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Price Differentials and Geographic Market Definitions
Roy B. Levy,
To delineate separate markets on the basis of price differentials and barriers to interregional competition, I divide the class into eastern and western sections. Three or four students act as border guards to preempt interaction between sections. For each section, I select a group of consumers and a group of suppliers. The suppliers in each section purchase pencils, at a positive cost, for resale to the respective consumer groups. One can administer an auction to derive the equilibrium set of prices.
Typically, the equilibrium price in the east differs from the equilibrium price in the west. The prices are revealed to the entire class. If the eastern price of pencils is higher than the western price of pencils, for example, then ask the standard questions below:
1. In the absence of border guards, would eastern consumers have purchased pencils exclusively from eastern suppliers?
2. Other factors equal, how would the change in the behavior of eastern consumers impact upon eastern and western prices?
3. In the absence of border guards, would western suppliers have sold pencils exclusively to western consumers?
4. Other factors equal, how would the change in the behavior of western suppliers impact upon eastern and western prices?
5. Given an absence of any geographic barriers, what would halt the interaction between the eastern and western sections?
The students learn that price differentials and the presence of geographic barriers are indications of distinct geographic markets. Students also recognize that uniform prices and an absence of geographic barriers are indications of a single geographic market.
One can easily extend the exercise to discuss the role of product differentials in the delineation of distinct markets. For example, one could derive an eastern price for pencils and a western price for pens.
Specialization and Least Comparative Disadvantage
Dale M. Sievert, University of Wisconsin-Madison
Comparative advantage is commonly expressed in terms of relative advantage. I have found that students understand this concept more easily if you emphasize least disadvantage. For example, this approach can be used to describe a situation where a child who wants to help his father with gardening chores, involving weeding, watering, and harvesting. Suppose the child is slower than the father in all tasks but most closely approximates his father in watering. The boy has a comparative advantage in watering and should do that chore, for he is least worst at watering.
Comparative Advantage in Yard Work
By Thomas Mitchell, Southern
Teaching Ricardo's theory of comparative advantage in principles classes always presents two challenges: (1) distinguishing between absolute and comparative advantage; and (2) demonstrating the gains from specialization and trade based on the pattern of comparative advantages, regardless of the pattern of absolute advantages. The textbook examples always seem too abstract and out of the students' experiences to be much help.
Recently, however, I have used the following numerical example with great success in meeting both of the challenges described above. The example concerns two homeowners who live next door to each other--"My Neighbor" and "Me"--each of whom must perform two weekly tasks: mowing the lawn (including edging and clean-up) and gardening (weeding, pruning, and clean-up). Suppose that the time requirements for performing each of these tasks are given in the following table:
Time Requirements for My Neighbor and Me to
Perform Two Weekly Tasks
Task My Neighbor Me
Mowing lawn 2 hours 3 hours
Gardening 1 hour 4 hours
Clearly, "My Neighbor" has an absolute advantage over "Me" in doing each task: "My Neighbor" requires only 2 hours to mow the lawn, which is one hour less than the 3 hours required by "Me"; and "My Neighbor" requires only 1 hour for gardening, which is three hours less than the 4 hours required by "Me".
Notwithstanding the fact that "My Neighbor" has an absolute advantage over "Me" in doing each of these tasks, the comparative advantage in mowing the lawn goes to "Me". To see this, we express the relative costs of doing each task in terms of doing the other task, but the significance is found in the gains accruing to each from specialization and trade. If the individuals specialize and trade so that "My Neighbor" does the gardening for "me" in exchange for having "Me" mow the lawn for "My Neighbor", then each individual saves time, or in economic terms, "is better off"; both "My Neighbor" and "Me" save an hour of work by specializing and "trading."
Hours
to Do Both Tasks: A Comparison of the "No Trade" and
"Trade" (Specialization) Outcomes
Outcome My Neighbor Me
No Trade* 3 hours 7 hours
Trade** 2 hours 6 hours
*Each individual mows his own lawn and does his own gardening.
**Gardening done by "My Neighbor"; lawn mowing done by "Me".
(Note in this case that the trader who is absolutely more efficient, "My Neighbor", achieves a greater relative time savings: roughly 33% versus roughly 14%!)
If is now obvious that even if one trading partner has an absolute advantage in doing both tasks, there may nevertheless be a strong economic incentive to trade, even with a partner who is "absolutely" less efficient.
