Exam 3 Study Guide (for final)
+ Study Exam 1 and 2 Study Guides
Chapter 2: The Power of Trade and Comparative Advantage
3 benefits of trade:
1. trade makes people better off when preferences differ.
a. eBay is a great example; someone could sell a broken laser pointer for money
when it’s broken because the buyer “collects” them so everyone benefits
2. Trade increases productivity through specialization and the division of knowledge
a. Farmers can produce food faster and in larger quantities so through specialization
b. Knowledge – all different kinds of doctors specializes in certain fields
3. Trade increases productivity through comparative advantage
Absolute Advantage is the ability to produce the same good using fewer inputs than another
(Martha Stewart could iron all her shirts because she’s really good at ironing or she can work on
her business which she’s even better at doing)
A Production Possibilities frontier shows all the combinations of goods that a country can
producer given its productivity and supply of inputs
A country has a comparative advantage in producing goods which it has the lowest opportunity
when each country produes according to its comparative advantage and then trades, total
production and consumption increase.
Importantly, US and Mexico gain from trade even though the US is more productive than Mexico
at producing both computers and shirts.
*A country (or a person) will always be the low-cost seller of some good. Why? The greater the
advantage a country has in producing A, the greater the cost to it of producing B.
The more productive ethe US is a tprorudcing computers, the greater its demand will be to trade
A producer has an absolute advantage over another producer if it can produce more output
formthe ame input. But what makes trade profitable is differences in comparative advantage, and
a country will always have some comparative advantage.
Wont a country like the US be uncompetitive in trade with low wage countries like Mexico?
Specialization and trade let workers make the most of what they hve – it raises wages as high as
possible given productivity – but trade does not directly increase productivity. Trade makes both
Einstein and his less clever accountant better off, but it doesn’t make the accountant a skilled
scientist like Einstein.
*differences in wages reflect differences in productivity. Trade means that workesr in both
countries can raise their wages to the highest levels allowed for by their respective productivities.
Adam Smith on Trade (1723-1790)
Chapter 9: International Trade
If there were no international trade, the equilibrium would be found as usual at the intersection of
the domestic demand and domestic supply curve. With trade, US consumers can buy as many
semicondutors as they want at the world price (US is small relative to world market) and a this price US consumers demand Q units. At the world price, the difference between domestic
demand and domestic supply is made up by imports.
Protectionism is the economic policy of restraining trade through quotas, tariffs, or other
regulations that burden foreign producers but not domestic producers
A tariff is a tax on imports.
A trade quota is a restriction on the quantity of goods that can be imported: Imports greater than
the quota amount are forbidden or heavily taxed.
Look at Figure 9.2 for tariff
Suppliers respond to the higher price by increasing production
Consumers respond by buying fewer semiconductors (the world price goes up)
The government collects revenues from the tariff equal to the tariff X the quantity of imports
The costs of Protectionism:
- us consumers pay more than double the world price for suhgar
- increases domestic production and reduces domestic consumption
- the tariff means that sugar is no longer supplied by the lowest cost sellesr and reouscres
that could have been used to produce other goods are services are instead wasted
producing sugar. (Brazi is better at producing sugar, Florida could be using the land,
labor to produce oranges and theme parks – things that will help the state more) Second,
the price of sugar rises and fewer people buy sugar
Figure 9.3 is helpful in showing the wasted resources/DWL that comes from a tariff on imports
Free market is efficnet…
1. the supply of goods is bought by the buyers with the highest willingness to pay
2. the supply of goods is sold by the sellers with the lowest costs
3. btw buyers and sellers, there are no unexploited gains from trade or any wasteful trades
^#2 and #3 are violated with tariffs and quotas
Domestic producers gain but U.S. consumers lose even more.
Why does government support the U.S. sugar tariff when U.S. consumers lose much more than
U.S. producers gain?
The benefits of the tariff flow to a small number of producers, each of who, benfits by millions of
dollars. And the cost per consumer is small. So producers argue more for it than consumer oppose
Arguments against international trade
-trade reduces the number of jobs in the United States
-its wrong to tradw with countries that use child labor
-we need to keep certain industries at home for reasons of national security
-we need to keep certain “key” industries at home cause of beneficial spillovers onto other sectors
of the economy. (benefits that go beyond the computer chips themselves ex page 169)
-We can increase U.S. well-being with strategic trade protectionism (firms to act like a cartel
when they sell to international buyers and limit or tax exports)
We pay for imports with our exports (We buy goods from Mexico and give them dollars and they
use those dollars to buy American goods). Trade doesn’t eliminate jobs. It moves jobs from
import-competing industries to export industries. And although trade doesn’t change the number
of jobs, it does raise wages.
The real cause of child labor is poverty, not trade. Thus, to reduce child labor, we should focus on
reducing poverty than on reducing trade; putting up trade barriers is likely to be ineffective or
even counterproductive. Restrictions on trade waste resources by transferring production from low-cost foreign producers
to high-cost domestic producers.
Takeaway page 170
Chapter 10: Externalities – When Prices Send the Wrong Signals
A private cost is a cost paid by the consumer or the producer. (market price)
An external cost is a cost paid by people other than the consumer or the producer trading in the
market (paid by bystanders in the transaction).
Ex: since the price of antibiotics is low, more people buy it, and thus increases the resistant
bacteria for us all.
The social cost is the cost to everyone; the private cost plus the external cost
Externalities are external costs or external benefits that falls on bystanders
^(negative or positive externalities) –when they are significant, markets work less well and
government actions can increase social surplus
Social surplus is consumer surplus plus producer surplus plus everyone else’s surplus (what we
want – we don’t want any bystanders to be harmed)
The efficient equilibrium is the price and quantity that maximizes social surplus.
