Lecture 1:

Key concepts and comparative

advantage

Reading: NW Ch.1 & 4

 What is economics?
•  Economics is the study of choice under scarcity.
o  Scarcity is faced by consumers, businesses,
government, countries, and so on.
→ need to make choices

•  Key issues that need to be addressed in an
economy are:
o  (a) what to produce;
o  (b) how to produce it; and
o  (c) who should get what is made.

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 What is economics?
•  In a modern economy, these quesMons are typically resolved
in the ‘market’.

•  A market is a place where buyers and sellers of a parMcular

good or service meet.
o  Markets can look quite different: e.g., a tradiMonal bazaar, an
online trading site, an aucMon.

•  Even in market economies, governments play a criMcal role in

markets
o  because of “market failures” and/or distribuMonal issues
o  for example, by imposing regulaMons and taxes

•  Our focus is on the behaviour of individuals (consumers,

firms, government) in markets.
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 Plan for today
•  Start with some key ideas in economics:
–  Choice under scarcity
–  Opportunity cost
–  Gains from exchange/trade
•  Familiarize with the tools and the way of thinking of
economists
–  Marginal analysis
–  CorrelaMon vs causaMon
–  Ceteris paribus
–  Math refresher – on your own
•  Reading covered: NW Ch.1 & 4 (& 2 on your own!)

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 Scarcity and opportunity cost

•  Resources are limited, so that not all wants can be met –

this is scarcity.
o  For example, if an individual uses her money to buy one product,
she cannot use it to buy something else.

•  Because of scarcity, any choice involves a trade-off or

opportunity cost
o  = what we give up when we make that choice, or “the value of
the next best forgone alternaMve”.
o  This concept applies to any resource used when making a
choice: how an individual spends their Mme and other resources

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 Opportunity cost
•  Examples of opportunity cost:

–  On Saturday night you decide to watch a movie on

TV with your flatmate but you could have also
accepted a babysihng job for $25/hour.
•  What´s the opportunity cost of spending your Mme (2
hours) watching a movie on a Saturday night?

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 Opportunity cost
•  Examples of opportunity cost:

–  Elizabeth prefers to spend Saturday amernoon
walking. Her next best choice would have been to
sleep, and her third best choice is to go
swimming.
•  Therefore, if Elizabeth goes for a walk, the opportunity
cost of going for a walk is sleeping – her best foregone
opportunity.
•  The opMon of swimming is not relevant here, because it
is not the next best opportunity.
–  Q: What is the opportunity cost to you of a5ending this
lecture?
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 Opportunity cost
•  Opportunity costs include both explicit costs
and implicit costs.
o  Explicit costs are costs that involve direct payment (or, in
other words, would be considered as costs by an
accountant).
o  Implicit costs are opportuniMes that are foregone that do
not involve an explicit cost.

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 Opportunity cost
•  Example:

–  Stephen decides to go to university, and his next best

opMon is to work at a construcMon site and earn $80K
over the year.
•  Total Opportunity Cost = explicit costs + implicit costs
•  The explicit costs are those that Stephen must directly pay
to go to university, such as student fees, the cost of
textbooks, and so on.
•  The implicit costs are the opportuniMes that Stephen must
forgo – that is, working at the construcMon site and earning
$80K.

–  Q: What’s your opportunity cost of going to university (3yrs)?

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 Opportunity cost
•  Opportunity cost does not include unrecoverable
or sunk costs.
o  For example, a business spent $100m on an adverMsing
campaign last year and needs to decide whether to keep the
campaign going for another year.
o  It cannot recoup the money (or the effort) spent on last year’s
campaign by deciding to stop the campaign now
•  Thus $100m=sunk cost, not part of the total oppportunity cost of
conMnuing the campaign.

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 Marginal analysis
•  Marginal means addiMonal or extra. We use
the term repeatedly in economics.
o  Marginal benefit
o  benefit of an extra unit consumed for an individual
o  Marginal cost
o  addiMonal cost of buying one more unit

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 Marginal analysis
•  Marginal analysis is useful as it allows us to
examine the behaviour of individuals in market.
o  Compare Marginal benefit (MB) with marginal cost
(MC) of an acMvity
Ø  If the MB of an acMvity is greater than its MC, an agent is
beser off doing that acMvity
Ø  if the MB is less than the MC, they are worse off if they do.

•  Decision-making = thinking at the margin

•  Marginal analysis is a reoccurring theme in
economics.
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 CorrelaMon and causaMon
•  CorrelaBon – when two or more factors are
observed to be moving up, down in the
opposite direcMons together.

•  CausaBon – a change in one variable brings

about, or causes, a change in another variable.
o  Economic theory, providing a framework for how
the world works, allows us to disMnguish between
correlaMon and causaMon.

