Chapter Two Definitions

A BASIC QUESTION How do you allocate scarce resources among competing needs and wants?

CHAPTER TWO DEFINITIONS Land - All natural resources, such as minerals, forests, water and unimproved land. Labor - The physical and mental talents people contribute to the production process. Capital - Produced goods that can be used as inputs for further production, such as factories, machinery, tools, computers and buildings. Entrepreneurship - The particular talent that some people have for organizing the resources of land, labor and capital to produce goods, seek new business opportunities, and develop new ways of doing things.

MORE DEFINITIONS Production - The conversion of labor, land, capital, and entrepreneurial ability into goods and services. Production Possibilities Curve - is a curve measuring the maximum combinations of outputs that can be obtained from a given number of inputs.

APPLICATION: A PRODUCTION POSSIBILITIES CURVE Econ Grade 100

A PPC demonstrates:

16 hrs for Econ and 4 hrs for History

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10 hrs for each History and Econ

70

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PP C 40 58

66

78

10 0

History grade

There is a limit to what you can achieve, given existing institutions, resources, and technology Every choice you make has an opportunity cost

CHAPTER TWO DEFINITIONS, CONT. Production efficiency - achieving as much output as possible from a given amount of inputs or resources. Inefficiency - getting less output from inputs which, if devoted to some other activity, would produce more output. Principle of increasing marginal opportunity cost - in order to get more of something, one must give up everincreasing quantities of something else.

INCREASING OPPORTUNITY COSTS OF THE TRADEOFF (FROM CHAPTER TWO) Butter

A

The principle of increasing marginal opportunity cost tells us that opportunity costs increase the more you concentrate on the activity • Slope is flat at A • This means there is a low opportunity cost to produce more guns

B

• Slope is steep at B • This means there is a high opportunity cost to produce more guns Guns

EFFICIENCY (FROM CHAPTER TWO) Butter

A

Productive efficiency is achieving as much output as possible from a given amount of inputs or resources

•

•D •C

• Points of efficiency • Unattainable with given amounts of inputs •

•B Guns

Point of inefficiency

Production Possibilities Application:

Comparative Advantage and International Trade

The Nature and Patterns of Trade (from Chapter 19) ◦ Differences in the importance of trade Total Output ($) Export Ratio (%) Netherlands

Import Ratio (%)

844

78

71

Germany

3,695

47

41

Canada

1,706

29

31

Italy

2,180

27

29

France

2,825

26

28

United Kingdom

2,462

30

33

Japan

6,078

15

14

15,094

13

16

United States

U.S. Exports by Region, 2012 (from chapter 19) Canada 19%

OPEC 4% Central and South America 11% Other 10%

Mexico 13% Pacific Rim 25% European Union 18%

U.S. Imports by Region, 2012 (from chapter 19) Canada 15%

Mexico 11%

European Union 17%

OPEC 9%

Central and South America 8% Other 9%

Pacific Rim 31%

David Ricardo (1772-1823) • David Ricardo (1772-1823) was one of the greatest theoretical economists of all time. The third child (of 17) of Abigail and Abraham (a prosperous Jewish stockbroker who had emigrated to London from Holland), Ricardo attended school in London and Amsterdam and at the age of fourteen entered his father's business. In 1793 he married a Quaker, Priscilla Wilkinson, with whom he was to have eight children. The couple's different religious backgrounds meant that the marriage created a rift with both their families, and Ricardo was forced to set up independently as a broker on the London Stock Exchange. Ricardo, though, prospered in the financial business to a far greater extent than his father, amassing a fortune of about £700,000 (equivalent to approximately £40 million today). http://eh.net/encyclopedia/david-ricardo/

