Saturday, April 26, 2014

Comparative Advantage

Danny wrote:

Hi professor, 
For example, given two countries and two outputs such as trains and planes, when determining which has the comparative advantage, do you compare within the country itself or between countries? That is, should you be comparing whether producing one particular good has a lower opportunity cost than the other in that same country? Or comparing whether producing one particular good has a lower opportunity cost in another country relative to your own country? 
In other words, are the comparisons of opportunity costs performed horizontally or vertically? I am confused. 
For an example, please see: At 2:00mins, the instructor suggests comparing between countries, however, isn't comparative advantage and opportunity costs compared within the same country? Or is it because the introduction of trade changes it around? Not really sure. 
Thanks for any help

My response:

The question that might help you to understand this is this.  Suppose trade between the two countries can occur and is costless.  Then an efficient production plan that produced a given amount of trains would maximize the number of airplanes produced.  How should production be divided across the two countries to attain an efficient production plan? 
If the efficient production plan entails one country specializing in production, for example say that country A produces Trains only while country B produces Trains and Planes, with the result an efficient plan, then we say that country A has a comparative advantage in producing Trains.   
Further, if you considered a different efficient production plan with a bit less production of Trains and a bit more production of planes, then the way to get from the first to the second is by having country B reduce its production of trains and increase its production of planes and have country A continue to specialize in the production of trains.  

The effect of a tax

Danny wrote:

Hi Professor, 
In regards to taxes, I have seen that in your video, that you name the vertical axes either the selling price or the buyer price and am I correct in saying that depending on whether the tax is levied on buyers or sellers is what determines what you name your vertical axes and thus determines which curve you shift. I have never seen it been done this way. I've always seen the vertical axes to just be denoted price. 
Since the burden of the tax is shared (doesn't have to be equally shared of course right) between buyers and sellers, does it really matter what curve you shift (demand or supply) when either the buyer pays the tax or the seller pays the tax? Is it correct to shift either one of the curves? The way my lecturer has demonstrated it is to draw a tax wedge between the supply and demand curves,however I get confused to how this is used or can be used to answer questions. Because there will be two intersections given a particular quantity with both the supply and demand curve, so how do you know which one to look at?

My lecturer has said he does not prefer shifting the supply or demand curves because that is not actually what is happening, it is just 'construction lines' to depict the tax levy and drawing a tax wedge is much more simpler and achieves the same thing, however I have difficulty grasping the tax concept. 
Furthermore, my lecturer and other online videos suggest that the price to the buyer is equal to the price to the producer PLUS the tax? (Pb = Ps + Tax) 
However isn't that only correct if we are assuming that the consumer PAYS the tax? What if the producer pays the tax, does that mean this equation (Pb = Ps + Tax) is invalid? And rather it should be the price to the producer equals the price to the consumer plus the tax? 
Or because the tax burden is shared between buyers and sellers, that it doesn't really matter? So in these cases, how do you know which curve to be shifting or to be looking at when determining the new tax equilibrium?

I hope that makes sense and would appreciate some help. 
Thank you so much,

My response:

In the presence of the tax, the buyer pays more than what the seller receives.  The difference is the tax.  That much is fundamental.  If Pb is what the buyer  pays and Ps is what the seller receives, then the equation Pb = Ps + Tax or Ps = Pb - Tax (which is the same equation rewritten) is always valid.   
The rest is on how to represent this graphically, going from no tax to a tax or going from a tax to then raising the tax.  What happens in these cases is called the comparative statics of competitive equilibrium with respect to the tax. You can do this as I have done in my video or via the wedge that your instructor prefers.  An advantage of the wedge, as your instructor has noted, is that the underlying demand and supply curves are not changing.  A disadvantage is that you may not be able to eyeball the vertical distance between demand and supply for a given quantity or, conversely, to eyeball the quantity where a given vertical distance is attained.  

Externalities and Curve Shifting

Danny wrote:

Hi Professor Arvan,

Can externalities be either on the production or consumption side? That is, for example, a negative externality, does it matter whether you shift the supply curve leftward/inward or the demand curve leftward/inward?

For example, when dealing with a good such as for example, a cologne that is extremely repugnant, is the negative externality related to the consumption or production of the good?

It could be argued from both perspectives, right?

Hence how would you know which curve to shift in order to find the socially optimal quantity? (If you shift either, they do however end up at the same socially optimal quantity, however the prices differ (if you shift the supply curve inward, the new equilibrium would be higher, and if you shift the demand curve inward, price would be lower)

I would appreciate your comments on this.

Thank you.


My response:

There can certainly be externalities in consumption and they can be either positive or negative.  For example, sometimes there is a desire to be "part of the crowd."  If many students wear bluejeans to class, other students might want to wear them for that reason.  This is a positive consumption externality that is sometimes referred to as a network effect.  Advertisers understand this and one economic rationale for advertisement of a certain sort is to encourage the market to congeal on that product.

I didn't quite get the example with the cologne.  Presumably a person wears a scent to attract others.  If the cologne were generally repugnant, that would seem to be a product without a market.  But one might consider a scent that most others like yet that a few are allergic to.  There would be a negative externality in that case in causing the allergic reaction.

One can a little nitpicking on products that are durable by separating out purchase from use.  The bluejeans mentioned about don't contribute to the network effect if they hang in the person's closet.  The networks effect only arises when the person is seen wearing them.  Something similar can be said for the cologne.  Normally we are not so finicky in making our analysis and assume purchase and use are strongly correlated.

The last point I'd make is to be careful about discussing curve shifting in the presence of the externality.  In the textbook case of a factory that is polluting the air as a byproduct when operating the plant, neither the supply curve nor the demand curve shift as a consequence of the externality.   Normally we analyze this case by saying the marginal social cost shifts inward (from the original supply curve) where social cost includes both the production costs and the abatement costs.   In contrast, in the presence of network effects the demand curve itself actually shifts.