∙ Comparative advantage – A situation when a country can produce a good or service at a lower cost than others can.
∙ Absolute advantage – A situation when a country can produce more of a good than others with a given amount of resources.
∙ If a country has comparative advantage in a good or service, it should specialize in it (produce that good).
∙ Gains from trade – Resulting increase in welfare in both the countries due to trade between them.
∙ When both countries trade:
o Total production is higher
o Consumption of both countries increases
∙ A country or a producer can know if they have a comparative advantage in a good or service by comparing the costs of inputs and the market price of different goods they can produce. They should specialize in the good which gives them the most profit.
∙ Factors influencing cost of production:
o Natural resources and climate – Climate and natural resources affect the cost of producing goods,
especially food. It also effects the costs of transporting goods once they are produced. For example, a country with access to seaports has a lower cost of
o Factor endowment – A country has comparative advantage at certain goods due to its abundance in certain factor of production:
A country with a lot of land relative to its
population can have a comparative advantage in
activities which use a lot of land like grazing cattle.
A country with a lot of capital can have a
comparative advantage in activities which use a lot of capital like producing electronics. Don't forget about the age old question of How does the federal reserve affect monetary policy?
A country with a lot of labor can have a comparative advantage in activities which use a lot of labor like producing shirts.
o Technology – At a given time, a technology which has been developed in a certain country gives a country a temporary comparative advantage in the good which is affected by the technology. When this technology spreads to other countries, the advantage is gone.
∙ Incomplete specialization – No country produces just one good because: Don't forget about the age old question of Why is inflation a tax?
o Trade between two nations is not perfectly free. This means, specialization is limited by trade agreements which are dependent on issues like national security, traditions, etc.
o Even if there is free trade, countries don’t specialize completely due to differences in different regions within the country. Due to the differences, each region
produces the good which has the lowest opportunity cost. If the country needs more of a good produced in one of its regions, it can import the remaining amount from other countries.If you want to learn more check out What is pauli's exclusion law?
∙ Imports – Goods and services produced in foreign countries and consumed in the domestic country.
∙ Exports – Goods and services produced in the domestic country and consumed in a foreign country.
∙ Autarky- An economy which is self-contained and doesn’t participate in trade with any other economy. An autarky doesn’t import or export. Everything is consumed and produced domestically.
∙ When an autarky is open to trade, it can become a net-exporter or a net-importer of a good depending on whether the domestic price is higher or lower than the world price of that good.
∙ When the world price for a good is lower than the domestic price, the domestic price falls and becomes equal to the world price. The quantity demanded by the domestic consumers increases and the quantity supplied by the domestic producers falls. The difference between them is made up by importing the good from other economies.
∙ When the world price for a good is higher than the domestic price, the domestic price rises and becomes equal to the world price. The
quantity demanded by the domestic consumers decreases and the quantity supplied by the domestic producers rises. The difference We also discuss several other topics like What are borderless diseases?
between them is exported to other economies.
∙ Becoming a net-exporter or net-importer increases the total surplus of the economy.
∙ In an economy which exports a good, the producer surplus increases and the consumer surplus decreases. However, the increase in
producer surplus is more than the decrease in consumer surplus and hence the total surplus increases.
∙ In an economy which imports a good, the consumer surplus increases and the producer surplus decreases. However, the increase in
consumer surplus is more than the decrease in producer surplus and hence the total surplus increases.
∙ Demand and supply shift when the number of consumers and producers change respectively. When an autarky opens up for trade, it can affect the world price of a good depending on the number of consumers and producers of the good in the economy. If the economy has a lot of consumers and/or consumers, it will affect the world price of that good. If the economy is small, it won’t affect the world price. ∙ Trade is restricted because of the following reasons:
o Global politics
o Protecting people who lose surplus due to trade, i.e., consumers in case of exports and producers in case of imports
∙ Protectionism - A policy that limits trade.
∙ Trade liberalization – A policy that reduces trade restriction. ∙ Tariff – It is a tax on goods that are imported.
