Download Opportunity cost, comparative advantage, absolute advantage An

ECON1101 Notes
COMPARATIVE ADVANTAGE
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Opportunity cost, comparative advantage, absolute advantage
An agent has the absolute advantage in a given activity if they can perform that activity more
efficiently than others in the economy. The opportunity cost of performing an activity is defined as
the value of the next best alternative sacrificed in order to perform the activity. An agent has the
comparative advantage in a given activity if they have the lowest opportunity cost for performing
that activity.
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The principle of comparative advantage and the low-hanging fruit principle
The principle of comparative advantage states that it is beneficial to all members of an economy if
each individual specialises in the activities for which they have the comparative advantage. The lowhanging fruit principle states that when increasing production of a good, the first resources
employed should be those with the lowest opportunity costs, and only when those are exhausted
should resources with higher opportunity costs be employed.
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Individual and economy-wide PPCs
The production possibility curve, or PPC, is the graph of all production possibilities for an economy or
individual. Points lying on the PPC are efficient production points, and are also attainable production
points. Points lying between the PPC and the axes are inefficient attainable production points. Points
lying outside the PPC are unattainable production points. The gradient of the PPC at any given point
is equal to the opportunity cost of producing one additional unit at that point (the marginal
opportunity cost). As per the low-hanging fruit principle, economy-wide PPCs can be drawn by
starting at the x-axis and drawing the line for the individual with the lowest opportunity cost, then
the line for the individual with the next lowest opportunity cost, and so on. In a small economy, this
will be a series of discrete curves – in a larger economy, it will be a single smooth curve.
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Individual and economy-wide CPCs
The consumption possibility curve, or CPC, is the graph of all consumption possibilities for an
economy or individual. In a closed economy, this curve will be identical to the PPC. In an open
economy, this curve will intersect the PPC at the point where all agents are specialising, and will
have gradient equal to the international exchange rate. The CPC will be above or equal to the PPC
for all values.
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Shifts in PPCs or CPCs
The PPC or CPC of an economy can be shifted outwards by: improvements in infrastructure, growth
in working population, increases in technology or knowledge.
SUPPLY AND DEMAND
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Perfectly competitive markets
A perfectly competitive market is a market with the following characteristics:
Consumers and suppliers are price-takers.
Goods throughout the market are homogeneous.
There are no externalities.
Goods are excludable and rival.
There is perfect information within the market.
There is free entry and exit.
When one of these conditions is not met, market failure occurs. Market failure is a situation where
the allocation of resources is not Pareto efficient. Pareto efficiency is where the market is at a state
where no individual can be made better off without another individual being worse off (no Pareto
improvements can be made).
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Marginal benefit and marginal cost, profit maximisation
The marginal benefit of an action (such as producing an additional unit of a good) is the extra benefit
gained by taking that action. The marginal cost of an action (such as producing an additional unit of a
good) is the extra opportunity cost of taking that action. The cost-benefit principle states that
actions should be taken if the marginal benefit is greater than the marginal cost. For this reason,
profit is maximised when MB = MC, as at this point no further actions should be taken.
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Cost functions and shutdown conditions
If a factor of production is fixed, its cost does not vary with production (it is a fixed cost). If a factor
of production is variable, its cost varies with production (it is a variable cost). A sunk cost is a cost
that cannot be recovered once paid. The short run is the period of time in which at least one factor
of production is fixed. The long run is the period of time in which all factors of production are
variable.
When the profit of production is greater than the (negative) fixed costs, even if the profit is less than
zero, the firm should continue running in the short run. This condition can also be given by MC >
AVC. Otherwise, it should shut down. In the long run, the firm should shut down if the profit of
production is less than zero (as there are zero fixed costs in the long run). This condition can also be
given by MC > ATC.
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MC, AVC, ATC graphs
In the short run, a continuous supply curve is given by the section of the MC (marginal cost) curve
above the AVC (average variable cost) curve. In the long run, a continuous supply curve is given by
the section of the MC (marginal cost) curve above the ATC (average total cost) curve. The MC curve
intersects these curves at their lowest points (as when the MC curve is below the other curves, they
have a negative gradient, and when it is above the other curves, they have a positive gradient).
Below these points, the operation will shut down.
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Price elasticity of supply and demand
The price elasticity of supply or demand represents the percentage change in the quantity supplied
or demanded resulting from a very small percentage change in price. It measures the responsiveness
of supply or demand to percentage changes in price.
Given a point A on a price/quantity graph,
ElasticityA = ΔQ/QA / ΔP/ PA).
Note that elasticity is a modulus measurement – even when the value is negative it is expressed as a
positive value. By definition, supply or demand are:
Elastic if the price elasticity is greater than 1.
Unit elastic if the price elasticity is equal to 1.
Inelastic if the price elasticity is less than 1.
Factors that can affect the price elasticity of supply include:
Availability of materials (higher availability leads to more elastic supply).
Mobility of factors (more mobile factors lead to more elastic supply).
Inventories and excess capacity (larger inventories and more excess capacity lead to more elastic
supply).
Time horizon (a longer time horizon leads to more elastic supply).
Factors that can affect the price elasticity of demand include:
Availability of substitutes and complements (higher availability leads to more elastic demand).
Definition of the good (a broader definition leads to more elastic demand).
Price of the good (a higher price leads to more elastic demand).
Time horizon (a longer time horizon leads to more elastic demand).
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Income effect and substitution effect
The substitution effect means that an increase in the price of a good leads to similar goods
(substitutes) becoming relatively cheaper and hence more attractive to consumers. Under the
substitution effect, an increase in price leads to a decrease in demand, and vice versa.
The income effect means that an increase in the price of a good leads to diminished purchasing
power by the consumer, meaning that they cannot buy as much. For normal goods, an increase in
price leads to a decrease in demand, and vice versa. For inferior goods, an increase in price leads to
an increase in demand, and vice versa.
Generally, the substitution effect dominates the income effect, and increases in the price of a good
will usually decrease demand (even of an inferior good).
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Complements and substitutes
A complement for a given good is any good that increases in demand when the other good
decreases in price, or vice versa. A substitute for a given good is any good that decreases in demand
when the other good decreases in price, or vice versa. Substitutes tend to be similar goods (e.g.
different brands of chips) whereas complements are goods that go well together (e.g. chips and
salsa).
MARKET EQUILIBRIUM
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Supply and demand curves (including shifts)
The law of supply states that supply curves tend to slope upwards, as the supply curve is given by
the MC curve past a certain point, and the production process is subject to increasing marginal costs.
Changes in price or quantity supplied result in movement along the supply curve, whereas changes
in factors of production affecting marginal costs shift the supply curve.
The supply curve is shifted to the right by:
A drop in the price of variable inputs.
Advancements in technology that increase productivity.
Increasing expectations on the future price or demand of the product.
A drop in the price or demand of other products.
An increase in the number of suppliers.
The law of demand states that demand curves tend to slope downwards, as the demand curve is
given by the MB curve, and the consumption process is subject to decreasing marginal utility.