Elasticity The price elasticities of demand for individual good are determined by the

economic characteristics of demand. Price elasticities tend to be higher when the good are luxuries, when

substitutes are available and when consumers have more time to adjust their behavior

Elasticites are lower for necessities for good with few substitutes, and for the short run.

Price-elastic demand – a 1 percent change in price calls forth more than a 1 percent change in quantity demanded

Price inelastic demand – a 1 percent change in price produces less than a 1 percent change in the quantity demanded

o Food & footwear are inelastic Unit elastic demand – the percentage change in quantity is exactly the same

as the percentage change in price Completely inelastic demands, ones with zero elasticity, are ones where the

quantity demanded responds not at all to price changes; such demand is seen to be a vertical demand curve

When demand is infinitely elastic, a tiny change in price will lead to an indefinitely large change in quantity demanded as in the horizontal demand curve.

Elasticity depends upon the slope of the demand curve, but it also depends upon the specific price and quantity pair

o Don’t confuse the elasticity of a curve with its slope Along a straight line demand curve, the price elasticity varies from zero to

infinity The slope is not the same as the elasticity because the demand curve’s slope

depends upon the changes in P and Q, whereas the elasticity depends upon the percentage changes in P and Q

o The only exceptions are the polar cases of completely elastic and inelastic demands

Elasticity can be calculated as the ratio of the length of the straight line or tangent segment below the point to the length of the segment above the point

Qd > P inelastic Total revenue = P x Q When demand is price inelastic a price decrease reduces total revenue When demand is price elastic a price decrease increases total revenue In the borderline case of unit elastic demand, a price decrease leads to no

change in total revenue Price discrimination is the practice of charging different prices for the same

service to different customers The paradox of the bumper harvest: the demand for basic food products such

as wheat and corn tend to be inelastic; for these necessitates, consumption changes very little in response to price. This means farmers as a whole receive less total revenue when the harvest is good than when it is bad. The

increase in supply arising from an abundant harvest tends to lower the price. But the lower price doesn’t increase quantity demanded very much.

Price elasticity of supply is the percentage change in quantity supplied divided by the percentage change in price

The major factor influenced supply elasticity is the ease with which production in the industry can be increased.

Restrictions on production are a typical example of government interference in individual markets, They often raise the income of one group at the expense of consumers. These policies are generally inefficient: the gain to farmers is less than the harm to consumers.

With price inelastic demand, farm incomes decline with increases in supplyConsumer behavior

Utility – how consumers rank different goods and services People choose those goods and services they value most highly In the theory of demand, we assume that people maximize their utility, which

means that they choose the bundle of consumption goods that they most prefer.

The expression “marginal” is a key term that means “additional” or “extra”. Marginal utility denotes the additional utility you get from the consumption of an additional unit of a commodity

Law of diminishing marginal utility: the amount of extra or marginal utility declines as a person consumes more and more of a good

o Utility tends to increase as you consume more of a good. However as you consumer more and more your total utility will grow at a slower and slower rate.

This is the same thing as saying that your marginal utility (the extra utility assed by the last unit consumed of a good) diminishes as more of a good is consumed.

o As the amount of a good consumed increases the marginal utility of that goods tends to decline

Total utility is the sum of all the marginal utilities that were added from the beginning

Consumer surplus The gap between the total utility of a good and its total market value is called

consumer surpluso The surplus arises because we “receive more than we pay for” as a

result of the law of diminishing marginal utility Because consumers pay the price of the last unit for all units consumed, the

enjoy a surplus of utility over cost. Consumer surplus measures the extra value that consumers receive above what they pay for a commodity

Production and Business Organization The production function specifies the maximum output that can be produced

with a given quantity of inputs. It is defined for a given state of engineering and technical knowledge

o Assuming that firms always strive to produce efficiently. – they always attempt to produce the maximum level of output for a given dose of inputs

Total product, which designates the total number of output produced, in physical units such as bushels of wheat or number of sneakers

Marginal product of an input is the extra output produced by one additional unit of that input while other inputs are held constant

Average product – total output divided by total units of input Under the law of diminishing returns a firm will get less and less extra output

when it adds additional units of an input while holding other inputs fixed. In other words the marginal product of each unit of input will decline as the amount of that input increases holding all other inputs constant.

