Transcript Econ 1000: Mod 1 - Leona Craig Art Gallery, Red Hill

Econ 1000: Mod 1
C.L. Mattoli
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Information Information
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Lecturer: Craig Mattoli
Email: [email protected]
Phone (text messages only) 136 3241 0877; include
your name and course in message.
Office hours: by appointment. Temporarily located in
room 221.
Don’t be shy. Ask Questions of your Instructor, not
your classmates. No one cares as much as he
does!
Sometimes, I talk fast, use words that you might not
know, and write abbreviations on the board. Again,
if you don’t understand my written or spoken word,
ask. It’s ok!
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Introduction to Economics
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10 Principles of Econ
Behavior of decision-making (people are self-interested)
1.
People face trade-offs in daily life.
2.
The cost of a choice between things is what you give up
to get it.
3.
Rational thinking is at the margin in all situations.
4.
People, in general, respond to incentives.
How people interact
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Trading can make everyone better off.
6.
Markets are usually a good way to organize economic
activity.
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Principles of Econ
Government (or law) can sometimes improve market
outcomes.
How the marcoeconomy works
8.
A country's standard of living depends on their ability to
produce.
9.
Prices rise when the government prints too much
money.
10. Societies will face a short-term tradeoff between
inflation and unemployment.
Governments have 2 reasons to become involved in the
economy: to promote efficiency or equity.
7.
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The course
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First we get our feet wet by looking at what
economics is, and how it is put together: it is
about opportunities and decisions.
Economics takes psychology and uses it in
logical and mathematical models, using a lot
of graphical analysis.
It looks at how resources of production are
pulled together to make things in the best way to
satisfy society.
Our first look, in this chapter will be the
production possibilities frontier (PPF).
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The course
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The way that an economy operates is that there
are people who want things, consumers, they
demand, and people who produce things, they
supply; and when supply meets demand, there
are transactions: buying and selling in the
market.
We shall study supply and demand in markets
and look at market structures.
Then, we will look at cost analysis to see how
producers determine how much to produce and
what prices to charge to make a profit. That will
include looking at elacticity.
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The course
8.
After that, we will look at economics on the
larger, country-wide scale, and look at
national production, price inflation, and
employment. We will look at aggregate
supply and demand.
9.
Governments are always involved in the
economy. First of all, they print the money,
which is a liability of the central bank, that is
used for all of the economic transactions.
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The course
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Governments are also part of the economy, in
that they spend money on large scale projects,
like highways, and they get revenues from
taxation, which also takes money away from
the society. They give money to the needy to
help the less fortunate in society. They also
borrow money to finance their spending.
Thus, governments will also need policy about
money, monetary policy, and spending and
taxation, fiscal policy.
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Material covered this week
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Chapters 1, Intro to Economics, plus appendix, &
2, Micro-econ Fundamentals, plus pages 532-40,
Int’l Trade
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Learning objectives
On successful completion of this module, you should be
able to:
 Discuss the social science of economics as the study of
scarcity and choice
 Discuss the ‘economic way of thinking’
 Describe the construction and testing of economic
models
 Apply graphical techniques in economic analysis
 Explain the concepts of opportunity cost , marginal
analysis and comparative advantage
 Apply the model of the production possibilities frontier
(PPF) to illustrate the concepts of opportunity cost,
economic growth , and the gains from trade.
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Economics: Social Science
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Economics is a so-called social science.
It looks at the behavior of society members,
separately and in mass, in producing and
exchanging goods and services. Thus, it is
social.
It looks at using the scientific method of
investigation to make logical and mathematical
models to describe the behavior. Thus it is a
soft science, a social science.
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Summed up
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Economics is based on psychology, logic
and a little math.
Scare resources must be allocated. There
are financial and opportunity costs.
People want, so producers produce to
satisfy them and make a profit to satisfy
themselves.
Consumers have sovereignty, and they
have decreasing marginal utility for things.
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Summed up
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We look at psychology for the underlying
behavioral motivations of people in
economic circumstances as buyers or
sellers.
People must make decisions: to be in
business, which business they should be in,
and what they must or should buy to live or
to make their lives better.
That involves choosing from among the
opportunities available to them.
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Summed up
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In choosing one opportunity, they
forego others, and the foregone other
opportunities are their opportunity
costs.
We use logic to set up causal chains,
which are simple summaries, using box
diagrams in flow charts, like:
One
thing
Leads to
(Causes)
Another
thing
Leads to
(Causes)
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Yet Another
thing
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Summed up
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They help us imagine the chain of events that
relate one thing that happens in an economy to
ultimate logical outcomes.
Thus, we develop logical relationships among
variables and concepts.
We use math to characterize those logical
relationships as best we can. Indeed, we rely
heavily on graphical analysis as the
mathematical framework. Actual equations are
so complicated as to be next to impossible, in
many cases, anyway.
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Economic Way if Thinking
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The economic way of thinking involves:
A logical framework for analyzing
problems.
A language of economic terms.
Graphical analysis and algebraic
equations.
A little logic, simple psychology and
basic math, using some special terms
that economists have made up.
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Economic Way if Thinking
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This course will emphasize the logic and
