Production Possibilities frontier

One of the central principles of economics is that everyone faces tradeoffs because resources are limited. These tradeoffs are present both in individual choice and in the production decisions of entire economies. The production possibilities frontier (PPF, also sometimes called a production possibilities curve) is a simple way to show these production tradeoffs graphically.

Since graphs are two-dimensional, economists make the simplifying assumption that the economy can only produce two different goods. Traditionally, economists use guns and butter as the two goods when describing an economy's production options, since guns represent a general category of capital goods and butter represents a general category of consumer goods.

Combinations of output that are inside the production possibilities frontier represent inefficient production, since an economy could produce more of both goods (i.e. move up and to the right on the graph) by reorganizing resources. On the other hand, combinations of output that lie outside the production possibilities frontier represent infeasible points, since the economy doesn't have enough resources to produce those combinations of goods. Therefore, the production possibilities frontier represents all points where an economy is using all of its resources efficiently. A production possibility frontier (PPF) is a curve or a boundary which shows the combinations of two or more goods and services that can be produced whilst using all of the available factor resources efficiently.

 

Indifferent Curve and its combinations

Utility: a generalized term for the satisfaction obtained by an individual from the 'use' of a product (good or service) measured by the price the individual is willing to pay for the product.

Indifference Curve:

    For any level of utility - U'  = f (x, y) - there is a locus of commodity combinations which graphically form an indifference curve, that is, all combination yield the same level of utility - U' meaning the consumer is 'indifferent' to any combination on the curve.  Usually an indifference curve is 'convex' in shape reflecting the fact that an increase in x can only be obtained by a reduction in y, and vice versa. The amount of y that is traded off to obtain an increase in x but maintaining the same level of utility is called the marginal rate of substitution, i.e., MUy/MUx  

Furthermore, in a sense, the 'f' in U = f (x, y) and 'f' is your taste function which is obviously different than mine or any other consumer and is reflected by different shape of indifference curves and different MRSs.  Anyone's indifference map will, for normal goods, be convex (opening away) from the origin.  The reason is diminishing marginal utility, i.e., at some point you are unwilling to give up x for any more y.  This is the point of inflection for the indifference curve.   The transitivity assumption ensures that curves do not intersect but rather rise

higher and higher.

c) Budget Line:

Given a specific level of income, a budget line shows all commodity combinations of x and and y that can be purchased by a consumer, i.e, .I = PxX + PyY.  One cannot consume above it (not attainable given income and prices) and it would be irrational to consume below it and pocket the cash.  Happiness in this model is only derived from the consumption of goods & services purchased on the market.  Saving money does not count other than as a 'good & service' that increases future consumption by 'selling' money for interest.  The maximum amount of x or y one can afford given income and prices is shown as the intercepts of the budget line and the respective axes.

If income goes up (and x and y are normal goods) a new higher budget line will be available to the consumer parallel to the original.

If the price of x decreases then the angle of the budget line changes and the intercept increases, that is, the consumer can buy more x with the same income The slope of the budget line is also the negative of the price ratio, i.e., - Px/Py.  Thus the price ratio is NOT the slope of the line which would be Py/Px (rise over run).  This formulation of the price ratio is a 'convention' or tradition in economics.  However, it also represents the 'relative price' of x and y at a given point in time, i.e., how many units of x can be bought with one unit of y at current prices, e.g., $1.00/50 cents = a relative price of '2'.

d) Equilibrium:

    The commodity combination which maximizes a consumer's utility is the one on the budget line tangent to the highest indifference curve.   In rare cases - a corner solution - an individual will consume none of a commodity x because no amount of x is worth the cost.  In such cases the consumer's maximum utility is obtained on the y -axis that is no x is consumed.

    Equilibrium occurs where the Budget Line just touches (is tangent to) the highest attainable indifference curve.  This equilibrium  or 'best affordable point' satisfies the following conditions:

Marginal Rate of  Substitution (MRS = MUy/MUx) equals the slope of the Budget Line or its negative, the price ratio - (Px/Py) therefore in equilibrium MUy/MUx = - Px/Py

at this point the 'rationale' consumer has equated the MU per dollar of each commodity consumed, i.e. MUx/Px = MUy/Py  Consumers will tend to remain at this point (or be 'in equilibrium') as long as taste, income and prices remain fixed.  This is called the 'initial equilibrium'.  We will now change these assumption one by one and see what happens to equilibrium.

