Final Summary ECON1101 PDF

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Chapter 1: Comparative Advantage and the Basis for Trade    

Model: Simplified representation of reality Less is more: The model must be simple to understand Has to be testable and verifiable: is the model true? Is the data outside predicting the reactions of my model? A model has agents, assumptions and resources (resources are scarce)

One Agent Economy   

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There are only 2 possible activities There are only 2 individuals When trading there are no o Transaction costs (negotiation/transportation) o Barriers (import quotas, tariffs) The amount of resources used to perform a productive activity is called productivity o Resources are scarce: Often we operate in a constrained environment (financial, time constraints)

Production Possibility Curve (PPC) If we bring together Extreme and Intermediary scenarios, we create a Production Possibility Curve (PPC). We join the 2 extreme points in a graph to obtain intermediary points. The largest value should be plotted in the x-axis. Definition: The Production Possibility Curve captures all maximum output possibilities for two (or more) goods, given a set of inputs (or resources - i.e. time) if inputs are used efficiently.

Efficient Production Point Represents a combination of goods for which currently available resources do not allow an increase in the production of a good without a reduction in the production of the other 

All points on the PPC are efficient production points, given ALL the time (resources) are used

Inefficient Production Point An Inefficient Production Point represents a combination of goods for which currently available resources allow an increase in the production of one good without a reduction in the production of other 

All the points below and to the left of the PPC are inefficient, given all the resources are not being used (for example, only 14 hrs are worked instead of the 16)

Attainable Production Point An attainable production point represents any combination of goods that can be produced with the currently available resources  

All the points on the PPC, or below and to the left of the PPC are attainable All these points are producing an output (producing)

Unattainable Production Point Represents any combination of goods (bananas and rabbits that cannot be produced with the currently available resources (Alberto’s time) 

All the points that lie outside of the PPC are unattainable, there is not enough time

Two Agents Economy When consumption needs are unattainable with one agent, add another Absolute Advantage

An agent (or an economy) has an Absolute Advantage in a productive activity when he can carry the activity with less resources (time) than another agent Opportunity Cost The Opportunity Cost of a given action is the value of the next best alternative to that particular action  

Trading our time of collecting one thing instead of the other (How many rabbits am I missing on collecting if I’m collecting bananas?) Slope of the PPC = rise/run

Calculating Opportunity Cost  OC Action 1 = loss in action 2 / gain in action 1 (denominator is always what you are after) o For action 2, just invert the results  No agent can have a comparative advantage in both goods.  If an agent has an advantage in good 1, then the other will have an advantage for good 2 When solving OC problems: For example, OC of taking 2 hours off work to see a movie. Forego the lowest value activity. Highest profit of working + price of movie = OC 

Also, confirm the resources are equal across all goods, whether it’s minutes, or hours, make the measure equally before solving.

Comparative Advantage When an agent (or economy) has a lower opportunity cost of carrying an activity than another agent 

No agent can have a comparative advantage in both goods. o If an agent has an advantage in good 1, then the other will have an advantage for good 2

Gains from Specialization 

Specialisation from comparative advantage: Only dedicating to that activity

Principle of comparative advantage Everyone is better off if each agent (or each country) specializes in the activities for which they have a comparative advantage 

The gains from specialisation grow larger as the difference in opportunity cost increases

Trading in a two-agent economy  

When purchasing a product, it will be worthwhile to buy as long as the price of the product is less than the opportunity cost of producing that product When selling a product, it will be worthwhile to sell at a price that is more than the opportunity cost of producing that good

The cost of a product should be greater than or equal to the opportunity cost of the buyer and less than or equal to the opportunity cost of seller

PPC in two-agent economy

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Any combination of goods that lies on this economy-wide PPC will result in the use of ALL inputs Any combination of goods that lies below/to the left of this economy-wide PPC indicates an underutilisation or inefficient use of resources The opportunity cost of bananas increases (the gradient of the blue slope becomes steeper). o This is due to the fact that resources are scarce

Drawing a 2 person PPC 1. Draw and label your axes 2. Calculate extreme values a. Everyone makes product A b. Everyone makes product B 3. Determine who will go first on the X-axis (first agent) a. Principle of low hanging fruit: Lowest opportunity cost first 4. Plot your kink point for first agent a. In Y-axis, subtract the number of maximum goods they can produce from the extreme point b. In X-axis plot the number for maximum capacity 5. Connect the 3 extreme points a. First portion of the PPC will be the 1st agent b. Second portion and more steep will be the 2nd agent Principle of Increasing Opportunity Cost (Low Hanging Fruit): In the process of increasing the production of any good, first employ those resources with the lowest opportunity cost and only once these are exhausted turn to resources with higher cost. 

Need to have resources available: Capital, labour, technology

The main factors driving economic growth (pushing the economy-wide PPC out and to the right) come from an increase in inputs. This can come in the form of:  an increase in infrastructure such as factories, equipment, etc  an increase in the population, such so in the labour force  advancements in knowledge and technology (education, R&D, IT and communications technologies)

Trading between economies   

Closed economy: CPC and PPC are the same Open economy: trade on the intern market. CPC is to the right and above the PPC Consumption opportunities in an open economy are always wider than in a closed one!

