The Economic Problem Prepared by Dr. Ikhlaas Gurrib.

The Economic Problem

Prepared by Dr. Ikhlaas Gurrib

The plan for this week’s lecture/seminar

Complete the Introduction to Economics (Chapter 1)

The Economic Problem (Chapter 2)


Scarcity is pervasive

Choices Must Be Made

Trade-offs Must Be Faced/ Opportunity costs must be considered

Last week we made a lot of progress in learning about microeconomics!

Often these choices occur at the margin and involve weighing marginal costs and marginal benefitsPrepared by Dr. Ikhlaas Gurrib

Warning… the next slide contains numbers!

Example: if Sam does an Honours degree instead of a Bachelor degree the marginal cost of the Honours year will include the extra fees he will pay. The marginal benefit will be the extra career income he expects to earn from having an Honours over a Bachelor degree

Marginal Costs: the extra cost associated with increasing the use of resources on a particular choice

Marginal Benefits: the extra benefit gained from increasing the use of resources on a particular choice


Years of study

Career earnings

Marginal benefit

Total costs

Marginal costs

3 (Bach)

$2.2m $75,000

4 (hons)

$2.5m $300,000 $135,000 $60,000

8 (PhD)

$2.7m $200,000 $400,000 $265,000

In this case the marginal benefit is the increase in Sam’s total career earnings if he does an Honour’s degree: $300,000= $2.5m - $2.2m.

In this case the Marginal cost is the extra fees plus the lost earnings associated with doing an Honour’s degree: $60,000=$135,000-$75,000.

The MB of a PhDThe MC of a PhD


Years of study

Career earnings

Marginal benefit

Total costs

Marginal costs

3 (Bach)

$2.2m $75,000

4 (hons)

$2.5m $300,000 $135,000 $60,000

8 (PhD)

$2.7m $200,000 $400,000 $265,000

In this case the Marginal benefit of Honours > marginal cost; Sam decides to do Honours

Marginal benefit of PhD < marginal cost; Sam decides not to do a PhD


Another example: The marginal costs & benefits of Xray machines

No. of Xray machines

No. of deaths

Marginal benefit

Total costs

Marginal costs

20

200 $200m

30

100 100 $300m $100m

40 90 10 $400m $100m


In this case the marginal benefit of the machines is the lives they help save

No. of Xray machines

No. of deaths

Marginal benefit

Total costs

Marginal costs

20

200 $200m

30

100 100 $300m $100m

40 90 10 $400m $100m

whilst the MC is the cost of purchasing the machines


The policy challenge

Policy makers need to weigh up the marginal costs and marginal benefits of government expendituresE.g. is the $100m cost of the extra 10

Xray machines worth the 100 lives saved??

Economics is a way of thinking. It can’t provide all the answers!


A final example of marginal thinking

You have spent $1000 building a hot dog stand believing sales will be $2000. Sales are now only estimated to be $800, and you need to spend another $300 to complete the stand.

Should you complete the stand?

The $1000 is known as a sunk

cost

$800 is the marginal benefit of completion

$300 is the marginal cost of completion


Economic Models and Theories

Economists often develop models to describe the relationship between key variables of interest

Example: a model of university enrolments that describes an inverse relationship between university fees and enrolments Prepared by Dr. Ikhlaas Gurrib

Another example of an economic model:

beersales

Are inversely related to

the price of beer


if the price of beer goes up

then

beer sales will fall


Beer sales

Price

Negative or inverse relationship


Hours studying

Grade

Positive relationship


Models and assumptions

Economic models and theories always include a set of assumptions

Role of assumptions: they define the circumstances under which the model is likely to be reliable

Assumptions can be a source of error with economic models!


Thus far, our model is


then


Will this model be right if there is a heat wave?


A better model

if the price of beer goes up thenbeer sales will fall, assumingthat the weather and other factors whichmay affect beer sales remain unchanged


Our New Model


then


CETERIS PARIBUSPrepared by Dr. Ikhlaas Gurrib

Meaning:Meaning:

Role:Role:

A key assumption: ceteris paribus


Which of the following is a necessary consequence of scarcity?A)racial discriminationb) high profitsc) the requirements of making choicesd) unfulfilled wantse) both c) and d)

ReviewReview


A rational person does not act unless

a. the action makes money for the person.

b. the action is ethical.

c. the action produces marginal costs that exceed marginal benefits.

d. the action produces marginal benefits that exceed marginal costs.

