topic 2 econ 103 -- page 1 microeconomics topic 2web.uvic.ca/~bettyj/103/topic_2_2015.pdf · topic...

Topic 2 Econ 103 -- page 1

Microeconomics

Topic 2

Text reference: Chapter 2

Chapter 17

►Production Possibilities Frontier

►Absolute Advantage

►Comparative Advantage

►Gains From Trade


Microeconomics

Resource Allocation in Society

There are three key resource allocation questions at the core

of microeconomics:

- 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


Microeconomics

In Topic 2, we will focus on the second question with three

aims:

■ Develop a sense of normative approach used in

economics

■ Practice simple model-building

■ Understand why economists really like trade


Microeconomics

Economic Efficiency

Our normative criterion is efficiency.

- “Efficiency, “economic efficiency”, Pareto efficiency”

all equivalent terms.


Microeconomics

General Idea: As long as we like something, if we can get

“something for nothing”, then we should get it.

It would be irrational not to exploit the circumstances if they

exist.

→However, the current situation cannot be efficient.


Microeconomics

Look at this idea in the context of the second question:

How should production of those goods take place?

Model of Production

•Start as simple as possible.

•Assume initially a one-person world

•There is no trade and no monetary system.

•One person can use their time and other resources to

‘produce’ food.

Two types of food: Fish and morel mushrooms:


Microeconomics

►Time spent fishing cannot be spent mushrooming; time

spent on mushrooming cannot be spent on fishing.

■The opportunity cost of fishing is mushrooms foregone.

■The opportunity cost of mushrooming is fish foregone.


Microeconomics

Production

How much food can be produced in a day?

Output per Day

Mushrooms Fish

0 15

10 14

20 11

30 6

40 0

If we split our time, we can have some of both.

If all time is spent on fishing:

We catch 15 fish. We cannot

have any mushrooms.

If all time is spent on

collecting mushrooms, we can

harvest 40 mushrooms, but

cannot have any fish.


Microeconomics

What is the opportunity cost of mushroom production?

Output per day

Mushrooms Fish

0 15

10 14

20 11

30 6

40 0

►To get the first 10 mushrooms, must give up one fish.

The marginal (opportunity) cost per mushroom = 1/10 Fish.

▪ To get an increase in mushrooms from 10 to 20, must give up

three fish: MC per mushroom = 3/10 fish.

▪ From 20 to 30 mushrooms, MC =5/10 fish.

▪ From 30 to 40 mushrooms, MC = 6/10 fish.

+10

+10

+10

+10

-1

-3

-5

-6


Microeconomics

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.


Microeconomics

Points on the PPF are as good as we can do, given scarce

resources and current technology.

If we are on the PPF, to get more of one good, we have to

give up some of the other good.

If we are on PPF, we cannot get ‘something for nothing’.

There are no “win-wins”.

Points on the PPF are efficient (in one-person world.)


Microeconomics

Fish

15

14

11

6

Mushrooms

0 10 20 30 40

PPF


Microeconomics

Fish

15 If we end up inside the PPF, we must

14 not be fully using our resources.

11

We can have more of one good

(or both) without having to give

any of the other.

6

Mushrooms

0 10 20 30 40

We can get something for nothing; there are ‘win-wins’.

Points inside the PPF are inefficient.


Microeconomics

Points outside the PPF would be nice, but aren’t available, given

the world in which we live.

Fish

15

14

Points outside the PPF are

11 infeasible; unattainable.

6

Mushrooms

0 10 20 30 40

Not possible


Microeconomics

The slope (absolute value) = MC of good on horizontal axis.

Fish slope = rise run

15

14 Inverse of slope = MC of good on vertical axis

11

6 As we move along the PPF,

the slope is steeper.

Mushrooms

0 10 20 30 40

If PPF is linear, then MC is constant.


Microeconomics

In a one-person economy, our opportunities for consumption

are constrained by PPF.

►Can only consume any combination 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 goods, relative to each other.

►Depends on our preferences.

Assume this person’s preferences are such that they

produce and consume 10 mushrooms and 14 fish per day.


Microeconomics

Specialization and Trade

Suppose another person arrives in our economy.

This new person can also produce fish and mushrooms, but

has different skills. Person 2

Output per day

Mushrooms Fish

0 27

10 26

20 23

30 17

40 9

50 0

Person 2 can produce more than person 1.

