Microeconomics

Lecture 02
Opportunity Cost and Relative Price

The Economic Problem

• What will be produced?
• Basic needs -- food, clothing, shelter
• Non-essentials -- fish tanks, televisions
• Capital goods -- machinery, tools, human skills, etc. to produce other goods


• How will it be produced?
• What resources are available?
• How should labor and capital be allocated to the production of each of the various products?


• Who will get what is produced?
• How should the products be allocated among members of society?

...

The Theme of International Trade Theory

• Countries gain from trade,
• if they specialize in producing the goods
• in which they have a comparative advantage,
• although there may be distributional effects to consider.

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Comparative Advantage

• The US has a comparative advantage in the production of a particular good, if the opportunity cost of producing that good is lower in the US than it is in other countries.
• Opportunity Cost -- how much of one good you must give up in order to gain more of another
• Unit Labor Requirement -- amount of labor needed to produce one unit of a good

...

Jack and Jill

• Jack and Jill are standed on a desert island. To survive, they must gather food and make clothes.
• Jill can make 12 clothes per day or gather 10 bushels of food per day
• Jack can make 5 clothes per day or gather 8 bushels of food per day

• Jill has a comparative advantage in making clothes because her opportunity cost of making clothes is less than Jack's.

• Jack has a comparative advantage in gathering food because his opportunity cost of gathering food is less than Jill's.


• Notice that Jill has an absolute advantage in the production of both goods,
• but she has a comparative advantage in the production of only one good (clothes).

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Relative Price

• If Jill and Jack valued clothes and food equally, then they would trade one clothing for one bushel of food.
• If you prefer to think in terms of dollar values:
• let the price of clothes be one dollar per clothing: $1/clothing
• let the price of food be one dollar per bushel: $1/bushel

Jill's Specialization: Making Clothes

• Jill should specialize in producing clothes because her opportunity cost of making clothes is less than the relative price of clothes.

...

• Jill should not gather food because her opportunity cost of gathering food is greater than the relative price of food.

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Jill's Gains from Trade

• By specializing in making clothes and trading her clothes for food, Jill receives more food than if she gathered food herself.
• If Jill were to trade the 12 clothes that she produces in one day at a rate of one bushel per clothing, she would receive 12 bushels.
• That's more food than Jill can produce in a day. Jill can only produce 10 bushels of food per day.

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Jack's Specialization: Gathering Food

• Jack should specialize in gathering food because his opportunity cost of gathering food is less than the relative price of food.

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• Jack should not make clothes because his opportunity cost of making clothes is greater than the relative price of clothes.

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Jack's Gains from Trade

• By specializing in gathering food and trading his food for clothes, Jack receives more clothes than if he produced clothes himself.
• If Jack were to trade the 8 bushels of food that he gathers in one day at a rate of one clothing per bushel, he would receive 8 clothes.
• That's more clothes than Jack can produce in a day. Jack can only produce 5 clothes per day.

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Gains from Trade

• Even though Jill can produce both goods more efficiently, she gains by specializing in clothes (the good in which she has a comparative advantage) and trading her clothes for food with Jack.
• analogy:   America gains by trading with less developed countries


• Even though Jack is less efficient at producing both goods, he gains by specializing in food (the good in which he has a comparative advantage) and trading his food for clothes with Jill.
• analogy:   less developed countries gain by trading with America

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Lower Productivity ⇒ Lower Wage

• Recall the dollar prices of each good: $1/bushel and $1/clothing
• Jill produces 12 clothes per day, so her wage is $12 per day.
• Jack produces 8 bushels per day, so his wage is $8 per day.


• This is why the factory workers (in a foreign country) who made your sneakers, receive a much lower wage than you do. On average, their workers produce less than American workers.

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The Theme of International Trade Theory

• Countries gain from trade,
• if they specialize in producing the goods
• in which they have a comparative advantage,
• although there may be distributional effects to consider.
• workers who are not working in the sector where the country has a comparative advantage will be adversely affected by free trade
• For example, in America, steel workers, textile workers and farmers are adversely affected by trade

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Production Possibilities Frontier

• PPF represents all combinations of goods that can be produced if resources are used efficiently
• one can produce at or below the PPF, but not above it.

>>   insert   graph   <<

• In one day, Jill can:
• make 12 clothes or gather 10 bushels
• or produce a combination, such as: 6 clothes and 5 bushels.

