ECO101: Introduction to

Microeconomics
Lectures 1-2
What is Economics?

• A social science that studies how individuals, businesses,

governments, entire societies and nations make decisions given
that we live in a world of scarcity

• “The ultimate purpose of economics, of course, is to understand

and promote the enhancement of well-being.” – Ben Bernanke

• Build models using a bunch of simplifying assumptions to

understand the real world
Economic Concepts

Scarcity:
• Unlimited needs and wants, limited resources
• Having more of one thing requires having less of something
else i.e. we have to give up X to get Y – a trade-off

• Opportunity cost: Next best alternative that we give up in

order to get something.

• Choices depend on incentives – an incentive is a reward that

encourages an action
In Broad Terms

Economics has two main branches:

• Microeconomics: focuses on the decisions of individuals and

firms
• Macroeconomics: focuses on the national and global
economy
Fundamental Questions of Microeconomics

• What goods and services should be produced?

• Who gets these goods and services?

 Two main actors in the economy: producers & consumers

 When these actors interact in a market, prices are determined
 Prices then dictate what is produced, how it is produced and how
goods and services are allocated
What gets produced?
DVDs vs Netflix
Positive vs Normative Economics
Positive Economics
 The way things are
 Universal Pension Scheme brings
the growing elderly population
under a social protection system
by providing monthly stipends.

Normative Economics
 The way things ought to be
 Citizens over the age of 50
should also be included in the
universal pension scheme.
Production Possibilities Frontier
What goods can we produce?
Trade-off: To produce more of something, we need to produce less of something else
We face scarcity in terms of resources and technology

A 2 goods model
Imagine a world where Bangladesh produces two goods only: clothing and computers
In this model economy, everything else remains the same (ceteris paribus) except the
production of these two goods
A Production Possibility Frontier (PPF) shows the different combinations of
these two goods that can be produced in a given time period, given the total
resources available.
 A PPF represents most key concepts that we have covered so far: scarcity, trade-offs,
opportunity costs.
 Production Possibilities Frontier
A 2 goods model

 On the x-axis, we have the quantity of computers

produced and on the y-axis, we have the quantity of

Clothing
clothing produced
 All points inside the PPF and on the PPF are attainable
i.e. these bundles can be produced
 All points outside the PPF are unattainable
 At point E, we are producing 5 million units of clothing
and 4 million computers.
 What happens if we move from point E to point B on
the PPF?
 What if we no longer wish to produce any computers?
 What happens at point Z?
Computers
 Production Possibilities Frontier
A 2 goods model

 Points on the PPF are feasible i.e. they can be

produced and efficient i.e. they represent full

Clothing
employment of available resources.
 Production efficiency is achieved when we cannot
produce more of one good without producing less of
another good.
 All points inside the PPF are inefficient i.e. resources
are not utilized properly.
 Movements along the PPF represent trade-offs e.g. we
must give up some computers to produce more units
of clothing
 Recall, the concept of opportunity cost : next best
alternative that we give up in order to get more of Computers
something else
 Production Possibilities Frontier
A 2 goods model

 Opportunity cost of producing an additional unit of

computer equals the units of clothing that we give up.

Clothing
 When we move from point D to E, we are producing
one additional unit of computer and giving up 4 units
of clothing i.e. 1 computer costs 4 pieces of clothing.
 What is the opportunity cost of moving from E to D? 9
 Notice the shape of the PPF – it is bowed outwards i.e.
concave to the origin.
 The shape of PPF represents increasing
opportunity cost – the more of either good that we
produce, the larger the opportunity cost of producing
an additional unit of that good. What is the intuition
behind this? Computers
 Production Possibilities Frontier

 Expansion of production possibilities is possible

through technological progress & economic

Clothing
growth.
 If Bangladesh devotes resources to capital
accumulation and technological development,
we become more capable in producing
computers – the PPF rotates outwards from
PPF0 to PPF1
 To expand our production possibilities in the
future, we must devote fewer resources to
producing consumption goods and some
resources to accumulating capital and
developing technologies so that we can produce
more consumption goods in the future. Computers
Exports: Goods and services that Onion prices go
we sell to other countries up as India slaps
Imports: Goods and services that fresh duty!
we buy from other countries