The efficient quantity is the quantity that maximizes social surplus.
The use of antibiotics creates an external cost, a cost to people who are neither buying nor selling
It’s the social cost curve that we use to figure out the efficient quantity
To maximize social surplus, output should be reduced to Qefficient, the point at which the social
cost curve intersects the demand curve and where the social costs of an additional unit just equal
For determing efficient quantities, who bears the costs is irrelevant – costs are costs regardless of
who bears them.
When other eopoell bera some of the costs ,antiobiotic users purchase more antiobiotics, so
Qmarket > Q efficient
A tax on ordinary good increases DWL, but a tax on a good with an external costs reduces DWL
and raises revenue.
Pigouvian tax is a tax on a good with external cosrts
Strong argument for taxing goods with external costs ^
An external benefit is a benefit received by people other than the consumers or producers trading
in the market
(vacinnes are benefits to the person who is bacinated but also to people around him/her)
^problem why people don’t is because they are bearing all the costs but not receiving all the
Efficient quantity is found where the social value curve intersects the supply curve
En other people receive some of the beneits, fewer people purchase flu shots, so Qmarket <
If set correctly, a subsidy will make the market equilibrium equal to the efficient equilibrium (if
every time someone was vaccinated, thye were given a subsidy of $20)
A pigouvian subsidy is a subsidy on a good with external benefits
I there are external costs, the market price is too low, thus resulting in overconsumption. A
pigouvian tax increases the price so that the after-tax price sends the correct signal. Similarly, if
there are external benefits, the market price is too high, thus resulting in underconsumption. Private solutions to externality problems
1. Taxes and subsidies
2. Command and control
3. Tradable permits
Market prices do not correctly signal true costs and benefits when there are significant external
costs or benefits.
Taxes/subsidies can adjust prices so that thye od send the correct signals.
When external costs are significant, the market price is too low, so an optimal tax raises the price.
When external benefits are significant, the market price is too high, so an optimal subsidy lowers
Command and control soltions can work but are often high-cost because they are inflexible and
do not take advantage of differences in the costs and benefits of eliminating and producing the
The market equilibrium can be efficnet even when there are externalities, if there is systematic
trading in those externalities.
transaction costs are all the costs necessary to reach an agreement
the costs of identifying and bringing buyers and sellers together, bargaining, and draweing up a
contract are all transation costs. Transation costs are low for beekeepers and farmers because
farms are large and bees don’t fly that far.
But in terms of the flu shot, to pay someone to get the vaccine have enormous transation costs
(impossible to identify beneficiaries and send a check)
When he spreads the flu – external cost
the coase theorem posits that if transcation costs are low and property rights are clearly defined,
private bargains will ensure that the market equilibrium is efficient even when there are
^explains that the ultimate source of the externality problem is too few markets. If property rights
can be clearly defined and transaction costs reduced, then markets in the externality will solve the
problem and will do so at the lowest cost. In reent years, successful market shave been created in
the right to emit sulfur dioxide, and new markets are being proposed to reduce the gases that
contribute to global warming.
In a free market, the quantity of goods sold ill maximize social surplus, the sum of consumer,
producer, and everyone else’s surplus.
But conditions of theorem are unlikely to be met. Transaction costs for many are high and
property rights are often not clearly defined.
Command and Control
When external costs are significant, we know that Qmarket > Qefficient, so the most obvious (but
not the best) method to reduce the external cost of electricity generation is for the government to
order firms to use (or make) less electricity. (makes acid rain – damages forests, cancer etc)
Government could make a really expensive clothes washer but people won’t wanna do that. They
will put insulation in the attic but usually the gov’s methods are not the lowest-cost methods
^a tax would cost less because a tax gives people the flexibility to reduce consumption in the way
that is least costly to them (leaves it up to them)
We don’t want to reduce electricity, we want to reduce pollution (so taxing the pollutants sends
the right signals)
Command and control continues to be used today in handling infectious diseases (shouldn’t be
flexible) Tradable Allowances
-to require that firms reduce pollutants by a specific quantity
the problem is that there are differences in location, fuel and technology – its much cheaper to
reduce emissions from some firms than from others
the EPA’s system of tradable allowances is a successful application of the Coase theorem.
Trading in markets has then allocated the allowances among firms in the way that minimizes the
costs of reducing pollution.
Some buy the rights to emit 30 pounds of some pollutant – ripped them up to create more clean
air. When markets in externalities are created ^, environmentalists can buy pollutants and industry
is happy to sell
Clean energy is subsidized and dirty energy is taxed
*To achieve efficient equilibrium, the government can either use taxes to raise the price to the
efficient price or it can use allowances to reduce the quantity to the efficient quantity.
So the best argument for command and control (and tradable allowances)) is when flexibility is
not a virtue (when a certain amount of pollutants can make an even more significant impact)
A tax is best because it can adjust to changes in supply and demand
Chapter 18: Public Goods and the Tragedy of the Commons
A good is nonexcludable if people who don’t pay cannot be easily prevented from using the
Jeans are different from asteroid deflection for two reasons. First, people are willing to pay for
jeans because paying makes the difference between getting the jeans or not but people aren’t
willing to pay for asteroid deflection because paying makes no appreciable difference to how
much deflection you consume.
jeans are excludable. Asteroid Deflection is nonexcludable.
A good is nonrival if one person’s use of the good does not reduce the ability of another person
to use the same good. (asteroid deflection)
When one person’s use of a good reduces the ability of another person to use the same good –
rival (jeans – 2 people cant use 1 pair of jeans)
4 Types of Goods
-private goods (jeans, hamburgers, contact lenses)
-public goods (asteroid deflectiom, national defence, mosquito control)