Introduction to
Macroeconomics
Econ 1011
A multi-lecture presentation for Air University – Sp-08
This presentation can be used freely for non commercial purposes.
Students MUST note that lecture slides are for reference only and the exam will rely
mostly on class discussions rather than slides.
The Economic Problem
 Unlimited
Wants
 Scarce Resources
– Land, Labour,
Capital
 Resource Use
 Choices
The Economic Problem



What goods and services should an economy
produce? – should the emphasis be on agriculture,
manufacturing or services, should it be on sport and
leisure or housing?
How should goods and services be produced? –
labour intensive, land intensive, capital intensive?
Efficiency?
Who should get the goods and services
produced? – even distribution? more for the rich?
for those who work hard?
Opportunity Cost



Definition – the cost expressed in terms of the next
best alternative sacrificed
Helps us view the true cost of decision making
Implies valuing different choices
QUIZ


What is PPF?
Where are the following zones located in PPF?
Optimum
 Inefficient
 Impossible


REMEMBER TO ADD THE UNDERTAKING
Choice in Scarcity

Scarcity Principle


Although we have boundless needs, resources
available to us are unlimited. So, having more of one
good means having less of another
Cost-Benefit Principle

An action should be taken if and only if, the extra
benefits from taking the actions are at-least as great
as the extra costs
Example of Cost-Benefit Principle

How many fellow students will you like to have
in your class?





100, 50, 20 or 10 ?
Professors Pay: Rs. 150,000/semester
Class Charges: Rs. 800/hr
All other charges: Rs. 2500/student-month
Fixed Charges: 5700,000. (Assume 1000
students)


Professors Pays: 10 x 150,000 = 1500,000
Class Charges: 3hrs x 16 weeks x 800 = 38,400
Fees Per Semester
If 100 Students in a class
31084
If 50 Students in a class = 40768 + 5700 = 46468
20 Students in a class = 86920 + 5700 = 92620
10 Students in a class = 169540
15,38,400/100 = Rs. 15384 + 2500x4 = 25384 + 5700 =

How many fellow students will you like NOW to
have in your class?
Mental Auctions

Ironing Your Shirt



Reservation Price:



How much (max) can you pay someone to iron your shirt?
How much (min) will you accept as payment for ironing
someone’s shirt?
Highest price someone is willing to pay to obtain any good or
service;
Or, the lowest payment someone would accept for giving up
a good or performing a service
Economic Surplus

The benefit of taking action minus its costs
Production Possibility Frontiers





Show the different combinations of goods and
services that can be produced with a given amount
of resources
No ‘ideal’ point on the curve
Any point inside the curve – suggests resources are
not being utilised efficiently
Any point outside the curve – not attainable with
the current level of resources
Useful to demonstrate economic growth and
opportunity cost
Production Possibility Frontiers
Capital Goods
Ym
Yo
Assume a country
can produce two
types of goods
with its resources
– capital goods
and consumer
goods
If the country is at
point A on the PPF It
can produce the
combination of Yo
capital goods and Xo
consumer goods
A
B
Y1
Xo
If it devotes all
resources to capital
goods it could
produce a maximum
of Ym.
If it devotes all its
resources to
consumer goods it
could produce a
maximum of Xm
If it reallocates its
resources (moving round
the PPF from A to B) it can
produce more consumer
goods but only at the
expense of fewer capital
goods. The opportunity
cost of producing an extra
Xo – X1 consumer goods
is Yo – Y1 capital goods.
X1 Xm Consumer Goods
Production Possibility
Production
Frontiers
inside the PPF
C
Y1
Capital Goods
Yo
.
A
B
Xo X1
– e.g. point B
means the
country is not
using all its
resources
It can only produce at
points outside the PPF
if it finds a way of
expanding its
resources or improves
the productivity of
those resources it
already has. This will
push the PPF further
outwards.
Consumer Goods
Positive and Normative
Economics




Health care can be
improved with more tax
funding
Pollution control is
effective through a system
of fines
Society ought to provide
homes for all
Any strategy aimed at
reducing factory closures in
deprived areas would be
helpful

Positive Statements:


Capable of being verified or
refuted by resorting to fact
or further investigation
Normative Statements:

Contains a value judgement
which cannot be verified by
resort to investigation or
research
The Production Possibilities
Frontier

Let’s introduce the Production Possibilities
Frontier



better known as the PPF.
The PPF is a basic workhorse in economics.
Often introduced in the first couple of
lectures in both micro and macro intro
courses.
The PPF



Important for understanding some basic issues
in economics and... more importantly….in
international trade theory.
Helps one understand opportunity cost and
distinguish between comparative advantage and
absolute advantage.
An important historical figure in all this is
David Ricardo.
David Ricardo





Famous 19th century British economist.
Some consider him the grandfather of
international trade theory.
Very influential in pioneering the theory of
comparative advantage, inter alia.
Very interesting, very bright guy.
Had a lot of say about the “corn laws” in
England.
The Production Possibility
Frontier - What Is It?



