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Economics -Production and Trade

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Prof. Rushen's Notes for MBA and BBA Students

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									           ECONOMICS



           Production and Trade
               Prof. Rushen Chahal




2/7/2012        Prof. Rushen Chahal
                           Today

I.         Opportunity cost
II.        Scarcity and choice
III.       The production possibilities frontier
IV.        The circular flow of money
V.         Trade and comparative advantage
VI.        Review questions



2/7/2012                  Prof. Rushen Chahal
                           Today

I.         Opportunity cost
II.        Scarcity and choice
III.       The production possibilities frontier
IV.        The circular flow of money
V.         Trade and comparative advantage
VI.        Review questions



2/7/2012                  Prof. Rushen Chahal
                      Opportunity Cost
   Consider the following:

   I only drink Yanjing Beer and smoke Zhongnanhai
   Cigarettes

   1 bottle of Yanjing beer = 1.5RMB
   1 pack of Zhongnanhai cigarettes = 4.5RMB

   If I buy 1 pack of cigarettes, that is 3 less bottles
   of beer that I can buy.

   Therefore the opportunity cost of 1 pack of cigarettes
   is 3 bottles of beer



2/7/2012                         Prof. Rushen Chahal
               Opportunity Cost

Definition:
In a world of scarcity, choosing one thing means
giving up something else. The opportunity cost
of a decision is the value of the good or service
forgone.
                           (Samuelson, 1998)



2/7/2012               Prof. Rushen Chahal
                Opportunity Cost
  • I love DVDs, I also like food
  • Let’s say one meal at the double pig restaurant costs
    me 21RMB and one DVD costs me 7RMB

  • Question:
  • What’s the opportunity cost of one meal at the
    double pig restaurant?
  • Answer:

  • By eating one meal at the restaurant, I’m giving up 3
    DVDs

2/7/2012                Prof. Rushen Chahal
    Opportunity cost – concept check
•   Who has an MP3 Player?
•   How much did it cost?
•   What’s the opportunity cost of that MP3 player?
•   What’s the opportunity cost of eating a meal at KFC?
•   What’s the opportunity cost of coming to class today?
•   What’s the opportunity cost of studying at ICB?




2/7/2012                Prof. Rushen Chahal
                          Today
I.         Opportunity cost
II.        Scarcity and choice
III.       The production possibilities frontier
IV.        The circular flow of money
V.         Trade and comparative advantage
VI.        Review questions



2/7/2012                  Prof. Rushen Chahal
             Scarcity and Choice
The Facts of Life:

- Resources are, and always will be, limited
- The amount of goods an economy can produce
  is determined by how many resources are
  available at a given time
- Given a set amount of available resources, an
  economy must decide how to cope with these
  limited resources.

2/7/2012              Prof. Rushen Chahal
           Scarcity and Choice
An Economy must choose:

- among different potential bundles of goods
   (what?)
- among different techniques of
  production(how?)
- who will consume the goods produced (for
   whom?)

2/7/2012           Prof. Rushen Chahal
            Scarcity and Choice
To answer these three questions, every society
must make choices about the economy’s inputs
and outputs.

Inputs are commodities or services that are used
to produce goods and services.

Outputs are the various useful goods or services
that result from the production process.

2/7/2012              Prof. Rushen Chahal
           Scarcity and Choice
Consider the production of pizza.

Inputs:
Eggs, flour, heat, pizza oven, chef’s labor

Output:
Pizza

2/7/2012             Prof. Rushen Chahal
           Inputs and Outputs – Concept
                      Check
•   What about the production of tea?
•   What are the inputs?
•   What are the outputs?
•   What about the production of 地三鲜?
•   What are the inputs?
•   What are the outputs?
•   What about the production of cars?
•   What are the inputs?
•   What are the outputs?