As more of an input such as labor is added to a fixed amount of land, machinery, and other inputs, the labor has less and less of the other factors to work with. The land gets more crowded, the machinery is overworked, and the marginal product of labor declines.

Diminishing returns and marginal products refer to the response of output to an increase of a single input when all other inputs are held constant

Returns to scale – the effects of scale increases of inputs on the quantity produced

o Constant returns to scale – a case where a change in all inputs leads to a proportional change in output

Handicraft industries – hair cuttingo Increasing returns to scale – also called economies of scale – arise

when an increase in all inputs leads to a more than proportional increase in the level of output.

o Decreasing returns to scale – when a balanced increase of all inputs leads to a less than proportional increase in total output.

Production shows increasing, decreasing or constant returns to scale when a balanced increase in all inputs leads to a more than proportional, less than proportional, or just proportional increase in output.

Short run – a period in which firms can adjust production by changing variable factors such as materials and labor but cannot change fixed factors such as capital

o The factors which are increased in the short run are variable factors. Long run – a period sufficiently long that all factors including capital can be

adjusted. Efficient production requires time as well as conventional inputs like labor.

We therefore distinguish between two different time periods in production and cost analysis. The short run is the period of time in which only some inputs, the variable inputs, can be adjusted. In the short run, fixed factors such as plant and equipment, cannot be fully modified or adjusted. The long run is the period in which all factors employed by the firm, including capital, can be changed.

Technological Change

We distinguished process innovation, which occurs when new engineering knowledge improves production techniques for existing products, from the product innovation, whereby new or improved products are introduced in the marketplace

Process innovation is equivalent to a shift in the production function Network markets are special because consumers derive benefits not simply

from their own use of a good but also from the number of other consumers who adopt the good

Productivity and the aggregate production function Productivity is a concept measuring the ratio of total output to a weighted

average of inputs o Labor productivity – calculates the amount of output per unit of laboro Total factor productivity – measures output per unit of total inputs

Total factor productivity is output divided by an index of all inputs (labor, capital, materials,…), while labor productivity measures output per unit of labor (such as hours worked)

When output is growing faster than inputs, this represents productivity growth

o Technological advances – process and product innovationso Economies of scale and scope

Economies of scope – when a number of different products can be produced more efficiently together than apart

o Like the specialization and division of labor that increase productivity as economies become larger and more diversified

Business Organizations Business firms are specialized organizations devoted to managing the

process of production Production is organized in firms because of economies of specialization.

Efficient production requires specialized labor and machinery, coordinated production, and the division of production into many small operations

Function of firms - Raising resources for large scale production A third reason for the existence of firms is to manage and coordinate the

production process o Once all the factors of production are engaged someone has to

monitor their daily activities to ensure that the job Is being done effectively and honestly.

Business firms are specialized organizations devoted to managing the process of production. Production is organized in firms because efficiency generally requires large scale production, the raising of significant financial resources, and careful management and coordination of ongoing activities.