David Ricardo (1772-1823) • Ricardo became interested in economics in 1799 after, apparently by chance, reading the work of Adam Smith. He subsequently published pamphlets and articles analyzing various economic problems of the day, including the stability of the currency and the national debt. After some struggle (“I fear the undertaking exceeds my powers,” he wrote), his classic work, The Principles of Political Economy, appeared in 1817. • Two of Ricardo’s most important contributions were the theory of rent and the concept of comparative advantage. The former, which drew on the writings of (among others) his close friend and critic Robert Malthus, defined rent as “that portion of the produce of the earth which is paid to the landlord [by the tenant farmer] for the use of the original and indestructible powers of the soil.” Rent, Ricardo argued, is what remains from gross farm revenue after all the farmer’s production costs have been paid, including remuneration for the capital and labor he had expended on the land. It is an unearned surplus (now referred to as an economic rent) in that its payment is not necessary to ensure a supply of farmland. For Ricardo, rent arises from the advantages that one site has over another due to differing degrees of soil fertility: rent per acre is highest on the most fertile land, and declines to zero on the worst quality soil.

http://eh.net/encyclopedia/david-ricardo/

David Ricardo (1772-1823) • Comparative advantage, Ricardo believed, ensured that international trade would bring benefits for all countries; his theory remains the foundation of the economic case for free trade today. He argued that each country should specialize in making the products in which it possessed a comparative advantage, that is could produce relatively efficiently. Portuguese sunshine, for example, gave Portuguese entrepreneurs a comparative advantage in producing wine, whereas England’s wet climate meant that her comparative advantage was in making cloth. Ricardo showed that, by specializing in production and then trading, Portugal and England would each achieve greater consumption of both wine and cloth than in the absence of international trade. • Not surprisingly, then, Ricardo opposed the protectionist Corn Laws in place during his lifetime, and upon retiring from the Stock Exchange in 1819, made his case directly to the House of Commons as the member for Portarlington, a pocket borough in Ireland. Ricardo’s Parliamentary career was influential but brief: four years later he died suddenly after contracting an ear infection.

http://eh.net/encyclopedia/david-ricardo/

Early Corn Laws History 

http://www.math.grin.edu/~simpsone/Teaching/Romantics/ellen.html

 In 1436 and 1463, England issued the first Corn Laws granting grain growers a

monopolistic advantage of the market. The laws mandated high grain prices and specified price levels necessary for exportation and importation. The Corn laws were constantly adapted to changing foreign and domestic market conditions during the 16th, 17th, and 18th centuries. Before 1660, consumer happiness was the chief concern. However, afterwards, wheat producers became equally influential and England grew to become a great consumer and producer of wheat.  With the Corn Laws, England established a well-defined system for regulating corn trade from 1660 through 1814. Importation and exportation duties or tariffs on a sliding scale, meaning that they are adjusted to changing economic conditions, enforced the laws' chief purpose to secure enough grain to supply domestic needs and to sustain profitable and reasonable grain price levels. Until 1750, the laws remained undisturbed.

End of War with France  On June 8, 1815, Napoleon is finally defeated at the Battle of

Waterloo. This ends a war between England and France that had essentially began in 1689.  The end of the war means that France can now export “corn” (this means grain) to England  The importation of grain will lower food prices.  But not everyone benefits from this trade.

Corn Law Economics Three groups in society Workers: Paid in Wages Landowners (aristocracy): Paid in

Rents Manufacturers (capitalists): Paid in Profits

Iron Law of Wages 

http://www.econlib.org/library/Ricardo/ricP2.html#Ch.5, Of Wages

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http://www.fordham.edu/halsall/mod/ricardo-wages.asp

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It is when the market price of labour exceeds its natural price, that the condition of the labourer is flourishing and happy, that he has it in his power to command a greater proportion of the necessaries and enjoyments of life, and therefore to rear a healthy and numerous family. When, however, by the encouragement which high wages give to the increase of population, the number of labourers is increased, wages again fall to their natural price, and indeed from a reaction sometimes fall below it.



Notwithstanding the tendency of wages to conform to their natural rate, their market rate may, in an improving society, for an indefinite period, be constantly above it; for no sooner may the impulse, which an increased capital gives to a new demand for labour, be obeyed, than another increase of capital may produce the same effect; and thus, if the increase of capital be gradual and constant, the demand for labour may give a continued stimulus to an increase of people....



Thus, then, with every improvement of society, with every increase in its capital, the market wages of labour will rise; but the permanence of their rise will depend on the question, whether the natural price of labour has also risen; and this again will depend on the rise in the natural price of those necessaries on which the wages of labour are expended....



