Nancy can produce 4 pizzas or 2 beers in an hour.

Bob can produce 6 pizzas or 2 beers in an hour.

Which one has a comparative advantage producing beer?

The opportunity cost of producing a beer is lower for Nancy. We can tell just by looking, because they can both produce the same beers per hour (2). But in that same amount of time, Nancy would only sacrifice 4 pizzas, while Bob would sacrifice 6. Also, the ratio of beers/pizza she can produce (2/4) is greater than the ratio of beers/pizza for Bob (2/6). Nancy has the comparative advantage producing beer.

Now, suppose things change:

Nancy can produce 4 pizzas or 2 beers in an hour.

Bob can produce 8 pizzas or 8 beers in an hour.

Which one has a comparative advantage producing beer?

The ratio of beers to pizzas for Nancy is 1/2. The ratio for Bob is 1. Bob's ratio of beer to pizza is higher, so we can conclude he has a comparative advantage producing beer.

Let's look at it in terms of opportunity cost. If you have a ratio of beer to pizza with 1 in the numerator, that tells you what you give up for one unit of beer. The opportunity cost is the number in the denominator.

Remember: in a ratio, the numerator is the top, the denominator is the bottom.

For Nancy, we have a ratio of beers to pizzas that already has 1 in the numerator. The ratio is 1/2. So we can conclude that her opportunity cost is 2 pizzas (because 2 is in the denominator).

What about for Bob? We have his ratio of beers to pizza, which is 8/8. If we convert this to an equivalent ratio with 1 in the numerator, we get 1/1. So the opportunity cost to Bob is 1 pizza.

His opportunity cost is lower than hers. This confirms what we already know, that he now has a comparative advantage producing beer.

How do you tell if someone has a comparative advantage producing something? If the ratio of good X to good Y is greater for Person A than for Person B, then Person A has a comparative advantage producing good X.

Alternatively, you can ask, what is the opportunity cost for person A of producing one unit of good X. You transform the ratio of X/Y for each person so that 1 is in the numerator, and you ask who has the smallest number in the denominator.

Note: when you compare two ratios with the same numerator, the one with the smaller denominator will always be the bigger number. Because if you divide by a bigger number, you get a smaller result. So 1/3 is smaller than 1/2, 1/4 is smaller than 1/3 etc.

This is why you can make the calculation either way--asking whether the ratio of X to Y is bigger for Person A is the SAME as asking if the opportunity cost of X in terms of Y is smaller.

Now, let's go over points about the slope of a production possibilities curve. In the graph below, the opportunity cost is has an increasingly negative slope. It starts out near horizontal and becomes nearly vertical. Note how the opportunity cost of beer goes up as you produce more beer. The opportunity cost of going from 1 beer to 2 is only .2 pizzas (the difference between 7 and 7.2) But the opportunity cost of going from 6 beers to 7 beers is 1.2 pizzas (the difference between 4 and 5.2). The first beers you produce are "cheaper" and their cost increases as you approach the maximum number of beers. This reflects the principle of increasing cost--in general, economists assume a "low hanging fruit" principle. People do the most efficient or productive tasks first.

Frank and Bernanke praise markets and criticize "central planning" or regulation.

Their main argument is that markets are more efficient--they do a better job matching the needs of buyers and sellers.

Pay attention. This is a historically momentous argument. It's an argument not only about capitalism versus socialism, but also about "unregulated" capitalism vs. "free market" capitalism.

In this chapter, Frank and Bernanke want to persuade you that regulations that restrict prices--such as rent control or minimum wages, hurt many more people than they help.

It's important for you to fully understand their argument, and also to gain some critical perspective on it.

First, what is a market?

many buyers and sellers, a price that is flexible

think of an auction (e.g. E-bay).

The buyers represent the "demand side."

The sellers represent the "supply side."

Take a look at Figures 4.1 and 4.2 in the text--they show you a hypothetical relationship between the price of something and the quantity that will be demanded or supplied.

These supply and demand curves are drawn with the assumption that everything is fixed except the relationship between price and quantity--income remains constant, technology remains constant, the prices of other goods and services remain constant. Etc.

Market "logic" applies to many situations that are metaphorical markets.

E.g. the demand for being an economics major, vs. the supply of services necessary for being an economics major.