Analysis of Costs Fixed costs – expenses that must be paid even if the firm produces zero

output – they do not change if output changes Variable costs – do vary as output changes

o VC begins at zero when q is zero. VC is a part of TC that grows with output; indeed the jump in TC between any two outputs is the same as the jump in VC

Total costs represents the lowest total dollar expense needed to produce each level of output q.

o TC rises as q rises Fixed cost represents the total dollar expense that is paid out even when no

output is produced; fixed cost is unaffected by any variation in the quantity of output

Variable costs represents expenses that vary with the level of output- such as raw materials, wages and fuel – and includes all costs that are not fixed

TC = FC + VC To attain the lowest level of costs, the firm’s managers have to make sure

that they are paying the least possible amount for necessary materials, that the lowest-cost engineering techniques are incorporated into the factory layout, that employees are being honest, and that countless other decisions are made in the most economical fashion

Marginal cost denotes the extra or additional cost of producing 1 extra unit of output

The marginal cost of production is the additional cost incurred in producing 1 extra unit of output

Average cost is a concept widely used in business; by comparing average cost with price or average revenue, businesses can determine whether or not they are making a profit

Average cost is the total cost divided by the total number of units produced Average fixed cost is defined as FC/q. Since total fixed cost is a constant,

dividing it by an increasing output gives a steadily falling average fixed cost curve

o As a firm sells more output, it can spread its overhead cost over more and more units

Average variable cost equals variable cost divided by output When marginal cost is below average cost it is pulling average cost down

o If MC is below AC this means that the last unit produced costs less than the average cost of all the previous units produced

When MC is above AC, it is pulling up AC When MC just equals AC AC is constant. At the bottom of the Ushaped AC,

MC=AC=minimum AC In terms of our cost curves, if the MC curve is below the AC curve, the AC

curve must be falling. By contrast if MC is above AC, AC is rising. Finally when MC is just equal to AC, the AC curve is flat. The AC curve is always pierced at its minimum point by a rising MC curve

Key elements of the costs curves are factor prices and firm’s production function

The short run is the period of time that is long enough to adjust variable inputs, such as materials and production labor, but too short to allow all

inputs to be changed. In the short run fixed or overhead factors such as plant and equipment cannot be fully modified or adjusted. Therefore in the short run, labor and materials costs are typically variable costs, while capital costs are fixed.

In the long run, all inputs can be adjusted – including labor, materials, and capital. Hence in the long run all cost are variable and none are fixed.

Diminishing returns to the variable factor will imply an increasing short run marginal cost this shows why diminishing returns lead to rising marginal costs

The u- ≥shaped cost curves are based on diminishing returns in the short run. With fixed land and variable labor the marginal product of labor first rises to the left of B, peaks at B and then falls at D as diminishing returns to labor set in

In the short run, when factors such as capital are fixed, variable factors tend to show an initial phase of increasing marginal product followed by diminishing marginal product. The corresponding cost curves show an initial phase of declining marginal costs, followed by increasing MC after diminishing returns have set in

Least cost rule: To produce a given level of output at least cost, a firm should buy inputs until it has equalized the marginal product per dollar spend on each input

Substitution rule: If the price of one factor falls while all the factor prices remain the same, firms will profit by substituting the now cheaper factor for the other factors until the marginal products per dollar equal for all inputs

Net income (profit) = total revenue – total expenses Income statement

o The first three cost categories – materials, labor cost, and miscellaneous operating costs – basically correspond to the variable costs of the firm, or its cost of goods sold

o The next three categories lines 6-8 correspond to the firm’s fixed costs, since in the short run they cannot eb changed

We call the amount that is used up “depreciation” and calculate that amount as the cost of the capital input for that year.

Depreciation measures the annual cost of a capital input that a company actually owns itself

Balance sheet – a picture of financial conditions on a given date – records what a firm person, or nation is worth at a given point in time

Assets – valuable prosperities or rights owned by the firm Liabilities – money or obligations owned by the firm Net worth – net value equal to total assets minus total liabilities One important distinction between the income statement and the balance

sheet is that between stocks and flows Stock – represents the level of a variable, such as the amount of water in a

lake or, in this case, the dollar value of a firm

Flow – variable represents the change per unit of time, like the flow of water in a river or the flow of revenue and expenses into and out of a firm

The income statement measures the flows into and out of the firm, while the balance sheet measures the stocks of assets and liabilities at the end of the accounting year

Total assets = total liabilities + net worth A balance sheet must always balance because net worth is a residual defined

as assets minus liabilities The income statement shows the flow of sales, cost, and revenue over the

year or accounting period. It measures the flow of dollars into and out of the firm over a specified period of time

The balance sheet indicates an instantaneous financial picture or snapshot. It is like a measure of the stock of water in a lake. The major items are assets, liabilities, and net worth

Resources are scarce – every time we choose to use a resource one way we’ve given up the opportunity to utilize it another way.

