BUSS1040 - Economics for Business

Decision Making, Semester 2, 2022

Lecture 1: Key Concepts and comparative advantage

Reading: NW Chapter 1 and 4
 What is economics?

› "Economics can be defined in a few different ways. It’s the study of

scarcity, the study of how people use resources and respond to incentives,
or the study of decision-making. It often involves topics like wealth and
finance, but it’s not all about money. Economics is a broad discipline that
helps us understand historical trends, interpret today’s headlines, and
make predictions about the coming years.”

› Economics is the study of choice under scarcity.

o Scarcity is faced by consumers, businesses, government, countries, and so on.
› Key issues that need to be addressed in an economy are:
o (a) what to produce;
o (b) how to produce it; and
o (c) who should get what is made.

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 What is economics?

› In a modern economy, these 3 questions are typically resolved in the

‘market’.
› A market is a place where buyers and sellers of a particular good or
service meet.
o Markets can look quite different, from a traditional bazaar to an online trading
site.
› Even in market economy, governments play a critical role in markets, for
example, by imposing taxes and regulations.
› Our focus is on the behaviour of individuals (consumers, firms,
government) in markets.

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 Topic 1: Introduction and Key Concepts

› Start with some key ideas in economics

- Choice under scarcity
- Opportunity cost
- Gains from exchange/trade
› Familiarize with the tools and the way of thinking of economists
- Marginal analysis
- Correlation vs causation
- Ceteris Paribus
- Math referesher – on your own (Chapter 2)
 Chapter 1 and 4 of NW Book. (& 2 on your own)
 Review Questions in Tutorial 2.

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 Basic Economic Questions

› Scarcity: resources are limited, so that not all wants and needs can be
met
- For example, if I use my money to buy one product, then I cannot use it to buy
something else

› Because of scarcity, any choice involves a trade-off or opportunity cost

- Opportunity cost = what we give up when we make that choice, or “the value of
the next best foregone alternative”.
- This concept applies to any resource used when making a choice: how an
individual spends their time and other resources

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 Opportunity cost

› Examples of opportunity cost:

- On Saturday night you decide to watch a movie on TV with your flatmate but
you could have also accepted a babysitting job for $25/hour.

- What´s the opportunity cost of spending your time (2 hours) watching a

movie on a Saturday night?

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 Opportunity cost

› Examples of opportunity cost:

- Elizabeth prefers to spend Saturday afternoon walking. Her next best choice
would have been to sleep, and her third best choice is to go swimming.

- Therefore, if Elizabeth goes for a walk, the opportunity cost of going for a walk
is sleeping – her best foregone opportunity.
- The option of swimming is not relevant here, because it is not the next best
opportunity.

- Q: What is the opportunity cost to you of attending this

lecture?

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 Opportunity cost

› Opportunity costs include both explicit costs and implicit

costs.
o Explicit
costs are costs that involve direct payment (or, in
other words, costs that would be considered as costs by
an accountant).
o Implicit
costs are opportunities that are foregone that do
not involve an explicit cost.

© 2016 Bonnie Nguyen and Andrew Wait

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 Opportunity cost

› Example:
o Stephen decides to go to university, and his next best option is to work at a
construction site and earn $80K over the year.
- Total opportunity cost = explicit costs + implicit costs
- The explicit costs are those that Stephen must directly pay to go to university,
such as student fees, the cost of textbooks, and so on. Lets say that it costs
$20k a year to go to university.
- The implicit costs are the opportunities that Stephen must forgo – that is,
working at the construction site and earning $80K.
- The total opportunity cost is thus $100k a year.

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 Opportunity cost

› Opportunity cost does not include unrecoverable or sunk costs.

o For example, a business spent $100m on an advertising campaign last year and
needs to decide whether to keep the campaign going for another year.
o It cannot recoup the money (or the effort) spent on last year’s campaign by
deciding to stop the campaign now
o Thus $100m=sunk cost, not part of the total opportunity cost of continuing the
campaign now.

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 Marginal analysis

› Marginal means additional or extra. We use the term

repeatedly in economics.
o Marginal benefit
o The additional benefit received from consuming an extra
unit of something.
o Marginal cost
o The additional cost incurred through buying one more unit
of something).

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 Marginal analysis

› Marginal analysis is useful as it allows us to examine the

behaviour of individuals in market.
o Compare marginal benefit (MB) of an activity with Marginal
cost (MC)
o if MB of an activity is greater than its MC, an agent is
better off doing the activity;
o if the MB <MC, they are worse off if they do the activity.
o Decision making is thinking at the margin.

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 Correlation and causation

› Correlation – an association between two or more factors whereby the

factors are observed to be increasing/decreasing together or moving in
opposite directions.
› Causation – a change in one variable brings about, or causes, a change
in another variable.
o Economic theory, providing a framework for how the world works, allows us to
distinguish between correlation and causation.
› Correlation does NOT imply a causation
https://www.youtube.com/watch?v=lbODqslc4Tg

© 2016 Bonnie Nguyen and Andrew Wait

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 Ceteris paribus

› In the real world, many things change at the same time

(prices, income, tastes, taxes, and so on).

