Introduction to Economics International Relations and international Organization
Week 2: Lecture 3 - Markets, perfect competition and welfare
The economic problem (p. 31-37)
Production possibilities and opportunity cost
The quantities of goods and services that we can produce are limited by both our available resources
and technology. If we want to produce more of one good, we must decrease our production of
something else - we face a trade-off. The production possibilities frontier (PPF) is the boundary
between those combinations of goods and services that can be produced and those that cannot. The
PPF can be visualized by a graph with two goods we are considering, ceteris paribus. The area under
the curve is ‘attainable’, the area above the curve is ‘unattainable’ (therefore, it shows scarcity).
We achieve production efficiency if goods and services are produced at the lowest possible cost. This
outcome occurs at all points on the PPF. At points inside the PPF, production is inefficient because we
are giving up more than necessary of one good to produce a given quantity of the other good;
resources are either unused or misallocated or both:
- Resources are unused when they are idle but could be working, e.g. e workers unemployed
- Resources are misallocated when they are assigned to tasks for which they are not the best match
Every choice along the PPF involves a trade-off. All trade-offs involve a cost - an opportunity cost.
The opportunity cost of an action is the highest-valued alternative forgone. The PPF helps us to make
this idea precise and enables us to calculate opportunity cost. The opportunity cost of an additional
good no. 1 is the quantity of good no. 2 that we must forgo.
- Opportunity cost is a ratio: decrease in quantity produced of one good/increase in quantity
produced of another good as we move along the production possibilities frontier
- Increasing opportunity cost: the opportunity cost of good no. 1 increases as the quantity of good
no. 2 produced increases. The outward-bowed shape of the PPF reflects this.
The PPF is bowed outward because resources are not all equally productive in all activities. People
with experience in making cola, are not as good in making pizzas. So, if we move cola producers to a
pizza factory (or vice versa), we will get a small increase in the quantity of pizza produced, but a large
decrease in the quantity produced of cola.
Using resources efficiently
We achieve production efficiency at every point on the PPF, but which point is best? When goods and
services are produced at the lowest possible cost and in the quantities that provide the greatest
possible benefit, we have achieved allocative efficiency.
Marginal cost is the opportunity cost of producing one more unit. We can calculate this from the
slope of the PPF: as the quantity of good no. 1 increases, the PPF gets steeper and the marginal cost
increases. The middle of each section of change at the PPF illustrates one point at the marginal cost
curve.
Marginal benefit from a good or service is the benefit received from consuming one more unit of it.
The benefit is subjective: it depends on people’s preferences. Marginal benefit and preferences stand
in sharp contrast to marginal cost and production possibilities. We use a marginal benefit curve to
illustrate preferences, which shows the relationship between the marginal benefit from a good and
the quantity consumed of that good. A marginal benefit curve is unrelated to the PPF and can, thus,
not be derived from it. We measure the marginal benefit curve from a good or service by the most
that people are willing to pay for an additional unit of it. Principle of decreasing marginal benefit: the
more we have of any good or service, the smaller is its marginal benefit.
At any point on the PPF, we cannot produce more of one good without giving up some other good.
At the best point on the PPF, we cannot produce more of one good without giving up some other
good that provides greater benefit. This is the case when the MC curve and MB curve intersect:
,Introduction to Economics International Relations and international Organization
- When MC is smaller than MB, we can get more value from our resources by moving some of them
out of producing cola into producing pizza
- When MC is greater than MB, we can get more value from our resources by moving them vice versa
- When MC equals MB, the resources between pizzas and cola are efficiently allocated
Demand and supply (p. 60-71)
Supply
Many useful things can be produced, but they are not produced unless it is profitable to do so. The
quantity supplied of a good or service is the amount that producers plan to sell during a given time
period at a particular price. The quantity supplied is not necessarily the same amount as the quantity
actually sold. The law of supply states that ceteris paribus, the higher the price of a good, the greater
is the quantity supplied and vice versa. Why does a higher price increase the quantity supplied?
After the demand curve, we will now study the supply curve, which shows the relationship between
the quantity supplied of a good and its price, ceteris paribus. A supply curve is a graph of a supply
schedule. To make a supply curve, we graph the quantity supplied on the x-axis and the price on the
y-axis. You can read the supply curve in two ways:
1. It tells us the quantity that is supplied at a given price;
2. It is the minimum-supply-price curve: it tells us the minimum price at which producers are willing
to produce a given quantity. This lowest price is marginal cost.