2/7/2012              Prof. Rushen Chahal
              Scarcity and Choice
Inputs are also known as “factors of production”:

The five categories of resources are:
•    Land (natural resources)
•    Labor (people’s work time)
•    Entrepreneurship (personal initiative to combine resources
     in productive ways; involves risk)
•    Technology
•    Capital (goods that increase productivity)
   – Human capital
   – Physical capital (buildings, equipment, machines)


2/7/2012                  Prof. Rushen Chahal
           Captial: WARNING!!!!!
 • In a finance and accounting class, what does
   capital mean?
     – It simply means money
 • In economics, capital DOES NOT MEAN
   MONEY!!!!!!
 • Capital in economics means the things that we
   use to produce things:
     – E.g. physical capital: factories, machines, etc
     – Human capital: Educated people
   • Generally speaking in this class, when we talk
        about capital, we’ll be talking about physical
2/7/2012capital             Prof. Rushen Chahal
                          Today
I.         Opportunity cost
II.        Scarcity and choice
III.       The production possibilities frontier
IV.        The circular flow of money
V.         Trade and comparative advantage
VI.        Review questions



2/7/2012                  Prof. Rushen Chahal
           The Production Possibilities
                    Frontier
Resources and technology are limited.

This scarcity limits an economy’s options, forcing
it to choose what and how much to produce.

When you analyze all of the different possible
choices a country could make, the result is the
production possibilities frontier.


2/7/2012               Prof. Rushen Chahal
                             The PPF
                                                        Six alternative combinations
   Production Possibilities frontier on
                                                        of fish and coconuts
   Castaway Island
     Data     Fish       Coconuts
                                                   25 F
     Point    caught     collected
                                                                 E
                                                   20                D
              per day    per day
                                                                             C
     A        5          0



                                        Coconuts
                                                   15
     B        4          10                                                          B
                                                   10
     C        3          16
                                                   5
     D        2          19
                                                   0                                     A
     E        1          21
                                                        0    1       2   3       4       5
     F        0          22
2/7/2012                      Prof. Rushen Chahal                    Fish
      The Production Possibility Frontier
  Definition:
  The production possibility frontier (or PPF)
  shows the maximum amounts of production
  that can be obtained by an economy, given its
  technological knowledge and quantity of
  inputs available. The PPF represents the
  menu of goods and services available to
  society.
                           or
  PPF is


2/7/2012               Prof. Rushen Chahal
                                                   The PPF
Data Point   Fish caught   Opportunity cost    Marginal
             per day       (total number of    opportunity   Opportunity Costs
                           coconuts forgone)   cost
                                               (change in
                                                             Total Marginal 22
                                               number of       1        1    21
                                               coconuts
                                               forgone)        3        2
                                                                             19                    F      E
F            0             0                   N/A             6           3                                      D
                                                                                          16
                                                                                                                      C




                                                                           Coconuts
E            1             1                   1
                                                               12          6
D            2             3                   2                                                                              B
                                                                                          10

C            3             6                   3
                                                               22          10                                                     A
B            4             12                  6
                                                                                      0        1   2          3   4       5
A            5             22                  10                                                      Fish


     2/7/2012                                            Prof. Rushen Chahal
           The Law of Increasing Costs

As the production of a product increases,
the opportunity cost of each additional
unit increases.

Stated another way: for each extra fish I
catch, I am giving up more and more
coconuts

2/7/2012             Prof. Rushen Chahal
                           The Law of Increasing Costs
Data Point   Fish caught   Opportunity cost    Marginal
             per day       (total number of    opportunity   Opportunity Costs
                           coconuts forgone)   cost
                                               (change in
                                                             Total Marginal 22
                                               number of       1        1    21
                                               coconuts
                                               forgone)        3        2
                                                                             19                    F      E
F            0             0                   N/A             6           3                                      D
                                                                                          16
                                                                                                                      C




                                                                           Coconuts
E            1             1                   1
                                                               12          6
D            2             3                   2                                                                              B
                                                                                          10

C            3             6                   3
                                                               22          10                                                     A
B            4             12                  6
                                                                                      0        1   2          3   4       5
A            5             22                  10                                                      Fish


