Principles of Microeconomics - PowerPoint Presentation

Slide1

Principles of Microeconomics

Lecture 2: Foundational microeconomic

concepts

Slide2

Overview

Production possibility frontiers

Proving gains from trade

Factors of production

The importance of property rights to trade

The Circular Flow Model

Slide3

Production possibility frontiers

PPFs and PPCs

Illustrate the principle of

opportunity cost

Shows the all of the possible combinations of two products that can be produced

Hence the name: production possibility curve!

Slide4

Production possibility frontiers

Assumptions:

Fixed resources

Fixed technology

Productive efficiency

Full employment

For

our

purposes, two products only

(although you could always draw in more products across more dimensions…)

Slide5

Production possibility frontiers

Example:

Type of product

Production alternatives

a b c d e f

Capital ($

bn

) 0 1 2 3 4 5

Consumer ($

bn

) 15 14 12 9 5 0

Slide6

Production possibility frontiers

Consumer

goods

Attainable

Unattainable

Capital

goods

0 1 2 3 4 5

5

10

15

a

b

d

c

z

f

e

Slide7

Production possibility frontiers

Capital

goods

0 1 2 3 4 5

5

10

15

a

b

c

d

e

f

0 1 2 3 4 5

5

Consumer goods

Increasing

(marginal)

opportunity

cost of capital goods

Slide8

Production possibility frontiers

How does economic growth affect the PPC?

How does technological progress affect the PPC?

How does an increase in population affect the PPC?

What if I told you that consumer products were more

labour

-intensive?

Slide9

Production possibility frontiers

More questions to think about:

Is it possible to have a concave PPC?

What about a straight-line PPC?

For those that are possible, what could we say about the opportunity cost?

Slide10

Proving gains from trade

W

hy do we trade?

And why

do we

specialise

?

Absolute advantage:

The ability to produce more of a product than other producers using the same amount of resources

Slide11

Proving gains from trade

Comparative

advantage:

The ability to produce a product at a lower opportunity cost than other producers

Slide12

Proving gains from trade

Example:

Sugar industry and financial services industry in Australia and Fiji

Does Australia have an absolute advantage or a comparative advantage in financial services?

Does Australia have an absolute advantage or a comparative advantage in sugar?

Slide13

Proving gains from trade

An example with numbers...

Harry and Sally live together and like to cook pizzas and garlic bread. Here is the maximum each can produce in an hour:

 

Pizzas (P)

Garlic Bread (G)

Harry

4

1

Sally

5

4

Slide14

Proving gains from trade

Step 1: Plot their PPCs

For one hour:

Note: Sally has an

absolute advantage

in both!

 

Pizzas (P)

Garlic Bread (G)

Harry

4

1

Sally

5

4

Harry

Sally

 

 

 

 

 

 

 

 

 

 

GB

 

 

 

 

 

GB

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Pizzas

Pizzas

Slide15

Proving gains from trade

Step 2: Compare opportunity costs

Pizzas

:

Harry: 1 pizza costs him 1/4 of a garlic bread

=> 1P : 0.25G

Sally: 1 pizza costs her 4/5 of a garlic bread

=> 1P : 0.8G

Harry has a lower cost of making pizzas (in terms of garlic bread)

than Sally

=> Harry has a

comparative advantage

in

producing pizzas

 

Pizzas (P)

Garlic Bread (G)

Harry

4

1

Sally

5

4

Slide16

Proving gains from trade

Step 2 (cont.)

Garlic Bread

:

Harry: 1 garlic bread costs him 4 pizzas

=> 1G : 4P

Sally: 1 garlic bread costs her 5/4 of a pizza

=> 1G : 1.25P

Sally has a lower cost of making garlic bread (in terms of pizzas)

than Harry

=> Sally has a

comparative advantage

in

producing garlic bread

 

Pizzas (P)

Garlic Bread (G)

Harry

4

1

Sally

5

4

Note:

These ratios are just the inverse of those we calculated with pizzas!

Slide17

Proving gains from trade

Step 3: Set a world price

What is the ‘world price’ in our closed world of Harry and

Sally? It

must

be within the range of their opportunity costs,

as this establishes the limits of their willingness to trade.

Therefore both Harry and Sally can gain from specialisation

I.e. Harry will only trade a pizza if he gets more than 1/4 of a garlic bread in return

Sally will only trade garlic bread if she gets more than 5/4 of a pizza in return

 

Pizzas (P)

Garlic Bread (G)

Harry

4

1

Sally

5

4

Slide18

Proving gains from trade

Step 3 (cont.):

So what do we do? Assume that both Harry and Sally specialise and trade at a price between these limits

E.g. Somewhere between 1P : 0.25G and 1P : 0.8G

(or, in terms of 1 pizza, between 1G : 1.25P and 1G : 4P)

So let’s set our world price at

1P : 0.5G

(this is the same as 1G: 2P)

 

Pizzas (P)

Garlic Bread (G)

Harry

4

1

Sally

5

4

Slide19

Proving gains from trade

Step 3:

Calculate a trade that works!

Harry produces 4 pizzas and 0 garlic bread

Sally produces 0 pizzas and 4 garlic breads

At the world price (1P : 0.5 G)

Harry trades 2 pizzas for 1 garlic bread / Sally trades 1 garlic bread for 2 pizzas

After trade:

Harry has 2 pizzas and 1 garlic breads

Sally has 2 pizzas and 3 garlic breads

 

Pizzas (P)

Garlic Bread (G)

Harry

4

1

Sally

5

4

Slide20

Proving gains from trade

Step 4:

Check on the PPC

Conclusion: They can consume more with trade!

Harry

Sally

 

 

 

 

 

 

 

 

 

 

GB

 

 

 

 

 

GB

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Pizzas

Pizzas

Produces

Produces

Consumes

Consumes

Slide21

Proving gains from trade

Extension: Ranges of possible trades

Harry

Sally

 

 

 

 

 

 

 

 

 

 

GB

 

 

 

 

 

GB

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Pizzas

Pizzas

Slide22

Factors of production

Labour

(‘

L

’)

Income paid on

labour

is a

wage

Capital (‘

K

’)

Income paid on capital is

rent

(or interest)

Land (‘T

’) (but the category is broader than ‘land’!)Income paid on land is rentEntrepreneurshipIncome paid on entrepreneurship is profit

Slide23

The importance of property rights to trade

What are property rights?

The exclusive (‘inalienable’) use of property, including the right to buy or sell it

Important to:

Increase certainty in economic transactions…

…and thus mitigate risk!

Acts as a

precondition

for effective markets

An aside: property rights in centrally planned economies…

Slide24

The Circular Flow Model