Microeconomics
Lecture 02
Opportunity Cost and Relative Price
The Economic Problem
- What will be produced?
- Basic needs -- food, clothing, shelter
- Non-essentials -- fish tanks, televisions
- Capital goods -- machinery, tools, human skills, etc. to produce other goods
- How will it be produced?
- What resources are available?
- How should labor and capital be allocated to the production of each of the various products?
- Who will get what is produced?
- How should the products be allocated among members of society?
...
The Theme of International Trade Theory
- Countries gain from trade,
- if they specialize in producing the goods
- in which they have a comparative advantage,
- although there may be distributional effects to consider.
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Comparative Advantage
- The US has a comparative advantage in the production
of a particular good, if the opportunity cost of producing that good is lower in the US
than it is in other countries.
- Opportunity Cost --
how much of one good you must give up in order to gain more of another
- Unit Labor Requirement --
amount of labor needed to produce one unit of a good
...
Jack and Jill
- Jack and Jill are standed on a desert island.
To survive, they must gather food and make clothes.
- Jill can make 12 clothes per day or gather 10 bushels of food per day
- Jack can make 5 clothes per day or gather 8 bushels of food per day
Jill's opp. cost of making clothes:
Jack's opp. cost of making clothes:
- Jill has a comparative advantage in making clothes because
her opportunity cost of making clothes is less than Jack's.
Jill's opp. cost of gathering food:
Jack's opp. cost of gathering food:
- Jack has a comparative advantage in gathering food because
his opportunity cost of gathering food is less than Jill's.
- Notice that Jill has an absolute advantage in the production of both goods,
- but she has a comparative advantage in the production of only one good (clothes).
...
Relative Price
- If Jill and Jack valued clothes and food equally,
then they would trade one clothing for one bushel of food.
- If you prefer to think in terms of dollar values:
- let the price of clothes be one dollar per clothing: $1/clothing
- let the price of food be one dollar per bushel: $1/bushel
relative price of clothes:
relative price of food:
Jill's Specialization: Making Clothes
- Jill should specialize in producing clothes because her
opportunity cost of making clothes is less than the relative price
of clothes.
...
- Jill should not gather food because her opportunity cost
of gathering food is greater than the relative price of food.
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Jill's Gains from Trade
- By specializing in making clothes
and trading her clothes for food,
Jill receives more food than if she gathered food herself.
- If Jill were to trade the
12 clothes that she produces in one day
at a rate of one bushel per clothing,
she would receive 12 bushels.
- That's more food than Jill can produce in a day.
Jill can only produce 10 bushels of food per day.
...
Jack's Specialization: Gathering Food
- Jack should specialize in gathering food because his
opportunity cost of gathering food is less than the relative
price of food.
...
- Jack should not make clothes because his opportunity cost
of making clothes is greater than the relative price of clothes.
...
Jack's Gains from Trade
- By specializing in gathering food
and trading his food for clothes,
Jack receives more clothes than if he produced clothes himself.
- If Jack were to trade the
8 bushels of food that he gathers in one day
at a rate of one clothing per bushel,
he would receive 8 clothes.
- That's more clothes than Jack can produce in a day.
Jack can only produce 5 clothes per day.
...
Gains from Trade
- Even though Jill can produce both goods more efficiently, she gains by
specializing in clothes (the good in which she has a comparative advantage)
and trading her clothes for food with Jack.
- analogy: America gains by trading with less developed countries
- Even though Jack is less efficient at producing both goods, he gains by
specializing in food (the good in which he has a comparative advantage) and
trading his food for clothes with Jill.
- analogy: less developed countries gain by trading with America
...
Lower Productivity ⇒ Lower Wage
- Recall the dollar prices of each good: $1/bushel and $1/clothing
- Jill produces 12 clothes per day, so her wage is $12 per day.
- Jack produces 8 bushels per day, so his wage is $8 per day.
- This is why the factory workers (in a foreign country) who made your
sneakers, receive a much lower wage than you do. On average, their
workers produce less than American workers.
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The Theme of International Trade Theory
- Countries gain from trade,
- if they specialize in producing the goods
- in which they have a comparative advantage,
- although there may be distributional effects to consider.
- workers who are not working in the sector where the country has a
comparative advantage will be adversely affected by free trade
- For example, in America, steel workers, textile workers and farmers are
adversely affected by trade
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Production Possibilities Frontier
- PPF represents all combinations of goods that can be produced if resources are used efficiently
- one can produce at or below the PPF, but not above it.