International Competitiveness and Productivity Growth
Michael Kuehlwein,
Productivity
growth may be important from an international perspective because of its
affects on the standard of living in the U.S. vis-ŕ-vis standards of living
elsewhere in the world, and consequently, on the ability of the United States
to be a world leader by setting an example. Some people, however, twist this
reasonable argument into a common misconception that productivity growth is
important so that we can compete in foreign markets. To refute this notion, I point out that most
of what we use (consume and invest) is produced in the
Figure 36-1
The remaining 10% we export, which we can think of trading for goods that we import.
Now if productivity increased, we would have more and possibly better goods to export, so we could import more goods. But that increase would affect only about 10% of what determines our living standards. The main effect is that most of any increase in output goes directly to boost consumption and investment at home. So it's the remaining 90% which matters most for our standard of living. Saying that we need productivity growth to boost our exports is a bit like the proverbial tail wagging the dog.
Loren Guffey,
Students remember longer those lessons learned in association with a game or activity. A game that is simple, quickly done, and drives home some important fundamentals is Unequal Resources.
Four teams of three to five students each are necessary to play the game. They first choose a name for their country. Each group is given a manila envelope containing resources and a task sheet of items to construct. The items must be constructed to specifications, for example, a green "T" four inches high, and represent food, clothing, industry, shelter and education. The task sheets are the same for all groups but, when they open their envelopes, they discover that the resources of scissors, paper clips, rulers, different colored paper, etc., are very unevenly distributed.
The instructor should record the time required by each group to complete the tasks. When the tasks are completed, several lessons will have been drawn and should be expressed by the students in post game discussion.
1. Resources are limited.
2. Technology (ruler, scissors) is important in providing necessary goods and services for society.
3. There is variation in the quality of products produced.
4. Resource rich countries and resource poor countries find trade mutually beneficial.
5. Feelings and attitudes develop between countries and these emotional factors effect trade relationships between them.
Establishing the Basis for Trade
Andrew D. Zimmerman,
This exercise draws upon students' own skills and abilities in the process of teaching them the basic concepts of subsistence, specialization, absolute and comparative advantage, unequal wealth, and interdependence among producers, so that they can understand the basis and logic of trade, whether at the individual, organizational, community, regional, or international level.
First, have each student identify one or two skills/abilities he currently possesses toward the production of a good or service, preferably one with direct survival value. Each student should then estimate the quantities of this good or service that she/he could produce in a given time period, e.g., a month or year, and a price per unit. For the sake of simplification, the possession of all necessary factor input will be assumed. The second major task requires that the students be organized into groups of five or six. Each member of the group is then given an endowment, in this case a sum of money ranging from $15,000 to $50,000. The important thing is that these endowments be unequally distributed within the group, although it is possible for two group members to receive the same amount. Each group is then charged with the task of developing, the basis for their collective survival. They will naturally have to engage in bargaining and trade, and can be encouraged to use both their endowments and their producible commodities for this purpose. Whether they utilize a competitive (market‑based) or cooperative approach is up to them.
After engaging in this part of the exercise for at least a half‑hour, stop the proceedings and ask each group to report to the class on the following issues:
1. Was the group able to work out the basis for the survival of its members? If not, why not? Get them to think about the implications of what was or was not accomplished.
2. Did the group utilize a competitive or cooperative approach in working out the solution? Ask them to explain why they chose the approach they did.
3. How did the unequal endowments affect the
outcome of trade arrangements? What are the implications of this for poorer as
opposed to richer individuals, communities, nations, etc.? This is a good
opportunity to discuss the example of
4. What did the students in the various groups learn about the concepts of specialization, advantage, interdependence, etc., as they relate to the value of engaging in trade?
As a follow‑up, a more detailed discussion of trade can be presented. Ricardo's ideas about advantage through resource endowments can be understood in the context of the exercise since the student's monetary endowments can be used to symbolize unequal resource endowments. A more contemporary discussion can be developed around the issues of uneven development, wage and other competitive advantages in a global economy made up of both developed and developing nations, both market‑based and centrally‑planned economies, etc.
If there is time and interest, the exercise can be continued by asking the groups to negotiate with each other as groups, where each group represents a community or nation. The goal would be to work out trade agreements which would be of mutual benefit. If this were done, it could be followed by a discussion of bilateral and multilateral trade agreements, including a discussion of trade policies.
Comparative Advantage in the Home
Kristine L. Chase, Saint
Mary's
Families "live" the principle of comparative advantage everyday, and mine is no exception. Imagine a harried working mother at dinnertime, and two hungry children hanging out in the kitchen. For the family to eat, dinner must be cooked, the dishwasher unloaded and the table set. Mom can do all three tasks faster than the children; she has the absolute advantage over the children in cooking, unloading dishes, and setting the table. If she were to do all three, however, the family would not eat as soon, nor as well! Instead, each person in the kitchen should do the task in which he/she has a comparative advantage.
