Production possibilities and opportunity cost Productive ...friesen/lecture_3.pdf · Production possibilities and opportunity cost Productive and allocative efficiency Gains from

© 2010 Pearson Education Canada

Review of last week’s lecture

Production possibilities and opportunity cost

Productive and allocative efficiency

Gains from trade


Review - Production possibilities and

opportunity cost

Simple model that illustrates

• Scarcity

• Trade-offs and opportunity cost

• Productive efficiency


Production Possibilities Curve -

assumptions

Two goods: cola and pizza

Fixed resources

Fixed technology

Efficiency - the economy is achieving

maximum production


Production Possibilities and

Opportunity Cost

Production Possibilities

Frontier

Any point on the frontier

such as E and any point

inside the PPF such as Z

are attainable.

Points outside the PPF

are unattainable.


Any point inside the frontier, such as Z, is inefficient.

At such a point, it is possible to produce more of one good without producing less of the other good.

At Z, resources are either unemployed or misallocated.


Opportunity Cost


Production Efficiency

We achieve production

efficiency if we cannot

produce more of one good

without producing less of

some other good.

Points on the frontier are

efficient.


Opportunity Cost


Tradeoff Along the PPF

Every choice along the

PPF involves a tradeoff.

On this PPF, we must give

up some cola to get more

pizzas or give up some

pizzas to get cola.


Opportunity Cost


Opportunity Cost

As we move down along

the PPF, we produce

more pizzas, but the

quantity of cola we can

produce decreases.

The opportunity cost of a

pizza is the cola forgone.


Opportunity Cost


Note that the opportunity cost of a can of cola is the inverse of the opportunity cost of a pizza.

One pizza costs 5 cans of cola.

One can of cola costs 1/5 of a pizza.


Opportunity Cost


At all the points along the PPF, we attain production

efficiency.

As we move from one point on the PPF to another, we get

more of some good and less of the other.

What attainable combination is best?

We want to choose the most highly valued combination.

This depends on preferences, as well as costs.

Allocative efficiency


If we move from E to F, we give up 5 cans of cola and gain one pizza.

If we value one more pizza more than we value the 5 cans of cola, this is a good move.

If we value the 5 cans of cola more than we value one more pizza, this is a bad move.



Is Point E preferred to point F? Depends both on:

(1) How many cans of cola we have to give up

(2) how many cans of cola we would be willing to give up



The Marginal Cost of pizza is the number of cans of cola that we have to give up to get one more pizza

The Marginal Benefit of pizza is the number of cans of cola that we would be willing to give up to get one more pizza (the value of something is what we are willing to give up to get it)

Starting at any point on the PPF, if:

MC of pizza < MB of pizza produce more pizza

MC of pizza > MB of pizza produce less pizza

MC of pizza = MB of pizza efficient (all resources are allocated to their most highly valued use)



Figure 2.4 illustrates allocative efficiency.

The point of allocative efficiency is the point on the PPF at which marginal benefit equals marginal cost.

This point is determined by the quantity at which the marginal benefit curve intersects the marginal cost curve.

Using Resources Efficiently


Gains from Trade

Gains from trade arise when:

• individuals (groups, nations) specialize in the production

of goods in which they have a comparative advantage

• and trade to obtain the other good

Trade can occur at any price that lies between the

individuals’ opportunity costs


Figure 2.6 shows the gains from trade.

Joe initially produces at point A on his PPF.

Liz initially produces at point A on her PPF.

Gains from Trade


Joe’s opportunity cost of producing a salad is less than Liz’s.

So Joe has a comparative advantage in producing salad.

Gains from Trade


Liz’s opportunity cost of producing a smoothie is less than

Joe’s.

So Liz has a comparative advantage in producing smoothies.

Gains from Trade


Joe specializes in producing salad and he produces

30 salads an hour at point B on his PPF.

Gains from Trade


Liz specializes in producing smoothies and produces

30 smoothies an hour at point B on her PPF.

Gains from Trade


They trade salads for smoothies along the red ―Trade line.‖

The price of a salad is 2 smoothies or the price of a

smoothie is ½ of a salad.

Gains from Trade


Joe buys smoothies from Liz and moves to point C—a point

outside his PPF.

