Economics 1 2011-12

1. Economics 12011-12 (Lecture 1) Welcome! Robin Naylor, Department of Economics, Warwick

2. Economics 1 Accompanying Resources Module Website (with links) MyEconomics Portal Module Manual (with reading list) Seminar Work and Problem Sets Departmental Handbooks and Web-Sites Robin Naylor, Department of Economics, Warwick

3. Economics 1 Organisation Lecture timetable Seminar arrangements Personal Essays Examination and Assessment Robin Naylor, Department of Economics, Warwick

4. Economics 1 • Term 1 Microeconomics • Term 2 Macroeconomics Robin Naylor, Department of Economics, Warwick

5. Economics Readings (Micro) Frank, R., Microeconomics and Behaviour, 8th Edition, 2010, McGraw- Hill Estrin, Laidler and Dietrich (ELD), Microeconomics, 2008 + Many other textbooks plus other literature: see Module Manual Robin Naylor, Department of Economics, Warwick

6. Term 1: Micro Topics • Introduction Scarcity and Trade • Topic 1 Household behaviour • Topic 2 Firm behaviour • Topic 3 Product markets • Topic 4 Factor markets • Topic 5 Market Structure, Efficiency and Failure Robin Naylor, Department of Economics, Warwick

7. Introduction • The fundamental problem of scarcity • Cause: excess of wants over ‘natural’ supply • Consequences: (i) Choices over production (ii) Trade-offs and opportunity costs (iii) Rationing of distribution (Markets etc . . .) Consider a 2-good economy: Robin Naylor, Department of Economics, Warwick

8. See Handout Introduction • The fundamental problem of scarcity Tanks Ta Max The Production Possibility Curve The Production Possibility Set 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

9. Introduction • The fundamental problem of scarcity Tanks On what does the position of the Production Possibility Curve depend? Ta Max 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

10. Introduction • The fundamental problem of scarcity Tanks Ta Max What can you say about point ‘a’? . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

11. Introduction • The fundamental problem of scarcity Tanks Ta Max ‘a’ is not ‘technically’ efficient. A ‘Pareto’ improvement can be made. . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

12. Introduction • The fundamental problem of scarcity Tanks Ta Max What can you say about point ‘b’? . b . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

13. Introduction • The fundamental problem of scarcity Tanks Ta Max There can be no Pareto Improvement from ‘b’. It is Pareto Efficient. . b . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

14. Introduction • The fundamental problem of scarcity Tanks . c Ta Max What can you say about point ‘c’? . b . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

15. Introduction • The fundamental problem of scarcity Tanks . c Ta Max How could we get to point ‘c’? . b . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

16. See Handout Introduction • The fundamental problem of scarcity Tanks Ta Max If we are at ‘a’, how can we have more Tractors? . b . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

17. See Handout Introduction • The fundamental problem of scarcity Tanks Ta Max If we are at ‘b’, how can we have more Tractors? . b . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

18. Introduction • The fundamental problem of scarcity Tanks Ta Max If we are at ‘b’, how can we have more Tractors? . b . d . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

19. See Handout Introduction • The fundamental problem of scarcity Tanks We have shown a PPC which is concave: what does this depend on? Ta Max . b . d . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

20. Introduction • The fundamental problem of scarcity Tanks The slope of the PPC is called the Marginal Rate of Transformation (MRT). Why? Ta Max . b . d . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

21. Introduction • The fundamental problem of scarcity Tanks The MRT is the amount of one good (Ta) we have to give up in order to have an extra unit of the other good (Tr). Ta Max . b . d . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

22. Introduction • The fundamental problem of scarcity The MRT is the amount of one good (Ta) we have to give up in order to have an extra unit of the other good (Tr). Tanks Ta Max . b So the MRT is increasing in the case of the concave PPC. Why? . d . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

23. Introduction • The fundamental problem of scarcity The MRT is the amount of one good (Ta) we have to give up in order to have an extra unit of the other good (Tr). Tanks Ta Max . b So the PPC and the MRT describe the Trade-off we have to make between the 2 goods. . d . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

24. Introduction • The fundamental problem of scarcity The MRT is the amount of one good (Ta) we have to give up in order to have an extra unit of the other good (Tr). Tanks Ta Max . b So the PPC and the MRT describe the Opportunity Cost of the extra Tr. . d . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

25. See Handout Introduction • The fundamental problem of scarcity The PPC shows us the trade-off that Society has to make between 2 goods. But what about the trade-off that the Society is prepared to make? Tanks Ta Max 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

26. See Handout Introduction • The fundamental problem of scarcity What about the trade-off that the Society is prepared to make? This is shown by an Indifference Curve. Tanks Ta Max IC 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

27. Introduction • The fundamental problem of scarcity What about the trade-off that the Society is prepared to make? This is shown by an Indifference Curve. Tanks Ta Max IC 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

28. Introduction • The fundamental problem of scarcity Tanks An Indifference Curve. It’s slope shows us how much of one good the society is prepared to give up in order to have an extra unit of the other good. Ta Max IC 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

29. Introduction • The fundamental problem of scarcity Tanks The slope of the IC shows us how much of one good the society is prepared to give up in order to have an extra unit of the other good: This is the Marginal Rate of Substitution (MRS). Ta Max IC 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

30. Introduction (Lecture 2) • The fundamental problem of scarcity Tanks The Marginal Rate of Substitution describes the trade-off society is prepared to make. Why might it be convex, as shown? Ta Max IC 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

31. Introduction • The fundamental problem of scarcity Tanks Ta Max Why might the PPC be convex, as shown? IC 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

