Chapter 1: Scarcity and Choice PDF

Chapter 1: Scarcity and choice A. Introduction This chapter has one main objective: introduce some important economic concepts, some of which will be used in some coming chapters. Specifically, we will introduce: the opportunity cost, Absolute Advantage/Comparative Advantage, the Production Possibi...

Chapter 1: Scarcity and choice A. Introduction This chapter has one main objective: introduce some important economic concepts, some of which will be used in some coming chapters. Specifically, we will introduce: the opportunity cost, Absolute Advantage/Comparative Advantage, the Production Possibility Frontier. First, we will briefly differentiate between the 2 main branches of economics: microeconomics and macroeconomics. B. Distinction between microeconomics and macroeconomics 1. Microeconomics Studying the way rational economic agents make decisions:  How a consumer spreads his income over a wide range of goods and services available in the market, how an individual divides their time between work and leisure...  How a firm decides how much to produce of a given good, how many workers to hire...  In sum, microeconomics examines the decisions made by small units: households, firms, a subset of households/firms  Micro deals with the trees of the forest individually 2. Macroeconomics Understanding the ways an economy as a whole works:  Instead of understanding what determines the output of a single (a group of) firms and what determines the consumption pattern of a single (group of) households, macroeconomics examines national (aggregate) production and national (aggregate) consumption  It also studies the causes of phenomena such as inflation, unemployment...and what are the best policies to deal with these problems: fiscal policy/monetary policy  In sum, macroeconomics looks at the big picture: it examines how the entire economy operates, as well as the main problems affecting the latter and provides possible solutions.  It examines the forest as a whole C. Resources and the microeconomic question 1. Resources 1/ There are 3 types of resources Natural resources (summarized by "land"): land, rain, wind, oil...etc that can be used in the production process of goods/services Physical resources (summarized by "capital/capital goods"): buildings, equipments, machines, storage. transportation...etc 1 Labor: physical action done by workers, as well as their mental activities used in the production process (talents and skills, knowledge) 2/ Those resources are also known as factors of production, or inputs They are used in the production process (combined) to get, at the end of the process a given output (a good or a service) 3/ Goods/services Goods: a good is a tangible thing of value that you can directly use for your own benefit (cloth, pencil, laptop...etc) - this is called a consumer good (used by consumers), or a capital good - used to produce other goods as an input (machine used to produce cars). Investment: the acquisition of a capital good is called investment Services: something not tangible of value (education, insurance, medical treatment, a hair cut...etc). 2. Scarcity and choice: the microeconomic question The question that could summarize the entire "Economic problem/question": how to satisfy unlimited human wants by a set of limited resources? Answering this question relies on answering three questions: what should be/is produced (available resources, human wants)? How is it produced (allocation of resources)? How to distribute what is produced? (Who gets what is produced)? 3. Opportunity cost Since the resources are limited (scarce) and the needs and wants of people are almost unlimited, there is a tradeoff: whenever a resource is used to produce a specific good/service, the society is sacrificing other goods/services that could have been produced with the set of resources used. The opportunity cost: to obtain more of one thing the society forgoes the opportunity of getting the next best thing that could have been created with those resources: that sacrifice is called the opportunity cost of the choice made (the good/service produced) D/ Scarcity, choice, and opportunity cost (revisiting Daniel Defoe’s “Robinson Crusoe”) 1/ Absolute advantage, comparative advantage, specialization, and exchange Absolute advantage: A producer (person, firm, country) of a certain good is said to have an absolute advantage over another producer, when he produces it with fewer resources; that is, at a lower cost (is more efficient). Suppose that Robinson and Friday have only 2 daily tasks: cutting logs of wood and gathering food (catching fish). Now suppose that Robinson is better than Friday in both activities ( he has an absolute advantage in both activities) (t0). (t0) Robinson and Friday’s daily production Wood (logs) Food (fish) Robinson 10 10 Friday 4 8 2 Let us examine what would be in this case the total monthly output, assuming that each one of Robinson and Friday wants an equal number of