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Lecture 1

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14 views29 pages

Lecture 1

Uploaded by

Charity Kwok
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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The Economic Problem

The Story of Silicon Valley

• Nowadays, Silicon Valley is home to many major


companies in the ICT industry
• However, Santa Clara County (the center of Silicon
Valley) was only an agriculture valley in 1940s.
• Even in 1950s there’re only a few electronic companies.

• How did Silicon Valley succeed?


The Story of Silicon Valley

Various factors contribute to Silicon Valley’s success


• The World War II and the aircraft manufacturing industry
• Weather conditions
• Federal funding
• Stanford
• Stanford Industrial Park
• Science, statistics and engineering departments
• The Korean War and the Vietnam War
• Strong demand for electronics-related products (semiconductors)
• Other factors
• The warm-summer Mediterranean climate zone
• The culture of entrepreneurship
• The venture capital industry
• …
The Story of Silicon Valley

The “Economic Way of Thinking”: How should we think about the case of Silicon
Valley as economists?
• People (entrepreneurs, investors, researchers, …) faces scarcity when making decisions
• Limited resources in production: land, labor, funding, …
• Limited demand in consumption: market, competitors, …
• People needs to make choices
• Tradeoff: invest in electronics or oranges?
• People makes rational choices based on the benefits and costs
• Decisions are made at the margin: Silicon Valley is not built in a day!

• To describe the cost (due to the scarcity of resources): Production Possibility Frontier
• To describe the benefit: Preferences
Production Possibilities

The production possibilities frontier (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.
Production Possibilities

The table and figure below show the PPF for two goods: cola and pizzas.
Production Possibilities

Any point on the frontier such as E and inside the PPF such as Z are attainable.
Points outside the PPF are unattainable.
Production Possibilities

We achieve production efficiency if


we cannot produce more of one good
without producing less of other good.
All points on the PPF are efficient.
Production Possibilities

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.
Production Possibilities

Every choice along the PPF involves a


tradeoff.
On this PPF, we must give up some
cola to get more pizzas or we must
give up some pizzas to get more cola.
Production Possibilities

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.
Production Possibilities

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.
Production Possibilities

In moving from F to E:
• The quantity of cola increases by 5
million cans.
• 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.
Production Possibilities

Opportunity Cost Is a Ratio


The opportunity cost of producing a
can of cola is the inverse of the
opportunity cost of producing a pizza.
• One pizza costs 5 cans of cola.
• One can of cola costs 1/5 of a pizza.
Production Possibilities

Opportunity Cost is Increasing


Because resources are not equally
productive in all activities, the PPF
bows outward.
The outward bow of the PPF means
that as the quantity produced of each
good increases, so does its
opportunity cost.
Using Resources Efficiently

PPF and Marginal Cost


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 determines opportunity cost.
The marginal cost of a good or service is the opportunity cost of producing
one more unit of it.
Using Resources Efficiently

The figure illustrates the marginal


cost of a pizza.
• As we move along the PPF, the
opportunity cost of a pizza increases.
• The opportunity cost of producing one
more pizza is the marginal cost of a
pizza.
Using Resources Efficiently

The bars illustrate the increasing


opportunity cost of a pizza.
• The black dots and the line MC show the
marginal cost of producing a pizza.
• The marginal cost curve (MC) passes
through the middle point of each bar.
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.
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.
Using Resources Efficiently

At point A, with 0.5 million pizzas available, people are willing to pay 5 cans
of cola for a pizza.
Using Resources Efficiently

At point B, with 1.5 million pizzas available, people are willing to pay 4 cans
of cola for a pizza.
Using Resources Efficiently

At point E, with 4.5 million pizzas available, people are willing to pay 1 can
of cola for a pizza.
Using Resources Efficiently

The line through the points shows the marginal benefit from a pizza.
Using Resources Efficiently

When we cannot produce more of any one good without giving up some
other good, we achieve 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 achieve allocative efficiency.
• We are producing at the point on the PPF that we prefer above all other points.

Question: Does achieving production efficiency imply that we have achieved


allocative efficiency, or is it the other way around?
Using Resources Efficiently

The figure 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.
• The efficient quantity is 2.5 million
pizzas.
Using Resources Efficiently

If we produce 1.5 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 produce
too few pizzas.
We are better off moving along the
PPF to produce more pizzas.
Using Resources Efficiently

If we produce 3.5 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 produce
too many pizzas.
We are better off moving along the
PPF to produce fewer pizzas.
Using Resources Efficiently

On the PPF at point B, we are


producing the efficient quantities of
pizzas and cola.
If we produce exactly 2.5 million
pizzas, marginal cost equals marginal
benefit.
We cannot get more value from our
resources.

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