The task in which you have a comparative advantage is the one for which you have the lowest opportunity cost. For Mom this task is cooking; her opportunity cost is not setting the table or unloading the dishes. This cost to the family is low, compared to the cost of her not cooking dinner. The kids should unload dishes and set the table; their opportunity cost for these tasks is the loss of leisure time, which is quite small at this point.
By allocating tasks this way, the family (society) is much better off, rather than worrying about who is absolutely most efficient. Finally, note that everyone, efficient and not efficient, has a contribution to make in maximizing the welfare of the group as a whole.
Life without Gains from Specialization and Exchange
Quote the suggestion that life in a state of nature would be "nasty, brutish and short." See if a student can provide the reference (Thomas Hobbes's Leviathan). Ask what life would be like if families had to be totally self sufficient, and suggest that Hobbes was correct for any situation without specialized production and exchange. Then suggest that the conclusion that there are gains from exchange is equally valid for both domestic and international transactions.
Comparative Advantage in a Pie Eating Contest
Paul G. Coldagelli, The
This is a welcome diversion from the usual "two country‑two good" comparative advantage problem. Suppose that the three stooges decide to enter a pie baking and eating contest. There are 2 kinds of pies: apple and pumpkin. Contest rules state that prize money will be awarded only if contestants collectively bake and eat at least 5 of each kind of pie. If this requirement is met, one dollar is paid for each pie eaten. The stooges' pie baking and/or eating production possibilities tables are as follows:
Curly Moe Larry
Apple Pumpkin Apple Pumpkin Apple Pumpkin
0 15 12 0 0 10
1 12 10 1 1 9
2 9 8 2 2 8
3 6 6 3 3 7
4 3 4 4 4 6
5 0 2 5 5 5
0 6 6 4
7 3
8 2
9 1
10 0
a. Draw each stooge's pie production possibility curve.
b. If the stooges bake the pies they will be eating, how much in prize money can each win? (Though Curly and Moe can bake more pies, only Larry could earn prize money.)
c. Suppose Curly and Moe decide to bake pies for each other in order to qualify for prize money. What is the maximum amount of prize money they could earn together?
d. What terms of trade are favorable to Curly? (That is, at what terms of trade (apple for pumpkin) could Curly earn at least some prize money?)
e. What terms are favorable to Moe?
f. Suppose Moe determines the terms of trade which make it just worthwhile for Curly to trade. Larry offers an alternative, "Trade with me and we'll split the prize money." Should Curly accept Larry's offer? If so, how should they divide production? How much could each win?
Comparative Advantages in Higher Education
Mark Zupan,
I ask students why trade occurs, the general answer being that it's because the autarkic (no‑trade) prices at which domestic supply and demand curves within two different countries meet are unequal and that the resulting price differential is less than transportation costs between the two countries, as reflected in Figure 36‑2. The reasons why equilibrium prices differ are varied: differences in tastes, relative factor abundances (i.e., Heckscher‑Ohlin models of trade), taxes/subsidies, technology, etc.
Figure 36‑2 Autarkic Price Differentials
The
Ricardian model focuses on technological reasons for differences in equilibrium
prices. To demonstrate how this model works I give them the example of two
countries (Massachusetts Institute of Technology and
From this data set, I can go into absolute and comparative cost advantages (tying it into opportunity cost‑‑it doesn't matter how many absolute number of freshmen you need to produce each jock, but what else that absolute number could be used for), having the students draw the two countries' PPFs before trade, and how the PPFs pivot with trade (Ricardo's theory says go to the corner of your PPF where you have a comparative advantage, produce only the good on that axis, and trade for the other good), and what the total supply and demand curves for jocks look like between the two countries. Figure 36‑3 shows how the with‑trade price is determined by the intersection of these two curves, and can be used to explain why both countries end up being better off as a result.
Figure 36‑3 Ricardian Price Determination
Mark Zupan,
In covering quotas and their effect on total within‑country supply curves, I typically pull out a ruler, piece of chalk, and a student's notebook or pencil and ask students to imagine that the quotas on cars is the length of the notebook long‑‑with the notebook being less than Qc ‑ Qp long, as reflected in Figure 36‑4. up to pw, the total within‑country supply curve is thus domestic. At pw, the notebook's length of cars can come in‑‑no more and no less. After that, all cars come only from domestic sources. the within‑country supply curve is thus the bold line. using a notebook that you have ferreted out from one of the students in the class is incredibly effective at getting the students to visualize and understand how a quota affects a marketplace.