psychology involved in economic
thought, which is in some ways more
difficult than a course with equations.
Although you will be required to
understand equations and interpret
graphical and tabular information, you
will have to be sharp on verbal skills and
on making well thought out, concise,
convincing, logical arguments.
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Advice to Remember
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The course requires thinking, not
memorization of things because
economics is easy when you think about it
in the right way.
Ask yourself: is it logical for people to want
to buy more of something if the price goes
down or when the price goes up?
Simple logic and psychology will give you
the answer, and your answer will also give
you the law of demand.
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Advice to Remember
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Lets suppose that you are given the following
table of data and asked to find the intersection of
supply and demand, given in the table, and you
are asked to draw a graph of the data.
Price
3.00
2.80
2.60
2.40
2.00
1.50
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Quantity Quantity
supplied demanded
900
200
800
300
700
400
500
500
300
700
100
1000
Without doing any “analysis” at all, the
intersection will occur when both are equal,
which is a P = 2.40 and S = D = 500.
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Graph from a table
3.5
3
2.5
2
1.5
1
Dem…
Supply
0.5
0
0
200
400
600
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800
1000
1200
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Scarcity: where economics begins
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Economics can be described, in part, as the
theory of the allocation of scarce
resources.
Scarcity is the condition that human wants
are forever greater than the available supply
of time, goods, services and resources.
Because of scarcity no society has enough
resources, the basic inputs for production of
goods and services, to fulfill all of its citizens’
wants and needs.
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Resources: factors of production
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Economics divides resources, the
factors of production, into 3 basic
categories:
Land
Labor
Capital
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Land: what mother nature provides
Land is anything above or below the
ground provided by nature. It includes:
water, air, crops, animals, minerals, the
moon, the sun, trees, and water.
Question: how could you make use of the moon
for a business?
 Renewable land resources are those that are
replaced by nature without help, for example,
animals, water, and the air we breath.
 Nonrenewable cannot be replaced by nature,
including things, like oil and coal.
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Labor: the people factor
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Labor is the mental and physical ability
of people to produce goods and services.
Both the number of people available in
the workforce and their level of skill are
measures of the labor resource.
Thus, increases in the labor resource
of a country can come from greater
population that is available to work and
produce or an increase in skills of the
present workforce
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Labor: the people factor
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A reason that nations differ in their ability
to produce is the education, experience,
health, and motivation of their labor
force.
Entrepreneurs are a special kind of labor.
They seek profits by taking on risk by
combining resources to create new
products. They are agents of change
who bring material progress to a society,
and they are a very scarce resource.
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Capital: the facilities of production
Capital in economics, is the physical
plant, machinery, and equipment that
is used to produce other goods and
services.
 Capital goods are man-made goods that
do not directly satisfy human wants.
 They are used to transform the other
factors of production into goods and
services that people want.
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Capital: the facilities of production
 Financial
capital, from studies of
finance, has no place in economics.
 Capital in economics has nothing to
do with money or monetary assets.
 Money is only a measure of value, it
is not economic capital.
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Pictorial Economics: Production
Land
Resource inputs are
pulled together and
transformed by
entrepreneurs into
output
Labour
Entrepreneur
Capital
Risk
Goods & Services
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Economics: the study of scarcity & choice
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Economics is the study of how society chooses to
allocate scarce resources to produce goods and
services to satisfy unlimited wants.
Society makes two kinds of choices: macro, from
the Greek word for large, is economy-wide;
micro, from the Greek word for small, refers to
individual choices.
Thus, the study of economics is broken into two
broad branches: microeconomics and
macroeconomics.
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Microeconomics
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The micro scale of economics looks at decisionmaking of individuals, firms, and industries.
Thus, small, in economic terms, ranges from one
person to groups of people but not the whole of
the society. Micro, for example, might look at
computer makers or households as groups.
Micro questions might involve looking at how
computer chip makers will respond to changes in
chip prices in terms of supply and at how
consumer demand might also change.
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Macroeconomics
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Macro is an overall perspective of the whole
economic system.
Macro variables are economy-wide things,
like unemployment, money supply, investment
in PP&E, GDP, imports & exports.
Macroeconomics looks at questions, like how
will an increase the money supply affect the
price of exports, or how will unemployment
affect GDP.
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Macroeconomics
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Macro and micro are interrelated.
On the one hand, the Macro economy is the sum
of all of the micro’s. We sum up all of the micro
activity of a country, and we get the macro
economy
However, changes on the Macro level can affect
micro change. For example, a new income tax
will affect how industries produce and how
consumers consume, and it might affect different
micro groups in the economy differently.
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Economic Methodology
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Economics uses the scientific method.
The scientific method involves: 1) observing a
system, 2) postulating a theory to explain the
workings of the system, 3) collecting appropriate
data, and 4) testing the theory against the data to
see how well data fits theory, then, 5) going back
to see how the theory might be revised to better fit
observation.
In economics it becomes: 1) identify a problem,
2) make a simplified model, and 3) test it.
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Economic Modeling
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Identify a problem: for example, why do gasoline
prices vary over the year? Part of the problem of
economics is to ask a question properly.