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 Ceteris paribus
•  In the real world, many things change at the
same Mme (prices, income, tastes, taxes, etc).
•  To isolate the impact of one factor, economists
examine the impact of one change at a Mme,
holding everything else constant – this is called
ceteris paribus (or ‘other things equal’).
o  If we are interested in the impact of the change in the
price of a good on the quanMty demanded, we analyse
this holding income, and any other relevant variables
constant.

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 ProducMon possibility fronMer (PPF)
•  A PPF graphs the output that an individual (or a
country) can produce with a parDcular set of
resources.

•  A country’s PPF shows all the combinaMons of goods

and services that a country can produce given its
resources and its current state of technology.
–  Note that if the country does not trade with others, the
PPF also describes the country’s consumpMon choices.

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 PPF: an example
Suppose a country can only produce 2 goods, guns and buser.
With its resources, it can produce the following combinaMons:

Guns Butter

Increasing opportunity
A 0 25000

cost of guns
B 100 24000
C 200 22000
D 300 18000
E 400 13000
F 500 0

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ProducMon PossibiliMes FronMer
Buser

Guns
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 ProducMon PossibiliMes FronMer
Buser
A B
25000
24000

E
13000

ProducMon
PossibiliMes
FronMer

F
100 400 500
Guns

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 ProducMon PossibiliMes FronMer
Buser
25000
Points out here:
Unasainable producMon
combinaMons

Points in here: ProducMon

Inefficient efficiency
producMon

500
Guns
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 The shape of the PPF
•  NoMce that the slope of this PPF increases as we
move down along it. Or, in words, the PPF is concave
à Why is that?
–  If we produce no guns but only buser (point A) and then
decide to produce 100 guns, how much buser do we need
to give up?
–  But if instead we were producing the bundle E, what’d
then be the opportunity cost of producing 100 addiMonal
guns?

–  Here, the opportunity cost of each good is increasing in

the level of output of that good

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 PPF and Opportunity Cost
Buser
A B
25000

24000

13000 E

F
100 400 500
Guns

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 The shape of the PPF
•  If either the amount of resources available or
the state of technology changes, the shape of
the PPF can also change.
o  An improvement of technology could shiE the
curve out (if it improves producMvity for both
goods) or rotate the PPF out or up (if the new
technology only improves producMon for one of
the goods).

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Changes in the PPF
With a technological shock that
boosts the producMon of both goods,
the PPF will shim outwards from
origin along both axes, i.e. increasing
the maximum amount of both goods
that can be produced.

PPF PPF'

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Changes in the PPF

If there is a shock that boosts the producMon

of X only, the PPF will shim outwards from
origin along the X-axis only.

PPF PPF'

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 PPF: Important to remember
•  The slope of the PPF is the opportunity cost of
producing an addiMonal unit of a good in
terms of the other.
•  It depends on the country’s producMve
resources (labour, capital, land, etc.) and the
current state of technology.

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The gains from trade (or exchange)
•  A crucial idea in economics is that trade can
make everyone beser off.
o  Trade = economic interacMon
o  Trade helps allocate goods to those who value them most.
This is the gains from exchange.
o  Gains from exchange = Improvements in income,
producMon or saMsfacMon owing to the exchange of goods
or services

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 Gains from trade
•  A simple example (with consumers):
–  Suppose Baz owns a bicycle he rarely rides and thus he
values lisle, say at $10.
–  Chloe would like to have a bike. She is ‘willing to pay’ (i.e,
values a bike) at $100.
–  If Baz sells the bike to Chloe for $40, then:
•  Chloe is beser off because she gets a $100 value bike for $40
•  Baz is beser off because he gets $40 when he only valued the bike
at $10.
–  This trade is Pareto improving –both agents are beser off.
•  Provided the price is between $10 and $100 both parMes can be
made beser off by trading the bike
27
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 Gains from trade
•  Key here is that exchange is voluntary
–  Leaves both parMes beser off
–  Whether the Pareto improving trade is weak or strong
depends on the valuaMons of each of the parMes
–  How much individuals benefit will depend on the terms
under which trade occurs:
•  a higher price suits the seller, a lower price the buyer.

•  Trade also allows people to take advantage of

gains from specializaBon, reducing overall costs
of producing and increasing output.
–  related to “comparaMve advantage” in producMon
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 Gains from trade
•  Consider economy when Robert can only wash clothes and
Mas can only cook.
- gains from trade, allows each to consume a new good

•  When each can perform both tasks, but Robert can only cook
at great cost and Mas can only wash clothes with a
substanMal effort.
- specialising lowers cost, can make both beser off

•  But what if one party is be4er at producing both services?

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 Gains from trade
Hours needed for => Amount produced in 12hrs
1 meal 1 basket meals baskets

R 2 4 6 3

M 1/2 3 24 4

If both do not trade they consume on their PPF

Proposed trade: Robert does 1.5 baskets of laundry
for Mas. Mas cooks 5 meals for Robert.

