Economics 103

Principles of Microeconomics

Dr. Jane Friesen

TAs: Mohsen Javdani

Graeme Walker
Lecture notes available at www.sfu.ca/~friesen

TUTORIALS BEGIN THIS WEEK

See tutorial questions on website (based on Chapter 1 and
Appendix 1A

Lecture this week based on Chapter 2.

© 2010 Pearson Education Canada

 Review of last week’s lecture

What is Economics?

The scope of Economics: two big economic questions

The methodology of economics

© 2010 Pearson Education Canada

 Review of last week’s lecture

What is Economics?

Economics is the social science that studies the

choices that individuals, businesses, governments,
and entire societies make as they cope with scarcity
and the incentives that influence and reconcile those
choices.

© 2010 Pearson Education Canada

 Review of last week’s lecture

First big economic question is really a set of questions:

How do choices end up determining what, how, and for

whom goods and services get produced?

Economics provides answers to these questions.

© 2010 Pearson Education Canada

 Review of last week’s lecture

Second big economic question: When is the pursuit of

self-interest in the social interest?

Do we produce the right things in the right quantities?

Do we use our factors of production in the best way?
Do the goods and services go to those who benefit
most from them?

Is it possible that when each one of us makes choices that

are in our self-interest, it also turns out that these
choices are also in the social interest?
© 2010 Pearson Education Canada
 Review of last week’s lecture

The Methodology of Economics

Choice under scarcity implies trade-offs – more of one

thing means less of another

The cost of something is its opportunity cost – the

highest-valued alternative

Basic economic explanation for behaviour: choices

respond to incentives – comparison of marginal cost and
marginal benefit.

© 2010 Pearson Education Canada

 Outline of today’s lecture

Production possibilities and opportunity cost

Productive and allocative efficiency

Gains from trade

Economic coordination

© 2010 Pearson Education Canada

 Production Possibilities and
Opportunity Cost
Production Possibilities
Two goods: cola and Pizzas Cans of cola
pizza
(millions) (millions)
Fixed resources A 0 15
B 1 14
Fixed technology
C 2 12
Efficiency - the economy D 3 9
is achieving maximum E 4 5
production F 5 0

The PP Table shows the combinations of the maximum

amounts of the two goods that can be produced under
these assumptions.
© 2010 Pearson Education Canada
 Production Possibilities and
Opportunity Cost
We can plot the values from the production possibilities
table to show the production possibilities frontier (PPF)

The PPF is the boundary between those combinations of

goods and services that can be produced and those that
cannot.

To illustrate the PPF, we focus on two goods at a time and

hold the quantities of all other goods and services
constant.

That is, we look at a model economy in which everything

remains the same (ceteris paribus) except the two goods
we’re considering.
© 2010 Pearson Education Canada
 Production Possibilities and
Opportunity Cost
Production Possibilities
Frontier

Any point on the frontier

such as E and any point
inside the PPF such as Z
are attainable.

Points outside the PPF

are unattainable.

© 2010 Pearson Education Canada

 Production Possibilities and
Opportunity Cost
Production Efficiency

We achieve production
efficiency if we cannot
produce more of one good
without producing less of
some other good.

Points on the frontier are

efficient.

© 2010 Pearson Education Canada

 Production Possibilities and
Opportunity Cost
Any point inside the
frontier, such as Z, is
inefficient.
At such a point, it is
possible to produce more
of one good without
producing less of the
other good.
At Z, resources are either
unemployed or
misallocated.

© 2010 Pearson Education Canada

 Production Possibilities and
Opportunity Cost
Tradeoff Along the PPF

Every choice along the

PPF involves a tradeoff.

On this PPF, we must give

up some cola to get more
pizzas or give up some
pizzas to get cola.

© 2010 Pearson Education Canada

 Production Possibilities and
Opportunity Cost
Opportunity Cost

As we move down along

the PPF, we produce
more pizzas, but the
quantity of cola we can
produce decreases.

The opportunity cost of a

pizza is the cola forgone.

© 2010 Pearson Education Canada

 Production Possibilities and
Opportunity Cost
In moving from E to F,
the quantity of pizzas
increases by 1 million.

The quantity of cola

decreases by 5 million
cans.

