MICROECONOMICS

2
CHAPTER
Objectives

After studying this chapter, you will be able to:

 Describe choice and scarcity
 Define the production possibilities frontier and calculate
opportunity cost
 Explain how current production choices expand future
production possibilities
 Explain how specialization and trade expand our
production possibilities
Microeconomics

 The word *micro* comes from the Greek word Mikros,

which means small.
 Therefore, microeconomics is the study of small
individual units of the economy and how they go about
meeting or satisfying their many needs or wants with the
available few/limited resources.
 Individuals and economies as a whole have to
understand how households, firms and industry operates
before one can understand how nations or economies
operate.
Principles of microeconomics

1. Scarcity: Scarcity refers to the limitedness of

resources, be it natural resource like time (24 hours in a
day) or man made are limited in nature compared to our
daily needs or wants.
2. Choice: Choices are decisions that us (individuals,
firms, industries and nations) make on a daily basis on
how to allocate the limited resources against the
numerous needs and wants.
 Decisions or choices have to be made on which needs
or wants to meet now and which ones to postponed for
later dates.
Principles of microeconomics

 Opportunity cost: is the cost of the next-best-forgone

alternative when a choice is made.
 It can also be defined as the highest-valued alternative
that we give up to get something of the activity chosen.
 It can simply be said to be the cost of the forgone or
forfeited alternative.
 We always forgo something in good to get something.
This is mainly due to scarcityness of resources.
Production Possibilities and Opportunity
Cost

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 possibility frontier

 In short, the Production Possibility Frontier (PPF) is the

curve that shows ALL the production possibilities or
alternatives of a nation or a frim.
 The other two names of the PPF are:
1. Production Possibility Curve (PPC)
2. Transformation Curve (TC)
Assumptions of the PPF/PPC/TC

1.Two good are involved, Eg good X and Y or commodity A

and B or maize and groundnuts.
2.There is limited income, or a budget or set aside money
to go in the production of the two goods.
3.The set aside money should be fully utilized. In short,
there must be full employment of resources ( no money
should be lying idle.
Production Possibilities and Opportunity
Cost

Production Possibilities
Frontier
Figure 2.1 shows the PPF
for CDs and pizza, which
stand for any pair of
goods and services.
Production Possibilities and Opportunity
Cost

Points along the frontier,

such as points A, B, C, D,
E, F, and Z are attainable.

Points outside the frontier

are unattainable.
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.
Production Possibilities and Opportunity
Cost

Any point inside the

frontier, such as point 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 and Opportunity
Cost

A move from C to D,
increases pizza production
by 1 million.
CD production decreases
from 12 million to 9 million,
a decrease of 3 million.
The opportunity cost of 1
million pizza is 3 million
CDs.
One pizza costs 3 CDs.
Production Possibilities and Opportunity
Cost

A move from D to C,
increases CDs production
by 3 million.
Pizza production
decreases by 1 million.
The opportunity cost of 3
million CDs is 1 million
pizza.
One CD costs 1/3 of a
pizza.
Production Possibilities and Opportunity
Cost

Note that the opportunity

cost of CDs is the inverse
of the opportunity cost of
pizza.
One pizza costs 3 CDs.
One CD costs 1/3 of a
pizza.
Production Possibilities and Opportunity
Cost

Because resources are

not all 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.
Using Resources Efficiently

Figure 2.2 illustrates the

marginal cost of pizza.
As we move along the
PPF in part a (shown here)
the opportunity cost and
the marginal cost of pizza
increases.
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

or service, 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

Efficient Use of Resources

When we cannot produce more of any one good without
giving up some other good, we have achieved production
efficiency, and 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, and we are
producing at the point on the PPF that we prefer above all
other points.
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.
Using Resources Efficiently

If we produce less than 2.5

million pizza, marginal
benefit exceeds marginal
cost.

We get more value from

our resources by
producing more pizza.

On the PPF at point A, we

are producing too many
CDs, and we are better off
moving along the PPF to
produce more pizza.
Using Resources Efficiently

If we produce more than

2.5 million pizza, marginal
cost exceeds marginal
benefit.

We get more value from

our resources by
producing less pizza.

On the PPF at point C, we

are producing too much
pizza, and we are better off
moving along the PPF to
produce less pizza.
Using Resources Efficiently

If we produce exactly 2.5

million pizza, 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 CDs and
pizza.
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.
Other factors affecting the PPF

 Natural hazards: natural hazards such as

 Floods
 Droughts
 Earth quakes and many more all negatively affect the
production of goods and the entire PPF shifts inward.
 This shows a reduction in the production of the two
specific products.
PPF for the Country ALPHA

Growth

CDs
Economic Growth

 The PPF can also show economic growth by moving

outward.
 This may occur due to additional resources, increasing
population, or new technology.
 It can also be caused by skilled labour
 An increase in income or budget allocated in the
production of the goods
 Increased capital
Reduction in economic growth

 In any case, when the factor is negatively

affecting production of the goods, the
PPF/PPC/TC shifts inward.

 This shows a reduction in the production

of both goods
PPF for the Country ALPHA

Reducti
on

CDs
Gains From Trade

Comparative 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.
Gains From Trade

Absolute Advantage
A person (or nation) has an absolute advantage if that
person (or nation) can produce more goods with a given
amount of resources than another person (or nation) can.
Because the gains from trade arise from comparative
advantage, people can gain from trade in that they also
have an absolute advantage.
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.
Review

 Any point on the graph shows how much of both goods

is being produced.
 Efficiency is shown by whether the point is on the curve
(efficient) or within the curve (inefficient).
 Tradeoffs are shown by any two points on the curve.
 Opportunity cost is shown by the decrease in one good
when the other is increased.
 Growth is shown by the frontier moving outward.
THE
END