Maximum utility is found where the budget line is tangent to the highest attainable  indifference curve - that is, where the negative slope of the indifference curve (or marginal rate of substitution of x for y) is equal to the slope of the budget line, that is, the marginal rate of substitution equals the (-) price ratio and here MUx/Px = MUy/Py.

2. Manipulations

  From the basic analytic mechanism of the indifference curve and budget line a range of additional information can be deduced including:

a) Income-Consumption Curve

    An increase in income increases the intercepts of the budget line but leaves its slope constant - assuming constant prices.  The locus of tangents of budget lines with indifference curves forms the 'income-consumption curve' or the set of commodity combinations (x, y) purchased as income increases - assuming constant prices and taste.

b) Engel Curve

    The amount of a given commodity (x) purchased at different levels of income, derived from the income-consumption curve, forms the 'Engel' curve.  The shape of an Engel curve depends on the type of commodity and consumer taste - assuming constant prices.  The quantity of a commodity (x) purchased will increase at either an increasing or decreasing rate as income rises - depending on the type of commodity.

c) Price-Consumption Curve

    If the price of one commodity (x) changes a new set of combinations (x, y) is created between the changing tangents of the budget line and indifference curves forming the 'price-consumption curve' for the commodity (x) - assuming constant income and prices of the other commodity (y).  The price-consumption curve shows how much of a commodity (x) is purchased if its price changes - assuming constant income and constant prices for the other good (y).

d) Demand Curve

    The demand curve for a given commodity (x) can be derived from the price-consumption curve showing how much of that commodity (x) is purchased at different prices - assuming constant income and constant prices for the other good (y) (MBB 10th Ed. Figs 6.5Aa & 6.5Ab; MBB 11th Ed. A5a & b; PB 4th Ed. Fig. 9.7; 5th Ed. Fig. 8.7). The shape of the demand curve (x) depends on taste, income and the type of commodity - assuming constant prices for the other good (y).

e) Substitution & Income Effects

    An increase in the price of a given commodity (x) causes the slope of the budget line to increase lowering the level of consumer utility, i.e. a new equilibrium on a lower indifference curve - assuming constant income and constant prices for the other good (y) .  The overall effect is called the 'price effect'.

     If, however, income is increased to maintain the initial level of utility the quantity of the commodity (x) consumed will still decrease as the slope of the budget curve increases in response to the price rise.  This decrease in consumption due to a price increase - varying income to maintain the initial level of utility - is called 'the substitution effect'.  It measures how much less of the now more expensive commodity (x) will be consumed. The difference between the amount of  the commodity (x) consumed - if income is not increased to maintain initial utility - and the amount consumed if income is increased is called the 'income effect'

f) Inferior Goods

    The substitution effect is always negative, that is if the price of a commodity (x) goes up, the quantity consumed goes down.  The income effect can be positive or negative.  For 'normal' goods, an increase in income results in an increase in consumption - assuming constant prices.  If the quantity decreases when income increases - assuming constant prices - the commodity is an 'inferior' good.  In most cases, if the price of an inferior good decreases consumption will still increase if income rises.  

3. Consumer Surplus & Price Index

a) Consumer Surplus

    Consumer surplus is the difference between the maximum a consumer is willing to pay for a total quantity of a commodity (x ) and what the consumer actually pays

b) Consumer Price Index

    A consumer price index measures the combined income effect of price changes of given commodity combination (x, y).  It measures how much income must increase or decrease to purchase the same commodity combination (x, y) at different price levels - through time.

Summary of Demand

In effect, Demand reduces to constrained maximization of our happiness subject to a budget constraint represented by two equations:

1. U = f (x, y)

2. I = PxX + PyY 

Utility and demand

The concept of 'utility' was innovated by Jeremy Bentham, founder of the last great school of philosophy to emerge from the Western period known as 'the Enlightenment'. For Bentham sense experiences involved a unit measure of pleasure and pain called the ‘utile’ from which the philosophical school of thought known as ‘Utilitarianism’ emerged.  The utiles would eventually, according to Bentham, be subject to physical measurement and he proposed a ‘felicitous calculus’ of human happiness. In simple terms, Bentham believed that human existence was simply the search for pleasure and the avoidance of pain.  This has been expressed as 'pleasure and pain are the sovereign rulers of the State'. Thus utilitarianism is radically materialistic at the root.