     2/7/2012                                            Prof. Rushen Chahal
                                                             A
                                                                     B
                                                            15
                                                                               C
Possibilities   Butter      Guns
                (millions   (thousands)                     12




                                          Guns *thousands
                of
                pounds)                                                                      D
A               0           15                              9

B               1           14                              6                                          E
C               2           12                              3
D               3           9                                                                              F
                                                            0
E               4           5
                                                                 0   1         2            3          4   5
F               5           0
                                                                         Butter (millions of pounds)
    2/7/2012                                Prof. Rushen Chahal
                       A
                      15                 B                                      Points J and I are outside the
                                                                                production Possibilities Frontier,
                                                          C                     and are thus

                      12                                                    J   unattainable with the given
    Guns *thousands


                                                                                available amount of inputs.

                                                                                D                I
                      9                  G

                      6                                                                        E
                           Points G and H are inside
                           The Production Possibilities
                                                               H
                      3    Frontier, indicating the economy
                           has not attained productive
                           efficiency

                      0                                                                                           F

                           0              1               2                 3                4                5
2/7/2012
                                                   Butter (millions of pounds)
                                                      Prof. Rushen Chahal
           Characteristics of the PPF
  • In summary:
  1) The ppf shows how much of one good can be
     produced for any amount of another

  2) When on the frontier, the opportunity cost of
     one good is less of the other good

  3) The frontier

  4) Every point on the frontier is technologically
     efficient economic growth
2/7/2012                Prof. Rushen Chahal
        Characteristics of the PPF
 • In summary:
 5) Points inside the frontier imply unemployed
    resources

 6) Points outside the frontier are unattainable with
    current resources and technology

 7) Shifting the frontier outward implies


  8) If the economy qcquires resources that are
       specialized in the production of a certain good,
       the ppf expands outward in the direction of more
2/7/2012                    Prof. Rushen Chahal
                                  Shifting the PPF
                   24
                   21
 Guns *thousands




                   18
                   15
                   12
                    9
                    6       Possibilities Expand
                    3
                    0
                        0     1         2              3        4    5   6
                                       Butter (millions of pounds)
When the PFF shifts outwards, the economy experiences economic growth
2/7/2012                                  Prof. Rushen Chahal
                                  Shifting the PPF

                     24
                     21
                                               Possibilities Shrink
   Guns *thousands




                     18
                     15
                     12
                      9
                      6
                      3
                      0
                          0   1       2              3          4     5   6
                                     Butter (millions of pounds)
  When the PFF shifts inwards, it is a sign of negative economic growth
2/7/2012                                  Prof. Rushen Chahal
                                       Shifting the PPF
                  24
                  21
Guns *thousands




                  18
                  15
                  12
                   9
                   6          An increase in productivity
                   3          of one product
                   0
                         0        1             2                3        4          5              6
                                             Butter (millions of pounds)
                    If new technology is introduced that can only apply to one industry, then the
                    PPF shifts out like this
              2/7/2012                              Prof. Rushen Chahal
           Specialized Growth
• Specialized growth pivots the production
  possibility frontier in the direction of more
  output in the industry affected by the
  technological change.




2/7/2012            Prof. Rushen Chahal
                     The PPF
• The PPF shows all of the different possible
  combinations of output an economy is able to
  produce
• The actual combination of goods an economy does
  produce is decided through the interaction of
  consumers and producers
• Stated simply, consumers will use their money to buy
  goods, and their decisions of what to buy will affect
  producers decisions about what to produce


2/7/2012              Prof. Rushen Chahal
                          Today
I.         Opportunity cost
II.        Scarcity and choice
III.       The production possibilities frontier
IV.        The circular flow of money
V.         Trade and comparative advantage
VI.        Review questions



