ECONOMICS 103. Topic 2: Specialization & Trade

Transcription

1 ECONOMICS 103 Topic 2: Specialization & Trade Key concepts: production possibilities, absolute advantage, comparative advantage, trade, gains from trade, economic efficiency. Model: production possibility frontier. 1

2 RESOURCE ALLOCATION IN SOCIETY 3 key resource-allocation questions at the core of micro: - 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. In Topic 2, we will focus on 2nd question, with 3 aims: - Develop more of a sense of normative approach used in economics; namely efficiency. - Practice simple model-building. - Understand why economists really like trade. Fundamental foundational idea in economics 2

3 ECONOMIC EFFICIENCY Our normative criterion is efficiency. - Efficiency, economic efficiency, Pareto efficiency : all equivalent terms, in economics. To get a sense of efficiency, recall the class in which I was trying to efficiently allocate objects in the classroom. It was silly (inefficient) to give the objects to the students who didn t value them. I could implement an improvement by reallocating (swapping) the objects. Not swapping the objects was inefficient, as it left on the table the chance for two students to be better off while making no one else worse off. 3

4 ECONOMIC EFFICIENCY Conclusion: - Inefficient to stay in a situation where - if we changed things - some could be better off and no one would be worse off. - A situation is inefficient if it is possible to make some better off an no one worse off. - Leaving win-wins or win-no-losses on the table is inefficient. Note that we want to keep implementing win-wins whenever they are available. After we have exhausted all win-wins, the only way to make one person better off will make someone worse off. 4

5 ECONOMIC EFFICIENCY From this follows our formal statement of the definition of economic efficiency: - If we are in position such that we cannot make one person better off without making someone else worse off, then this position is (Pareto) efficient. Where can we make a change such that at least somebody wins and nobody loses, we call such a change a Pareto improvement. It follows logically from the above, that: - A situation is efficient if there are no Pareto improvements available; and - A situation is inefficient if there are Pareto improvements available. 5

6 ECONOMIC EFFICIENCY Principles of Microeconomics Note: major limitation of the notion of efficiency (thus far): - It offers us no direction on the desirability of changes that make some people better off while making others worse off. - It tells us nothing about how to trade off win-losses. Very important, since win-wins are rare (non-existent?), especially in the world of policy making. - We will come back to this idea a little later. For now, stick with the idea that not implementing win-win changes is inefficient (i.e., stupid). We will look at this in the context of 2nd question from slide 2: - How should production of goods take place? 6

7 MODEL OF PRODUCTION (SUBSISTENCE ECONOMY) Start as simple as possible. Assume initially a one-person world (so no money, no trade). One person can use their time and other resources (land, basic tools etc.) to produce food. Two types of food: fish and morel mushrooms. - Time spent fishing can t be spent mushrooming, & vice versa. - Opp. cost of fishing is mushrooms foregone, & vice versa. Note that production capacity will always be limited by scarcity: - Not just time is scarce; so are the stocks of resources, access to tools, technology etc. Scarcity means that there is an upper bound on how much stuff we can produce. 7

8 PRODUCTION Principles of Microeconomics How much food can be produced in a day? Working through an example. If all time is spent fishing: - We can catch 15 fish (F) - But can t have any M. If all time is spent collecting: - We can catch 40 M - But can t have any F If we split our time, we can have some of both. 8

9 PRODUCTION Principles of Microeconomics What is the opportunity cost of mushroom production? To get 1st 10M, must give up 1F. - Marginal (opportunity) cost (MC) per M = 1/10F. To get increase M from 10 to 20, must give up 3F. - MC per M = 3/10F. From 20 to 30 M, MC = 5/10F. From 30 to 40 M, MC = 6/10F Opportunity cost is increasing. Why? 9

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. 10

11 PRODUCTION POSSIBILITY FRONTIER F M 11

12 PRODUCTION POSSIBILITY FRONTIER Points on the PPF are as good as we can do, given scarce resources & current technology F If we are on PPF, to get more of one good, we have to give up some of the other good If we are on PPF, we can t get something for nothing; there are no win-wins. M Points on the PPF are efficient, in one-person world. 12

13 PRODUCTION POSSIBILITY FRONTIER If we end up inside the PPF, we must not be fully using our resources F We can have more of one good (or both) without having to give up any of the other. We can get something for nothing; there are win-wins M Points inside the PPF are inefficient. 13

14 PRODUCTION POSSIBILITY FRONTIER Points outside the PPF would be nice, but aren t available, given the world in which we live F Nice, but impossible 11 6 Points outside the PPF are infeasible; unattainable M 14

15 PRODUCTION POSSIBILITY FRONTIER A couple more important things to note about PPFs F Slope (absolute value) = MC of good on horizontal axis. - Recall, slope = rise run. Inverse of slope = MC of good on vert. axis Moving PPF: steeper slope MC M If PPF is linear, then MC is constant. 15