logs and fishes  i) since Robinson’s daily output is 10 logs and 10 fish  he only needs to split the month equally in terms of days allotted to cut logs and days allotted to fish  15 (days ) × 10; and 15 (days) × 10; ii) since Friday’ s productivity in terms of cutting logs is half his productivity in terms of fishing, he will need to allocate twice the time needed for fishing to cut woods  20 (days) × 4 and 10 (days) × 8 (t1) Monthly production, with no specialization and no exchange Wood (logs) Food (fish) Robinson 150 150 Friday 80 80 Total 230 230 Based on the above, Robinson could conclude that he should go and live on the other side of the island and do both tasks, because he will be better-off this way (t1). David Ricardo (late 18th century, early 19th century) begs to differ (he developed the theory of comparative advantage (CA) in his book “Principles of political economy” and showed the benefits from specializing/exchanging according to CAs). According to Ricardo, Robinson and Friday would benefit from specializing according to their respective comparative advantage and from trading To grasp Ricardo’s analysis, let us first define the concept of CA Comparative advantage: A producer of a given good is said to have a CA over another one if he produces the good at a lower opportunity cost. The example: Who has a CA in fishing?  Calculating Robinson’s opportunity cost of fishing (the number of logs he should give up in order to get an additional fish the relative price of a fish in terms of logs of wood): Robinson can either cut 10 logs per day or catch 10 fish per day  to get an additional 10 fish he must give up 10 logs of wood  to get an additional fish Robinson should give up 1 log of wood  Robinson’s opportunity cost of a single fish is 1 log  Calculating Friday’s opportunity cost of fishing: Friday can either cut 4 logs of wood per day or catch 8 fish per day  to get an additional 8 fish he should give up 4 logs  to get a single fish he should give up only 0.5 log  Friday’s opportunity cost of a single fish is half a log All in all, Friday has a CA over Robinson in terms of fishing Who has a CA in cutting wood?  Calculating Robinson’ s opportunity cost of cutting wood (the number of fish Robinson should give up in order to get an additional log of wood  the relative price of a log in terms of fish): Robinson can either cut 10 logs per day or catch 10 fish per day  to get an additional 10 logs of wood he must give up 10 fish  to get one additional log, he 3  will give up only 1 fish  Robinson’s opportunity cost of cutting 1 log of wood is a single fish  Calculating Friday’s opportunity cost of cutting wood: Friday can either cut 4 logs of wood per day or catch 8 fish per day  to obtain 4 additional logs he must forgo 8 fish  to obtain 1 additional log he must forgo 2 fish  Friday’s opportunity cost of cutting 1 log of wood is 2 fish All in all, Robinson has a CA over Friday in terms of cutting wood Let us now see if Ricardo got it right: i) if specialization implies a higher total output (t2) and ii) if trade can make both of Robinson and Friday better off (t3) 1/ Specialization: When we say that, according to Ricardo, each producer should specialize in the production of the good in which she/he has a CA => she/he must devote most of her/his resources to produce that good Suppose that Friday spends all his time in fishing  he will catch 240 fish/month (8 × 30). Also, suppose that Robinson spends 3 days on fishing and 27 days on cutting logs  he will catch 30 fish (10 × 3) and will cut 270 logs of wood (10 × 27) (t2) Monthly production with specialization Wood (logs) Food (fish) Robinson 270 30 Friday 0 240 Total 270 270 Notice that the total output (in terms of logs and fish) is now greater than that of the situation without specialization ((t1), where total output was 230 units of both logs and fishes) 2/ Exchange: Let us now check how the exchange (t3) can indeed make each one of Robinson and Friday better-off relatively to (t1) Suppose that Robinson and Friday specialize each according to their CA (t2) and that Robinson gives 100 logs to Friday in exchange for 140 fish  Robinson will have 170 logs and 170 fish; whereas Friday will have 100 logs and 100 fish (t3) Monthly production with specialization and trade Wood (logs) Food (fish) Robinson 170 170 Friday 100 100 Total 270 270 Notice that the total output (in terms of both logs and fish) is higher than that of (t1), and that each one of Robinson and Friday is better off relatively to (t1) Ricardo did get it right! All the subtlety of Ricardo’s argumentation lies in the fact that he took into consideration the opportunity cost. In fact, the analysis of CA is one of the most subtle, 4  important and counterintuitive concepts in economics. Stanislaw Ulam (a mathematician) once challenged Paul Samuelson (economist, Nobel prize laureate) to name one theory in all social sciences which is both true and nontrivial. Samuelson named David Ricardo’s CA E/ The Production Possibility Frontier (PPF) 1/ Definition The PPF shows all the possible combinations of goods and services that can be produced in a society if all of the society’s resources are i) fully and ii) efficiently employed (with fixed technology and resources). 