› To isolate the impact of one factor, economists examine the

impact of one change at a time, holding everything else
constant – this is called ceteris paribus (or ‘other things
equal’).
o If we are interested in the impact of the change in the price of a good on
the quantity demanded, we analyse this holding income, and any other
relevant variables constant.

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 Production possibility frontier (PPF)

› A PPF graphs the output that an individual (or a country)

can produce with a particular set of resources.

› A country’s PPF shows all the combinations of goods and

services that a country can produce given its resources
and its current state of technology.

- Note that if the country does not trade with others, the
PPF also describes the country’s consumption choices.

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 PPF: an example
Suppose a country can only produce 2 goods, guns and butter.
With its resources, it can produce the following

Guns Butter

Increasing opportunity
A 0 25000

cost of guns
B 100 24000
C 200 22000
D 300 18000
E 400 13000
F 500 0

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 Production Possibilities Frontier

Butter

Guns

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 Production Possibilities Frontier

Butter
A
B
25000
24000
D

E
13000

Production
Possibilities
Frontier

100 400 500

Guns

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 Production Possibilities Frontier

Butter
25000

Points out here:

Unattainable production
combinations

Points in here: Production

Inefficient production efficiency

500
Guns

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 PPF

The production possibility frontier

(PPF) traces out combinations of
the quantity of two goods (X and
Y) that can be produced if all
resources are used.
• Point A is attainable, as is B.
Point C is unattainable given
current technology and
resources.
• Production efficiency is
achieved at A, as at Point A, it
is not possible to produce more
X without producing less Y
(and vice versa).
• Point B is not efficient, as at
Point B, more X can be
produced keeping the amount
of Y the same (and vice versa).
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 The shape of the PPF

› Notice that the slope of this PPF increases as we

move down along it. Or, in words, the PPF is
concave  Why is that?
- If we produce no guns but only butter (point A) and then
decide to produce 100 guns, how much butter do we
need to give up?
- But if instead we were producing the bundle E, what’d
then be the opportunity cost of producing 100 additional
guns?

- Here, the opportunity cost of each good is increasing in

the level of output of that good
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 PPF and Opportunity Cost
Butter
A
B
25000

24000

E
13000

100 400 500

Guns

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 The shape of the PPF

› If either the amount of resources available or the state of

technology changes, the shape of the PPF can also change.

o An improvement of technology could shift the curve out (if it

improves productivity for both goods) or rotate the PPF out
or up (if the new technology only improves production for
one of the goods).

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 Changes in the PPF

With a shock that boosts the production

of both
Withgoods,
a shock thatthe PPF
boosts the will shift
production of both goods, the
outwards
PPF from origin along both
will shift outwards from origin along bothaxes
axes
(technology used in both industries, an increase in the labour
(technology used
force, and so on). in both industries

improves, an increase in the labour

force, and so on).

PPF PPF'

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 Changes in the PPF

If there is a shock that boosts the production

of Xis only,
If there a shock the PPFthewill
that boosts shiftofoutwards
production X only, the PPF from
will shift
outwards from origin along the X-axis only.
origin along the X-axis only.

PPF PPF'

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 PPF: Important to remember

› The slope of the PPF is the opportunity cost of producing an

additional unit of a good in terms of the other.

› It depends on the country’s productive resources (labour,

capital, land, etc.) and the current state of technology.

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 The gains from trade

› A basic tenant of economics is that trade can make everyone

better off.

o Trade = economic interaction

o Trade helps allocate goods to those who value them most.
This is the gains from exchange.
o Gains from exchange = Improvements in income, production
or satisfaction owing to the exchange of goods or services

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 Gains from trade

› A simple example (with consumers):

- Suppose Baz owns a bicycle he rarely rides and thus he
values little, say at $10.
- Chloe would like to have a bike. She is ‘willing to pay’ (i.e,
values a bike) at $100.
- If Baz sells the bike to Chloe for $40, then:
- Chloe is better off because she gets a $100 value bike for $40
- Baz is better off because he gets $40 when he only valued the bike at
$10.
- This trade is Pareto improving –both agents are better off.
- Provided the price is between $10 and $100 both parties can be made
better off by trading the bike

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 Gains from trade
› Key here is that exchange is voluntary
- Leaves both parties better off
- Whether the Pareto improving trade is weak or strong depends on the
valuations of each of the parties
- How much individuals benefit will depend on the terms under which trade
occurs:
- a higher price suits the seller, a lower price the buyer.

› Trade also allows people to take advantage of gains from

specialization, reducing overall costs of producing and increasing
output.
- related to “comparative advantage” in production

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 Gains from trade
› Consider economy when Rob can only wash clothes and
Matt can only cook.
- gains from trade, allows each to consume a new good

› When each can perform both tasks, but Robert can only cook
at great cost and Matt can only wash clothes with a
substantial effort.
- specialising lowers cost, can make both better off

› But what if one party is better at producing both services?

