Economics 1 (EC107) LECTURE 1 INTRODUCTORY TOPIC. Importance of scarcity and trade in economics

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1 Economics 1 (EC17) INTRODUCTORY TOPIC Importance of scarcity and trade in economics LECTURE 1 PROLEM OF SCRCITY (PRODUCTION POSSILITY FUNCTION)! If the natural world provided the needs of every consumer in munificent abundance, we would not have a need for the concepts of economics! In actual fact, there is an excess of wants over natural availability! This means individuals and societies have to decide how to allocate limited resources (i.e. inputs, for example, time, human capital etc.) to the production of different amounts of outputs! Economic problems are not only concerned with the trade off in the production of such goods, but also their methods of distribution! Focusing on trade offs, we can establish a Production Possibility Curve, with the particular example of an economy deciding between the production of food and provision of defence! If all the scarce resources from the economy are allocated towards the production of food, we achieve F max, but it would leave a low level of defence provision within the economy! If all scarce resources are allocated towards defence, we would achieve D max, but the production of food would be close to zero! Given that we would want some level of defence and food, the PPC plots the productive potential of an economy, given all scarce resources are allocated to the production of the two goods! Inside the PPC is the Production Possibility Set, which are all the combinations of food and defence possible within the economy, given the resources available within the economy (providing they are not allocated as efficiently as possible) Defence D max C F max Food! Point in the diagram is attainable, but not a technically efficient point within the economy (i.e. given the resources and technology available, more of food and defence could be produced)! Point is attainable and technically efficient, whereby all available resources and technology are being used to the economy s potential

2 ! Point C is unattainable under the current level of resources and technology given in the short run. In the longer term, resources and technology could become less scarce, hence, shifting the PPC outwards and making a higher combination of composite goods attainable (for example at point C)! In the case the economy wants more food to be produced, o t point, resources can be used more efficiently o t point, resources have to be reallocated away from defence to produce more food o Hence, we say a Pareto Improvement is possible from point as no resources have to be given up to increase the production of either good o Hence, at point, Pareto improvement is not possible, as one good has to be given up for the production of the other. Hence, point is Pareto-efficient MRGINL RTE OF TRNSFORMTION! Suppose the economy is initially at Point and that there is a re-allocation of resources from defence to food, to move the economy to point D Defence D max dd df D Food! For the given increase in food production, df, the slope of the PPC between points and D determines the reduction in defence, dd! The slope of the PPC is therefore a measure of the trade-off between two goods (i.e. food and defence), given the levels of resources and technology within the economy! Formally, the slope of the PPC is known as the Marginal Rate of Transformation! It is calculated by differentiating the PPC curve; in this example dd, but more generally, dy d! The Marginal Rate of Transformation is negative because the PPC is downward sloping (i.e. negative gradient). Intuitively, more of one good means less of the other (as resources have to reallcoated when the economy Is technically efficient)! It is evident from the three tangents on the graph above, that the slope of the PPC is getting steeper to the right (i.e. as food production increases). Hence, MRT is increasing along the PPC! This means that the trade off between the two goods becomes greater (i.e. greater amounts of Defence have to be forgone to gain more food) F max df

3 OPPORUNITY COST! If society want additional food, df, then it must trade off defence at the MRT! Therefore, opportunity cost is the value of the next best alternative forgone (in this case, the value of the defence forgone to gain additional food)! The opportunity cost of producing more of one good, can come at the cost of other goods and services (not necessarily just one other)! For example, the time spent playing a sport could otherwise have been spent doing homework and washing the dishes and watching television! However, what is the society willing to give up for the production of other goods and services? INDIFFERENCE CURVES! We said that at D max, the economy would be producing little or no food. t F max the economy would be providing little or no defence. However, this would not be the desired outcome for society! The indifference curve shows how much of one good the society is willing to give up in order to have an additional unit of the other good Defence dd df Food! long the indifference curve, consumers are indifferent between (equally satisfied with) all the combinations of defence and food possible! To move from point to point on the indifference curve, consumers would be prepared to give up dd levels of defence, in order to gain df levels of food! The slope of the indifference curve is called the marginal rate of substitution! Marginal Rate of Substitution is the consumer s willingness to substitute one good for another while maintaining the satisfaction received from consumption! The MRS is negative because an individual is willing to forgo one good for another! The curve is convex because MRS is diminishing. Hence, an individual becomes less and less willing to forgo one good for another! There are an infinite number of indifference curves that form an indifference map (i.e. family of ICs). Hence we move on to different indifference curves if we can gain more satisfaction from the consumption of both goods! For example, a rise in income, means individuals can consume more of two goods, hence they move onto a higher indifference curve! Non-satiation implies that when an individual consumes a given bundle of goods, there exists a bundle of goods the consumer strictly prefers (i.e. more a good is always better) IC

