1 econ 1000: mod 1 c.l. mattoli (c) red hill capital corp., 2008

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Econ 1000: Mod 1

C.L. Mattoli

(C) Red Hill Capital Corp., 2008

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Information Information 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


4(C) Red Hill Capital Corp., 2008

5(C) Red Hill Capital Corp., 2008

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10 Principles of EconBehavior 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

5. Trading can make everyone better off.

6. Markets are usually a good way to organize economic activity.


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Principles of Econ7. 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.


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The course1. First we get our feet wet by looking at what

economics is, and how it is put together: it is about opportunities and decisions.

2. Economics takes psychology and uses it in logical and mathematical models, using a lot of graphical analysis.

3. It looks at how resources of production are pulled together to make things in the best way to satisfy society.

4. Our first look, in this chapter will be the production possibilities frontier (PPF).


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The course5. 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.

6. We shall study supply and demand in markets and look at market structures.

7. 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

10. 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.

11. Thus, governments will also need policy about money, monetary policy, and spending and taxation, fiscal policy.


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Material covered this week

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 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 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 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 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)

Yet Another

thing

Another thing

Leads to (Causes)


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Summed up 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 The economic way of thinking involves:1. A logical framework for analyzing

problems.2. A language of economic terms.3. 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 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.


Advice to Remember 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.

(C) Red Hill Capital Corp., 2008 21

Advice to Remember 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.

Without doing any “analysis” at all, the intersection will occur when both are equal, which is a P = 2.40 and S = D = 500.


Price Quantity supplied

Quantity demanded

3.00 900 2002.80 800 3002.60 700 4002.40 500 5002.00 300 7001.50 100 1000

Graph from a table


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Scarcity: where economics begins 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 Economics divides resources, the

factors of production, into 3 basic categories:

1. Land

2. Labor

3. 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 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 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 Labour Capital

Goods & Services

Resource inputs are pulled together and transformed by entrepreneurs into output

Entrepreneur Risk


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Economics: the study of scarcity & choice 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 The micro scale of economics looks at decision-

making 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 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 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 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 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 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

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 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 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 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 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 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 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? 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 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

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 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

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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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 self-interest…greed.


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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 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

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 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 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. 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. Then, slope becomes:

Slope = rise/run = ΔD/Δt = (D2 – D1)/(t2 – t1) We show a graphical demonstration calculation of

slope in the figure, below:

D1

D2

t1 t2


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Slope of a line: variation of one variable with respect to another. We can make the general statements:

1. Slope is positive number, if the relationship is direct

2. Slope is negative, if the relation is inverse.

3. 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 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 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 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

X

Z=Z1

Z=Z2

Z=Z3


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A Note on Graphs 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

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 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:

1. 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 Questions2. 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 Questions3. 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?

Individual decision in markets Collective decisions by governments

How do we produce? 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•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.

A

B

C

D

E

F

Units of Good 1

Un

its

of G

ood

2

A

B

C

D

E

F

Units of Good 1

Un

its

of G

ood

2


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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 2-dimensional. 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 Opportunity Costs

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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.


An Opportunity Example Consider another example producing corn

or pigs:

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.


Corn 1000 900 800 700 600

Pigs 10 40 60 50 55

Opportunity cost = (C1 – C2)/(P1 – P2)

Opportunity cost of producing pigs (corn/pig)

-100/30 = -3.33

-100/20 = -5

-100/10 = -10

-100/5 = -20

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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 highly-educated 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

Aut

os

U.D.’s E(C) Red Hill Capital Corp., 2008

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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.


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 decreaseOr

Capital ScrappedPPF recedes

Resource increaseOr

Techno advancePPF 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.


99

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.


100

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.


101

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.


Example of Positive investment


Cap

ital

go

ods

A

B C

Consumer goods

103

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.


104

Trade


105

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.


106

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.


107

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.


108

2 economy’s PPF’s

Econ 1 Econ 2

Ag.

20,

000

tons

/day

Electronics 10,000 tons/day

B without trade

CD without trade

A

Constant opportunity cost PPF’s


109

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.


110

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.


111

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.


112

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.


113

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.


114

International Trading PPF’s

Econ 1 Econ 2

Ag.

20,

000

tons

/day

Electronics 10,000 tons/day

B’ with trade

B without trade

C

D’ with trade

D without trade

A


115

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.


116

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).


117

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.


118

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.


119

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.


120

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.


121

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.


122

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.


123

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


124

Extra credit HW (Exam tips) Tin Tin and Lin Lin’s PPF schedules are shown below.

Their current mixes of production are shown in bold face.

a) Draw graphs of their PPF’s.

b) What are Tin Tin and Lin Lin’s opportunity costs of producing 1 kg wheat?

c) Who has the comparative advantage in wheat?

d) 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.


125

Extra credit HW (Exam tips)Tin Tin

Wheat (kg/week)

Cloth (m/week)

25 0

20 10

15 20

10 30

5 40

0 50

Lin Lin

Wheat (kg/week)

Cloth (m/week)

20 0

10 5

0 10


Extra credit HW (Exam tips) Question 2: Consider the following table on labor hours needed

per unit of output:

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


Product Australia Japan

Computers 50 40

Wine 25 10

Ask yourself

1. What does econ study, in a few words?

2. When is the PPF a straight line?

3. Are there any other costs but opportunity costs?

4. Why, in your own words and thoughts, can a country with absolute advantage in everything gain from trade?

5. How can a country expand its PPF outward?

6. What does it mean to be inside the PP set?


Exam-caliber QuestionQuestion: 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 Product X Product Y

A 0 2000

B 400 1800

C 800 1400

D 1200 800

E 1600 0

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?


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 QB3.00 900 2002.80 800 3002.60 700 4002.40 500 5002.00 300 7001.50 100 1000

131

END


1 econ 1000: mod 1 c.l. mattoli (c) red hill capital corp., 2008

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