Microeconomics. Topic 2

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Solomon Page
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1 Topic 2 Econ page 1 Topic 2 Text reference: Chapter 2 Chapter 17 Production Possibilities Frontier Absolute Advantage Comparative Advantage Gains From Trade

2 Topic 2 Econ page 2 Resource Allocation in Society There are three key resource allocation questions at the core of microeconomics: - What goods and services should society produce, given our scarce resources? - How should production of those goods take place? - Who should get to consume those goods? Normative questions we need a normative criterion

Topic 2 Econ 103 -- page 3 In Topic 2, we will focus on the second question with three aims: Develop a sense of

3 Topic 2 Econ page 3 In Topic 2, we will focus on the second question with three aims: Develop a sense of normative approach used in economics Practice simple model-building Understand why economists really like trade

Topic 2 Econ 103 -- page 4 Economic Efficiency Our normative criterion is

4 Topic 2 Econ page 4 Economic Efficiency Our normative criterion is efficiency. - Efficiency, economic efficiency, Pareto efficiency all equivalent terms.

Topic 2 Econ 103 -- page 5 General Idea: As long as we like something, if we can get something for nothing, then we should get

5 Topic 2 Econ page 5 General Idea: As long as we like something, if we can get something for nothing, then we should get it. It would be irrational not to exploit the circumstances if they exist. However, the current situation cannot be efficient.

6 Topic 2 Econ page 6 Look at this idea in the context of the second question: How should production of those goods take place? Model of Production Start as simple as possible. Assume initially a one-person world There is no trade and no monetary system. One person can use their time and other resources to produce food. Two types of food: Fish and morel mushrooms:

Topic 2 Econ 103 -- page 7 Time spent fishing cannot be

7 Topic 2 Econ page 7 Time spent fishing cannot be spent mushrooming; time spent on mushrooming cannot be spent on fishing. The opportunity cost of fishing is mushrooms foregone. The opportunity cost of mushrooming is fish foregone.

8 Topic 2 Econ page 8 Production How much food can be produced in a day? If all time is spent on fishing: We catch 15 fish. We cannot have any mushrooms. If all time is spent on collecting mushrooms, we can harvest 40 mushrooms, but cannot have any fish. Output per Day Mushrooms Fish If we split our time, we can have some of both.

9 Topic 2 Econ page 9 What is the opportunity cost of mushroom production? Output per day Mushrooms Fish To get the first 10 mushrooms, must give up one fish. The marginal (opportunity) cost per mushroom = 1/10 Fish. To get an increase in mushrooms from 10 to 20, must give up three fish: MC per mushroom = 3/10 fish. From 20 to 30 mushrooms, MC =5/10 fish. From 30 to 40 mushrooms, MC = 6/10 fish.

Topic 2 Econ 103 -- page 10 Production Possibility Frontier It is useful to represent production technology graphically.

10 Topic 2 Econ page 10 Production Possibility Frontier It is useful to represent production technology graphically. This is the production possibility frontier (PPF). The PPF plots the maximum combinations of goods that can be produced given available resources and technology.

Topic 2 Econ 103 -- page 11 Points on the PPF are as good as we can do, given scarce resources and current technology.

11 Topic 2 Econ page 11 Points on the PPF are as good as we can do, given scarce resources and current technology. If we are on the PPF, to get more of one good, we have to give up some of the other good. If we are on PPF, we cannot get something for nothing. There are no win-wins. Points on the PPF are efficient (in one-person world.)

12 Topic 2 Econ page 12 Fish PPF 11 6 Mushrooms

13 Topic 2 Econ page 13 Fish 15 If we end up inside the PPF, we must 14 not be fully using our resources We can have more of one good (or both) without having to give any of the other. Mushrooms We can get something for nothing; there are win-wins. Points inside the PPF are inefficient.

14 Topic 2 Econ page 14 Points outside the PPF would be nice, but aren t available, given the world in which we live. Fish Not possible Points outside the PPF are 11 infeasible; unattainable Mushrooms

15 Topic 2 Econ page 15 The slope (absolute value) = MC of good on horizontal axis. Fish slope = rise run Inverse of slope = MC of good on vertical axis 6 As we move along the PPF, the slope is steeper Mushrooms If PPF is linear, then MC is constant.

16 Topic 2 Econ page 16 In a one-person economy, our opportunities for consumption are constrained by PPF. Can only consume any combination of goods on PPF. Would be nice to be outside PPF, but not feasible. The bundle we choose to produce and consume depends on how much we like goods, relative to each other. Depends on our preferences. Assume this person s preferences are such that they produce and consume 10 mushrooms and 14 fish per day.