Develop a simplified model. A model is a
simplified description of something, based on the
important variables that one would expect to be
involved in the description according to some sort
of underlying theoretical framework.
A model can involve logical verbal arguments,
graphical or tabular information, or precise
equations.
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Example: A Model of the Atmosphere
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The earth’s atmosphere is made up of billions
upon billions of air molecules, each speeding
around bumping into each other.
We could try to describe the atmosphere by
trying to find the speeds and directions of all
of those molecules.
Instead, we have built a simpler model using
variables of temperature, pressure and wind
speed.
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Economic Modeling
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Part of the art of modeling is to choose the
right question to ask and the use of minimal
important variables to formulate an answer.
Finally, a model must be tested. That
involves taking data for the variables, using
it as input for the model, looking at the
result that the model generates, and seeing
how well the model’s predictions fit the
reality of the situation.
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Economic Modeling
The true test of a model is how well it can
predict the future. After all, that is the
true value of any model.
 Models may do well. They may not, and
we have to go back to the drawing board.
Or models might work for a while and
then stop working as other things change.
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Hazards in Economic Thinking
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There are always problems in theoretical
pursuits.
The first is called ceteris paribus. It is the
assumption that everything else remains
fixed and constant, while only certain key
variables change.
For example, you might make a model of
cola demand which says that demand will
decrease, ceteris paribus, if price
increases.
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Hazards in Economic Thinking
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However, if, in the summer time, demand
increases after a price rise, it does not
make the model invalid.
It was just that the temperature was
extremely hot and the model did not
include temperature as a variable.
Another common error in modeling in any
field, even the hard sciences, like physics,
is taking correlation for causation.
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Hazards in Economic Thinking
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For example, for many years it was observed
that the length of women’s skirts (hem-line)
was a good predictor of the level of the stock
market in the U.S.
As hem-lines went up (as dresses got
shorter), the stock market rose, and as
hemlines went down (as dresses got longer),
the market went down.
However, it would be foolish to think that the
direction of moves in women’s hemlines was
actually the cause for moves in stock market
prices.
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Hazards in Economic Thinking
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It is often very difficult to distinguish between
simple statistical correlations and cause and
effect relationships.
What can happen, in reality, is that the two
variables that seem to be related are both
affected by a common third variable. Then,
changes in that third variable causes
changes in the first two, and they move like
they are related.
Thus, great care must be taken in postulating
true relationships among economic variables.
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Why Economists disagree
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One reason that economists seem to
disagree is the difference between
positive and normative economics.
Positive economics deals with verifiable,
“if A, then B” statements, which can be
proved true or false. It is objective.
Normative economics is about value
judgments, not facts.
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Why Economists disagree
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Disagreement can arise around positive
economics.
For example, 2 economists might agree that, if
GNP falls, unemployment will rise, but in the
newspaper, one might be quoted as saying that
unemployment will be stable, while the other says
it will fall.
The disagreement arises because of their
different assumptions about GNP.
Disagreements in positive economics can also
arise around which model is the better model of
something
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Test yourself: Can a simple model explain
housing prices?
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Many analysts had postulated that housing in
Australia could be explained by immigration
patterns, consumer confidence, government
policy, interest rates, and seasonal affects.
When the latest housing boom came to an abrupt
end in 2004, their forecasts turned out to be
wrong.
Why might explanations of house prices turn out
to be incorrect?
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Explanation
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What are true relations of prices and other
variables? Are some of these assumptions of
relations really relations or just correlations?
To really find the true answer to prices would require
surveying thousands of buyers and potential buyers.
What many observers have done is simply look at
the coincidence of prices with some other variables.
Moreover, even if some of the relationships are
genuine, there might be other variables in the
process that had not been prominent in the past but
did become in the last cycle, overshadowing the
assumed variables…ceteris paribus.
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Why Economists disagree
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Normative economics deals with what
should be. It is subjective analysis
based on value judgments, not facts.
Normative statements express
opinions that cannot be proven true
of false.
Key words include in normative are:
good, bad, should.
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Why Economists disagree
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When considering the answer to a
problem, be careful to separate the
arguments into positive and normative
components.
Then, you can see if you are reaching a
conclusion based on the facts or
opinions.
Normative differences between
economists can also lead them to different
conclusions about the same topic.
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Test yourself
Are the following statements positive or
normative?
1. All people who want a job should have
one.
2. Demand for a good is a decreasing
function of price.
3. China should adopt Western market
structures.
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Economics and Ethics
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Economics assumes that economic agents
will pursue their own self-interest.
Producers are in business to make profits,
and the more profits they make the
happier they are about being in business.
People want the best deal they can get
when they purchase goods and services,
which might involve price and other
factors.
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Economics and Ethics
A subsidiary assumption, in
economics, is that the self-interest is
enlightened, i.e., that it conforms to
the boundaries of law and social
norms.
 The economic model can, however,
