Economics

ECONOMICS
Production and Trade

Prof. Rushen Chahal
2/12/2012
Prof. Rushen Chahal
Today
I. II. III. IV. V. VI. Opportunity cost Scarcity and choice The production possibilities frontier The circular flow of money Trade and comparative advantage Review questions
2/12/2012
Prof. Rushen Chahal
Today
2/12/2012
Prof. Rushen Chahal
Opportunity Cost
Consider the following: I only drink Yanjing Beer and smoke Zhongnanhai Cigarettes 1 bottle of Yanjing beer = 1.5RMB 1 pack of Zhongnanhai cigarettes = 4.5RMB If I buy 1 pack of cigarettes, that is 3 less bottles of beer that I can buy. Therefore the opportunity cost of 1 pack of cigarettes is 3 bottles of beer
2/12/2012
Prof. Rushen Chahal
Opportunity Cost
Definition: In a world of scarcity, choosing one thing means giving up something else. The opportunity cost of a decision is the value of the good or service forgone. (Samuelson, 1998)
2/12/2012
Prof. Rushen Chahal
Opportunity Cost
I love DVDs, I also like food Let s say one meal at the double pig restaurant costs me 21RMB and one DVD costs me 7RMB Question: What s the opportunity cost of one meal at the double pig restaurant? Answer: By eating one meal at the restaurant, I m giving up 3 DVDs
2/12/2012 Prof. Rushen Chahal
Opportunity cost concept check

Who has an MP3 Player? How much did it cost? What s the opportunity cost of that MP3 player? What s the opportunity cost of eating a meal at KFC? What s the opportunity cost of coming to class today? What s the opportunity cost of studying at ICB?
2/12/2012
Prof. Rushen Chahal
Today
2/12/2012
Prof. Rushen Chahal
Scarcity and Choice

The Facts of Life: - Resources are, and always will be, limited - The amount of goods an economy can produce is determined by how many resources are available at a given time - Given a set amount of available resources, an economy must decide how to cope with these limited resources.
Scarcity and Choice

An Economy must choose: - among different potential bundles of goods (what?) - among different techniques of production(how?) - who will consume the goods produced (for whom?)
Scarcity and Choice

To answer these three questions, every society must make choices about the economy s inputs and outputs. Inputs are commodities or services that are used to produce goods and services. Outputs are the various useful goods or services that result from the production process.
Scarcity and Choice

Consider the production of pizza. Inputs: Eggs, flour, heat, pizza oven, chef s labor Output: Pizza
Inputs and Outputs Concept Check

What about the production of tea? What are the inputs? What are the outputs? What about the production of ? What are the inputs? What are the outputs? What about the production of cars? What are the inputs? What are the outputs?
Prof. Rushen Chahal
2/12/2012
Scarcity and Choice

Inputs are also known as factors of production : The five categories of resources are: Land (natural resources) Labor (people s work time) Entrepreneurship (personal initiative to combine resources in productive ways; involves risk) Technology Capital (goods that increase productivity) Human capital Physical capital (buildings, equipment, machines)
2/12/2012
Prof. Rushen Chahal
Captial: WARNING!!!!!
In a finance and accounting class, what does capital mean?
It simply means money
In economics, capital DOES NOT MEAN MONEY!!!!!! Capital in economics means the things that we use to produce things:
E.g. physical capital: factories, machines, etc Human capital: Educated people
Generally speaking in this class, when we talk about capital, we ll be talking about physical capital 2/12/2012 Prof. Rushen Chahal
Today
2/12/2012
Prof. Rushen Chahal
The Production Possibilities Frontier

Resources and technology are limited. This scarcity limits an economy s options, forcing it to choose what and how much to produce. When you analyze all of the different possible choices a country could make, the result is the production possibilities frontier.
2/12/2012
Prof. Rushen Chahal
The PPF
Production Possibilities frontier on Castaway Island
Data Point Fish caught per day Coconuts collected per day
Six alternative combinations of fish and coconuts

