Economic Parables and Policies: An Introduction to Economics

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Trade makes both producers better off because trade allows for specialisation, and specialisation increases the total production available to be shared. The decision to specialise and the resulting gains from trade are based on comparative advantage, not absolute advantage. In summary, trade allows producers to exploit the differences in their opportunity costs of production. Each specialises in the production of the good for which they have the lower opportunity cost of production and, thus, a comparative advantage.


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This increases total production which makes the economic pie larger. Everyone can benefit. The additional production generated by specialisation is the gain from trade. The principle of comparative advantage applies to firms and countries as well as individuals. Recall, absolute advantage does not determine specialisation in production.

For example, Ian Thorpe may have an absolute advantage in swimming and lawn mowing. Ian Thorpe will be better off by using his time to do media commercials and trade for other services. He does this because he has a comparative advantage in media because of his swimming prowess and a comparative disadvantage in lawn mowing even though he has an absolute advantage in both.

Trade between countries is subject to the same principle of comparative advantage. Goods produced abroad and sold domestically are called imports. Goods produced domestically and sold abroad are called exports. Even if Australia has an absolute advantage in the production of both cars and food, it should specialise in the production of the item for which it has a comparative advantage.

Since the opportunity cost of food is low in Australia more and better land and high in Japan, Australia should produce more food and export it to Japan in exchange for imports of cars from Japan. While Australia gains from trade, the impact of trade on Australian car workers is different from the impact of trade on Australian farmers.

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A reduction to barriers to free trade improves the welfare of the importing country as a whole but it does not improve the welfare of the domestic producers in the importing country. For this reason domestic producers often lobby their governments to maintain or increase barriers to free trade.

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We will analyse the effects of trade barriers in Chapter 9. Read More. Upcoming Events. Tuesday, September 24, AM. National Voter Registration Day Celebration. North Korea: Perspectives from a Defector and Policymaker. Tuesday, September 24, PM. Caste Matters. Finance economists rarely asked the seemingly obvious though not easily answered question of whether asset prices made sense given real-world fundamentals like earnings.

Instead, they asked only whether asset prices made sense given other asset prices. But neither this mockery nor more polite critiques from economists like Robert Shiller of Yale had much effect. Finance theorists continued to believe that their models were essentially right, and so did many people making real-world decisions.

Not least among these was Alan Greenspan, who was then the Fed chairman and a long-time supporter of financial deregulation whose rejection of calls to rein in subprime lending or address the ever-inflating housing bubble rested in large part on the belief that modern financial economics had everything under control.


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One brave attendee, Raghuram Rajan of the University of Chicago, surprisingly , presented a paper warning that the financial system was taking on potentially dangerous levels of risk. What should policy makers do? Unfortunately, macroeconomics, which should have been providing clear guidance about how to address the slumping economy, was in its own state of disarray.

The result is that our possibilities of wealth may run to waste for a time — perhaps for a long time.

Frederic Bastiat

I like to explain the essence of Keynesian economics with a true story that also serves as a parable, a small-scale version of the messes that can afflict entire economies. To ensure that every couple did its fair share of baby-sitting, the co-op introduced a form of scrip: coupons made out of heavy pieces of paper, each entitling the bearer to one half-hour of sitting time.

Initially, members received 20 coupons on joining and were required to return the same amount on departing the group.


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As a result, relatively few people wanted to spend their scrip and go out, while many wanted to baby-sit so they could add to their hoard. But since baby-sitting opportunities arise only when someone goes out for the night, this meant that baby-sitting jobs were hard to find, which made members of the co-op even more reluctant to go out, making baby-sitting jobs even scarcer. In short, the co-op fell into a recession. Forty years ago most economists would have agreed with this interpretation.

Freshwater economists are, essentially, neoclassical purists. They believe that all worthwhile economic analysis starts from the premise that people are rational and markets work, a premise violated by the story of the baby-sitting co-op. And that would solve the problem: the purchasing power of the coupons in circulation would have risen, so that people would feel no need to hoard more, and there would be no recession.

Appearances can be deceiving, say the freshwater theorists. Yet recessions do happen. In the s the leading freshwater macroeconomist, the Nobel laureate Robert Lucas, argued that recessions were caused by temporary confusion: workers and companies had trouble distinguishing overall changes in the level of prices because of inflation or deflation from changes in their own particular business situation.

And Lucas warned that any attempt to fight the business cycle would be counterproductive: activist policies, he argued, would just add to the confusion. By the s, however, even this severely limited acceptance of the idea that recessions are bad things had been rejected by many freshwater economists. Instead, the new leaders of the movement, especially Edward Prescott, who was then at the University of Minnesota you can see where the freshwater moniker comes from , argued that price fluctuations and changes in demand actually had nothing to do with the business cycle.

Economic Parables And Policies An Introduction To Economics

Unemployment is a deliberate decision by workers to take time off. Put baldly like that, this theory sounds foolish — was the Great Depression really the Great Vacation? And to be honest, I think it really is silly. Meanwhile, saltwater economists balked. Where the freshwater economists were purists, saltwater economists were pragmatists. While economists like N.

So they were willing to deviate from the assumption of perfect markets or perfect rationality, or both, adding enough imperfections to accommodate a more or less Keynesian view of recessions. And in the saltwater view, active policy to fight recessions remained desirable. They tried to keep their deviations from neoclassical orthodoxy as limited as possible. This meant that there was no room in the prevailing models for such things as bubbles and banking-system collapse.

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Even so, you might have thought that the differing worldviews of freshwater and saltwater economists would have put them constantly at loggerheads over economic policy. Somewhat surprisingly, however, between around and the disputes between freshwater and saltwater economists were mainly about theory, not action. They believed that monetary policy, administered by the technocrats at the Fed, could provide whatever remedies the economy needed. We did it.

And as long as macroeconomic policy was left in the hands of the maestro Greenspan, without Keynesian-type stimulus programs, freshwater economists found little to complain about. View all New York Times newsletters. It would take a crisis to reveal both how little common ground there was and how Panglossian even New Keynesian economics had become.

Take, for example, the precipitous rise and fall of housing prices. Some economists, notably Robert Shiller, did identify the bubble and warn of painful consequences if it were to burst. Yet key policy makers failed to see the obvious. How did they miss the bubble?

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To be fair, interest rates were unusually low, possibly explaining part of the price rise. And the finance theorists were even more adamant on this point. The bidding process is very detailed. Indeed, home buyers generally do carefully compare prices — that is, they compare the price of their potential purchase with the prices of other houses.

But this says nothing about whether the overall price of houses is justified. In short, the belief in efficient financial markets blinded many if not most economists to the emergence of the biggest financial bubble in history. And efficient-market theory also played a significant role in inflating that bubble in the first place.

Now that the undiagnosed bubble has burst, the true riskiness of supposedly safe assets has been revealed and the financial system has demonstrated its fragility. More than six million jobs have been lost, and the unemployment rate appears headed for its highest level since So what guidance does modern economics have to offer in our current predicament?



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