∙ Tariff causes deadweight loss and leads to inefficient market. ∙ Tariffs are introduced in order to protect domestic producers. ∙ Tariffs increases producer surplus but decreases the consumer surplus as the imports fall.
World price after tariff Old world price
∙ An import quota is a limit on the quantity of a good that can be imported. It has the same effect as a tariff.
∙ Instead of government revenue, there is a quota rent which are the profits earned by foreign firms or governments to whom the right to import a good into the domestic economy is given.
∙ Private costs – Costs that fall directly on the economic decision maker. ∙ External costs – Costs imposed on someone (without any compensation) other than the person who caused them.
∙ Social costs – Private cost + External cost
∙ Private benefits – Benefits that accrue directly to the economic decision maker.
∙ External benefits – Benefits that accrue to someone (without any compensation) other than the person who caused it.
∙ Social benefit- Private benefit + External benefit
∙ Externality- A cost or benefit imposed on someone (without compensation) other than the person who caused it.
∙ Positive externality = External benefit
∙ Negative externality = External cost
∙ Production externality – Externality that occurs due to the production of a good or a service.
∙ Consumption externality- Externality that occurs due to the consumption of a good or service.
∙ Due to an externality, there is a deadweight loss in the market and it becomes inefficient.
MCsocial S=MC private
D=MB private ∙ In case of a negative externality (either consumption or production), too much of a good or service is produced which leads to deadweight loss.
∙ In case of a positive externality, too less of a good or a service is produced which also leads to a deadweight loss.
∙ Private solutions to Externalities: Coase theorem - If there is an externality, individuals can reach an efficient equilibrium through private exchanges if we assume there are zero transaction costs. ∙ Public solutions to externalities –
o Tax and subsidy- A negative externality can be countered using a tax which solves the problem of over-consumption and gets the market back to an efficient equilibrium. Such taxes are called Pigovian taxes. A positive externality can be countered using a subsidy which solves the problem of under-consumption and gets the market back to an efficient equilibrium.
However, setting the taxes and subsidies at right level is difficult and if the tax or subsidy is not set correctly, the
resulting market is inefficient as well.
o Quotas and tradeable allowance- Quotas can be used to limit the quantity of the good’s consumption or production. However, this doesn’t make the market efficient as well. However, a tradeable allowance, which is a production or consumption quota which can be traded, allows different producers to trade their quotas which then creates a market which is efficient.
∙ Excludable goods- Goods whose use can be prevented by people who have not paid for it.
∙ When a good is excludable, the sellers of the good can set a price on the good and can prevent its consumption. ∙ Rival good – A good which when consumed by one person, decreases or prevents the ability of another person to consume it.
∙ Most goods are rival as when one person consumes it, the other can’t.
∙ Private goods- Goods that are both excludable and rival. ∙ Private goods (jeans, food, etc.) – Rival and Excludable
∙ Public Goods (streetlights, national defense, etc.)- Non-rival and non-excludable
∙ Common resources (fish, forests, wildlife, etc.) – Rival and non-excludable
∙ Artificially scarce goods (movies in theatres, songs, etc.) – Excludable and non-rival
∙ Markets aren’t efficient in allocating public goods and common resources as the price charged doesn’t involve the actual costs and benefits. The problem of allocating public goods efficiently is the free-rider problem.
∙ The free-rider problem is the problem of undersupply of a public good due to its non-excludability. When a good is non excludable, it is difficult for sellers to make profit from its sale. As profits are hard to make, there is an undersupply of these goods in the economy.
∙ Solutions to free-rider problem:
o Social norms- In case of a free-rider problem, people enjoy benefits of a good without paying for it. However, we can impose costs on those people by using social norms which try to get people to act in the interest of the society. Examples of these costs can be guilt, disapproval, or conflict with the society.
o Government provision – The government can provide public goods which otherwise could have been
undersupplied, if provided by the private sector. It supplies that amount of the good where the marginal social benefit to the consumers equals the cost of the good. When it is possible to make the good excludable, the people can pay for it, for example tolls and bus fares. When the good or service is used by everyone (national defense, police, etc.) it is paid for by tax revenue of the government.
o Assigning property rights – A public good can be made more excludable by assigning property rights to people.
