Economics 1 (EC107) : Micro (Term 1) Robin Naylor, Department of Economics, Warwick 1 Economics (Lecture 1) Welcome!

Robin Naylor, Department of Economics, Warwick 2 Economics 1 Accompanying Resources Module Website – (with links) MyEconomics Portal Module Manual – (with reading list) Seminar Work and Problem Sets Departmental Handbooks and Web-Sites

Robin Naylor, Department of Economics, Warwick 3 Economics 1 Organisation Lecture timetable Seminar arrangements Personal Essays Examination and Assessment

Robin Naylor, Department of Economics, Warwick 4 Economics 1 Term 1Microeconomics Term 2Macroeconomics

Robin Naylor, Department of Economics, Warwick 5 Economics Readings (Micro) Frank, R., Microeconomics and Behaviour, 8 th Edition, 2010, McGraw- Hill Estrin, Laidler and Dietrich (ELD), Microeconomics, Many other textbooks plus other literature: see Module Manual

Robin Naylor, Department of Economics, Warwick 6 Term 1: Micro Topics IntroductionScarcity and Trade Topic 1Household behaviour Topic 2Firm behaviour Topic 3Product markets Topic 4Factor markets Topic 5Market Structure, Efficiency and Failure

Robin Naylor, Department of Economics, Warwick 7 Introduction The fundamental problem of scarcity –Cause: excess of wants over ‘natural’ supply –Consequences: (i) Choices over production (ii) Trade-offs and opportunity costs (iii) Rationing of distribution (Markets etc...) Consider a 2-good economy:

Robin Naylor, Department of Economics, Warwick 8 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta MaxThe Production Possibility Curve The Production Possibility Set See Handout

Robin Naylor, Department of Economics, Warwick 9 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max On what does the position of the Production Possibility Curve depend?

Robin Naylor, Department of Economics, Warwick 10 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a What can you say about point ‘a’?

Robin Naylor, Department of Economics, Warwick 11 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a ‘a’ is not ‘technically’ efficient. A ‘Pareto’ improvement can be made.

Robin Naylor, Department of Economics, Warwick 12 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a What can you say about point ‘b’?. b

Robin Naylor, Department of Economics, Warwick 13 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a There can be no Pareto Improvement from ‘b’. It is Pareto Efficient.. b

Robin Naylor, Department of Economics, Warwick 14 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a What can you say about point ‘c’?. b. c

Robin Naylor, Department of Economics, Warwick 15 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a How could we get to point ‘c’?. b. c

Robin Naylor, Department of Economics, Warwick 16 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a If we are at ‘a’, how can we have more Tractors?. b See Handout

Robin Naylor, Department of Economics, Warwick 17 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a If we are at ‘b’, how can we have more Tractors?. b See Handout

Robin Naylor, Department of Economics, Warwick 18 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a If we are at ‘b’, how can we have more Tractors?. b. d

Robin Naylor, Department of Economics, Warwick 19 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a We have shown a PPC which is concave: what does this depend on?. b. d See Handout

Robin Naylor, Department of Economics, Warwick 20 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a The slope of the PPC is called the Marginal Rate of Transformation (MRT). Why?. b. d

Robin Naylor, Department of Economics, Warwick 21 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a The MRT is the amount of one good (Ta) we have to give up in order to have an extra unit of the other good (Tr).. b. d

Robin Naylor, Department of Economics, Warwick 22 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a The MRT is the amount of one good (Ta) we have to give up in order to have an extra unit of the other good (Tr).. b. d So the MRT is increasing in the case of the concave PPC. Why?

Robin Naylor, Department of Economics, Warwick 23 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a The MRT is the amount of one good (Ta) we have to give up in order to have an extra unit of the other good (Tr).. b. d So the PPC and the MRT describe the Trade-off we have to make between the 2 goods.

Robin Naylor, Department of Economics, Warwick 24 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a The MRT is the amount of one good (Ta) we have to give up in order to have an extra unit of the other good (Tr).. b. d So the PPC and the MRT describe the Opportunity Cost of the extra Tr.

Robin Naylor, Department of Economics, Warwick 25 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max The PPC shows us the trade-off that Society has to make between 2 goods. But what about the trade-off that the Society is prepared to make? See Handout

Robin Naylor, Department of Economics, Warwick 26 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max What about the trade- off that the Society is prepared to make? This is shown by an Indifference Curve. IC See Handout

Robin Naylor, Department of Economics, Warwick 27 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max What about the trade- off that the Society is prepared to make? This is shown by an Indifference Curve. IC

Robin Naylor, Department of Economics, Warwick 28 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max An Indifference Curve. It’s slope shows us how much of one good the society is prepared to give up in order to have an extra unit of the other good. IC

Robin Naylor, Department of Economics, Warwick 29 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max The slope of the IC shows us how much of one good the society is prepared to give up in order to have an extra unit of the other good: This is the Marginal Rate of Substitution (MRS). IC

Robin Naylor, Department of Economics, Warwick 30 Introduction (Lecture 2) The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max The Marginal Rate of Substitution describes the trade-off society is prepared to make. Why might it be convex, as shown? IC

Robin Naylor, Department of Economics, Warwick 31 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max Why might the PPC be convex, as shown? IC

Robin Naylor, Department of Economics, Warwick 32 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max A set or family of Indifference Curves IC1 IC2 IC3 See Handout

Robin Naylor, Department of Economics, Warwick 33 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a ‘a’ is not technically efficient. ‘b’ is. So is ‘d’. So how can we choose between ‘b’ and ‘d’? They are both ‘technically’ efficient. But they are not both Allocatively Efficient.... b. d See Handout

Robin Naylor, Department of Economics, Warwick 34 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a. b. d On which IC would society like most to be? See Handout

Robin Naylor, Department of Economics, Warwick 35 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a. b. d On which IC would society like most to be? At what point is this?

