Part 1 – Comparative Advantage and the Basis for Trade 1. Comparative Advantage and The Basis for Trade
• Model assumptions:
o 2 possible activities o 2 individuals
o No transaction costs (negotiation/transportation) o No other barriers (import quotas, tariffs).
• PPC – captures all
maximum output
possibilities of two (or more) goods, given that the set of inputs are used efficiently.
• Efficient Production Point – combination of goods for which currently available resources do not allow an increase in the production of one good without a reduction in the production of the other à on the PPC (B, D, C)
• Inefficient Production Point – combination of goods for which currently available resources allow an increase in the production of one good w/o a reduction in the production of others à inside the PPC (A).
• Attainable Production Point – combination of goods that can be produced with the currently available resources à efficient and inefficient points (A, B, C, D).
• Unattainable Production Point – combination of goods that cannot be produced with the currently available resources à outside the PPC (X).
• An agent has an Absolute Advantage in a productive activity when she can carry on this activity with fewer resources/time than another agent.
• The Opportunity Cost of a given action is the value of the next best alternative to that particular action.
o Gradient/slope of the PPC in absolute term à dividing rise by the run = OC of producing one unit of the good depicted on the x-axis.
o OCA = !"## !" !
!"#$ !" ! or OCR = !"## !" !
!"#$ !" !
• An agent has a Comparative Advantage in a productive activity when she has a lower OC of carrying on that activity than another agent.
• Principle of Comparative Advantage: Everyone is better off if each agent specialises in the activities for which they have a comparative advantage. The gains from specialisation grow larger as the difference in OC increases.
o If 2 countries are trading, different OC of production are required.
• Assumptions of PPC:
o Only two productive activities can be carried out o Limited amount of time per day
o Productivities are constant.
• Specialisation increases production.
• Trade allows consumption target to be reached.
• Trade can only occur at an allowable price that is mutually beneficial.
• E.g. Alberto specialises in bananas, Leo specialises in rabbits:
Alberto will sell banana to Leo when:
Pricebanana ≥ Alberto’s OCbanana (= 0.5kg rabbit) Leo will sell rabbits to Alberto when:
Pricebanana ≤ Leo’s OCbanana ( = 1kg rabbit)
Allowable price: 0.5kg rabbit ≤ Pricebanana ≤ 1kg rabbit
• In an economy-wide PPC, specialising correctly à produce more g/s à curve bows out.
• Slope of the curve is increasing – as we increase the quantity of goods on the x-axis, the PPC’s negative gradient becomes steeper à the OC of collection additional good on the x-axis is increasing.
• Principles of Increasing Opportunity Cost (Low Hanging Fruit): in the process of increasing production of any good, first employ those resources with the lowest OC and only once these are exhausted turn to resources with higher cost.
• Main factors driving eco growth (push the economy PPC outward):
o Increase in infrastructure – factories, equipment o Increase in population – labour force
o Advancements in knowledge and technology – education, R&D, IT, communications technology à increases productivity à more goods can be produced with the same Q of resources.
• A country’s eco welfare does not depend on what it produces (PPC), but on what it consumes (CPC).
• Consumption Possibility Curve – all possible combinations of 2 goods that the agents in an economy can consume when it is open to international trade.
• Closed economy (no trade), PPC = CPC. Agents only consume what they produce.
• Open economy (trade on international market), CPC is to the right and above the PPC because part of what the agents produce can be traded for other g/s at world price à increase consumption.
• Consumption opportunities in an open economy are always wider than in a closed one. However, economic consumption ultimately depends on needs and wants (preferences).
• An economy produces a combination represented by point A.
o Assume: in the international market, it is possible to exchange 1kg of banana for 0.75kg of rabbit à A’ &
A” can be consumed.
o Lose 1kg of banana à ‘run’ to the left by 1. Gain 0.75 kg of rabbit à ‘rise’ by 0.75.
o Connecting A, A’ and A” à straight line = consumption possibilities available when the company produces a combination represented by A.
o Same concept can be applied at point C, whereby maximum amount of consumption is guaranteed.
• A change in the international price can affect the CPC.
• Utilising the principle of increasing OC in a many-agent economy à smoothens out the PPC à a curve which bows out from origin.
• OC in a smooth curve = gradient of tangent to a point.
• As Q of the good in the x-axis increase, the PPC’s negative slope increases à OC rises.
• Classic critiques to the model – we assumed:
o No psychological cost associated with performing the same activity the entire day (dissatisfaction).
o No transaction costs (negotiation/transportation).
o No import quotas or tariffs – would limit gains from specialisation by making specialisation (beyond a certain level) pointless.
Part 2 – Perfectly Competitive Markets
• Market – the set of all the consumers and suppliers who are willing to buy and sell that g/s at a given price.
• Market Equilibrium – when the price and quantity sold of a given good is stable. Or market equilibrium occurs when the equilibrium price is such that the quantity consumers want today is the same as the quantity suppliers want to sell.
• Characteristics of perfectly competitive markets:
o Consumers and suppliers are price-takers o Homogenous goods
o No externality
o Goods are excludable and rival o Full information
o Free entry and exit.