2/7/2012                  Prof. Rushen Chahal
           The Circular Flow Of Money
• Money is a medium of exchange
• It is a representation of value
• It allows people to buy and sell goods
• Without money, people would have to
  exchange goods directly
• Barter: the exchange of goods and services
  directly for one another, without the use of
  money
• Imagine how I would buy things if there were
  no money
2/7/2012             Prof. Rushen Chahal
           The Circular Flow of Money
• Money flows to and from businesses/firms, and to
  and from households/individuals
• This can be better shown by the circular flow of
  money diagram
• The circular flow of money shows how markets use
  the medium of money to determine what gets
  produced, and who gets to buy the goods
• The model depicts both the input market and the
  output market


2/7/2012             Prof. Rushen Chahal
              The Circular Flow Model
                of Economic Activity
                      Goods & Services


                         $ Purchases



 Households                                     Businesses


                           $ Incomes



              Land, Labor, Capital, Entrepreneurship
2/7/2012                  Prof. Rushen Chahal
                          Today
I.         Opportunity cost
II.        Scarcity and choice
III.       The production possibilities frontier
IV.        The circular flow of money
V.         Trade and comparative advantage
VI.        Review questions



2/7/2012                  Prof. Rushen Chahal
 Trade and Comparative Advantage
•   Economies will trade with other economies
•   This will be beneficial to both economies
•   What is trade?
•   What countries does China trade with?
•   How do you think this benefits China?




2/7/2012             Prof. Rushen Chahal
 Trade and Comparative Advantage
• Trade is going to benefit all involved
• Through trade, an economy can have access to
  more goods than it would if it simply relied on
  its own production capability (depicted by the
  PPF)
• Let’s take a look at how trade benefits
  economies


2/7/2012            Prof. Rushen Chahal
Comparative Advantage Vs. Absolute
            Advantage
  • Absolute advantage: The ability to produce a good
    with fewer resources than other produces.
  • So, if one economy (China) can produce a good
    (bicycle) using less resources than another economy
    (Korea), we say China is having an absolute
    advantage over Korea in making bicycle.
  • Example: USA may require 200 labor hours to
    produce one car
  • Japan may require only 150 labor hours to produce
    one car
  • Japan has an absolute advantage over USA in the
    production of cars
2/7/2012               Prof. Rushen Chahal
           Comparative advantage Vs.
              Absolute advantage
• Comparative advantage: The ability to produce a good at a
  lower opportunity cost (other goods forgone) than others
  could do.
• So, if an economy (China) can produce a good (Table) at a
  lower opportunity cost than another country (Korea), we say
  China is having a comparative advantage over Korea in making
  table.

• This suggests that each country will produce goods that they
  are best at producing
• Let’s take a look at how this works, using international trade
  as an example

2/7/2012                   Prof. Rushen Chahal
           Trade and Comparative
                 Advantage
   • Countries will trade with each other
   • Exports are goods that are produced in the home
     country, and then sent to another country for
     consumption
   • Imports are goods that are produced in another
     country, and then brought to the home country
     for consumption
   • Through imports and exports, an economy can
     consume more than it could if it were to rely on
     it’s own productive capability (at a point outside
     the PPF
2/7/2012                Prof. Rushen Chahal
           Exports as a Percentage of GDP




2/7/2012              Prof. Rushen Chahal
           Specialization According to
            Comparative Advantage

  Country Computer Memory Chips             Barrels of Oil
   Japan     10 units per day                4 per day
  England     5 units per day                3 per day

              Productivity per worker in
                 Japan and England


2/7/2012              Prof. Rushen Chahal
       Country Computer Memory Chips                  Barrels of Oil
        Japan     10 units per day                     4 per day
       England     5 units per day                     3 per day

Product Location      Opportunity Cost                Opportunity Cost
                      (C is computer chips and B is
                      Barrels of oil)
                                                          (per unit)

