Class 3 - Comparative Advantage

Great Economists

Adam Smith - "An Inquiry into the Nature and Causes of the Wealth of Nations" 1776
David Ricardo - "Principles of Political Economy and Taxation" 1817
John Maynard Keynes (1883-1946) - "The General Theory of Employment, Interest and Money" 1936. 3 volume biography by Robert Skidelsky. Now compacted into a 1 volume summary. Ran British economic policy during WWII. One of the founders of the IMF.

Almost all economic worth knowing comes from these 3 economists. The rest is commentary. All were British. Smith was Scottish.

Adam Smith set up the idea that economic wealth is created by specialization, which requires trade. Human beings have a natural propensity to truck, barter and exchange. Therefore, they need to specialize. The desire to trade leads to the need to specialize. (Not the opposite.)

Now the question became: how do we facilitate trade. Smith: set up markets with incentives. People are primarily movitated by self love and the love/well-being of their close family and friends. (Marx's theory depended on the idea that people are just as concerned with everyone else as well.) To motivate the baker to bake bread, you need to appeal to his "self-love" and offer him something in return. Don't appeal to his altruistic side for the good of all mankind.

2002 book by Steven Pinker "The Blank Slate". Human psychology is not a blank slate. There are certain things in human nature that are a product of evolution and natural selection.

Adam Smith spent a long period of time as the tutor of a Scottish duke. He took him on a 2 year tour of Europe. During this tour, he was able to meet with many of the great minds of Europe of the time.

Ricardo's story is very different. Ricardo was a Jewish millionaire stock trader at a very young age. He got bored of that and became a politician. (Similar to the Kennedy story.) He was involved in the debate over the "Corn Laws". In Europe, they call cob corn "maize". When they refer to "corn", they mean any kind of grain. In those days in England, there were tariffs and quotas on grain, particularly French grain. It had to due with their dislike of Napolean. In 1815, Napolean was history. (In US today, we have quotas on sugar from Jamaica and West Indies. Also on Brazilian ethanol. Originally, they had a political motive, but in the end it expanded.) Motivation may be political, but the consequences are economic.

By limiting corn, land owners became richer, food prices went up, urban manufacturing wage rates went up, urban manufacturing profits went down.

Principle of Comparative Advantage

Paul Samuelson called the idea of comparative advantate one of the things that economists understand well, but most people don't.

Gains from Trade (to both trading countries):
1. Exports
2. Imports
3. Specialization
4. Opportunity costs

Pareto Optimal Transaction - voluntary trades will continue when both parties gain. When one party feels he's no longer benefitting, the voluntary trade will end. e. g. buying a Starbucks coffee.

Exports - some are invisible, such as education delivered to foreign students. Tourism is an Austrian export.

Specialization is based on opportunity costs (as defined by economists). See Mankiw's example in Ch 3 - based on Rogers and Hammerstein's play Oklahoma! The example has one country that has an absolute advantate in manufacturing both goods. And yet still they benefit from trade.

Slope of farmer's production frontier is -1/3.
Slope of rancher's production frontier is -1/2.

Class 2 - Basic Principles

See Financial Times - US Tyre Duty Sparks Clash
See The Economist article - It Still Pays to Study. A study by the OECD about the benefits of a college degree.

Ch 1 & 2 tonight. Then two weeks on Ch 3 (Int'l trade and theory of competitive advantage). Oct 5 will be the first exam. Some multiple choice (scantron) and some short answer.

Ten Principles of Economics

How People Make Decisions
1. People face trade-offs
2. The cost of something is what you give up to get it
3. Rational people think to the margin
4. People respond to incentives

How People Interact
5. Trade can make everone better off (Not trading may have been the downfall of the Neanderthals)
6. Markets are usually a good way to organize economic activity. (Usually is the key word here. Not an absolute. The health care debate is relevant here. In Great Britian, there is no open market for health insurance. Austrian health insurance provides government vouchers. Good doctors collect more vouchers and earn more. French system is similar to Austrian system, but with a form of copay.)
7. Governments can sometimes improve market conditions (see review of G. A. Cohen's book Why Not Socialism?. See also Isaiah Berlin. Governments sometimes have to step in because there are externalities. An externality is any effect on a non-market participant that has a cost or provides a benefit which is not paid for by that non-market participant. Research to develop a polio vaccine was a positive externality. Cigarette smoke is a negative externality. It has an external cost to others. Loud music is also a negative externality. Most important externality today is climate change. Copenhagen Convention is coming up. Evolutionary biologist: E O Wilson, expert on ants and sociobiology. Compared ants and humans. Humans have both a social and individualist side. Ants are completely social and altruistic. Marxism and Socialism are great theories, wrong species.)

How the Economy as a Whole Works
8. A country's standard of living depends on its ability to produce goods and services (fundamental question: what makes a country rich or poor. Jeffrey Sachs. Worldbank does serious research on economic policy. In porr countries, the marginal pay-off for an education dollar is higher for high school girls than for college boys.)
9. Prices rise when the government prints too much money (The Ben Bernanke question)
10. Society faces a short-run trade-off between inflation and unemployment (The Larry Summers/Christine Romer question. FT article: It's never too early to fear inflation. Question: will there be inflation and, if so, how much? We currently have some deflation, resulting from high unemployment. This inverse relationship is called the Phillips Curve.)

We'll focus on the last 3 points at the end of the semester.
GDP
Inflation
Banking, Federal Reserve

Chapter 2 - Propositions about which most economists agree
From Richard M. Alston, et al "Is There Consensus among Economists in the 1990s" in American Economic Review

See page 35

4. Fiscal policy is stimulative. Even McCain (or his economists) would agree to this, as would Bernanke (who was appointed by Bush and approved by a Republican Senate).
5. Don't restrict outsourcing. This is just like trade. It's either goods and services or people (through immigration). Trade takes advantage of comparative advantage.
6. US should eliminate agricultural subsidies. not popular in rural areas
7. Eliminate subsidies to pro sports facilities. This just makes the rich richer. See books and articles on sports economics by Allen Sanderson from U of Chicago. 1992 Olympics transformed the city of Barcelona. This is more typical for "second cities", not capital or main cities.
8. Balance the federal budget.
12. Minimum wage increases unemployment among young people
14. Effluent taxes are better than pollution ceilings. (A market-based system is better than command and control system.)

For next week: see pp 25-28 and then chapter 3.