25 F 20
D C
Coconuts
A B C D E F
2/12/2012
5 4 3 2 1 0
0 10 16 19 21 22
15 10 5 0 0 1 2 3 4
A
5
Prof. Rushen Chahal
Fish
The Production Possibility Frontier

Definition: The production possibility frontier (or PPF) shows the maximum amounts of production that can be obtained by an economy, given its technological knowledge and quantity of inputs available. The PPF represents the menu of goods and services available to society. or PPF is
2/12/2012
Prof. Rushen Chahal
The PPF
Data Point Fish caught per day Opportunity cost (total number of coconuts forgone) Marginal opportunity cost (change in number of coconuts forgone)
Opportunity Costs Total Marginal 22 1 1 21 3 2 19 6 3

Coconuts
F E D C B A
0 1 2 3 4 5
2/12/2012
0 1 3 6 12 22
N/A 1 2 3 6 10
16
D C B
12
10
22
10 0 1 2
Fish
A
3 4 5
Prof. Rushen Chahal
The Law of Increasing Costs

As the production of a product increases, the opportunity cost of each additional unit increases. Stated another way: for each extra fish I catch, I am giving up more and more coconuts
The Law of Increasing Costs

Data Point Fish caught per day Opportunity cost (total number of coconuts forgone) Marginal opportunity cost (change in number of coconuts forgone)
Opportunity Costs Total Marginal 22 1 1 21 3 2 19 6 3

Coconuts
F E D C B A
0 1 2 3 4 5
2/12/2012
0 1 3 6 12 22
N/A 1 2 3 6 10
16
D C B
12
10
22
10 0 1 2
Fish
A
3 4 5
Prof. Rushen Chahal
15
Possibilities
B C
G u n s * th o u sa n d s
Butter (millions of pounds)
Guns (thousands)
12
D
A B C D E F
2/12/2012
0 1 2 3 4 5
15 14 12 9 5 0
9 6 3
F E
0 0 1 2 3 4 5

Prof. Rushen Chahal
15 G un s * th o u sa n d s 12 9 6 3 0 0
2/12/2012
B C J
Points J and I are outside the production Possibilities Frontier, and are thus unattainable with the given available amount of inputs.
D G
Points G and H are inside The Production Possibilities Frontier, indicating the economy has not attained productive efficiency
E H
2
Prof. Rushen Chahal
Characteristics of the PPF

In summary: 1) The ppf shows how much of one good can be produced for any amount of another 2) When on the frontier, the opportunity cost of one good is less of the other good 3) The frontier 4) Every point on the frontier is technologically efficient economic growth
Characteristics of the PPF

In summary: 5) Points inside the frontier imply unemployed resources 6) Points outside the frontier are unattainable with current resources and technology 7) Shifting the frontier outward implies
8) If the economy qcquires resources that are specialized in the production of a certain good, the ppf expands outward in the direction of more 2/12/2012 Prof. Rushen Chahal of that good
Shifting the PPF

24 21 18 15 12 9 6 3 0 0 G un s *thousands
Possibilities Expand

When the PFF shifts outwards, the economy experiences economic growth
Shifting the PPF

24 21 18 15 12 9 6 3 0 0 1 2
Guns *thousands
Possibilities Shrink
When the PFF shifts inwards, it is a sign of negative economic growth

Shifting the PPF

24 21 18 15 12 9 6 3 0 0 Guns *thousands
An increase in productivity of one product

2/12/2012
If new technology is introduced that can only apply to one industry, then the PPF shifts out like this
Prof. Rushen Chahal
Specialized Growth
Specialized growth pivots the production possibility frontier in the direction of more output in the industry affected by the technological change.
2/12/2012
Prof. Rushen Chahal
The PPF
The PPF shows all of the different possible combinations of output an economy is able to produce The actual combination of goods an economy does produce is decided through the interaction of consumers and producers Stated simply, consumers will use their money to buy goods, and their decisions of what to buy will affect producers decisions about what to produce
2/12/2012
Prof. Rushen Chahal
Today
2/12/2012
Prof. Rushen Chahal
The Circular Flow Of Money