The public goods like ideas and knowledge can be made more excludable using patents and copyrights.
∙ Common resources are overconsumed.
∙ Tragedy of the commons – It is the problem of the depletion of a common resource due to a rational individual consumption but an inefficient collective overconsumption. ∙ Solutions to tragedy of the commons:
o Social norms- In a society, there may be some norms which can prevent from overconsuming a common resource.
o Government regulation- In places where social norms are not enough, bans and quotas can be set by the government to prevent overexploitation of the common resource. In countries where there are enough
resources to enforce bans and quotas, it is a very
effective method. In poorer countries, bans and quotas have been very ineffective.
o Privatization- Since private goods are effectively allocated by the markets, it is beneficial if the common resource is also privatized, i.e., its non-excludability is removed. By doing this, the owners of the common resource can make sure that it isn’t overused.
o Tradeable allowance- In this method, the common resource is allocated to people. After this, their share of the resource can be bought or sold. This ensures that the resource is allocated to the people with the highest willingness to pay and lowers the quantity in the market to the efficient level. Now these people have the
incentive to make sure the resource is not overused. TAXES
∙ Governments use taxes to:
o Raise their revenue which can be used to fund public projects like roads and schools.
o Change the behavior of people by reducing the demand for certain undesirable goods like tobacco, alcohol, etc.
∙ A tax creates inefficiency in the market but the revenue from the tax can be used to fix another inefficiency. ∙ A tax creates two types of inefficiencies:
o Deadweight loss: Difference between the loss of surplus to taxpayers and the tax revenue. The more elastic are the demand and supply curves in the
market, the more deadweight loss occurs.
o Administrative burden: The costs associated with implementing a tax. It includes the time and money spent by the government and the taxpayers during the implementation of the tax.
∙ Tax revenue = Tax per unit * Number of units
∙ Raising the tax rate first increases the revenue, then reaches a maximum and then decreases the revenue. The point at which the tax revenue is maximum depends on the elasticity of supply and demand. The more elastic are the curves, the quicker the point will be reached.
∙ Incidence describes the person who bears the burden of any tax. ∙ In the market, the side (consumers or producers) with the more inelastic curve will bear a higher burden of the tax.
∙ Policy-makers don’t have the power to redistribute the tax burden between consumers and producers. However, they have the power to change the relative economic incidence of the tax burden on the rich and the poor.
∙ Taxes are of three types:
o Proportional (Flat tax) – A tax that takes the same percentage of income from all the people who pay the tax.
o Progressive- A tax that only takes a smaller percentage of poor people’s income, but a larger percentage of the rich people’s income. The poorer people owe a smaller dollar amount of tax as compared to the richer people.
o Regressive- A tax that takes a larger percentage of poor people’s income and a smaller percentage of rich people’s income. ∙ Incomes taxes are mostly progressive taxes whereas sales tax is regressive.
∙ Sales tax reduces deadweight loss as there is no administrative burden, however it takes a higher proportion of the income from the poor people.
∙ An income tax is generally progressive however, it has high administrative burden and hence more deadweight loss. ∙ An income tax is a tax on the individual or corporate earnings. ∙ Marginal tax rate- The tax rate on the last dollar of your income. ∙ Capital gains tax- Tax on income earned by buying investments and selling them at higher prices.
∙ Payroll tax- Tax on the wages paid to an employee.
∙ These taxes are collected to pay for Social Security and Medicare. Half of the tax is paid by the employee and the other half by the employer. ∙ Differences between payroll tax and income tax in the US: o Payroll tax is used to pay for specific government programs, namely Social Security and Medicare while the income tax goes into the general government revenue.
o Payroll tax isn’t paid on other sources of income like investments or gifts whereas income tax is.
o The Social Security part of payroll tax applies only till the annual income limit of $127,000 (in 2017). That means people who earn more than $127,000 pay less in payroll taxes expressed as a percentage of their income.
