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Unformatted text preview: Principles of Economics I
Economics 101 Section 400 Class 3 Readings Chapter 2: Production Possibilities and Comparative Advantage Chapter 3 iPod watch: p53 Chapter 4 Specifically p75 79: Supply side of the market iPod watch: p6667, p75, p9091 Specifically p 103105 Next Class: Chapter 3 Chapter 4 Specifically p6775 Specifically p.101103
Class 3 2 1/14/2007 Announcements Pooled Office Hours Schedule Discussion Section Schedule On CTools On CTools HW Assignment 2 Quiz 1 On CTools after class In section this week
Class 3 3 1/14/2007 Australia
Coarse wool (bales) Opportunity cost of 1 bale of fine wool is a bale of coarse wool Opportunity cost of 1 bale of coarse wool is 2 bales of fine wool Slope = rise/run = 1/2 1 m 2 m
1/14/2007 Class 3 Fine wool (bales) 4 New Zealand
Coarse wool (bales) 0.75 m Opportunity cost of 1 bale of fine wool is 3/2 bales of coarse wool Opportunity cost of 1 bale of coarse wool is 2/3 of a bale of fine wool Slope = rise/run = 3/2 0.5 m
1/14/2007 Class 3 Fine wool (bales) 5 Comparative Advantage
If Producer A has a lower opportunity cost of producing a good than Producer B, we say that Producer A has a comparative advantage in production of that good.
Australia has the comparative advantage in producing fine wool New Zealand has the comparative advantage in producing coarse wool 1/14/2007 Class 3 6 Comparative Advantage The principle of comparative advantage directs production efficiently: Production of a good should be undertaken by the producer with the comparative advantage in production of that good i.e. the producer with the lowest opportunity cost 1/14/2007 Class 3 7 Coarse wool (bales) 1.75 m Joint PPF
Opportunity cost of 1 bale of fine wool is a bale of coarse wool Slope = rise/run = 1/2 Opportunity cost of 1 bale of fine wool is 3/2 bales of coarse wool Slope = rise/run = 3/2 0.75 m Fine wool (bales) 2 m
1/14/2007 Class 3 2.5 m
8 Joint PPF The joint PPF tends to be bowed out from the origin i.e. in an economy, the opportunity cost of incremental units of output tends to rise as output increases
Good 2 Good 1 Another Question How will production be organized? Depends in the economic system Assume that producers respond to the incentives provided by the market system
Market provides prices for both of these goods Individual farmers make selfinterested decisions about production, to improve their own welfare 1/14/2007 Class 3 10 Nominal and Relative Prices Nominal price: That thing we usually think of when we talk about price Example: Pfine = $600/bale Pcoarse = $300/bale Relative price: the exchange rate between two goods Example: Pfine/Pcoarse = $600/$300 = 2 i.e. Fine wool is twice as expensive as coarse i.e. one bale of fine wool has an equal market value to two bales of coarse wool If I sell one bale of fine wool, I can buy two bales of coarse wool
Class 3 11 1/14/2007 Production decisions How does a producer decide what to produce? Take an Australian wool grower, for example: Opportunity cost of producing 1 bale of fine wool is a bale of coarse wool (i.e. 1 bale of fine wool could be swapped for a bale of coarse wool simply by reallocating productive resources) Compare the opportunity cost to the relative price of fine wool: this tells us the rate at which the market will swap bales of fine wool for bales of coarse wool 1/14/2007 Class 3 12 Example continued... Suppose Pfine = Pcoarse = $500/bale i.e. relative price of fine wool = 1 Aus. producer's op. cost of fine wool is a bale of coarse wool Relative price of fine wool is 1 Producing a bale of fine implies she gives up a bale of coarse Australian producer prefers to produce fine wool Market exchanges 1 bale of fine wool for 1 bale of coarse 1/14/2007 Class 3 13 Example continued... Suppose Pfine =$100 and Pcoarse =$400/bale Aus. producer's op. cost of fine wool is a bale of coarse wool Relative price of fine wool=$100/$400= Producing a bale of fine implies she gives up a bale of coarse Australian producer prefers to produce coarse Market exchanges 1 bale of fine wool for 1/4 bale of coarse 1/14/2007 Class 3 14 Conclusion Producers will choose to produce fine wool when the relative price of fine wool exceeds the opportunity cost of producing the fine wool If the relative price of fine wool is below the opportunity cost of producing fine wool, then producers will choose to produce coarse wool
Class 3 15 1/14/2007 If the relative price of fine wool is...
1. Less than a bale of coarse wool (i.e. if fine wool is very cheap), then 2. More than 3/2 bales of coarse wool (i.e. fine wool is very expensive), then Wool growers in both countries will produce only coarse wool 3. Between and 3/2 bales of coarse wool Wool growers in both countries will produce only fine wool Wool growers in Aus. will produce fine wool Wool growers in NZ will produce coarse wool
Class 3 1/14/2007 16 The efficiency of the market Trading at market prices provides incentives to do precisely the efficient thing When some fine wool and some coarse wool is produced, Australia produces fine wool and NZ produces coarse wool This is a foreshadowing of a more general result: under certain conditions, markets provide exactly the right incentives to ensure efficient allocation of resources
Class 3 17 1/14/2007 Some other observations This model of production choice becomes a model for making predictions about trading relationships
Suppose for a moment that Aus and NZ were the only countries in the world Suppose that consumers in both locations wish to consume both fine wool (in garments) and coarse wool (in carpets) 1/14/2007 Class 3 18 Predictions about trading relationships Our analysis suggests the following: If both goods are consumed, then production will be determined on the basis of comparative advantage If both goods are consumed, the relative price of fine wool will be no lower than a bale of coarse wool and no higher than 3/2 bales of coarse wool
Class 3 19 1/14/2007 Model Identifies the role for specialization Australia can produce more of both goods Australia could be selfsufficient Australians are better off if they We say that Australia has an absolute advantage in production of both goods specialize in fine wool production, allow the NZ farmers to produce the coarse wool at low cost trade 1/14/2007 Class 3 20 Model provides insight into general supply decisions
1. 2. 3. When the relative price of fine was low, nobody produced fine wool When the relative price of fine wool was moderate, then some producers wished to produce fine wool When the relative price of fine wool was high, everyone wanted to produce fine wool Quantity of fine wool supplied to the market increases as the relative price of the good increases
Class 3 21 1/14/2007 Supply Decisions Suppose that Pcoarse = $500/bale If Pfine < $250/bale, (i.e. if the relative price is lower than ), then no fine wool is supplied to the market If $250/bale < Pfine < $750/bale (i.e. relative price is between and 3/2), then Australia supplies 2m bales to the market If Pfine > $750/bale (i.e. relative price is greater than 3/2) then both countries supply fine wool, for a total supply of 2.5m bales Class 3 22 1/14/2007 The Supply Curve
Pfine ($/bale) $750 Supply $250 2m
1/14/2007 Class 3 2.5m Qfine (bales) 23 The Law of Supply Increasing the price of a good tends to increase the quantity of that good supplied to the market
Reflection of the response we observed previously to changes in the relative price of a good Supply curve is drawn for: Other goods prices given Technology given Input costs given
Class 3 1/14/2007 24 ...
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This note was uploaded on 04/01/2008 for the course ECON 101 taught by Professor Gerson during the Winter '08 term at University of Michigan.
- Winter '08
- Comparative Advantage