promote unenlightened selfinterest…greed.
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Economics and Ethics
However, that does not promote the
general welfare of the community.
 In the end, these enlightened ethical
economic people are part of
normative economics, which must
be assumed before we embark on a
trail of positive economic analysis.
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Simple Mathematical
Methods
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Relationships
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Economics looks at relationships among
variables. One variable is the independent
variable and the other is dependent.
In a model, the dependent variable is the
one that we are modeling. We say the
dependent variable Y is a function of X,
the independent variable: Y = f(X)
For example, we might ask how supply of
gasoline will vary with price. Then, supply
depends on price: S = F(P), supply is a
function of price.
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Relationships
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We might form an equation, like Supply =
S = AxP = a constant A times P=price.
It might be too difficult to find an equation,
so we might just graph data that we have,
like: 10,000 gallons at $2, 12,000 gallons
at $2.20, 13,000 at $2.30, etc.
Two general possibilities for
relationships are: direct and inverse
relationships.
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Direct Relationships
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In a direct relationship, the dependent variable
increases with increases in the independent
variable(s).
We show a graphical example of such a
relationship.
S
P
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Inverse Relationships
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In an inverse relationship, the dependent
variable increases when the independent
variable(s) decrease. An example might be the
demand, D, for gasoline with respect to price.
Graphically, it would be as shown, below:
D
P
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Slope of a line: variation of one variable
with respect to another.
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The slope of a line is the change, or variation, in
the dependent variable (vertical axis) per unit
change in the independent variable (horizontal
axis).
A common example is speed, the distance
covered per unit of time.
We often write slope in short hand notation, using
the symbol Δ, called delta, for the change in a
variable, i.e., ΔD = D2 – D1 = change in D
between point 2 and 1.
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Slope of a line: variation of one variable
with respect to another.
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Then, slope becomes:
Slope = rise/run = ΔD/Δt = (D2 – D1)/(t2 – t1)
We show a graphical demonstration calculation of
slope in the figure, below:
D2
D1
t1
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t2
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Slope of a line: variation of one variable
with respect to another.
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1.
2.
3.
We can make the general statements:
Slope is positive number, if the relationship is
direct
Slope is negative, if the relation is inverse.
If slope is zero, the relationship is independent,
as shown in the figure, below:
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Slope of a curve: slope of the tangent line
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Straight lines are easy to deal with, but curved ones are
not that much more difficult.
Since a curve is curved, the variation, the slope, will be
different at each point.
What we do to find the variation at any point is to find the
slope of a line tangent at that point, as in the graph,
below.
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Example: Finding slope of a curve from a
graph
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Formally, the slope of a curved line comes from
calculus.
We can find it from algebra, as we did in the
previous slide.
We can do it approximately in a graph by drawing in
a line that is exactly tangent to the point where we
want to find the slope.
You can do it with a straight-edge and making sure
that the line hits only one point in the curve.
Then, you find points for the line on the graph and
calculate the slope.
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Example: Finding slope of a curve from a
graph
•First, we find a curve
by plotting the data
points that we have.
Then, we sketch in the
curve.
•Next, we draw in a line
tangent at the point
where we want to find
the slope.
•Finally, we calculate
the slope. S = rise/run =
ΔY/ΔX = (Y2 – Y1)/(X2
– X1) = (4.25 – 1.25)/(8
– 0) = 3/8 = 0.375
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A third variable in two dimensions
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If the dependent (vertical axis) depends on more than one
variable, say 2, we could draw a 3-dimensional graph.
To include 2 independent variables in a 2-dimensional
drawing, we simply show two curves, each one will be for
specific values of the extra variable. We show an
example, below.
Y
Z=Z3
Z=Z2
Z=Z1
X
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A Note on Graphs
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Don’t just memorize graphs.
In each chapter, look at the graph and
describe to yourself what it means.
Take data and make graphs on your own,
and do the same with theoretical concepts
by drawing general shapes of graphs
described by the theory.
You will find it useful and necessary to use
graphs in your assignment and the final
exam.
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Break time
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Please take a 5 minute break
You can take advantage of the time by
coming up and asking any questions you
have
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Production Possibilities and
their costs.
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3 Fundamental Economic Questions
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1.
Given that we have limited resources, society
must decide how to use them to best suit its
wants and needs. This leads to three basic
questions:
What goods and services will be produced?
More cakes and notebook computers, or more
military hardware. Limited resources, including
time, means that we have to make sacrifices and
choices among what is produced in a given
period of time. Ultimately, preferences will
determine the mix of what is produced, either in
the marketplace or through the government..
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The 3 Fundamental Economic Questions
2.
How to produce them? How should we
combine technology and scarce resources to
produce them. Should the towels that we will
make be made by hand (labor) or by machine
(capital-intensive). Thus, part of the question
will also be how capital or labor intensive
should the production of something be? This
decision is also a matter of education of the
workforce.
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The 3 Fundamental Economic Questions
3.
For whom should we produce? Of all of
the people with wants and desires who will
we choose to satisfy? That will partly
depend on the distribution of income, but the
question of “for whom” might beg the
question of should the government override
market outcomes to ensure that things are
produced to satisfy the needs of the less well
off in the society.
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3 Fundamental Economic Questions