∙ Corporate income tax – It is an income tax paid by corporations. It is also progressive in the US. Although the corporations are legally responsible to pay this tax, they can shifted to shareholders by giving
lower dividends, employees by giving lower wages, or customers by charging higher prices.
∙ Sales tax – Tax charged on the value of the good or service being purchased.
∙ Excise tax- Sales tax on specific goods or services.
∙ Property tax- Tax on the estimated value of a property such as a house.
∙ Gross domestic product (GDP) – Sum of market value of all final goods and services produced within a country during a given period of time. ∙ The government has to balance its spending and revenue eventually. ∙ Revenue collected by the government can either be used directly at that time or can be saved to pay for future expenditures.
∙ Discretionary spending – Public expenditure that has to be approved every year. In the US, most of the expenditure of the government isn’t discretionary. Spending on defense, construction, research, etc. are examples of discretionary spending.
∙ Entitlement spending – Public expenditure that entitles people to benefits due to their age, income, or other factor. It is non discretionary.
∙ Budget deficit- The difference between the government expenditure and government revenue.
∙ Budget surplus – The difference between the government revenue and government expenditure.
∙ Budget revenue and surplus is generally expressed as a percentage of the economy’s GDP.
∙ Governments must try to balance their budget. If they spend more than they earn, they have to borrow and eventually have to pay interest on the borrowed money. The more time they take to repay the loan, the more interest they have to pay.
∙ However, it’s very difficult to balance the budgets every year because the planned revenue and the planned expenditures may not equal each other due to unexpected events like an economic recession.
∙ In an economic recession, people start to lose jobs and companies earn lower profits which means the government’s tax revenue decreases. It also has to increase its spending on helping unemployed people. As such the government has to decrease its discretionary spending. However, some argue that the discretionary spending should be increased during in order to help the economy bounce back.
∙ Therefore, governments should try to balance the budgets over the business cycle. It allows the government to have surplus when the
economy is doing well and deficits when the economy is poor. This gives a balance of the budget in the long run.
∙ However, this is also difficult as policy-makers are pressurized from the public to spend when the economy is doing well.
∙ Behavioral economics- A field of economics which draws on ideas from psychology to expand models of individual decision making. ∙ People decide to do one thing in the future, but when the time comes, they do some other thing. This can be explained using a principle of people holding two inconsistent sets of preferences:
o The first set holds what we like to do or want in the future. o The other set holds what we actually want or do in the future. ∙ Time inconsistency- A situation in which we change our minds about what we desire because of the timing of the decision.
∙ Our future-oriented set decides what we want, however when the time comes, the present-oriented set takes charge and decides what we want.
∙ Time inconsistency explains the battle between these two sets of ourselves. A person who is time inconsistent is neither rational or irrational. Instead, the two sets of ourselves are trying to achieve their goals.
∙ We can solve the problem of the competition between the two sets by using a commitment device.
∙ Commitment device- A mechanism that allows people to restrict their choices by themselves to make it easier to stick to a plan.
∙ A deadline is an example of a commitment device.
∙ People don’t always weigh benefits and costs rationally. Two common mistakes people make are:
o Failing to ignore sunk-costs
o Undervaluing opportunity costs
∙ The above-mentioned mistakes result from cognitive bias. Our brains aren’t built to think rationally in certain situations.
∙ Sunk cost- Costs that have already been incurred and can’t be recovered.
∙ People consider sunk costs in deciding what to do next even though they can’t be recovered anymore. This is called sunk-cost fallacy. ∙ For example, when you pay a ticket to watch a movie and you realize it isn’t a good one, you still watch the entire movie since you take the sunk cost into calculations. You feel that the money would be wasted if you walk out instead to spend your time doing something else.
∙ People also undervalue the opportunity cost of something when the alternatives of that thing aren’t clear. For example, when you decide to buy a jacket with $100, and you think about other items on which you could spend the $100 on. However, the opportunity cost isn’t very clear and after thinking hard the alternatives may seem distant while the jacket is immediate. So, you decide to buy the jacket and hence you may undervalue the opportunity cost of it.