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Jenny makes $20 an hour as a welder. She must take two hours off work (without

pay) to go to the dentist to have a tooth filled. The dentist charges $100.

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The opportunity cost of Jenny's trip to the dentist is

a. $40

b. $100

c. $120

d. $140

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The Production Possibility Frontier (PPF)

A more complex model

Used to: identify the concepts of scarcity, opportunity costs and ideas about the benefits of trade


A simple example

Peter is a wiz at economics, whilst John can fix any problem with cars

Both Peter and John have scarce time resources and need to choose whether to spend time on their economics course or on their cars


Economics grade

Car speed

We can graph thechoices available to Peter and John on a production possibility frontier


Our hypothetical data to be graphed

Amount Produced in 10 hours

Maximum car speed

Maximum assignment grade

Peter 50kmph 100

John 150kmph 50


Peter’s Production Possibility Frontier shows the maximum combinations of the 2 choices he can achieve

Grade

100

50Car speedPrepared by Dr. Ikhlaas Gurrib

John’s PPF shows the maximum combinations of the 2 choices he can achieve

Grade

50

150Car speed



can also be used to show the concept of opportunity cost


Peter’s PPF

Grade

100

50Car speed

5

90: gains an extra 5 kmph

:but loses or trades-off 10 marks

Thus, his Opportunity Cost of each extra kmph = 10/5=2 marks

If Peter spends 1 hour on his car


John’s PPF

Grade

50

150Car speed

If John spends 1 hour on his car

15

45

Loses or trades-off 5 marks

Gain = extra 15 kmph

Thus, his Opportunity Cost of each kmph=5/15=0.3 marks



can also be used to show the important NEW concept of COMPARATIVE

ADVANTAGE

Comparative Advantage: Identifies the person/nation/firm that is able to produce a commodity or service at the lowest opportunity cost


Comparative Advantage

John’s opportunity cost of extra car speed is lower than Peter’s He has a comparative advantage in car fixing

Opportunity Cost of each additional kmph of car speed

John Peter

0.3 marks 2 marks


Who has the Comparative Advantage in Economics???

Grade

100

50Car speed

5

90: gains an extra 10 marks

:but loses or trades-off 5 kmph

Thus, his Opportunity Cost of each extra mark = 5/10=1/2 kmph

If Peter spends 1 hour on his assignment

0 Prepared by Dr. Ikhlaas Gurrib

John’s PPF

Grade

50

150Car speed

If John spends 1 hour on his assignment

15

45

Loses or trade-off 15 kmph

Gain = extra 5 marks

Thus, his Opportunity Cost of each mark=15/5=3 kmph

0 Prepared by Dr. Ikhlaas Gurrib

Comparative Advantage

Peter’s opportunity cost of extra assignment marks is lower than John’s He has a comparative advantage in economic assignments

Opportunity Cost of each additional assignment mark in economics

John Peter

3 kmph 1/2 kmph


A Key Idea in Economics:

When comparative advantage exists people can benefit from specialising in the activity they have a comparative advantage in and then trading with others

Example: Suppose John offered to spend 1 hr on Peter’s car in return for Peter spending 1 hr on John’s assignment

Comparative Advantage and Gains From Trade


•By spending 1 hour on John’s assignment, Peter can lift John’s grade by 10 marks.

•In return, John has to spend one hour less on his own car (cost = 15 kmph)

• By trading with Peter, each assignment mark will cost John 15/10=1.5 kmph

•If he didn’t trade, the cost of each mark would be 3 kmph•John gains by trading (better marks at lower opportunity cost)

•Scenario 1: John gains by trading with PeterScenario 1: John gains by trading with Peter


John’s PPF and Trade Line

Grade

50

150Car speed

If John spends 1 hour on Peter’s car in return for his help with the assignment

15

45

Loses or trade-off 15 kmph

Gain = extra 10 marks

Thus, his Opportunity Cost of each mark=15/10=1.5 kmph

0

55 Trade line


•If he trades with John, John will spend one hour on his car and increase its speed by 15 kmph•In return, Peter will have to spend1 hour less on his own assignment (cost = 10 marks)•By trading with John, each extra kmph in Peter’s car speed is now 10/15=2/3 mark•Before trade the cost of each kmph was 2 marks•Peter gains by trading (more speed at lower opportunity cost)

•What about Peter?What about Peter?


