Agenda Econ 200 Session 13
1. Using the Principle of Comparative Advantage to discuss a conventional
wisdom: We lose our jobs to jobs in low wage countries.
2. The Production Possibility Frontier for an economy with many producers
3. The marginal cost of production and the supply curve for a good
a. How the private interests of producers and the public (consumers’) interest
may coincide in production of goods and services
4. The marginal cost of production and the supply curve for a good—the industry
5. What are rents and why do they exist?
6. Are rents just a transfer from consumers to producers or are they a resource
7. What is the role of clearly defined property rights in economic efficiency
8. Some insights on Efficiency versus Equity
Readings for Thursday, Nov. 18: Chapter 6, Sections 6.2-6.5, and 6.7
Readings to be done before Tuesday, Nov. 23: Chapter 7, Sections 7.1 and
Problems to do with your peer group (or on your own) from Chapter 6:
“Review Questions”: numbers 1-6 and in the “Problems” section: numbers 1-
16, 18-20, and 24-25.
The information about the material of Quiz 5 (held on Friday, Nov. 19) is
posted on the course website in the “Announcement” section. The same
section will display the information for your quiz 6 (held on Friday, Dec. 3)
by Saturday, Nov. 20.
These notes highlight important concepts that are covered in the lectures. They
may not coincide exactly with the materials discussed in this particular session.
These summary notes are provided as a scaffold to focus your learning.
Summary Notes for Session 13-Econ 200
Chapter 6--Costs and Production
Extension of the principle of comparative advantage to international trade: If
specialization and trade (free international trade) are so good, why are there
people who oppose free trade?
The main argument against free international trade: We lose our jobs to lower
Let’s try a scenario that disproves this conventional wisdom.
It is true that people around the world buy goods from a country that can produce
it relatively cheaply. So a country that produces a good cheaper will keep the jobs
for its workers since the goods will be produced in this country (and exported to
the rest of the world).
Suppose US worker earns $15 per hour in T-shirt production.
An Egyptian worker earns $3 per hour.
U.S. is the high wage country and if we freely trade with them, we will lose our
jobs in the apparel industry in the U.S. since the cost of shirt is lower in Egypt
(due to low wage) and consumers would prefer to purchase the lower priced
Suppose an American worker can producer 6 T-shirts in an hour.
An Egyptian worker can produce 1 T-shirt in an hour.
Cost of a T-shirt produced in US is --------
Cost of a T-shirt produced in Egypt is -------
Which country has comparative advantage in T-shirts?
Which country will be losing its apparel industry? Which country will keep its
The main points:
The difference in wages is not the reason we lose our jobs to other countries.
In the above example, our wages are 5 times those of Egyptians! But we are
6 times as productive. So even though we are the high wage country, indeed
the cost of production of shirts are lower in the U.S. and the U.S. has
comparative advantage in apparel!
On the other hand, if our productivity is close to the productivity of Egyptian
workers but our wages are higher, then we do not have comparative
advantage in apparel.
Deriving the economy’s PPF with many producers
First remember the PPF with Tom and Don:
4 fish, 10
Up to 10 coconuts, the MC of coconut is ---------
If we want more than 10 coconuts, the MC of an additional coconut is ---------
Now suppose we add one more person—Kathryn Blondell (the make-up artist for
Movie “Cast Away”!) to this island economy:
Kathy’s PPF is:
Fish Kathy’s Production
Adding Kathy to the joint PPF of Tom and Don:
No. of Joint Production
Fish Possibility Frontier of
Don, Kathy, and Tom
The maximum amount of fish is 13 and the maximum amount of coconuts is
The Production Possibility Frontier with many producers—Deriving the MC
A Smooth PPF!
Frontier with many Producers
Guns Production Possibility Frontier
with many Producers
10 20 30 Butter
10 20 30 Q of Butter
Why does the marginal cost of production of butter rise as we produce more
We term the above phenomenon:
“Increasing Costs at the Extensive Margin!
What is the definition (or characterization) of MC?
Why does the MC of a good rise as the level of output of this good increase?
How do we define the Supply curve of a producer?
Marginal Cost and Supply:
Suppose an oil company is drilling for oil in a vast area.
This firm has various drilling sites.
Each site produces 1000 barrels per day.
These sites are not uniform in that some sites are easy to get the oil out of
and in some, oil is in deep ground and requires more drilling, and it is more
Consider the easiest drill site first. Suppose it costs $ 5 per barrel to drill the
1000 barrels a day in this site.
For the second 1000 barrels, we have to go to the slightly deeper site (2nd
site) and that costs $10 per barrel to dig the oil out. For the 3rd 1000 barrel, it
costs $15 per barrel and so forth.
1 2 3 4 Oil in thousands
The total cost of 1000 barrels of production of oil is $5,000.
For 2000 barrels, the total cost is $5,000 + $10,000 = $15,000
For 3000 barrels, 5,000 + 10,000+ 15,000 =$ 30,000
It is -------- for 4000 barrels per day. This represents society’s cost of producing
4000 barrels per day. This means that labor and other resources that must be used
to produce 4000 barrels per day, could have been used to produce ---------- dollars
worth of other goods and services.
1 2 3 4 Oil in thousands
Now suppose that the market price of oil is $15 per barrel and at that price,
consumers will buy whatever output this firm produces. Which sites will be
drilled and what is the total cost to the society of this output?
The first drill site can produce 1000 barrels at $ 5 per barrel, and selling it for $15
so there is a $10 profit per barrel. The firm -------- (will or will not) voluntarily
employ the first site for production of 1000 barrels of oil.