Robin Naylor, Department of Economics, Warwick 36 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a. b. d On which IC would society like most to be? At what point is this?. e

Robin Naylor, Department of Economics, Warwick 37 Introduction The fundamental problem of scarcity Tractors Tanks 0Tr Max Ta Max. a. b. d At ‘e’, MRS = MRT. Discuss.. e

Robin Naylor, Department of Economics, Warwick 38 Introduction Gains from Trade Consider now 2 economies, Red and Blue: Let’s assume they have the same inputs. X Y PPC-R PPC-B See Handout

Robin Naylor, Department of Economics, Warwick 39 Introduction Gains from Trade Consider 2 economies, Red and Blue: X Y PPC-R PPC-B Who has an absolute advantage in producing X? And Y? See Handout

Robin Naylor, Department of Economics, Warwick 40 Introduction Gains from Trade Consider 2 economies, Red and Blue: X Y PPC-R PPC-B The fact that PPC-B is flatter than PPC-R has an important implication. To raise output of X by the amount dX, the required reduction in Y is smaller in Blue than in Red. dX See Handout

Robin Naylor, Department of Economics, Warwick 41 Introduction Gains from Trade Consider 2 economies, Red and Blue: X Y To raise output of X by the amount dX, the required reduction in Y is smaller in Blue than in Red. In other words, the Opportunity Cost of the extra X is lower in Blue than in Red. We say that Blue has a Comparative Advantage in the production of X. And Red has a Comparative Advantage in producing Y. dX

Robin Naylor, Department of Economics, Warwick 42 Introduction Gains from Trade Consider 2 economies, Red and Blue: X Y Blue has a Comparative Advantage in the production of X. And Red has a Comparative Advantage in producing Y. This follows entirely from the relative slopes of the 2 PPCs. The MRT (i.e., the slope of the PPC) is greater in Red than in Blue. Thus, Blue has the Comparative Advantage in X.

Robin Naylor, Department of Economics, Warwick 43 Introduction Gains from Trade Consider 2 economies, Red and Blue: X Y PPC-R PPC-B As a numerical example, let’s say that to raise output of X by the amount dX, the required reduction in Y is 1 unit in Blue and is 3 units in Red. dX dY=1 dY=3 See Handout

Robin Naylor, Department of Economics, Warwick 44 Introduction Gains from Trade Consider 2 economies, Red and Blue: X Y Suppose that to raise output of X by the amount dX, the required reduction in Y is 1 unit in Blue and is 3 units in Red. Then this has an implication for Trade and Specialisation. Suppose initially, Blue is at point ‘a- B’ and Red is at ‘a-R’. (Why might this be?) dX dY=1 dY=3 a-B a-R

Robin Naylor, Department of Economics, Warwick 45 Introduction Gains from Trade Consider 2 economies, Red and Blue: X Y Suppose initially, Blue is at point ‘a- B’ and Red is at ‘a-R’. Why might this be? a-B a-R

Robin Naylor, Department of Economics, Warwick 46 Introduction Gains from Trade Consider 2 economies, Red and Blue: X Y Suppose initially, Blue is at point ‘a- B’ and Red is at ‘a-R’. If Blue gives up one unit of Y, it raises output of X by dX. Suppose that at the same time Red cuts production of X by the same amount, dX: then it can raise output of Y by 3 units. So what is the total change in ‘World’ production of X? And of Y? dX dY=1 dY=3 a-B a-R

Robin Naylor, Department of Economics, Warwick 47 Introduction Gains from Trade Consider 2 economies, Red and Blue: X Y So with an unchanged total production of X and a higher total production of Y, the countries could*: Trade such that Blue exports dX to Red and, in return, Red exports 2 units of Y to Blue. What would this look like in terms of each country’s PPC? a-B a-R * They ‘could’ trade in the manner we have suggested. In general, how much they trade of each good will depend on... ? b-R b-B dY=1 See Handout

Robin Naylor, Department of Economics, Warwick 48 Introduction Gains from Trade Consider 2 economies, Red and Blue: X Y So, the countries could trade such that Blue exports X to Red and, in return, Red exports Y to Blue. Where does this argument lead? What can you say about the extent of specialisation in this case? On what assumptions does this result depend? What change in assumptions might modify this result? b-R b-B See Handout

Robin Naylor, Department of Economics, Warwick 49 Introduction Key Concepts Scarcity Wants Opportunity Cost Trade-offs Rationing Markets Efficiency Equity Constraints Changes at the margin See Handout

Robin Naylor, Department of Economics, Warwick 50 Introduction Key Concepts Choices Preferences Constraints PPC MRS MRT Optimisation Absolute advantage Comparative advantage Specialisation Trade See Handout

Robin Naylor, Department of Economics, Warwick 51 Introduction Self-study Questions Show and explain a PPC for a country What determines the position and shape of the PPC Explain the concept of the MRT Economists often argue that Choices depend on two key concepts: Preferences and Constraints. Explain this argument. Explain the concept of the MRS Define ‘trade-offs’ (in terms of both preferences and constraints) and ‘Opportunity Cost’ and explain their meanings in a diagram using the concept of the PPC. What is meant by Absolute Advantage? What is meant by Comparative Advantage? Explain how the concepts of comparative advantage and of opportunity cost are related. Show how trade and specialisation can lead to potential gains for both parties in a trade. See Handout