econ 2113: principles of microeconomics -...

Econ 2113: Principles of Microeconomics

Spring 2009 ECU

Opportunity Cost, Comparative Advantage

and Efficiency

Chapter 2

Plan

  Expand on the concept opportunity cost   Introduce the idea of economic efficiency   Understand how we can increase welfare by specializing and trading with each other

Production Possibilities and Opportunity Cost

  The production possibilities frontier (PPF) of an economy (or of an individual) is the boundary between those combinations of goods and services that can be produced by the economy (or the individual) and those that cannot, given the amount of resources available

  To illustrate the PPF, we focus on two goods at a time and hold the quantities of all other goods and services constant

  That is, we look at a model of an economy in which everything remains the same (ceteris paribus) except the two goods we’re considering

The Production Possibilities Frontier

Bread (millions of pounds)

Coffee (1000s of punds)

•  A

PPF: The boundary between the combination of goods and services that can and cannot be produced.

•  B

•  C


  Any point on the frontier such as A and any point inside the PPF such as C are attainable.

  Points outside the PPF are unattainable. (point B)

  Production Efficiency: We achieve production efficiency if we cannot produce more of one good without producing less of some other good


 Points on the frontier are efficient.

  Any point inside the frontier, such as C, is inefficient.

  At such a point, it is possible to produce more of one good without producing less of the other good (WHY????)

  At C, resources are either unemployed or misallocated.

  The opportunity cost of an action is the value of the next best alternative that must be foregone in order to undertake the activity.

  When you undertake an action there are many other things you could possibly do. The opportunity cost of that action is the value of the next best alternative.

  Along the PPF, there are only 2 goods, so there is only 1 alternative foregone: some quantity of the other good.

  To produce more coffee, the economy needs to free resources. That means that some workers and capital have to move from the bread industry into the coffee industry

  Then if we choose to produce some quantity of coffee, its opportunity cost is the quantity of bread that we have to give up in order to achieve the desired quantity coffee

Opportunity Cost

6

60 •  • 

• 

A

B

C

Opp. cost of bread

Point A to B ____

Point B to C ____

Point C to D ____

D• 

10

20

30

40

50

70

1 2 3 4 5

Opportunity Cost and the Production Possibilities Frontier



 Note that the opportunity cost of a pound of coffee is just the inverse of the opportunity cost of a pound of bread (blackboard)

 The outward bow of the PPF means that as the quantity produced of each good increases, so does its opportunity cost

 Why do we expect opportunity costs to be increasing?

Opportunity Cost

Marginal Cost

  The PPF determines opportunity cost.

  The marginal cost of a good or service is the opportunity cost of producing one more unit of it

Marginal Cost

  As we move along the PPF, the opportunity cost of pizza increases.

 That is, the more pizzas we currently produce, the more CDs we have to stop producing to free the resources necessary to produce one more pizza

  The opportunity cost of producing one more pizza is the marginal cost of a pizza

  As the opportunity cost is expected to be increasing, so it is the marginal cost

Using Resources Efficiently

  Preferences and Marginal Benefit   Preferences are a description of a person’s likes and dislikes.   To describe preferences, economists use the concepts of marginal benefit and the marginal benefit curve.   The marginal benefit of a good or service is the benefit received from consuming one more unit of it.   We measure marginal benefit by the amount that a person is willing to pay for an additional unit of a good or service.


  It is a general principle that the more we have of any good, the smaller is its marginal benefit and the less we are willing to pay for an additional unit of it.

 Think about yourself really hungry in front of a hot dog stand…

  The marginal benefit curve shows the relationship between the marginal benefit of a good and the quantity of that good consumed

 The curve slopes downward to reflect the principle of decreasing marginal benefit


 At point B, with pizza production at 1.5 million, people are willing to pay 4 CDs for a pizza

 At point E, with pizza production at 4.5 million, people are willing to give up 1 CD for a pizza.


  Production efficiency: We are producing at a point on the PPF.

  Allocative efficiency: We are producing at the point on the PPF that we prefer above all other points

 How do we find the allocative efficient point?

 This point is determined by the quantity at which the marginal benefit curve intersects the marginal cost curve (INTUITION????)


 If we produce fewer than 2.5 million pizzas, marginal benefit exceeds marginal cost

 We get more value from our resources by producing more pizzas


 If we produce more than 2.5 million pizzas, marginal cost exceeds marginal benefit

 We get more value from our resources by producing fewer pizzas.


 If we produce exactly 2.5 million pizzas, marginal cost equals marginal benefit

 We cannot get more value from our resources

Economic Growth   The expansion of production possibilities—and increase in the standard of living—is called economic growth

  Two key factors influence economic growth:   Technological change is the development of new goods and of better ways of producing goods and services   Capital accumulation is the growth of capital resources, which includes human capital

Economic Growth

  The Cost of Economic Growth   To use resources in research and development and to produce new capital, we must decrease our production of consumption goods and services.   So economic growth is not free   The opportunity cost of economic growth is less current consumption

Economic Growth

  Say that we can produce pizzas or pizza ovens along PPF0.   By using some resources to produce pizza ovens today, the PPF shifts outward in the future.

Economic Growth

  In general countries become more productive every year (WHY????)

 This means that they can produce more of all the goods and services that they produce

 Then we expect the PPF to shift outwards in time

The Production Possibilities Frontier



PPF in 1980

PPF in 2000

Exchange and Opportunity Cost

  Absolute Advantage  One person has an absolute advantage

over another if he\she takes fewer hours to perform any task than the other person

 That is, absolute advantage refers to total productivity


  Comparative Advantage  One person has a comparative advantage

over another if his\her opportunity cost of performing a task is lower than the other person’s opportunity cost

 That is, comparative advantage refers to relative productivity


  The Principle of Comparative Advantage  Should Paula update her own web page?


