1. University of Papua New Guinea Principles of Microeconomics Lecture 2: Foundational microeconomic concepts

2. The University of Papua New Guinea Slide 1 Lecture 2: Foundational microeconomic concepts Michael Cornish Overview Production possibility frontiers Proving gains from trade Factors of production The importance of property rights to trade The Circular Flow Model

3. The University of Papua New Guinea Slide 2 Lecture 2: Foundational microeconomic concepts Michael Cornish Production possibility frontiers PPFs and PPCs Illustrate the principle of opportunity cost Shows the all of the possible combinations of two products that can be produced –Hence the name: production possibility curve!

4. The University of Papua New Guinea Slide 3 Lecture 2: Foundational microeconomic concepts Michael Cornish Production possibility frontiers Assumptions: –Fixed resources –Fixed technology –Productive efficiency –Full employment –For our purposes, two products only (although you could always draw in more products across more dimensions…)

5. The University of Papua New Guinea Slide 4 Lecture 2: Foundational microeconomic concepts Michael Cornish Production possibility frontiers Example: Type of product Production alternatives a bcdef Capital ($bn) 0 12345 Consumer ($bn)15 1412950

6. The University of Papua New Guinea Slide 5 Lecture 2: Foundational microeconomic concepts Michael Cornish Production possibility frontiers Consumer goods Attainable Unattainable Capital goods 012345012345 5 10 15 a b d c z f e

7. The University of Papua New Guinea Slide 6 Lecture 2: Foundational microeconomic concepts Michael Cornish Production possibility frontiers Capital goods 012345012345 5 10 15 a b c d e f 012345012345 5 Consumer goods Increasing (marginal) opportunity cost of capital goods

8. The University of Papua New Guinea Slide 7 Lecture 2: Foundational microeconomic concepts Michael Cornish Production possibility frontiers How does economic growth affect the PPC? How does technological progress affect the PPC? How does an increase in population affect the PPC? What if I told you that consumer products were more labour-intensive?

9. The University of Papua New Guinea Slide 8 Lecture 2: Foundational microeconomic concepts Michael Cornish Production possibility frontiers More questions to think about: –Is it possible to have a concave PPC? –What about a straight-line PPC? –For those that are possible, what could we say about the opportunity cost?

10. The University of Papua New Guinea Slide 9 Lecture 2: Foundational microeconomic concepts Michael Cornish Proving gains from trade Why do we trade? And why do we specialise? Absolute advantage: –The ability to produce more of a product than other producers using the same amount of resources

11. The University of Papua New Guinea Slide 10 Lecture 2: Foundational microeconomic concepts Michael Cornish Proving gains from trade Comparative advantage: –The ability to produce a product at a lower opportunity cost than other producers

12. The University of Papua New Guinea Slide 11 Lecture 2: Foundational microeconomic concepts Michael Cornish Proving gains from trade Example: –Sugar industry and financial services industry in Australia and Fiji –Does Australia have an absolute advantage or a comparative advantage in financial services? –Does Australia have an absolute advantage or a comparative advantage in sugar?

13. The University of Papua New Guinea Slide 12 Lecture 2: Foundational microeconomic concepts Michael Cornish Proving gains from trade An example with numbers... Harry and Sally live together and like to cook pizzas and garlic bread. Here is the maximum each can produce in an hour: Pizzas (P)Garlic Bread (G) Harry41 Sally54

14. The University of Papua New Guinea Slide 13 Lecture 2: Foundational microeconomic concepts Michael Cornish Proving gains from trade Step 1: Plot their PPCs For one hour: Note: Sally has an absolute advantage in both! Pizzas (P) Garlic Bread (G) Harry 41 Sally 54 HarrySally GB Pizzas

15. The University of Papua New Guinea Slide 14 Lecture 2: Foundational microeconomic concepts Michael Cornish Proving gains from trade Step 2: Compare opportunity costs Pizzas: Harry: 1 pizza costs him 1/4 of a garlic bread => 1P : 0.25G Sally: 1 pizza costs her 4/5 of a garlic bread => 1P : 0.8G Harry has a lower cost of making pizzas (in terms of garlic bread) than Sally => Harry has a comparative advantage in producing pizzas Pizzas (P) Garlic Bread (G) Harry 41 Sally 54