The opportunity cost of

the fifth 1 million pizzas is
5 million cans of cola.

One of these pizzas costs

5 cans of cola.
© 2010 Pearson Education Canada
 Production Possibilities and
Opportunity Cost
In moving from F to E, the
quantity of cola produced
increases by 5 million.

The quantity of pizzas

decreases by 1 million.

The opportunity cost of

the first 5 million cans of
cola is 1 million pizzas.

One of these cans of cola

costs 1/5 of a pizza.

© 2010 Pearson Education Canada

 Production Possibilities and
Opportunity Cost

Note that the opportunity

cost of a can of cola is the
inverse of the opportunity
cost of a pizza.
One pizza costs 5 cans of
cola.
One can of cola costs 1/5
of a pizza.

© 2010 Pearson Education Canada

 Production Possibilities and
Opportunity Cost

Because resources are

not equally productive in
all activities, the PPF
bows outward—is
concave.

The outward bow of the

PPF means that as the
quantity produced of each
good increases, so does
its opportunity cost.

© 2010 Pearson Education Canada

 Using Resources Efficiently

All the points along the PPF are efficient.

To determine which of the alternative efficient quantities

to produce, we compare costs and benefits.

The PPF and Marginal Cost

The PPF determines opportunity cost.

The marginal cost of a good or service is the opportunity

cost of producing one more unit of it.

© 2010 Pearson Education Canada

 Using Resources Efficiently

Figure 2.2 illustrates the

marginal cost of pizza.
As we move along the
PPF in part (a), the
opportunity cost of a
pizza increases.
The opportunity cost of
producing one more
pizza is the marginal
cost of a pizza.

© 2010 Pearson Education Canada

 Using Resources Efficiently

In part (b) of Fig. 2.2, the

bars illustrate the
increasing opportunity
cost of pizza.
The black dots and the
line MC show the
marginal cost of pizza.

The MC curve passes

through the centre of each
bar.

© 2010 Pearson Education Canada

 Using Resources Efficiently

Preferences and Marginal Benefit

Preferences are a description of a person’s likes and

dislikes.

To describe preferences, economists use the concepts of

marginal benefit and the marginal benefit curve.

The marginal benefit of a good or service is the benefit

received from consuming one more unit of it.

We measure marginal benefit by the amount that a

person is willing to pay for an additional unit of a good or
service.
© 2010 Pearson Education Canada
 Using Resources Efficiently

It is a general principle that the more we have of any

good, the smaller is its marginal benefit and the less we
are willing to pay for an additional unit of it.

We call this general principle the principle of decreasing

marginal benefit.

The marginal benefit curve shows the relationship

between the marginal benefit of a good and the quantity
of that good consumed.

© 2010 Pearson Education Canada

 Using Resources Efficiently

Figure 2.3 shows a

marginal benefit curve.

The curve slopes

downward to reflect the
principle of decreasing
marginal benefit.
At point A, with pizza
production at 0.5 million,
people are willing to pay
5 cans of cola for a
pizza.

© 2010 Pearson Education Canada

 Using Resources Efficiently

At point B, with pizza

production at 1.5 million,
people are willing to pay
4 cans of cola for a
pizza.
At point E, with pizza
production at 4.5 million,
people are willing to pay
1 can of cola for a pizza.

© 2010 Pearson Education Canada

 Using Resources Efficiently
Allocative Efficiency

When we cannot produce more of any one good without

giving up some other good, we have achieved production
efficiency.

We are producing at a point on the PPF.

When we cannot produce more of any one good without

giving up some other good that we value more highly, we
have achieved allocative efficiency.

We are producing at the point on the PPF that we prefer

above all other points.

© 2010 Pearson Education Canada

 Using Resources Efficiently

Figure 2.4 illustrates

allocative efficiency.
The point of allocative
efficiency is the point on
the PPF at which marginal
benefit equals marginal
cost.
This point is determined by
the quantity at which the
marginal benefit curve
intersects the marginal
cost curve.

© 2010 Pearson Education Canada

 Using Resources Efficiently

If we produce fewer than

2.5 million pizzas,
marginal benefit exceeds
marginal cost.
We get more value from
our resources by
producing more pizzas.
On the PPF at point A,
we are producing too
much cola, and we are
better off moving along
the PPF to produce
more pizzas.
© 2010 Pearson Education Canada
 Using Resources Efficiently

If we produce more than

2.5 million pizzas,
marginal cost exceeds
marginal benefit.