Liz buys salads from Joe and moves to point C—a point

outside her PPF.

Gains from Trade


Unfinished business from last week’s lecture

– Economic coordination

The economy is made up of a huge number of individuals

and firms making decentralized decisions

How are these decisions coordinated in order to ensure

that the gains from trade are realized?

To make coordination work, four complimentary social

institutions have evolved over the centuries:

Firms

Markets

Property rights

Money


A firm is an economic unit that hires factors of production and organizes those factors to produce and sell goods and services.

A market is any arrangement that enables buyers and sellers to get information and do business with each other.

Property rights are the social arrangements that govern ownership, use, and disposal of resources, goods or services.

Money is any commodity or token that is generally acceptable as a means of payment.

Economic Coordination


Circular Flows

Through Markets

Figure 2.7 illustrates

how households and

firms interact in the

market economy.

Factors of production

and goods and

services flow in one

direction.

Money flows in the

opposite direction.



Coordinating

Decisions

Markets coordinate

individual

decisions through

price adjustments.



How does a market economy solve the

coordinating problem? What, how and

for whom?

1. How is it determined what and how much will be

produced?

Firms that produce the wrong stuff will lose money and

contract or close.

Firms that produce the right stuff will be highly profitable

and expand.



coordinating problem?

2. How is it determined how output will be produced?

Firms that find the least costly ways of combining

productive inputs will be able to sell the good most

profitably and will expand.



coordinating problem?

3. How is it determined who is to receive the output

that is produced?

Will talk about this in depth, but distribution of consumer

goods is determined by willingness and abililty to pay

for them in a market system.


Overview of this week’s lecture

Supply and demand

How are prices and quantities determined through

market exchange?


Markets and Prices

A market is any arrangement that enables buyers and

sellers to get information and do business with each other.

A competitive market is a market that has many

buyers and many sellers so no single buyer or seller can

influence the price.

The money price of a good is the amount of money

needed to buy it.

The relative price of a good—the ratio of its money

price to the money price of the next best alternative

good—is its opportunity cost.


Demand

If you demand something, then you

1. Want it,

2. Can afford it, and

3. Have made a definite plan to buy it.

Wants are the unlimited desires or wishes people have

for goods and services. Demand reflects a decision about

which wants to satisfy.

The quantity demanded of a good or service is the

amount that consumers plan to buy during a particular

time period, and at a particular price.


The Law of Demand

The law of demand states:

Other things remaining the same, the higher the price of

a good, the smaller is the quantity demanded; and

the lower the price of a good, the larger is the quantity

demanded.

The law of demand results from

Substitution effect

Income effect

Demand


Substitution effect

When the relative price (opportunity cost) of a good

or service rises, people seek substitutes for it, so the

quantity demanded of the good or service decreases.

Income effect

When the price of a good or service rises relative to

income, people cannot afford all the things they

previously bought, so the quantity demanded of the

good or service decreases.

Demand


Demand Curve and Demand Schedule

The term demand refers to the entire relationship

between the price of the good and quantity demanded of

the good.

A demand curve shows the relationship between the

quantity demanded of a good and its price when all other

influences on consumers’ planned purchases remain the

same.

Demand


Figure 3.1 shows a

demand curve for energy

bars.

A rise in the price, other

things remaining the same,

brings a decrease in the

quantity demanded and a

movement along the demand

curve.

Demand


Willingness and

Ability to Pay

A demand curve is also

a willingness-and-ability-to-

pay curve.

The smaller the quantity

available, the higher is the

price that someone is

willing to pay for another

unit.

Willingness to pay

measures marginal benefit.

Demand


A Change in Demand

When some influence on buying plans other than the

price of the good changes, there is a change in demand

for that good.

The quantity of the good that people plan to buy

changes at each and every price, so there is a new

demand curve.

When demand increases, the demand curve shifts

rightward.

When demand decreases, the demand curve shifts

leftward.

Demand


Six main factors that change demand are

The prices of related goods

Expected future prices

Income

Expected future income and credit

Population

Preferences

Demand


Prices of Related Goods

A substitute is a good that can be used in place of

another good.

A complement is a good that is used in conjunction

with another good.