International Trade
 Why does Bangladesh import
onions?
 Who gains from international
trade?
 Who loses?
 2X2 Model
• 2 goods: clothing & computers
• 2 countries: Bangladesh and the UK
• It is much easier to produce computers in the UK due to the availability of a high-skilled
labor force and it is much easier to produce clothing in Bangladesh due to a large pool of
low-wage workers

Bangladesh United Kingdom

Clothing Computer Clothing Computer
30 0 10 0
0 10 0 30

Opportunity cost of producing clothing = 1/3 Opportunity cost of producing clothing = 3

computers computers
Opportunity cost of producing computers = 3 Opportunity cost of producing computers =
pieces of clothing 1/3 pieces of clothing
Comparative Advantage
 The opportunity cost of producing 35

clothing for Bangladesh is lower than 30

that for the United Kingdom i.e. it is
cheaper for Bangladesh to produce 25

clothing

Computers
20

 Therefore, Bangladesh has a comparative 15

advantage in the production of clothing
relative to the UK 10

 An individual/country has a comparative 5

advantage in an activity if they can 0

perform the activity at a lower 0 5 10 15 20 25 30 35
opportunity cost than others. Clothing

 Who has a comparative advantage in the UK Bangladesh

production of computers? Why?

 Comparative Advantage
 If both parties specialize in the production of the good in
which they have a comparative advantage and then
35
trade with each other, they can get an outcome that is
beyond their individual production possibilities frontier. 30

 If Bangladesh specializes in clothing and the UK 25

specializes the production of computers, Bangladesh

Computers
20
T
produces 30 units of clothing each day and the UK 15
produces 30 units of computer each day.
10
 However, both countries want to consume some 5
combination of each good so they decide to trade with
each other at some price below their opportunity cost. 0
0 5 10 15 20 25 30 35
 Assuming they decide to trade at: 1 clothing = 1 Clothing
computer – they trade 15 computers for 15 units of
UK Bangladesh
clothing i.e. point T of the new line (trade line)
 Both countries are better off once they trade
Absolute Advantage
• An individual or a country has an absolute advantage in the production of a good/service if they can
produce a higher quantity of that good/service given the same resources compared to another
individual.
• Assume, Bangladesh has an influx of new technology and improves dramatically in its capability to
produce both goods
• Therefore, Bangladesh now has an absolute advantage in the production of both clothing and
computer compared to the UK.
• Does it still make sense for the two countries to specialize and trade?

Bangladesh United Kingdom

Clothing Computer Clothing Computer
40 0 10 0
0 40 0 30
Absolute Advantage
Bangladesh United Kingdom
Clothing Computer Clothing Computer
40 0 10 0
0 40 0 30

Opportunity cost of producing clothing = 1 Opportunity cost of producing clothing = 3

computers computers
Opportunity cost of producing computers = 1 Opportunity cost of producing computers =
pieces of clothing 1/3 pieces of clothing

A country can have an absolute advantage in both goods and still benefit from trade.
 Differences in productivity give rise to absolute advantage.
 Differences in opportunity costs give rise to comparative advantage.
 By trading, countries are able to consume at a point which is beyond their individual
PPF – gains from trade
Example
In an hour, Sue can produce 40 caps or 4 jackets and Tessa can
produce 80 caps or 4 jackets.
a. Calculate Sue’s opportunity cost of producing a cap.
b. Calculate Tessa’s opportunity cost of producing a cap.
c. Who has a comparative advantage in producing caps?
d. If Sue and Tessa specialize in producing the good in which
each of them has a comparative advantage, and they trade 1
jacket for 15 caps, who gains from the specialization and
trade?
Example
Country Hours/Sweater Hours/Gown
Bangladesh 18 6
Vietnam 16 4

1. Which country has absolute advantage in which product?

2. Calculate the opportunity costs for each country in producing these items.
3. Identify which country has a comparative advantage in which product.