►Person 2’s PPF lies entirely outside person 1’s.

Person 2’s Production

possibilities for fish and

mushrooms.


Microeconomics

Person 1 Person 2

Output per day Output per day Mushrooms Fish Mushrooms Fish

0 15 0 27

10 14 10 26

20 11 20 23

30 6 30 17

40 0 40 9

50 0

In this case, Person 2 has the absolute advantage in the production of

both goods.

Person 2 can produce more mushrooms than person 1 at a given

level of fish.

Person 2 can produce more fish than person 1 at a given level of

mushrooms.

Work through the examples in the supplementary exercises.


Microeconomics

Fish

27

26

23

17

15

14

11

9

6

Mushrooms

0 10 20 30 40 50

If all time is spent on fishing:

We catch 15 fish. We cannot

have any mushrooms.

If all time is spent on

collecting mushrooms, we can

harvest 40 mushrooms, but

cannot have any fish.


Microeconomics

Recall: Person 1 produces and consumes 10 mushrooms and

14 fish per day.

Assume initially that:

- There is no interaction or cooperation between person

1 and 2.

- Person 2 chooses to produce and consume 40

mushrooms and 9 fish.

Aggregate output in this economy is 50 mushrooms and 23

fish.

- Are production combinations efficient?

- Can the economy get something for nothing?

- Can we have more mushrooms or fish without having

to give anything up?


Microeconomics

- If we can, this production combination cannot be

efficient.

- Doing what we are doing leaves win-wins on the table.


Microeconomics

Current production:

Person 1 – 10 mushrooms and 14 Fish

Aggregate output

50 Mushrooms and 23 Fish

Person 2 – 40 mushrooms and 9 fish

Different feasible production combination:

Person 1 – 20 mushrooms and 11 Fish

Aggregate output

50 Mushrooms and 28 Fish

Person 2 – 30 mushrooms and 17 fish

Original production choice left ‘win-wins’ on the table.

Same total mushrooms and more fish.

►Net gain of 5 fish at zero overall cost.


Microeconomics

►Original production choice cannot be efficient.

Those extra fish can improve the well-being of both people.

*Person 1 trades extra 10 mushrooms produced in exchange for

6 fish.

Each ends up with the same amount of mushrooms as

before, but now:

- Person 1 has 14 Fish in total

►A net gain of 3 fish

- Person 2 has 11 fish in total

►A net gain of 2 fish

This is what we mean when we talk about gains from trade.

Each gets to consume at a point that is outside their

PPF.


Microeconomics

Where did this “something for nothing” come from?

Person 1 increased mushroom production from 10 to 20.

- Cost the economy 3 fish.

- MC of each new mushroom now produced by person 1 is

3/10 fish.

Person 2 decreased mushroom production from 40 to 30.

- Gain to the economy of 8 fish.

- MC of each mushroom no longer produced by person 2

was 8/10 fish.

Gain possible because there was a difference between MC.


Microeconomics

Recall, Person 2 has the absolute advantage in mushroom

production.

He is able to produce more mushrooms for given fish, and

vice versa.

But, at the original production point, the marginal cost of

mushroom production is lower for Person 1 than for Person 2.


Microeconomics

Distinction between absolute advantage and comparative

advantage:

Economic agent with the 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” in the good for which they

have the comparative advantage.

Some important conclusions follow from material covered so far:


Microeconomics

Summary:

1) If Person 1 has a comparative advantage in mushroom

production, then Person 2 must have the comparative

advantage in fish production.

- Follows since the MC of fish = inverse of MC of

mushrooms.

2) A producer may not have the comparative advantage at

all levels of production.

- As Person 1 increased mushroom production, his MC

of mushroom production increased.

- As Person 2 decreased mushroom production, her MC

of mushroom production decreased.


Microeconomics

- At some point, Person 2 will gain the comparative

advantage in mushroom production.

►So, Person 1 will gain the comparative advantage in

fish.

3) Specialization need not be complete:

- That is, efficiency does not necessarily require a

producer to produce only the good for which it has a

comparative advantage.

- Partly true because comparative advantage can change

as output changes.

- But, true also because we might not want much of the

good.


Microeconomics

- If a producer has a comparative advantage in

producing bean sprouts, but everyone hates bean

sprouts, we will not want bean sprouts.

What ends up being produced is partly a function of

costs, but also partly a function of preferences.


Microeconomics

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