∙ People undervalue opportunity costs of nonmonetary things like time. In the movie example, you also undervalue the opportunity cost of the time you are wasting watching this terrible movie. You could have spent the time doing something else.
∙ Implicit cost of ownership is another nonmonetary opportunity cost that isn’t taken into consideration by people. Everything we own has an opportunity cost as we can choose to sell it if the benefits from them are low. However, people don’t sell them as people value things more that they own.
∙ A good is said to be fungible if it is easily exchangeable and substitutable.
∙ Money is an example of a fungible good.
∙ Sometimes, people don’t behave as if money is fungible, which leads to irrational decisions.
∙ When people divide their savings into different categories, it helps them realize their savings goals. However, in some cases, it can be very costly as people forget that money is fungible, i.e., easily exchangeable and substitutable.
∙ For example, if you have $1,000 in your savings account and you keep it aside for doing something in the future. However, before you do that thing, you encounter some unexpected spending for which you could either borrow and pay the interest or take some money from your savings and lose interest on that money. Most of the people would actually borrow money even though you lose more money (as interests on borrowed money is always higher) as people don’t want to spend their savings that is reserved for doing something else. They forget about money’s fungibility and hence act irrationally.
∙ Game – A situation with at least two people in which they have to think strategically.
∙ Game theory- Study of how people behave strategically under different situations.
∙ A person is said to be behaving strategically if he/she is acting to achieve a goal by anticipating the relationships between his/her decisions and others’ decisions.
∙ When the trade-offs faced by one person is dependent on other people’s choices, behaving rationally involves behaving strategically. ∙ All games have three features:
o Rules – Define actions allowed in the game. In real life, rules can be something like laws which constraint people’s behavior. o Strategies – Plans followed by the players to achieve their goals. o Payoffs- Rewards resulting from particular actions. Payoffs can be monetary or nonmonetary.
∙ Prisoner’s dilemma – A game of strategy in which two people make rational choices which leads to a less than ideal result for both people. ∙ In the prisoner’s dilemma situation, two people are arrested on suspicion of committing a serious and a minor crime. The policeman holds them separately and explains to both of them that he lacks evidence to convict either of them of the serious crime but has the evidence to convict both of them of the minor crime. Hence, he offers a deal to both of them. If one confesses and the other doesn’t the first person will get 1 year in prison while the other gets 20 years. If both don’t confess, they both get 2 years in prison for the minor crime. If both confess, they both get 10 years each in prison. So whatever the second person does, the first person is always better off if he confesses. The same logic is used by the second person and hence they both confess and get 10 years in prison which is obviously not the ideal result for both. If both people had an opportunity to cooperate, they would avoid this outcome by not confessing and getting away with only 2 years each, which is the ideal situation for both.
10 yrs 10 yrs
1 yr 20 yrs
∙ Dominant strategy – It is the strategy that a person should choose no matter what the other players choose.
∙ In the prisoner’s dilemma, confessing is a dominant strategy. ∙ Some games like rock-paper-scissors don’t have a dominant strategy since it is a simultaneous move game, i.e., both players move at the same time. Hence it is very hard to predict your opponent’s next move. ∙ Nash equilibrium – Equilibrium reached when all the players in a game choose the best strategy they can, given the choices of all the other players. It can also be defined as a situation when given the consequences, the players have no regrets about their decisions. ∙ In rock-paper-scissors, there is no Nash equilibrium as the players always have regrets about their decisions and have an incentive to change them.
∙ In the prisoner’s dilemma, there is a Nash equilibrium where both confess as that is the situation where nobody has any regrets about their decisions.
∙ In prisoner’s dilemma, the equilibrium isn’t beneficial for the players. This negative-negative outcome is called noncooperative equilibrium as the participants don’t cooperate and pursue their individual interests only.
∙ Some games (like driving on a road) have a positive-positive outcome even when the players are after their own self-interest.