Peter’s PPF and Trade Line

Grade

100

50Car speed

90: gains an extra 15 kmph

:but loses or trades-off 10 marks

Thus, his Opportunity Cost of each extra kmph = 10/15=2/3 marks

If Peter spends 1 hour on John’s assignment in return for his help with the car

15

Trade line


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The Production Possibilities Frontier can also be used to study the choices available to nations

Imagine an economy (named Lounge) that has some land, labour and capital resources.

These resources are used to produce only two goods – DVDs and pizza


Lounge’s Production Possibilities Frontiershows the maximum attainable combinations of the 2 choices (DVDs & pizza) available to the people of Lounge

DV

Ds

(mil

lion

s)

Attainable

Pizzas (millions)0 1 2 3 4 5

5

15a

b

d

c

f

e

unattainable12

9

Z

inefficient


Production Possibilities in Lounge

Points inside and on the frontier; such as points A, B, C, D, E, F, and Z; are attainable.

Points outside the frontier are unattainable (at least without trade).

What about points such as point Z? which are inside the PPF?These are called inefficient - it is possible for

Lounge to use its resources better. E.g. it is able to achieve more Pizzas at E without trading off any DVDs by, for example, using unemployed labour.


If we move along the PPF from C to D … the opportunity cost of the increase in pizza is 3 DVDs.

From D to E, the opportunity cost is 4. Why might this happen?

Answer: Because resources are not all equally productive in all activities.

• Although Lounge may be able to shift resources from the production of DVDs to the production of pizzas easily to begin with (e.g. by transferring some workers)

• The ability to transfer resources (e.g. specialised machinery) from the production of DVDs to the production of pizzas is likely to become increasingly difficult and, thus, the trade offs will rise

Notice that Lounge’s PPF is concave

This implies that its opportunity costs increase as production increases


Also notice that all the points along the PPF are achievable and production efficient (e.g. no unemployment)

but which is the ‘best’ point?

what point on the PPF should Lounge choose?


This brings us to the important idea of Allocative Efficiency

The general answer in economics to this question is that we should try to find a balance between the extra (marginal) cost of, say, producing an extra DVD and the extra (marginal) benefits If the marginal costs of an extra DVD is high

(e.g. at point b) and the marginal benefits from an extra DVD is low (e.g. we won’t get much benefit from yet another Jim Carey movie) then allocating more resources to the production of extra DVDs would not represent an efficient allocation of Lounge’s scarce resources


A final point about the PPF: It can be use to show economic growth & technological change

the PPF is drawn at a point in time:resources are fixedas well as technology

what might happen over time?


Economic growth will cause a shift in the PPF

Quantity of pizza0

Quantity ofDVDs

A

Example: Lounge’s resources might increase over time due to scientific discovery


Copyright © 2004 South-Western

Quantity of pizza0

DVDs

Example, if only the technology for producing DVDs improves the PPF will rotate upwards

The way the PPF shifts over time depends on the nature of the technological change


The bowed out shape of the PPF

a. reflects the scarcity of resources

b. reflects the existence of increasing opportunity cost

c. is due to production inefficiency

d. reflects the occurrence of economic growth

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What is the opportunity cost of the movement from point D to point B?

a. 750 pretzelsb. 500 pretzelsc. 250 pretzels d. 150 pretzelse. 0 pretzels

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Which of the following would not shift a country’s production possibility frontier outward?

a.an increase in the capital stock.

b. an advance in technology.

c. a reduction in unemployment.

d. an increase in the labour force.

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The Economic Problem Prepared by Dr. Ikhlaas Gurrib.

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Transcript of The Economic Problem Prepared by Dr. Ikhlaas Gurrib.