4 THE INTERCTION ETWEEN IC ND PPC! Given that we had point and point D on the PPC, both are technically efficient within the economy. Hence, to differentiate, we need to include the indifference curves of the consumer to see which bundle of goods they would prefer! The assumption from non-satiation is that the higher the indifference curves, the more utility an individual would gain from consumption! Hence, given the level of resources and technology within the economy and the utility gained by society, we would achieve the following diagram Defence D max D IC 2 IC 3 IC 1! The highest indifference curve possible for an individual is one that is tangent to the PPC at the given points of production on the PPC! s the two curves are tangential, the slopes of the of the two curves are identical! Hence, MRS = MRT (i.e. the level of goods a consumer is willing to forgo in consumption is equal to the amount of goods the economy has to forgo in production)! Therefore, at point the economy can produce more, and the consumers can gain more utility. Hence, point is undesired! The indifference curve IC 2 is above IC 1, hence, the economy and consumers would equilibrate the market at point or D! NOTE: Indifference curves cannot cross, which they would do at point and D, hence the consumers are said to be weakly indifferent between the two goods! lthough there is a higher indifference curve, IC 3, this is unattainable within the economy, and hence the highest indifference curve for consumers is IC 2 F max COMPRTIVE ND SOLUTE DVNTGE Food! Consider the following two economies, green and blue and their PPCs Y dy-g PPC-G dx! dy- dx PPC-

5 ! s the green economy can produce more of good and more of good Y than the blue economy, we say that the green economy has an absolute advantage in production on good and Y! This means that the green economy has a greater capacity to produce (e.g. US v Ethiopia)! Given the increase in production of, d, in the diagram above, the blue economy has to give up less Y, dy-, than the green economy, dy-g. Hence, the blue economy has comparative advantage in the production of! Hence, the green economy has comparative advantage in the production of Y GINS FROM TRDE! Given than the green economy is initially at point, comparative advantage in the production of Y means the economy is likely to give up d units of to increase the production of Y by 3 units! Given the blue economy is initially at point, they would give up 1 unit of Y to make an additional d units of! Hence, the world output of has not changed. d units has been decreased by green, and d units has been increased by blue! Hence, the world output of Y has increased by 2 units because the decrease in 1 unit of Y by the blue economy is offset by the increase of 3 units of Y by green! Therefore, due to existence of comparative advantage, specialisation leads to a Pareto Improvement in the world economy, where no units of production have to be given up, to increase the production of another good Y PPC-G dy=3 dy=1 dx dx PPC-! In addition, with trade, assume that green exports two units of Y to blue and in return, blue exports 1 unit of to green! This means that each country is consuming the same levels of as they were under autarky! lso, both economies are consuming more Y than they were under autarky

6 LECTURE 2 DEMND FUNCTION! Consider the demand function for an average consumer below: P p 1 p 2 1 2! ssuming the price of a commodity is at price p 1, the consumer would demand quantity 1 and hence be at point in the diagram! ssuming the price of the commodity decreases to p 2, the average consumer would demand more good, and hence quantity demanded increases to 2! This results in the consumer being at point, thus deriving the downward sloping demand curve! Demand can be influenced by a number of factors, for example: o Changes in the level of disposable income o The quality of the good or service provided o The level of advertising building awareness for products o The level of substitutes and complements available for the products o Expectations of the future state of the economy, namely through inflation and interest rates! The slope of the demand curve shows the responsiveness of the quantity demanded by consumers to changes in the price level! The demand relation is therefore a composite function made up of the quantity demanded by consumers, the price of the good, and the various demand factors, which may be denoted in many ways! For example, the price of complements can be denoted as p y and the level of disposable income as M for money supply etc.! Hence, the demand relation is: d = d (p x p y, p z, M, )! NOTE: a movement along the demand curve is price related! NOTE: a shift in the demand curve is related the demand factors above INVERSE DEMND FUNCTION D! Given that demand is the relationship between price and quantity demanded, the inverse demand function is the relationship between demand factors and it s influence on price (i.e. the price a firm can charge)! Hence, p x = p x ( d p y, p z, M, ), which can also be written as p = a b d! Given that this is a demand function, a is the y-intercept of the graph, i.e. the consumer reservation price (the highest price a consumer is willing to pay) and b

