Dr. Fidel Gonzalez Department of Economics and Intl. Business Sam Houston State University 2 OPPORTUNITY COST MARGINAL ANALYSIS Elasticity Elasticity SUPPLY DEMAND MARKET EQUILIBRIUM CONSUMER SURPLUS PRODUCER SURPLUS AND TOTAL SURPLUS MARKET EFFICIENCY MARKET FAILURE Pigouvian Taxes Quotas Coase Theorem Command and control TAXES EXTERNALITIES PUBLIC GOODS COMMON GOODS ARTIFICIALLY SCARCE GOODS GAME THEORY 3 Opportunity costs and gains from trade The economic problem is a problem of scarcity and equity. Scarcity refers to the fact that we have a lot of desires and a finite number of resources. This topic talks about scarcity and introduces some important concepts. In particular we will talk about 1) Slope and equation of the line 2) Opportunity cost 3) Production possibilities frontier 4) Efficiency 5) Absolute and comparative advantage 6) Terms of trade 4 Opportunity costs I will explain this concepts using an example Consider Rob who lives in a desert island. For survival Rob can collect coconuts (C) or bananas (B) If he spends the whole day working he can collect EITHER 8 coconuts and 0 bananas (if he spends the day collecting only coconuts) OR 0 coconuts and 10 bananas (if he spends the day collecting only coconuts) Note that he is can NOT collect 10 coconuts and 8 bananas that is impossible. 5 So what is the scarce resource In this case time is scarce there is a fixed number of hours. If there were more hours then Rob will work longer and obtain more coconuts and bananas. Next I will graph the options for Rob. This point represents zero bananas and eight coconuts. C 8 This point represents 10 bananas and zero coconuts. 10 B 6 Now we allow Rob to collect any linear combination of the two point in the previous graph. Hence I can draw a straight line between the two points and any point on the line will be feasible. Why we allow Rob to have a linear combination and not some other kind We do this to keep things simple. We will relax this assumption later on. C For example before only the y and x-intercept were possible but now Rob can collect 4 coconuts and 5 bananas. Any point on the line. 8 Next lets obtain the slope of the line and the equation of the line (PLEASE refer to the power point presentation on how to do this). 4 5 10 B Slope -8/10 0.8 Equation of the line in a general form is y slopex y-intercept In this case C -0.8 B 8 7 The equation of the previous line is very useful because it gives me all the possible combinations of C and B that are feasible (that is the all possible points on the line). For example if B1 then C 7.2 B6 then C5.2 B4 then C4.8 Imagine that Rob decides to collect the following C8 and B 0 Eating only coconuts is very boring so Rob decides to eat one banana now we have the following C -0.8 (1) 8 7.2 Hence C7.2 and B1 Note that in order to increase bananas by one unit Rob has to reduce his consumption of coconuts by 0.8 (from 8 to 7.2 coconuts) C 8 10 B What if C4.8 and B4 and Rob decides to increase bananas by one unit then now he will have C-0.8(5) 8 4 that is C4 and B5 8 In every single case in order to increase the amount of bananas Rob has to give up 0.8 coconuts. This is the idea behind opportunity cost. The opportunity cost is the is the value of the best alternative to any choice. In our example the opportunity cost of one extra banana for Rob is 0.8 coconuts. Note that there is a relationship between opportunity cost of one banana and the slope of the line in the previous graph. In both cases we measure how much of C decreases when B goes up by one unit. Actually the absolute value of the slope is equal to the opportunity cost of one extra unit of B in terms of C. First why did I say the absolute value Because the slope in the graph is negative -0.8. The opportunity cost is not negative. Hence I need to take the absolute value of the slope. Remember that the absolute value of any number is the positive value of the number. The absolute value is denoted by . For example the absolute value of -10 is 10 the absolute value of 10 is also 10. Think of it as the positive version of any number. Using the notation -10 10 -5 5 6 6 etc. 9 In general the opportunity cost of one extra unit of the variable in the x-axis is equal to the absolute value of the slope in terms of the y variable. In our previous example The opportunity cost of one extra unit of B slope of C The opportunity cost of one extra unit of B 0.8 of C We have not talked about the opportunity cost of coconuts. Lets use the equation of the line first Start at