ECON 2100 Principles of Microeconomics (Summer 2016) Scarcity, Opportunity Cost, and the Gains from Trade

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1 EON 21 Principles of Microeconomics (Summer 216) Scarcity, Opportunity ost, and the Gains from Trade Relevant readings from the textbook: Mankiw, h. 3 Interdependence and the Gains from Trade Suggested problems from the textbook: hapter 3 Questions for Review (Page 59): 1, 2, 3, 4, 5, and 6 hapter 3 Quick heck Multiple hoice (Page 59-6): 1, 2, 3, and 6 hapter 3 Problems and pplications (Pages 6): 1, 2, 4, 5, 8, and 9 Definitions and oncepts: Three Fundamental Economic Questions every society must answer three fundamental economic questions: 1. What to produce? (i.e., what mix of goods and services should be created) 2. How to produce it? (i.e., what resources and productive techniques should be used to provide these goods and services) 3. How to allocate it? (i.e., which individuals in society will get the benefits of consuming these goods and services) Most individuals in modern economies engage in a great deal of Specialization, in that they produce a very narrow set of goods/services while consuming a much greater variety of goods/services. Production process which transforms scarce resources into useful goods and services. Inputs or Factors of Production scarce resources that can be used to directly or indirectly satisfy human wants. Outputs finished, usable products which result from production. Production Possibilities Frontier (PPF) graph that illustrates the combinations of output that a society can produce, given the currently available resources and production technology. The PPF essentially presents a society with a menu of available options (from which the society must choose one particular combination of goods ). ttainable versus Unattainable combinations of output: ttainable combination of goods that can possibly be produced with the currently available resources and technology. Unattainable combination of goods that cannot possibly be produced with the currently available resources and technology.

2 Efficient versus Inefficient combinations of output (a further characterization of attainable combinations): Inefficient an attainable combination for which it is possible to increase the production of one good without decreasing the production of any other good. Efficient an attainable combination for which it is not possible to increase the production of any good without decreasing the production of some other good. Notion of Opportunity ost in the 2 Good Production Model. If a worker with a limited amount of labor can produce either good () or good (), then the Opportunity ost of producing a unit of good () is measured by the number of units of good () that must be foregone in order to produce the additional unit of good (). For example, if lice can produce either 1 baseballs or 5 carrots in a single day, Decrease_ arrots 5 then her opportunity cost of a baseball is: O 5. Increase_ aseballs 1 That is, the true cost of each additional baseball is 5 carrots, since that is what she actually has to give up in order to get 1 baseball. Recall that when considering any worker () who produces good () and 1 good (), the following relation always holds: O. O bsolute dvantage one worker has an absolute advantage over another in the production of a good if she can produce a greater quantity of output with a common amount of inputs (or equivalently, if she requires fewer inputs to produce a common amount of output). omparative dvantage one worker has a comparative advantage over another in the production of a good if her opportunity cost for producing the good is lower. Existence of Differing omparative dvantages in the 2 Worker, 2 Good Production Model. Suppose that worker () and worker (D) each have a limited amount of labor with which to produce two goods, good () and good (). If one worker has a omparative dvantage in the production of good (), then the other worker must have a omparative dvantage in the production of good (). 1 Result follows from the above general observation that O. O More precisely: suppose worker () possesses a omparative dvantage over worker (D) in producing good (). That is, O OD. pplying the 1 1 general rule above, it follows that:. This implies O D O, so O OD that worker (D) possesses a omparative dvantage over worker () in producing good ().

3 Principle of omparative dvantage a society can produce a greater amount of total output when individuals focus their production on those activities for which they have a comparative advantage. Principle of Increasing Opportunity ost (or Low-Hanging-Fruit Principle ) in expanding the production of any good, always use the available resource with the lowest Opportunity ost. Individual benefits of voluntary trade. Generally, voluntary trade makes all parties to the trade individually better off. Intuition: if a voluntary trade did NOT make an individual better off, then she would simply choose NOT to trade.

