Lecture 1

Opportunity Cost Opportunity cost: The highest valued activity sacrificed in making a choice. Opportunity costs are incurred when a choice is made. They are subjective and vary across persons. If an option becomes more costly, an individual will be less likely to choose it. The opportunity cost of college: Monetary cost: tuition, books. Non-monetary cost: forgone earnings. If the opportunity cost of college rises (e.g. tuition rises), then one will be less likely to attend college.

Trade Mutual gain is the foundation of trade. Value can be created by exchanges that move goods to individuals who value them more. Transactions costs: the time, effort, and other resources needed to search out, negotiate, and consummate an exchange. Transactions costs reduce our ability to produce gains from potential trades.

Comparative Advantage: The Basis for Exchange What Do You Think? Do the Nepalese perform their own services because they are poor or are they poor because they perform their own services?

Exchange and Opportunity Cost Should Joe Jamail write his own will? Jamail is the most renowned trial lawyer in American History He is listed 195 on the Forbes list of the 400 richest Americans, with net assets over $1 billion.

Exchange and Opportunity Cost Absolute Advantage One person has an absolute advantage over another if he takes fewer hours to perform a task than the other person

Exchange and Opportunity Cost Comparative Advantage One person has a comparative advantage over another if his opportunity cost of performing a task is lower than the other person’s opportunity cost

Exchange and Opportunity Cost The Principle of Comparative Advantage Should Paula update her own web page? Time to update web page Time to complete bicycle repair Paula 20 minutes 10 minutes Beth 30 minutes

Opportunity Costs for Paula and Beth The Principle of Comparative Advantage Should Paula update her own web page? Opportunity Cost of updating a web page Opportunity Cost of a bicycle repair Paula 2 bicycle repairs 0.5 web page updates Beth 1 bicycle repair 1 web page update

Exchange and Opportunity Cost The Principle of Comparative Advantage Should Paula update her own web page? How many web pages and bicycle repairs can Paula and Beth produce a day if they both work eight hour days?

Exchange and Opportunity Cost The Principle of Comparative Advantage (Updated) If they split their time evenly and produce 16 web pages Web Pages Bicycle Repairs Paula 12 8 24 8 Beth Total 20 32

Exchange and Opportunity Cost The Principle of Comparative Advantage If they specialized in their comparative advantage Web Pages Bicycle Repairs Paula 16 48 Beth Total 16 48

Exchange and Opportunity Cost The Principle of Comparative Advantage Should Barb update her own web page? Productivity in programming Productivity in bicycle repair Pat 2 web page updates per hour 1 repair/hr Barb 3 web page updates per hour 3 repairs/hr

Exchange and Opportunity Cost The Principle of Comparative Advantage Everyone does best when each person (or each country) concentrates on the activities for which his or her opportunity cost is lowest

Exchange and Opportunity Cost Economic Naturalist Where have all the .400 hitters gone?

Exchange and Opportunity Cost Sources of Comparative Advantage Individual Inborn talent Education Training Experience

Exchange and Opportunity Cost Sources of Comparative Advantage National Level Natural resources Cultural Institutions

Exchange and Opportunity Cost Sources of Comparative Advantage Noneconomic Adoption of a language Institutions

Exchange and Opportunity Cost Economic Naturalist Televisions and videocassette recorders were developed and first produced in the U.S. Why did the U.S. fail to retain its lead in these markets?

Comparative Advantage and Production Possibilities The Production Possibilities Curve A graph that describes the maximum amount of one good that can be produced for every possible level of production of the other good.

Comparative Advantage and Production Possibilities The Production Possibilities Curve Assume A small economy that: Produces only two goods - coffee and nuts Has only one worker who works 6 hrs/day

Susan’s Production Possibilities Opportunity Cost (OC) 1. OC nuts = Loss in coffee/gain in nuts 2. OC coffee = Loss in nuts/gain in coffee Coffee (lb/day) 24 A B 16 Production Possibilities Curve: All combinations of coffee and nuts that can be produced with Susan’s labor C 8 D Nuts (lb/day) 4 8 12

Susan’s Production Possibilities Coffee (lb/day) The scarcity principle: Having more of one good generally means having less of another good. 24 A B 16 C 8 D Nuts (lb/day) 4 8 12

Attainable and Efficient Points on Susan’s Production Possibilities Coffee (lb/day) 24 A Combination F: Unattainable B 16 Combination E: Inefficient C 8 Combinations A, B, C, and D: Efficient D Nuts (lb/day) 4 8 12