16. The University of Papua New Guinea Slide 15 Lecture 2: Foundational microeconomic concepts Michael Cornish Proving gains from trade Step 2 (cont.) Garlic Bread: Harry: 1 garlic bread costs him 4 pizzas => 1G : 4P Sally: 1 garlic bread costs her 5/4 of a pizza => 1G : 1.25P Sally has a lower cost of making garlic bread (in terms of pizzas) than Harry => Sally has a comparative advantage in producing garlic bread Pizzas (P) Garlic Bread (G) Harry 41 Sally 54 Note: These ratios are just the inverse of those we calculated with pizzas!

17. The University of Papua New Guinea Slide 16 Lecture 2: Foundational microeconomic concepts Michael Cornish Proving gains from trade Step 3: Set a world price What is the ‘world price’ in our closed world of Harry and Sally? It must be within the range of their opportunity costs, as this establishes the limits of their willingness to trade. Therefore both Harry and Sally can gain from specialisation I.e. Harry will only trade a pizza if he gets more than 1/4 of a garlic bread in return Sally will only trade garlic bread if she gets more than 5/4 of a pizza in return Pizzas (P) Garlic Bread (G) Harry 41 Sally 54

18. The University of Papua New Guinea Slide 17 Lecture 2: Foundational microeconomic concepts Michael Cornish Proving gains from trade Step 3 (cont.): So what do we do? Assume that both Harry and Sally specialise and trade at a price between these limits E.g. Somewhere between 1P : 0.25G and 1P : 0.8G (or, in terms of 1 pizza, between 1G : 1.25P and 1G : 4P) So let’s set our world price at 1P : 0.5G (this is the same as 1G: 2P) Pizzas (P) Garlic Bread (G) Harry 41 Sally 54

19. The University of Papua New Guinea Slide 18 Lecture 2: Foundational microeconomic concepts Michael Cornish Proving gains from trade Step 3: Calculate a trade that works! Harry produces 4 pizzas and 0 garlic bread Sally produces 0 pizzas and 4 garlic breads At the world price (1P : 0.5 G) Harry trades 2 pizzas for 1 garlic bread / Sally trades 1 garlic bread for 2 pizzas After trade: Harry has 2 pizzas and 1 garlic breads Sally has 2 pizzas and 3 garlic breads Pizzas (P) Garlic Bread (G) Harry 41 Sally 54

20. The University of Papua New Guinea Slide 19 Lecture 2: Foundational microeconomic concepts Michael Cornish Proving gains from trade Step 4: Check on the PPC Conclusion: They can consume more with trade! HarrySally GB Pizzas Produces Consumes

21. The University of Papua New Guinea Slide 20 Lecture 2: Foundational microeconomic concepts Michael Cornish Proving gains from trade Extension: Ranges of possible trades HarrySally GB Pizzas

22. The University of Papua New Guinea Slide 21 Lecture 2: Foundational microeconomic concepts Michael Cornish Factors of production Labour (‘L’) –Income paid on labour is a wage Capital (‘K’) –Income paid on capital is rent (or interest) Land (‘T’) (but the category is broader than ‘land’!) –Income paid on land is rent Entrepreneurship –Income paid on entrepreneurship is profit

23. The University of Papua New Guinea Slide 22 Lecture 2: Foundational microeconomic concepts Michael Cornish The importance of property rights to trade What are property rights? –The exclusive (‘inalienable’) use of property, including the right to buy or sell it Important to: –Increase certainty in economic transactions… …and thus mitigate risk! Acts as a precondition for effective markets –An aside: property rights in centrally planned economies…

24. The University of Papua New Guinea Slide 23 Lecture 2: Foundational microeconomic concepts Michael Cornish The Circular Flow Model