4 omputation of O.. s and sketching of PPF s in 2 Person, 2 Good Model : Example: Two individuals (indy and Dave) produce two goods (owling alls and Steaks). onsider their production decision over the course of a workweek. Each person is endowed with one unit of labor which they can continually split among the two tasks. owling alls: Steaks: indy: 8 per week 2 per week Dave: 6 per week 12 per week Decrease _ 8 Decrease _ S 2 1 indy s O.. s: O S 4 and O Increase _ S 2 Increase _ 8 4 Decrease _ 6 1 Decrease _ S 12 Dave s O.. s: O S and O 2 D D Increase _ S 12 2 Increase _ Individual PPF s (without specialization): owling alls indy: Slope of PPF illustrates the tradeoff between the two goods that indy faces: S (slope)= 4 O 6 owling alls Dave: Slope of PPF illustrates the tradeoff between the two goods that Dave faces: 1 S (slope)= O D Steaks 6 12 Steaks (continued on next page)

5 bsolute dvantage: indy has an.. in producing bowling balls since: 8>6. indy has an.. in producing steaks since: 2>12. omparative dvantage: 1 indy has.. in producing bowling balls since: O 2 O 4 S 1 S Dave has.. in producing steaks since: OD 4 O 2 pplying Low-Hanging-Fruit Principle to obtain a Societal PPF : always have Dave produce the next steak so long as he still has time to switch from bowling balls to steaks. only ever want indy to produce the next steak if she is the only available resource (i.e., if we have already used all of Dave s labor to produce steaks). Societal PPF : 86 owling alls S 1 (Slope of PPF) O D (.5) 2 D 8 S (Slope of PPF) O 4 Steaks as a direct result of applying this principle, the Societal PPF becomes steeper (i.e., more negatively sloped) as we move down the PPF Division of labor along Societal PPF: vertical intercept both produce only bowling balls red indy produces only bowling balls and Dave produces both bowling balls and steaks kink indy produces only bowling balls and Dave produces only steaks green Dave produces only steaks and indy produces both bowling balls and steaks horizontal intercept both produce only steaks

6 Summary of important concepts related to PPF: PPF provides society with a menu of available options, from which society chooses one particular combination of goods (the choice obviously depends upon preferences/priorities of society) Downward sloping nature of PPF illustrates the tradeoff that society faces between output of the two goods The value of the slope of the PPF is equal to minus the opportunity cost of the good on the horizontal axis for the marginal resource => application of the Low- Hanging-Fruit Principle implies that the PPF becomes steeper as we move down the curve (i.e., PPF is outward bending ) For a society with many different resources/workers, we would likely end up with a PPF that is a smooth curve ttainable versus Unattainable: ttainable combination of goods that can possibly be produced with the currently available resources and technology. [points,,, D] Unattainable combination of goods that cannot possibly be produced with the currently available resources and technology. [point E beyond the curve ] Efficient versus Inefficient (further characterization for attainable combinations): Inefficient an attainable combination for which it is possible to increase the production of one good without decreasing the production of any other good. [point D below the curve ] Efficient an attainable combination for which it is not possible to increase the production of any good without decreasing the production of some other good. [points,, on the curve ] [illustrates the maximum amount of guns that can be produced for each possible level of roses production ] 13, Guns E 12, 9, 6, D Roses 35, 65, 85, 1,