Making a choice in effect costs us the opportunity to do something else. The value of the best alternative forgone is called the opportunity cost

The opportunity costs of a decision include all its consequences, whether they reflect monetary transactions or not

Decisions have opportunity costs because choosing one thing in a world of scarcity means giving up something else

The opportunity cost is the value of the most valuable good or service forgone

Opportunity cost is the actual expenses and the forgone cost In well functioning markets, when all costs are included, price equals

opportunity costs Economic costs include, in addition to explicit money outlays, those

opportunity costs incurred because resources can be used in alternative ways.

Analysis of Perfectly Competitive Markets Perfect competition is the world of price takers A perfectly competitive firm sells a homogenous product (one identical to the

product sold by others in the industry). o The firm is so small relative to its market that it cannot affect the

market price; it simply takes the price as given Because a competitive industry is populated by firms that are small relative

to the market, the firm’s segment of the demand curve is only a tiny segment of the industry’s curve

o Graphically, the competitive firm’s portion of the demand curve is so small that to the Lilliputian eye of the perfect competitor, the firm’s dd demand curve looks completely horizontal or infinitely elastic

Under perfect competition, there are many small firms, each producing an identical product and each too small to affect the market.

The perfect competitor faces a completely horizontal demand of dd curve

The extra revenue gained from each extra unit sold is therefore the market price.

The maximum profit comes at that output where marginal cost equals price The competitive firm can always make additional profit as long as the price is

greater than the marginal cost of the last unit o Total profit reaches its peak – is maximized where there is no longer

any extra profit to be earned by selling extra output o At the maximum-profit point, the last unit produced brings in an

amount of revenue exactly equal to that unit’s cost Extra revenue – the price per unit Extra cost – marginal cost

Rule for a firm’s supply under perfect competition: A firm will maximize profits when it produces at that level where marginal cost equals price

o Marginal cost = price Zero profit point – the production level at which the firm makes zero

economic profits; at the zero profit point, price equals average cost, so revenues just cover costs.

A profit maximizing firm will set its output at that level where marginal cost equals price. Diagrammatically, this means that a firm’s marginal cost curve is also its supply curve

the firm should not necessarily shut down if it is losing money. The firm should minimize its losses, which is the same thing as maximizing profits.

The critically low market price at which revenues just equal variable costs (or, equivalently, at which losses exactly equal fixed costs) is called the shutdown point. For prices above the shutdown point, the firm will produce along its marginal cost curve because, even though the firm might be losing money, it would lose more money by shutting down.

Shutdown rule: The shutdown point comes where revenues just cover variable costs or where losses are equal to fixed costs. When the price falls below average variable costs, the firm will maximize profits (minimize its losses) by shutting down

The zero profit point comes where price is equal to AC, while the shutdown points comes where price is equal to AVC.

The quantity supplied by a firm will be determined by each firm’s marginal costs.

The total quantity brought to market at a given price will be the sum of the individual quantities that all firms supply at that price.

The market supply curve for a good in a perfectly competitive market is obtained by adding horizontally the supply curves of all the individual producers of that good

Short run equilibrium – when output changes must use the same fixed amount of capital

Long run equilibrium – when capital and all other factors are variable and there is free entry and exit of firms into and from the industry

Increased inputs of variable factors will produce a greater quantity of fish along the short run supply curve

The high price lead to high profits, which in the long run coax out more shipbuilding and attract more sailors into the industry. Additionally new firms may start up or enter the industry. This gives the long run supply curve and long run equilibrium.

o The intersection of the long run supply curve with the new demand curve yields the long run equilibrium attained when all economic conditions have adjusted to the new level of demand

The long run supply curve of industries using scarce factors rises because of diminishing returns

N the long run firms will produce only when price is at or above the zero profit condition where price equals average cost

In the long run the price in a competitive industry will tend toward the critical point where revenues just cover full competitive costs.

