2. Administrative Notes
Articles for exam.
Online class articles available now.
Live class articles will become available by the end of this week.
Online Class:
Online students should also pay attention to the quizzes that have been given after the
midterm especially Quiz 5 Parts A and B.
Live class.
Pay attention to the CSUN enrollment example from the notes.
The Online Class Final will be made available on the MoodleCourse Outline after their exam
is finished.
3. Production Possibilities Frontier
Individuals, groups, countries, and societies can enrich themselves collectively and
individually by specializing in the production of goods in which they have a comparative
advantage and exchanging in the market for goods in which they have a comparative
disadvantage (specialization and exchange).
No coercion is necessary to make individuals, groups, countries, and societies specialize
and exchange because it is in their self interest to do so.
The policy or system which increases wealth is therefore to do nothing. This is policy is
also referred to as a free markets policy, capitalism, letting the market operate, etc.
In fact, any interference in voluntary exchange will reduce collective and individual
wealth by limiting the extent to which comparative advantage is exploited.
If comparative advantage exists enrichment is possible through specialization and
exchange. The amount of enrichment, both individual and collective, is proportional to the
degree of comparative advantage.
The more different two parties to a voluntary exchange, the greater the benefits from
exchange.
4. A Second Example of the Benefits of Specialization
According to Comparative Advantage and Exchange.
Original Example
Consider a second example.
Compute opportunity cost in the second example.
Can you characterize the change in
Opportunity costs?
The difference in opportunity costs has
widened, i.e. the farmer and rancher are more
different.
TheSuppose the farmergreater in theproductive
difference in OC is and rancher
second example compared in the original example.
resources, i.e. labor as to the first
What
example. will happen to collective welfare?
What has happened to the individual and collective
For gains from 1/8th vs. 8 to 1/8th. exchange?
Meat: 2 to specialization and
For Potatoes: 1 to 8slide. th to 8.
See next vs. 1/8
Hours Needed to Make 1
pound of
Amount Produced in 40 hrs
Meat
Potatoes
Meat
Potatoes
Farmer
20 hrs./lb
10 hrs./lb
2 lbs.
4 lbs.
Rancher
1 hr./lb.
8 hrs./lb
40 lbs.
5lbs.
Second Example
Hours Needed to Make 1
pound of
Amount Produced in 40 hrs
Potatoes
Meat
Potatoes
Farmer
In the second example to Rancher and the
Farmer are “More Different”.
Meat
40 hrs./lb
5 hrs./lb
1 lbs.
8 lbs.
Rancher
1 hr./lb.
8 hrs./lb
40 lbs.
5lbs.
Opportunity Costs
Original Example
Second Example
Meat
Potatoes
Meat
Potatoes
Farmer
2
1/2
8
1/8
Rancher
1/8
8
1/8
8
5. The Effect of Specialization According to Comparative
Advantage and Exchange: Second Example
Farmer sells 3 lbs. of potatoes for 3 lbs. of meat.
The Outcome Without
Trade
What they Produce
and Consume
Farmer
Rancher
What They
Trade
Get 3 lbs. of Meat
for 1 lb. of
Potatoes
The Gains From Trade
What They Consume
3 lbs. of Meat
3 lbs. of Meat
The Increase in
Consumption
2 lbs. Meat
2 ½ lbs. Meat
Point
A*
A to A*
Point B
4 lbs. Potatoes
8 lbs. Potatoes
Get 3 lbs. of Meat
for 3 lb. of
Potatoes
3 lbs. of Potatoes
5 lbs. of Potatoes
1 lbs. Potatoes
1 lbs. Potatoes
24 lbs. Meat 24
lbs. Meat
Point A
20 lbs. meat
20 lbs. meat
2 ½ lbs.
potatoes
2 ½ lbs.
potatoes
What They
Produce
O lbs. meat O
lbs. meat
1 lb. meat
½ lb. meat
2 lbs.
potatoes
4 lbs.
potatoes
The Outcome With Trade
Give 3 lbs. of Meat
for 1 lb. of
Potatoes
21 lbs. of Meat
21 lbs. of Meat
1 lb. Meat
1 lb. Meat
Give 3 lbs. of Meat
for 3 lb. of
Potatoes
3 lbs. of Potatoes
5 lbs. of Potatoes
2 lbs. Potatoes
2 lbs. Potatoes
Second Example in Blue.
Point
B*
B to B*
½ lb. of Potatoes
2 1/2 lb. of
Potatoes
6. Review of Supply and Demand Concepts
Movement to equilibrium occurs as a result of suppliers and demanders
pursuing their own self interest, e.g. will occur without outside interference.
