lecture 1

L E C T U R E

Introduction

1

Lieberman & Hall Chapters 1-2, 16

Scarcity

Scarcity: a situation in which the available amount of a good or service is insufficient to satisfy the

desire for said good or service

scarcity of time

scarcity of spending power

What is Economics?

Economics: the study of choice under scarcity

how people decide how much to work, what to buy, how much to save, how to invest

how firms decide how much to produce, how many workers to hire

how society decides how to divide its resources between national defense, health care, education,

scientific research, etc.

Scarcity and Individual Choice

Making decisions requires comparing the costs and benefits of alternative choices.

The opportunity cost of an item is whatever must be given up to obtain it.

Explicit cost: monetary payments

Implicit cost: non-monetary sacrifice, e.g., time

Scarcity and Individual Choice

The opportunity cost of

going to college for a year is not just the tuition, fees, and books,

but also the foregone wages.

a movie is not just the price of the ticket, but also the value of the time you spend in the

theater.

Scarcity and Social Choice

Society faces a scarcity of resources.

Labor

Capital: physical capital and human capital

Land and natural resources

Entrepreneurship

Microeconomics & Macroeconomics

Microeconomics

mikros, or small

the study of how households and firms make decisions and how they interact in markets

Macroeconomics

makros, or large

the study of economy-wide phenomena, including inflation, unemployment, and economic growth

Positive & Normative Economics

As scientists, economists make positive statements, which attempt to describe the world

as it is.

As policy advisors, economists make normative statements, which attempt to prescribe how the

world should be.

Every normative analysis is based on an underlying positive analysis.

Positive statements can be confirmed or refuted, normative statements cannot.

A C T I V E L E A R N I N G 1

Identifying positive vs. normative

Which of these statements are positive and which are normative? Why?

A. Housing prices rise when interest rates are low.

B. The government should introduce a petrol/gas tax

to curb pollution and traffic congestion.

C. A tax cut is needed to stimulate the economy.

D. An increase in the price of char koay teow will

cause an increase in consumer demand for iPads.

Why Economists Disagree

Economists often give conflicting policy advice.

Positive disagreements different views about how the economy works.

Normative disagreements different values, e.g., the role of government.

Yet, there are many propositions about which most economists agree.

Propositions about Which Most Economists Agree (percent who agree)

A ceiling on rents reduces the quantity and quality of housing available. (93%)

Tariffs and import quotas usually reduce general economic welfare. (93%)

The United States should not restrict employers from outsourcing work to foreign countries. (90%)

A large federal budget deficit has an adverse effect on the economy. (83%)

A minimum wage increases unemployment among young and unskilled workers. (79%)

The Methods of Economics

Model

A highly simplified representation of a more complicated reality

Makes two types of assumptions

simplifying assumptions

critical assumptions

The Production Possibilities Frontier

Production Possibilities Frontier (PPF): a graph that shows all combinations of two goods

that can be produced given the resources and

technology currently available

Example:

Two goods: computers and wheat

One resource: labor (measured in hours)

Economy has 50,000 labor hours per month available for production.

EXAMPLE: The PPF Producing one computer requires 100 hours of labor.

Producing one ton of wheat requires 10 hours of labor.

0

10,000

25,000

40,000

0 500 0 50,000

E

D

C

B

A

Wheat Computers Wheat Computers

Production Employment of

labor hours

Point

on

graph

Production

Com-

puters Wheat

A 500 0

B 400 1,000

C 250 2,500

D 100 4,000

E 0 5,000 0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Wheat (tons)

Computers

A

B

C

D

E

EXAMPLE: The PPF

A. On the graph, find the point that represents

(100 computers, 3,000 tons of wheat); label it F.

Would it be possible for the economy to produce

this combination of the two goods?

Why or why not?

B. Next, find the point that represents

(300 computers, 3,500 tons of wheat); label it G.

Would it be possible for the economy to produce

this combination of the two goods?

Why or why not?


Points off the PPF


Answers

Point F: 100 computers,

3,000 tons wheat

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat

(tons)


Answers

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat

(tons) Point G:

300 computers,

3,500 tons wheat

The PPF

Points on the PPF

possible

efficient: all resources are fully utilized

Points under the PPF

possible

not efficient: some resources underutilized (e.g., workers unemployed, factories idle)

Points above the PPF

not possible

The PPF and Opportunity Cost

Recall: The opportunity cost of an item is whatever must be given up to obtain it.

Moving along a PPF involves shifting resources (e.g., labor) from the production of one good to the

other.

Society faces a trade-off; getting more of one good requires sacrificing some of the other.