7 Problems: 1. Imagine a society that produces two goods: Tanks and Tulips. The Production Possibilities Frontier for this society is illustrated below. Tanks D E Tulips. Which points illustrated above are attainable? Which points illustrated above are unattainable? Explain.. Which of the attainable points identified in part () are efficient? Which of the attainable points identified in part () are inefficient? Explain.. Is the Opportunity ost of Tulips greater at Point or at Point E? Explain. 2. manda and urt devote each workday to producing coffee and donuts. On any given day manda can produce either 1 pounds of coffee or 4 donuts, while urt can produce either 6 pounds of coffee or 2 donuts.. Which individual has an bsolute dvantage in the production of coffee? Explain. Which individual has an bsolute dvantage in the production of donuts? Explain.. Determine the opportunity cost of an additional pound of coffee and the opportunity cost of an additional donut for each individual.. Which individual has a omparative dvantage in the production of coffee? Explain. Which individual has a omparative dvantage in the production of donuts? Explain. D. ssuming that no specialization can occur, graph the Production Possibilities Frontier for manda. learly label all relevant points, and state the value of the slope of the PPF at every point. E. Supposing that manda and urt can specialize in their production, graph the Production Possibilities Frontier for this two person society. learly label all relevant points, and state the value of the slope of the PPF at every point. F. Suppose that Edward joins the society in which manda and urt live. On any given day, Edward can produce either 3 pounds of coffee or 3 donuts. Supposing that manda, urt, and Edward can specialize in their production, graph the Production Possibilities Frontier for this three person society. learly label all relevant points, and state the value of the slope of the PPF at every point.

8 Multiple hoice Questions: 1. The Principle of omparative dvantage. provides a graphical illustration of the different combinations of output that a society can produce, given the currently available resources and production technology.. states that the most productive worker in a society will always have a omparative dvantage in the production of every good.. states that a society can produce a greater amount of total output when individuals focus their production on those activities for which they posses a omparative dvantage. D. states that in a comparative sense, citizens of wealthy countries have an advantage over citizens of poor countries, since the former have easier access to higher quality and lower cost education, healthcare, and consumer goods. 2. Mike and Xavier spend each workday assembling bicycles and fixing computers. Mike can assemble 12 bicycles in a single day, while Xavier can fix 8 computers in a single day. ased upon this information, we know that. Mike possesses an bsolute dvantage in assembling bicycles.. Xavier possesses an bsolute dvantage in fixing computers.. Mike posses a omparative dvantage in both assembling bicycles and fixing computers. D. None of the above answers are necessarily correct. 3. Output refers to. the process by which scarce resources are transformed into finished goods/services.. the scarce resources which can be used to directly or indirectly satisfy human wants.. finished, usable products which result from the production process. D. None of the above answers are correct. 4. Worker 1 has a omparative dvantage over Worker 2 in the production of a good if:. Worker 1 can produce more units of the good in any single day.. Worker 1 has a lower Opportunity ost for producing the good.. Worker 1 has a higher Opportunity ost for producing the good. D. Worker 1 is more intelligent than Worker Voluntary Trade generally. makes buyers better off, but sellers worse off.. makes sellers better off, but buyers worse off.. makes both parties to the trade better off. D. makes both parties to the trade worse off.

9 6. Which of the following statements is true?. ll Unattainable combinations of output are Efficient.. n output combination is Inefficient if it is ttainable (i.e., all ttainable combinations of output are Inefficient).. n output combination is Efficient if it is ttainable (i.e., all ttainable combinations of output are Efficient). D. n output combination is Efficient if it is an ttainable combination for which it is not possible to increase the production of any good without decreasing the production of some other good. For Questions 7 though 9, consider a society facing the Production Possibilities urve illustrated below: orn 1,35 1, 8 5 D ars 7. Which of the following combinations of output is feasible but inefficient?. (15 ars and 375 bushels of orn).. (3 ars and 5 bushels of orn).. D (21 ars and 1, bushels of orn). D. More than one of the above answers is correct. 8. Starting at Point (i.e., 21 ars and 8 bushels of orn), if this society wanted to produce 9 more ars, then. they could also increase their output of orn by 9 bushels.. they could not increase their output of orn, but they also would not have to decrease their output of orn at all.. they would have to decrease their output of orn by at least 3 units. D. they would no longer be able to produce any orn whatsoever. 9. If this society wanted to produce 1,2 bushels of orn, then. they would not be able to produce any ars.. they could produce a positive number of ars, but fewer than 16 ars.. they could produce up to 21 ars. D. None of the above answers are correct.

