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Unformatted text preview: Principles of Economics I
Economics 101 Section 400 Class 2 Readings Chapter 1: Introduction Chapter 2: Production Possibilities and Comparative Advantage iPod watch: p78 iPod watch: p53 Next class: Look at Chapter 3 Specifically p75 79: Supply side of the market iPod watch: p6667, p75, p9091
Class 2 2 1/10/2007 Other issues First assignment available Syllabus isn't online yet (Sorry) Will appear this evening 1/10/2007 Class 2 3 The Economic Problem How best to allocate scarce resources while trying to satisfy limitless wants?
What to produce? How to produce? For whom to produce? 1/10/2007 Class 2 4 Economists do it with Models The approach we adopt is to build models of economic decisionmaking scenarios, and draw insights from those models But what makes a good model? 1/10/2007 Class 2 5 A short detour... What makes a good model? Ask this in a less challenging context: What makes a good model airplane? 1/10/2007 Class 2 6 1/10/2007 Class 2 7 1/10/2007 Class 2 8 1/10/2007 Class 2 9 1/10/2007 Class 2 10 1/10/2007 Class 2 11 Building Models A model is useful only insofar as it abstracts from reality The more closely a model corresponds to reality, the less useful it becomes Parsimony in model building demands that we make our models sufficiently realistic to capture the phenomenon of interest, but no more realistic Models should be judged on how useful they prove (and how accurate their predictions), rather than on how realistic their assumptions are. 1/10/2007 Class 2 12 Production Possibilities Frontier
Simple model demonstrating some implications of the scarcity of productive resources Production is the process of transforming factors of production (inputs) into goods and services (outputs) Scarcity of factors of production limits the quantities of various outputs that can be produced
Class 2 13 1/10/2007 Production Possibilities Frontier Assume The production decision reveals a tradeoff: Two goods can be produced Production of these goods requires at least some common inputs The common inputs are limited in supply (i.e. are scarce) If all productive resources are employed, then increasing output of one good implies that output of the other good will fall.
Class 2 1/10/2007 14 iPhones A All resources used to produce iPhones Production Possibilities Frontier All resources used to produce macs B
1/10/2007 Class 2 Macs
15 The Production Possibilities Frontier (PPF) Definition: The PPF shows the maximum quantity of one good that can be produced (e.g. iPhones), for any given quantity of the other good produced (macs). 1/10/2007 Class 2 16 Observation 1 The PPF must be negatively sloped
Suppose this point is on the PPF iPhones A B Production Possibilities Frontier Macs Observation 2 Points inside the PPF are inefficient If a point lies inside the PPF, either Productive resources are unused, so those unused resources could be used to increase output of at least one good; or Productive resources could be reallocated to increase output of one good without reducing output of the other Class 2 1/10/2007 18 iPhones Points B, C and D are able to satisfy more wants than point A, and can do so without making anyone worse off B D C A Production Possibilities Frontier Macs
1/10/2007 Class 2 19 Observation 3 All efficient allocations are represented by points on the PPF We will say that all the points on the PPF are productively efficient: i.e. it is impossible to increase the output of one good without decreasing the output of the other 1/10/2007 Class 2 20 A only iPhones produced iPhones A F D B only Macs produced C feasible and efficient D feasible and efficient E inefficient F infeasible Production Possibilities Frontier C E B Macs
1/10/2007 Class 2 21 An example: wool production Sheeps wool grows in different thicknesses, from about 16 to 40 microns. Fine wool (between 16 and 24 microns) is used for making garments Thicker wool is used for other purposes, such as making carpets Determinants of wool thickness include climate, the animals' diet and (most importantly) the breed of sheep
Class 2 22 1/10/2007 Example continued... Australia and New Zealand are the two largest wool producers in the world Aust: Human population around 20 million Sheep population around 120 million NZ i.e. 6 sheep per person Human population around 4 million Sheep population around 44 million i.e. 11 sheep per person
Class 2 1/10/2007 23 Example continued... Different types of sheep yield different qualities of wool Different conditions are favorable to different types of sheep Given available land resources, sheep farmers in both countries need to decide which type of sheep to farm (and therefore, which type of wool to produce)
Class 2 24 1/10/2007 Australia
Coarse wool (bales) 1 m 2 m
1/10/2007 Class 2 Fine wool (bales) 25 New Zealand
Coarse wool (bales) 0.75 m 0.5 m
1/10/2007 Class 2 Fine wool (bales) 26 Opportunity Cost When one chooses to devote resources to one task, one necessarily forgoes the opportunity to use those resources for some other purpose. The opportunity cost is the value of the best opportunity forgone E.g. If one country produced an extra bale of fine wool, it would typically need to give up some coarse wool production. That course wool is the opportunity cost of the extra bale of fine wool. 1/10/2007 Class 2 27 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 0.4 m Fine wool (bales) 1 m 0.2 m 2 m
1/10/2007 Class 2 28 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 0.6 m Slope = rise/run = 3/2 0.4 m 0.5 m
1/10/2007 Class 2 Fine wool (bales) 29 Questions How should production be organized? Suppose you wanted to ensure that some fine wool was produced. Where would you have it produced? Why?
Australia? New Zealand? 1/10/2007 Class 2 30 How should production be organized? Suppose all resources are used for coarse wool production: Total output = 1m bales + 0.75m bales = 1.75m bales To produce the first bale of fine wool implies that coarse wool production must drop Who should produce the first bale of fine wool?
Class 2 1/10/2007 31 How should production be organized? If NZ produces the first bale of fine wool, output of coarse wool must fall by 3/2 bales Opportunity cost of fine wool in NZ = 3/2 If Australia produces the first bale of fine wool, output of coarse wool must fall by 1/2 bale Opportunity cost of fine wool in NZ = If Australia produces the first bale of fine wool, we observe a smaller decrease in coarse wool output Efficiency demands that Australia produce the first bale of coarse wool Why? Because Australia is the producer with the low opportunity cost 1/10/2007 Class 2 32 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. Example: Australia has the comparative advantage in producing fine wool 1/10/2007 Class 2 33 How should we organize production? A similar argument shows that New Zealand has the comparative advantage in production of coarse wool
Australia's opportunity cost of producing a bale of coarse wool is 2 bales of fine wool New Zealand's opportunity cost of producing a bale of coarse wool is 2/3 of a bale of fine wool 1/10/2007 Class 2 34 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 1/10/2007 Class 2 35 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 2 36 1/10/2007 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 1/10/2007 Class 2 37 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 1/10/2007 Class 2 38 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 1/10/2007 Class 2 39 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 2 40 1/10/2007 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 2 1/10/2007 41 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 2 42 1/10/2007 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) 1/10/2007 Class 2 43 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 2 44 1/10/2007 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 1/10/2007 Class 2 45 ...
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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