16 PRODUCTION POSSIBILITY FRONTIER Linear PPF - constant MC 100 y Example: a PPF given by the equation y = 100-2x. Moving PPF: same slope so constant MC. 50 x 16

17 ICLICKERS Q (45 secs): Given the linear PPF below, what is the marginal opportunity cost (MC) of producing good x? That is, how many units of y must be foregone, in order to produce one extra unit of x? 100 y 50 x a) 100. b) 50. c) 1/2. d) 2. 17

18 ICLICKERS Principles of Microeconomics A: Slope = rise/run = y/ x. One simple way to calculate y/ x is to note that, moving from top of line to bottom of line: 100 y y = -100 = - value of the y-int. x = +50 = value of the x-int y = -100 = - So can calculate abs. value of slope by ratio of y-int/x-int. 50 x Every one unit increase in x must be accompanied by a 2 unit decrease in y, so MC of x = 2 units of y. 18

19 ICLICKERS A: Given the linear PPF below, what is the marginal opportunity cost (MC) of producing good x? That is, how many units of y must be foregone, in order to produce one extra unit of x? 100 y 50 x a) 100. b) 50. c) 1/2. d) 2. 19

20 ICLICKERS Q (30 secs): Given the linear PPF below, what is the total opportunity cost (TC) of producing 10 units good x? That is, how many units of y must be foregone, in order to produce ten extra units of x? 100 y 50 x a) 50. b) 20. c) 10. d) 5. 20

21 ICLICKERS A: We already know that one x costs two y (MC of x = 2y). So 10 x must cost 20 y. 100 y 50 x a) 50. b) 20. c) 10. d) 5. 21

22 ICLICKERS Q (30 secs): Given the linear PPF below, what is the marginal cost (MC) of producing good y? 100 y 50 x a) 100. b) 50. c) 1/2. d) 2. 22

23 ICLICKERS A: One x costs 2 y, so one y costs 1/2 x. Slope tells us MC of x. Inverse of slope tells us MC of y. y x a) 100. b) 50. c) 1/2. d) 2. 23

24 PRODUCTION POSSIBILITY FRONTIER In a one-person economy, our opportunities for consumption are constrained by the PPF. - Can consume any combo ( bundle ) 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 the goods, relative to each other. - Depends on our preferences. Back to fish/mushroom example, and assume preferences are such that 10M and 14F are produced and consumed per day. 24

25 PRODUCTION POSSIBILITY FRONTIER F A That is, assume production and consumption is at point A M 25

26 SPECIALIZATION AND TRADE Suppose another person arrives in our economy. New person can also produce F & M, but has different skills. Person Person 2 s production possibilities for F & M

27 SPECIALIZATION AND TRADE Person 2 can produce more than person 1. - By this, we mean that 2 s PPF lies entirely outside 1 s. Person Person

28 SPECIALIZATION AND TRADE In this case, we say that Person 2 has the absolute advantage in the production of both goods. Person 2 can produce: - More M than person 1 at a given level of F; and - More F than person 1 at a given level of M New person s PPF lies outside original person s PPF. Exercise: draw Person 1 and Person 2 s PPF on the same diagram to convince yourself this is true. 28

29 SPECIALIZATION AND TRADE Recall: Person 1 produces and consumes 10M and 14F per day. Assume to begin that: - There is no interaction or cooperation between 1 & 2; and - Person 2 chooses to produce and consume 40M & 9F. Aggregate output in this economy is 50M and 23F. Question: is production combination efficient? - Rephrasing: can the economy get something for nothing? - Can we have more M or F without having to give anything up? - If we can, this this production combination can t be efficient. - Doing what we are doing leaves win-wins on the table. 29

30 SPECIALIZATION AND TRADE Original aggregate output = 50M & 23F. New aggregate output = 50M & 28F. Person Person

31 Original production combination: - Person 1-10M & 14F. Aggregate output: 50M & 23F - Person 2-40M & 9F. New production combination: - Person 1-20M & 11F. - Person 2-30M & 17F. Principles of Microeconomics SPECIALIZATION AND TRADE Aggregate output: 50M & 28F Original production choice left win-wins on the table - Same total M & more F; net gain of 5F at zero overall cost. Original production choice cannot be efficient. 31

32 SPECIALIZATION AND TRADE Those extra F can improve the well-being of both people. Eg: Person1 trades extra 10M produced in exchange for 6F. Each ends up with same M as at the original production choices, before, but now: - Person 1 has 17F in total. A net gain of 3F. - And Person 2 has 11F in total. A net gain of 2F. This is what we mean when we talk about gains from trade. Each gets to consume at a point that is outside their own PPF. 32

33 PRODUCTION POSSIBILITY FRONTIER Before trade, production and consumption were at point A for person 1. F A M 33

34 PRODUCTION POSSIBILITY FRONTIER F Before trade, production and consumption were at point A for person C A B After trade, production is at point B and consumption is at point C. Consumption beyond PPF! M 34