Movement to equilibrium causes suppliers and demanders to enrich
themselves individually and collectively, i.e. the operation of the market
enriches.
Price at which exchange occurs divides the potential gain from trade
between buyers and seller so that both parties are left better off after
moving to equilibrium than before.
Changes in price act as signals to the market. For the market to operate,
prices must be allowed to fluctuate freely in response to market forces.
7. The Effects of Crop Failure in Africa (1)
The world food market starts in equilibrium with a world price of P1.
The crop failure causes the African food supply to fall.
The decrease in the African food supply creates a situation of excess demand at the price P1. As the market moves to a new short
term equilibrium the price will rise to P2.
There is now a difference in the food prices in Africa vs. the Rest of the World and an opportunity for profit exists by reallocation
food from the Rest of the World to Africa.
Rest of World
Price
Africa
Price
Supply
P1
Supply
P2
Demand
0
Quantity
Demand
0
Quantity
8. The Effects of Crop Failure in Africa (2)
Owners of food in the Rest of the World will ship food to Africa because it is their own self-interest to do so.
As the food is reallocated to Africa, Rest of the World’s food supply falls and Africa’s food supply increases.
Food will continue to be reallocated until it is no longer in the food owners interest to do so, i.e. the price of food in Africa and the Rest the
World has equalized at P3.
If the food supply in the Rest of the World is large relative to the Africa, there will be a small increase in food prices in the Rest of the World
and a large drop in Africa.
Rest of World
Price
Africa
Price
Supply
P3 P
Supply
P2
1
Demand
0
Quantity
Demand
0
Quantity
9. The Effects of Crop Failure in Africa (3)
If governments and international aid organizations “do nothing” market forces will prevent mass starvation by reallocating the
existing supply of food from low valued use in the Rest of the World to high valued use in Africa.
This reallocation of food which alleviates the famine will only occur if the price of food is allowed to move in response to market
forces.
Rest of World
Price
Africa
Price
Supply
P3 P
Supply
P2
1
Demand
0
Quantity
Demand
0
Quantity
10. Effects of Violating the Do-Nothing Policy (1)
Any regulation or interference in the normal operation of the market can be thought as an action that
prevents the market from moving to equilibrium.
In previous slides, we discussed the real world forces that move the market to equilibrium (excess supply
and demand, desire to engage in trade which makes one better off, etc.).
Any interference in the movement to equilibrium can be thought of as an attempt to prevent people
from engaging in a behavior that they want to engage in or in engaging in behavior that will make the
person, in his own mind, better off or richer.
When government tries to prevent people from engaging in behavior that they believe will make
them better off, people will resist.
The regulation will set off a process of resistance, increasing regulation/enforcement, more
resistance, more regulation, etc.
It may be impossible or extremely costly for the government to effectively impose regulation and
the result of regulation or interference in the normal operation may not be what was originally
intended.
Regulation will also force people to rely on non-price measures to allocate scarce supplies of the
good.
The type of non-price rationing that will be used depends on the particulars of the good and the
details of the regulation scheme.
11. CSUN Enrollment Policy
Price
Why is the supply curve vertical?
Supply
If the price were not regulated how
would the market allocated the scarce
supply of course?
Controlled Price
Shortage
Demand
0
Quantity
12. CSUN Enrollment Policy
P
Supply
CSUN Course Enrollment.
The goal of CSUN enrollment policy
is to allocate the scarce supply of
classes according to non-price
criteria.
Number of classes fixed by the
physical plant and number of
professors.
Is the allocation of classes “better”
or just different under a non-price
allocation system?
Instead of allocating courses
according to their value to the
student, the courses are
allocated according to other
criteria.
Number of units
completed.
Is the allocation of classes the one
intended by CSUN administrators?
Gaming the system.
First time freshman.
Graduating seniors.
Orientation Aides.
Controlled Price
Shortage
1
Demand
Q
20K
13. Review
Change in the World:
1. Price.
2. Price of Related Goods
3.Income
4. Other
Elasticities tell us how much and in
which direction will demand change?
1. Price Elasticity-Elastic or Inelastic
2. Cross Price Elasticity-Complements or
Substitutes
3. Income Elasticity-Normal or Inferior
4. Other
Price Elasticity of Demand
Cross Price Elasticity
Income Elasticity
d
=
% Q
% P
Percent Change in Quantity of Good 1
Percent Change in Price of Good 2
Percent Change in Quantity
Percent Change in Income
14. Start off in Long Run Equilibrium
Constant or Increasing Cost Industry?