Money is a medium of exchange It is a representation of value It allows people to buy and sell goods Without money, people would have to exchange goods directly Barter: the exchange of goods and services directly for one another, without the use of money Imagine how I would buy things if there were no money
The Circular Flow of Money

Money flows to and from businesses/firms, and to and from households/individuals This can be better shown by the circular flow of money diagram The circular flow of money shows how markets use the medium of money to determine what gets produced, and who gets to buy the goods The model depicts both the input market and the output market
2/12/2012
Prof. Rushen Chahal
The Circular Flow Model of Economic Activity

Goods & Services $ Purchases
Households
Businesses
$ Incomes
Land, Labor, Capital, Entrepreneurship

Today
2/12/2012
Prof. Rushen Chahal
Trade and Comparative Advantage

Economies will trade with other economies This will be beneficial to both economies What is trade? What countries does China trade with? How do you think this benefits China?
2/12/2012
Prof. Rushen Chahal

Trade is going to benefit all involved Through trade, an economy can have access to more goods than it would if it simply relied on its own production capability (depicted by the PPF) Let s take a look at how trade benefits economies
2/12/2012
Prof. Rushen Chahal
Comparative Advantage Vs. Absolute Advantage

Absolute advantage: The ability to produce a good with fewer resources than other produces. So, if one economy (China) can produce a good (bicycle) using less resources than another economy (Korea), we say China is having an absolute advantage over Korea in making bicycle. Example: USA may require 200 labor hours to produce one car Japan may require only 150 labor hours to produce one car Japan has an absolute advantage over USA in the production of cars
Comparative advantage Vs. Absolute advantage

Comparative advantage: The ability to produce a good at a lower opportunity cost (other goods forgone) than others could do. So, if an economy (China) can produce a good (Table) at a lower opportunity cost than another country (Korea), we say China is having a comparative advantage over Korea in making table. This suggests that each country will produce goods that they are best at producing Let s take a look at how this works, using international trade as an example

Countries will trade with each other Exports are goods that are produced in the home country, and then sent to another country for consumption Imports are goods that are produced in another country, and then brought to the home country for consumption Through imports and exports, an economy can consume more than it could if it were to rely on it s own productive capability (at a point outside the PPF
Exports as a Percentage of GDP

Exports as a Percentage of GDP
80 70 60 50 40 30 20 10 0
75.6 45.7 35.2 23 19.7 9.6 7.3
2/12/2012
Prof. Rushen Chahal
Specialization According to Comparative Advantage

Country Japan England Computer Memory Chips 10 units per day 5 units per day Barrels of Oil 4 per day 3 per day
Productivity per worker in Japan and England
2/12/2012
Prof. Rushen Chahal
Country Japan England
Computer Memory Chips 10 units per day 5 units per day

Opportunity Cost
(C is computer chips and B is Barrels of oil)
Barrels of Oil 4 per day 3 per day

Opportunity Cost (per unit) 2/5 barrel of oil (.4B)* 3/5 barrel of oil (.6B) 5/2 computer chips (2.5C) 5/3 computer chips (1.67C)*
Product Location Computer chips in Japan Computer chips in England Oil in Japan
2/12/2012
10C=4B 5C=3B 4B=10C

Prof. Rushen Chahal
Oil in England
3B=5C

Japan will produce computer chips, as it has a comparative advantage in producing them England will produce oil, as it has a comparative advantage in producing oil The countries will then trade, benefiting both of them Don t worry too much about how this works for them moment, just be aware that
2/12/2012
Prof. Rushen Chahal
Comparative Advantage: Concept Check

