Chapter 2, Continued - Foothill College



Chapter 2, Continued

V. Concerns about Free Trade

A. One characteristic of a lot of trade, especially when the countries vary greatly in wealth, is that “gains” (benefits to society) are spread out while “losses” such as failing domestic industries and the concurrent loss of jobs are usually “concentrated.”

In other words, a local area may become a ghost town, or a city may have to find a new industry to rely on for jobs and tax revenue, but the lower prices from cheap imports will allow a much broader range of people across the county enjoy somewhat more consumption. It is for this reason that anti-trade pressures can be applied by groups who feel they have endured concentrated losses, but there isn’t much organization among the broader population to fight for small but widespread gains in the form of lower-priced goods.

1. Solutions to remedy these concentrated losses: Fiscal or Monetary policy that is expansionary, and job-retraining programs.

B. Competition is assumed on both sides of the exchange for either good under the comparative advantage analysis.

C. Accurate prices are essential. This means externalities are incorporated into the cost structure.

D. Prices also must reflect true scarcity and demand in a given country. This means distortions in the price of a good are not introduced by the government propping up the industry.

“Protectionism”: efforts by governments to protect industries from competing imports. Recommended to read Ch 5 lec notes part I-B.

VI. Government Functions in the Economy – recommended to read “III. Roles of Government” in for more detail.

A. Provide a stable, reasonably well-enforced set of institutions and rules.

i. Institutions are described in II-F above

ii. Rules are established by Congress (the legislative branch of the government) and the many regulatory agencies. Regulators also bring court actions, have agency-specific penalty/fine authority, and non-governmental groups may access the court to redress violators of the rules.

B. Maintain and ensure a high degree of competition

Mainly the FTC (Federal Trade Commission) and the Justice Department have the authority to bring “antitrust” cases if they believe they have sufficient evidence of anticompetitive practices, such as:

i. Merging with, absorbing or otherwise eliminating the existence of a competitor, leading to the expansion of monopoly power for the offending firm.

ii. “Colluding” or acting in cooperation with a sufficient number of competitors that the coalition (“Cartel”) is acting like a virtual monopolist.

iii. Similar actions that tend to result in loss of quality or variety (consumer choice) for the product.

C. Correct for Externalities. From part II of the first class notes, “Sellers must bear the full cost of the products they sell and pass them on in the sale price.”

If there are costs in the production, distribution, or consumption of a good that are not covered by the producer, but instead must be covered by someone who is neither buyer nor seller, then a negative externality exists

D. Ensure Economic Stability and Growth

E. Identify and Provide Public Goods

F. Adjust for Undesired Market Results

i. Tax Policy; see II-H

ii. Farmers (and Agribusiness) in the U.S. and developed European countries receive subsidies from the government as protection from market share loss due to cheaper imports.

iii. Conduct constituting merit activities and production of merit goods are rewarded with government assistance

“Demerit” illegal or regulated goods and activities are punished or highly taxed.

Chapter 2 – Appendix A

VII. The Scientific Approach in Economics

A. A Significant Difference between Economics and many other sciences is that Economic theories cannot (usually) be tested in a laboratory, where the experimenter controls many influencing factors. Economic Theories can only be tested and verified if they actually hold true in real-world human behavior.

B. Economic research generally does not predict what any one person would do, since any large group will have individuals who respond in unexpected ways to a given change; rather, economics predicts what the group on average will do.

For Example, if the question is “How much of an impact on spending (Consumption=C) will result from a one thousand dollar increase in income (Income=Y). If 100 people have an extra thousand dollars each, and overall spending increases $80,000, we can estimate that the average person is spending 80% of their additional income.

The “Law of Large Numbers” justifies taking sample sizes that are not very small in number (like 10). In the above example, sample size is 100 people. The “Law” simply holds that irregularities will cancel each other out, and this occurs more reliably the larger the sample size, and the more the experiment is repeated.

C. Theories make linkages between observable phenomena. In economics this mostly refers to numerical data, such as the amount various individuals will increase “C” when they have $1,000 increase in “Y”. Theories contain three parts:

1. Variables – must be clearly defined in each theory

Variables can be of two kinds: Endogenous - explained by the theory, “C” in our example; and Exogenous - influence the other variable but not themselves explained in the theory, “Y” in our example.

There are other words, like independent and dependent that classify the two types of variables.

|C |Y |

|Endogenous |Exogenous |

|Dependent |Independent |

|Induced |Autonomous |

Often real economic models will take multiple exogenous variables to explain one endogenous variable.

Another Example:

A macro economist working for the Fed researching the effect of Interest Rates (IR) on spending by firms (I) might start with the simple equation: Y+X*IR=I. Then data on national Investment Spending over the course of several years, as well as interest rate data from the same time period, would be collected. The result in the formula will be an estimate of what Y and X are, therefore a policy recommendation for IR if there is a given optimal level of I.

In this model, I is dependent and IR is the independent variable. The relationship is called inverse since the variables correlate negatively.

The decision-maker often is an executive (micro) or politician (macro)

2. Assumptions

Most theories involve some elements of assuming how the world works, and many of these assumptions are accepted as they for the basis for most economic theorizing. Assumptions of utility maximization for consumers, profit maximization for firms, inputs leading to the production of outputs, all are mostly true, and tend to hold often enough that theories based on these assumptions are not inherently flawed.

3. Predictions

The prediction, or hypothesis, that is deduced from the theory is a conditional (if, then) statement.

D. A Function is a formal relationship between two or more variables. If an increase in the independent variable leads to an increase in the dependent variable, the relationship is “positive” (If the two variables were plotted on two-dimensional graph, the slope of the line would be positive, going up and to the right).

If an increase in the independent variable leads to a decrease in the dependent variable, the relationship is “negative” (If the two variables were plotted on two-dimensional graph, the slope of the line would be negative, going down and to the right).

Not only do these functions tell us the direction (positive or negative) but also the magnitude, the numerical size of the impact a change in one variable has on the other.

E. Economic Models

In the scientific process, economists must make abstractions from reality, leaving out many details in order to focus on those believed be have the most influence on the dependent variable. The result is a model, involving (one or more) exogenous and (one) endogenous variables.

F. Statistical Analysis

1. As a primarily a non-laboratory science, economic data is accumulated from actions (behavior) in the real world, in markets, by households (consumption choices), by firms (production choices), and by governments (regulatory, taxation/ spending choices). Much of this data is publicly available. For more specific inquiries, the economist or researcher will have to have specific data, such as a firm’s various production expenditures.

2. Accept or Reject: In working with economic models (and other sciences involving statistics) the decision of whether to accept or reject a result is based on a “confidence interval,” or the “cutoff point” which are econometric terms. A confidence interval of 5% means that the likelihood the experiment’s results could be caused by chance are no more than one in 20. A higher level of confidence would be the 1% level, meaning that the likelihood the experiment’s results could be caused by chance are no more than one in 100. If the independent/exogenous variable meets the 95% or 99% confidence level, it is said to be statistically significant. In the vocabulary of chapter 3, whether the independent/exogenous variable does or does not make a “significant” difference is a positive rather than a normative question.

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