17 Topic 2 Econ page 17 Specialization and Trade Suppose another person arrives in our economy. This new person can also produce fish and mushrooms, but has different skills. Person 2 Output per day Mushrooms Fish Person 2 s Production possibilities for fish and mushrooms. Person 2 can produce more than person 1. Person 2 s PPF lies entirely outside person 1 s.

18 Topic 2 Econ page 18 Person 1 Person 2 Output per day Output per day Mushrooms Fish Mushrooms Fish In this case, Person 2 has the absolute advantage in the production of both goods. Person 2 can produce more mushrooms than person 1 at a given level of fish. Person 2 can produce more fish than person 1 at a given level of mushrooms. Work through the examples in the supplementary exercises.

19 Topic 2 Econ page 19 Fish If all time is spent on fishing: We catch 15 fish. We cannot have any mushrooms. If all time is spent on collecting mushrooms, we can harvest 40 mushrooms, but cannot have any fish Mushrooms

20 Topic 2 Econ page 20 Recall: Person 1 produces and consumes 10 mushrooms and 14 fish per day. Assume initially that: - There is no interaction or cooperation between person 1 and 2. - Person 2 chooses to produce and consume 40 mushrooms and 9 fish. Aggregate output in this economy is 50 mushrooms and 23 fish. - Are production combinations efficient? - Can the economy get something for nothing? - Can we have more mushrooms or fish without having to give anything up?

21 Topic 2 Econ page 21 - If we can, this production combination cannot be efficient. - Doing what we are doing leaves win-wins on the table.

22 Topic 2 Econ page 22 Current production: Person 1 10 mushrooms and 14 Fish Person 2 40 mushrooms and 9 fish Aggregate output 50 Mushrooms and 23 Fish Different feasible production combination: Person 1 20 mushrooms and 11 Fish Person 2 30 mushrooms and 17 fish Aggregate output 50 Mushrooms and 28 Fish Original production choice left win-wins on the table. Same total mushrooms and more fish. Net gain of 5 fish at zero overall cost.

23 Topic 2 Econ page 23 Original production choice cannot be efficient. Those extra fish can improve the well-being of both people. *Person 1 trades extra 10 mushrooms produced in exchange for 6 fish. Each ends up with the same amount of mushrooms as before, but now: - Person 1 has 14 Fish in total A net gain of 3 fish - Person 2 has 11 fish in total A net gain of 2 fish This is what we mean when we talk about gains from trade. Each gets to consume at a point that is outside their PPF.

24 Topic 2 Econ page 24 Where did this something for nothing come from? Person 1 increased mushroom production from 10 to Cost the economy 3 fish. - MC of each new mushroom now produced by person 1 is 3/10 fish. Person 2 decreased mushroom production from 40 to Gain to the economy of 8 fish. - MC of each mushroom no longer produced by person 2 was 8/10 fish. Gain possible because there was a difference between MC.

25 Topic 2 Econ page 25 Recall, Person 2 has the absolute advantage in mushroom production. He is able to produce more mushrooms for given fish, and vice versa. But, at the original production point, the marginal cost of mushroom production is lower for Person 1 than for Person 2.

26 Topic 2 Econ page 26 Distinction between absolute advantage and comparative advantage: Economic agent with the lower MC of producing a good has the comparative advantage in the production of that good. Efficient production is determined by comparative advantage, not absolute advantage. Producers should specialize in the good for which they have the comparative advantage. Some important conclusions follow from material covered so far:

27 Topic 2 Econ page 27 Summary: 1) If Person 1 has a comparative advantage in mushroom production, then Person 2 must have the comparative advantage in fish production. - Follows since the MC of fish = inverse of MC of mushrooms. 2) A producer may not have the comparative advantage at all levels of production. - As Person 1 increased mushroom production, his MC of mushroom production increased. - As Person 2 decreased mushroom production, her MC of mushroom production decreased.

28 Topic 2 Econ page 28 - At some point, Person 2 will gain the comparative advantage in mushroom production. So, Person 1 will gain the comparative advantage in fish. 3) Specialization need not be complete: - That is, efficiency does not necessarily require a producer to produce only the good for which it has a comparative advantage. - Partly true because comparative advantage can change as output changes. - But, true also because we might not want much of the good.

Topic 2 Econ 103 -- page 29 - If a producer has a comparative advantage in producing bean sprouts, but everyone hates bean sprouts,

29 Topic 2 Econ page 29 - If a producer has a comparative advantage in producing bean sprouts, but everyone hates bean sprouts, we will not want bean sprouts. What ends up being produced is partly a function of costs, but also partly a function of preferences.

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ECONOMICS 103. Topic 2: Specialization & Trade

ECONOMICS 103. Topic 2: Specialization & Trade ECONOMICS 103 Topic 2: Specialization & Trade Key concepts: production possibilities, absolute advantage, comparative advantage, trade, gains from trade, economic efficiency. Model: production possibility