Change in the world: Newspaper article or other source.
1. Change in Demand (normal/inferior, complements/substitutes).
• Change in income, change in the price of a related good, change in preferences.
2. Change in the price of inputs.
• Increased wages, higher interest rates, higher fuel costs, higher insurance, etc.
3. Change in technology.
4. Other
Unit cost curves: Will a firm’s unit cost curves shift up or
down?
At the current price, will existing firms produce more or less
Short Run Supply: Shift to the right or left
Where is the new short run equilibrium?
At the new price will existing firms be losing money,
making money breaking even.
Long Run Changes: What effect will entry and exit of firms
cause to the short run supply curve, output, and price. Is
this an Increasing or Constant Cost Industry
Demand: Shift to the right or left.
1. Where is the new short run Equilibrium?
2. What is the new price?
Short Run Changes: at the new price how will existing
firms adjust output?
Apply 3-Part Output Rule, i.e. shutdown decision and short
run output decision
Long Run Changes: What effect will entry and exit of firms
cause to the short run supply curve, output, and price. Is this
an Increasing or Constant Cost Industry?
16. The left hand graph shows the unit cost curves for a single firm producing the good. An industry is composed of many
firms with identical cost curves all producing the same good.
Initial Condition: Long Run Equilibrium
The Short Run Market Supply curve shows the amount produced by the existing firms as price varies. The Long Run
supply curve shows how the amount produces as price varies when the effects of entry and exit to the industry are
included.
Market
Representative Firm
$/unit
MC
Price
ATC
S 100 firms
A
P1
Long-run
supply
P1
D1
0
Quantity
(firm)
0
Q1
Quantity
(market)
18. Short-Run Response to an increase in Demand
The increase in demand (D1 to D2)
causes the price in to increase.
At current output levels (Q1-industry, q1-firm) the
existing firms are producing where P >MC.
Therefore, they can increase profits by increasing
Market
Firm
output.
$/unit
Price
MC
ATC
B
S 100 firms
A
P1
Long-run
supply
P1
D2
D1
0
q1
Quantity
The increase in output by existing firms causes 0
a
(firm)
movement along the short run supply curve (S1) from A
to B.
Q1
Quantity
(market)
19. Short-Run Response to an increase in Demand
Since all existing firms are increasing output,
industry output increases from Q1 to Q2.
Market
Firm
$/unit
Price
MC
P2
P1
0
ATC
B
P2
Existing firms choose their output P1
level by setting price equal to MC.
Since the price has risen, the
quantity at which P=MC is now
higher.
Therefore, existing firms increase 0
Quantity
output. (firm)
S 100 firms
A
Long-run
supply
D2
D1
Q1
Q2
Quantity
(market)
20. Short-Run Response to an increase in Demand
In the short run, the existing firms will earn a profit.
Market
Firm
$/unit
Price
Profit
MC
ATC
B
P2
P2
P1
S 100 firms
P1
A
Long-run
supply
D2
D1
0
Quantity
(firm)
0
Q1
Q2
Quantity
(market)
21. Increase in Demand in the Long Run
Over time, the short-run supply curve shifts as
profits encourage new firms to enter the market.
Price falls as new firms enter the market
In the new long-run equilibrium profits return to
zero and price returns to minimum average total
cost.
The market has more firms to satisfy the greater
demand.
22. At price P2, existing firms are earning a profit.
Entrepreneurs see the profit earned by existing firms and open new firms (enter
the industry).
Long-Run Response
Market
Firm
Price
Price
Profit
MC
ATC
B
P2
P2
P1
S100 firms
P1
A
Long-run
supply
D2
D1
0
Quantity
(firm)
0
Q1
Q2
Quantity
(market)
23. As new firms enter, the amount of the good produced at each price by the
existing firms (new and old) has increased.
This is depicted as a shift in the short run supply curve from S1 to S2.
Long-Run Response
Market
Firm
Price
Price
Profit
MC
ATC
B
P2
P2
P1
S100firms
S150 firms
Long-run
supply
D2
D1
Q2
Quantity
(market)
P1
0
Quantity
(firm)
0
A
Q1
24. Long-Run Response
As the new firms begin producing, the price falls from P2 to P1.
Market
Firm
$/unit
Price
MC
ATC
B
P2
P1
0
S100firms
S150 firms
Long-run
supply
D2
D1
Q2
Quantity
(market)
A
P1
Quantity
(firm)
0
Q1
25. Increase in Demand in the Short and
Long Run
New firms will continue to enter the industry, increasing the quantity produced,
shifting the short run supply curve outward, and driving down the price until
potential entrants no longer anticipate earning a profit after entering the industry.
