Micro Economics - Production and Trade

8/3/2019 Micro Economics - Production and Trade

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Production and TradeProduction and Trade

MicroeconomicsMicroeconomics

Prof. Rushen ChahalProf. Rushen Chahal

2/12/20122/12/2012 Prof. Rushen ChahalProf. Rushen Chahal


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In Chapter 2In Chapter 2

DefinitionsDefinitions Opportunity CostOpportunity Cost

Resources (factors of production) andResources (factors of production) andTechnologyTechnology The Production Possibilities Frontier (PPF)The Production Possibilities Frontier (PPF) The Law ofIncreasing CostThe Law ofIncreasing Cost

Shifting the PPFShifting the PPF

The Circular Flow ModelThe Circular Flow Model Specialization and TradeSpecialization and Trade



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Opportunity CostOpportunity Cost

Scarcity means we must choose. WhenScarcity means we must choose. Whenyou spend money on one good, you cantyou spend money on one good, you cant

use that money for anything else.use that money for anything else.

Opportunity costOpportunity cost the value of the bestthe value of the bestalternative opportunity foregone.alternative opportunity foregone.



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Examples:Examples: You decide to play basketball this weekend in aYou decide to play basketball this weekend in a

tournament. The next best thing (the thing you valuetournament. The next best thing (the thing you value

second most) is to go on a camping trip with yoursecond most) is to go on a camping trip with yourfriends. The opportunity cost of playing basketballfriends. The opportunity cost of playing basketballthis weekend is the camping trip.this weekend is the camping trip.

You have 10 RMB for lunch. You look at the menuYou have 10 RMB for lunch. You look at the menu

and the two things you like most are chicken andand the two things you like most are chicken andduck. Both cost 7 RMB. If you buy the chicken, whatduck. Both cost 7 RMB. If you buy the chicken, whatis the opportunity cost?is the opportunity cost? The opportunity cost of the buying the chicken is the duck.The opportunity cost of the buying the chicken is the duck.



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Example:Example:

You only eat tea and dumplings.You only eat tea and dumplings.

1 bottle of tea costs 3 RMB.1 bottle of tea costs 3 RMB.

1 dumpling costs 1 RMB.1 dumpling costs 1 RMB.

What is the opportunity cost of one bottle of tea?What is the opportunity cost of one bottle of tea?

If you buyIf you buy one bottle of tea, that is three dumplings that youone bottle of tea, that is three dumplings that youcan buy. Therefore the opportunity cost of one bottle of tea iscan buy. Therefore the opportunity cost of one bottle of tea isthree dumplings.three dumplings.



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Resources and TechnologyResources and Technology

Resources (also called factors of production) are used asResources (also called factors of production) are used asinputs with technology to create outputs that we caninputs with technology to create outputs that we canconsume.consume.

TechnologyTechnology

Resources (factors of production)Resources (factors of production)

LandLand LaborLabor

CapitalCapital

EntrepreneurshipEntrepreneurship



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TechnologyTechnology possible techniques ofpossible techniques ofproduction.production.

Example:Example: Compare the technology for building fromCompare the technology for building from

today and from 2000 years ago. Thetoday and from 2000 years ago. Thetechnology has progressed over time.technology has progressed over time.



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LandLand natural resources in their natural states.natural resources in their natural states. Examples: minerals, oil, water, forestsExamples: minerals, oil, water, forests

LaborLabor the human capacity to work.the human capacity to work.

EntrepreneurshipEntrepreneurship personal initiative topersonal initiative tocombine resources in productive ways. Involvescombine resources in productive ways. Involvesrisk.risk. Example: you quit your job to start your ownExample: you quit your job to start your own

newspaper business.newspaper business.



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CapitalCapital anything that is produced in order toanything that is produced in order toincrease productivity in the future; includesincrease productivity in the future; includeshuman capital and physical capital.human capital and physical capital.

In economics, capital does NOT include financialIn economics, capital does NOT include financialcapital, such as money, stocks, and bonds!!!capital, such as money, stocks, and bonds!!!

Examples:Examples: Machines, vehicles, buildings (factories, warehouses,Machines, vehicles, buildings (factories, warehouses,

offices, etc.), skills.offices, etc.), skills.



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Physical capitalPhysical capital includes buildings, machinery, and equipment.includes buildings, machinery, and equipment.

Human capitalHuman capital acquired skills and abilities embodied within aacquired skills and abilities embodied within aperson.person.

In other words:In other words: A persons skills and abilities. Knowledge.A persons skills and abilities. Knowledge.

Examples:Examples: Medical training, math training, electronics training.Medical training, math training, electronics training.