Zero profit long run equilibrium – in a competitive industry populated by identical firms with free entry and exit, the long run equilibrium condition is that price equals marginal cost equals the minimum long run average cost for each identical firm

o P=MC = minimum long run AC = zero profit priceo This is the long run zero economic profit condition

The long run equilibrium in a perfectly competitive industry is therefore on with no economic profits

Demand ruleo Generally an increase in demand for a commodity (the supply curve

being unchanged) will raise the price of the commodity.o For most commodities an increase in demand will also increase the

quantity demanded. A decrease in demand will have the opposite effects

Supply rule o An increase in supply of a commodity (the demand curve being

constant) will generally lower the price and increase the quantity bought and sold

o A decrease in supply has the opposite effects. When the quantity supplied is constant at every price, the payment for the

use of such a factor of production is called rent or pure economic rent At firms the more labor supplied rises as higher wages coax out more labor.

But beyond a certain point higher wages lead people to work fewer hours and to take more leisure. An increase in demand raises the price of labor, as was stated in the demand rule

Increased supply must decrease price and increase quantity demanded An increased supply will decrease P most when demand is inelastic An increased supply will increase Q lease when demand is inelastic

An economy is efficient when it provides its consumers with the most desired set of goods and services given the resources and technology of the economy

Pareto efficiency (or sometimes just efficiency) occurs when no possible reorganization of production or distribution can make anyone better off without making someone else worse off. Under conditions of allocative efficiency, one person’s satisfaction or utility can be increased by lowering someone else’s utility.

An a minimum an efficient economy is on its ppf, but efficiency goes further and requires not only the right mix of goods be produced but also that these goods be allocated among consumers to maximize consumer satisfactions

Economic surplus – between the supply and demand curves at the equilibrium – the sum of the consumer surplus, which is the area between the demand curve and the price line

o The welfare or net utility gain from production and consumption of a good; it is equal to the consumer surplus plus the producer surplus

Producer surplus – the area between the price line and the SS curve – the producer surplus includes the rent and profit to firms and owners of specialized inputs in the industry and indicates the excess of revenues over cost of production

The marginal gain to society from the last unit consumed equals the marginal cost to society of that last unit produced- which guarantees that a competitive equilibrium is efficient

A perfectly competitive economy is efficient when marginal private cost equals marginal social cost and when both equal marginal utility

The perfectly competitive market is a device for synthesizing the willingness of consumers possessing dollar votes to pay for goods with the marginal costs of those goods as represented by firms’ supply. Under certain conditions, competition guarantees efficiency, in which no consumer’s utility can be raised without lowering another consumer’s utility. This is true even in a world of many factors and products

Marginal cost is a fundamental concept for efficiency. For any goal oriented organization, efficiency requires that the marginal cost of attaining the goal should be equal in every activity. In a market, an industry will produce its output at minimum total cost only when each firm’s MC is equal to a common price

Markets may be inefficient in situations where pollution or other externalities are present or when thee is imperfect competition or information

The distribution of incomes under competitive markets, even when it is efficient, may not be socially desirable or acceptable

Market failureso Imperfect competition – drug patent – the firm can raise the price of

its product above its marginal cost. – consumers buy less of such goods than they would under perfect competition

o Externalities – some of the side effects of production or consumption are not included in market prices

o Imperfect information Monopoly

There is a single seller of a good or service which has not close substitute The monopoly power of a firm refers to the extent of its control over the

supply of the product that is produced by the industry of which it is a part The monopoly power of a firm in a imperfectly competitive market is greater

the larger the firm’s output is relative to the output of the industry as a whole. It is less the smaller the firm’s output is relative to the output of the entire industry

