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The Economic Problem, Comparative Advantage and the Production Possibility Frontier

The Economic Problem, Comparative Advantage and the Production Possibility Frontier. According to the readings for today ’ s class, what question best summarizes the economic problem?. How do we set prices so that supply and demand are in balance? How do we maximize monetary value?

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The Economic Problem, Comparative Advantage and the Production Possibility Frontier

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  1. The Economic Problem, Comparative Advantage and the Production Possibility Frontier

  2. According to the readings for today’s class, what question best summarizes the economic problem? • How do we set prices so that supply and demand are in balance? • How do we maximize monetary value? • How do we ensure that all people can satisfy their basic needs? • How do we allocate limitless resources towards limited wants? • How do we allocate limited resources towards unlimited wants?

  3. The Economic Problem • Unlimited wants • Contradicted by hunter gatherer economies • Limited resources • Confirmed by the laws of thermodynamics • Some resources however are “unlimited”, .i.e not depleted by use (e.g. information, some ecosystem services) • What should we produce?

  4. The Economic Problem and Natural Capital • Neoclassical economics: how do we allocate natural capital among the production of different economic goods and services? • Ecological economics: • How do we allocate natural capital/ecosystem structure between economic production and ecosystem services, both of which are essential to our survival? • How do we distribute natural capital, within and between generations?

  5. Comparative advantage vs. absolute advantage • Absolute advantage: Hilary is a better lawyer and a better typist than Jon • Comparative advantage: Hilary is a much better lawyer than Jon, but only a slightly better typist • If the opportunity to practice law is the cost, then Jon has a comparative advantage in typing

  6. Opportunity cost and exchange • Hilary can type twice as fast as Jon • She gets paid $200/hr for practicing law, and only pays Jon $10/hr for typing. • With 1 hr practicing law, she can pay for 20 hours of Jon’s typing. It would take her 10 hours to type that much. She saves 9 hours=$1800. • Hilary will practice law, and pay Jon to type

  7. Guns and Butter(manufactured goods and ag) • Mary can produce 12 gallons of butter per day, 4 assault rifles, or any combination thereof • Jon can produce 4 gallons of butter per year, 12 assault rifles, or any combination thereof

  8. Production possibility frontier, individuals Mary’s opportunity cost for 1 gallon of butter = 1/3 gun OCbutter= loss in guns gain in butter Jon’s opportunity cost for 1 gallon of butter = 3 guns Ocbutter= loss in guns gain in butter Butter is 9 times more ‘expensive’ for Jon to produce than for Mary

  9. Production possibility frontier, with trade Maximum amount of one good that can be produced for every possible level of production of the other good

  10. Gains from trade • If each person produces both items for their own consumption, and like to consume the same amount of each, each one will produce and consume 3 of each item. • If they specialize, Mary can make 12 gallons of butter, Jon 12 guns. Production has doubled. • They can trade, and both consume more • What if Mary produces everything in 2 hours a day, while Jon does so in 8?

  11. Many person PPF Productive Efficiency

  12. What is happening to the marginal cost of producing butter? • Increasing opportunity costs are everywhere. • What is happening to the marginal benefits of butter? • When should we stop producing butter?

  13. PPFs of different nations

  14. Sources of comparative advantage Individuals Natural abilities Education and training Experience Capital Nations Natural capital Human capital Language Social capital Institutions and culture Built capital

  15. Benefits of specialization • Economy produces more • Everyone gets better at the task in which they specialize

  16. Costs of specialization Each person can only do one activity What if someone wants to do many different things with their life? What if something you’re not the best at gives you the most satisfaction? E.g. self employment What will be the impact on income stability if relative prices change?

  17. Costs of specialization NYT: What Work Is Really For Work vs. leisure

  18. Macro opportunity cost: What is lost when we produce more guns and butter?

  19. Macro-opportunity cost and linear throughput First and second laws of thermodynamics Matter/energy cannot be created or destroyed Usefulness is lost All resource extraction degrades ecosystems All waste output degrades ecosystems THERE ARE REAL COSTS TO GREATER ECONOMIC OUTPUT

  20. Shifts in the production possibility frontier Improved technology, capital, organizational structure, etc. shifts PPF i.e. increases in any of the 4 capitals

  21. Why do shifts lead to more production instead of more leisure? What happens to the opportunity cost of leisure when productivity increases? Do different cultures react differently? What happens to cultures that prefer leisure to production? Agriculturalists vs. hunter gatherers Industrialization vs. agriculturalists

  22. Downward shifts in the production possibility frontier

  23. What would be the most likely cause of this type of shift in the production possibility frontier? • Extensive soil erosion • Climate change • Dwindling fossil fuel supplies • Genetically modifiedcows that produce more butterfat • A loss of skilled labor in manufacturing

  24. Downward shifts through time

  25. What is the intergenerational PPF? Do our activities today have any impact on production by future generations? Non-renewable resources—OIL Global warming and loss of coastlines Renewable resources Loss of Louisiana wetlands, sandbars Technology Advances, but also superfund sites Dealing with uncertainty

  26. Using resources efficiently What is efficient? Producing the most output from a given quantity of inputs Producing the greatest value of goods and services from a given quantity of inputs What determines market value? Preferences weighted by income Who determines value? Rich folks (us) alive today How do we determine the value of a clean environment or stable climate?

  27. Where should the economy produce? What quantity of guns and what quantity of butter?

  28. E Could point E be efficient?

  29. Productive efficiency When we cannot produce more of one good or service without producing less of another i.e. we are at a point on the PPF

  30. Allocative efficiency • We produce the combination of goods that we value most highly. • Who is ‘we’? • General Motors All-New Sierra: "What 1% of the world wants, it gets." • Lexus V8 LX 470: "Let nature worry about you for a change.“ • Demand = preferences weighted by income

  31. Neoclassical logic… 'Dirty' Industries: Just between you and me, shouldn't the World Bank be encouraging MORE migration of the dirty industries to the LDCs [Less Developed Countries]? I can think of three reasons: 1) The measurements of the costs of health impairing pollution depends on the foregone earnings from increased morbidity and mortality. From this point of view a given amount of health impairing pollution should be done in the country with the lowest cost, which will be the country with the lowest wages. I think the economic logic behind dumping a load of toxic waste in the lowest wage country is impeccable and we should face up to that.

  32. 2) The costs of pollution are likely to be non-linear as the initial increments of pollution probably have very low cost. I've always though that under-populated countries in Africa are vastly UNDER-polluted, their air quality is probably vastly inefficiently low compared to Los Angeles or Mexico City. Only the lamentable facts that so much pollution is generated by non-tradable industries (transport, electrical generation) and that the unit transport costs of solid waste are so high prevent world welfare enhancing trade in air pollution and waste.

  33. 3) The demand for a clean environment for aesthetic and health reasons is likely to have very high income elasticity. The concern over an agent that causes a one in a million change in the odds of prostrate cancer is obviously going to be much higher in a country where people survive to get prostrate cancer than in a country where under 5 mortality is 200 per thousand. .... While production is mobile the consumption of pretty air is a non-tradable.

  34. Who Said That? • Lawrence Summers’ World Bank Memo • Former chief economist at the World Bank • Former head of council of economic advisors under Clinton • Former President of Harvard • Former chief economist for Obama • Poor countries have a comparative advantage in dying from toxic waste dumps

  35. Global Sludge Ends in Tragedy for Ivory Coast Candace Feit for The New York Times A worker helping to clean up toxic sludge last week in Abidjan, Ivory Coast. The sludge, dumped from a tanker, has been blamed for eight deaths.

  36. Is Increasing Economic Output the Economic Problem?

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