Absolute advantage exists, when one country can make a particular product with less expenditures than any other country. It means that financial costs are less. Comparative advantage exists, when opportunity costs of producing particular goods in one country (it means what it has to give up in order to make goods) are less than in other country.

Providing that only two countries exist, for example, the USA and China, the only two goods produced are machines and cheese. There is no difference in the quality of products, and there are equal hourly wages in both countries. The only type of production cost is labor costs, and there is no transportation or other expenditures.

Table 1

The Time Spent on the Production of Goods

Hours needed to make

1 machine

1 ton of cheese

China

4

2

USA

15

5

As labor costs per hour per worker are equal in both China and the USA and amount to $ X, it is clear that the former has absolute advantage in machine production (4 X is less than 15 X). When it comes to cheese production, China also has absolute advantage (2 X is less than 5 X).

In order to find out which country has comparative advantage, it is necessary to calculate opportunity costs: to make 1 machine, China sells 2 tons of cheese (4 units of resources to make 1 machine or 2 tons of cheese), while the USA sells 3 tons of cheese (15 units per 1 machine or 3 tons of cheese). Thus, it is clear that when making a machine, the lowest opportunity costs are in China, therefore, it has comparative advantage in machine production due to giving less cheese.

To make 1 ton of cheese, China should sell 0.5 machine (2 units of resources to make 1 ton of cheese or 0.5 machine), while the USA needs only 0.33 machine (5 units of resources to make 1 ton of cheese or 0.33 machine). Therefore, when producing cheese, the lowest opportunity costs are in the USA, and it has comparative advantage in cheese production due to giving less machines.

Thus, both countries will benefit in case of trade relationships. China will export machines and import cheese, while the USA will export cheese and import machines.

The Demand Schedule and the Demand Curve

The demand schedule is a table, which demonstrates the link between various quantities of goods or commodities demanded at different prices, while other things (family size, incomes, tastes, and others) that can affect the demand remain constant.

The demand curve is a curve on a graph, which shows the link between various quantities of goods or commodities demanded at different prices. In other words, it is the graphical representation of the demand schedule.

Table 2

The Demand Schedule

Price of goods

Quantity of Goods

$0.50

10

$1.00

8

$1.50

6

$2.00

4

$2.50

2

$3.00

0

The demand curve slopes downwards due to the number of buyers, the income effect, and the substitution effect.

When the price of goods is high, only a small number of buyers can afford to purchase them. When the price decreases, the number of consumers is on the rise. Therefore, it stimulates the market demand for the product.

If the price of goods decreases, the buyer can afford more goods in relation to his income. Therefore, his purchasing power or real income increases. Such income effect stimulates the buyer to purchase more goods.

When the price of the product decreases, it becomes cheaper in comparison to other substitute goods. It stimulates the buyer to substitute the product, whose price has decreased, for other goods, which have in turn become more expensive. Therefore, the demand for the product, which has become cheaper, rises due to the substitution effect.

The following five non-price factors determine the quantity of goods that buyers demand:

  1. Prices of related goods. A change in the price of complement goods encourages buyers to demand the less or greater quantity of both goods. An increase in the price of a substitute stimulates buyers to purchase less substitute goods.
  2. Buyer’s income. As a rule, a greater income means increased buying opportunities (normal goods). However, in case of inferior goods, more income implies less demand.
  3. Tastes or preferences of buyers. If goods provide greater satisfaction, consumers are motivated to buy more.
  4. The number of buyers willing and able to purchase goods influences the total demand. With fewer buyers, there is less demand and vice versa.
  5. Expectations. If buyers expect the price to rise in the future, they are buying more now and vice versa.

The Equilibrium of a Market

The equilibrium of a market is a situation, when the demand for goods is exactly equal to their supply. Since there is no shortage or surplus in the market, the price of goods is likely to be stable.

E – equilibrium

Pe – equilibrium price

Qe – equilibrium quantity

Figure 2. The equilibrium of a market. This figure illustrates that there is only one price level (Pe), at which the quantity demanded is equal to the quantity supplied (Qe), and that price is the point, at which the demand (D) and supply (S) curves intersect.

If the price P2 is higher than the equilibrium price,  suppliers are trying to produce and sell more goods in order to increase profits. However, if the price is too high, goods become less attractive for consumers, and they will purchase less. The demanded quantity (Q1) will be less than the one supplied (Q2), and there will be a surplus of goods in the market (EKL triangle). The increased supply will push the price down, making customers demand more. The price will go to its equilibrium.

If the price P1 is less than the equilibrium price, the demanded quantity (Q2) will be less than the one supplied (Q1), and there will be a shortage of goods in the market (EMN triangle). There are insufficient goods to satisfy consumers’ demands. On the other hand, buyers need to compete to purchase products at such a low price. The increased demand will force the price to increase, stimulating suppliers to produce and supply more. The price will go to its equilibrium.

The law of supply and demand states that when other things are equal, with an increase in demand, prices will be on the rise. It stimulates suppliers to produce and supply more, bringing the price back to its equilibrium and vice versa.

A Price Ceiling and a Price Floor

A price ceiling is the situation, when the government sets a limit on how high the price of goods (P1) can be. In this situation, the supply (Q1) is less, and the demand (Q2) is higher than when there is the equilibrium price (Qe). Therefore, there is less quantity supplied than demanded. When a price ceiling is introduced, a shortage of goods occurs in the market (EMN triangle). For example, in the 1970's, the government set a price ceiling on gas, and there were long gas lines because of a gas shortage.

A price floor is the situation, when the government sets a limit on how low the price of goods (P2) can be. Such situation occurs when it wishes to prevent prices from being too low. In this situation, the supply (Q2) is higher, and demand (Q2) is less than when there is the equilibrium price (Qe). Therefore, there is more quantity supplied than demanded. When a price floor is introduced, a surplus of goods occurs in the market (EKL triangle).

The Bureau of Labor Statistics

The Bureau of Labor Statistics divides everyone into three categories:

  1. Employed – adult individuals (aged 16 and older), who spent the previous week working at a paid job.
  2. Unemployed – adult individuals, who did not spend the previous week working at a paid job, but who looked for one.
  3. Not belonging to the labor force – adult individuals, who did not spend the previous week working at a paid job, and who did not look for one.

The Bureau of Labor Statistics computes the labor force as the sum of the employed and the unemployed. The unemployment rate is calculated through dividing the unemployed by the labor force. The labor-force participation rate is the percentage of the total adult population that belongs to the labor force.

Bonus

The Federal Reserve Bank uses three tools of monetary policy to control the money supply: the discount rate, open market operations, and the required reserve ratio.

The Fed lends money to other banks that are in financial trouble. If it lowers the discount rate, borrowing commercial banks becomes easier. If banks borrow more, the money supply increases.

Every day, the Federal Reserve Bank takes part in open market operations. When it purchases securities, the loan funds available to banks increase. The latter situation forces the money supply to increase.

The required reserve ratio sets the fraction of deposits that banks must keep either in the Fed or on hand in the vault. Lowering this ratio provides banks with the opportunity to offer more loans, and, therefore, increases the money supply. If the Fed needs to decrease the latter, it raises the required reserve ratio.

Open-market operations are the most delicate out of three, while a variation in the discount rate has a more evident impact on the money supply.

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