Equilibrium price and quantity is where buyers and sellers are in perfect agreement;

quantity demanded equals quantity supplied. Markets "clear." See Figure 4.3

What does "equilibrium" mean? A balance, a tendency to move towards something and then stay there...if quantity supplied exceeds quantity demanded, prices tend to fall. If quantity demanded exceeds quantity supply, prices to increase. If quantity supplied equals quantity demanded prices tend to remain the same.

Is the "equilibrium" outcome of supply and demand always efficient?

What does efficiency mean? Nothing wasted, nothing you could do to make someone better off without making someone else worse off. (Note, this is a pretty narrow definition of efficiency).

Is the free market efficient? Yes, under certain conditions. I'll list 4.

1. If the market is perfectly competitive. So many buyers and sellers that no one individual can affect the price (no monopoly or oligopoly). What are some examples of markets in which a seller has a lot of "market power"?

Microsoft.
Coca-Cola.

2. "Consumer sovereignty" Each of these buyers and sellers has the information they need to make the best decisions, e.g. every buyers know the quality of the product. What are some examples of a violation of consumer sovereignty?

Corporate accounting fraud--shareholders thought they were buying a share of a company that had made X amount of profits, but actually the company had made only Y amount (Y was generally considerably less than X).

3. There are no "spillover" effects--or unintended consequences for third parties. Examples of spillover effects:

environmental pollution--toxic waste, air pollution, global warming

social pollution--disruption of neighborhoods through sudden gentrification, or deterioration of living standards for workers through abrupt declines in wages

cultural and moral pollution--violation of moral values

4. Everyone affected by markets has access to or ability to participate in them. (This relates to former point--those who can't participate have no "voice" and are likely to bear the brunt of "unintended consequences").

Economics is not just about the market. It is about the market and the family and the community and the state. We need to look at the logic of markets in this larger context. This comes back to "capitalism for consenting adults." How much of your life do you want to be ruled by market logic?

Let's go back to the workings of supply and demand. What happens when regulation restricts prices? The example of rent control. Figure 4.7.

Housing shortages, which in turn lead to deterioration of housing quality. But what are the spillover effects? Who is hurt, who is helped?

Another example of interference with supply and demand is zoning restrictions. One purpose of these is to "protect property values."

These have the effect of artificially raising the price of housing. Result--increased homelessness even while buildings lie empty.

So far, we've only looked at movements along supply and demand curves, along with forms of "interference" with the tendency to move toward "equilibrium."

Remember that we drew those supply and demand curves under the assumption that "all else was equal"

Now let's allow some other things to change--e.g. income, technology, prices of other goods.

There's an important distinction between movement along a supply or demand curve and a shift of one of these curves. Figures 4.9 ("An Increase in the Quantity Demanded Versus an
Increase in Demand") and 4.10  ("The Effect on the Skateboard Market of an Increase in the Price of Fiberglass") focus on shifts in supply and demand curves, which are distinct from movement along the curves. Shifts are brought about by factors other than price and quantity, factors which affect the relationship between price and quantity.

Some examples of factors that affect supply are technological change, change in the cost of an input, and weather. Some examples of factors that affect demand are a change in preferences, a change in income, or a change in the price of a substitute or a complement.

An increase in income usually leads to an increase in the quantity demanded of a good.

So, we call a good the demand for which goes up when income goes up a "normal" good.

But some goods you are going to buy the same amount of no matter what your income...

The brilliant example someone in class offered was, toilet paper.

Some goods you might buy less of as your income went up, because you are able to buy substitutes. For instance, you might buy fewer pinto beans because you start buying steak.

Or you might buy fewer t-shirts because you start wearing silk. We call a good the demand for which goes down when income goes up an "inferior" good.

It's really important that you be able to analyze, interpret, and graph shifts in supply and demand, so I want to focus on some particular figures in the text:

Figure 4.10. The Effect on the Skateboard Market of an Increase in the Price of Fiberglass

Figure 4.12. The Effect of Technical Change on the Market for Manuscript Revisions

Figure 4.13 The Effect on the Market for Tennis Balls of a Decline in Court Rental Fees

Figure 4.14. The Effect on the Market for Overnight Letter Delivery of a Decline in the Price of Internet Access

Figure 4.15 The Effect of a Federal Pay Raise on the Rent for Conveniently Located Apartments in Washington, D.C.

Figure 4.17 The Effects of Simultaneous Shifts in Supply and Demand

Don't try to memorize these graphs. Try to understand what's going on in them, so that you will be able to reason through the effects of a variety of changes on the relative position of these curves.