Market
Firm
$/unit
Price
MC
ATC
B
S100firms
S150 firms
C
Long-run
supply
D2
D1
Q2
Q3
A
P1
0
P1
Quantity
(firm)
0
Q1
Quantity
(market)
26. An Increasing Cost Industry-Oil Industry
$/unit
MCSaudia Arabia
P1=$30
Profit
ATCSaudia Arabia
P1=$10
Profit
Price is above
ATC so SA
makes a profit
at P-$10
In 1930, oil was only produced in the Middle East, the demand for oil was
not that great, and the price of oil was low—P1. At P1 it was profitable to
produce oil in Saudi Arabia and other parts of the Middle East but not in
other parts of the world.
As the 20th century progressed, the demand for oil increased. There was a
short term increase in Middle Eastern oil production and in the long run (point
B), the high price of oil led to the discovery of higher cost deposits in other
parts of the world.
Will the entry of new firms, i.e. the discovery of new oil deposits outside
the Middle East, eliminate the oil profits of Saudi Arabia?
Quantity
(firm)
$/unit
MCrest of world
At P-$30, the price is above min
ATC so the Rest of the World
P
produces oil.
ATCrest of world
B
A
P2=$30
AVCrest of world
D1970
A
P1=$10
0
SMiddle East
SME + rest of world
LRS
P1
q1
Quantity
(firm)
Price is below
min AVC so
Rest of World
does no
produce at P$10
D1930
0
Q1
Quantity
(market)
28. Supply Side Changes.
Changes in input prices
Changes in Technology.
Start off by shifting unit cost curves.
Winners and losers.
29. Analyzing the effect of a decrease in the price of labor
1.
2.
3.
4.
Will the likely new contract increase of decrease the cost of production?
Will unit costs at any output level increase or decrease?
At any given price will existing firms produce more or less?
What effect will this have on the short run supply curve?
After the decrease in the price of labor, the unit costs of production are lower at
each level of output. At every price each firm will produce more (at P1 the firm will
increase output from q1 to q2).
The increase in output at each price by existing firms causes
the short run supply curve to shift right, lowering price to P2
L
$/unit
Price
MC
S100 firms
P1
ATC
A
A
Long-run
supply
P1
AVC
P2
S100 firms
D1
0
q1
q2
Quantity
(firm)
0
Q1
Quantity
(market)
30. Who benefits and loses from a reduction in the cost of labor.
Consumers are better off because the price of the good has fallen.
In the short run, firms are better off because their costs fall and they earn a profit.
In the long run, if the existing firms are earning a profit because of lower costs, new firms will enter shifting the short run supply curve to the
right, increasing output, and further lowering price.
If this were a constant cost industry, the reduction in the cost of labor would cause the long run supply curve to shift down.
In the Long Run, consumers are the sole beneficiary of the drop in the price of labor.
The reduced unit costs of production mean that at any given price the existing firms will produce more, shifting the short run supply curve
outward. Even at the new lower price, the existing firms will earn a profit in the short run.
In the long run, new firms will continue entering shifting the SR supply curve farther to the right, increasing supply, and reducing price until
the existing firms are just breaking even with their lower costs.
$/unit
Price
MC
S100 firms
P1
ATC
A
A
S150 firms
Long-run
supply
P1
AVC
P2
P3
0
S100 firms
D1
q1
q2
Quantity
(firm)
0
Q1
Quantity
(market)
31. Who benefits from an improvement in technology?
An improvement in technology is any change which allows a firm to produce more output with the same inputs.
A degredation in technology is any change which means a firm to produces less output with the same inputs.
The reduced unit costs of production mean that at any given price the
existing firms will produce more, shifting the short runs supply curve
The improvement in technology allows the firm to produce more
outward. Even at the new lower price, the existing firms will earn a profit
output with the same inputs.
in the short run.
Because the firm is producing more output with fewer inputs, and
the price of inputs hasn’t changed, the unit costs of producing will
In the long run, new firms will continue entering shifting the SR supply
fall.
curve farther to the right, increasing supply, and reducing price until the
existing firms are just breaking even with their lower costs.
In the SR, firms and consumers benefit from the improvement in
technology. In the LR just consumers benefit.
$/unit
Price
MC
S1
ATC
A
P1
A
S2
S3
Long-run
supply
P1
AVC
D1
Quantity
q1
(firm)
If this were a constant cost industry, the technological change
would shift the long run supply curve down.
0
0
Q1
Quantity
(market)