Computer chips in                                        2/5 barrel of oil
                              10C=4B
    Japan                                                     (.4B)*
Computer chips in                                       3/5 barrel of oil
                                5C=3B
   England                                                    (.6B)
                                                      5/2 computer chips
    Oil in Japan              4B=10C
                                                             (2.5C)
                                                      5/3 computer chips
  Oil in England
 2/7/2012                       3B=5C
                             Prof. Rushen Chahal
                                                            (1.67C)*
   Trade and Comparative Advantage
• Japan will produce computer chips, as it has a
  comparative advantage in producing them
• England will produce oil, as it has a comparative
  advantage in producing oil
• The countries will then trade, benefiting both of
  them
• Don’t worry too much about how this works for
  them moment, just be aware that




 2/7/2012               Prof. Rushen Chahal
     Comparative Advantage: Concept
                 Check
Which country has an absolute
advantage in producing MP3             Country        MP3     PS2
players?                                              Players
Answer:
Which country has an absolute
advantage in producing PS2             Country A 20          5
Answer:

Yes, Country A has has an
absolute advantage in                  Country B 15          3
producing both PS2 and MP3
players
But what about comparative
  2/7/2012                      Prof. Rushen Chahal
advantage?
      Comparative Advantage: Concept
                  Check
What is the opportunity cost of
producing 20 MP3 players for        Country        MP3     PS2
country A?                                         Players
5 PS2
1 MP3 player?                       Country A 20          5
5/20 (0.25) PS2

Therefore, the opportunity cost
of producing one MP3 player         Country B 15          3
in country A is 0.25 PS2


 2/7/2012                    Prof. Rushen Chahal
      Comparative Advantage: Concept
                  Check
What is the opportunity cost of
producing 15 MP3 players for        Country        MP3     PS2
country B?                                         Players
3 PS2
1 MP3 player?                       Country A 20          5
3/15 (0.20) PS2

Therefore, the opportunity cost
of producing one MP3 player         Country B 15          3
in country B is 0.20 PS2


 2/7/2012                    Prof. Rushen Chahal
      Comparative Advantage: Concept
                  Check
The opportunity cost of
producing 1 MP3 player for          Country        MP3     PS2
country A is 0.25 PS2                              Players
The opportunity cost of
producing 1 MP3 player for          Country A 20          5
country B is 0.20 PS2

As a result, Country B will
produce MP3 players, as it has      Country B 15          3
a comparative advantage in
producing them

 2/7/2012                    Prof. Rushen Chahal
      Comparative Advantage: Concept
                  Check
What is the opportunity cost of
                                         Country   MP3     PS2
producing 5 PS2 for country A?
20 MP3 players                                     Players
1 PS2?
20/5 (4) MP3 Players                     Country A 20     5
Therefore, the opportunity cost
of producing one PS2 in country
A is 4 MP3 players                       Country B 15     3



 2/7/2012                    Prof. Rushen Chahal
     Comparative Advantage: Concept
                 Check
What is the opportunity cost of
                                         Country   MP3     PS2
producing 3 PS2 for country B?
15 MP3 players                                     Players
1 PS2?
15/3 (5) MP3 Players                     Country A 20     5
Therefore, the opportunity cost
of producing one PS2 in country
A is 5 MP3 players                       Country B 15     3



 2/7/2012                    Prof. Rushen Chahal
     Comparative Advantage: Concept
                 Check
The opportunity cost of
                                          Country   MP3     PS2
producing one PS2 in country A
is 4 MP3 players                                    Players
The opportunity cost of
producing one PS2 in country B            Country A 20     5
is 5 MP3 players

As a result, Country A will
produce PS2 as it has a                   Country B 15     3
comparative advantage in
producing them

 2/7/2012                     Prof. Rushen Chahal
                 To Sum Up
• First today we looked at the concept of
  opportunity cost
• Opportunity cost is the value of the next best
  option we give up when we make a decision
• The opportunity cost of my buying 1 pack of
  Zhongnanhai cigarettes is 3 Yanjing Beers