∙ Some games like driving can have two equilibria. If both players drive on either right or left, they both have the highest payoffs. This game
also doesn’t have a dominant strategy as the best decision depends on what other players do.
∙ If players could coordinate, they would be better off. However, coordinating can be a problem as the players have a strong incentive to defect.
∙ One solution for this problem is to create a punishment for defecting which outweighs the incentive of not cooperating. This is an example of a commitment strategy which is an agreement to submit to a penalty for defecting from a given strategy.
∙ When players in a game cooperate, it can benefit everyone. However, preventing players from cooperating can help the public in some cases. ∙ Repeated game- A game that is played more than once. ∙ In repeated games, don’t need commitment strategies to reach a mutually beneficial equilibrium.
∙ Tit-for-tat- A strategy in which a player in a repeated game does the same thing that his/her opponent did in the previous round. ∙ Sequential games- Games in which one player has to make a decision before the other.
∙ In sequential games, the strategy is to work backwards using backward induction to figure out the best strategy. Backward induction is the process of analyzing a problem in reverse, starting from the last choice and working backwards from there, to determine the best strategy.
∙ A game in which the player who chooses first gets a higher payoff is said to have a first-mover-advantage. This advantage is very important in one round sequential games. For example, if a company offers the labor union 1% of its surplus first, then the union has to decide whether to accept the decision or reject it and shut down production which gives both the company and the union 0 surplus. Realizing that 1% is better than nothing, they have to accept the offer.
Company Labor union Yes Company: 99%
What should we pay our employees? Accept or reject
No Company: 0%
∙ If the union move first, it could demand 99% of the surplus and the company would pay that as it is better than nothing.
∙ Ultimatum game: It is a game in which one player makes an offer and the other player has the choice of whether to accept or reject. ∙ Repeated play can change the outcome in sequential games by reducing the first-mover advantage.
∙ In repeated sequential games, the person who has the most patience has more bargaining power and receives a better payoff.
∙ In wage negotiations, if each player knows how patient other is, they don’t play all rounds, but the company offers the split which would eventually occur if both players played all rounds. In this case, the surplus is divided in proportion to each player’s patience.
∙ Complete information – It is a situation in which all economic actors are fully informed about the choices that they face.
∙ However, people rarely have complete information. They often have good information to make acceptable choices. Sometimes people are underinformed and they make decisions which they will regret later.
∙ Information asymmetry- It is a situation when one person in a transaction knows more than the other.
∙ An example of information asymmetry occurs when you take your car to the mechanic. A mechanic can tell you that something needs to be repaired even though it is working properly. However, you still pay for it as you have very little information. Hence, the mechanic may succeed in making more money by charging you money for some repair you didn’t need.
∙ If the incentives of the people are aligned, information asymmetry doesn’t create a problem.
∙ Adverse selection – A situation in which buyers and sellers have different information about the quality of a good or the riskiness of a situation, which results in failure to complete some transactions that would have been completed if both sides had the same information.
∙ Information asymmetry also causes problems after selection has occurred and the two parties have entered into an agreement. It is called a principal-agent problem. In a principal agent-problem a person called principal entrusts someone else (called an agent) with a task.
∙ Moral hazard- Tendency of people to behave in a riskier way when they don’t face full consequences of their actions. Moral hazard can be avoided by correcting information asymmetry through better monitoring.
∙ Sometimes, being underinformed is better as the costs of obtaining information are high.
∙ Screening- Taking action to reveal private information about someone else.
∙ Signaling- Taking action to reveal our own private information. ∙ Signaling can be positive or negative. A successful positive signal must not be easily faked.
∙ Information asymmetry problem can also be solved if people don’t risk losing their reputation by using their information or lack of others’ information to take advantage of them.
∙ Statistical discrimination- Distinguishing between different choices by generalizing based on observable characteristics in order to fill in the missing information.
∙ Governments can solve the problem of information asymmetry by: o Providing missing information to less-informed parties o Requiring more-informed parties to reveal more information