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The Production Possibilities FrontierThe Production Possibilities Frontier

(PPF)(PPF) Production Possibilities FrontierProduction Possibilities Frontier a model thata model that

shows the various combinations of TWO (2)shows the various combinations of TWO (2)goods the economy is capable of producing.goods the economy is capable of producing.

It is a model for scarcity and choice.It is a model for scarcity and choice. It assumes that only TWO (2) goods can beIt assumes that only TWO (2) goods can be

produced.produced.

FrontierFrontier the limit of output possibilities.the limit of output possibilities.



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The PPFThe PPF

0

5

10

15

20

25

0 1 2 3 4 5

Fish

Coconuts

Data PointData Point FishFishcaughtcaughtper dayper day

CoconutsCoconutscollectedcollectedper dayper day

AA 55 00

BB 44 1010

CC 33 1616

DD 22 1919

EE 11 2121

FF 00 2222

A

B

C

ED

F

Six alternative combinationsof fish and coconutsProduction Possibilities frontier onCastaway Island



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The PPFThe PPF

Marginal Opportunity CostMarginal Opportunity Cost the additionalthe additionalopportunity cost of producing one moreopportunity cost of producing one more

unit of a good.unit of a good.

Example:Example: If you catch one more fish, how many lessIf you catch one more fish, how many less

coconuts can you collect?coconuts can you collect?



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The PPFThe PPF

0 1 2 3 4 5

Fish

C

oconu

ts

A

B

C

ED

F

Data PointData Point Fish caught Fish caught

per dayper day

Opportunity cost ofOpportunity cost of

fish (total number offish (total number ofcoconuts forgone)coconuts forgone)

MarginalMarginal

opportunityopportunitycost of fishcost of fish(change in(change innumber ofnumber ofcoconutscoconutsforgone)forgone)

FF 00 00 N/AN/A

EE 11 11 11

DD 22 33 22

CC 33 66 33

BB 44 1212 66

AA 55 2222 1010

Opportunity CostsTotal Marginal

1 1

3 2

6 3

12 6

22 10

10

16

19

21

22



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The Law ofIncreasing CostsThe Law ofIncreasing Costs

The Law ofIncreasing CostsThe Law ofIncreasing Costs the rise inthe rise inthe marginal cost of producing a good asthe marginal cost of producing a good as

more of that good is produced.more of that good is produced.

Why does the marginal opportunity costWhy does the marginal opportunity cost

increase?increase? This happens because resources areThis happens because resources are

specialized.specialized.



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Consider two goods: guns and butter. Because resources are specialized,Consider two goods: guns and butter. Because resources are specialized,some resources are very good at producing butter but are not good atsome resources are very good at producing butter but are not good atproducing guns.producing guns.

If we want to make more guns and less butter, we first take the resourcesIf we want to make more guns and less butter, we first take the resourcesfrom butter that are not the best at making butter. This means we lose afrom butter that are not the best at making butter. This means we lose a

small amount of butter.small amount of butter.

Later, if we still want to make more guns, we take resources that are betterLater, if we still want to make more guns, we take resources that are betterat making butter and use them to make guns. This time we lose moreat making butter and use them to make guns. This time we lose morebutter than before.butter than before.

Now we have only the very best butter making resources making butter. IfNow we have only the very best butter making resources making butter. Ifwe take these away from butter production and use them for making guns,we take these away from butter production and use them for making guns,we lose more butter than we lost the first two times.we lose more butter than we lost the first two times.



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Specialized resources mean that:Specialized resources mean that:

1. The PPF is curved, not straight. If1. The PPF is curved, not straight. Ifresources were NOT specialized, the PPFresources were NOT specialized, the PPFwould be a STRAIGHT line.would be a STRAIGHT line.

2. The marginal cost of a good increases as2. The marginal cost of a good increases asmore of it is produced.more of it is produced.



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0

3

6

9

12

15

0 1 2 3 4 5

Butter (millions of pounds)

*

A

B

C

D

E

F

G

H

I

J

Points G and H are inside

The Production Possibilities

Frontier, indicating the economy

has not attained productive

efficiency

Points J and I are outside the

production Possibilities

Frontier, and are thusunattainable with the given

available amount of inputs.



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The PPFThe PPF

Which points on the previous PPF are efficient?Which points on the previous PPF are efficient?

Which ones are technologically efficient?Which ones are technologically efficient?A, B, C, D, E, and FA, B, C, D, E, and FAny point ON the frontierAny point ON the frontier

Which ones are allocatively efficient?Which ones are allocatively efficient? Only one. It depends on the preferences of the consumers.Only one. It depends on the preferences of the consumers.It must be on the frontier.It must be on the frontier.



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Economic GrowthEconomic Growth the ability of the economy tothe ability of the economy toproduce more or better output.produce more or better output.