Concentration ratio – the percentage of industry sales accounted for by the four (or eight) largest firms in an industry; a measure of monopoly power.

o Significant degree of monopoly power when the concentration ratio reaches 70 or 80 percent

The price which sellers are able to charge is always limited by what buyers are willing to pay

Marginal revenue – the increase in revenue accruing to the firm from selling an additional unit of its product

Profits – the difference between total revenue and total cost; maximized by producing the output at which marginal revenue equals marginal cost

MR is les than Mc and profits decrease MR is greater than Mc, an increase in output level will increase profits Profits are maximized by producing the output level at which MR equals MC

(competitive) The monopolist faces the market demand curve which is downward sloping

to the right instead of horizontal. This fact has important implications for marginal revenue. Any firm that faces a demand curve that is sloping downward to the right will find that its marginal revenue is less than product price at any given output level.

To recapitulate the analysis, in a monopolized market the price of the product tends to be higher and the output tends to be less that it would be if the industry could be and were competitive

Monopolist – downward sloping demand curve Deadweight welfare loss due to monopoly- the reduction in social welfare

due to the exercise of monopoly power Barriers to entry – impediments to the entry of new firms into a market, such

as product differentiation and government licensing, usually used by monopolists to protect their favored positions

Firms or firms already in a market won or control most of some key raw material needed for making the product. All they must do to restrict entry is deny potential entrants access to it

Suppose that when new firms are in the process of entering, the existing firms threaten to lower prices to the extent that the newcomers would experience substantial losses.

Product differentiation may be successful in retarding entry in some instances

Network economies – situation in which the value of a product to a consumer is enhanced when others also choose to consume the same product

Government barriers – legislation and licensed occupations Advertising is a major form of non price competition Periodic change in the design and quality of the product is another major

form of non price competition When imperfectly competitive firms restrict output and increase prices, they

impose an economic cost on society in the form of reduced social well being o Deadweight welfare loss due to monopoly

When firms grow extremely large in terms of employment, the economic decision to simply let them fail becomes a difficult call for politicians, especially those from states that would be hard hit by the collapse of one or more of their primary employers

Average cost – ratio of costs to the number of units being produce, sometimes called the per unit cost

Economies of scale – situation that occurs when long run average cost can be reduced simply be increasing the firm’s size and producing more of the product diseconomies of scale – situation that occurs beyond a certain size and production level, when average cost rises as production is increase.

Natural monopoly – an industry in which the average cost of production is minimized by having only one firm produce the product

Capture theory of regulation – the belief that regulatory agencies, regardless of their initial intentions eventually come to service the interest of the firms being regulated rather than the interest of the general public

Corporations – firms organized as legal entities separate from their owners, the stockholders, who by law, have limited liability

Stock options – guarantees issued by a corporation which allow the holder to purchase a set number of shares at a fixed price, often called the strike price; stock options are frequently used as a form as managerial compensation

Natural resources and the environment Externality is an activity that imposes involuntary costs of benefits on others,

or an activity whose effects are not completely reflected in its market price Public good – a commodity that can be provided to everyone as easily as it

can be provided to one person The decision to provide a certain level of a public good like national defense

will lead to a number of battalions, airplanes, and tanks to protect each of us. By contrast the decision to consume a private good like bread is an individual act

Public goods are ones who benefits are indivisibly spread among the entire community, whether or not individuals desire to consume the public good. Private goods, by contrast, are ones that can be divided up and provided separately to different individuals with no external benefits or costs to others. Efficient provision of public goods often requires government action, while private goods can be efficiently allocated by private markets

Managers therefore decide to clean up just to the point where profits are maximized this requires that the benefits to the firm from additional abatement “marginal private benefits” be equal to the cost of additional cleanup “marginal cost of abatement”

In an unregulated environment, firms will determine their most profitable pollution levels by equating the marginal private benefit from abatement with the marginal private cost of abatement

Efficiency requires that the marginal social benefits from abatement equal the marginal social cost of abatement

Cost benefit analysis – efficient emissions are set by balancing the marginal costs of an action against the marginal benefits of that action

Reducing pollution to zero would generally impose astronomically high cleanup costs while the marginal benefits of reducing the law few grams of pollution may be quite modest.