10 1. Scott spends his workday making hamburgers and hotdogs. His Opportunity ost of making a hamburger is 3 hotdogs. s a result, his Opportunity ost of making a hotdog. is greater than 3 hamburgers.. is equal to 3 hamburgers.. is equal to 3 1 of a hamburger. D. cannot be determined from the given information. 11. Ed and Fred produce Raincoats and Shirts. Ed s Opportunity ost for making a Shirt is 3 Raincoats, while Fred s Opportunity ost for making a Shirt is 5 Raincoats. ased upon this information, we know that. Ed has an bsolute dvantage in Raincoat production.. Fred has an bsolute dvantage in Shirt production.. Fred has a omparative dvantage in Raincoat production. D. More than one of the above answers is correct. 12. Production Possibilities Frontier. essentially presents a menu of available combinations of output from which a society can choose.. should be outward bending, as a direct result of applying the Low- Hanging-Fruit Principle.. should be positively sloped, illustrating how more inputs are needed in order to produce higher levels of output. D. More than one of the above answers are correct.

11 nswers to Problems: 1. When examining a PPF, the points on or below the curve are attainable (meaning that they could possibly be produced, given the scarce resources and technology currently available). Thus, Points (), (), (D), and (E) are all attainable. The points beyond the curve are unattainable (meaning that they cannot possibly be produced, given the scarce resources and technology currently available). Thus, Point () is unattainable. 1. ll attainable points are further characterized as either efficient (if it is not possible to increase the production of any good without decreasing the production of another good) or inefficient (if it is possible to increase the production of at least one good without decreasing the production of any other good). Visually, efficient points lie on the PPF while inefficient points lie below the PPF. Thus, Points (), (), and (E) are each efficient and Point (D) is inefficient. 1. Recall that the slope of the PPF is equal to the Opportunity ost of producing the good on the horizontal axis (in this case, the slope captures the value of the Opportunity ost of producing Tulips). The PPF appears to be flatter at Point () than at Point (E), implying that the Opportunity ost of Tulips is greater at Point (E) than at Point (). Further, as a direct result of correctly applying the Low-Hanging-Fruit Principle, we know that the Opportunity ost of Producing Tulips must become greater as more Tulips are produced. Since more Tulips are being produced at Point (E) than at Point (), this provides a further explanation for why the Opportunity ost of Tulips must be greater at Point (E) than at Point (). 2. urt has an bsolute dvantage in coffee production, since he can produce a greater amount of output than manda in any given day (6>1). manda has an bsolute dvantage in donut production, since she can produce a greater amount of output than urt in any given day (4>2). Decrease _ D 4 2. manda s Opportunity ost for producing coffee is O 4 Increase _ 1 donuts. Likewise, manda s Opportunity ost for producing donuts is Decrease _ 1 1 O D of a pound of coffee. urt s Opportunity ost for Increase _ D 4 4 Decrease _ D 2 1 producing coffee is O of a donut, while his Increase _ 6 3 Decrease _ 6 Opportunity ost for producing donuts is O D 3 pounds of Increase _ D 2 coffee. 2. urt has a omparative dvantage in the production of coffee, since he has a 1 lower Opportunity ost for producing the good ( O O 4). manda 3 has a omparative dvantage in the production of donuts, since she has a lower D 1 D Opportunity ost for producing the good ( O O 3 ). 4

12 2D. manda s PPF: Donuts 4 Slope of PPF at every point is equal to: (slope)= O 4 1 offee 2E. Societal PPF with Specialization : 6 Donuts (Slope of PPF) O 1 3 (Slope of PPF) O 4 4 offee 6 7

13 3 2F. Note that Edward s Opportunity ost for producing coffee is O E 1 donut. 3 Since O O E O, it follows that when increasing coffee production by applying the Low-Hanging-Fruit Principle we should: first use urt s labor, next use Edward s labor, and lastly use manda s labor. Since the three different workers have three different values for their Opportunity ost of producing coffee, our PPF now has two kinks, as illustrated below. Societal PPF with Specialization (with Edward) : 9 Donuts (Slope of PPF) O 1 3 (Slope of PPF) O 1 E 7 (Slope of PPF) O 4 4 offee nswers to Multiple hoice Questions: D D D