In other words:In other words: If there is an increase in either QUANTITY orIf there is an increase in either QUANTITY or

QUALITY, or both, of the goods and services availableQUALITY, or both, of the goods and services available

in the economy, then there is economic growth.in the economy, then there is economic growth.

Economic growth causes the PPF to shift.Economic growth causes the PPF to shift.



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The PPF will shift if there is a change inThe PPF will shift if there is a change intechnology or resources (factors of prodction):technology or resources (factors of prodction):

TechnologyTechnology

LandLand LaborLabor CapitalCapital EntrepreneurshipEntrepreneurship



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0

3

6

9

12

15

18

21

24

0 2 4 6


Guns*

thousands

When the PFF shifts outwards, the economy experiences economic growth

Possibilities Expand



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0

3

6

9

12

1518

21

24

0 1 2 3 4 5 6


Guns*thousan

ds

When the PFF shifts inwards, it is a sign of negative economic growth

Possibilities Shrink



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If new technology is introduced that can only apply to one industry, then the

PPF shifts out like this

0

3

6

912

15

18

21

24

0 2 4 6


Guns*thousands

An increase in productivity

of one product



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Specialized growthSpecialized growth an increase in thean increase in thetechnology in only one of the two goods.technology in only one of the two goods.

General growthGeneral growth an increase in technology inan increase in technology inthe both of the two goods, or an increase in anythe both of the two goods, or an increase in anyresource (land, labor, capital, entrepreneurship).resource (land, labor, capital, entrepreneurship).

How do these shift the PPF in different ways?How do these shift the PPF in different ways?



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butter

Starting

PPF

New PPF

General Growth

butter

Starting

PPF

New PPF

Specialized Growth



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DepreciationDepreciation the amount of capital decreasesthe amount of capital decreasesover time because machines, vehicles, andover time because machines, vehicles, and

buildings, etc. (examples of capital) wear out orbuildings, etc. (examples of capital) wear out orbreak down. They are no longer useful. The arebreak down. They are no longer useful. The areless productive. Also, people, who have humanless productive. Also, people, who have humancapital, retire or die.capital, retire or die.

What will depreciation do to the PPF?What will depreciation do to the PPF?



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Capital

A

If a country invests

nothing, its PPFwith shift inward.

The point A

represents all

consumption and

no investment incapital.

PPF as Capital

Depreciates andis Not Replaced.




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InvestmentInvestment by consuming less and usingby consuming less and usingresources for investment, we can increaseresources for investment, we can increase

capital.capital.

To increase the capital stock (the amountTo increase the capital stock (the amount

of capital), we must invest greater thanof capital), we must invest greater thanthe amount of depreciation.the amount of depreciation.



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Capital

B

Sacrificing currentconsumption for

capital formation

causes economic

growth.

The point B

represents some

consumption and

some investment

in capital.

PPF as Capital

Grows.

Why is it hard for a poor country to invest in capital?Why is it hard for a poor country to invest in capital?




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Characteristics of the PPFCharacteristics of the PPF The ppf shows how much of one good can beThe ppf shows how much of one good can be

produced for any amount of anotherproduced for any amount of another When on the frontier, the opportunity cost ofWhen on the frontier, the opportunity cost of

one good is less of the of the other goodone good is less of the of the other good

The frontier is bowed outwardThe frontier is bowed outward

Every point on the frontier is technologicallyEvery point on the frontier is technologicallyefficientefficient

Only one point is allocatively efficient. It mustOnly one point is allocatively efficient. It mustbe on the frontier.be on the frontier.

Points inside the frontier imply unemployedPoints inside the frontier imply unemployedresourcesresources

Points outside the frontier are unattainablePoints outside the frontier are unattainable Shifting the frontier outward impliesShifting the frontier outward implies

economic growtheconomic growth2/12/20122/12/2012 Prof. Rushen ChahalProf. Rushen Chahal


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The Circular Flow ModelThe Circular Flow Model

MoneyMoney a medium of exchange thata medium of exchange thatremoves the need for barter; also aremoves the need for barter; also a

measure of value and a way to store valuemeasure of value and a way to store valueover time.over time.

BarterBarter the exchange of goods andthe exchange of goods andservices directly for one another, withoutservices directly for one another, withoutthe use of money.the use of money.



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Barter is less efficient because you must findBarter is less efficient because you must findsomeone with what you want to consume thatsomeone with what you want to consume thatalso wants to consume what you have.also wants to consume what you have.