When the price of substitute for an energy bar rises or

when the price of a complement of an energy bar falls, the

demand for energy bars increases.

Demand


Expected Future Prices

If the price of a good is expected to rise in the future,

current demand for the good increases and the demand

curve shifts rightward.

Income

When income increases, consumers buy more of most

goods and the demand curve shifts rightward.

A normal good is one for which demand increases as

income increases.

An inferior good is a good for which demand

decreases as income increases.

Demand


Expected Future Income and Credit

When income is expected to increase in the future or when credit is easy to obtain, the demand might increase now.

Population

The larger the population, the greater is the demand for all goods.

Preferences

People with the same income have different demands if they have different preferences.

Demand


Figure 3.2 shows an

increase in demand.

Because an energy

bar is a normal good, an

increase in income

increases the demand

for energy bars.

Demand


A Change in the Quantity

Demanded Versus a

Change in Demand

Figure 3.3 illustrates the

distinction between a

change in demand and a

change in the quantity

demanded.

Demand


A Movement along the

Demand Curve

When the price of the

good changes and

everything else remains

the same, the quantity

demanded changes and

there is a movement along

the demand curve.

Demand


A Shift of the Demand

Curve

If the price remains the

same but one of the other

influences on buyers’

plans changes, demand

changes and the demand

curve shifts.

Demand


Supply

If a firm supplies a good or service, then the firm

1. Has the resources and the technology to produce it,

2. Can profit from producing it, and

3. Has made a definite plan to produce and sell it.

Resources and technology determine what it is

possible to produce. Supply reflects a decision about which

technologically feasible items to produce.

The quantity supplied of a good or service is the

amount that producers plan to sell during a given time

period at a particular price.


The Law of Supply

The law of supply states:

Other things remaining the same, the higher the price of

a good, the greater is the quantity supplied; and

the lower the price of a good, the smaller is the quantity

supplied.

The law of supply results from the general tendency for

the marginal cost of producing a good or service to

increase as the quantity produced increases

Producers are willing to supply a good only if they can

at least cover their marginal cost of production.

Supply


Supply Curve and Supply Schedule

The term supply refers to the entire relationship

between the quantity supplied and the price of a good.

The supply curve shows the relationship between the

quantity supplied of a good and its price when all other

influences on producers’ planned sales remain the same.

Supply


Figure 3.4 shows a supply

curve of energy bars.

A rise in the price of an

energy bar, other things

remaining the same,

brings an increase in the

quantity supplied.

Supply


Minimum Supply Price

A supply curve is also a minimum-supply-pricecurve.

As the quantity produced increases, marginal cost increases.

The lowest price at which someone is willing to sell an additional unit rises.

This lowest price is marginal cost.

Supply


A Change in Supply

When some influence on selling plans other than the

price of the good changes, there is a change in supply of

that good.

The quantity of the good that producers plan to sell

changes at each and every price, so there is a new supply

curve.

When supply increases, the supply curve shifts

rightward.

When supply decreases, the supply curve shifts

leftward.

Supply


The five main factors that change supply of a good are

The prices of factors of production

The prices of related goods produced

Expected future prices

The number of suppliers

Technology

State of nature

Supply


Prices of Factors of Production

If the price of a factor of production used to produce a

good rises, the minimum price that a supplier is willing to

accept for producing each quantity of that good rises.

So a rise in the price of a factor of production decreases

supply and shifts the supply curve leftward.

Supply


Prices of Related Goods Produced

A substitute in production for a good is another good

that can be produced using the same resources.

The supply of a good increases if the price of a

substitute in production falls.

Goods are complements in production if they must be

produced together.

The supply of a good increases if the price of a

complement in production rises.

Supply


Expected Future Prices

If the price of a good is expected to rise in the future,

supply of the good today decreases and the supply curve

shifts leftward.

The Number of Suppliers

The larger the number of suppliers of a good, the

greater is the supply of the good. An increase in the

number of suppliers shifts the supply curve rightward.

Supply


Technology

Advances in technology create new products and lower

the cost of producing existing products, so advances in

technology increase supply and shift the supply curve

rightward.

The State of Nature

The state of nature includes all the natural forces that

influence production—for example, the weather.

A natural disaster decreases supply and shifts the

supply curve leftward.