For the 2nd site, it costs $10 per barrels, and the firm can make profit of $5 per
barrel so the 2nd site will also be drilled.
For the 3rd, it costs $15 and the price is $15 so the firm is indifferent. According to
our earlier reasoning (on consumer demand, chapter 2) the producers do indeed
take up this site too.
For the 4th drill site, it costs $---- per barrel and the firm makes a -------- (profit or
loss) of $---- per barrel so it ---- (will or will not) drill this site.
If the firm uses the 4th site, the value of output in this economy would decrease by
the excess cost over consumers’ MV of oil.
The drill site 4 costs consumers $20,000 worth of other goods in the economy
while they only value it at $15,000.
Since this cost is borne by the operators of the drill site, no coercion is necessary
to stop them from drilling, they would do so voluntarily.
1. If rights to the operation of drill sites are clearly defined, the private
interest of the mine operator and the public interest of consumers coincide.
2. The supply curve for oil
If price of oil goes up to $20 per barrel, then how many sites will be drilled?
What is the supply curve for oil production?
The supply curve is the MC curve!
Given a market price, the producer of a good produces a quantity up to where
price = MC
3. How do we define the industry supply curve (with many producers of a
The industry supply curve is simply the lateral sum of firm’s MC curves.
4. What are rents and why do rents exist?
Are rents just payments that make some people rich, or are they an essential
mechanism of allocating resources to their most valuable use (i.e., efficient
The textbook explains this question in page 212 via an example. We will do a
different example—taking a case from privatization of state property in Russia
after the fall of socialism—in our lecture session.
An interpretation of rents: In the following graph of supply of bread, where the
price is given at $2 per unit (demand is considered perfectly elastic at P = $2),
rents show the excess of valuation of consumers over the value/cost of resources
used in bread production (the Total Value of bread to consumers in the graph
below is $2*100 = $200).
This means that the producers of bread, using the most cost effective ways of
producing bread from raw material (wheat) and using labor and capital are
producing a product that consumers value above and beyond the value of those
resources used. This is the contribution of the entrepreneur and their “reward” is
the rent accrued to them in the production of this and other goods.
To see the importance of rents from a different angle, suppose the consumers’
demand for bread rises in an economy. Consumers want more bread and they
signal this desire to the producers by the way of a higher price that they are willing
to pay for this good. The higher price of bread raises the potential for earning
increased rent in this sector. It is indeed the incentive for earning this potential
reward that drives the producers to divert scarce resources (labor, land, and
machinery) away from production of another good, say rice, and into the
production of more bread to comply with consumers’ desire.
P = $2
Cost of resources
Q = 100 Q of bread
What are property rights, and, what do clearly defined property rights have
to do with the efficient allocation of resources (and occurrence of rents)?
We use examples of property rights and explain the role of clearly defined and
legally enforced property rights in efficient allocation of resources. There is an
example provided in page 212 of the textbook. We do a different example in our
How do we define economic efficiency?
Revisited from Chapter 4:
A corollary/conclusion to our understanding of the role of rents in economic
Presence of rents in a system of clearly defined and enforced private property
ensures efficiency (maximum gains from trade and allocation of resources to
production where consumers value them most). If we consider all goods produced
in this fashion, we can say that in a market economy, clear definition, protection,
and enforcement of private property rights leads to maximization of the total value
of our production (or, visually, we reach maximum size of the “economic pie”).
Economic pie with
Economic pie with efficient use of resources
inefficient use of resources
However, since in this system some individuals receive rents (that others do not),
the slices of the large economic pie—distributed to each individual—will be
unequally cut. In other words, in such an economy, some people will receive more
income than others. Therefore an economy with an efficient allocation of
resources may also be an unequal one where there are large disparities between
incomes of different groups. These types of economies also utilize new
technologies, inventions, improvements in skill of their workforce, etc. better than
economies with inefficient mechanism of allocation and so efficient economies
tend to grow more over time (the size of the economic pie increases over time).
At the margin, the governments may create some “re-distribution of income”
schemes as an attempt to alleviate some of the inequity in a market economy. This
means they devise ways in which they take some income from those with large
slices (those with high income) and give them to those with small slices of the
economic pie (low income individuals). In other words, there may be some trade-
off between equity and efficiency at the margin where government decides to
sacrifice a little efficiency to get a little more equity. Can you name some of the
redistribution schemes that governments use?
Ironically, attempts to equalize the income of citizens (i.e., giving equal slices of
the economic pie to each person) usually results in having neither equity nor
efficiency! In other words, when the governing body engages in major re-
distribution schemes, the economy ends up with both a smaller value of output and
also with lots of inequity! These economies are usually awash in corruption and
non-price types of competition as different groups and individuals compete and
struggle to grab larger slices of the fixed (i.e., non growing) pie. Those who are
successful in ensuring larger slices (thus leaving less for others) are the ones who
know people in high places or have relationships to highly ranked government
In an economy concentrated on growth, people spend their resources producing
goods and services. If the government in this economy now instead concentrates
on “re-distribution”, many would give up productive activity and “stand in line”
or join the line for getting some of what government is distributing. In other
words, with private property, growth results as productive resources are efficiently
used. The advent of “redistribution” is similar to that of “common” property
problem (we study this issue in Ch. 7) where there are gains up for grabs by
citizens. In this case productive activity and many gains from trade are lost as
people use their time and other resources to “grab” some of what is being