B10 and C0 now increase C by one unit and obtain the value of B 1 -0.8 B 8 -7 -0.8B B 8.75 B decreased by 1.25 units What if B 4 and C4.8 increase C by one unit and obtain B 5.8 -0.8 B 8 -2.2 -0.8 B B 2.75 B decreased by 1.25 units 10 That is in order to get an extra unit of C Rob has to give up 1.25 units of B. That is the opportunity cost of one extra unit of C is 1.25 units of B. Notice the 1.25 is the inverse of the slope. That is In general the opportunity costs of one extra unit of the variable in the y-axis is equal to the inverse of the absolute value of the slope in terms of the variable in the x-axis. In the Rob example 11 Production Possibilities Frontier Now assume that Rob gets tired as the day passes by. In the morning Rob is very productive however in the afternoon Rob is not very productive because he is tired. These are Robs new options In the morning 3C and 0B or 0 C and 6 B In the afternoon 5 C and 0B or 0 C and 4 C We can graph the previous information C Afternoon Slope-5/4-1.25 Morning Slope-3/6-0.5 C 5 3 6 4 B B 12 Combining the morning and afternoon graph into one graph C C Morning Slope-3/6-0.5 Afternoon Slope-5/4-1.25 5 3 6 C C 4 B 8 Morning Slope-3/6-0.5 3 5 Afternoon Slope-5/4-1.25 6 10 B 13 Note that the slope changes from the morning to the afternoon. In fact the slope gets flatter. This means that the opportunity cost of B increases from morning to afternoon. In other words B is getting more expensive in the afternoon. The opposite is happening to C it is getting cheaper from morning to afternoon. Morning Slope-3/6-0.5 C 8 Afternoon Slope-5/4-1.25 5 B 10 6 Now imagine that we can reduce the day not in two parts but in milliseconds. In that case the previous graph will be a curve C 8 The slope of the curve on the left is always changing. The slope starts from almost zero at the origin and gets steeper and steeper and B increases. In other words the opportunity cost of B increases as we have more of B. B 10 14 The line that shows all the maximum different possible production combinations is called the production possibilities frontier (PPF). The production possibilities frontier can be a straight line or a curve like in the previous graph. If the PPF is a straight line the slope dos not change along the line and the opportunity cost is also constant. If the PPF is curved like in the last graph then the slope increases as the variable in the x-axis goes up. That means that the opportunity cost of the variable in the x-axis increases In the graph on the left you can see that a change in the x variable when y is big produces a very small decrease in the y variable. However the same change in x when y is big produces a large change in the y variable. That is in order to obtain the same extra x you give up of y when y is higher. Q Why does this happen Imagine that y is the amount of computers produced and x is the amount of car (see graph in the next) y x 15 Computers When we produce a lot of computers we have resources that are specialized (cars engineers) and non-specialized resources (assemblers). When we increase the production of cars most of the non-specialized resources moves to the cars industry. Why Because they have skills that can be used in either industry. Since most of the specialized computer workers stays in the computer industry then the drop in the production of computers does not change that much. If we continue increasing the production of cars we will be taking more and more specialized computer workers into car production. Therefore the production of computers will drop more and more. Cars At the end we will be transferring very specialized computer workers into the production of cars and the production of computer will drop significantly. 16 Computers C We want to know if point on the PPF are efficient. First we need to defined what is efficiency. We will use the definition Pareto efficiency (Pareto was an Italian economist) We say that an allocation is efficient if in order to make someone better of we have to make someone else worse off. In terms of the PPF we say that an allocation is efficient if in order to increase the production of one good I have to reduce the production on another good. B A PPF Cars The point A is below the PPF this means that we can increase the production of both goods at the same time so this is clearly and inefficient point. Allocations below the PPF are inefficient. The point B is efficient because in order to increase the production of any good we have to reduce the production of the other good. Any allocation on the PPF is efficient. No single allocation on the PPF is more efficient the others they are all equally efficient. The point C is above the PPF this means that this point is not feasible. We would like to produce at point C because it represents higher production but our resources are not enough to reach it. Allocations above the PPF are desired but unfeasible. 