An unregulated market economy will generate levels of pollution (other than externalities) at which the marginal private benefits of abatement equals the marginal private cost of abatement. Efficiency requires that the marginal social benefit of abatement equals the marginal social cost of abatement. In an unregulated economy, there will be too little abatement and too much pollution

An efficient strategy for containing climate change requires weighing the marginal costs of reducing carbon dioxide emissions against the marginal benefits

International Trade Trade promotes specialization and specialization increases productivity Over the long run increased trade and higher productivity raise living

standards for all nations The major advantage of international trade is that it expands the scope of

trade Sovereign nations – each nation is a sovereign entity which regulates the

flow of people, goods, and finance crossing its borders The international financial system must ensure a smooth flow and exchange

of dollars, yen, and other currencies- or else risk a breakdown in trade. Benefits of international trade: diversity in the conditions of production,

differences in tastes among nations, and decreasing costs of large scale production

An important feature in today’s world is that some companies or countries enjoy economies of scale that is they tend to have lower average costs of production as the volume of output expands

o When a particular country gets a head start in producing a particular product it can become the high volume, low cost producer. The economies of scale give it a significant cost and technological advantage over other countries, which find it cheaper to buy from the leading producer than make the product themselves.

The principle of comparative advantage holds that a country can benefit from trade even if it is absolutely more efficient than other countries in production of every good

The principle of comparative advantage holds that each country will benefit if it specializes in the production and export of those goods that it can produce at relatively low cost. Conversely, each country will benefit if it imports those goods, which it produces at relatively high cost.

We can most easily reckon the gains from trade by calculating the effect of trade upon the real wages of workers. Real wages are measured by the quantity of goods that a worker can buy with an hour’s pay

When countries concentrate on their areas of comparative advantage under free trade each country is better off. Compared to a no-trade situation, workers in each region can obtain a larger quantity of consumer goods for the same amount of work when the specialize in their areas of comparative advantage and trade their own production for goods in which they have a relative disadvantage.

Outsourcing refers to the locating services or production processes abroad The ratio of export prices to import prices the terms of trade The world PPF represents the maximum output that can be obtained from

the world’s resources when goods are produced in the most efficient manner that is with the most efficient division of labor and regional specialization

Free trade in competitive markets allows the world to more to the frontier of its production possibility curve

Notwithstanding its limitations, the theory of comparative advantage is one of the deepest truths in all of economics. Nations that disregard comparative advantage pay a heavy price in terms of their living standards and economic growth

Tariff – is a tax levied on imports Quota – is a limit on the quantity of imports. A tariff will tend to raise price, lower the amounts consumed and imported,

and raise domestic production of the covered good Tariffs crease economic inefficiencies. When tariffs are imposed, the

economic loss to consumer exceeds the revenue gained by the government plus the extra profits earned by producers.

Imposing a tariff has three effects: it encourages inefficiently high domestic production; it raises prices, thus inducing consumers to reduce their purchases of the tariffed good below efficient levels; and it raises revenues for the government. Only the first two of these necessarily impose efficiency costs on the economy.

The cheap foreign labor argument is flawed because it ignores the theory of comparative advantage. A country will benefit from trade even though its wages are far above those of its trading partners. High wages come from high efficiency, not from tariff protection.

Tariffs and import protection are an inefficient way to create jobs or to lower unemployment. A more effective way to increase productive employment is through domestic monetary and fiscal policy.