Consumption possibility curve

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The Consumption Possibility Curve represents all possible combinations of two goods that the agents in the economy can consume o Different definition when it is open to international trade: The Consumption Possibility Curve represents all possible combinations of two goods that the economy can feasibly consume when it is open to international trade If a country is an open economy (trades on an international scale), the CPC is usually greater than the PPC because part of what domestic agents produce can be traded for other goods which relieves restrictions on consumption o Since PPC is always below CPC, we can conclude that consumption opportunities in an open economy are always wider than in a closed one Changes in the international price can change the CPC

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What should an economy consume? This depends on preferences

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PPC in a 2-agent economy

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Begin drawing PPC with the 2 agents (in grey) For CPC, begin with a point in the PPC and count how you would trade (2 kgs of banana for 1 kgs of rabbit)

PPC in a Many-agent economy

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Start by considering the two scenarios in which all workers collect bananas or catch rabbits. This gives you the points on the x & y axis With just two agents, the curve started to arc from its origin. With millions of agents, this will translate to a smooth arc o Low hanging fruit principle Remember that this slope reflects the opportunity cost of 1 kg of bananas in terms of forgone rabbits As we increase the quantity of bananas produced, the PPC slope also increases, meaning the opportunity cost rises As in the two-agent case, if we need more bananas, we will assign the task to the agent with the lowest opportunity cost at picking bananas in the economy. If society wants even more bananas, it will be necessary to employ another agent that has a higher opportunity cost than the first agent

Critiques to the model 1. No psychological cost: Human beings enjoy variety and performing the same activity can result in dissatisfaction 2. No transaction cost: Did not account for transaction costs associated with trading (negotiation costs, transportation costs) 3. No import quotas or tariffs: Would limit the gains from specialization and render it pointless 4. No change in preferences: Demand for goods which an economy specialises in can change and furthermore, social norms (political, religious) can also prevent trade

Chapter 2: Supply in Perfectly Competitive Markets Market The set of all the consumers and suppliers who are willing to buy and sell that good or service at a given price. Market Equilibrium 

Occurs when the price and the quantity sold of a given good are stable

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o They do not change Or occurs when the equilibrium price is such that the quantity that consumers want today is the same as the quantity that suppliers want to sell. o Consumers and customers do not deviate o No surplus on the market – same offer and demand

Perfectly Competitive Market Characteristics 1) Consumers and Suppliers are price takers: Both suppliers and consumers are not willing/able to affect the equilibrium price (if suppliers increased price, consumers will buy from competitor and suppliers will lose profits if they reduced prices. If consumers try to ask for lower price, supplier will just serve another customer and there is no incentive for customer to pay a higher price) 2) Homogenous goods: all suppliers sell exactly the same product 3) No externality: an externality is a cost or benefit that is incurred by someone who is not involved in the production or consumption of a certain good 4) Goods are excludable and rival: suppliers can prevent consumers from consuming a certain good (excludability) and once consumed, that good becomes unavailable to other customers (rivalry) 5) Full information: the suppliers and the consumers are perfectly informed regarding the characteristics of the good (price and quality of good) 6) Free entry and exit: there is no cost to entry and no penalty for leaving

Supply Curve for an Individual

Marginal time is the time it takes to complete one action (per unit). -

Total time take into account the sum of all (stacking units together).

Marginal Benefit The Marginal Benefit of producing a certain unit of a given good is the extra benefit accrued by producing that unit. -

For a producer, MB is the marginal revenue In a perfectly competitive market, marginal revenue = market price

Marginal Cost The Marginal Cost of producing a certain unit of a given good is the extra cost of producing that unit. -

(The relevant cost includes the “opportunity cost” and not just the “absolute cost” of producing the good.)

Cost-Benefit Principle The Cost-Benefit Principle states that an action should be taken if the marginal benefit is greater or equal than the marginal cost -

Producers use it to determine the optimal quantity to produce, where MB = MC

Economic Surplus The Economic Surplus of a certain action is the difference between the marginal benefit and the marginal cost of taking that action. MB – MC when MB >= MC. If the result is negative and MB < MC, then it is an economic deficit. Quantity Supplied The Quantity Supplied by a supplier represents the quantity of a given good or service that maximizes the profit of the supplier. (quantity of supply until the marginal benefit < marginal cost) Profit (pi) Total revenue (TR) – Total Cost (TR). Where Revenue = price * quantity supplied Cost = quantity supplied * avg cost/unit

Supply Curve The Supply Curve represents the relationship between the price of a good or service and the quantity supplied of that good or service. -

MC above AVC in short run Upward slope

Law of supply The tendency for a producer to offer more of a certain good or service when the price of that good or service increases. Supply Curve for an Individual Supply curve can be interpreted: 

Horizontally: Start from a certain Price and then use the supply curve to derive the Quantity of goods that will be supplied at that price.