  In the previous slide we see that Paula has an absolute advantage over Beth in both web updates and repairs

  However, we will see that they each have comparative advantage in one of these services


  How many web pages and bicycle repairs can Paula and Beth produce a day if they both work eight hour days?

If they split their time evenly

Opportunity Costs for Paula and Beth

  Looking at the opportunity costs, we see that Beth’s opp. cost of a repair is lower that Paula’s, and that Paula’s opp. cost of a web update is lower than Beth’s

  Therefore Paula has a comparative advantage in web updates, and Beth has a comparative advantage in repairs

  This suggests that they should probably specialize in the production of the goods or services that they have comparative advantage on


If they specialized in their comparative advantage: Say that Beth works only in web pages, and Paula works 6 hours in bike

repairs and 2 hours on web pages


  Then we see that there is a potential total gain from specialization

  Now, will individuals realize these gains trough trade?

  Or in other words, could these individuals gain from trading with each other?


  The Principle of Comparative Advantage: Everyone does best when each person (or each country) concentrates on the activities for which his or her opportunity cost is lowest

  We will see now how all individuals can simultaneously benefit from trade

Another Example

  Susan has absolute advantage in both coffee and nuts

Opportunity costs

  Susan has comparative advantage in coffee, and Tom has a comparative advantage in nuts


  Assume that each individual works 8 hours per day

  How many nuts and coffee can they produce?

  We graph the PPF for each individual

Susan’s Production Possibilities

0

Coffee (lb/day)

Nuts (lb/day)

24

Production Possibilities Curve: All combinations of coffee and nuts that can be produced with Susan’s labor

12

Susan’s Production Possibilities Curve for an 8 hour day

Tom’s Production Possibilities Curve

0 Nuts

(lb/day)

Tom’s Production Possibilities Curve for an 8 hour day

Coffee (lb/day)

4 Tom’s Production Possibilities Curve: All combinations of coffee and nuts that can be produced with Tom’s labor

8

No Trade

  Assume that initially they work 4 hours each in coffee and nuts

  Susan’s production (and consumption): 12 lb. of coffee and 6 lb. of nuts

  Tom’s production (and consumption): 2 lb. of coffee and 4 lb. of nuts

  Total output: 14 lb. of coffee and 10 lb. of nuts

Individual Production Possibilities Curves Compared

Nuts (lb/day) 0

24

12

Susan’s PPC

Coffee (lb/day)

12

6

Individual Production Possibilities Curves Compared

Nuts (lb/day) 0

4

8

Tom’s PPC

Coffee (lb/day)

4

2

Production and Consumption without Trade

Total 14 lb 10 lb

Specialization and the Gains From Trade

  Susan and Tom now figure out that they each have a comparative advantage, and that trading would benefit both of them

  How?

  Assume that they both specialize in the production of the good they have a comparative advantage in

  Assume that Susan produces 18 lb. of coffee and 3 lb. of nuts (how?)

  Tom produces 8 lb. on nuts and no coffee (how?)

  Total output: 18 lb. of coffee and 11 lb. of nuts

  There is more of everything!!!

Production with Specialization and Trade

Total 18 lb 11 lb

But if they can’t trade, Tom may choose not to follow this arrangement (why???)


  Now assume that Susan trades 3 lb. of coffee in exchange for 3.5 lb. of nuts

  Then the consumptions are: Susan: 15 lb. of coffee and 6.5 lb. of nuts Tom: 3 lb. of coffee and 4.5 lbs of nuts

  They are both better off, compared with the no specialization and no trade situation!!!

Consumption with Specialization and Trade

Total 18 lb 11 lb


Nuts (lb/day) 0

24

12

Coffee (lb/day)

18

3

production

consumtion

15

6.5


Nuts (lb/day) 0

4

8

Coffee (lb/day)

4.5

3 production

consumption

  Trade allows both individuals to consume beyond their PPF!!! (they still produce on their PPF)

  So by specializing and trading, they can both consume more than before

  Therefore total welfare in higher


  Could trade take place in a market?

  Assume Pc = $1.16/lb. and Pn = $1/lb.

  Blackboard


  Dynamic Comparative Advantage   Learning-by-doing occurs when a person (or nation) specializes and by repeatedly producing a particular good or service becomes more productive in that activity and lowers its opportunity cost of producing that good over time.   Dynamic comparative advantage occurs when a person (or nation) gains a comparative advantage from learning-by-doing.   What this means is that as individuals (or countries) specialize, they make their comparative advantage even larger   Therefore, the gains from trade become even greater in time

Gains From Trade

  To reap the gains from trade, the choices of individuals must be coordinated

  To make coordination work, four complimentary social institutions have evolved over the centuries:   Firms   Markets   Property rights   Money

Economic Coordination


  A firm is an economic unit that hires factors of production and organizes those factors to produce and sell goods and services.

  A market is any arrangement that enables buyers and sellers to get information and do business with each other.

  Property rights are the social arrangements that govern ownership, use and disposal of resources, goods or services.

  Money is any commodity or token that is generally acceptable as a means of payment.


 Circular Flows Through Markets   A circular flow diagram illustrates how households and firms interact in a market economy:

  Factors of production and goods and services flow in one direction.   Money flows in the opposite direction.   Markets coordinate individual decisions through price adjustments.

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