32. See Handout Introduction • The fundamental problem of scarcity A set or family of Indifference Curves Tanks Ta Max IC3 IC2 IC1 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

33. See Handout Introduction • The fundamental problem of scarcity ‘a’ is not technically efficient. ‘b’ is. So is ‘d’. So how can we choose between ‘b’ and ‘d’? They are both ‘technically’ efficient. But they are not both Allocatively Efficient . . . Tanks Ta Max . b . d . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

34. See Handout Introduction • The fundamental problem of scarcity On which IC would society like most to be? Tanks Ta Max . b . d . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

35. Introduction • The fundamental problem of scarcity On which IC would society like most to be? At what point is this? Tanks Ta Max . b . d . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

36. Introduction • The fundamental problem of scarcity On which IC would society like most to be? At what point is this? Tanks Ta Max . b . e . d . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

37. Introduction • The fundamental problem of scarcity Tanks At ‘e’, MRS = MRT. Discuss. Ta Max . b . e . d . a 0 Tr Max Tractors Robin Naylor, Department of Economics, Warwick

38. See Handout Introduction Gains from Trade • Consider now 2 economies, Red and Blue: • Let’s assume they have the same inputs. Y PPC-R PPC-B X Robin Naylor, Department of Economics, Warwick

39. See Handout Introduction Gains from Trade • Consider 2 economies, Red and Blue: Y Who has an absolute advantage in producing X? And Y? PPC-R PPC-B X Robin Naylor, Department of Economics, Warwick

40. See Handout Introduction Gains from Trade • Consider 2 economies, Red and Blue: Y The fact that PPC-B is flatter than PPC-R has an important implication. To raise output of X by the amount dX, the required reduction in Y is smaller in Blue than in Red. PPC-R PPC-B dX dX X Robin Naylor, Department of Economics, Warwick

41. Introduction To raise output of X by the amount dX, the required reduction in Y is smaller in Blue than in Red. In other words, the Opportunity Cost of the extra X is lower in Blue than in Red. We say that Blue has a Comparative Advantage in the production of X. And Red has a Comparative Advantage in producing Y. Gains from Trade • Consider 2 economies, Red and Blue: Y dX dX X Robin Naylor, Department of Economics, Warwick

42. Introduction Blue has a Comparative Advantage in the production of X. And Red has a Comparative Advantage in producing Y. This follows entirely from the relative slopes of the 2 PPCs. The MRT (i.e., the slope of the PPC) is greater in Red than in Blue. Thus, Blue has the Comparative Advantage in X. Gains from Trade • Consider 2 economies, Red and Blue: Y X Robin Naylor, Department of Economics, Warwick

43. See Handout Introduction Gains from Trade • Consider 2 economies, Red and Blue: Y As a numerical example, let’s say that to raise output of X by the amount dX, the required reduction in Y is 1 unit in Blue and is 3 units in Red. dY=3 dX PPC-R dY=1 PPC-B dX X Robin Naylor, Department of Economics, Warwick

44. Introduction Gains from Trade • Consider 2 economies, Red and Blue: Suppose that to raise output of X by the amount dX, the required reduction in Y is 1 unit in Blue and is 3 units in Red. Then this has an implication for Trade and Specialisation. Suppose initially, Blue is at point ‘a-B’ and Red is at ‘a-R’. (Why might this be?) Y dY=3 a-R dX a-B dY=1 dX X Robin Naylor, Department of Economics, Warwick

45. Introduction Gains from Trade • Consider 2 economies, Red and Blue: Suppose initially, Blue is at point ‘a-B’ and Red is at ‘a-R’. Why might this be? Y a-R a-B X Robin Naylor, Department of Economics, Warwick

46. Introduction Suppose initially, Blue is at point ‘a-B’ and Red is at ‘a-R’. If Blue gives up one unit of Y, it raises output of X by dX. Suppose thatat the same time Red cuts production of X by the same amount, dX: then it can raise output of Y by 3 units. So what is the total change in ‘World’ production of X? And of Y? Gains from Trade • Consider 2 economies, Red and Blue: Y dY=3 a-R dX a-B dY=1 dX X Robin Naylor, Department of Economics, Warwick

47. See Handout Introduction So with an unchanged total production of X and a higher total production of Y, the countries could*: Trade such that Blue exports dX to Red and, in return, Red exports 2 units of Y to Blue. What would this look like in terms of each country’s PPC? Gains from Trade • Consider 2 economies, Red and Blue: Y b-R dY=1 a-R b-B dY=1 a-B X * They ‘could’ trade in the manner we have suggested. In general, how much they trade of each good will depend on . . . ? Robin Naylor, Department of Economics, Warwick

48. See Handout Introduction So, the countries could trade such that Blue exports X to Red and, in return, Red exports Y to Blue. Where does this argument lead? What can you say about the extent of specialisation in this case? On what assumptions does this result depend? What change in assumptions might modify this result? Gains from Trade • Consider 2 economies, Red and Blue: Y b-R b-B X Robin Naylor, Department of Economics, Warwick

49. See Handout Introduction Key Concepts • Scarcity • Wants • Opportunity Cost • Trade-offs • Rationing • Markets • Efficiency • Equity • Constraints • Changes at the margin Robin Naylor, Department of Economics, Warwick

50. See Handout Introduction Key Concepts • Choices • Preferences • Constraints • PPC • MRS • MRT • Optimisation • Absolute advantage • Comparative advantage • Specialisation • Trade Robin Naylor, Department of Economics, Warwick