Scarcity Choice Trade

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THE UNIVERSITY OF SYDNEY

BUSINESS SCHOOL

Foundations of economic reasoning


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Learning Objectives

1. Explain these three important economic ideas:people are rational; people respond to incentives;optimal decisions are made at the margin.

2. Understand the issues of scarcity and trade-offs,and how the market makes decisions on theseissues.

3. Understand the role of models in economicanalysis.

4. Use production possibility frontier to analyseopportunity costs and trade-offs.

5. Understand comparative advantage and explainhow it is the basis of trade.

Copyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442531772/Hubbard/Microeconomics/2nd edition


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Reading list

1. EBDM: Chapter 2 and Chapter 32. Borland: B1.3



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Water scarcity in the world- Many countries face severe

water shortages. In Australia,

while some regions often have

significant rainfall, many cities

and agricultural regions facewater shortages.

! The challenge facing Australiais the efficient management of

this scarce resource to

maximise the possible

benefits across various uses.

Is Water a Scarce Resource?



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Three Key Economic Ideas

Three important ideas in economics are:

1. People are rational.2. People respond to economic incentives.3. Optimal decisions are made at the margin.

Marginal analysis:Analysis that involvescomparing marginal benefits and marginal

costs.

LEARNINGOBJECTIVE 1



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Scarcity and Trade-offs

-Scarcity: The situation in which unlimited wantsexceed the limited resources available to fulfill those

wants.

-Resources: Inputs used to produce goods andservices, including natural resources such as land,water and minerals, labour, capital and

entrepreneurial ability.

-Trade-off: The idea that, because of scarcity,producing more of one good or service meansproducing less of another good or service.

LEARNINGOBJECTIVE 2



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Trade-offs force society to make choices.

This is especially true with respect to three fundamental

questions:

1. Whatgoods and services will be produced?2. Howwill the goods and services be produced?3. Whowill receive the goods and services produced?

LEARNINGOBJECTIVE 2



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Efficiency and equity

Productive efficiency: When a good or service is produced using the leastamount of resources.

Allocative efficiency: When production reflects consumer preferences; inparticular, every good or service is produced up to the point where the last

unit provides a marginal benefit to consumers equal to the marginal cost ofproducing it.

Dynamic efficiency: Occurs when new technology and innovation areadopted over time.

Equity: The fair distribution of economic benefits between individuals andbetween societies.

An efficient outcome may or may not be considered by society to beequitable.

LEARNINGOBJECTIVE 2



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Economic Models

-Economic models: Simplified versions of reality usedto analyse real-world economic situations.

LEARNINGOBJECTIVE 3



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Economic Models

To develop a model economists generally follow these steps:

1. Decide on the assumptions to be used in developing the model.2. Formulate a testable hypothesis.3. Use economic data to test the hypothesis.4. Revise the model if it fails to explain the economic data.5. Retain the revised model to help answer similar economic questions in

the future.

LEARNINGOBJECTIVE 3



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Economic Models

Forming and testing hypotheses in economic models.

A hypothesisin an economic model is a statement that may be eithercorrect or incorrect about an economic variable.

In testing hypotheses, economists distinguish between correlation andcausality. Correlation does not imply causation!

- E.g. when ice-cream prices increase, there are more deaths fromdrowning. Does increasing the price of ice-cream cause deaths from

drowning?

- E.g. sleeping with shoes on is strongly correlated with waking up witha headache. Does sleeping with ones shoes on cause headaches?

LEARNINGOBJECTIVE 3



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Economic Models

Normative and positive analysis

-Positive analysis: Analysis concerned with what is,and involves value-free statements that can be checked

by using the facts.

-Normative analysis: Analysis concerned with whatought to be, and involves value judgements, which

cannot be tested.

LEARNINGOBJECTIVE 3



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BMWs management has faced many decisions

which involve trade-offs. For example, whetherto concentrate production in Germany, or to

build factories in overseas markets.

Managers making choices at BMW



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Opportunity costs

Opportunity costs include both explicitand implicitcosts. Opportunity costs do notinclude unrecoverable or sunk costs.-Example 1: Mary works as an independentaccountant. She makes $100,000 a year and has

already paid a registration fee of $20,000. She isconsidering starting her own company. This wouldinvolve withdrawing $40,000 from her savingsaccount for the start-up costs. What is theopportunity cost of starting her own business?