7 is the gradient of the graph, which is loosely based on the responsiveness of demand to price SUPPLY RELTION! Consider the supply function for an average supplier below: P S p 1 p 2 2 1! ssuming the price of a commodity is at price p 1, the supplier would supply quantity 1 and hence be at point in the diagram! ssuming the price of the commodity decreases to p 2, the average supplier would supply less good, and hence quantity supplied decreases to 2! This results in the supplier being at point, thus deriving the upward sloping supply curve! Supply can be influenced by a number of factors, for example: o Changes in the cost of production o Changes in level of technology in the economy o Changes in the number of producers o Expansion in the capacity of existing firms o Changes in the supply of related goods o Changes in the level of taxes to affect the price and cost of goods o Changes in the level of government subsidies! The slope of the demand curve shows the responsiveness of the quantity supplied by suppliers to changes in the price level! The supply relation is therefore a composite function made up of the quantity supplied by suppliers, the price of the good, and the various supply factors, denoted as previously stated for the demand relation! Hence, the supply relation is: S = S (p x p y, p z, M, )! The inverse supply function can subsequently be denoted as p x = p x ( s p y, ), which can also be written as p = c + d s! Given this supply function, c is the y-intercept of the supply function, i.e. the supplier reservation price (the lowest price a supplier is willing to pay) and d is the gradient of the graph, which is based on the responsiveness of supply to price INTERCTION ETWEEN DEMND ND SUPPLY! Given the supply and demand functions derived, we can interact them as they form a market: demand from consumers for goods produced from suppliers

8 ! Hence, we can establish the market equilibrium below: P S p e E e! Demand and supply are equal at the equilibrium price, p e, where there is no tendency for anything to change! This is because if price was different to p e, there would be a difference between demand and supply. To equilibrate, the market clears! Excess supply arises from a higher price p 1. This is because supply would increase as suppliers would be tempted by the higher revenues to produce more. Consumers however, would demand less at a higher price, and hence supply would exceed demand! Excess demand arises from a lower price p 2. This is because demand would increase and goods are more affordable. However, lower prices mean lesser profits for suppliers. Hence demand would exceed supply! In the case of excess supply, we assume suppliers reduce prices as the market clears! However, when there are short term perturbations (deviations) so that the supply and demand shift momentarily (before returning to its original position), markets may overshoot and achieve prices above or below the equilibrium price SHIFTS IN DEMND ND SUPPLY D! ssuming the demand curve shifts out, a new equilibrium will be established with the original supply curve! This leads to a higher market price and greater quantity traded! The steepness of the supply curve affects the extent of the market price increase! If the supply curve is steep (i.e. supply is not responsive to price inelastic) then a sharper price increase will arise! The intuition is that to induce supply to rise to a new higher demand, price must rise by a large extent if supply is unresponsive to price! This means that equilibrium market output does not increase to a great extent! ssuming the supply curve shifts out, goods become less scarce, thus driving down prices, but increasing the equilibrium market output! The steepness of the demand curve affects the extent of the price and output change, whereby the steeper the demand curve the greater the price reduction! The intuition is that to induce demand to rise to a higher supply, price must rise to a great extent to alter consumption patterns of a fairly price inelastic good

9 SOLVING THE EQUILIRIUM! The demand function = p = a b d and the supply function = p = c + d s! t equilibrium, demand = supply. Hence, a b = c + d a c = b + d! lso at equilibrium, = a p b function). Hence a p b = p c d = d(a p) = b(p c) = bp dp = ad bc = p = ad bc b!!d Hence, = a!!c b + d (from demand function) and = p c d ad + bc = b!+"d (from the supply! Hence the equilibrium output is = a!!c b + d and the equilibrium price is p = ad + bc b!+"d! One observation could be that output and price are determined by reservation price, denoted through a and c. Hence, if incomes of consumers were to change, we would expect price and output to change, which the algebra corroborates