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 Gains from trade

Hours needed for => Amount produced in 12hrs

1 meal 1 basket meals baskets

R 2 4 6 3

M 1/2 3 24 4

If both do not trade they consume on their PPF

Proposed trade: Rob does 1.5 baskets of laundry for Matt.

Matt cooks 5 meals for Rob.

Note: The trade rate is given.

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Meals Meals

24 24
Rob’s ppf Matt’s ppf
Amount produced in 12hrs Amount produced in 12hrs
meals baskets meals baskets
R 6 3
M 24 4

Laundry 4 Laundry
3
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 Gains from trade
Without trade With trade

Prod. Prod Trade Cons Gains from

and cons trade

Rob 4 meals
1 basket

Matt 12 meals
2 baskets

(as an example)

Prod = production (quantity of goods produced)

Cons = consumption (quantity of goods consumed) 33
 Gains from trade

Without trade With trade

Prod. Prod Trade Cons Gains from

and cons trade

Rob 4 meals 0 meals

1 basket 3 baskets

Matt 12 meals 18 meals

2 baskets 1 basket

(as an example)

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 Gains from trade
Without trade With trade

Prod. Prod Trade Cons Gains from

and cons trade

Rob 4 meals 0 meals gets 5 meals

1 basket 3 bask for 1.5 bask

Matt 12 meals 18 meals gives 5 meals

2 baskets 1 basket for 1.5 bask

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 Gains from trade
Without trade With trade

Prod. Prod Trade Cons Gains from

and cons trade

Rob 4 meals 0 meals gets 5 meals 5 meals

1 basket 3 bask for 1.5 bask 1.5 bask

Matt 12 meals 18 meals gives 5 meals 13 meals

2 baskets 1 basket for 1.5 bask 2.5 bask

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 Robert’s PPF and consumption

Meals

Robert’s cons
with trade
6

4 Robert’s cons
without trade

1 3 Laun

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 Matt’s PPF and consumption
Meals
24
Matt’s cons
with trade

13
12
Matt’s cons
without trade

2 2.5 4 Laun

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 Gains from trade

Without trade With trade

Prod. Prod Trade Cons Gains from

and cons trade

R 4 meals 0 meals gets 5 meals 5 meals 1 meal

1 basket 3 bask for 1.5 bask 1.5 bask 0.5 bask

M 12 meals 18 meals gives 5 meals 13 meals 1 meal

2 baskets 1 basket for 1.5 bask 2.5 bask 0.5 bask

End results: Both parties can consume outside of their ppf

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 Absolute and comparative advantage

› Party A has an absolute advantage over Party B in the production of a

good if, for a given amount of resources, A can produce a greater number
of that good than B.
› Party A has a comparative advantage over Party B in the production of a
good if A's opportunity cost of producing that good is lower than B's
opportunity cost of producing the same good.

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 Gains from trade

› Matt needs 3 hours to produce 1 basket. In that time she could

produce 6 meals
- opportunity cost of 1 basket is 6 meals
- reflected in the slope of the ppf (-6)

› Robert’s opportunity cost of 1 basket is 2 meals

- slope of ppf -2

› Note, the opp cost for Matt of producing 1 meal is 1/6 baskets
- it takes 30 minutes to make a meal, in that time would wash
1/6 a basket
› Also, opp cost for Robert of producing 1 meal is 1/2 baskets
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 Gains from trade
Opportunity cost of 1:

Meals (in terms of Baskets (in terms of

baskets forgone) meals forgone)

R 1/2 2
M 1/6 6

• Producer with the lower opp cost has a comparative

advantage in that good
– Hence, Robert has a comparative advantage in laundry; Matt in cooking

• Note: as opp cost is the inverse for the other good it is impossible for a
person to have a comparative advantage in both goods

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 Gains from trade
• Differences in opportunity costs of production create
gains from specialisation and trade

• Each person specialises in the good in which they

have a comparative advantage

• Because economic pie increased in size everyone

can be better off
- each party can obtain the good for a lower price than his/her
opportunity cost
- i.e. Robert buys each meal for 3/10 basket of laundry while his
opportunity cost of cooking is 1/2 a basket of laundry.

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 Intuition underlying gains from trade

› Total output increases because trade allows parties to specialise in

producing the good in which they have the lower opportunity cost.

o With more output, both trading parties can potentially be made better off.

o Trade creates an environment for specialization to be feasible, increasing

the size of the economic pie.

o This increase in output can potentially be shared so as to make everyone

better off than without trade.

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 Intuition underlying gains from trade
› This concept is very general:
o Trade is beneficial to individuals (and indeed countries) because it allows them to
specialize in industries where they have the comparative advantage, and trade
with others for things that would cost them more to produce personally.

o Moreover, this principle holds even if one party has the absolute advantage in
the production of both goods; what matters is the comparative advantages or
opportunity costs of the parties.

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 Summary

› Key economic concepts

› Economics is the study of choice
- how society deals with scarcity of resources
› Scarcity => opportunity cost
- Reflected in Production Possibilities Frontier
› Gains from trade: everyone can be made better off through exchange of
goods & services
- Through specialization in production (based on comparative advantage), extra
gains from trade are possible

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