-Example 2: Businessmen & transport.14


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Production possibility frontiers and real worldtrade-offs

Graphing the production possibility frontier

- Production possibility frontier:A curve showingthe maximum attainable combinations of two

products that may be produced with availableresources.

- Opportunity cost:The highest-valued alternativethat must be given up to engage in an activity.

LEARNINGOBJECTIVE 4



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BMWs production choices per day: Fig. 2.1

Choice Roadstersper day

Convertiblesper day

A 800 0

B 600 400

C 400 500

D 200 575

E 0 600

LEARNINGOBJECTIVE 4



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0

Roadsters

/day

600

300

400

400 500 575 600

800

F

C

200

200

G

Convertibles/day

A

B

D

E

Inefficient

combination

Unattainable

combination

BMW faces a production trade-off betweenRoadsters and Convertibles: Fig. 2.1


LEARNINGOBJECTIVE 4


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Increasing marginal opportunity costs The bowed out shape of the production possibility frontier illustrates the

concept of increasingmarginal opportunity costs.

Increasing marginal opportunity costs demonstrates an importanteconomic concept:

- The more resources already devoted to an activity,the smaller the payoff to devoting additional

resources to that activity.

LEARNINGOBJECTIVE 4



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Computers0

400

500

Televisions

350

200

200 400

A

B

C

Increasing computerproduction here by 200only reduces

television production

by 50.

Increasing computer

production here by 200

reduces television

production by 150.

Increasing marginal opportunity cost: Figure 2.2


LEARNINGOBJECTIVE 4


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Opportunity costs in the PPF

Suppose that PPF is a straight line with slope = -1. What can you inferabout the opportunity costs?

20

apples

oranges


LEARNINGOBJECTIVE 4


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Economic growth Economic growth:The expansion of societys production potential.

Economic growth can be illustrated using the production possibility frontier.

LEARNINGOBJECTIVE 4



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0

Televisions

Computers

400

200

300

400 450 500 650

500

A

B

Shifting out the production possibility frontier:Economic growth: Figure 2.3a


LEARNINGOBJECTIVE 4


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0

400

500 800

Technological change and the computer industry:Figure 2.3b

Televisions

ComputersCopyright 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442531772/Hubbard/Microeconomics/2nd edition

LEARNINGOBJECTIVE 4


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Comparative advantage and trade

We use the production possibility frontier and the concept of opportunitycost to explain the economic gains from specialisation and trade.

Trade:The act of buying or selling a good or service in a market.

Specialisation and gains from trade: example We use a simple example of two people - you and your neighbour. And two goods, apples and cherries, measured in kilograms (kgs).

LEARNINGOBJECTIVE 5



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Fruit picked each month without trade: Table 2.1

You Your neighbour

Apples Cherries Apples Cherries

All time picking apples 20 kg 0 kg 30 kg 0 kg

All time picking cherries 0 kg 20 kg 0 kg 60 kg


LEARNINGOBJECTIVE 5


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A summary of the gains from trade : Table 2.2

You Your NeighbourApples (kg) Cherries (kg) Apples (kg) Cherries (kg)

Production andconsumption

without trade8 12 9 42

Productionwith trade 20 0 0 60

Consumptionwith trade 10 15 10 45

Gains fromtrade 2 3 1 3


LEARNINGOBJECTIVE 5


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Absolute advantage versus comparative advantage-Absolute advantage:The ability of an individual,firm or country to produce more of a good or service

than competitors using the same amount of

resources.

-Comparative advantage:The ability of anindividual, firm or country to produce a good or

service at a lower opportunity cost than otherproducers.


LEARNINGOBJECTIVE 5


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1 kg of apples 1 kg of cherries

You 1 kg of cherries 1 kg of apples

Your neighbour 2 kg of cherries 0.5 kg of apples

Opportunity cost of picking fruit: Table 2.3


LEARNINGOBJECTIVE 5


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Comparative advantage and the gains from trade-The basis for trade is comparative advantage, notabsolute advantage.

-Individuals, firms or countries are better off if theyspecialise in producing goods and services forwhich they have a comparative advantage and

obtain other desirable goods and services by

trading.


LEARNINGOBJECTIVE 5


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Solved Problem 1

Suppose Jack and Jenny both live alone on two small deserted islands inthe Pacific Ocean. Both produce only two food products, mangoes and

fish.

If Jack spends all his time fishing he can catch 8 kilograms of fish eachweek. If he spends all his time picking mangoes he can pick 2 kilograms aweek.

