Principle of microeconomics

If he makes frame houses instead, he can build 1 frame house in that month... Person A has an absolute advantage over person B in the production of a good if person A can produce the g

Resource Utilization

Economics:

The study of the allocation

of scarce resources

The Economic Problem:

How do we use scarce resources to best

satisfy unlimited human wants?

To say that a good is scarce means that less of the good is freely

available than consumers would

like.

examples of scarce goods:

bread, spinach, clean water, parks

positive economics:

what is or will be

normative economics: what ought to be

ceteris paribus:

other things constant

At a particular price of apples, people buy a

certain quantity of apples

apples

$0.30

Ceteris paribus, when the price of apples

increases, people buy fewer apples

apples

$0.30

$0.50

But suppose people’s incomes increase at the same time that the price of fruit goes up

Perhaps, originally we had a little income

and now we have a lot more income

has gone up The ceteris paribus assumption

(other things constant) has been violated

Income is not constant

apples

$0.30

$0.50 Then people may buy more

apples even though the price of apples

Suppose we see both wages and prices rising Did the increase in wages cause the increase

in prices?

Did the increase in prices cause the increase

in wages?

Perhaps neither Other factors could be

causing both wages and prices to rise.

Association is not Causation.

Fallacy of Composition:

What is true for the individual may

not be true for the entire group.

Suppose you suddenly have twice as much income as you did before Then you could buy twice as much as you could before.

Now suppose everyone has twice as much

income as before Could everyone buy

twice as much?

Probably not The higher incomes are likely

to cause an increase in the price level.

Example

ex: The opportunity cost of going to a

basketball game may be the five or ten

extra points that you might have earned

on an exam by staying home and studying that night.

Opportunity Cost:

the next best alternative that you had to give

up because you chose a particular option

Production Possibilities Frontier

or Production Possibilities Curve

(PPF or PPC):

a curve that outlines all possible combinations

of total output that could be produced assuming

◆fixed resources

◆full and efficient use of resources

◆fixed technology

If you used all your time for Economics,

you might get a 96 average in Economics, but a 48 in History

If you used all your time for History, you might get a 96 average in History, but a

If you studied some time for each, you might have a 72 average in each course, or perhaps

a 60 in one and a 84 in the other

If you sketch these points on a graph

and connect the points, you have the following picture.

History Grade

Economics Grade

96

96 48

72

72

84

84 60

60

History Grade

Economics Grade

96

96 48

The Production Possibility Frontier shows the best you can do in current circumstances.

◆ You have fixed resources.

your brain and your time

◆ You are making full and efficient use of those resources

You are not getting up to get a snack every

five minutes.

◆ You have fixed technology.

Your knowledge of study techniques is fixed.

Suppose your circumstances change Perhaps you quit your job, so you now have more

time for studying

Before, the only way you could get an A in Economics is if you flunked History

Now with the extra time, you can get an A

in Economics and still have enough time

to get a D in History.

History Grade

Economics Grade

96

96 48

Your new production possibilities frontier

is higher and further to the right than

your old PPF.

Suppose now that you are a country

producing food and clothing Your options

include the following:

option food clothing

A 11 4

B 10 5

C 8 6

D 5 7

As you move from one option to another, how much food must you give up to produce

another unit of clothing?

This amount is the slope of the

production possibility frontier.

slope = ( ∆ Food / ∆ Clothing)

|slope|

option Food Clothing | ∆F/∆C |

As the amount of clothing increases and the amount of food decreases, the amount of food that you have to give up in order to get

another unit of clothing increases

When you are producing a lot of clothing and not much food, you have only a few resources used to produce food.

These are the ones that are much better at making food than at making clothing.

If you move those resources from food to clothing production, you will give up a lot

of food for only a little clothing.

We see this shape when resources are not equally good at producing the

different commodities

Since productivity differences seem reasonable, we will usually draw our PPFs with the concave (rather than straight-line) shape

The concave shape reflects the changing

slope we just described

clothing

Production Possibility Frontier (PPF)

Points below the PPF represent unemployment

or inefficient use of resources.

X

clothing

Production Possibility Frontier (PPF)

Points above the PPF represent unattainable combinations.

Y

clothing

Production Possibility Frontier (PPF)

If economic growth occurs, so that it becomes possible to produce more output, the PPF shifts to the right and up.

clothing

Production Possibility Frontier (PPF)

If, for some reason, there

is a reduction in resources available for production, the PPF shifts to the left and down.

Comparative Advantage and Gains

from Specialization and Trade

Consider two people, Carl and Sam Both are

in the construction business

Suppose that Carl can build 2 brick houses in

a month If he makes frame houses instead,

he can build 4 frame houses in that month.

Sam can build 1 brick house in a month If

he makes frame houses instead, he can build

1 frame house in that month.

Person A has an absolute advantage over

person B in the production of a good if

person A can produce the good with fewer resources than person B or equivalently, that person A can produce more of the good than person B with the same resources

In our example, Carl has an absolute

advantage over Sam in the construction

of both frame and brick houses.

For Carl, the opportunity cost of producing one brick house is two frame houses For Sam, the opportunity cost of producing one brick house

is one frame house

So the opportunity cost of the

production of a brick house is lower

for Sam than for Carl.

For Carl, the opportunity cost of producing one frame house is 1/2 brick house For Sam, the opportunity cost of producing one frame house

is one brick house

So the opportunity cost of the

production of a frame house is lower for Carl than for Sam.

Person A has a comparative advantage over

person B in the production of a good if person A has a lower opportunity cost of producing the

good

person comparative advantage

Sam brick

Carl frame

Law of Comparative Advantage:

The total output of a group, an economy, or a

group of nations will be greatest when the output

of each good is produced by the person (or firm

or nation) with the lowest opportunity cost

Let’s see how this law applies to Carl and Sam

12 Months Production without Specialization

frame brick Carl 16 16

Sam 6 6

Total 22 22

11 Months Production with Specialization

frame brick

Recall that the opportunity cost of 1 brick house for Sam is 1 frame house.

If Sam can trade some of his brick houses for

at least one frame house per brick house, he will be happy.

The opportunity cost of 1 brick house for

Carl is 2 frame houses.

If he can get some brick houses from Sam for less than 2 frame houses per brick house, he will be happy.

So the terms of trade will be between 1 and 2 frame houses per brick house.

After construction, Carl and Sam have the following:

Suppose that Carl and Sam agree to trade 6

frame houses for 5 brick houses So we have

build trade

Sam brick 11 - 5

frame 0 + 6

Carl brick 11 + 5

frame 22 - 6

The result is:

build trade result Sam brick 11 - 5 6

frame 0 + 6 6

Carl brick 11 + 5 16

frame 22 - 6 16

Now Carl and Sam each have the same number

of houses as before specialization and trade

However, they are better off now because they get a month of vacation

Alternatively, if they worked a 12-month year, they could produce more houses

than before.

It is comparative advantage, not absolute

advantage, that makes gains from trade possible.