35 SPECIALIZATION AND TRADE Thinking about the source of these gains from trade. - Where did this something for nothing come from? Person 1 M production from 10 to Cost the economy 3F. - MC of each new M now produced by 1 is 3/10F. cost Person 2 M production from 40 to Saving to the economy of 8F. - MC of each M no longer produced by 2 was 8/10F. saving Net gain of F because there was a difference between MCs. 35

36 SPECIALIZATION AND TRADE Recall Person 2 has the abs. adv. in M production. - Able to produce more M for given F, and vice versa. BUT, at original production point, the marginal cost of M production is lower for Person 1 than for Person 2. Distinction between absolute advantage & comparative advantage: - Economic agent with 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 (at least to some degree) in the good for which they have the comp. adv. 36

37 SPECIALIZATION AND TRADE Recall: original aggregate output = 50M & 23F; new aggregate output = 50M & 28F. Person Person

38 SPECIALIZATION AND TRADE We moved from an inefficient point to a better point. Are we done? Or can we still get something for nothing? Person Person

39 SPECIALIZATION AND TRADE Consider another 10 unit change in responsibility for mushroom production, across the 2 producers. Person Person

40 SPECIALIZATION AND TRADE This move changes agg output from 50M & 28F to 50M & 29F. Can get even more of a gain through even more specialization. Person Person

41 SPECIALIZATION AND TRADE Additional gain due to the fact that Person 1 is still the relatively low MC producer of mushrooms. Person Person

42 SPECIALIZATION AND TRADE Person 1 s MC of mushroom production has increased (from 3/10F to 5/10F), but still below Person 2 s. Person Person

43 SPECIALIZATION AND TRADE Now are we done? Let s try another 10 unit reallocation of M production. Person Person

44 SPECIALIZATION AND TRADE This take us from 50M & 29F to 50M and 26F. Bad move. We ve run out of opportunities to get something for nothing. Person Person

45 SPECIALIZATION AND TRADE Tells us that this production choice is efficient. Can t get more F for the given level of M. Person Person

46 SPECIALIZATION AND TRADE Tells us that this production choice is efficient. Equivalently, can t get more M for given level of F. Person Person

47 SPECIALIZATION AND TRADE No win-wins left on the table. Person Person

48 ICLICKERS Q (60 secs): Given the PPFs below, which statement is true? y PPF1 PPF2 a) Producer 1 has the comparative advantage in producing y. b) Producer 2 has comparative advantage in producing x. c) Producer 1 has the comparative advantage in producing x. d) Producer 1 has the comparative advantage in both x and y x 48

49 ICLICKERS Principles of Microeconomics A: Producer 1 has a flatter PPF than producer 2, so has lower MC of producing x than does producer 2. a) Producer 1 has the comparative advantage in producing y y PPF1 PPF b) Producer 2 has comparative advantage in producing x. c) Producer 1 has the comparative advantage in producing x. d) Producer 1 has the comparative advantage in both x and y. x 49

50 SPECIALIZATION AND TRADE Some important conclusions follow from material covered so far. - Work outside lecture is designed in part to understand those conclusions. You need to understand everything in the course materials, not just what is talked about in lecture. Summary of those conclusions: 1) If Person 1 has comp. adv. in M production, then Person 2 must have the comp. adv. in F production. - Follows since the MC of F = inverse of MC of M. 50

51 SPECIALIZATION AND TRADE 2) As we've seen a producer may not have the comp. adv. at all levels of production. - As Person 1 M production his MC of M. - As Person 2 M production her MC of M. - At some point, Person 2 will gain the comp. adv. in M. So Person 1 will gain the comp. adv. in H. - But if both have linear PPFs with different slopes, then each producer will have a lower MC of producing one of the goods across all ranges of possible output. 51

52 SPECIALIZATION AND TRADE 3) Important: There is NOT just one production point that is efficient - there are an infinite number. - We know that if Person 1 produces 30M & 6F, and 2 produces 20M & 23F, this is efficient; we can t get something for nothing. - Another way to think about this: conditional on wanting 50M in total, this is the best way to produce those 50M. - It maximizes the F we get, given our desire for 50M. - But what if collective prefs were such that we wanted more than 50M? or less than 50M? - Then there would be an optimal (efficient) way to produce that different desired level of M. - Exercise: suppose that we wanted 60 M in total. What is efficient way to produce it? 52

53 SPECIALIZATION AND TRADE 4) Specialization need not be complete: That is, efficiency doesn t necessarily require a producer to produce only the good for which it has comp adv. - We ve already seen this in the M and F example. Partly true because comp. adv. can change as output changes. But true also because we might not want much of the good. - If a producer has a comp. adv. in producing anchovies, but everyone hates anchovies, we won t want anchovies. - So what ends up being produced is partly a function of costs, but also partly a function on preferences. More in this later in the term. Points 1) - 4) will only make complete sense once you have worked through all questions in the textbook. 53