If Jenny devotes all her time to fishing, she can catch two kilograms of fisha week. If she spends all her time picking mangoes, she can pick 10

kilograms a week. Currently, both devote half their time to fishing and half

their time to picking mangoes.


LEARNINGOBJECTIVE 5


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Solved Problem 1

a) Calculate the opportunity cost of fish and mango production for Jackand Jenny.

b) Does your calculation in part (a) suggest Jack and Jenny could benefitfrom specialisation and exchange? If so, who should specialise in the

production of each good?

c) How will specialisation impact total output.d) Suppose Jack and Jenny both keep half of their total output after

specialisation, and trade the other half for the good they do not have.

How much will each person gain from this exchange?


LEARNINGOBJECTIVE 5


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Solved Problem 1

Solving the problem:-STEP 1: Review the material. The problem is aboutthe gains from specialisation and trade, which is

covered on pages 3640 of the text.


LEARNINGOBJECTIVE 5


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Solved Problem 1

-STEP 2: Answer (a) by calculating the opportunitycosts of each good for both individuals.

OCfish/Jack= 82

= 0.25 mangoes

OCfish/Jenny=2

10 = 5 mangoes


LEARNINGOBJECTIVE 5


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Solved Problem 1

-STEP 2: cont.

OCmangoes/Jack=2

8 = 4 fish

OCmangoes/Jenny=10

2 = 0.2 fish


LEARNINGOBJECTIVE 5


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Solved Problem 1

-STEP 3: Answer (b). The individual with the lowestopportunity cost has the comparative advantage in

the production of that good.

- Jack has the lower opportunity cost and therefore thecomparative advantage in fish production.

- Jenny has the lower opportunity cost and therefore thecomparative advantage in mango production.


LEARNINGOBJECTIVE 5


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Solved Problem 1

-STEP 4: Answer (c). To determine the impact ontotal output we must compare output prior to

specialisation with output post specialisation. In

order to make this comparison, we recall that Jenny

and Jack both initially spent half their time catchingfish and half their time picking mangoes.

- This information enables us to construct the table shown onthe following slide.

-Note: we assume complete specialisation; that is, postspecialisation, both Jenny and Jack produce only the goodin which they have a comparative advantage.


LEARNINGOBJECTIVE 5


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Solved Problem 1

-STEP 4: cont.Pre-Specialisation and

TradePost Specialisation

Fish Mangoes Fish MangoesJack 4 1 8 0

Jenny 1 5 0 10

TOTAL 5 6 8 10

+3 +4


LEARNINGOBJECTIVE 5


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Solved Problem 1

-STEP 4: cont. The table shows that production ofboth goods has increased due to specialisation.

-STEP 5: Answer (d). We compare the pre-tradeand pre-specialisation consumption and production

of Jack and Jenny with their post specialisationconsumption. That is, each will keep half their total

output and exchange half for the other good. This

enables us to construct the table shown on the next

slide. The table demonstrates that both individualshave gained in consumption from trade.


LEARNINGOBJECTIVE 5


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Solved Problem 1

-STEP 5: cont.Pre-Specialisation and

Trade

After Trade

Fish Mangoes Fish MangoesJack 4 1 4 5

Jenny 1 5 4 5


LEARNINGOBJECTIVE 5


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The market system

Market:A group of buyers and sellers of a good or service and theinstitution or arrangement by which they come together to trade.

Product markets:Markets for goods such as computers - and services such as medical treatment.

Factor markets:Markets for the factors of production, such as labour,capital, natural resources and entrepreneurial ability - the factors of

production.



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The market system

Free Market:A market with few government restrictions on how a good orservice can be produced or sold, or on how a factor of production can be

employed.

Adam Smith argued the benefits of a free market system in his famousbook An Inquiry into the Nature and Causes of the Wealth of Nations(published in 1776).



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Making the Connection 2.2

Story of the market system in action: I, Pencil.The marketcoordinates theactivities of themany people

spread around theworld whocontribute to themaking of a pencil.



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Property Rights

Property rights:The rights individuals or firms have to the exclusive useof their property, including the right to buy or sell it.

Private property rights provide the legal basis of a successful marketsystem.

To enforce contracts and property rights there must be an independentcourt system with impartial judges.

Production will fall if property rights are not well enforced a move to apoint inside the PPF.



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Making the Connection 2.3

Copying movies and music from cyberspaceRecording studios,movie studios andartists worry that thecopyrights for their

music and films arenot being protectedon the internet.


Scarcity Choice Trade

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