What do we produce?



How do we produce?



Individual decision in markets
Collective decisions by governments
Entrepreneurs in firms
Public servants in governments
For whom do we produce?


Market outcomes (dollar votes)
Non-market outcomes (government and
voluntary sectors)
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Opportunity Costs
Opportunity costs are a concept that
comes up in finance and economics but is
also part of our daily lives.
 Life is full of choices, and when we
decide to choose one among several
alternatives, we give up the others. We
leave behind those other opportunities
… that sacrifice is a cost.

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Opportunity Costs



True opportunity cost is the best available
opportunity that we have sacrificed.
Although opportunity cost is everywhere, it
takes practice to be aware of and to
recognize such costs. Often, it is foolish to
not be aware of such costs.
Even though it sounds simple, opportunity
costs are a large part of this course, and
you should make sure that you understand
them so that you can pass the course.
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Opportunity cost examples
In addition to the real costs of getting an
education at Kangda, there is the
opportunity cost of not working, now,
and not earning money the whole time
that you are in college.
 Not sleeping 8 hours a day is the
opportunity cost of staying up late and
studying so that you will get good grades
in your courses.

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Opportunity cost examples
If you buy a car, you will have real costs
to pay for it and maintain it, but there is
the opportunity cost of what you could do
with all of the extra money you would
have if you just took buses.
 In economics, the opportunity costs are
the choices of other things that could
have been produced.

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Marginal Analysis
 Another
important concept in finance
and economics is the concept of
marginal.
 Marginal means at the margin, at the
edge, in the next step.
 The use of marginal thinking and
analysis brings the focus to the next
step into the future, not the present or
the past.
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Marginal Analysis
For example, if you study one more hour
each night, the marginal affect might be
that you will pass this course rather than
fail.
 If a company has produced 1 million
widgets at 5¢/unit, what will the marginal
cost per unit be if it wants to produce
10,000 more? That is what is important,
not how much it cost to produce the others.
It might cost 6¢ or 4¢ to produce more.

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Production Possibilities Frontier



Since an economy has limited resources, if
some goods and services are produced in
given volumes, then, other goods and
services will have to not be produced or be
produced in less volumes.
In the end, there will be many different
possibilities for combinations of final
production among which the economy can
choose.
These alternative possibilities can be plotted
in a graph called the Production Possibilities
Set, bounded by the Production
Possibilities Frontier, which is the set of
maximum possibilities
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Defining the Fixed-Time PPF


The PPF Model describes the set of all
possibilities for production given the
available resources and technology of an
economy.
Of course, both of those things change
over time, so that what we are really
referring to by the PPF Model is a static
model, i.e., at a given instant of time or,
more properly, over a fixed period of
time, of production possibilities.
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Defining the Fixed-Time PPF
Thus, when we talk about the PPF, we
assume:
1. The quantity and quality of resources is
fixed and known.
2. All resources are fully employed with no
waste or mismanagement.
3. Technology, the body of knowledge
applied to the way things are produced,
is unchanged.
This is an example of ceteris paribus

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Production Possibilities, Graphically
A
Units of Good 2
•The graph describes the
production possibilities for 2
goods or services.
•The Production possibilities
set is contained to the left of
the PPF.
•Thus, Points A,B,C,D, and
F are part of the set, while E
is unattainable.
•A, C, and F are on the
frontier, which represents
maximum production
•Point E is beyond the
possibilities.
C
E
B
D
F
Units of Good 1
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Further PP Discussion


The PPF is a full capacity line, and points
on the line are called efficient. In that
sense, points in the interior of the line, like
B and D, represent inefficient use of
resources for one reason or another.
The graph in the preceding slide is for 2
goods or services, and is, thus 2dimensional. For n goods/services, it
would have to be an n-dimensional
graph, which we could not draw.
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Further PP Discussion


Production can involve goods and services
for general consumption, as well as
production of capital good, which are goods
that will be bought by businesses to be
used in the production process.
Production, output/time period, is a flow
concept, as opposed to stock, which is the
amount of, for example, capital goods
available to produce. A certain stock of
capital can produce certain flows of
production.
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PP and Opportunity