2. Supply in a Perfectly Competitive Market
• The Marginal Benefit of producing a certain unit of a given good is the extra benefit accrued by producing that unit.
• The Marginal Cost of producing a certain unit of a given good is the extra cost of producing that unit.
• Thinking at the margin – comparing the MB with the MC.
• Marginal time – extra time required to produce an extra unit of the good.
• Cost-Benefit Principle – an action that should be taken if MB is greater than the MC (MB ≥ MC à take the action).
• The Economic Surplus of a certain action is the difference b/w the MB and the MC of taking that action.
• The Quantity Supplied by a supplier represents the Q of a given g/s that maximises the profit of the suppliers.
• Supply Curve – represents the relationship between the price of a g/s and the quantity supplied of that g/s.
• Vary the price of the good to see how its supply would change:
• Law of Supply: The tendency for a producer to offer more of a certain g/s when the price of that g/s increases.
• Interpretation of the supply curve:
o Horizontal interpretation: start from a certain price and find the associated quantity on the supply curve.
The price indicates how many units the producer is willing to supply at that price.
o Vertical interpretation: start from a certain quantity and find the associated price on the supply curve.
The price indicates the minimum amount of money the producer is willing to accept to offer the marginal unit = producer reservation price.
• Producer Reservation Price – the minimum amount of money the producer is willing to accept to offer a certain g/s.
o Producer reservation price for 2 apples = $1.50
• Sunk Cost – a cost that once paid cannot be recovered.
• Factor of production is fixed when its cost does not vary with the quantity produced.
• Fixed Cost – cost associated with a fixed factor of production. Cost is still incurred even when the firm shuts down.
• Factor of production is variable when its cost tends to vary with the quantity produced.
• Variable cost – cost associated with a variable factor of production.
• The Short Run is a period of time which at least one factor of production is fixed.
• The Long Run is a period of time during which all factors of production are variable, i.e. producers can change factor of production as they pleased.
• When Q = 40 and MB = 1.20 therefore MC = 12/40 = 0.30 ($/unit) MB > MC à first worker should be hired.
Continuing this process, the optimal number of employee is 4.
• Profit – the difference between total revenue and total cost.
𝜋!"#$%&'(#) =𝑇𝑅−𝑇𝐶 Total revenue = price x quantity Total cost = fixed cost + variable cost
• When 4 workers are hired, Q = 130 cans ($1.20/can) πproduction = TR – TC = (1.20 x 130) – (100 + 48) = $8.
• Shut Down Condition (Short Run): if πproduction < FC.
• When 4 workers are hired, πproduction = $8 πshut-down = -$100 πproduction > πshut-down à Continue production.
• Shut Down Condition (Long Run): if πproduction < 0, because FC = 0 in the long run.
• In the long run, by exiting the industry the entrepreneur gains and loses because there is no fixed cost (πexit = 0).
• If πproduction = 0 the entrepreneur is indifferent between exiting and continuing operations.
A representation of the production costs in a discrete model – entrepreneur could only hire workers in whole numbers.
A representation of the production costs in a continuous model - the labour supply are more flexible and employees were hired for as many hours the employer wants.
• Shut down condition:
o Short run: price line below AVC.
o Long run: price line below ATC.
• MC eventually increases with the quantity produced, i.e.
the production process is subject to increasing MC.
o Increasing employees does not necessarily increase production (maybe there are too many workers and limited capital) à declined productivity.
• Supply curve:
o Short Run: part of the MC curve above the AVC.
o Long Run: part of the MC curve above the ATC.
• Entrepreneur will not produce anything if the price is below these points, in the short and long run respectively.
• Difference between ATC and AVC = Average Fixed Cost (FC/Q).
• ATC and AVC must converge, when Q à ∞, AFC à 0.
• Change in market price (and hence a change in Q) à movement along the supply curve.
• Change in some other factor other than price that affects MC à shift the entire supply curve.
o Technology – reduces unit cost of production through increased productivity
o (Variable) input prices o Expected future price/demand o Changes in pricing for other products
o Number of suppliers – larger amount of suppliers à right shift.
• Price Elasticity of Supply – the percentage change in quantity supplied resulting from a very small percentage change in price.
o Measures the responsiveness of supply to changes in price.
Or
∆𝑄= 𝑄!−𝑄!
∆𝑃= 𝑃!−𝑃!
• Elasticity of supply is usually positive because price and quantity supplied goes in the same direction.
o Price increases, the quantity supplied increases – vice versa.
• Law of Supply – supply curves have the tendency of being upward sloping.
• Elastic Supply – price elasticity of supply > 1
• Unit Elastic Supply – price elasticity of supply = 1
• Inelastic Supply – price elasticity of supply < 1
• Determinants of price elasticity of supply:
o Availability of raw materials o Factors mobility
o Inventories / Excess capacity
§ Excess capacity – there is relative abundance of fixed factors of production compared to variable one.
o Time horizon.
3. Demand in a Perfectly Competitive Market
• Utility – the satisfaction that an individual derives from consuming a given good or taking a certain action (utils per unit of time).
Decreasing Marginal Utility – the utility from consuming an extra unit of a given good decreases with the number of units that have been previously consumed