The slope of the PPF tells you the opportunity cost of one good in terms of the other.

The slope of a

line equals the

rise over the run, the amount the line rises

when you move to

the right by one

unit.

Here, the

opportunity cost

of a computer is

10 tons of wheat.

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat

(tons)1000

100 slope = = 10

The PPF and Opportunity Cost


PPF and Opportunity Cost

22

In which country is the opportunity cost of cloth lower?

0

100

200

300

400

500

600

0 100 200 300 400

Cloth

Wine

0

100

200

300

400

500

600

0 100 200 300 400

Cloth

Wine

France England

01,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat

(tons)

Economic Growth and the PPF

With additional

resources or

an improvement in

technology,

the economy can

produce

more computers,

more wheat,

or any combination

in between.

Economic

growth shifts

the PPF

outward.

The Shape of the PPF

The PPF could be a straight line, or bow-shaped.

It depends on what happens to opportunity cost as the economy shifts resources from one industry

to the other.

If the opportunity cost of a good remains constant, the PPF is a straight line.

If the opportunity cost of a good rises as the economy produces more of the good,

the PPF is bow-shaped.

Why the PPF Might Be Bow-Shaped

Bikes

Teh tarik As the economy

shifts resources

from teh tarik to

bikes:

PPF becomes steeper

opportunity cost of bikes

increases

At point A,

most workers are

producing teh tarik,

even those that

are better suited

to producing bikes.

So, we do not have

to give up much teh

tarik to get more

bikes.

A

Bikes

Teh tarik At A, opportunity

cost of bikes is

low.


B

At point B, most

workers are producing

bikes. The few left in

teh tarik are the best

brewers.

Producing more bikes

would require shifting

some of the best

brewers away from

the production of teh

tarik, and would cause

a big drop in teh tarik

output.

Bikes

Teh tarik At B, opportunity

cost of bikes is

high.


The PPF is bow-shaped when different workers have different skills, and thus different opportunity

costs of producing one good in terms of the other.

More generally, the PPF is bow-shaped when there are different resources with varying

opportunity costs.

E.g., different types of land are suited for different

uses.


The PPF: A Summary

The PPF shows the combinations of output that an economy can possibly produce, given its

resources and technology.

The PPF illustrates the concepts of trade-off and opportunity cost,

efficiency and inefficiency,

unemployment, and economic growth.

A bow-shaped PPF depicts increasing opportunity cost.

Specialization and Exchange

Example:

Two countries: the U.S. and Japan

Two goods: computers and wheat

One resource: labor, measured in hours

We will look at how much of both goods each country produces and consumes:

if the country chooses to be self-sufficient

if it trades with the other country

Production Possibilities in the U.S.

The U.S. has 50,000 hours of labor available for production, per month.

Producing one computer requires 100 hours of labor.


4,000

100

5,000

2,000

1,000

3,000

500 200 300 400 0

Computers

Wheat

(tons)

The U.S. PPF

The U.S. has enough labor to

produce 500 computers,

or 5,000 tons of wheat,

or any combination along

the PPF.

4,000

100

5,000

2,000

1,000

3,000

500 200 300 400 0

Computers

Wheat

(tons)

The U.S. Without Trade

Suppose the U.S. uses half its labor

to produce each good.

Then it will produce and consume

250 computers and

2,500 tons of wheat.

Use the following information to draw Japans PPF.

Japan has 30,000 hours of labor available for production, per month.

Producing one computer requires 125 hours of labor.


Suppose Japan uses half its labor to produce each good. How much of each good will it

produce and consume?


Derive Japans PPF

Computers

Wheat

(tons)

2,000

1,000

200 0

100 300

Japans PPF

Japan has enough labor to

produce

or

or any combination along

the PPF.

Japan Without Trade

Computers

Wheat

(tons)

2,000

1,000

200 0

100 300

Suppose Japan uses half its labor to

produce each good.

Then it will produce and consume

Consumption With and Without Trade

Without trade,

U.S. consumers get 250 computers and 2,500 tons wheat.

Japanese consumers get 120 computers and 600 tons wheat.

We will compare consumption without trade to consumption with trade.

First, we need to see how much of each good is produced and traded by the two countries.

A. Suppose the U.S. produces 3,400 tons of

wheat. How many computers would the U.S.

be able to produce with its remaining labor?

Draw the point representing this combination of

computers and wheat on the U.S. PPF.

B. Suppose Japan produces 240 computers.

How many tons of wheat would Japan be able

to produce with its remaining labor? Draw this

point on Japans PPF.