In looking at PP’s we are looking at
simultaneous opportunities and the
associated opportunity costs
associated with producing one amount of
one thing and another amount of another
thing.
To produce more of one thing, we give
up the opportunity of producing some
more of another.
Scarcity
Choice
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Opportunity
Costs
86
PP and Opportunity


Thus, if we can produce 100 cars or 1000
CD players, and we have to produce only
900 CD players, if we want to produce 105
cars, then, the opportunity cost of
producing 5 more cars (105 – 100) is 100
CD players (1000 – 900), or 20 CD
players/car opportunity cost.
In general, we can put opportunity costs
into a variation format: opportunity cost in
in good A to produce more of good B =
A/B, the change in the number of units
of A per unit of B.
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An Opportunity Example

Consider another example producing corn
or pigs:
Corn
1000
900
800
700
600
Pigs
10
40
60
50
55
Opportunity cost = (C1 – C2)/(P1 – P2)
Opportunity cost -100/30
-100/20 -100/10 -100/5
of producing pigs = -3.33
= -5
= -10
= -20
(corn/pig)

It says that at first, we give up 3.333 corns
to produce 1 pig; by the end we give up 20
corns to produce 1 pig.
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Law of Increasing Opportunity Costs




We get our first chance to look at marginal
analysis.
As happens in cases of other costs, marginal
opportunity costs can change.
In this case of opportunity costs, marginal
opportunity cost is always increasing; this is
the law of increasing opportunity costs.
The reason that opportunity costs increase as
we move to produce more of one good or
service over the other is that the factors of
production are usually not equally suited
to producing the two outputs.
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Increasing Opportunity cost example



Consider the choice between producing
automobiles or university degrees (U.D.).
At point A all production is devoted to
autos.
Auto production requires a large amount of
purpose-built equipment, computers, and
some moderately educated labor
University degree production requires
some buildings, computers, and highlyeducated personnel.
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Increasing Opportunity cost example



To move from A to B we move some
buildings, computers and educated personnel
from auto production to U.D. production, and
sacrifice one grid-unit of autos to produce
about 2 1/3 grid-units of U.D.’s.
However, to move from B to C we sacrifice
the same amount of autos as in the first step
to produce less U.D.’s.
Even less, in steps from C to D and D to E
(see next slide).
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Autos vs. University Degree production



Recall that on the PPF, all factors of production are fully
employed, so that by the time we have gone from A to E all of
the capital and laborers have been moved from autos to
university degrees.
However, some of those resources, like unskilled labor and
robots, were better suited to auto making than U.D.
production.
Thus, at first those well-suited to U.D.
production were moved.
However, more and more resources that
were better suited to autos are moved to
U.D.’s and we have to sacrifice more
auto production for incremental U.D.
production.
A
B
C
D
Autos

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U.D.’s
E
92
Law of increasing opportunity cost
explained


In this example, because the factors of
production are not equally suited to
autos and U.D.’s, the marginal addition of
U.D. production for each equal decrease
of auto production decreases.
In another way of looking at it, the slope of
the line ΔA/ΔU is negative and becomes
more negative as we move down the
curve.
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Law of increasing opportunity cost
explained
On the other hand, in a case where
the factors of production were equally
suited to production of the two
outputs, the PPF would be a straight
line.
 A straight line has a constant slope
and constant opportunity costs.

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Shifting the PPF
An economy’s productive capacity is
not necessarily fixed for all time.
 If the resource base increases or
technology advances, the economy
can grows.
 Workers can enter the workforce, oil
can be discovered, new equipment
can be invented.

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Shifting the PPF
 If
the resource base decrease,
the economy can contract.
 People can retire, resources can
run out, and equipment can
become scrap.
 As a result, the PPF can shift as
time goes on.
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Graphic changes in the PPF
Causal Chain Diagrams
Resource decrease
Or
Capital Scrapped
PPF recedes
Resource increase
Or
Techno advance
PPF expands
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Present Investment and future PPF



The process of producing capital goods,
like, equipment, factories, and inventories
is referred to as investment.
Inventories are raw materials are stocks of
raw materials, work-in-progress and
finished goods. They are investment
because they represent future sold output.
When the production of capital goods just
covers the depreciation of existing capital,
we say that the economy has zero net
investment.
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Present Investment and future PPF


When production of capital goods
exceeds that required to match
depreciation, we say that the economy
has positive net investment.
When choices for present production
involve trade-offs between consumer and
capital goods, the future PPF can be
affected by the present choice of the
particular combination on the PPF.
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Present Investment and future PPF


For example, if we choose to produce just
enough capital goods to replace worn out
equipment each year, we will not be able
to increase production capacity, and the
PPF will remain where it is.
If we produce more capital goods than are
needed for simply replacing junked
equipment, then, we can expand the
production capacity of the economy and
the PPF will expand for the subsequent
period.
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Present Investment and future PPF