Which country has an absolute advantage in producing MP3 players? Answer: Which country has an absolute advantage in producing PS2 Answer: Yes, Country A has has an absolute advantage in producing both PS2 and MP3 players But what about comparative 2/12/2012 advantage?
Country
MP3 PS2 Players 5
Country A 20
Country B 15
Prof. Rushen Chahal

What is the opportunity cost of producing 20 MP3 players for country A? 5 PS2 1 MP3 player? 5/20 (0.25) PS2 Therefore, the opportunity cost of producing one MP3 player in country A is 0.25 PS2
Country
MP3 PS2 Players 5
Country A 20
Country B 15
2/12/2012
Prof. Rushen Chahal

What is the opportunity cost of producing 15 MP3 players for country B? 3 PS2 1 MP3 player? 3/15 (0.20) PS2 Therefore, the opportunity cost of producing one MP3 player in country B is 0.20 PS2
Country
MP3 PS2 Players 5
Country A 20
Country B 15
2/12/2012
Prof. Rushen Chahal

The opportunity cost of producing 1 MP3 player for country A is 0.25 PS2 The opportunity cost of producing 1 MP3 player for country B is 0.20 PS2 As a result, Country B will produce MP3 players, as it has a comparative advantage in producing them
2/12/2012
Country
MP3 PS2 Players 5
Country A 20
Country B 15
Prof. Rushen Chahal

What is the opportunity cost of producing 5 PS2 for country A? 20 MP3 players 1 PS2? 20/5 (4) MP3 Players Therefore, the opportunity cost of producing one PS2 in country A is 4 MP3 players
Country
MP3 PS2 Players 5
Country A 20
Country B 15
2/12/2012
Prof. Rushen Chahal

What is the opportunity cost of producing 3 PS2 for country B? 15 MP3 players 1 PS2? 15/3 (5) MP3 Players Therefore, the opportunity cost of producing one PS2 in country A is 5 MP3 players
Country
MP3 PS2 Players 5
Country A 20
Country B 15
2/12/2012
Prof. Rushen Chahal

The opportunity cost of producing one PS2 in country A is 4 MP3 players The opportunity cost of producing one PS2 in country B is 5 MP3 players As a result, Country A will produce PS2 as it has a comparative advantage in producing them
2/12/2012
Country
MP3 PS2 Players 5
Country A 20
Country B 15
Prof. Rushen Chahal
To Sum Up
First today we looked at the concept of opportunity cost Opportunity cost is the value of the next best option we give up when we make a decision The opportunity cost of my buying 1 pack of Zhongnanhai cigarettes is 3 Yanjing Beers
2/12/2012
Prof. Rushen Chahal
To Sum Up
We then saw that in an economy, resources are scarce We must decide what we are going to produce, given the amount of resources/inputs we have available We saw that in economics, we are generally going to consider land, labor, and capital as our inputs/resources Remember, capital does not mean money in economics, but rather things like factories, etc.
To Sum Up
We then looked at the production possibilities frontier (PPF) The PPF shows all of the different combinations of output we can make, given the amount of scarce inputs we have available The PPF can shift out, as our productive capabilities increase Points inside the PPF are technologically inefficient Points on the frontier of the PPF are technologically efficient Points outside of the PPF are unattainable
To Sum Up
We then looked briefly at the circular flow of money This concept will become even more important as we look at macroeconomics in the second half of the semester Just realize for now that money is flowing to and from businesses, and to and from individuals and households
2/12/2012
Prof. Rushen Chahal
To Sum Up
Finally we looked at the concept of trade and comparative advantage We saw that a country has a comparative advantage when it is able to produce a good at a lower opportunity cost than another country Countries will produce goods which they have a comparative advantage in They can then trade with other countries, allowing them to consume more than they would have been able to if they relied solely on their own productive capability
To Sum Up
Today has been another largely introductory day Some key concepts you will definitely want to remember:
Opportunity Cost The PPF Comparative Advantage
2/12/2012
Prof. Rushen Chahal
Test Yourself
1. The opportunity cost of a new city police contract is:
a. b. the amount of money it takes in order to provide the city with the most highly qualified personnel. the value of the other goods and services that the city and taxpayers will be forced to give up in order to pay for the contract. the cost to victims of crimes that the new contract would prevent. the value of the opportunities that city policemen acquire by accepting it.
Prof. Rushen Chahal
c. d.
2/12/2012
Test Yourself
2. Which of the following items is the best example of an economic resource? a. A stock certificate. b. A one-hundred dollar bill. c. A tractor. d. A plate of spaghetti.
2/12/2012
Prof. Rushen Chahal
Test Yourself
3. A production possibilities frontier shows combinations of: a. inputs that can produce a specific quantity of output. b. outputs that people consume. c. outputs that can be achieved as technology improves. d. outputs that can be achieved in a given time period with all available resources employed using current technology.
Test Yourself
4. If a Nation s production possibilities indicates that 1,000,000 battle tanks and 6,000,000 houses could be produced, or alternatively, 750,000 tanks and 8,000,000 houses could also be produced, the opportunity cost of each additional house would be: a. 250,000 tanks. b. 8 tanks. c. 0.125 tanks. d. 2,000,000 tanks.
Test Yourself
5. As a nation develops economically, its production possibilities frontier: a. remains stable. b. shifts towards the origin. c. shifts away from the origin. d. becomes steeper, but does not shift.
2/12/2012
Prof. Rushen Chahal
Test Yourself
6. When a country can produce a good with fewer resources than any other country, the country has: a. a comparative advantage. b. a resource advantage. c. an absolute advantage. d. an unfair advantage.
Homework
Test your self pages 51-52
Questions 1-20 Page 53: questions 3, 12 Page 54: question 1a-1h
Read in Ayers and Collinge pages 57-69
2/12/2012
Prof. Rushen Chahal