As population increases, these necessaries will be constantly rising in price, because more labour will be necessary to produce them. If, then, the money wages of labour should fall, whilst every commodity on which the wages of labour were expended rose, the labourer would be doubly affected, and would be soon totally deprived of subsistence. Instead, therefore, of the money wages of labour falling, they would rise; but they would not rise sufficiently to enable the labourer to purchase as many comforts and necessaries as he did before the rise in the price of those commodities....



These, then, are the laws by which wages are regulated, and by which the happiness of far the greatest part of every community is governed. Like all other contracts, wages should be left to the fair and free competition of the market, and should never be controlled by the interference of the legislature.

LANDOWNERS AND RENT • Given the Iron Law of Wages, changing the price of corn will not alter the “natural price” of labor. So this does not directly impact workers in the long-run. • The higher price does benefit landowners. • The key is the concept of “rent” • The following slides are taken from: people.westminstercollege.edu/faculty/jwatkins/105 /.../ricardo2.PPT

RENT • Return to an factor of production for which there are no substitutes or no “good” substitutes • Examples: land, a particular location, a living legend, etc.

RICARDIAN RENT • Ricardo defined rent as follows: • different between output on the most and least fertile land in cultivation • difference between costs of production on the most and least fertile lands in cultivation

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Summarizing the impact of the Corn Laws  Workers are not impacted in the long-run

(although food riots did happen in the short-run)  Landowners see their “rents” increase as more and more marginal land is put into production  Manufacturers see their “profits” decline as higher Corn Laws increase wages.

Why 1815 to 1846?  In 1815, the House of Commons is dominated by Landowners 

http://www.parliament.uk/about/livingheritage/evolutionofparliament/houseofcommons/reformacts/overview/reformact1832/

 The Reform Act of 1832 

The Representation of the People Act 1832, known as the first Reform Act or Great Reform Act:

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disenfranchised 56 boroughs in England and Wales and reduced another 31 to only one MP

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created 67 new constituencies

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broadened the franchise's property qualification in the counties, to include small landowners, tenant farmers, and shopkeepers

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created a uniform franchise in the boroughs, giving the vote to all householders who paid a yearly rental of £10 or more and some lodgers

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Limited change had been achieved but for many it did not go far enough. The property qualifications meant that the majority of working men still could not vote. But it had been proved that change was possible and over the next decades the call for further parliamentary reform continued

 Why 1846? The Irish Potato Famine appears to be the key event that leads to the

triumph of the Anti-Corn League

Triumph of Free Trade?  The movement to repeal the Corn Laws has been commonly treated in the literature as

an example of the power of non-self-interested ideology to influence economic policy. Without denying that ideology played a role, there is ample evidence to question the dominance of ideology in motivating the repeal campaign. Specifically, we have presented considerable evidence to support two propositions: 1) the Anti-Corn Law League, despite its name, devoted substantial efforts towards preventing and impeding the passage of further Factory Acts in the cotton textile industry and towards the repeal of the raw cotton duty; and 2) the principal financial support for the League came from the cotton textile industry, which had a strong economic interest in these activities (if not repeal of the Corn Laws per se). A concentrated and localized industry group, sharing very specific common interests, invested heavily in promoting the League and its activities.  Gary M. Anderson and Robert D. Tollison (1985)

Interdependence and the Gains from Trade Absolute advantage - the comparison among producers of a good according to their productivity. Comparative advantage - the comparison among producers of a good according to their opportunity cost.

“England may be so circumstanced, that to produce the cloth may require the labour of 100 men for one year; and if she attempted to make the wine, it might require the labour of 120 men for the same time. England would therefore find it her interest to import wine, and to purchase it by the exportation of cloth. To produce wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time. It would therefore be advantageous for her to export wine in exchange for cloth.” [Ricardo (1817) as reprinted in McCulloch (1888, p. 76-77)]

“This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced with less labour than in England. Though she could make the cloth with the labour of 90 men, she would import it from a country where it required the labour of 100 men to produce it, because it would be advantageous to her rather to employ her capital in the production of wine, for which she would obtain more cloth from England, than she could produce by diverting a portion of her capital from the cultivation of vines to the manufacture of cloth.”(Ricardo (1817) as reprinted in McCulloch (1888, p. 76-77).

