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Contents:
Introduction to macroeconomics
Opportunity cost and the Production Possibilities Curve
Comparative advantage and the gains from trade
Demand
Supply
Markets
In this unit, you'll learn fundamental economic concepts like scarcity, opportunity cost, and
supply and demand. You will learn things like the distinction between absolute and comparative
advantage, how to identify comparative advantage from differences in opportunity costs, and
how to apply the principle of comparative advantage to determine the basis on which mutually
advantageous trade can take place between individuals and/or countries.
Introduction to Macroeconomics:
If you want to sum up what economics means, you could do so with the
following statement:
Any economic system must provide society with a means of making choices
that answer three basic questions:
Key Terms
Term Definition
the study of how individuals and societies choose to
economics allocate scarce resources.
Common Misperceptions
Economics is not the study of stock markets, money, or how to run a
business. Although many new students believe they will be learning about
these concepts, economics is a social science that seeks to better understand
and predict human interactions; unlike business and finance, which focus on
how to manage a business organization and invest money in a way to earn the
highest return for investors.
One of the four economic resources that societies must decide how to
allocate is capital. When people use the word capital in everyday
conversation, many people are referring to money or “financial capital.” In
economics, capital is defined as the already-produced goods (tools,
machinery, equipment, and physical infrastructure) that are used in the
production of other goods or services. A robot on a car factory floor is
defined as capital in economics; money you borrow to start your own
business is not.
Discussion questions
Victorian historian Thomas Carlyle once called economics the "dismal
science" because he believed it obsessively focused on the scarcity of
resources. What does the field of economics provide society that other
sciences such as chemistry, biology and physics cannot?
Using at least three key terms from this lesson, explain how scarcity
affects you in your everyday life.
What are the three basic economic questions? How have different
societies that you know about or have studied in other classes attempted to
answer these questions?
Opportunity cost and the PPC
The Production Possibilities Curve (PPC) is a model used to show the
tradeoffs associated with allocating resources between the production of two
goods. The PPC can be used to illustrate the concepts of scarcity, opportunity
cost, efficiency, inefficiency, economic growth, and contractions.
For example, suppose Carmen splits her time as a carpenter between making
tables and building bookshelves. The PPC would show the maximum amount
of either tables or bookshelves she could build given her current resources.
The shape of the PPC would indicate whether she had increasing or constant
opportunity costs.
Key terms
Term Definition
(also called a production possibilities frontier) a
graphical model that represents all of the different
production combinations of two goods that can be produced; the
possibilities PPC captures scarcity of resources and opportunity
curve (PPC) costs.
Key model
The shape of the PPC also gives us information on the production technology
(in other words, how the resources are combined to produce these goods).
The bowed out shape of the PPC in Figure 111 indicates that there are
increasing opportunity costs of production.
We can also use the PPC model to illustrate economic growth, which is
represented by a shift of the PPC. Figure 222 illustrates an agent that has
experienced economic growth. Combinations that were once impossible, such
as 6 iPads and 4 watches, are now on the new PPC, thanks to the increase in
resources or technology.
For example, suppose we knew that the following table represented all of the
possible combinations of iPads and Apple Watches that could be produced.
4 3
6 2
8 1
10 0
If a producer is producing 666 Apple Watches and 222 iPads, but wants to
make one more iPad, they can instead produce 444 Apple Watches
and 333 iPads:
{Opportunity cost of one iPad}: (6-4)\(3-2) Apple Watches
=2÷1 Apple Watches
=2 Apple Watches
Note that opportunity costs are always expressed in terms of the good that is
given up.
We can use the same procedure if given a graph. Figure 3 shows a PPC that
has been created from our table. The two points used in this formula are the
two efficient points indicated in the graph in Figure 3.
Common Misperceptions
Not all costs are monetary costs. Opportunity costs are expressed in
terms of how much of another good, service, or activity must be given up in
order to pursue or produce another activity or good. For example, when you
head out to see a movie, the cost of that activity is not just the price of a
movie ticket, but the value of the next best alternative, such as cleaning your
room.