17 Trade Lets go back to our previous example with Rob and assume the PPF is a straight line. So far we have Rob is alone in the island. Because Rob has nobody to trade with everything that he produces he has to consume it. That is in the absence of trade production equals consumption WITHOUT TRADE PRODUCTIONCONSUMPTION Now Sam appears in the island too. There are only Rob and Sam in the desert island. Sam can collect 12 coconuts and 0 bananas OR 0 coconuts and 4 bananas Graphing Sams production possibilities frontier C 12 Slope -12/4 -3 PPF 4 B 18 Hence The opportunity cost of 1 B 3 C The opportunity cost of 1 C 1/3 C Now imagine they do not trade and each produce the following Rob decides to produce 5 B and 4 C Sam decide to produce 2 B and 6 C World Production and Consumption without Trade Total World Production of B is 7 and C is 10 19 Graphing the information in the table we obtain the PPF for Rob and Sam Sam Rob C C 12 8 6 4 2 4 B 5 10 B Remember that because there is not trade their production possibilities frontier also dictates how much they can consume. None of them can consume above their PPF when there is not trade. However they would like to consumer above their PPF. Both of them will enjoy to consume more of both goods. Remember points above PPF are desired but unfeasible without trade. 20 Before we move one we need to have some definitions. Absolute Advantage someone has an absolute advantage if he is able to produce more of a good or service with the same amount of resources. In our previous example Sam has an absolute advantage in the production of coconuts and Rob has an absolute advantage in the production of B. Comparative Advantage someone (or a country) has an comparative advantage in the production of a good or service if it has a lower opportunity cost than the other person (country) in the production of that good or service. In our previous example Rob has a comparative advantage in the production of bananas (its opportunity cost of one B is 0.8 C which is lower than Sams 3 C). Sam has a comparative advantage in the production of coconuts (its opportunity cost of one C is 1/3 which is lower than Sams 1.25 C). The concept of comparative advantage is key to understand trade. Having a comparative advantage in the production of a good means that it is cheaper for that person to produce the good. It is cheaper in the sense that the person has to give up less of the other good. That is for Rob is cheaper to produce bananas (in terms of the coconuts he has to give up) and for Sam is cheaper to produce coconuts (in terms of the bananas he has to give up). 21 Assume each person specializes in the production of the good in which they have a comparative advantage. In the example Sam will specialize in coconuts and Rob will specialize in bananas. The following table shows the new world production World Production with Specialization We have just showed the power of specialization based on comparative advantage. Comparing the world production with and without specialization we can see that the world production with specialization increase the total production of B by 3 units and the total production of C increases by 2 units. The theory of comparative advantage tell us that total production will increase if producers specialize in the good in which they have a comparative advantage. Because no one can have a comparative advantage in all goods 22 However with specialization the production is not equal to production. Part of the production is consumed by the producer and the rest is traded for other goods. WITH SPECIALIZATION (OR WITH TRADE) CONSUMPTION PRODUCTION Once Rob and Sam specialize in the production of B and C respectively they have to trade. The question now is What is the price at which they will be willing to trade In other words how many C for B are they willing to trade. This price is called terms or trade. Rob will love to have a price of 1 B for 12 C clearly Sam will not want this. Sam will love to have a price of 1C for 10 B but Rob will not like it. So what kind of price is Rob and Sam willing to accept 23 Lets start with Rob Rob