1996 ”American rose growers are the causalities of free trade policies that my friend-excuse me Senator Dole-has supported again and again” TSS Opportunity Cost and Comparative Advantage Opportunity Cost To produce rose for the winter market in US the economy has to use Green houses that consumes resources like energy, capital etc. which could be used to produce other good like computer Opportunity Cost “Value of the next best alternative that is forgone for making a choice” What is the reason for Opportunity Cost? TSS Opportunity Cost and Comparative Advantage Example In US given the amount of resource, it can be used to produce 10mn Kg of roses or 100,000 computers. In Colombia the same amount of resources used to produce 10mn Kg of roses can produce......... computers. What is the opportunity cost of producing 10mn kg of roses in USA and Colombia? Question: Which country should produce roses from the used of World resource? Why? Efficiency TSS Opportunity Cost and Comparative Advantage Comparative Advantage Comparative Advantage “A country/individual had CA in producing a good or service if it has lowest OC in its production compared to other goods and services”. Important: Trade/Exchange between country/individual can benefit both countries/individual if each country/individual exports/exchanges the good in which it has CA. Questions How CA or lowest OC is determined? What are the determinant of CA? Is there any gain from trade/exchange? If country/individual exchanges goods or services what are the terms of trade? TSS Opportunity Cost and Comparative Advantage Comparative Advantage-1 CA in a production/specialization for a country/individual is determined by the efficiency of the use of its factor of production/s that is determined by its technology Consider the following Example: There are two countries “home” and “foreign” One factor of production, say labor L, that is limited in supply Both country can use labor to produce either or both of the goods Technology is each country is determined by labor productivity of producing each good in each country. Let 1 unit of labor/labor-hour can produce 1pb of Cheese 1 unit of labor/labor-hour can produce 2Gallon of wine TSS Opportunity Cost and Comparative Advantage Productivity Let aLC : Number of labor/labor hour required to produce one unit of cheese in the home economy Let aLW : Number of labor/labor hour required to produce one unit of cheeseif in the home economy Let QC : Total production of Cheese in home Let QW : Total production of Wine in home Total labor used in the production of Cheese in Home economy is...... Total labor used in the production of Wine in Home economy is...... Total labor used in the production in the home economy...... TSS Opportunity Cost and Comparative Advantage Production Possibility Function(PPF) Production possibility frontier: It is the maximum amount of goods or services that an economy can produce given the amount of resource. Draw the PPF; Interpret the slope of the PPF. Opportunity Cost of Good Cheese: Is the amount of W that has to be given up to produce 1 unit of Wine and vice-versa aLW unit of labor can produce −− 1 gallon of Wine 1 1 unit of labor can produce −− aLW gallon of Wine aLC unit of labor can produce −− aaLW LC gallon of Wine Thus, the OC of producing 1 unit of Cheese is aaLW LC Wine. The OC of producing 1 unit of Wine is....... TSS Opportunity Cost and Comparative Advantage Intuition aLC The OC of 1 unit of Cheese is aLW is Wine. What is the Intuition:..................... The foreign economy f : Productivity of labor in the production of Let aLC cheese in the foreign economy f : Productivity of labor in the production of Wine Let aLW in the foreign economy Let QCf : Total production of Cheese in foreign Let QCf : Total production of Wine in foreign TSS Opportunity Cost and Comparative Advantage Home Economy CA The OC of the producing cheese in the foreign country in af terms of the Wine is −− afLC LW Suppose aLC af < fLC aLW aLW OCC < OCCf Home country has CA in the production of cheese and it should specialize only in the production of cheese. Intuition: The amount of labor (scarce resource) that is required to produce cheese relative to wine is less in home compared to the foreign country TSS Opportunity Cost and Comparative Advantage Foreign Economy CA In which commodity the foreign country have CA? Absolute Advantage (AA) If a/an country/individual can produce a unit of good with less labor(or the scarce resource) than another country/individual then we say that the country/individual has absolute advantage in the production of good and service Suppose aLC < aLC f ; Home economy has AA in the production of cheese Also, aLW < aLWf ; Home economy has AA in the production of Wine Does it implies that the home country has CA in the production of Cheese and Wine. TSS Opportunity Cost and Comparative Advantage Is CA Static for a Country TSS Opportunity Cost and Comparative Advantage High Technology as Percentage to total Export TSS Opportunity Cost and Comparative Advantage Conclusion Indvidual/Country produces goods and specializes in the production of that good in which it has CA. CA is determined by the technology in produciton of the good and services which determines the productivity of of the factors of production A country/individual has CA in the production of good in which it uses the factor or production more efficiently than the other good. CA of India between 1995 − 2005 Textile Natural and Cultured Pearl Footwears and Handgears Raw hides and skin Vegetable products TSS Opportunity Cost and Comparative Advantage Problem-1 Suppose home country can produce textile and computer with a given amount of labor. The productivity of labor in the production of textile is 20 man-hour and the productivity of labor in the production of computer is 10 man hour. The foreign country can also produce textile and computer with the given amount of labor. The productivity of labor in the foreign country in the production of textile is 40 man-hour and the productivity of labor in the production of computer is 20 man hour. Do any country have CA in the production of Textile. Suppose there is a technological innovation and the productivity of laborers in the production of computers increased. A computer can be produced in 5 man-hour. Does the technological advancement made the home country competitive in the production of computer. TSS Opportunity Cost and Comparative Advantage