Production under trade

4,000

100

5,000

2,000

1,000

3,000

500 200 300 400 0

Computers

Wheat

(tons)

U.S. Production With Trade

Japans Production With Trade

Computers

Wheat

(tons)

2,000

1,000

200 0

100 300


Consumption under trade

Suppose the U.S. exports 700 tons of wheat to

Japan, and imports 110 computers from Japan.

(So, Japan imports 700 tons wheat and exports

110 computers.)

How much of each good is consumed in the U.S.? Plot this combination on the U.S. PPF.

How much of each good is consumed in Japan? Plot this combination on Japans PPF.

4,000

100

5,000

2,000

1,000

3,000

500 200 300 400 0

Computers

Wheat

(tons)

U.S. Consumption With Trade

= amount

consumed

0 110 + imported

700 0 exported

3,400 160 produced

wheat computers

Japans Consumption With Trade

Computers

Wheat

(tons)

2,000

1,000

200 0

100 300

= amount

consumed

700 0 + imported

0 110 exported

0 240 produced

wheat computers

Trade Makes Both Countries Better Off

2,500 wheat

250 computers

gains from

trade

consumption

with trade

consumption

without trade

U.S.

600 wheat

computers

gains from

trade

consumption

with trade

consumption

without trade

Japan

120

Where Do These Gains Come From?

Absolute advantage: the ability to produce a good using fewer inputs than another producer

The U.S. has an absolute advantage in wheat. Producing a ton of wheat requires

10 labor hours in the U.S. versus

25 labor hours in Japan.

If each country has an absolute advantage in one good and specializes in that good, then both

countries can gain from trade.

Where Do These Gains Come From?

Which country has an absolute advantage in computers?

Producing one computer requires 100 labor hours in the U.S. versus

125 labor hours in Japan.

The U.S. has an absolute advantage in both goods!

So why does Japan specialize in computers?

Why do both countries gain from trade?

Two Measures of the Cost of a Good

Two countries can gain from trade when each specializes in the good it produces at lowest cost.

Absolute advantage measures the cost of a good in terms of the inputs required to produce it.

Another measure of cost is opportunity cost.

In our example, the opportunity cost of a computer is the amount of wheat that could be produced

using the labor needed to produce one computer.

Comparative Advantage

Comparative advantage: the ability to produce a good at a lower opportunity cost

than another producer

Which country has the comparative advantage in computers?

To answer this, we must determine the opportunity cost of a computer in each

country.


The opportunity cost of a computer is

10 tons of wheat in the U.S., because producing one computer requires 100 labor hours,

which instead could produce 10 tons of wheat.

5 tons of wheat in Japan, because producing one computer requires 125 labor hours,

which instead could produce 5 tons of wheat.

So, Japan has a comparative advantage in computers.

Absolute advantage is not necessary for comparative advantage!


Gains from trade arise from comparative advantage (differences in opportunity costs).

When each country specializes in the good(s) in which it has a comparative advantage,

total production in all countries is higher,

the worlds economic pie is bigger, and all countries can gain from trade.

The same applies to individual producers specializing in different goods and trading with

each other.

Argentina and Brazil each have 10,000 hours of labor per month.

In Argentina,

producing one pound of coffee requires 2 hours

producing one bottle of wine requires 4 hours

In Brazil,

producing one pound of coffee requires 1 hour

producing one bottle of wine requires 5 hours

Which country has an absolute advantage in the production of coffee?

Which country has a comparative advantage in the production of wine?


Absolute & comparative advantage


Answers

Argentina Brazil

1 lb coffee

1 bottle wine

Resource Allocation

How much of each good and service should be produced with societys resources?

Which producers should produce them?

Which consumers should consume them?

Resource Allocation

Traditional economy: resources are allocated according to long-lived practices of the past

Command economy: resources are allocated according to explicit instructions from a central

authority

Market economy: resources are allocated through individual decision making

Understanding the Market

Market: a group of buyers and sellers with the potential to trade with each other

Adam Smith,The Wealth of Nations,1776:

A private resource owner in a market economy intends only his own gain and he is in this led by an invisible hand to promote an end which was no part of his intention By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.

Understanding the Market

The invisible hand works through the price system.

The interaction of buyers and sellers determines prices.

Each price reflects the goods value to buyers and the sellers cost of producing the good.

Prices guide self-interested households and firms to make decisions that, in many cases,

maximize societys economic well-being.

lecture 1

Documents

scarcity scarcity

scarcity of resources

positive statements

normative statements

normative analysis

study of choice

study of economy

underlying positive