The description of the best possible
combinations of two goods to produce using
all of the available resources.
Shows the trade-off between more of one
good in terms of the other.
Assumes: input endowments given,
technology given, time given and efficient
production.
Opportunity Cost


The opportunity cost of an activity is the
value of the resources used in that activity
when they are used in their next best
alternative.
The slope of the Production Possibility
Frontier measures the opportunity cost of
producing one good in terms of the amount
of the other good foregone.
Exercise – Productivity Advantage
for Paula and Beth
Time to update a web Time to repair a bipage
cycle
Paula 20 Minutes
10 Minutes
Beth
30 Minutes
30 Minutes
QUESTIONS
Total Working hours per day: 6
Draw “Web-Page vs Bike Repair” PPF for Paula and Beth
Who is more Productive?
What should Paula do as a business?
What should Beth do as a business?
web pages a day
Paula 60/20 x 6 = 18
Beth 60/30 x 6 = 12
Bike repairs a day
60/10 x 6 = 36
60/30 x 6 = 12
15
10
0
5
We pages development
20
PPF of Paula and Beth
Bike Repairs
0
5
10
15
20
25
30
35
40
10
15
36/20 = 1.8 Bike Repair
0
5
We pages development
20
What is Paula’s Opportunity Cost of
Updating a Web Page?
Bike Repairs
0
5
10
15
20
25
30
35
40
Opportunity Costs
15
Paula Develops a Web Page
36/20 = 1.8 Bike Repair
10
Beth Repairs a Bike
12/12 = 1 Web Page
Beth Develops a Web Page
12/12 = 1 Bike Repair
0
5
We pages development
20
Paula Repairs a Bike
20/36 = .55 Web Pages
Bike Repairs
0
5
10
15
20
25
30
35
40
Production Possibility Schedule
Paula
Beth
BR/day
WP/Day
BR/day
WP/Day
36
0
12
0
32
2
10.64
1.33
28
4
9.31
2.66
24
6
7.98
3.99
20
8
6.65
5.32
16
10
5.32
6.65
12
12
3.99
7.98
8
14
2.66
9.31
4
16
1.33
10.64
0
18
0
12
25
15
20
Kink added with
addition of
worker in
economy
5
10
We pages development
30
PPF of Paula + Beth
0
5
10
15
20
25
Bike Repairs
30
35
40
45
50
25
15
20
Kinks
increase
with
increase in
workers
5
10
We pages development
30
PPF of Paula + Beth + 3rd Worker
0
5
10
15
20
25
Bike Repairs
30
35
40
45
50
Comparative and Absolute
Advantages

Paula has Absolute Advantage in both Bike
Repairing and Web Page Developing

Beth Has Absolute Advantage in none.

Paula has Comparative Advantage in Bike
Repairing
Beth has Comparative Advantage in Web
Development

Comparative Advantage


The person with the lower opportunity cost
of an activity has the comparative advantage
at that activity.
This means that the person with the
comparative advantage can produce the
activity by giving up the smallest amount of
the alternative activity.
The Idea of Comparative
Advantage and Trade


Specialization and free trade will benefit all
trading parties, even when some are
“absolutely” more efficient producers than
others.
Need to understand absolute vs. comparative
advantage.
Absolute vs. Comparative
Advantage Applied to Trade





Absolute advantage: If your country uses fewer resources
to produce a given unit of output than the other country.
Comparative advantage: if your country can produce the
output at a lower opportunity cost than the other country.
Every country (or person, or economy) has a comparative
advantage at some activity.
Absolute advantage is not important and may not always
happen. Sometimes people or countries have the absolute
advantage in nothing! Yet trade possibilities still exist.
It’s all about comparative advantage.
Concepts Affecting Trade
 Absolute advantage – exists when one nation


can produce goods more cheaply than another
nation.
Comparative advantage – ability of a nation to
specialize in the production of the good for
which it has the greatest comparative
advantage or lowest opportunity cost.
Competitive advantage – economic
competitive of a nation reflected in the
absolute cost of a given good in a given
market at a particular point in time.
Sunk Costs

The costs that are beyond recovery at the
moment a decision is to be made
Discussion Examples

Should you drive 100 kms through a snow storm
to watch a football game?
Ticket purchased in own city for $ 30.
 Your friend had decided to buy the ticket on the
ground, where it is $ 25, but seat choice may not be
available.
 If you and your friend are both rational, is one of
you more likely to attend the game than the other?




Since you have paid $ 30, it is a sunk cost. It cannot be recovered
whether you watch the gamer or not. So in deciding whether to
go to the game, you should compare benefits of going to the
game (your reservation price, the largest dollar amount you will
be willing to pay to watch it) to the additional costs you must
incur to see the game (OC of your time, costs you assign to
driving through the storm). You should not include the ticket
cost, that $ 30 is gone, you will never see it again, whether you
watch the game or not.
Your friend, must however include the cost of ticket since
he/she has not paid yet, and it is not a sunk cost.
Suppose your friend got a ticket as gift form anther friend before
going. What will happen now?
Example 2



How much should you eat at an all you can eat
restaurant, if the buffet price is $ 10?
How much should you eat at an all you can eat
restaurant, if the buffet price is $ 5?
How much if you are a lucky winner of a free
meal at the same restaurant?