2/ Illustration Illustration: the PPF/PP curve K goods A G F 800 550 C D Consumer goods 1100 1300 B The Y axis (the quantity of capital goods produced), the X axis (the quantity of consumer goods produced); Points on the curve: Extreme production choices: point A (if the economy produces only capital goods) and point B (if the economy produces only consumer goods); A production choice: any point on the PPF/PPC is a combination reflecting a certain amount of capital goods produced with a corresponding amount of consumer goods produced (given the assumptions): example: points F and C. The opportunity cost: 5 When an economy is operating at the PPF, the opportunity cost of additional capital goods is forgone consumer goods (from C to F): capital production increases (from 550 to 800 units  250 additional units), but consumer goods production decreases (from 1300 to 1100  200 units) → this is due to the fact that the only way to produce more capital goods, is a shift of resources out of the production of consumer goods to capital goods. The trade-off between consumer goods and capital goods  to have more of one type of goods we must forgo a certain amount of the other is reflected by the negative slope of the PPF The slope of a PPF is called the Marginal Rate of Transformation (From C to F) (the rate at which one good must be forgone in order to obtain an additional (marginal) unit of the other good). Points below and to the left of the curve: All points below and to the left of the curve represent combinations of goods that are possible given the available resources and technologies of production; what is interesting about such points is that, starting from a given point inside the PPF (say point D) the economy can produce more of each type of goods. This can be due to i) unemployed resources and/or ii) inefficiently used resources. Points outside of the curve: Point G → a combination of goods which is not attainable given the available resources and technologies of production; The law of increasing opportunity cost: Points on the PPF Total corn production Total wheat production (millions of bushels/year) (millions of bushels/year) A 700 100 B 650 200 C 510 380 D 400 500 E 300 550 6  Corn 700 A B 650 C D 400 E 300 Wheat 100 200 500 550 Illustrating the concept via a numerical example (from E to D; and then from B to A): moving from E to D → we get 100 million additional bushels of corn by sacrificing 50 million bushels of wheat (the opportunity cost of a bushel of corn in terms of wheat is 0.5 bushel). Moving from B to A → we can get only 50 million additional bushels of corn by sacrificing 100 million bushels of wheat (the opportunity cost of a bushel of corn in terms of wheat is 2 bushels)  Greater quantity of wheat must be given up in order to produce one more bushel of corn is needed. This is why the curve is concave Explaining the concept: suppose that the demand for corn increases → farmers would likely shift some of their land from wheat production to corn production  from point C towards points B and A. As this happens, it becomes more difficult to produce additional corn (the best land for corn was presumably already used for corn, and the best land for wheat was presumably used for wheat)  (as farmers shift to produce more corn, the land will become less suited for the latter + as farmers take more land out of wheat production, they are taking increasingly better wheat- producing land)  the opportunity cost of additional corn production in terms of wheat increases  As an economy specializes in the production of one product (corn), the opportunity cost of producing it increases, because we are using more and more resources that are less suitable to produce it it reflects the fact that resources are not easily interchangeable across different sectors of production 7 Note on linear PPF: this can exist in reality between sectors where the factors of production are not very specialized and can be substituted for each other without additional cost. Example: bread and pastry → labor in both sectors has practically the same expertise/skills  a continuous movement from one sector to another will not induce higher opportunity cost (there will be a constant opportunity cost). Economic growth: When the economy is growing it means that its potential maximum output increases. Graphically it is represented by an outward shift of the PP curve. This might happen when some of the assumptions are no longer fixed:  larger stock of/better resources  better/new technology If we consider the agricultural sector (use of fertilizers, tractors and other equipments, more efficient farming techniques/or larger number of more skilled farmers/agricultural engineers) K goods 2000 1970 C goods 8