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ECO1000 Economics

ECO1000 Economics. Semester One, 2004 Lecture Two. Outline or Plan of Today’s Lecture. Material Covered: Module One, Part Two Reading: Chapter 3 of the Text and Chapter 3 of the Study Guide (Hakes and Parry) Topics Considered: Interdependence and Gains From Trade.

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ECO1000 Economics

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  1. ECO1000Economics Semester One, 2004 Lecture Two

  2. Outline or Plan of Today’s Lecture • Material Covered: Module One, Part Two • Reading: Chapter 3 of the Text and Chapter 3 of the Study Guide (Hakes and Parry) • Topics Considered: Interdependence and Gains From Trade

  3. Objectives of Today’s Lecture • You will learn about: • The benefits of trade • Absolute and comparative advantage • How comparative advantage explains the benefits of trade • How comparative advantage and trade applies to your daily lives and your nation’s policies

  4. Relevant Economic Principles • The cost of something is what you give up to get it • Trade can make everyone better off

  5. How do we satisfy our wants and needs? • We can be economically self-sufficient; or • We can specialise and trade with others, leading to economic interdependence.

  6. The Production Possibilities Frontier A Model of Production Capacity

  7. The Production Possibility Frontier • A representation of two choices of production based on full utilisation of known resources • All points within the PPF are also combinations of production of goods • Illustrates opportunity cost • movement along the frontier means giving up production of one to gain production in another

  8. Building the Model • Start with individual behaviour & capacity • ‘Robinson Crusoe’ economics • Add more people to the model • Used to illustrate a general tendency, not detailed reality • Assume the principles are still valid in a complex society

  9. Scenario • One person (George) on an island • Only producing two goods • Food & cloth • Limited by: • Physical capacity • Skill • Trade-off between the 2 goods

  10. George’s production possibilities in relation to food & cloth

  11. Graphing George’s PPF Food (Kgs/wk) Point A * 10 Point B 8 * Point C 6 * Point D 4 * Point E * Cloth (m/wk) 0 3 6 9 15

  12. Principles of a PPF Food (Kgs/wk) Point A: possible but can produce more 10 8 * Point B: At full capacity 6 * * Point C: Not possible under current conditions 4 Cloth (m/wk) 0 2 3 6 9 15

  13. Shifting along the PPF Food (Kgs/wk) Give up 2 kgs of food Gain 3 m of cloth 10 Give up 2 kgs of food Gain 3 m of cloth 8 * * 6 Give up 2 kgs of food Gain 3 m of cloth * 4 Cloth (m/wk) 3 6 9 15

  14. Calculating opportunity cost • George gives up 2 kgs of food/wk to gain 3 m of cloth/wk • Converting this to single units, each extra metre of cloth ‘costs’ 2/3 (0.66) kgs of food • Therefore, the opportunity cost of increasing cloth production by 1 m/wk = 0.66 kgs/wk of food

  15. Points to note • George could gather 10 kgs/wk of food and make no cloth or make 15 m of cloth and gather no food • NB. There is always a time factor • per/day, per/wk, per month etc • It is likely that opportunity cost will vary, usually increasing with any shift of resources • This is based on constant opportunity cost

  16. John’s PPF

  17. Comparing PPFs Food (Kgs/wk) John 12 * Gives up 3 kgs/wk * 9 Gains 3 m/wk * 6 George * 3 * Cloth (m/wk) 3 6 9 12 15

  18. Comparing the Cost of Food: John’s Absolute Advantage • Absolute advantage is a term used when comparing productivity. • In our example, John has an absolute advantage in producing food because he requires less time than George to produce a unit of this good.

  19. Another Way of Comparing Costs: Opportunity Cost and Comparative Advantage • John’s opportunity cost of producing cloth: • John gives up 3 kgs of food/wk to gain 3 m of cloth/wk • Opportunity cost for 1 m/wk of cloth = 1 kg of food/wk • Compared with George’s opportunity cost of 0.66 kg of food/wk • George has a lower opportunity cost than John for the production of cloth (he gives up less food) • John has a lower opportunity cost than George for the production of food (he gives up less cloth) WORK IT OUT!

  20. Comparative Advantage • The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good. • George has a comparative advantage in cloth production and John has a comparative advantage in food production

  21. Comparative Advantage and Specialisation • George could specialise in cloth production (where he has a comparative advantage) and John could specialise in food production (where he has a comparative advantage) • The result of specialisation is a greater total production of both goods

  22. The logic of specialisation Food (Kgs/wk) 12 john Maximum combined production 9 6 george 3 Cloth (m/wk) 3 6 9 12 15

  23. George & John Trade… • George specialises in cloth production and produces 15 m/wk • John specialises in food production and produces 12 kgs/wk • John eats 6 kgs of food and trades the other 6 kgs for 8 m of cloth • He ends up with 6 kgs of food and 8 m of cloth

  24. John’s Consumption Possibilities Food (Kgs/wk) 12 The PPF (does not change) Consumption without trade 9 Consumption with trade * * 6 3 Cloth (m/wk) 3 6 8 9 12 15

  25. George’s Situation With Trade • George uses 7 m of cloth and trades the other 8 m for 6 kgs of food. • George ends up with 7 m of cloth and 6 kgs of food.