Psychologists and economists have found
experimental evidence that people in these
groups do not eat similar amounts on average.
In particular, the lucky winner tend to eat
substantially less than those who paid $ 10.
People in the paid group somehow seem
determined to “get their money’s worth”. Their
apparent goal is to minimize the average cost of
the per bite food they eat.
Example of Absolute Advantage
Units of Output/Unit of Labor
United States
Mexico
Tons/man hour
Tons/man hour
Wheat
10
2
Coffee
4
6
The U.S. is the most efficient producer of wheat while Mexico is the
most efficient producer of coffee. With trade, the U.S. would specialize
in wheat and exchange part of its surplus for coffee. Mexico would
specialize in coffee and trade part of the surplus for wheat
Example of Comparative Advantage
Units of Output/Unit of Labor
United States
Mexico
Tons/man hour
Tons/man hour
Wheat
10
2
Coffee
4
3
Mexico has the absolute disadvantage in producing both goods because
its productivity fell by 50% from the previous example). While the U.S.
is more productive in both goods, its relative advantage is greatest in
wheat (5.0>1.33). The U.S. therefore has a comparative advantage in
wheat while Mexico has the least comparative disadvantage in coffee, or
comparative advantage in coffee.
Factors Affecting Comparative
Advantage….
 National differences in opportunity costs
 Costs affected by availability of resources
 Costs affected by production requirements for


goods and services produced
Costs affected by resource combinations
Costs affected by resource mobility
Production Possibilities Schedule
U.S.
U.S.
Mexico
Mexico
Wheat
Tons/year
Coffee
Tons/year
Wheat
Tons/year
Coffee
Tons/year
200
160
120
100
0
16
32
40
40
32
24
20
0
12
24
30
80
40
0
48
64
80
16
8
0
36
48
60
Based upon assumption that both countries fully
employ all resources, technology and specific
amounts of labor per year.
U.S produces 100
tons of wheat and
40 tons of coffee.
U.S produces 100
tons of wheat and
40 tons of coffee.
Mexico produces 32
tons of wheat and 12
tons of coffee
Through trade, the U.S.
specializes in wheat at
point B, trades 50 tons of
wheat to Mexico for 45 tons
of coffee, and consumes
more of both goods at
point C (45 tons of coffee
and 150 tons of wheat).
By comparing point C with
point A, we see that the
U.S. has gained from trade.
Mexico will specialize in
coffee, producing 60 tons
at point B’ and no wheat.
They would trade 45 tons
of coffee for 50 tons of
wheat, and consumer more
of both goods (50 tons of
wheat and 15 tons of
coffee at point C’) than it
could at point A’.
Home Assignment
Due on Monday 21 Apr 08



Consider a society whose only worker is Helen, who
allocated her production time between cutting hair and
baking bread. Each hour she devotes to cutting hair
yields 4 hair cuts, and each hour she devotes to baking
bread yields 8 loaves of bread.
Q No 1-A. If Helen Works a total of 8 hours per day,
graph her Production Possibility Curve.
Q No 1-B. Which of the points listed below is
efficient? Which is unattainable?



28 Haircuts/day, 16 loaves/day
16 Haircuts/day, 32 loaves/day
18 Haircuts/day, 24 loaves/day
Home Assignment
Due on Monday 21 Apr 08


Question No 2
Determine whether the following statements are True
or False, and Briefly Explain Why?
A. Toby can produce 5 gallons of apple cider or 2.5 ounces of
feta cheese per hour. Kyle can produce 3 gallons of apple
cider or 1.5 ounces of feta cheese per hour. Therefore Toby
and Kyle cannot benefit from specialization from trade.
B. A doctor who can vacuum her office faster and more
thoroughly than commercial cleaners should clean her office
herself.
Home Assignment
Due on Monday 21 Apr 08

Larry and Harry are stranded together on a desert island. The
raw material on the island are only suitable for making beer and
pizza, but their quantities are unlimited. What is scarce is labor.
Harry and Larry each spend 10 hours a day making beer or
pizza. The following table specifies how much beer and pizza
Harry and Larry can produce each hour.

Question No 3
A. Draw the Daily PPC for Harry and Larry.
B. Who has absolute advantage in making pizza? In brewing beer?
C. Who has comparative advantage in making pizza? In brewing beer?
Home Assignment
Due on Monday 21 Apr 08
Harry
Larry
Beer/hr
1 bottle
0.5 bottle
Pizza/hr
0.2
1.5

Now suppose their preferences are as follows: Harry wants 2
beers and as much pizza as he can eat each day; Larry wants 2
pizzas and as much beer as he can consume each day.

Question No 3
D. If each man is self reliant, how much pizza and beer will Harry and
Larry eat and drink, each day?
E. Suppose the two men decide to trade with each other. Draw their joint
PPC, and give an example of a trade that will make each of them better
off.