Comparative Advantage and Production Possibilities The Production Possibilities Curve Attainable Point: Any combination of goods that can be produced using currently available resources Unattainable Point: Any combination that cannot be produced using currently available resources

Comparative Advantage and Production Possibilities The Production Possibilities Curve Efficient Point Any combination of goods for which currently available resources do not allow an increase in the production of one good without a reduction in the production of the other

Comparative Advantage and Production Possibilities The Production Possibilities Curve Inefficient Point Any combination of goods for which currently available resources enable an increase in the production of one good without a reduction in the production of the other

Tom’s Production Possibilities Curve Tom’s Production Possibilities Curve for a 6 hour day Coffee (lb/day) Tom’s Production Possibilities Curve: All combinations of coffee and nuts that can be produced with Tom’s labor A 12 B 8 C 4 D Nuts (lb/day) 8 16 24 How Individual Productivity Affects the Slope and Position of the Production Possibilities Curve

Individual Production Possibilities Curves Compared Susan has an absolute and comparative advantage in gathering coffee Coffee (lb/day) 24 Susan’s PPC 12 24 Tom’s PPC Tom has an absolute and comparative advantage in gathering nuts Nuts (lb/day) 12

Production Without Specialization Coffee (lb/day) Tom’s Output = 2 hrs picking nuts = 8 lbs 4 hrs picking coffee = 8 lbs 24 Susan’s Production Possibilities Curve Susan’s Output = 2 hrs picking coffee = 8 lbs 4 hrs picking nuts = 8 lbs 12 Total Output = 16 lbs each B 8 Tom’s Production Possibilities Curve Nuts (lb/day) 8 12 24 Assume: Susan and Tom allocate their time so each person’s output is half nuts and half coffee

Production With Specialization Coffee (lb/day) Tom’s comparative advantage is in nuts so he specializes in nuts and produces 24 lbs 24 Susan’s Production Possibilities Curve Susan gives Tom 12 lbs of coffee for 12 lbs of nuts E 12 Susan’s comparative advantage is in coffee so she specializes in coffee and produces 24 lbs Tom’s Production Possibilities Curve Nuts (lb/day) 12 24

Comparative Advantage and Production Possibilities The gains from specialization grow larger as the difference in opportunity cost increases For Example Susan: 5 lb coffee/hr 1 lb nuts/hr Tom: 1 lb nuts/hr 5 lb coffee/hr

Comparative Advantage and Production Possibilities The gains from specialization grow larger as the difference in opportunity cost increases Without Specialization Tom: 5 hrs coffee = 5 lb 1 hr nuts = 5 lb Susan: 1 hr coffee = 5 lb 5 hrs nuts = 5 lb Total: 10 lb 10 lb

Comparative Advantage and Production Possibilities The gains from specialization grow larger as the difference in opportunity cost increases With Specialization Tom: 30 lb coffee 0 lb nuts Susan: 0 lb coffee 30 lb nuts Total: 30 lb 30 lb

Production Possibilities Curve For a Large Economy Assume: An economy that produces only two goods, coffee and nuts Coffee (1000s of lb/day) A 100 B Why would the Production Possibilities Curve have an outward bow? 95 C 90 D 20 15 E Nuts (1000s of lb/day) 20 30 75 80 77

Comparative Advantage and Production Possibilities The Principle of Increasing Opportunity Cost (“The Low-Hanging-Fruit Principle”) In expanding the production of any good, first employ those resources with the lowest opportunity costs, and only afterward turn to resources with higher opportunity costs

Economic Growth: An Outward Shift in the Economy’s PPC New PPC Factors Shifting the PPC 1. Increases in productive resources (i.e. labor or capital) 2. Improvements in knowledge and technology Coffee (1000s of lb/day) Original PPC Nuts (1000s of lb/day)

Factors That Shift The Economy’s Production Possibilities Curve Increasing Productive Resources Investment in new factories and equipment Population growth Improvements in knowledge and technology Increasing education Gains from specialization

Factors That Shift The Economy’s Production Possibilities Curve Why Have Countries Like Nepal Been So Slow to Specialize? Low population density Isolation Factors that my limit specialization in other countries Laws Customs

Factors That Shift The Economy’s Production Possibilities Curve Can we have too much specialization? What do you think? What are the costs of specialization?

