Quiz 2: Some Tools of the Economist


The statement saying that there is no welfare gain from the trade of a used car in exchange of $5000 since there is no new creation of good is a wrong statement. The very essence of trade and welfare gains lies in that fact that trade is a form of transaction that results from mutual decision of both the parties (that is the buyer and seller) since both are better off from the transaction. The welfare gain is a result of redistribution of resources to those who value them the most. In other words we can say that when people are able to gain access to those resources which they value the most through a mutual transaction which is voluntary in nature, there is a gain in welfare. In the given question Smith desired the used car and valued it more than Jones and similarly Jones were in need of cash more than the used car; hence both through a voluntary transaction of the car feels better off as both is able to gain the goods that they value the most. This proves that irrespective of creation of new good there is a gain from trade as trade results into redistribution of goods.

It is true that wage rate reflects the productivity but the wage earned by a labor also reflects the nation wealth and output. The painters though uses the same production method as that of 50 years ago but since the overall nation output and wealth has increased over the years the average wage income has also increased irrespective of the "wage rate". As national income has increased the wage rate, which is a section of the economic pie has also increased. Thus, the size of the economic pie, which is the income, varies with national income that is a function of various factors.

In order to estimate the true cost of a commodity or service we need to take into consideration both the monetary cost as well as the opportunity cost. Opportunity cost is the cost of the opportunity lost in the process of selecting one commodity over another. In other words, it is the value of the highest activity/commodity/time that is forgone since another activity was chosen instead of it. When a traveler whose value for time is $6 per hour will have an opportunity cost of $30; meaning he could have earned 30$ by working for 5 hours. Hence his total cost of traveling by bus from New York to Washington will be the sum of the monetary cost of the bus that is the bus fare of $70 and his opportunity cost of 5 hours that is $30 that is $100. On the other hand by travelling by air the total cost will be the airfare that is $110 and the opportunity cost of 1 hour of travel time that $6 that is $116. Clearly, for someone having opportunity cost of $6 per hour it would be cheaper to travel by bus. Following the same logic, someone having an opportunity cost of $10 per hour will have a cost of 120$ for travelling by air (that is 1 hour of travel time $10 and airfare of $110) and a cost of $120 for travelling by bus ($50 as opportunity cost of travel time and $70 as bus fare). The traveler would be indifferent to travel by bus or air as the true cost of travel would be same in this case. On the other hand, when the opportunity cost of someone is $14 per hour then travelling by bus would cost him $140 (that is $70 for opportunity cost of travel time of 5 hours at $14/hour and the bus fare of $70). On the other hand the cost of travelling by air would be $124 (that is $14 for the opportunity cost of travel time and $110 as the airfare). Thus someone having $14 as opportunity cost per hour would find it cheaper to travel by air as the true cost is less than the true cost of travelling by bus.

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