>> insert graph <<
- In one day, Jill can:
- make 12 clothes or gather 10 bushels
- or produce a combination, such as: 6 clothes and 5 bushels.
- In one day, Jack can:
- make 5 clothes or gather 8 bushels
- or produce a combination, such as: 2.5 clothes and 4 bushels.
- Slope of the PPFs (above) is: -1*opp. cost of gathering food
...
Gains from Trade
- Add a red line whose slope represents the relative price:
- If Jill specializes in making clothes:
- she can trade some of her clothes for bushels of food and
- consume a combination that exceeds any combination that she could produce on her own.
- If Jack specializes in gathering food:
- he can trade some of his bushels of food for clothes and
- consume a combination that exceeds any combination that he could produce on his own.
...
Production Function
- Quantity produced is a function of capital and labor:
- Q = f (K, L)
- If you have one unit of kapital (for example, one stove in a kitchen),
- and you keep increasing number of workers (labor) at that machine the quantity produced will increase
- but at a decreasing rate
- because the workers start to get in each other's way
- "too many cooks in the kitchen"
>> insert graph <<
- Q = f (K, L)
- This production function is drawn for a fixed amount of capital.
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Production Possibilities Frontier
>> insert graph <<
- PPF represents:
- all the possible combinations of goods (and services)
- that can be produced,
- if resources are used efficiently.
- Production possibilities are constrained by amount of labor and capital in the economy.
- Cannot produce above PPF
- If we shift labor from production of X and into production of Y,
- less X will be produced
- more Y will be produced
- PPF summarizes opportunity cost of all such shifts.
- If resources are not used efficiently
- labor unemployment,
- inefficient management
- the economy is producing at a point below the PPF.
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Cuba's Ten Million Ton Sugar Harvest
- In the 1960s, Cuba produced about 6 to 7 million tons of sugar a year,
which was sold primarily to countries in the Soviet bloc.
- Beginning in 1969, Cuban dictator Fidel Castro sent
hundreds of thousands of urban workers into the fields in an effort
to produce 10 million tons of sugar in 1970.
- Ultimately, Cuba missed its goal, but managed to produce
8.5 million tons -- the largest harvest in Cuban history.
What were the effects on Cuban economy?
- For simplicity, assume that before the plan:
- Cuba produced 6 million tons of sugar and 5 million tons of "everything else"
- relative price of sugar was one ton of everything else per ton of sugar,
- at a relative price of , Cuba traded 2 million tons of sugar for 2 million tons of everything else and
- consumed 4 million tons of sugar and 7 million tons of everything else
massive disruptions in the Cuban economy
- Since Cuba allocated all of its production to sugar, it produced at the "sugar corner" of its PPF.
- At that corner, the opportunity cost of producing sugar exceeds the relative price of sugar.
- For simplicity, let's pretend that Cuba:
- succeeded in producing all 10 million tons of sugar, but didn't produce anything else
- at a relative price of , Cuba traded 6 million tons of sugar for 6 million tons of everything else and
- consumed 4 million tons of sugar and 6 million tons of everything else
- So (in this example) Cubans consumed the same amount of sugar, but
- their consumption of everything else fell from 7 million tons to 6 million tons -- a 15 percent decrease.
...
sweet it wasn't
>> insert graph <<
- Q: Would a 15 percent decrease in consumption of everything else a massive disruption in the economy?
- A: If you could consume the same amount of sugar that you did last year, but your consumption of everything else fell 15 percent,
- would you be happy?
...
lesson from Cuba's experiment
- a country should produce at the point along its PPF, where the opportunity
cost of producing a good (ex. sugar) equals the relative price of that good
- Cubans suffered because their country produced at a point where the
opportunity cost of producing sugar exceeded the relative price of sugar
- Similarly, had Cuba allocated all of its resources to producing "everything else"
and produced no sugar it also would have suffered
- because at such a point, the opportunity cost of producing everything else would
have been greater than the relative price of everything else
- (from the opposite perspective...) because at such a point, the opportunity cost
of sugar would have been less than the relative price of sugar
Why did Jack and Jill completely specialize in one good?
- A country should completely specialize in the production of one good
- ONLY if the relative price of that good is greater than the country's
opportunity cost of producing it at every point along the PPF
- Jack and Jill's opportunity cost was constant all along their PPFs
- the PPF I drew for Cuba assumes increasing opportunity cost -- i.e. Cuba's
opportunity cost of producing sugar increases as it produces more sugar