Examples that high levels of investment
lead to high growth rates for the economy
can be found in Asian countries, like
Singapore, Korea, and China.
Many poorer countries have failed to
achieve economic growth because they
have been unable to produce positive net
investment.
They might either not have enough
productive capacity or a lack of
technologically advanced capital goods.
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Capital goods
Example of Positive investment
B
C
A
Consumer goods
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Example of Positive investment



If the economy chooses the point A on the
PPF in period 0, it produces only enough
capital goods to maintain present capital
stock and remains on that PPF.
If it moves its current mix to B, it will have a
positive net investment, and it can increase
its PPF to point C in the future.
It must sacrifice some current production of
consumer goods, at present, to have the
ability to produce many more in the future.
It can, in the end, increase the standard of
living for its society.
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Trade
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The importance of trading



Both individuals and nations engage in trade.
Individuals tend to specialize in certain
productive activities that give them income,
which they use to purchase other goods and
services.
Instead of weaving my own cloth to make my
own clothing and growing vegetables and pigs, I
specialize in financial research and buy my
clothing at a boutique and groceries at the market
from other people who special ize in other goods
and services.
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The importance of trading



By engaging in trade, both individuals and
nations can benefit from levels of output that
are outside of their PPF boundaries.
The accountant specializes in accounting and
buys clothing from clothing stores. A nation
might specialize in farming, export the excess
produce, and use the money derived from that
to import computers.
Assume 2 countries that produce the same 2
goods: agricultural products and electronics.
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Trade and the PPF


Further assume, for simplicity, that their
resources are equally suited for both industries,
so that the PPF’s of each are linear, i.e., straight
lines instead of curves: constant opportunity
costs.
Econ 1 starts at B, producing 60,000 tons of
agricultural goods and 20,000 tons of electronics.
Econ 2 starts at D, producing 30,000 tons
agricultural goods and 10,000 tons electronics.
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2 economy’s PPF’s

Constant opportunity cost PPF’s
Econ 1
Econ 2
Ag. 20,000 tons/day
A
B without trade
C
D without trade
Electronics 10,000 tons/day
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Trade and the PPF



We assume that points along the PPF’s
also describe the consumption possibilities
of the country in a closed self-sufficient
system without trade.
The opportunity costs for the 2 goods are
different for each economy.
For Econ 1 the opportunity cost is 100,000
tons ag/50,000 tons electronics = 2 tons
Ag/ton electronics.
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Trade and the PPF



For Econ 2 the opportunity cost is 40,000 tons
Ag/40,000 tons Electronics = 1 ton Ag/1 ton
Electronics.
Thus, they each have an advantage in one
good, compared to the other economy.
Econ 1 has to give up 2 tons of Ag to produce
one ton of Electronics. If Econ 2 gives up 1
ton of electronics it can produce only one ton
of Ag.
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Trade and the PPF
If each specializes, Econ 1 producing
only agriculture, and 2 producing only
electronics, they can trade the excesses
and each can go beyond their PPF’s.
 To do that they have to arrive at a terms
of trade that splits the difference in their
opportunity costs. 2 Ag/1 Elec. vs. 1
Ag/1 Elec. Say, for example, 1.5 Ag/1
Elec.

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Trade and the PPF

Then, econ 1 will produce 100, 000 tons of
agricultural goods and economy 2 will
produce 50,000 tons of electronics.

Econ 1 trades 30,000 tons of agricultural
goods for 20,000 tons electronics from Econ 2.
(1.5:1)
Economy 1 ends up with 70,000 tons of
agricultural goods and 20,000 tons of
electronics, more than they would have had on
their own.

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Trade and the PPF



Similarly, economy 2 ends up with 3,000
ton of agricultural goods and 20,000 tons
of electronics, again, beyond what they
could have done on their own
Both move beyond their PPF’s to points B’
and D’.
In the figure, below, we show the results of
trade and the move beyond the PPF.
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International Trading PPF’s
Econ 1
Econ 2
Ag. 20,000 tons/day
A
B’ with trade
B without trade
C
D without trade
D’ with trade
Electronics 10,000 tons/day
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What happened to move beyond PPF



What was the advantage that each had in
changing their production mixes and trading?
As Economic mathematical graphical analysts,
we notice that the obvious answer is that the
slopes of the PPF’s are different for the two
economies.
Econ 1 slope =ΔA/ΔE = 2, while Econ 1
=ΔA/ΔE = 1.
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What happened to move beyond PPF



That means that for each unit of electronics
that Econ 1 gives up, it can produce 2 units of
agriculture. For each unit of agriculture that
Econ 2 gives up, it can produce 1 unit of
electronics.
Opportunity costs are different for each.
Thus, econ 2 is more efficient at producing
electronics versus agriculture than is econ 1
(1elec/2 ag).
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What happened to move beyond PPF




The terms of trade are 1.5 agriculture/1
electronic.
That number could have been different.
It is only important to notice that 1.5
agriculture/electronics is between the
opportunity costs of the 2 nations: 2/1 and
1/1, so it splits their opportunity costs down
the middle: 2 > 1.5 > 1.
In truth, any number between 2 and 1 would
lead to benefits of trading.
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Comparative Advantage