We get more value from

our resources by
producing fewer pizzas.

On the PPF at point C, we

are producing too many
pizzas, and we are better
off moving along the PPF
to produce fewer pizzas.
© 2010 Pearson Education Canada
 Using Resources Efficiently

If we produce exactly
2.5 million pizzas,
marginal cost equals
marginal benefit.

We cannot get more

value from our resources.

On the PPF at point B,

we are producing the
efficient quantities of cola
and pizzas.

© 2010 Pearson Education Canada

 Economic Growth

The expansion of production possibilities—and increase in

the standard of living—is called economic growth.

Two key factors influence economic growth:

 Technological change

 Capital accumulation

Technological change is the development of new goods

and of better ways of producing goods and services.

Capital accumulation is the growth of capital resources,

which includes human capital.
© 2010 Pearson Education Canada
 Economic Growth
The Cost of Economic Growth

To use resources in research and development and

to produce new capital, we must decrease our
production of consumption goods and services.

So economic growth is not free.

The opportunity cost of economic growth is less

current consumption.

© 2010 Pearson Education Canada

 Economic Growth

Figure 2.5 illustrates the

tradeoff we face.

We can produce pizzas or

pizza ovens along PPF0.

By using some resources

to produce pizza ovens
today, the PPF shifts
outward in the future.

© 2010 Pearson Education Canada

 Gains from Trade
Comparative Advantage and Absolute Advantage

A person has a comparative advantage in an activity if

that person can perform the activity at a lower opportunity
cost than anyone else.

A person has an absolute advantage if that person is

more productive than others.

Absolute advantage involve comparing productivities

while comparative advantage involves comparing
opportunity costs.

© 2010 Pearson Education Canada

 Gains from Trade
Liz's Smoothie Bar

In an hour, Liz can

produce 30 smoothies
or 30 salads.

Liz's opportunity cost of

producing 1 smoothie is
1 salad.
Liz's opportunity cost of producing 1 salad is 1 smoothie.

Liz’s customers buy salads and smoothies in equal number,

so she produces 15 smoothies and 15 salads an hour.
© 2010 Pearson Education Canada
 Gains from Trade

Joe's Smoothie Bar

In an hour, Joe can produce 6 smoothies or 30 salads.

Joe's opportunity cost of

producing 1 smoothie is
5 salads.

Joe's opportunity cost of

producing 1 salad is 1/5
smoothie.

Joe spends 10 minutes making salads and 50 minutes making

smoothies, so he produces 5 smoothies and 5 salads an hour.
© 2010 Pearson Education Canada
 Gains from Trade

Liz’s Absolute Advantage

Liz is three times as productive as Joe.
Liz can produce 15 smoothies and 15 salads an hour
whereas Joe can produce only 5 smoothies and 5
salads an hour.
Liz has an absolute advantage in producing smoothies
and salads.

© 2010 Pearson Education Canada

 Gains from Trade

Liz’s Comparative Advantage

Liz’s opportunity cost of a smoothie is 1 salad.
Joe’s opportunity cost of a smoothie is 5 salads.
Liz’s opportunity cost of a smoothie is less than Joe’s.
So Liz has a comparative advantage in producing
smoothies.

© 2010 Pearson Education Canada

 Gains from Trade

Joe’s Comparative Advantage

Joe’s opportunity cost of a salad is 1/5 smoothie.
Liz’s opportunity cost of a salad is 1 smoothie.
Joe’s opportunity cost of a salad is less than Liz’s.
So Joe has a comparative advantage in producing
salads.

© 2010 Pearson Education Canada

 Gains from Trade
Achieving Gains from Trade

Liz and Joe produce the

good in which they have a
comparative advantage:

 Liz produces 30 smoothies

and 0 salads.

 Joe produces 30 salads

and 0 smoothies.

© 2010 Pearson Education Canada

 Gains from Trade
Liz and Joe trade:

 Liz sells Joe 10 smoothies

and buys 20 salads.

 Joe sells Liz 20 salads and

buys 10 smoothies.

After trade:

Liz has 20 smoothies and

10 salads.