Going from an inefficient amount of production to an efficient amount
of production is not economic growth. For example, suppose an economy can
make two goods: chocolate donuts and cattle prods. But half of their donut
machines aren’t being used, so they aren’t fully using all of their resources.
Graphically, that would be represented by a combination of goods in the
interior of their PPC. If they then put all of those donut machines to work,
they aren’t acquiring more resources (which is what we mean by economic
growth). Instead, they are just using their resources more efficiently and
moving to a new point on the PPC.
On the other hand, if this economy is making as many donuts and cattle
prods as it can, and it acquires more donut machines, it has experienced
economic growth because it now has more resources (in this case, capital)
available. This would be represented in a PPC graph as a shift outward of the
entire PPC curve.
Discussion Questions
How would you show with a PPC that a country has constant
opportunity costs of production?
Using a correctly labeled PPC model, show an economy that has
increasing opportunity costs that can produce cattle prods and chocolate
donuts that is underutilizing its labor.
[Got it, thanks!]
The United States, for example, has a skilled workforce, abundant natural
resources, and advanced technology. Because of these three things, the US
can produce many goods more efficiently than potential trading partners,
giving it an absolute advantage in the production of goods from corn to
computers, to maple syrup and cars. This does not, however, mean that the
US does not benefit from trading for these goods with other nations.
Mexico, on the other hand, with its ample sunshine and warm climate. can
grow avocados at a much lower opportunity cost in terms of maple syrup
given up than Canada.
Specialization
Production specialization according to comparative advantage, not absolute
advantage, results in exchange opportunities that lead to consumption
opportunities beyond the PPC. Trade between two agents or countries allows
the countries to enjoy a higher total output and level of consumption than
what would have been possible domestically.
Canada and Mexico can each specialize in the good they have a comparative
advantage in and exchange with one another. This lets both countries enjoy
more maple syrup and avocados than they could have enjoyed without trade.
Mexico will export avocados and import maple syrup; this way Mexicans can
enjoy their tasty breakfasts and Canadians will enjoy delicious guacamole!
In order for Canadians to benefit from trade with Mexico, they must be able
to import avocados at a lower opportunity cost than it would cost them to
grow domestically. Likewise, Mexico must get maple syrup more cheaply (in
terms of avocados given up) than it could have produced it for domestically.
The terms of trade refer to the trading price agreed upon by two agents,
which when beneficial, will allow both countries to enjoy gains from trade.
Key terms
Term Definition
the ability to produce more of a good than another
entity, given the same resources. For example, in a
single day, Owen can embroider 10 pillows and
absolute Penny can embroider 15 pillows, so Penny has
advantage absolute advantage in embroidering pillows.
The gains from trade can be shown in a PPC by drawing a line originating at
the point on the axis on which an agent is specializing its production (in the
good it has a comparative advantage in) out to a point on the opposite axis
beyond what it could have achieved without trade.
Assuming terms of trade are beneficial (e.g. offering each agent a lower
opportunity cost than could be achieved without trade) an individual or
country will be able to consume at a point beyond its PPC through
specialization and trade (as in Figure 2).
Figure 2: Countries A and B's potential gains from trade
Common Misperceptions
A country that has an absolute advantage in producing all goods still
stands to benefit from trade with other countries, since the basis of the gains
for trade is comparative advantage, not absolute advantage.
If two countries have identical opportunity costs for two goods, then the
countries do not stand to gain from trade with one another for the goods in
question.
4. Smartphones Apples
Tonju 39 13
Emria 48 24
a. Which country has the absolute advantage in smartphones and which
has the absolute advantage in apples?
c. If the two countries were to specialize and trade with one another,
which country would import smartphones?
For example, if the price of scented erasers decreases, buyers will respond to
the price decrease by increasing the quantity of scented erasers demanded. A
market for a good requires demand and supply.
Key Terms
Term Definition
all of the quantities of a good or service that buyers
would be willing and able to buy at all possible prices;
demand is represented graphically as the entire demand
demand curve.
The demand curve shows all of the quantities that a buyer is willing to
purchase at all possible prices. In Figure 1, the curve D_1D1D, start subscript,
1, end subscript represents a buyer that would be willing to nothing when the
price is \$9$9dollar sign, 9, 222 units when the price is \$7$7dollar sign,
7, 666 units with the price is \$3$3dollar sign, 3, and 999 units if the price
was \$0$0dollar sign, 0.
