Production Possibilities Frontier

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Class

4

The importance of models

International Trade

Marginal Utility

Money!

Economic models

• Economists use models to to improve our understanding of the world. Models simplify difficult concepts.

• The circular-flow diagram

• The production possibilities frontier

The circular-flow diagram

“A visual model of the economy that shows how money flows through markets amongst households and firms”

The circular-flow diagram

• Firms

– Produce and sell goods and services.

– Hire and use factors of production.

• Households

– Buy and consume goods and services.

– Own and sell factors of production

.

• Markets for goods and services

– Firms sell

– Households buy

• Markets for factors of production

– Households sell

– Firms buy

The PPF

• The

Production Possibilities Frontier

(PPF) is a graph that shows the various combinations of output that the economy can possibly produce given the available factors of production and the available production technology.

Quantity of computers produced

3,000

2,200

2,000

1,000

The production possibilities frontier

D

C

A

Production possibilities frontier

B

0 300 600 700 1,000

Quantity of cars produced

Copyright©2003 Southwestern/Thomson Learning

The PPF

• Concepts illustrated by the production possibilities frontier:

– efficiency

– trade-offs

– opportunity cost

– economic growth

Quantity of computers produced

4,000

3,000

2,100

2,000

A shift in the PPF

A

E

0

700 750 1,000

Quantity of cars produced

Copyright © 2004 South-Western

Consumption

“Consumption means the act of using goods and services to satisfy human wants during a given period of time”

If we had unlimited income we would satisfy unlimited wants:

But income is limited!

A. What should be buy amongst all the goods and services?

B. How much to allocate to each good and service?

Marginal Utility Analysis

Economists use the term “UTLITY” to measure happiness of satisfaction.

Economics is amoral

The Law of Diminishing Marginal Utility

Marginal Utility will not only tell me whether I am going to consume a good or service but also how much of it I will consume.

Total Utility and Marginal Utility

6

7

4

5

1

2

3

Qty Consumed

0

0

-5

10

5

25

20

15

Marginal Utility

0

75

70

70

75

25

45

60

Total Utility

0

Economic Surplus

Consumer Surplus is the utility for consumers by being able to purchase a product for less than the highest price that they would be willing to pay.

Problem 1

You purchase 4 chocolates for the price of Rs.15 per bar. You are willing to pay 25 for the bar 22 for the second 18 for the third and 15 for the

4th How much consumer surplus is derived from the 4 bars?

Problem 2

Show graphically the change in consumer surplus resulting from a rise in product price.

Budget Constraints

Paper Money

Does Paper Money have any intrinsic value?

“Intrinsic” - if your currency is not recognized will it have value?

Money that does not have intrinsic value is known as

“Fiat Money

If there was no money then we would have to barter

For barter to work – trade is said to require the double

of coincidence of wants.

The history of money

Mesopotamian civilization developed a large scale economy based on “Commodity money”

Many other cultures also developed commodity money

Tobacco in America, Shells in India, Spices in

Europe, Alcohol in New South Wales

If you were in prison, what would be good forms of money to smuggle in.

3 important functions of money

Medium of exchange

Anything that facilitates trade by being generally accepted by all parties in payment for goods and services.

Unit of Account

A common unit for the measuring the value of every good and service.

Store of Value

Anything that retains its purchasing power over time.

The characteristics of Commodity money

Durable

Portable

Divisible

Uniform Quality

Gresham’s law – people tend to horde good money and trade away the rest.

Low opportunity cost

Value of money should not fluctuate erratically.

The need to specialize!

When countries specialize world output increases.

Comparative advantage.

The ability of a country to price a good at a lower opportunity cost than another country.

Absolute Advantage.

The ability of a country to produce a good using a fewer resources than another country.

Free Trade – The flow of good and services between countries without restrictions.

Fair Trade – a county should only reduce its barriers to entry if the other country does not have some sort of “unfair competitive” advantage. And also provided that the other country also reduces its trade barriers.

Type of protections

Embargo

Tariff

Quota

The infant industry argument

New domestic industries need protection because it is not yet ready to compete.

National Security argument.

A nation should not be dependent on other countries for defense.

Employment argument.

Job increases in protected industries.

Cheap foreign labor argument.

Other countries have cheaper labour, it is difficult to compete.

How do we use incentives to reduce the number of cars driving into Colombo?

The American Housing Crisis was a major component of the Global Financial Crisis.

Explain what happened.

Private Medical Colleges is a good for the country, discuss.

Up until 2000 – The Diamond Industry was run as a monopoly by South African company

De Beers. Give a history of diamonds and how they managed to maintain this monopoly.

 http://www.forbes.com/athletes/list/

Athletes are paid millions of dollars. Are they being overpaid?

Using the concepts that we learned in class.

How do we ask for a salary increase?

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