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 Amount produced in 12hrs
Robert’s ppf Mas’s ppf meals baskets
R 6 3

Meals Meals M 24 4

24 24

Laun 4 Laun
3
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 Gains from trade
Without trade With trade

Prod. Prod Trade Cons Gains from
and cons trade

Rob 4 meals
1 basket


Mas 12 meals
2 baskets

Prod = producMon (quanMty of goods produced)
Cons = consumpMon (quanMty of goods consumed)

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 Gains from trade
Without trade With trade

Prod. Prod Trade Cons Gains from
and cons trade

Rob 4 meals 0 meals
1 basket 3 baskets


Mas 12 meals 18 meals
2 baskets 1 basket

(as an example)

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 Gains from trade
Without trade With trade

Prod. Prod Trade Cons Gains from
and cons trade

Rob 4 meals 0 meals gets 5 meals
1 basket 3 bask for 1.5 bask


Mas 12 meals 18 meals gives 5 meals
2 baskets 1 basket for 1.5 bask

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 Gains from trade
Without trade With trade

Prod. Prod Trade Cons Gains from
and cons trade

Rob 4 meals 0 meals gets 5 meals 5 meals
1 basket 3 bask for 1.5 bask 1.5 bask


Mas 12 meals 18 meals gives 5 meals 13 meals
2 baskets 1 basket for 1.5 bask 2.5 bask

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Robert’s PPF and consumpMon
Meals

Robert’s cons
with trade
6

4 Robert’s cons
without trade

1 3 Laun
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 Mas’s PPF and consumpMon
Meals
24
Mas’s cons
with trade

13
12
Mas’s cons
without trade

2 2.5 4 Laun
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 Gains from trade
Without trade With trade

Prod. Prod Trade Cons Gains from
and cons trade

R 4 meals 0 meals gets 5 meals 5 meals 1 meal
1 basket 3 bask for 1.5 bask 1.5 bask 0.5 bask


M 12 meals 18 meals gives 5 meals 13 meals 1 meal
2 baskets 1 basket for 1.5 bask 2.5 bask 0.5 bask

End results: Both parBes can consume outside of their ppf

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 Absolute and comparaMve advantage
•  Party A has an absolute advantage over Party B in
the producMon of a good if, for a given amount of
resources, A can produce a greater number of that
good than B.

•  Party A has a comparaBve advantage over Party B in

the producMon of a good if A's opportunity cost of
producing that good is lower than B's opportunity
cost.

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 Gains from trade
•  Mas needs 3 hours to produce 1 basket. In that Mme she
could produce 6 meals
–  opportunity cost of 1 basket is 6 meals
–  reflected in the slope of the ppf (-6)

•  Robert’s opportunity cost of 1 basket is 2 meals
–  slope of ppf -2

•  Note, the opp cost for Mas of producing 1 meal is 1/6 baskets
–  it takes 30 minutes to make a meal, in that Mme would
wash 1/6 a basket

•  Also, opp cost for Robert of producing 1 meal is 1/2 baskets

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 Gains from trade
Opportunity cost of 1:

Meals (in terms of Baskets (in terms of
baskets forgone) meals forgone)

R 1/2 2
M 1/6 6

•  Producer with the lower opp cost has a comparaMve
advantage in that good
–  Hence, Robert has a comparaMve advantage in laundry; Mas in cooking

•  Note: as opp cost is the inverse for the other good it is impossible
for a person to have a comparaMve advantage in both goods
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 Gains from trade
•  Differences in opportunity costs of producMon create
gains from specialisaMon and trade

•  Each person specialises in the good in which they have a
comparaBve advantage

•  Because economic pie increased in size everyone can be
beser off
-  each party can obtain the good for a lower price than his/her
opportunity cost
-  i.e. Robert buys each meal for 3/10 basket of laundry while his
opportunity cost of cooking is 1/2 a basket of laundry.
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 IntuiMon underlying gains from trade
•  Total output increases because trade allows
parMes to specialise in producing the good in
which they have the lower opportunity cost.
o  With more output, both trading parMes can
potenMally be made beser off.

o  Trade creates an environment for specializaMon to be

feasible, increasing the size of the economic pie.
o  This increase in output can potenMally be shared so as
to make everyone beser off than without trade.

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 IntuiMon underlying gains from trade
•  This concept is very general:
o  Trade is beneficial to individuals (and indeed
countries) because it allows them to specialize in
industries where they have the comparaBve
advantage, and trade with others for things that
would cost them more to produce personally.

o  Moreover, this principle holds even if one party has

the absolute advantage in the producMon of both
goods; what masers is the comparaMve advantages or
opportunity costs of the parMes.

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 Summary
•  Key economic concepts
•  Economics is the study of choice
–  how society deals with scarcity of resources

•  Scarcity, trade-offs => opportunity cost

–  Reflected in ProducMon PossibiliMes FronMer

•  Gains from trade: everyone can be made beser off

through exchange of goods&services
–  Through specializaMon in producMon (based on comparaMve
advantage), extra gains from trade are possible

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