- Supply: entire relationship between the quantity supplied and the price of a good
- Quantity supplied: a point on a supply curve - the quantity supplied at a particular price
When any factor that influences selling plans other than the price of the good changes (shift along
the supply curve), there is a change in supply (shift of the supply curve left-, in case of a decrease, or
rightward, in case of an increase):
- Prices of factors of production: if the price of a factor of production rises, the lowest price a
producer is willing to accept rises, so supply decreases (or vice versa)
- Prices of related goods produced: if price of substitute in production (good that can be produced
using same resources) rises, the supply of the original good decreases. If the price of a complement in
production (goods that must be produced together) rises, supply of a complementary good increases.
- Expected future prices: if the prices are expected to be higher next week, supply will decrease now
and increase later.
- Number of suppliers: larger number of firms that produce a good, the greater is supply of the good
- Technology: a technology change occurs when a new method is discovered that lowers the cost of
producing a good, which makes that supply will increase
- State of nature: this includes all the natural forces that influence production
Market equilibrium
Equilibrium is a situation in which opposing forces balance each other. Equilibrium in a market occurs
when the price balances the plans of buyers and sellers. The equilibrium price is the price at which
the quantity demanded equals the quantity supplied. The equilibrium quantity is the quantity
bought and sold at the equilibrium price. A market moves towards its equilibrium because:
- Price regulates buying and selling plans
- Price adjusts when plans don’t match: if the price is below the equilibrium there is a shortage, and if
the price is above the equilibrium there is a surplus. The price goes up when there is shortage and,
therefore, supply increases; the price goes down if there is a surplus and, therefore, supply decreases
Predicting changes in price and quantity
The demand and supply theory provides us with a powerful way of analysing influences on prices and
the quantities bought and sold. According to the theory, a change in price stems from:
, Introduction to Economics International Relations and international Organization
1. A change in demand:
- When demand increases, both the price and the quantity increase.
- When demand decreases, both the price and the quantity decrease.
2. A change in supply:
- When supply increases, the quantity increases and the price falls
- When supply decreases, the quantity decreases and the price rises
3. Changes in both demand and supply:
- Demand and supply change in the same direction: equilibrium quantity changes in the same
direction. If demand increases by more than supply increases, the price rises. But if supply
increases by more than demand increases, the price falls.
- Demand and supply change in opposite directions:
- if demand changes by more than supply, the equilibrium quantity changes in the
same direction as change in demand (& vice versa)
- when demand decreases and supply increases by same amount, at initial price,
there is a surplus, so the price falls. A decrease in demand decreases quantity and an
increase in supply increase quantity, so when these changes occur together, we can’t
say what happens to the quantity unless we know the magnitudes of the changes
- when demand increases and supply decreases by the same amount, at the initial
price, there is a shortage, so the price rises. An increase in demand increases the
quantity and a decrease in supply decreases the quantity, so, again, …
Efficiency and equity (p. 106-113)
Benefit, cost and surplus
Resources are allocated efficiently and n the social interest when they are used in the ways that
people value most highly. The relationship between the price of a good and the quantity demanded
by one person is called individual demand. And the relationship between the price of a good and the
quantity demanded by all buyers is called market demand. A demand curve is a marginal benefit
curve. The market demand curve is society’s marginal benefit curve (marginal social cost): therefore,
the market supply curve is also the marginal social benefit curve (MSB).
We don’t always have to pay what we are willing to pay. A consumer surplus is the excess of the
benefit received from a good over the amount paid for it: Formula = marginal benefit of a good - its
price, summed over quantity bought. A consumer surplus can be seen as an area under the demand
curve, but also on a certain point on a demand curve the consumer surplus can be measured: the
difference between that point and the price is the consumer surplus at that particular point.
Whereas consumers distinguish between value and price, producers distinguish between cost and
price. The relationship between price of a good and quantity supplied by producer is called individual
supply. And relationship between price of a good and quantity supplied by all producers is called
market supply. A supply curve is a marginal cost curve. The market supply curve is society’s marginal
cost curve (marginal social cost): therefore, market supply curve is marginal social cost curve (MSC).
When price exceeds marginal cost, the firm receives a producer surplus: the excess of the amount
received from the sale of a good or service over the cost of producing it: Formula = price received for
a good or service - its minimum supply price, summed over the quantity sold. A producer surplus can
be seen as an area above the supply curve (and below the price curve), but also on a certain point on
a supply curve the producer surplus can be measured: the difference between that point and the
price is the producer surplus at that particular point.
Is the competitive market efficient?
Consumer surplus and producer surplus can be used to measure the efficiency of a market. At the
intersection point between the demand and supply curve, marginal social benefit and marginal social