Ricardo, the numbers Nation

Wine

Cloth

England

120

100

Portugal

80

90

In Ricardo’s example, Portugal has an absolute advantage with respect to both goods. However, Portugal’s comparative advantage only lies in the production of wine.

Another Example • Venezuela can produce a unit of cloth with 15 units of

labor while a unit of grain requires 30 units of labor. Spain can produce a unit of cloth with 6 units of labor while a unit of grain requires 3 units of labor. Let’s assume each nation has 3,000 units of labor. • Prior to trade: • For Venezuela one unit of cloth costs ½ a unit of grain. • one unit of grain costs 2 units of cloth • For Spain one unit of cloth costs 2 units of grain • one unit of grain costs ½ a unit of cloth

More on “another example” • With free trade Venezuela can specialize in cloth, Spain can

specialize in grain. Without trade, a unit of cloth costs Spain two units of grain. What if the terms of exchange allowed Spain to acquire a unit of cloth for only one unit of grain? Spain would be better off. • Would Venezuela benefit from this trade? Grain costs Venezuela two units of cloth before trade. After trade, one unit of grain only costs one unit of cloth. Venezuela is also better off. • Trade allows a nation to expand its consumption possibilities beyond its production possibilities. And everyone ends up with more.

Ricardo’s conclusions 1. Comparative advantage, not absolute

advantage, determines the pattern of trade. 2. Free trade benefits every nation by expanding each nation’s consumption possibilities beyond its production possibilities. 3. NOTE: Free trade benefits every nation but not everybody in every nation.

Additional Benefits from Trade

1. Increased Variety of Goods 2. Increase Competition 3. Enhanced flow of technology

WHY PROTECTIONISM? • If free trade is so wonderful, why isn’t it universal? • Free Trade Benefits Every Nation, but Not Everyone in Every Nation • Back to the Corn Laws...

• Free trade in corn benefits industry and hurts landowners • Free trade in textiles might harm industry (and help landowners) • Even Great Britain was not practicing completely free trade in the latter 19th century. And neither was the U.S.

THE INFANT INDUSTRY ARGUMENT • Imagine a nation attempting to develop a manufacturing industry where economies of scale (what is this?) are important. • If the nation practices free trade, its domestic manufacturers will have higher cost than existing firms in more established nations. • So allowing free trade means the nation will never develop its manufacturing industry.

• Has this argument ever persuaded people in the U.S.?

HENRY CLAY AND ABRAHAM LINCOLN •

from, Land of Promise: An Economic History of the United States (Michael Lind)

• The centerpiece of Henry Clay’s plan for the industrialization of the United States had been a high protective tariff (Hamilton had preferred government subsidies to infant industries). Lincoln told a correspondent in 1859, “I was an old Henry-ClayTariff Whig. In old times I made more speeches on that subject than any other. I have not since changed my views.” • In arguing for a protective tariff, Lincoln followed Clay in identifying industrial Britain as America’s economic rival, and claimed that those who purchased imported British goods were unpatriotic snobs: “Those whose pride, whose abundance of means, prompt them to spurn the manufactures of their own country, and to strut in British cloaks, and coats, and pantaloons, may have to pay a few cents more on the yard for the cloth that makes them. A terrible evil, surely, to the Illinois farmer, who never wore, nor never [sic] expects to wear, a single yard of British goods in his whole life.”