Supply


Figure 3.5 shows an

increase in supply.

An advance in the

technology for producing

energy bars increases the

supply of energy bars and

shifts the supply curve

rightward.

Supply


A Change in the Quantity

Supplied Versus a

Change in Supply


distinction between a

change in supply and a

change in the quantity

supplied.

Supply


A Movement Along the

Supply Curve

When the price of the

good changes and other

influences on sellers’ plans

remain the same, the

quantity supplied changes

and there is a movement

along the supply curve.

Supply


A Shift of the Supply

Curve

If the price remains the

same but some other

influence on sellers’ plans

changes, supply changes

and the supply curve

shifts.

Supply


Market Equilibrium

Equilibrium is a situation in which opposing forces

balance each other. Equilibrium in a market occurs when

the price balances the plans of buyers and sellers.

The equilibrium price is the price at which the quantity

demanded equals the quantity supplied.

The equilibrium quantity is the quantity bought and

sold at the equilibrium price.

Price regulates buying and selling plans.

Price adjusts when plans don’t match.


Price as a Regulator


equilibrium price and

equilibrium quantity.

If the price is $2.00 a bar,

the quantity supplied

exceeds the quantity

demanded.

There is a surplus of

6 million energy bars.

Market Equilibrium


If the price is $1.00 a bar, the quantity demanded exceeds the quantity supplied.

There is a shortage of 9 million energy bars.

If the price is $1.50 a bar, the quantity demanded equalsthe quantity supplied.

There is neither a shortage nor a surplus of energy bars.

Market Equilibrium


Price Adjustments

At prices above the equilibrium price, a surplusforces the price down.

At prices below the equilibrium price, a shortageforces the price up.

At the equilibrium price, buyers’ plans and sellers’ plans agree and the price doesn’t change until some event changes either demand or supply.

Market Equilibrium


An Increase in Demand

Figure 3.8 shows that

when demand increases

the demand curve shifts

rightward.

At the original price,

there is now a shortage.The price rises, and the

quantity supplied increases

along the supply curve.

Market Equilibrium


Predicting Changes in Price and

QuantityAn Increase in Supply

Figure 3.9 shows that

when supply increases

the supply curve shifts

rightward.

At the original price,

there is now a surplus.

The price falls, and the

quantity demanded

increases along the

demand curve.


All Possible Changes in

Demand and Supply

A change in demand or

supply or both demand

and supply changes the

equilibrium price and the



Quantity


Change in Demand with

No Change in Supply

When demand increases,

equilibrium price rises and

the equilibrium quantity

increases.


Quantity


Change in Demand with

No Change in Supply

When demand decreases,

the equilibrium price falls

and the equilibrium

quantity decreases.


Quantity


Change in Supply with No

Change in Demand

When supply increases,

the equilibrium price falls

and the equilibrium

quantity increases.


Quantity


Change in Supply with

No Change in Demand

When supply decreases,

the equilibrium price rises

and the equilibrium

quantity decreases.


Quantity


Increase in Both Demand

and Supply

An increase in demand and

an increase in supply

increase the equilibrium

quantity.

The change in equilibrium

price is uncertain because the

increase in demand raises

the equilibrium price and the

increase in supply lowers it.


Quantity


Decrease in Both Demand

and Supply

A decrease in both demand

and supply decreases the



price is uncertain because

the decrease in demand

lowers the equilibrium price

and the decrease in supply

raises it.


Quantity


Decrease in Demand and

Increase in Supply

A decrease in demand and

an increase in supply lowers

the equilibrium price.


quantity is uncertain because

the decrease in demand

decreases the equilibrium

quantity and the increase in

supply increases it.


Quantity


Increase in Demand and

Decrease in Supply

An increase in demand and a

decrease in supply raises the

equilibrium price.


quantity is uncertain because

the increase in demand

increases the equilibrium

quantity and the decrease in

supply decreases it.


Quantity


Homework

Reading: Chapter 3 (skip mathematical note for now)

Chapter 3 Problems and Applications

15, 18, 19, 20, 22, 24

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Production possibilities and opportunity cost Productive ...friesen/lecture_3.pdf · Production possibilities and opportunity cost Productive and allocative efficiency Gains from