1

Chapter 2 Prices, Costs and the Gains from Trade

2

OverviewIn this chapter we want to 1) understand the meaning of the microeconomic term price, and 2) Understand why differences in cost can lead to beneficial trade for all.

3

section 2.1 absolute priceThe number of dollars necessary to purchase a unit of product is called the absolute price of the product. As an example, say in 1990:

bread: $1/loaf Wine: $2/bottle

Note that we put the price of bread as a fraction and read the fraction as “dollars per unit.”

4

sec. 2.1 a basic math calculation

Let’s do a basic math calculation of the form

absolute price of yabsolute price of x .

From the previous screen make bread = y and wine = x.The calculation is

($1/loaf) ($1/loaf) times(bottle/$2)($2/bottle)

=((1/2) bottle)/loaf

5

sec. 2.1 relative price

Before we saw the absolute price of a product is how many dollars one must give up per unit of the product.

The calculation we made allows us to see how many units of another product we must give up to get a unit of the product in question. This is the notion of relative price.The number of units of product x you must give up to purchase 1 unit of product y is called the relative price of y. absolute price of y = relative price of y

absolute price of x .

6

sec. 2.1 exampleabsolute price 1990 1995bread $2/loaf $2/loafwine $4/bottle $8/bottle

relative pricesbread (1/2)bottle/loaf (1/4)bottle/loaf

wine 2 loaves/bottle 4 loaves/bottle

In this example the absolute price of bread stayed the same and the absolute price of wine doubled. BUT, the relative price of bread fell while the relative price of wine increased.

7

Sec. 2.1 RulesRule: In microeconomics, the single word price means relative price and one good’s value should be stated in terms of the other good.

Qualification to the rule: We can still use dollars to measure relative price of good y - bread in our example - provided the dollar or absolute price of good x does not change. We simply must remember that the dollars in which we express the price of good y are really just stand-ins for good x.Note: good x may actually be a whole basket of goods and so we compare good y to the basket.

8

sec. 2.2 costAll costs in economics represent forgone opportunities.

Example: Say you go to the Orange Bowl to watch the big game. What is the cost to go to the game?$1,000 you could sell ticket for on the street before game 500 hotel room 250 airline tickets 300 lost wages$2,050Wait, you say. You already paid $50 for the ticket! Well, then the ticket cost $50 out of your pocket plus the additional $950 you could put back in your pocket if you didn’t go to the game.

9

sec. 2.2 costRemember cost is what you forgo when you undertake an activity.Example: We will look at some data about how much time it takes two people to do a “standard” amount of work. The numbers presented do not really represent cost because we don’t have forgone opportunities, but we can get there from the data given.

Job Electrician Carpenterrewiring 10 hours 20 hourspaneling 15 hours 18 hours

10

sec. 2.2 costNote for the electrician

10 hours/rewiring job15 hours/paneling job

= 2/3 paneling jobsrewiring job

11

sec. 2.2 cost and comparative advantage

In terms of cost

Job Electrician Carpenterrewiring 2/3 paneling 10/9 paneling paneling 3/2 rewiring 9/10 rewiring

Now the electrician does the rewiring job cheaper than the carpenter - the electrician only gives up 2/3 of a paneling job as opposed to 10/9 of a paneling job.We say the electrician1) has a comparative advantage, or 2) is more efficient at rewiring relative to the carpenter.

12

sec. 2.2 terms of tradeNote the carpenter has a comparative advantage in paneling.Terms of tradeSay the carpenter and the electrician each have a paneling and a rewiring job to get accomplished. If they don’t work together the electrician will work 25 hours and the carpenter 38 hours(from original table).

If we look at the table of costs we note that 1 rewiring takes either 2/3 paneling or 10/9 of a paneling job. If the two decide between them that 1 rewiring job trades for more than 2/3 of a paneling job, but less than 10/9 of a job, then both can benefit from trade.

13

sec. 2.2 terms of tradeSay the two decide 1 rewiring job can be traded for 1 paneling job. 1 rewiring = 1 paneling is called the terms of trade.

14

sec. 2.2 benefits from tradeNow with trade the electrician will have to work10 hour on one rewiring +10 hours on the rewiring if he trades for the 1 paneling. He works for a total of only 20 hours instead of the 25 before the trade occurred.The carpenter reduces his hours from 38 to 36, a similar benefit.Conclusion:Everyone in society can be made better off if each specializes in the area where each is most efficient and then trades for the goods each wants - provided agreeable terms of trade can be negotiated.

15

sec 2.2 another solutionNote:electrician went from 25 to 20 hourscarpenter went from 38 to 36 hours.It seems the electrician benefited more. This is based on the terms of trade used in the example. We said the terms of trade must be, for 1 rewiring job, between 2/3 and 10/9 of a paneling job. Say they agree the terms of trade will be

1 rewiring = 7/9 paneling.

electrician would work 10 + 10 + (2/9)(15) = 23 and 1/3 hours.Carpenter works 18 + (7/9)(18) = 32 hours.

16

sec 2.2 middlemanNote that the benefits on the previous screen can be achieved because of differences in costs of production between the two people.

What is a middleman? Someone between the producer or manufacturer of a good and the final consumer.

The middleman provides a useful service by reducing the time it takes producers and consumers to get what they want. Retails stores are a good example of middlemen.Why don’t we have a large sporting goods store in Wayne? Can’t find reasonable terms of trade?