Comparative Advantage and International Trade Economic Naturalist If trade between nations is so beneficial, why are free-trade agreements so controversial?

for Susan’s grades in English and Economics (10 hrs of study) Production Possibilities Curve for Susan’s grades in English and Economics (10 hrs of study) Susan is a student who only has 10 hours of study to divide between her economics and English classes. Expected grade in Economics 101 Production Possibilities Curve ( PPC ) If she spends most of her time studying economics, she can earn an A in economics … A and a D in her English class. B If she splits her time between the two, she can earn a B in economics … and a B in her English class. C If she spends most of her time studying English, she can earn a D in economics … D and an A in her English class. Expected grade in English 101 F Mapping out all the possibilities of how Susan can divide her time (limited resources) between these activities shows us her Production Possibilities Curve ( PPC ). F D C B A

Production Possibilities Curve ( PPC ) for a nation’s economy (given limited resources) Consider an economy which has limited resources to divide between the production of clothing and food. Production Possibilities Curve ( PPC ) Only clothing is produced Output of clothing If it allocates all of its resources toward the production of clothing, then it can produce at point S. S All output combinations on the frontier curve are efficient. - Inefficiency - A If the it allocates all of its resources toward the production of food, then it can produce at point T. B D Mapping out all the possibilities of how an economy can divide the use its resources gives us the economy’s Production Possibilities Curve. C Only food is produced Output combinations A, B, & C are all on the PPC and are, therefore, efficient allocations of resources. T Output of food D is within the PPC and represents an inefficient resource allocation. Combination B delivers more food with the same output of clothing.

Shifting the Production Possibilities Curve Outward An increase in the economy’s resource base would expand our ability to produce goods and services. Advancements in technology can expand the economy’s production possibilities. An improvement in the rules (laws, institutions, and policies) of the economy can increase output. By working harder and giving up current leisure, we could also increase our production of goods and services. This requires us to give up something else we value: leisure.

Investment and Production Possibilities in the Future The long-term benefits of investment include greater output in the future. Thus, decisions we make today regarding how much to save (investment) and consume determine the shape of the PPC 10 years from now. Investment goods PPC 2015 with A PPC 2005 If we choose to produce a mixture of consumption and investment goods which corresponds to bundle A … A IA then the future PPC might move out to PPC 2015 with A – due to the new buildings, equipment, training, and other forms of investment goods that IA represents. CA Consumption goods

Investment and Production Possibilities in the Future If we choose to produce a mixture of consumption and investment goods which corresponds to bundle B, with fewer consumption goods (CB < CA) and more investment (IB > IA) … Investment goods PPC 2015 with B PPC 2015 with A PPC 2005 then the future PPC might move out to PPC 2015 with B instead. B IB The level of investment (savings) in an economy is only one determinant of the movement outward (or inward) of the production possibilities curve. A IA CB CA Consumption goods

Law of Comparative Advantage Law of comparative advantage: The proposition that the joint output of trading partners will be greatest when each good is produced by the low opportunity cost producer. Implies that trading partners can gain by specializing in the production of goods they can produce at a relatively low opportunity cost and trade for goods they could only produce at a relatively high opportunity cost. The principle of comparative advantage is universal as it applies across individuals, firms, regions and countries.

Economic Organization: Markets vs. Political Planning

Market Organization Market organization: A method or organization that allows for unregulated prices and the decentralized decisions of private property owners to resolve the basic economic problems. Sometimes called capitalism.

Political Planning Political organization is the major alternative to the use of markets. Political organization involves the use of collective decision making (government) to decide what, how, and for whom goods and services will be produced. An economic system in which the government owns the income-producing assets and directly determines what goods they produce is called socialism. In a democracy, political decision makers have to consider how their actions will influence their election prospects.

Questions for Thought: 1. Suppose Amy is a doctor who has records that need to be entered. Doing this work herself would take 10 hours per week. She is thinking about hiring an assistant who could do the same work in 40 hours. If Amy can make $80 per hour seeing patients, should she hire the assistant at $10 an hour? 2. Do you make the food that you consume and clothing you wear for yourself? What are the sources of gains from trade? Would modern living standards be possible without trade?

Questions for Thought: 3. What does a production-possibilities curve demonstrate? Can the production possibilities of an economy be increased? If so, how? 4. “Modern living standards are primarily the result of brain power, capital formation, and the quality of institutions.” What is the meaning of this statement? Is it true?