Figure 36‑4
James A. Kurre, The
In the early 1960s, imported cars accounted for less than 10
percent of
(a) Draw two supply and demand graphs, one showing the market for American‑made cars, and the other showing the U.S. market for imported cars like Hondas and Toyotas. In the early 1970s, American auto makers were making mostly large gas hogs, while most foreign cars were small and fuel efficient. Show what effect the dramatic increases in gasoline prices in the 1970s would have on each market. Which curve would shift on each graph, and what would cause it to shift? Indicate what would happen to the equilibrium price, and number of each type of car sold.
(b) What effect would you expect this to have on the market for inputs used in making cars in this country? Specifically, what effect would this have on employment for auto workers? In terms of supply and demand for auto workers, which curve would shift, and what effect would this have on the number of jobs in the industry?
(c) In 1980, the United Auto Workers and the American automobile producers joined in requesting mandatory auto import quotas from the government. The Reagan Administration responded by asking the Japanese to "voluntarily" restrict the number of cars they export to this country. Show how these import restrictions would affect both the market for imported cars and the market for domestically‑produced cars. If you were in the market for a Honda, what effect would the restrictions have on the price that you'll pay, and the availability of the car for which you're looking? What effect will the import restrictions have on the market for American auto workers?
(d) As is the case with most government actions, this one had an effect on the distribution of the economy's output. In other words, it redistributed the American pie, taking income or resources away from some participants and giving them to others. Who benefits from the import restrictions? In other words, who would you expect to back the import quotas politically? Who loses from (i.e., bears the costs of) the import restrictions?
(e) Normative implications. Are you for or against import quotas for foreign automobiles? Before answering, realize that your answer will depend in large part on whether you personally would gain or lose as a result of the quotas. Taking a larger view, if the cost to American consumers were only $50 for each job saved, would you be willing to vote for quotas? . . . if it were only $5? . . . if it were $5,000? In other words, might you agree with this policy, even though it would redistribute from some people to others, if the benefits received by the gainers were much greater than the costs to the losers? Or would that still be "unfair"?
I have placed in the Library a two‑page reading from Consumer Reports (March 1985, pp. 149‑150) that discusses these ideas. It cites an economic study that estimates the cost to consumers of each job saved by the quotas to be about $160,000 per year. You might wish to take a look at it and see if their analysis agrees with yours. Editors Note: By 2002, each American job “saved” when President George W. Bush imposed limits on imported steel was estimated to cost American consumers and investors more than $1.2 million per year in higher prices for cars, structural steel, etc.
ANSWERS
(a) Figure 36‑5 shows the results typical students should be able to illustrate graphically. The price of a complement (gas) went up, causing the demand for domestic cars to decrease. While gas is also a complement for imported cars, as the cost of driving big cars (a substitute for the small imports) increased, the demand for imports increased. The quantity of domestic cars sold would be expected to fall, while the quantity of imports would rise.
Figure 36‑5
(b) The demand for U.S. auto workers derives from the demand for American‑made cars, so if demand for domestically‑made cars falls, demand for auto workers will also fall‑‑i.e., there will be fewer jobs for them. If the UAW resists a wage cut (P1 ‑ P2) ‑‑i.e., if the supply curve of labor is relatively flat at the current wage‑‑the decrease in the number of jobs will be even larger. (Draw two graphs, one with a flat and one with a steep supply curve, and look at the effect on employment.)
Figure 36‑6
(c) Import quotas would reduce the supply of imports, driving their price up and quantity down. At the old price there would be a shortage of Hondas, so dealers will add premiums to their sticker prices and imports may be harder to get. These price hikes for imports will raise demand for domestically‑produced cars (which are substitutes), with the effects on P and Q shown in Figure 36‑7. More U. S. auto workers will have jobs.
Figure 36‑7
Figure 36‑8
(d) The auto workers benefit because there will be more jobs for them than without the quotas, perhaps at a higher wage, also. The owners (i.e., stockholders) of the American auto companies would benefit from higher prices, and profits, for their product. Consumers of both domestic and imported cars would pay higher prices, and have a harder time finding the import cars that they might want. They lose. Also, don't the quotas cause (allocative) inefficiency? They push us to a different point on the production possibilities curve than we would otherwise choose, as illustrated in Figure 36‑8.