If you barter, you are not likely to find lots ofIf you barter, you are not likely to find lots ofpeople you want to trade with. So, you mustpeople you want to trade with. So, you mustknow how to make what you want. Thus, youknow how to make what you want. Thus, you

will have some knowledge about many things,will have some knowledge about many things,but you will not be very skilled in anything. So,but you will not be very skilled in anything. So,no one will be very skilled in anything, andno one will be very skilled in anything, andsociety will be less productive.society will be less productive.



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Circular flowCircular flow a model of the economy thata model of the economy thatdepicts how the flow of money facilitates adepicts how the flow of money facilitates acounter flow of resources, goods, and services incounter flow of resources, goods, and services in

the input and output markets.the input and output markets.

Output marketOutput market the market where goods andthe market where goods andservices are bought and sold.services are bought and sold.

Input marketInput market the market where resources arethe market where resources arebought and sold.bought and sold.



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Households Businesses

$ Purchases

Output markets: Goods & Services

$ Incomes

Input markets: Land, Labor, Capital,

Entrepreneurship

GovernmentGovernment

(tax, regulation,(tax, regulation,

production)production)

$$

$$

$$$ $



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Specialization and TradeSpecialization and Trade

Comparative advantageComparative advantage the ability to producethe ability to producea good at a lower opportunity cost (other goodsa good at a lower opportunity cost (other goods

foregone) than another producer could.foregone) than another producer could.

An economy has a comparative advantage inAn economy has a comparative advantage inproducing a good if it can produce that good atproducing a good if it can produce that good at

a lower opportunity cost than could anothera lower opportunity cost than could anothereconomy.economy.



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Specialization and TradeSpecialization and Trade Comparative advantageComparative advantage

Example:Example: Assume the only TWO (2) goods are rice and wine.Assume the only TWO (2) goods are rice and wine.

For France to make one bottle of wine, theFor France to make one bottle of wine, theopportunity cost is 2 kilos of rice.opportunity cost is 2 kilos of rice. For China to make one bottle of wine, the opportunityFor China to make one bottle of wine, the opportunity

cost is 8 kilos of rice.cost is 8 kilos of rice. Who has the comparative advantage in wine?Who has the comparative advantage in wine?

France does, because it has a lower opportunity cost forFrance does, because it has a lower opportunity cost forwine.wine.

How do we calculate comparative advantage?How do we calculate comparative advantage?



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Product LocationProduct Location Opportunity CostOpportunity Cost(C is computer chips and B(C is computer chips and B

is Barrels of oil)is Barrels of oil)


(per unit)(per unit)

Computer chips inComputer chips inJapanJapan

10C = 4B10C = 4BOpp. Cost of C =Opp. Cost of C =2/5 barrel of oil2/5 barrel of oil

Computer chips inComputer chips inEnglandEngland

5C = 3B5C = 3BOpp. Cost of C =Opp. Cost of C =3/5 barrel of oil3/5 barrel of oil

Oil in JapanOil in Japan 4B = 10C4B = 10COpp. Cost of B =Opp. Cost of B =

5/2 computer5/2 computerchipschips

Oil in EnglandOil in England 3B = 5C3B = 5C

Opp. B = 5/3Opp. B = 5/3

computer chipscomputer chips

Country Computer Memory Chips Barrels of Oil

Japan 10 units per day 4 per day

England 5 units per day 3 per day



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Specialization and TradeSpecialization and Trade Absolute advantageAbsolute advantage the ability to produce a good withthe ability to produce a good with

fewer resources than another producer.fewer resources than another producer.

If we assume Japan and England use the same resources:If we assume Japan and England use the same resources: Who has an absolute advantage in computer chips?Who has an absolute advantage in computer chips?

JapanJapan

Who has an absolute advantage in oil?Who has an absolute advantage in oil?

JapanJapan

Country Computer Memory Chips Barrels of Oil

Japan 10 units per day 4 per day

England 5 units per day 3 per day2/12/20122/12/2012 Prof. Rushen ChahalProf. Rushen Chahal


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ExportsExports goods and services a countrygoods and services a countrysells to other countries.sells to other countries.

ImportsImports goods and services a countrygoods and services a countrybuys from other countries.buys from other countries.



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If a country trades, in can CONSUMEIf a country trades, in can CONSUMEoutside its PPF.outside its PPF.

A country can NEVER produce outside itsA country can NEVER produce outside itsPPF. However, it can consume outside itsPPF. However, it can consume outside its

PPF, if it trades. See next slide.PPF, if it trades. See next slide.



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0

3

6

9

12

15

0 1 2 3 4 5


*

A

B

C

D

E

F

G

H

I

J

The country can produce anywhere

on or in the frontier

(like points A to H). The country

can NOTproduce I or J,

even if it trades.

Points J and I are possible

consumption points if the

country trades. If it does nottrade, it can only consume on or

in the frontier.


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Micro Economics - Production and Trade

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