101+Class+03+W2009 - Principles of Economics I Economics...

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: Principles of Economics I Economics 101 Section 400 Class 3 Announcements First assignment available on CTools First assessable quiz in this week's discussion section Today's Readings: For next class: Chapter 2: Production Possibilities and Comparative Advantage Chapter 3: Supply decisions (p 75 79) Chapter 3: Consumption decisions (p 66 75) Chapter 4: Measuring benefits (p 101 105) Class 3 2 1/14/2009 Australia Coarse wool (bales) 1 m Slope = 1/2 2 m 1/14/2009 Class 3 Fine wool (bales) 3 New Zealand Coarse wool (bales) 0.75 m Slope = 3/2 0.5 m 1/14/2009 Class 3 Fine wool (bales) 4 Who should produce the first bale of fine wool? Compare opportunity costs of producing that bale of fine wool In NZ, opportunity cost = 3/2 bale of coarse wool In Australia, opportunity cost = bale of coarse wool If Australia produces the first bale of fine wool, we observe a smaller decrease in total coarse wool output Australia should produce the first bale of fine wool 1/14/2009 Class 3 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. From our example: Australia has the comparative advantage in producing fine wool NZ has the comparative advantage in producing coarse wool 1/14/2009 Class 3 6 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 1/14/2009 Class 3 2.5 m 7 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 1/14/2009 Class 3 Good 1 8 Another Question How will production be organized? Depends in the economic system Suppose that the market system allocates resources Private property rights are allocated over all resources Market provides prices for both of these goods Individuals make selfinterested decisions about how to use their resources in an effort to improve their own welfare 1/14/2009 Class 3 9 Wool example continued... Consider the following prices: Pfine = $500/bale Pcoarse = $500/bale Australian producers will want to produce fine wool Sell one bale of fine wool for $500, or Sell a bale of coarse wool for $250 NZ producers will want to produce coarse wool Sell one bale of fine wool for $500, or Sell 3/2 bales of coarse wool for $750 Class 3 1/14/2009 10 Wool example continued... Consider the following prices: Pfine = $50/bale Pcoarse = $50/bale Australian producers will want to produce fine wool Sell one bale of fine wool for $50, or Sell a bale of coarse wool for $25 NZ producers will want to produce coarse wool Sell one bale of fine wool for $50, or Sell 3/2 bales of coarse wool for $75 Class 3 1/14/2009 11 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 Class 3 12 1/14/2009 Production decisions Compare: the relative price of a good the opportunity cost of producing it vs. E.g.: Producers wish to produce fine wool when the relative price of fine wool exceeds the opportunity cost of producing the fine wool Class 3 13 1/14/2009 Wool example continued... Suppose Pfine =$100/bale Pcoarse =$400/bale Relative price of fine wool = 100/400 = i.e. each bale of fine wool is worth the same amount as of a bale of coarse wool Australia's opportunity cost of fine wool = i.e. each bale of fine wool requires Australian producers to give up bale of coarse wool NZ's opportunity cost of fine wool = 3/2 i.e. each bale of fine wool requires NZ producers to give up 3/2 bales of coarse wool All producers will choose to produce coarse wool Class 3 14 1/14/2009 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 Wool growers in both countries will produce only coarse wool 1. More than 3/2 bales of coarse wool (i.e. fine wool is very expensive), then Wool growers in both countries will produce only fine wool 1. Between and 3/2 bales of coarse wool Wool growers in Aus. will produce fine wool Wool growers in NZ will produce coarse wool Class 3 1/14/2009 15 Coarse wool (bales) 1.75 m Joint PPF Slope = rise/run = 1/2 0.75 m Slope = rise/run = 3/2 Fine wool (bales) 2 m 1/14/2009 Class 3 2.5 m 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 1/14/2009 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) 1/14/2009 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 1/14/2009 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 1/14/2009 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 1/14/2009 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 > $750/bale (i.e. relative price is greater than 3/2) then both countries supply fine wool, for a total supply of 2.5m bales Class 3 22 1/14/2009 The Supply Curve Pfine ($/bale) Supply $750 $250 2m 1/14/2009 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 1/14/2009 24 ...
View Full Document

This note was uploaded on 05/16/2010 for the course ECON Section 40 taught by Professor Hogan during the Winter '09 term at University of Michigan.

Ask a homework question - tutors are online