# Principles of Economics - Gregory Mankiw ![[Principles Of Economics by N. Gregory Mankiw (z-lib.org).pdf]] ## Resources are scarce: people face trade-offs. ## Opportunity cost: the cost of something is what you give up to get it. ## People respond to incentives. ## Good economists think in terms of marginal changes. - ## Trade is a positive sum game Every day, we rely on many people, most of whom we have never met, to provide ourselves with the goods and services that we enjoy. Such interdependence is possible because people trade with one another. Those people providing us with goods and services are not acting out of generosity. People provide us with the goods and services they produce because they get something in return. **Absolute and comparative advantages** To understand why people choose to depend on others for goods and services and how this choice improves their lives, let’s examine a simple economy. Imagine that there are only two goods in the world: meat and potatoes. And there are only two people: a cattle rancher named Ruby and a potato farmer named Frank. Both Ruby and Frank would like to eat a diet of both meat and potatoes. - **Absolute advantage** One way to answer the question about the cost of producing potatoes is to compare the inputs required by the two producers. Economists use the term absolute advantage when comparing the productivity of one person, firm, or nation to that of another. The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good. In our example, time is the only input, so we can determine absolute advantage by looking at how much time each type of production takes. Ruby has an absolute advantage in producing both meat and potatoes because she requires less time than Frank to produce a unit of either good. Ruby needs to input only 20 minutes to produce an ounce of meat, whereas Frank needs 60 minutes. Similarly, Ruby needs only 10 minutes to produce an ounce of potatoes, whereas Frank needs 15 minutes. Thus, if we measure cost in terms of the quantity of inputs, Ruby has the lower cost of producing potatoes. - **Opportunity cost and comparative cdvantage** There is another way to look at the cost of producing potatoes. Rather than comparing inputs required, we can compare opportunity costs. Time spent producing potatoes takes away from time available for producing meat. When reallocating time between the two goods, Ruby and Frank give up units of one good to produce units of the other, thereby moving along the production possibilities frontier. The opportunity cost measures the trade-off between the two goods that each producer faces. When Ruby spends those 10 minutes producing potatoes, she spends 10 fewer minutes producing meat. Because Ruby needs 20 minutes to produce 1 ounce of meat, 10 minutes of work would yield ½ ounce of meat. Hence, Ruby’s opportunity cost of producing 1 ounce of potatoes is ½ ounce of meat. Now consider Frank’s opportunity cost. Producing 1 ounce of potatoes takes him 15 minutes. Because he needs 60 minutes to produce 1 ounce of meat, 15 minutes of work would yield ¼ ounce of meat. Hence, Frank’s opportunity cost of producing 1 ounce of potatoes is ¼ ounce of meat. ![[Screenshot 2024-01-12 at 11.55.16.png]] Economists use the term comparative advantage when describing the opportunity costs faced by two producers, this is, the ability to produce a good at a lower opportunity cost than another producer. The producer who gives up less of other goods to produce Good X has the smaller opportunity cost of producing Good X and is said to have a comparative advantage in producing it. In our example, Frank has a lower opportunity cost of producing potatoes than Ruby: An ounce of potatoes costs Frank only ¼ ounce of meat, but it costs Ruby ½ ounce of meat. Conversely, Ruby has a lower opportunity cost of producing meat than Frank: An ounce of meat costs Ruby 2 ounces of potatoes, but it costs Frank 4 ounces of potatoes. Thus, Frank has a comparative advantage in growing potatoes, and Ruby has a comparative advantage in producing meat. **Comparative advantage and trade** The gains from specialization and trade are based not on absolute advantage but on comparative advantage. When each person specializes in producing the good in which he or she has a comparative advantage, total production in the economy rises. This increase in the size of the economic pie can be used to make everyone better off. **The price of the trade** Because Frank and Ruby have different opportunity costs, they can both get a bargain. That is, each of them benefits from trade by obtaining a good at a price that is lower than his or her opportunity cost of that good. For both parties to gain from trade, the price at which they trade must lie between their opportunity costs. Frank and Ruby agreed to trade at a rate of 3 ounces of potatoes for each ounce of meat. This price is between Ruby’s opportunity cost (2 ounces of potatoes per ounce of meat) and Frank’s opportunity cost (4 ounces of potatoes per ounce of meat). The price need not be exactly in the middle for both parties to gain, but it must be somewhere between 2 and 4. If the price of meat were below 2 ounces of potatoes, both Frank and Ruby would want to buy meat, because the price would be below each of their opportunity costs. Similarly, if the price of meat were above 4 ounces of potatoes, both would want to sell meat, because the price would be above their opportunity costs. A mutually advantageous trade can be struck at a price between 2 and 4. In this price range, Ruby wants to sell meat to buy potatoes, and Frank wants to sell potatoes to buy meat. Each party can buy a good at a price that is lower than his or her opportunity cost of that good. In the end, each person specializes in the good in which he or she has a comparative advantage and, as a result, is better off. ## Markets are usually a good way to organize economic activity. ## Governments can sometimes improve market outcomes. ## A country's standard of living depends on its ability to produce goods and services. ## Prices rise when the government prints too much money. ## Society faces a short-run trade-off between inflation and unemployment.