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Vertically: Start from a given Quantity, find the associated Price on the supply curve

Producer Reservation Price The minimum amount of money the producer is willing to accept to supply the marginal unit of the good

Supply Curve for a firm Everything discussed still applies. However, costs for a company vary:

Factors of productions = fixed or viable Sunk Cost A cost that once paid cannot be recovered. For example, the interest for a loan. -

All sunk costs are fixed costs

Fixed Cost A Factor of Production is Fixed when its cost does not vary with the quantity produced. Example: Machinery, same cost does not matter production.  Not all fixed costs are sunk costs  Fixed costs may include opportunity costs Variable Cost If a Factor of Production is Variable, when its cost tends to vary with the quantity produced. A Variable Cost is a cost associated with a variable factor of production. Example: Labor. -

Variable costs may include opportunity costs. For example, lost hours of work.

Short Run The Short Run is a period of time during which at least of one factor of production is fixed.  

Producers must at least cover their VCs in the short run The short-run supply curve is the portion of the marginal cost curve that lies above the average variable cost curve.

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Price must be greater than or equal to min AVC

Long Run The Long Run is a period of time during which all factors of production are variable. -

Price must be greater than or equal to min ATC Producers must make a profit

Production costs in the presence of a fixed cost

Shut Down Condition (Short Run): In the short run, the entrepreneur should shut down production if π production (TR – TC) < -FC. In shut down Q=0. So, π shut down = 0 – FC = -FC Otherwise, she should hire the optimal number of workers and continue operations. In Stef’s example, profit = 8, π shut down = -100. Therefore, she should continue production.

Shut Down Condition (Long Run): In the long run, fixed costs are 0. In the long run, the entrepreneur should exit the industry if π production < 0. Otherwise, she should hire the optimal number of workers and continue operations. Continue operations if π exit >= 0. π exit = TR (0) – TC (Variable costs)  Why? All factors are variable in the long run  Exiting the industry brings zero profit: π exit = 0

From a Discrete to a Continuous Model Discrete

MC = Marginal Cost ATC = Average total cost AVC = Average variable cost (Last 3 columns in table) Optimal quantity

At a certain price (marginal revenue), simply extend that line until it intersects the marginal cost curve and see what quantity it corresponds to Shut down (short run)

Seeing if the price line is below the minimum point on the AVC (Average Variable Cost Curve) Shut down (long run)

They should shut down if the price is lower than the minimum of the ATC (average total cost) curve Profit

The stripe between MC and ATC. Quantity is first given by MC, then follow the line down until it intersects with ATC. -

If a perfectly competitive firm faces a price that is higher than its average total cost, then it will operate in the short run and the long run, and will maximise profit by producing where MR = MC

Important supply curve analysis 

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The supply curve for a firm is equal to the Marginal Cost (MC) curve o Only for values that are higher than the minimum AVC (in the short run) o Only for values that are higher than the minimum ATC (in the long run) o When the firm is producing The MC curve eventually increases with quantity produced (subject to increasing marginal costs) due to productivity losses/decrease o When a firm produces a quantity such that AVC is minimized, MC equals AVC The MC curve cuts the AVC curve and ATC curve at their minimum points In the long run, the AVC curve would become identical to the ATC curve (this is not shown in the diagram above) because all costs become variable (fixed costs don’t exist)

What shifts the supply curve to the right (increase supply): • Drop in the price of (variable) inputs • Advancements in technology (via its impact on productivity) • Expectations (on future prices/demand going up) • Drop in the price/demand of other products • Increase in number of suppliers

Price Elasticity of Supply The Price Elasticity of Supply represents the percentage change in the quantity supplied resulting from a very small percentage change in price. It also measures the responsiveness of the supply to changes in price. - Elasticity: How responsive quantity supplied is to changes in price

Other case If given P = 2Q + 10 - 10 is the Y-intersect - 2 is the slope - Price is given, replace P for value and solve equation to obtain Q - Then use slope formula o Example if Q=10 and P=30: 30/10 x ½ = 1.5 Law of Supply Supply curves have the tendency of being upward sloping. -

When price increases, supply increases

Elastic Supply: Supply is elastic when the price elasticity of supply is greater than 1. Unit Elastic Supply: Supply is unit elastic when the price elasticity of supply is equal to 1. Inelastic Supply: Supply is inelastic when the price elasticity of supply is less than 1. -

Elasticity is not the same at each point

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E = 0 -> Perfectly Inelastic

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E = Infinity -> Perfectly Elastic

What changes the elasticity of supply (4 determinants):

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Availability of Raw Material: Large availability = elastic supply and vice versa

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Factors mobility: the more mobile factors of production are, the higher the elasticity o

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Inventories/excess capacity: the larger amount of inventories, the higher the elasticity o

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Factory workers going on strike reduce elasticity

Loss of inventory reduces elasticity of supply

Time horizon: Time horizon is the length of time in which a producer has to respond to a change in price. A longer time horizon leads to a higher elasticity because they can search for more efficient inputs and revise production plans o

Reducing timeframes reduces supply elasticity

* Increased availability of substitutes does NOT increase elasticity of supply

Chapter 3: Demand in a Perfectly Competitive Market Demand curve for an individual Utility Represents the satisfaction that an individual derives from consuming a given good or taking a certain action. It is measured in utils per unit of time. Decreasing Marginal ...