2/7/2012            Prof. Rushen Chahal
                    To Sum Up

   • We then saw that in an economy, resources are
     scarce
   • We must decide what we are going to produce,
     given the amount of resources/inputs we have
     available
   • We saw that in economics, we are generally going
     to consider land, labor, and capital as our
     inputs/resources
   • Remember, capital does not mean money in
     economics, but rather things like factories, etc.
2/7/2012               Prof. Rushen Chahal
                    To Sum Up
• We then looked at the production possibilities frontier
  (PPF)
• The PPF shows all of the different combinations of output
  we can make, given the amount of scarce inputs we have
  available
• The PPF can shift out, as our productive capabilities
  increase
• Points inside the PPF are technologically inefficient
• Points on the frontier of the PPF are technologically
  efficient
• Points outside of the PPF are unattainable

 2/7/2012               Prof. Rushen Chahal
                  To Sum Up
• We then looked briefly at the circular flow of money
• This concept will become even more important as we
  look at macroeconomics in the second half of the
  semester
• Just realize for now that money is flowing to and
  from businesses, and to and from individuals and
  households




2/7/2012              Prof. Rushen Chahal
                   To Sum Up
  • Finally we looked at the concept of trade and
    comparative advantage
  • We saw that a country has a comparative
    advantage when it is able to produce a good at a
    lower opportunity cost than another country
  • Countries will produce goods which they have a
    comparative advantage in
  • They can then trade with other countries,
    allowing them to consume more than they would
    have been able to if they relied solely on their
    own productive capability

2/7/2012               Prof. Rushen Chahal
                    To Sum Up
• Today has been another largely introductory
  day
• Some key concepts you will definitely want to
  remember:
      – Opportunity Cost
      – The PPF
      – Comparative Advantage



2/7/2012               Prof. Rushen Chahal
                       Test Yourself

1. The opportunity cost of a new city police contract
   is:
a.     the amount of money it takes in order to provide the city
       with the most highly qualified personnel.
b.     the value of the other goods and services that the city and
       taxpayers will be forced to give up in order to pay for the
       contract.
c.     the cost to victims of crimes that the new contract would
       prevent.
d.     the value of the opportunities that city policemen acquire
       by accepting it.
 2/7/2012                    Prof. Rushen Chahal
                Test Yourself

2. Which of the following items is the best
   example of an economic resource?
a. A stock certificate.
b. A one-hundred dollar bill.
c. A tractor.
d. A plate of spaghetti.


2/7/2012            Prof. Rushen Chahal
                 Test Yourself
3. A production possibilities frontier shows
   combinations of:
a. inputs that can produce a specific quantity of
   output.
b. outputs that people consume.
c. outputs that can be achieved as technology
   improves.
d. outputs that can be achieved in a given time period
   with all available resources employed using current
   technology.
 2/7/2012             Prof. Rushen Chahal
                  Test Yourself
4. If a Nation’s production possibilities indicates that
   1,000,000 battle tanks and 6,000,000 houses could
   be produced, or alternatively, 750,000 tanks and
   8,000,000 houses could also be produced, the
   opportunity cost of each additional house would
   be:
a. 250,000 tanks.
b. 8 tanks.
c. 0.125 tanks.
d. 2,000,000 tanks.
 2/7/2012               Prof. Rushen Chahal
               Test Yourself

5. As a nation develops economically, its
   production possibilities frontier:
a. remains stable.
b. shifts towards the origin.
c. shifts away from the origin.
d. becomes steeper, but does not shift.


2/7/2012            Prof. Rushen Chahal
               Test Yourself

6. When a country can produce a good with
   fewer resources than any other country, the
   country has:
a. a comparative advantage.
b. a resource advantage.
c. an absolute advantage.
d. an unfair advantage.

2/7/2012           Prof. Rushen Chahal
                     Homework

• Test your self pages 51-52
      – Questions 1-20
      – Page 53: questions 3, 12
        Page 54: question 1a-1h
• Read in Ayers and Collinge pages 57-69



2/7/2012                 Prof. Rushen Chahal

								
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