We refer to this difference in opportunity costs
for the two economies as comparative
advantage (CA).
We look at the opportunity cost of producing one
output in terms of the other. That is the slope of
the line of PPF.
World output and consumption are maximized
when each country produces the goods and
services in which it has a comparative
advantages and trades the excess with those who
have comparative advantages in other goods
and services.
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The next approximation in CA




Also, note that we have used simplified models with
linear PPF’s.
In PPF models with curves, the slope of the curve will
be different at each point.
In that case, the comparative advantage will change at
each point along the curves.
What is important in comparisons in the more
complicated situation is the total in terms of what is
given up in total opportunities of specializing in one
good over another, so it is the average slope of the PPF
from its non-trading output to its specialization output.
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Absolute advantage




In comparative advantage, we compare
production tradeoffs in terms of opportunity costs
without regard to the actual costs of the inputs to
production, like how much labor, land or capital went
into production of the goods.
Absolute advantage is used to describe the ability
of an economy to produce a good or service using
the absolute least amount of resource inputs.
Even if one economy has an absolute advantage in
producing goods, it should still specialize and take
advantage of its comparative advantage.
In that manner, world output and consumption can
be maximized.
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Comparative vs. absolute advantages
We all specialize in producing what
we are better at and trading for other
things.
 A person could grow their own food,
make their own clothing and build
their own houses, and they did that
hundreds of years ago.
 However, the whole community
benefits by specializing and using the
money they earn to by other’s
specialties.

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Comparative vs. absolute advantages
It minimizes time spent to produce
things, and it achieves higher
economic welfare.
 Similarly, even if one country has
absolute advantage in all of its output,
it can benefit from comparative
advantage
 The crux of the benefit is that by
specializing, it can move off of its PPF
into the unachievable territory by
using comparative advantage.

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Homework due in tutorial this week




Chapter 1: Q’s 1-12; MC1-12
Chapter 1 appendix: all
Chapter 2: 1-12 & MC
Chapter 18: Q’s 1-3 ; MC 1-8
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Extra credit HW (Exam tips)

a)
b)
c)
d)
Tin Tin and Lin Lin’s PPF schedules are shown below.
Their current mixes of production are shown in bold
face.
Draw graphs of their PPF’s.
What are Tin Tin and Lin Lin’s opportunity costs of
producing 1 kg wheat?
Who has the comparative advantage in wheat?
Assume each specializes in producing their advantage.
Choose a reasonable trading ratio for them to trade.
Then, find how much wheat and cloth each can end up
with. Show point on your charts.
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Extra credit HW (Exam tips)
Lin Lin
Tin Tin
Wheat
(kg/week)
Cloth
(m/week)
Wheat
(kg/week)
25
0
20
10
15
20
10
30
5
40
0
50
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Cloth
(m/week)
20
0
10
5
0
10
125
Extra credit HW (Exam tips)

Question 2: Consider the following table on labor hours needed
per unit of output:
Product
Computers
Wine
Australia
50
25
Japan
40
10
Ignoring non-labor inputs, which of the following statements is
correct?
a) All of the following are correct
b) The opportunity cost of a computer equals 1/4 unit of wine in Japan
c) The opportunity cost of a computer equals 1/2 unit of wine in
Australia
d) Japan has a comparative advantage in computers
e) Japan has a comparative advantage in wine
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Ask yourself
1.
2.
3.
4.
5.
6.
What does econ study, in a few words?
When is the PPF a straight line?
Are there any other costs but opportunity
costs?
Why, in your own words and thoughts, can a
country with absolute advantage in
everything gain from trade?
How can a country expand its PPF outward?
What does it mean to be inside the PP set?
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Exam-caliber Question
Question: The table below contains the
production possibility data of country Z that can
only produce two products X and Y. Answer the
subsections of the question as listed below the
table, providing written or mathematical
explanations to justify your answer.
Combination
A
B
C
D
E
Product X
0
400
800
1200
1600
Product Y
2000
1800
1400
800
0
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Exam-caliber Question (cont’d.)
(a) What is the opportunity cost of the first 400
units of product X?
(b) At which level of consumption of product X is
the opportunity cost the highest?
(c) If an economy produced a combination F of
product X of 800 units and of product Y of 1200,
what economic assessment of the economy
could be made?
(d) What does the data in the table reveal about
the behavior of the opportunity costs of
production of product X in terms of product Y?
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Can you do it?


Given the table of numbers, below, QA(P)
and QB(P) are functions of variable P. Just
from looking at the table, tell where the two
curves, described by QA and QB intersect.
Draw the curves on graph paper.
P
QA
3.00
2.80
2.60
2.40
2.00
1.50
QB
900
800
700
500
300
100
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200
300
400
500
700
1000
130
END
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