can do two things 1) he can not specialize and trade with himself or 2) specialize and trade with Sam. If Rob does not specialize he is fact trading with himself and the price he is paying is his opportunity cost. For example imagine that Rob is producing 5 bananas and 4 coconuts. He now wants to have another coconut. He can figuratively trade with himself he will do that by increasing the production of coconuts by one. But this requires that he lowers the production of bananas by 1.25 bananas. In fact he has traded 1 coconut for 1.25 bananas with himself. The opportunity cost is the price of trading with himself. Rob will accept any price that is better than the price of trading with himself. In other words we will accept any price that is better than his opportunity cost. A good to see this is by using a number line. We will use the number line that you used in kindergarten. The number line goes from left to right and increases from zero to infinity 0 24 I will show the opportunity cost in the number line. Robs opportunity cost 1C 1.25 B Next put C on the other side Now graph 1.25 B/C in the number line B/C 0 1.25 We know that Rob has bananas and wants coconuts so he will love to have a price of very few bananas for a lot of coconuts. When B is low and C is high then B/C will be a low number. That is Rob prefers small B/C. This implies that Rob will be better off compared to trading with himself to the left of the opportunity cost. For example if the price happens to be 0.5 bananas for 1 coconut Rob will be better off because if he trades with himself he would have to give up 1.25 for 1 coconut. As long as the price is to the left of his opportunity cost Rob will be better off. 25 Robs opp. cost B/C 0 1.25 Rob is better off to the left of the opp. cost Now lets consider Sam. His opportunity cost is 1 C 1/3 B Again moving C to the other side Now let show Sams opportunity cost in the number line B/C 0 0.33 Sam has coconuts and wants bananas so he wants to have a price of very few coconuts for a lot of bananas. When B is high and C is low then B/C will be a high number. Sam prefers small B/C.. For example if the price happens to be 2 bananas for 1 coconut Sam will be better off because if he trades with himself he would have to give up 3 coconuts for 1 banana. As long as the price is to the right of his opportunity cost Sam will be better off. 26 Placing both opportunity costs in the same number line Sam is better off to the left of his opp. cost Sams opp. cost B/C 1.25 0.33 0 Robs opp. cost Rob is better off to the left of his opp. cost The place where both Sam and Rob can be better off is between 0.33 and 1.25 Both better off in this range B/C 1.25 0.33 0 We really do not know where in the range between 0.33 and 1.25 B/C the real price will be. This will depend on their negotiations but we know that for sure that they will trade. 27 Lets assume that they decide the price to be 1. bananas for 1 coconut. Actual price B/C 0.5 1.25 0.33 0 Also assume that Rob decides to sell two bananas. This implies that Sam has to pay 4 coconuts. The final allocation of coconuts and bananas is the following World Production with Specialization World Consumption After Trade 28 Finally lets compare consumption with trade and consumption without trade World Consumption without Trade World Consumption After Trade NOTE THAT WITH TRADE BOTH SAM AND ROB CONSUME MORE THAN WITHOUT TRADE We have reached our main conclusion Trade will be better than no trade for all parties involved IF AND ONLY IF 1) the parties specialize in the production of the good in which they have a comparative advantage AND 2) the terms of trade are better than their respective opportunity costs. 29 However the advantages of trade are not only that both can consume more but also they consumer above the production possibilities frontier. That brings us to our second main result If 1) the parties specialize in the production of the good in which they have a comparative advantage AND 2) the terms of trade are better than their respective opportunity costs. The involved parties will consume above their production possibilities frontier. A point that is not feasible (but desired) without trade The point 8C and 2 B is above the PPF so it is preferred over any point on the PPF but it is only available with trade Rob Sam The point 4C and 8 B is above the PPF so it is preferred over any point on the PPF but it is only available with trade C C 12 8 6 4 2 4 B 5 10 B
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