Joe has 20 smoothies and

10 salads.
© 2010 Pearson Education Canada
 Gains from Trade

Gains from trade:

 Liz gains 5 smoothies and

5 salads an hour

 Joe gains 5 smoothies and

5 salads an hour

© 2010 Pearson Education Canada

 Gains from Trade
Figure 2.6 shows the gains from trade.

Joe initially produces at point A on his PPF.

Liz initially produces at point A on her PPF.

© 2010 Pearson Education Canada

 Gains from Trade
Joe’s opportunity cost of producing a salad is less than Liz’s.

So Joe has a comparative advantage in producing salad.

© 2010 Pearson Education Canada

 Gains from Trade

Liz’s opportunity cost of producing a smoothie is less than

Joe’s.

So Liz has a comparative advantage in producing smoothies.

© 2010 Pearson Education Canada

 Gains from Trade

Joe specializes in producing salad and he produces

30 salads an hour at point B on his PPF.

© 2010 Pearson Education Canada

 Gains from Trade
Liz specializes in producing smoothies and produces
30 smoothies an hour at point B on her PPF.

© 2010 Pearson Education Canada

 Gains from Trade
They trade salads for smoothies along the red ―Trade line.‖

The price of a salad is 2 smoothies or the price of a

smoothie is ½ of a salad.

© 2010 Pearson Education Canada

 Gains from Trade
Joe buys smoothies from Liz and moves to point C—a point
outside his PPF.

Liz buys salads from Joe and moves to point C—a point
outside her PPF.

© 2010 Pearson Education Canada

 Gains from Trade

Dynamic Comparative Advantage

Learning-by-doing occurs when a person (or nation)

specializes and by repeatedly producing a particular
good or service becomes more productive in that
activity and lowers its opportunity cost of producing that
good over time.

Dynamic comparative advantage occurs when a

person (or nation) gains a comparative advantage from
learning-by-doing.

© 2010 Pearson Education Canada

 What is the source of gains from
trade?

Resources are released from high-cost activities and

allocated towards relatively low-cost activities – total
production increases

Trade will take place at any price ratio that lies between the
opportunity costs of the two parties
• each person acquires one of the goods at a lower cost
through trade than through self-production
• both are better off

© 2010 Pearson Education Canada

 Economic Coordination

To reap the gains from trade, the choices of individuals

must be coordinated.

To make coordination work, four complimentary social

institutions have evolved over the centuries:

 Firms
 Markets
 Property rights
 Money

© 2010 Pearson Education Canada

 Economic Coordination

A firm is an economic unit that hires factors of production

and organizes those factors to produce and sell goods and
services.
A market is any arrangement that enables buyers and
sellers to get information and do business with each other.
Property rights are the social arrangements that govern
ownership, use, and disposal of resources, goods or
services.
Money is any commodity or token that is generally
acceptable as a means of payment.

© 2010 Pearson Education Canada

 Economic Coordination
Circular Flows
Through Markets

Figure 2.7 illustrates

how households and
firms interact in the
market economy.

Factors of production
and goods and
services flow in one
direction.

Money flows in the

opposite direction.
© 2010 Pearson Education Canada
 Economic Coordination
Coordinating
Decisions

Markets coordinate
individual
decisions through
price adjustments.

© 2010 Pearson Education Canada

 How does a market economy solve the
coordinating problem? What, how and
for whom?
1. How is it determined what and how much will be
produced?

Firms that produce the wrong stuff will lose money and
contract or close.

Firms that produce the right stuff will be highly profitable

and expand.

© 2010 Pearson Education Canada

 How does a market economy solve the
coordinating problem?

2. How is it determined how output will be produced?

Firms that find the least costly ways of combining

productive inputs will be able to sell the good most
profitably and will expand.

© 2010 Pearson Education Canada

 How does a market economy solve the
coordinating problem?

3. How is it determined who is to receive the output

that is produced?

Will talk about this in depth, but distribution of consumer

goods is determined by willingness and abililty to pay
for them in a market system.

© 2010 Pearson Education Canada

 Homework

Reading: Chapter 2

Tutorial questions:

Chapter 2 Problems and Applications

12, 13, 14, 15, 17, 18

© 2010 Pearson Education Canada