Common misperceptions
Key Terms
Term Definition
a schedule or a curve describing all the possible
quantities that sellers are willing and able to produce, at
all possible prices they might encounter in a particular
period of time; supply is represented in a graphical
supply model as the entire supply curve.
change in
quantity a movement along a supply curve resulting from a
supplied change in a good’s price
Common Misperceptions
You may often hear people say, incorrectly, that higher prices lead to
“more supply” and that lower prices lead to “less supply.” However, this is an
incorrect use of the terms. Higher prices will result in an increased quantity
supplied and lower price will result in a decrease in quantity supplied. Only a
change in a non-price determinant of supply causes a good's supply to
increase or decrease.
Discussion questions
1. How would producers of a good, such as candy canes, adjust their
current supply if they expect its price to rise in the future?
[Hide explanation]
If businesses expect future prices to be higher, they will most likely withhold
current supply, which would reduce the market supply. If prices are expected
to fall in the future, they would benefit from increasing supply today in order
to sell while the price is still relatively high.
In the candy cane market, producers would withhold supply in the summer
and early fall because they expect prices to rise around the holiday season.
Towards the end of the holiday season, when they expect candy cane prices
to fall in the future, they’ll supply as much as they can while prices are still
high.
Equilibrium
MARKETS: Equilibrium is achieved at the price at which quantities
demanded and supplied are equal. We can represent a market in equilibrium
in a graph by showing the combined price and quantity at which the supply
and demand curves intersect.
Disequilibrium
Whenever markets experience imbalances—creating disequilibrium prices,
surpluses, and shortages—market forces drive prices toward equilibrium.
A shortage will exist at any price below equilibrium, which leads to the price
of the good increasing.
Key Terms
Term Definition
an interaction of buyers and sellers where goods,
market services, or resources are exchanged
Figure 1: The market for salamander stickers
Changes in Supply
Suppose the price of glitter, which is used to make giant shiny salamander
stickers, increases so that it now costs the seller \$2$2dollar sign, 2 more per
sticker to produce them. This will cause the supply of this good to decrease.
To see the impact a decrease in supply will have on the equilibrium price and
quantity, grab the interactive supply curve and shift it to the left until the
price is \$2$2dollar sign, 2higher at every level of output (the new supply
curve should start at \$4$4dollar sign, 4).
What change did you notice? If you adjusted the graph correctly, you should
see the equilibrium price increases to \$6$6dollar sign, 6, and the equilibrium
quantity in this market decreases to 222 stickers.
How did you do? If you adjusted the graph correctly, you should see the
equilibrium price decreases to \$4$4dollar sign, 4 and equilibrium quantity
increases to 444stickers.
Changes in demand
Suppose a famous, trendsetting actress starts wearing giant shiny salamander
stickers, which makes them instantly the must-have accessory. This would
cause the demand for this good to increase. To see the impact on equilibrium
price and quantity in the market from an increase in demand, grab the
demand curve Figure 222 and shift it to the right to represent an increase in
demand.
Figure 2: The market for salamander stickers
Suppose shiny salamander stickers fall out of popularity, and therefore the
demand for them decreases. At the same time, the price of glitter goes up,
which leads to a decrease in supply.
Common Misperceptions
When showing an equilibrium price and quantity, it is important to
clearly label these on the appropriate axis, not just the interior of the graph.
Remember that the point on either axis represents the market price and the
market quantity, not a point in the middle of the graph.
When both supply and demand change at the same time, we will not be
able to make a statement about what happens to both price and quantity, one
of these will be uncertain.
Discussion Questions
1. When both supply and demand increase at the same time, why can't we
tell what will happen to the equilibrium price?
2. Can you think of an example of a good in your own life for which there
was a shortage?
3. What happened to the price of that good?
4. Using a correctly labeled graph, show the impact on equilibrium price
and quantity in the market for pumpkin spiced lattes if the cost of producing
them increases.
[Hide explanation]