ECON 110 Introductory Microeconomics

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ECON 110Introductory Microeconomics

• Lecture 3
• Fall, 2009
• William Chow

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Highlights

• Concept of Allocative Efficiency
• Implication of Economic Growth
• Comparative Advantage
• Absolute Advantage

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Allocative Efficiency

• The is a single point on the PPF that implies a
  special kind of efficiency that other points
  dont
• This point achieves what we call allocative
  efficiency
• To understand this, we need to introduce notions
  of Marginal Cost and Marginal Benefit

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Marginal Cost

• The marginal cost (MC) of a good or service is
  the opportunity cost of producing one more unit
  of it
• Consider butter production in our example, the
  slope of the PPF opportunity cost of producing
  an additional unit of butter
• An MC curve is like the following

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Marginal Benefit

• The marginal benefit (MB) of a good or service is
  the benefit received from consuming one more unit
  of it
• It is obvious that this relates to the
  preferences of consumers
• marginal benefit is amount that a person is
  willing to pay for an additional unit of a good
  or service

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Marginal Benefit

• What is this MB like?
• It is a declining function in quantities
  consumed, as in the next diagram
• Recall the hamburger example, the more you have
  eaten, the less satisfaction you get from
  additional hamburgers

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Allocative Efficiency

• In terms of resources allocation, the optimum is
  achieved when the MB equals MC
• Consider producing 1.5 tons of butter, the MC is
  2 guns while the MB of consuming this 1.5 tons
  of butter is 4 guns
• The cost of producing this amount of butter is
  less than what consumers are willing to pay (in
  terms of MB)

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Allocative Efficiency

• For 3.5 tons of butter, the opposite is true
• The MC of producing it is 4 guns vs. the MB
  derived, which is just 2 guns
• Both cases imply NO efficiency in an allocative
  sense

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Allocative Efficiency

• At 2.5 tons of butter, however, both MC and MB
  3 guns
• This point is allocative efficient because there
  is no mismatch in resource usage
• Note There is only one point on the PPF that
  corresponds to this allocative efficiency

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Economic Growth

• For any country, their PPF can shift outwards
  if they experienced economic growth
• This usually comes as a result of human capital
  accumulation or technological advancement

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Trade

• Another extension of PPF analysis is to impose 2
  PPFs (for 2 economies) in the same diagram
• We can understand the production capabilities of
  these 2 economies and how they can trade between
  themselves

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Trade

• Trade makes the concerned parties better off
• Comparative Advantage is the necessary and
  sufficient condition required for trade to take
  place
• E.g. China's accession to the WTO
• Tariffs will be lower. Trade will expand. Growth
  will be sustained.

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Trade

• European butter, milk powder, pasta, mandarins,
  olives and wheat gluten will be more accessible
  to Chinese consumers.
• China's edge in textiles, clothing, toys,
  consumer electronics and other labor-intensive
  products will gain access to overseas markets.
• This indicates a ''win-win'' situation.

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Trade

• Note that Tom can produce Either 1,333 cases Or
  4,000 discs
• The opportunity cost of producing 1 disc is 1/3
  case
• Opportunity cost is constant across all output
  levels
• The opportunity cost of producing 1 case is 3
  discs

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Trade

• Note that Nancy can produce Either 4,000 cases Or
  1,333 discs
• The opportunity cost of producing 1 disc is 3
  cases
• Opportunity cost is constant across all output
  levels
• The opportunity cost of producing 1 case is 1/3
  disc

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Comparative Advantage

• The cost of producing disc is lower for Tom
• Tom has a comparative advantage in producing disc
• The cost of producing case is lower for Nancy
• Nancy has a comparative advantage in producing
  case

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Comparative Advantage

• Nancy and Tom should specialize in what they are
  good at (what they can produce more cost
  effectively)
• Tom should use all resources for production of
  disc, and Nancy should concentrate on case
• Now determine the terms of trade

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Comparative Advantage

• To have an idea of this, consider the following
  question
• By focusing on disc production, how many cases
  can Tom exchange in return by giving up the 4,000
  discs he produces
• The maximum possible is 4,000 cases which Nancy
  produces

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Comparative Advantage

• That means a term of trade where you trade 1 unit
  of case for 1 unit of disc is acceptable by Tom
• Same is true for Nancy, although they dont have
  to trade all they produced
• The term 11 is exactly the slopes of the 2 PPFs
  at the point of intersection

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Absolute Advantage

• A person (or country) has an absolute advantage
  if that person (or nation) can produce more goods
  with a given amount of resources than another
  person (or nation) can
• Because the gains from trade arise from
  comparative advantage, people can gain from trade
  if they also have an absolute advantage

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Absolute Advantage

• This is because comparative advantage concerns
  about the slopes of PPFs
• Absolute advantage concerns how far out the PPFs
  lie