  26. George’s Consumption Possibilities Food (Kgs/wk) 12 PPF (does not change) 9 Consumption with trade * 6 * 3 Cloth (m/wk) 3 6 7 9 12 15

  27. Points to Note • Interdependence and trade can allow people to enjoy a greater quantity and variety of goods and services. • The person who can produce a good with a smaller quantity of inputs has an absolute advantage. • The person with a smaller opportunity cost has a comparative advantage. • The gains from trade are based on comparative advantage, not absolute advantage.

  28. National Production Possibilities Applying the Same Principles to National Economies

  29. A National PPF Information gigabytes/yr *Assume full use of resources 1 m 750,000 500,000 Textiles cu m/yr 4 m 8 m 16 m

  30. Points to note • Country produces either textiles or information • At 750,000 gb/yr & 4 m cu metres/yr, an increase of 4 m cu metres will mean giving up 250,000 gb/yr • Opp cost of 4 m cu m. = 250,000 gb of info. • Opp cost of 1 cu m = 0.0625 gb of info

  31. A Positive Change in the PPF Information gigabytes/yr * NB: It is a change in potential production Increase in population, discovery of new resources, invention of new technology, higher education Textiles cu m/yr

  32. A Negative Change in the PPF Information gigabytes/yr * NB: It is a change in potential production Decrease in population, depletion of resources, environmental degradation, natural disaster, human disaster Textiles cu m/yr

  33. A Positive Change in Textile Technology Information gigabytes/yr Textiles cu m/yr

  34. Changes within the PPF Information gigabytes/yr There has been no change in population, resources or technology, but there has been a change in policy or work practices * * Textiles cu m/yr

  35. The Impact of Policy 1. Government cuts assistance to industry Information gigabytes/yr 2. Resources shift to another industry and production moves closer to PPF. (Greater efficiency) 1 m 750,000 *This is a more realistic situation. There is not full use of all resources. * 500,000 Initial production * Textiles cu m/yr 5m 6.5 m 16 m

  36. More efficient use of resources Low unemployment Change in government policy Less efficient use of resources High unemployment Change in government policy Political favours for some inefficient sectors of groups Towards PPF & Away from PPF

  37. An Example of Production Without Trade 12 11 10 9 8 7 6 5 4 3 2 1 0 Televisions million/yr Japan Australia 0 2 4 6 8 10 12 13 14 16 18 20 22 Wheat million tonnes/yr

  38. Opportunity Costs • Japan can either produce 1 tonne of wheat or 1 TV. Opp Cost of 1 t. of wheat = 1 TV • Australia can produce 1 TV or 3 tonnes of wheat. Opp cost of 1 TV = 3 tonnes of wheat

  39. Opportunity Costs Compared

  40. The Development of Trade • Japan wants to get wheat cheaper than at a cost of 1 TV/tonne if possible • Australia wants to get TVs cheaper than at a cost of 3 tonnes of wheat/TV if possible • Suppose they agree to specialise and trade

  41. New Consumption Possibility with trade 12 11 10 9 8 7 6 5 4 3 2 1 0 Australia produces 16 million tonnes of wheat, keeps 7 million tonnes and trades 9 million tonnes for 5 million televisions. Televisions million/yr Australia’s consumption with trade * Australia’s PPF * 0 2 4 6 8 10 12 13 14 16 18 20 22 Wheat million tonnes/yr

  42. New Consumption Possibility with trade 12 11 10 9 8 7 6 5 4 3 2 1 0 Japan produces 10 million TVs, keeps 5 million and trades the other 5 million for 9 million tonnes of wheat Televisions million/yr Japan’s consumption with trade * * Japan’s PPF 0 2 4 6 8 10 12 13 14 16 18 20 22 Wheat million tonnes/yr

  43. Points to note • The PPF (production) cannot increase, but consumption can • It just shows the potential for an increase in goods and services • No country fully specialises • However, this idea is the basis for free trade arguments

  44. Conclusions • Lower opportunity cost creates the conditions for benefits from exchange • In the absence of other impediments & costs, countries will increase possible consumption through trade • This is true even where one country has an absolute advantage over another

  45. Next Week • Next week’s lecture: • Material: Module Two, Part One • Reading: Text Chapter Four plus Hakes and Parry Chapter Four • Topics: Supply and Demand

  46. THE END

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