Economics - Production and Trade

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Economics - Production and Trade

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Production and Trade

Prof. Rushen Chahal

Prof. Rushen Chahal

Prof. Rushen Chahal

Prof. Rushen Chahal

Prof. Rushen Chahal

Opportunity cost concept check

Prof. Rushen Chahal

Prof. Rushen Chahal

Scarcity and Choice

Scarcity and Choice

Scarcity and Choice

Scarcity and Choice

Inputs and Outputs Concept Check

Scarcity and Choice

Prof. Rushen Chahal

Prof. Rushen Chahal

The Production Possibilities Frontier

Prof. Rushen Chahal

Six alternative combinations of fish and coconuts

Prof. Rushen Chahal

The Production Possibility Frontier

Prof. Rushen Chahal

Opportunity Costs Total Marginal 22 1 1 21 3 2 19 6 3

Prof. Rushen Chahal

The Law of Increasing Costs

The Law of Increasing Costs

Opportunity Costs Total Marginal 22 1 1 21 3 2 19 6 3

Prof. Rushen Chahal

Butter (millions of pounds)

Butter (millions of pounds)

Butter (millions of pounds)

Characteristics of the PPF

Characteristics of the PPF

Shifting the PPF

Butter (millions of pounds)

Shifting the PPF

Butter (millions of pounds)

When the PFF shifts inwards, it is a sign of negative economic growth

Shifting the PPF

An increase in productivity of one product

Butter (millions of pounds)

Prof. Rushen Chahal

Prof. Rushen Chahal

Prof. Rushen Chahal

The Circular Flow Of Money

The Circular Flow of Money

Prof. Rushen Chahal

The Circular Flow Model of Economic Activity

Land, Labor, Capital, Entrepreneurship

Prof. Rushen Chahal

Trade and Comparative Advantage

Prof. Rushen Chahal

Trade and Comparative Advantage

Prof. Rushen Chahal

Comparative Advantage Vs. Absolute Advantage

Comparative advantage Vs. Absolute advantage

Trade and Comparative Advantage

Exports as a Percentage of GDP

Prof. Rushen Chahal

Specialization According to Comparative Advantage

Productivity per worker in Japan and England