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Published on October 4, 2007

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Production Possibility Frontier, Opportunity Cost and Supply and Demand:  Production Possibility Frontier, Opportunity Cost and Supply and Demand Class 2 People must make choices because of scarcity. If there were no scarcity, there would be no need to study economics.:  People must make choices because of scarcity. If there were no scarcity, there would be no need to study economics. Scarcity We want more than there is Whenever a person or a society wants more than they have, or more than they can produce, there is scarcity. Diamonds are a scarce good. Beer is a scarce good. Idaho tumbleweed is not scarce. It is a free good. Scarcity means that we must choose among different alternatives; we cannot have unlimited amounts of everything:  Scarcity means that we must choose among different alternatives; we cannot have unlimited amounts of everything Opportunity Cost The opportunity cost of a chosen action is the loss of the sacrificed alternative Sacrificed money, time, and other stuff The opportunity cost of buying a diamond necklace might be a trip to Europe or eating during the fall semester The opportunity cost of going to an A’s game might be four hours of studying and the price of the ticket The opportunity cost of going to an A’s game the night before an economics exam might be quite high What is the opportunity cost of taking this summer class? What is the opportunity cost of buying the Case and Fair textbook? Example: Textbook costs $100 Pizza Pie costs $10 You have $300 to spend on textbooks & pizza pies:  Example: Textbook costs $100 Pizza Pie costs $10 You have $300 to spend on textbooks & pizza pies If you buy… 0 books, you can buy 30 pizza pies (0*$100 + 30*10 = $300) 1 book, you can buy 20 pizza pies (1*$100 + 20*10 = $300) The opp. cost of buying one textbook is the loss of 10 pizza pies 2 books, you can buy 10 pizza pies (2*$100 + 10*$10 = $300) The opp. cost of buying a second textbook is the loss of 10 pizza pies What happens if you buy 3 books? The production possibilities frontier (PPF) illustrates the ideas of scarcity and opportunity cost:  The production possibilities frontier (PPF) illustrates the ideas of scarcity and opportunity cost Production Possibilities Schedule for Tanks and Wheat The opportunity cost of one unit of tanks is also the marginal rate of transformation (MRT). The MRT can change, as it does in this case. The Production Possibility Frontier is a graph that shows all the combinations of goods (or services) that can be produced at maximum efficiency:  The Production Possibility Frontier is a graph that shows all the combinations of goods (or services) that can be produced at maximum efficiency Production Possibilities Frontier for Tanks and Wheat The line is the frontier. All resources are being used Combinations of Tanks and Wheat outside the frontier are not possible Combinations of Tanks and Wheat inside the frontier are possible, but inefficient When an economy is “inside its PPF,” it is operating inefficiently :  When an economy is “inside its PPF,” it is operating inefficiently A C B Point A is on the PPF: 15 tons of Wheat, 2 thousand Tanks Point C is inefficient: 10 tons of Wheat, 2 thousand Tanks Point B is inefficient: 15 tons of Wheat, 1 thousand Tanks Note negative slope! Economies must choose how they want to allocate resources efficiently:  Economies must choose how they want to allocate resources efficiently To Eat or To War? A Normative Question We can make lots of food, but be vulnerable to attack We can be militarily strong, but be very hungry Economic growth pushes the PPF out – better combinations are possible. :  Economic growth pushes the PPF out – better combinations are possible. PPF with new Wheat-making technology The old PPF The new PPF, with growth in Wheat-making possibilities You can improve your PPF by trading with other economies, as long as they have different opportunity costs than you.:  You can improve your PPF by trading with other economies, as long as they have different opportunity costs than you. Diamonds and Cabernet If Mary and John work efficiently individually, they will have different PPFs:  If Mary and John work efficiently individually, they will have different PPFs Different PPF Slopes When two people or economies have different opportunity costs, they can benefit from specialization and trade:  When two people or economies have different opportunity costs, they can benefit from specialization and trade Comparative Advantage and Opportunity Cost Mary has a comparative advantage in making diamonds (her opportunity cost of making diamonds in terms of cabernet is lower than John’s) John has a comparative advantage in making cabernet (his opportunity cost of making cabernet in terms of diamonds is lower than Mary’s) … Mary should specialize in making diamonds, and John should specialize in making cabernet Another example of opportunity cost:  Another example of opportunity cost Who should produce what? What is Mary’s opportunity cost of lawn mowing? Of typewriting? Do the same for John Is this fair?? Mary is better at everything! We will see how the price system will award Mary for her superior skills. That does not change the fact that both Mary and John are better off specializing and trading with each other than working individually to produce both goods for themselves Let’s shift gears… and think about money (since that is why you are taking this course):  Let’s shift gears… and think about money (since that is why you are taking this course) Since we live in societies that go beyond Mary and John, we must define the major players:  Since we live in societies that go beyond Mary and John, we must define the major players Firms and Households Goods and services flow clockwise. Firms provide goods and services; households supply labor services. Payments (usually money) flow in the opposite direction (counterclockwise) as the flow of labor services, goods, and services. Markets for inputs and outputs are established arrangements through which buyers and sellers come together to exchange goods or services:  Markets for inputs and outputs are established arrangements through which buyers and sellers come together to exchange goods or services Markets Lots of different kinds of markets Prices – the rate of exchange – are set through the levels of supply and demand Demand for a good is a schedule of the amounts of the good or service consumers are prepared to buy at different prices:  Demand for a good is a schedule of the amounts of the good or service consumers are prepared to buy at different prices Law of Demand There is a negative (or inverse) relationship between the price of a good and quantity demanded, holding other factors constant Quantity demanded is the amount of a good that consumers are prepared to buy at a given price Why is there a negative relationship between price and quantity demanded? People find substitutes (see future slide) We enjoy extra units less and less (see class 4) The Demand Curve:  The Demand Curve A shift in demand is different than movement along the demand curve:  A shift in demand is different than movement along the demand curve Quantity Demanded vs Demand Price changes the quantity demanded; other factors change the demand:  Price changes the quantity demanded; other factors change the demand Influences on Demand Income For normal goods, higher income leads to higher demand Prices of related goods Substitutes: increase in price of good A causes increase in demand for good B (Diet Pepsi and Diet Coke) Complements: increase in price of good A causes decrease in demand for good B (iPod and songs on iTunes) Preferences Changes in preferences (fads, demographic changes) can increase or decrease demand Number of potential buyers More buyers can increase demand (eg baby boomers) Expectations Future (expected) income can affect today’s demand The difference between a change in demand and a change in quantity demanded is important:  The difference between a change in demand and a change in quantity demanded is important Summarize Change in price of good change in quantity demanded Change in income, preferences, or prices of other goods change in demand Supply of a good/service is a schedule showing the amounts of the good firms offer to sell at different prices:  Supply of a good/service is a schedule showing the amounts of the good firms offer to sell at different prices Law of Supply There is a positive relationship between the price of a good and the quantity supplied, holding other factors constant Quantity supplied is the amount of the good offered for sale at a given price Why is there a positive relationship between price and quantity supplied? The Supply Curve:  The Supply Curve A shift in supply is different than movement along the supply curve:  A shift in supply is different than movement along the supply curve Quantity Supplied vs Supply Price is not the only factor that influences the supply schedule:  Price is not the only factor that influences the supply schedule Influences on Supply Cost of Production Increase in cost will decrease supply Prices of Related Products Increase in price of other producable goods can decrease supply The difference between a change in supply and a change in quantity supplied is important:  The difference between a change in supply and a change in quantity supplied is important Summarize Change in price of good change in quantity supplied Change in costs, input prices, technology, or prices of other goods change in supply The equilibrium (market clearing) price is the price at which the quantity demanded by consumers equals the quantity supplied by producers:  The equilibrium (market clearing) price is the price at which the quantity demanded by consumers equals the quantity supplied by producers Equilibrium At any price other than P0, quantity supplied does not equal quantity demanded Prices will not be stable outside of equilibrium Excess demand (shortage) is the condition that exists when quantity demanded exceeds quantity supplied:  Excess demand (shortage) is the condition that exists when quantity demanded exceeds quantity supplied Excess supply (surplus) is the condition that exists when quantity supplied exceeds quantity demanded :  Excess supply (surplus) is the condition that exists when quantity supplied exceeds quantity demanded Sometimes prices change, and this changes the equilibrium:  Sometimes prices change, and this changes the equilibrium Changes in the Equilibrium Price Higher demand leads to higher equilibrium price and higher quantity Higher supply leads to lower equilibrium price and higher equilibrium quantity The relative magnitudes of change in supply and demand determine the outcome of market equilibrium:  The relative magnitudes of change in supply and demand determine the outcome of market equilibrium Relative Magnitudes of Change Q0 P1 Q1 P0 Quantity Price Quantity Price D0 D1 S0 S1 Q0 Q1 P1 P0 S0 S1 D1 D0 Next Week:  Next Week Supply and Demand Elasticity

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