• In one day, Jack can:
• make 5 clothes or gather 8 bushels
• or produce a combination, such as: 2.5 clothes and 4 bushels.

• Slope of the PPFs (above) is: -1*opp. cost of gathering food

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Gains from Trade

• Add a red line whose slope represents the relative price:

• If Jill specializes in making clothes:
• she can trade some of her clothes for bushels of food and
• consume a combination that exceeds any combination that she could produce on her own.
• If Jack specializes in gathering food:
• he can trade some of his bushels of food for clothes and
• consume a combination that exceeds any combination that he could produce on his own.

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Production Function

• Quantity produced is a function of capital and labor:
• Q = f (K, L)
• If you have one unit of kapital (for example, one stove in a kitchen),
• and you keep increasing number of workers (labor) at that machine the quantity produced will increase
• but at a decreasing rate
• because the workers start to get in each other's way
• "too many cooks in the kitchen"

>>   insert   graph   <<

• Q = f (K, L)
• This production function is drawn for a fixed amount of capital.

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Production Possibilities Frontier

>>   insert   graph   <<

• PPF represents:
• all the possible combinations of goods (and services)
• that can be produced,
• if resources are used efficiently.
• Production possibilities are constrained by amount of labor and capital in the economy.
• Cannot produce above PPF
• If we shift labor from production of X and into production of Y,
• less X will be produced
• more Y will be produced
• PPF summarizes opportunity cost of all such shifts.
• If resources are not used efficiently
• labor unemployment,
• inefficient management
• the economy is producing at a point below the PPF.

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Cuba's Ten Million Ton Sugar Harvest

• In the 1960s, Cuba produced about 6 to 7 million tons of sugar a year, which was sold primarily to countries in the Soviet bloc.
• Beginning in 1969, Cuban dictator Fidel Castro sent hundreds of thousands of urban workers into the fields in an effort to produce 10 million tons of sugar in 1970.
• Ultimately, Cuba missed its goal, but managed to produce 8.5 million tons -- the largest harvest in Cuban history.

What were the effects on Cuban economy?

• For simplicity, assume that before the plan:
• Cuba produced 6 million tons of sugar and 5 million tons of "everything else"
• relative price of sugar was one ton of everything else per ton of sugar,
• at a relative price of , Cuba traded 2 million tons of sugar for 2 million tons of everything else and
• consumed 4 million tons of sugar and 7 million tons of everything else

massive disruptions in the Cuban economy

• Since Cuba allocated all of its production to sugar, it produced at the "sugar corner" of its PPF.
• At that corner, the opportunity cost of producing sugar exceeds the relative price of sugar.

• For simplicity, let's pretend that Cuba:
• succeeded in producing all 10 million tons of sugar, but didn't produce anything else
• at a relative price of , Cuba traded 6 million tons of sugar for 6 million tons of everything else and
• consumed 4 million tons of sugar and 6 million tons of everything else
• So (in this example) Cubans consumed the same amount of sugar, but
• their consumption of everything else fell from 7 million tons to 6 million tons -- a 15 percent decrease.

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sweet it wasn't

>>   insert   graph   <<

• Q: Would a 15 percent decrease in consumption of everything else a massive disruption in the economy?
• A: If you could consume the same amount of sugar that you did last year, but your consumption of everything else fell 15 percent,
• would you be happy?

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lesson from Cuba's experiment

• a country should produce at the point along its PPF, where the opportunity cost of producing a good (ex. sugar) equals the relative price of that good
• Cubans suffered because their country produced at a point where the opportunity cost of producing sugar exceeded the relative price of sugar
• Similarly, had Cuba allocated all of its resources to producing "everything else" and produced no sugar it also would have suffered
• because at such a point, the opportunity cost of producing everything else would have been greater than the relative price of everything else
• (from the opposite perspective...) because at such a point, the opportunity cost of sugar would have been less than the relative price of sugar

Why did Jack and Jill completely specialize in one good?

• A country should completely specialize in the production of one good
• ONLY if the relative price of that good is greater than the country's opportunity cost of producing it at every point along the PPF
• Jack and Jill's opportunity cost was constant all along their PPFs
• the PPF I drew for Cuba assumes increasing opportunity cost -- i.e. Cuba's opportunity cost of producing sugar increases as it produces more sugar

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