EC1A5 - Topic 3 (poorly worded - trade, types of economies)

Absolute advantage

The ability of an individual or country to produce more of a good with the same resources.

Comparative advantage

The ability to produce a good at a lower opportunity cost than another producer.

Importance of comparative advantage

It determines the pattern of trade and allows all parties to benefit through specialization.

Specialization based on comparative advantage

Mutual gains from trade and higher overall welfare.

Gains from trade

It allows consumption beyond the production possibility frontier (PPF).

Production possibility frontier (PPF)

The set of all combinations of two goods that can be produced using all resources efficiently.

Slope of the PPF

The opportunity cost of one good in terms of the other.

Opportunity cost

The value of the next best alternative forgone when a choice is made.

Beneficial trade

When each agent specializes in goods with lower opportunity cost and trades for others.

Key condition for mutual gain from trade

The trade price must lie between each participant's opportunity costs.

Consumer surplus

The difference between what consumers are willing to pay and what they actually pay.

Measurement of consumer surplus

The net benefit consumers receive from participating in the market.

Producer surplus

The difference between the price a producer receives and the minimum they would accept.

Measurement of producer surplus

The net benefit to producers from selling at the market price.

Total surplus

The sum of consumer and producer surplus.

Allocative efficiency

When total surplus is maximized and no reallocation can make someone better off without making someone else worse off.

Conditions for allocative efficiency

Under perfect competition, with no externalities or information failures.

Equilibrium outcome in a competitive market

The price and quantity where supply equals demand, maximizing total surplus.

Surplus when prices deviate from equilibrium

Total surplus decreases, creating deadweight loss.

Deadweight loss

The reduction in total surplus from inefficient market outcomes.

Causes of deadweight loss

Price controls, taxes, subsidies, or market power.

Graphical representation of welfare

Consumer surplus is the area under the demand curve and above price; producer surplus is the area above the supply curve and below price.

First Welfare Theorem

Under certain conditions, a competitive market equilibrium is Pareto efficient.

Pareto efficiency

A situation where no one can be made better off without making someone else worse off.

Second Welfare Theorem

Any Pareto efficient outcome can be achieved by redistributing resources and allowing markets to operate freely.

Central planning

A system where decisions about production and distribution are made by a central authority rather than markets.

Challenge of central planning

It requires vast information on resources, technology, and preferences.

Markets solving the information problem

Price mechanism

Signals scarcity and preferences automatically.

Efficient information systems

Markets aggregate dispersed information held by individuals.

Winners and losers in market outcomes

Total welfare increases, but gains and losses are distributed unevenly.

Redistribution policy implication

Governments may use redistribution to compensate the losers from market outcomes.

Market evaluation criteria

The balance between efficiency gains and fairness of distribution.

Free trade

Trade between nations without tariffs or quotas.

Tariff

A tax on imported goods.

Effects of tariffs

They raise domestic prices, reduce imports, create government revenue, and cause deadweight loss.

Welfare impact of free trade

It increases total world welfare, though some groups within countries may lose.

Tariff distortion of efficiency

By reducing mutually beneficial trade below the optimal level.

Prisoners' Dilemma

A game where rational self-interest leads to a worse outcome for all compared to cooperation.

Trade policy and Prisoners' Dilemma

Countries have an incentive to impose tariffs even though mutual free trade benefits both.

Solutions to trade-based Prisoners' Dilemma

Repeated interaction, credible commitments, or trade agreements.

Sources of market failure

Equity considerations and market pathologies.

Equity considerations

Market outcomes may be efficient but unfairly distributed.

Market pathologies

Situations where markets fail to allocate resources efficiently.

Forms of market pathology

Externalities, public goods, monopolies, and information asymmetry.

Externality

A cost or benefit of an activity borne by third parties not involved in the transaction.

Information asymmetry

When one party in a transaction has more or better information than the other.

Public goods underprovision

Due to the free-rider problem — individuals have no incentive to pay for non-excludable goods.

Monopoly

A single seller with market power to set prices above competitive levels.

Correcting market failures

Through taxes, subsidies, regulation, or provision of public goods.

Wider social concern about markets

They can influence human behaviour and values beyond economics.

Market attitudes

Individualism, materialism, and competition.

Market evaluation implications

Assessments should consider moral and social consequences, not just efficiency.

Conclusion about market outcomes

Markets are powerful mechanisms for cooperation and efficiency but not perfect.

Conditions for market performance

When competition is strong, property rights are defined, and externalities are minimal.

Poor market performance conditions

When there are externalities, monopolies, inequality, or missing markets.

Role of government in markets

To intervene where markets fail or produce outcomes considered unfair.

Economist's task in market evaluation

To understand both their strengths (efficiency, innovation) and weaknesses (inequality, instability).