Week 1 Economics - Basic Tools of Economic Analysis PDF

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Week 1 Economics – Basic Tools of Economic Analysis       

Basic Micro-Economics Factors of production Opportunity cost The role of prices Economic models The theory of comparative advantage – that an agent will produce more and consume less of a product for which they hold a comparative advantage Comparative advantage – when an agent can produce a good at a lower opportunity cost or greater autarky (self-sufficiency) price

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Factors of production Land (natural resources) Labour (quality and quantity) Capital (physical not financial e.g. machinery, vehicles, factories etc.) Time is also a scarce resource

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Microeconomics – the study of the allocation of scarce resources to satisfy competing needs

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Opportunity Cost Choices need to be made Costs are incurred in making choices – the choices that are lost when another is made (the next best alternative that is lost) This is an opportunity cost The opportunity cost is the next best alternative forgone in choosing the given action Also the quantity of goods that must be sacrificed in order to obtain another unit of that good

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The economic system The economic system comprises: A finite set of resources A population with unlimited wants A social control mechanism that allows scarce resources Central planning system: a government that makes micro-decisions in terms of trade and quantity of goods (i.e. communist Cuba) Free market economy: an economy where goods, price and trade are selfdetermined Invisible hand: we see people who are providing good services as doing it for the customers, however under the radar he is producing high quality goods so that he can feed his family

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Central planning systems may be used because the market is unstable or to contain scarce resources or spread them out equally

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Prices as a social control mechanism The price system is the “automatic” social control mechanism The price system co-ordinates the de-centralised decisions of individuals For this reason Adam Smith described the price system as the ‘invisible hand’ Invisible hand: by serving yourself, you are also serving the interests of others

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Prices perform three functions: They provide information – high prices indicate good quality They provide incentives – low prices are attractive They determine who gets how much of what

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Valuing economic output allows us to compare apples and oranges, rather than compare two very different products we can compare their prices

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Profit as a criterion for production Π=Price-Cost= P-C Assumes: P= “willingness to pay” = value to user C = true cost of resources used in production

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Centrally Planned Systems: The “very visible hand” Central planner decides what is produced, how and for whom Problems with data requirements, bad incentives etc.

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Governments and Markets: Most common outcome: somewhere in the middle between free market and control Sometimes the price system fails to produce efficient results This leads to market failure – sometimes control is good

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Positive vs Normative Statements: Positive statements are descriptive and assert things about the world They are mostly testable “if the price for X rises, the demand for X falls”

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Normative statements are prescriptive and assert how things ought to be They are not testable

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Economic Models

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Simplified representations of reality

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Assumptions The motives of the decision makers such as consumers and producers The physical relationship between the variables The conditions under which the model applies

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Predictions (or implications) Monopoly markets dominating sales of a product

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Empirical Evidence and Measurement Time series (TS) A sequence of measurements of the same variable at different points in time

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Cross Section (CS) Measurement of an economic variable across different individuals or groups, at a point in time

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Panel A mixture of TS & CS: measurement of an economic variable across different individuals at different points in time

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Comparative Advantage: As an individual, one may have a comparative advantage over something over another because the opportunity cost or autarky is lower “if I am better at football than running, I have a comparative advantage with football as spending an hour doing it will give me more reward”

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Comparative vs Absolute Advantage: A country has an absolute advantage in producing a good if more of that good can be produced relative to another country using the same resources A country has a comparative advantage in producing a good relative to another country if its opportunity cost of producing the good, relative to the other country, is lower

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Adam Smith argued that absolute advantage was required for gains from trade

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David Ricardo showed only a comparative advantage is required for gains from trade

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The Production Possibilities Frontier (PPF) The PPF gives all the combinations of goods an economy can produce if it makes full use of all its factors of production:

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Full employment Efficiency

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The diagram shows the PPF for an agent to produce smartphones and food simultaneously

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Point D is the point at which the agent is only producing smartphones and is at its maximum output for the production of smartphones

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Point E is the point at which the agent is at its maximum output for the production of food

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It is unlikely that an agent would be producing goods at either of these points if the agent is one that needs to produce both smartphones and food

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More likely is that the agent would be operating at one of points A, B or C, where the production of each is balanced so that both can be produced in as efficient a way as possible

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Point G, along with any point inside the frontier would be seen as inefficient production and therefore the agent would not produce goods at this point

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Point F, along with any point outside the frontier, is unattainable when the resources of the agent are considered

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The frontier is a curve or ‘bowed’ in this case, this is due to the opportunity cost incurred by producing the goods increasing as time goes on

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If there is a constant opportunity cost, the PPF will be linear, i.e. a straight line

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The opportunity cost is the amount of one good that must be used in order to produce a certain amount of the other good

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Shape and Position of the PPF The shape and position of the PPF is determined by: Endowment of factors of production

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Technology

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Example 1: if there is a uniform technological improvement, the curve will expand outwards at the same magnitude all the way along

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Example 2: if there is sector-biased technological improvement, as in if an agent decided to improve the production facilities for smartphones but not for food, point D on the curve would move up the Y-axis, however point E would remain in the same position on the X-axis (this would cause the curve to expand around point D, but gradually decrease back to normal as it approached point E

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Example 3: if there is an increase in the endowment of capital, assuming that the production of smartphones is more capital-intensive than food, the curve will expand at all points however not in a uniform way

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Example 3 cont.: both points D and E would move up the axes but point D would move up the Y-axis more than point E would move along the X-axis

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Comparative Advantage Example What determines what goods a country imports/exports? Can there be mutual gains from trade even if a country is less productive than its trading partner in all sectors? What is the mechanism through which countries gain from trade?

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Assuming:

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We are considering two economies: UK and US

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There are two sectors: wheat and cloth

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One factor of production: labour (100 workers in each country)

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The table shows output per unit of labour

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The US has an absolute advantage over the UK as it produces more cloth and more wheat with the same number of workers (the only factor of production we are considering)

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To determine who has the comparative advantage we must look at the opportunity cost

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The output per unit of labour in the UK is 5 for wheat and 2 for cloth

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There are 100 workers

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Therefore, the maximum amount of goods that can be produced at any one time is 500 for wheat and 200 for cloth

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5 extra units of wheat means 2 less units of cloth, because when each good is at maximum production, the other is at 0

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So, the opportunity cost for wheat for the UK is: 200/500 = 2/5

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The output per unit of labour for the US is 20 for wheat and 6 for cloth

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With 100 workers that means maximum output is 2000 for wheat and 600 for cloth

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Therefore, the opportunity cost for wheat for the US is: 600/2000 = 3/10

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So, if we compare the UK’s opportunity cost of 2/5 (4/10) with the US’s opportunity cost of 3/10 we see that the opportunity cost for wheat the US is lower therefore the US holds a comparative advantage

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However, if we were to calculate the opportunity cost for cloth the UK would hold a comparative advantage as its opportunity cost would be 2.5 compared to the US’s 3.33 and so it would have a comparative advantage in cloth

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So, applying this information to trade, we could see that:

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If the US exports 20 units of wheat to the UK, it has sacrificed 6 units of cloth

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But if the UK wanted to produce 20 units of cloth it would have to use 8 units of cloth to do so

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Hence, the UK is willing to pay up to 8 units of cloth and the US looking for over 6 units

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Therefore, a mutually beneficial deal can be struck...