<< back to the main page

This page is best viewed with Mozilla Firefox or Apple Safari.

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.

...

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's opp. cost of making clothes:

one day 12 clothes one day 10 bushels = 10 bushels 12 clothes = 0.833 bushels clothes

Jack's opp. cost of making clothes:

one day 5 clothes one day 8 bushels = 8 bushels 5 clothes = 1.600 bushels clothes
  • Jill has a comparative advantage in making clothes because her opportunity cost of making clothes is less than Jack's.

Jill's opp. cost of gathering food:

one day 10 bushels one day 12 clothes = 12 clothes 10 bushels = 1.200 clothes bushels

Jack's opp. cost of gathering food:

one day 8 bushels one day 5 clothes = 5 clothes 8 bushels = 0.625 clothes bushels
  • 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).

...

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

relative price of clothes:

$1/clothing $1/bushel = 1 bushel clothing

relative price of food:

$1/bushel $1/clothing = 1 clothing 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's opp.
cost clothes
< rel. price
clothes
0.833 bushels clothes < 1.000 bushels clothes

...

  • Jill should not gather food because her opportunity cost of gathering food is greater than the relative price of food.
Jill's opp.
cost food
> rel. price
food
1.200 clothes bushels > 1.000 clothes bushels

...

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.

...

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.
Jack's opp.
cost food
< rel. price
food
0.625 clothes bushels < 1.000 clothes bushels

...

  • Jack should not make clothes because his opportunity cost of making clothes is greater than the relative price of clothes.
Jack's opp.
cost clothes
> rel. price
clothes
1.600 bushels clothes > 1.000 bushels clothes

...

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.

...

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

...

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.

...

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

...

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

...

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.

...

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.

...

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.

...

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.

...

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?

...

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

© 2017 Eryk Wdowiak

<< back to the main page