THE TARIFF AND THE 1860 ELECTION • from, Land of Promise: An Economic History of the United States (Michael Lind) • The tariff was part of the Republican Party platform of 1860, whose wording, the product of the efforts of Henry Carey among others, sought to please every constituency: “While providing revenue for the support of the general government by duties upon imports, sound policy requires such an adjustment of these imports as to encourage the development of the industrial interests of the country; and we recommend that policy of national exchanges, which secures to the working man liberal wages, to agriculture remunerative prices, to mechanics and manufacturers an adequate reward for their skill, labor, and enterprise, and to the nation commercial prosperity and independence.” • One observer reported: “The Pennsylvania and New Jersey delegations were terrific in their applause over the tariff resolution, and their hilarity was contagious, finally pervading the whole vast auditorium.” • The electoral votes of protectionist Pennsylvania and New Jersey were crucial in helping Lincoln and the Republicans win the White House in 1860. “Protection made Mr. Lincoln president,” Carey said.

REPUBLICANS AND PROTECTIONISM •

from, Land of Promise: An Economic History of the United States (Michael Lind)

• In May 1860, before the election, the House had passed the Morrill Tariff, which was passed by the Senate between Lincoln’s election and his inauguration.

• Tariffs were raised again during the Civil War in 1862 and 1864. • The administration of Abraham Lincoln inaugurated an era that lasted until World War II, in which the United States had the most protected home market in the world. Between 1867 and 1914, while many goods were admitted free from duties, the US tariff on dutiable imports, chiefly manufactured goods, hovered between 40 and 50 percent. • From Ulysses S. Grant to Herbert Hoover, Lincoln’s Republican successors shared his view that the government should protect and promote American manufacturing. President Grant pointed out that Britain had industrialized behind a wall of protective tariffs, turning to free trade only when its manufactured exports were superior to those of other countries: “After two centuries, England found it convenient to adopt free trade because it thinks that protection can no longer offer it anything. Very well, Gentlemen, my knowledge of our country leads me to believe that within 200 years, when America has gotten out of protection all that it can offer, it too will adopt free trade.”

PROTECTION IN THE 20TH CENTURY • from, Land of Promise: An Economic History of the United States (Michael Lind) • William McKinley, who published a book on the tariff, succeeded Justin Morrill as the leading spokesman for protectionism in the Republican Party and gave his name to the 1890 McKinley Tariff. McKinley and his vice president and successor, Theodore Roosevelt, recognized the need for reciprocal trade liberalization in sectors where infant industry protection had successfully created mature American industries. • But like other Republicans of their time, they remained committed economic nationalists. Roosevelt wrote in 1895: “Thank God I am not a free-trader. In this country pernicious indulgence in the doctrine of free trade seems inevitably to produce fatty degeneration of the moral fibre.” • The US model of import substitution became a model for other industrializing countries like Germany, Japan, Russia, and the British Dominions of Canada, Australia, and New Zealand. • In the early twentieth century, the economist Frank W. Taussig, despite his commitment to free trade, conceded that without protectionism the development of American manufacturing might not have taken place as rapidly as it did

LABOR UNIONS AND TRADE LIBERALIZATION • From the Council of Industrial Organization in 1943, specifically the director of research J. Raymond Walsh.... • " '...almost unanimous consensus of informed opinion for over a century... had held that obstacles to trade were invariable costly to a nation. Unfettered trade enabled every nation to realize the highest standard of living; specialization in producing things with the greatest efficiency induced maximum productiveness. Nothing less than national defense considerations could justify, in the CIO view, 'artificial obstacles' in the way of free international trade." (from the U.S. Congress (1943) as reprinted (Donahue 1992, p. 9)

MORE FROM THE CIO  "Without 'free trade'... at least half of the American people would be doomed to a life of poverty. The nation would be consumed by crime, civil disorders, race riots, violence, forcing an end to all civil and individual liberties. America's roads would be clogged with masses of wandering, homeless people, threatening the existence of the family as an institution and giving rise to a generation of juvenile delinquents. Sickness and disease would plague the population. Demagogues would harangue the people and mislead and confuse them. The crisis would convulse the nation, threatening private property and democratic political institutions alike" (Donahue 1992, p. 23).

DEATH OF PROTECTIONISM

WHY DID PROTECTIONISM END?  During the Cold War, the United States became committed to spreading capitalism throughout the world.  Access to the U.S. market was considered essential to promoting capitalism (i.e. anti-communism).  Hence, the U.S. became a nation of “free trade” (although today, labor unions are opposed to free trade and prefer a policy of “fair” trade)