Evaluating Some Arguments Against Free Trade
Ralph T. Byrns
Discuss the widespread alarm at recent huge U.S. trade deficits. Much of this alarm harks back to mercantilist reasoning (rebutted by Adam Smith in his Wealth of Nations) or parallels Keynes's rationale for trade restrictions during a depression (see his appendix on mercantilism in the General Theory). One stimulating rebuttal to mercantilist thinking is to ask how many students believe that in commercial transactions, "it is better to give than to receive". Few hands will rise. Then ask how many believe that people who "get more than they give" are ahead. Most students will raise their hands. This leads to the following points:
(a) The U.S. trade deficit is a situation wherein we give up less than we get from foreigners, making up the difference by "exporting" dirty green paper that has a very low production cost. Argue that the largest U.S. export since 1951 have been the dollar and dollar‑denominated securities. To answer the response that this paper will return and imposes a future burden, point out that Japanese use dollars to buy Brazilian coffee, Arabs use dollars to buy Toyotas, etc. The U.S. dollar is the world's major medium of exchange, so Americans gain through international "seignorage" when our balance of trade (or payments) is in deficit because our FED is the de facto world's banker.
(b) When a pattern of trade first emerges, both sides to any exchange may believe that it has "cheated" the other, because it trades something with a low subjective value for something it values comparatively highly. After the pattern of trade becomes customary and both sides have adjusted their patterns of consumption and production, the gains from exchange are taken for granted.
(c) Point out that the static gains from trade are positively related to the autarkic production cost differentials, and that relative prices will change most (and be most disruptive to the status quo) when potential gains are greatest. That is, the domestic prices of exported goods will rise more and the domestic prices of imported goods will fall farther the greater are the gains from trade.
Perhaps nothing attests to the power of the gains from trade more than the diversity of the arguments against free trade policies. In addition to those cited in the text, you may want to address the following anti‑trade positions:
(a) XENOPHOBIA. Nationalistic or chauvinistic pleas to "Buy American" (or from local merchants instead of going to a big town, etc.) entail asking or requiring people to act against their own interests. Policymakers who impose barriers to trade on the basis of such arguments deny us the gains from exchange by doing this (although there may be some psychic income generated by such behavior) in order to e.g., subsidize domestic producers or hold down the real incomes of foreigners. But you should point out to students that our own economic power is reduced when trade restrictions are imposed, and so these may be contrary to our national interests.
(b) SCIENTIFIC BALANCE. The argument for "scientific balance" suggests that tariffs should be structured to eliminate cost disadvantages to American producers (e.g., higher cost American labor versus "cheap" foreign labor), and then "let the best man win." The fallacy of this argument is that a "scientific tariff" voids comparative advantage. Should an Alaskan coffee grower be protected from cost disadvantages relative to a Columbian grower? The gains from trade derive from differences in production costs; with a scientific tariff there would be no gains from trade and hence, no trade in the long run.
(c) SAVING MARGINAL PRODUCERS. Point out that competition always yields producers who are at the margin of extinction. Moving some currently marginal producers into an inframarginal category by restricting imports of competing goods may work, but in short order such a policy will simply generate another group of firms that will hover on the brink of failure and another group of workers threatened with unemployment.
(d) COUNTERING DEPRESSION. Point out that Keynes's suggestion that trade barriers can bolster aggregate demand (raising X‑M) to help offset recessionary pressures is only valid if retaliation by other countries is insignificant, and may backfire if retaliation is significant. Indicate that, moreover, restrictions are very difficult to eliminate once in place. For example, rescinding the "voluntary" restrictions of Japanese exports of automobiles to the United States was powerfully opposed by U. S. automakers even after our domestic industry had recovered (by 1984) so that even Chrysler was profitable. Students also enjoy discussing just how voluntary Japanese export restrictions on autos have been.
Trade Restrictions and our Standard of Living
David E. R. Gay,
When discussing the trade balance, I emphasize that foreigners will hold more dollars when they sell more to us than we buy from them. They do not burn the money. Instead they use it to buy American property (the Japanese will pay the top dollar in cash) and they buy part of the U.S. debt issues (otherwise we would have to buy more of it ourselves and that would require higher interest rates), among other things. Prior to class I collect a sack full of goods, or their container's, and begin to pull them out of the sack. With tariffs and quotas rising then goods like coffee would be more expensive, aiding Hawaiian producers but lowering out standard of living in general, and then I toss the coffee can into the waste basket about 20 feet away. And just like sinking basketball shots this continues until the sack of goods is empty. Then I check my shoes and likewise toss each into the trash can, which is nearly full by now. After tossing my belt into the trash can, I begin to remove my trousers but stop before going too far , although you could come prepared to actually remove them for the grand dunk. Thus, you have attempted to strip for free trade. Ha!