Another name for utilitarianism, as defined by Bentham, is 'ethical hedonism'. The search for pleasure was inhibited in Bentham's scheme by the assumption that human beings carried what today we would call genetic ethic of right and wrong - essentially the  Protestant work ethic.   Once that ethic faded, however, we were left with only 'Me-ism': only my pleasure counts, and anything I do to increase it, no matter the pain and suffering to others, does not matter!

Terms

a) Utility: a generalized term for the satisfaction obtained by an individual from the 'use' of a product (good or service) measured by the price the individual is willing to pay for the product where:

i - total utility - total satisfaction yielded by the product

ii - marginal utility - the additional utility yielded by an additional unit of the product

iii - diminishing utility - at some level of consumption an additional unit of the product yield less utility than the preceding unit, i.e. utility increases at a decreasing rate

iv - maximizing utility: rational individual will purchase that combination of products or commodities yielding the maximum utility subject to income constraint and prevailing prices

b) Consumption: the use of a product whereby its utility is destroyed, or 'negative production'.

c) Income: payment for work used to purchase products in order to obtain utility.

d) Work: physical or intellectual effort made not for any pleasure derived from itself but rather to earn income to purchase products to obtain utility.

e) Price: the current exchange rate of a product for the utility derived by a consumer.

2. Assumptions

a) Rationality: consumer chooses between alternative commodity combinations to maximize utility assuming -

 i - perfect knowledge, that is, aware of all alternative commodity combinations and their prices

 ii - competence, that is, capable of evaluating the alternatives

 iii - transitivity, that is, if A = B and B = C then A = C (which means that indifference curves do not intersect: see 3(b) below)

b) Ordinality: consumer is able to order commodity combinations by level of utility, 1st, 2nd, 3rd etc.  Does not require cardinality, that is, the ability to specify the actual numeric level of utility

a) Utility Function

                U = f (x, y) where:

i - U is the utility derived from consuming commodity combinations of x and y

ii - U is assumed to be continuous (and has first- and second-order partial derivatives) or there is continuity of commodity combinations of x and y, that is, there is an infinite number of combinations yielding the same level of utility, U is a dense set

iii - U is not unique, that is, any utility number - U' - assigned to a given commodity combination indicates only that it is preferable or superior to all combinations with a lower number and inferior to those with a higher number, in other words, U' does not possess any cardinal meaning

iv - U is defined for consumption within a specified timeframe - long enough to allow substitution among existing commodity combinations but short enough to insure constancy of taste

CONSUMER PREFERENCE

Generally, consumers prefer a certain number of commodities. Some of the goods are normal goods and can be substituted by others. The price of such commodities has an impact on demand. At the same time, the substitution of some normal goods is not possible. Such commodities are bought at fixed intervals and they are a part of the basic consumer basket such as food, water, gas, and power.

The consumer buys normal goods at a regular price, and as a proportion of their income.But the prices of goods can change so consumer’s income. The supply of commodities can also be affected by a number of factors. The consumer decides what to purchase and what not to purchase. A consumers’ preference changes when the consumer decides to maximize utility at a lower price level.

Preference relations

Any consumer preference has two important relations. The strict and weak preference relation decides the overall preference.

The strict preference is defined as

x>y→x≥y but y≥x

This means x is preferred to y. Note, here y is  considered equal to x. The consumer can either prefer x or y.

Completeness

Any commodity is always preferred to its close substitute.sThey are very different from each other in terms of characteristics.For e.g. Colgate toothpaste may be preferred to such substitutes such as close up, Pepsodent or sensodyne. The qualities of each toothpaste may differ in size, colour, shape, and price. But the real choice depends on the income and the taste of the same consumer.

Transitivity

Sometimes more commodities are available as substitutes.Transitivity is slightly different from completeness. It implies that it is impossible to face the decision maker with a sequence of pairwise choices in which preferences appear to be cyclical. For eg. An apple is as good as an orange and an orange is as good as a mango. But then an apple is preferred to a mango. Transitivity explains that consuming any goods will give equal satisfaction to a consumer.

Reflexivity

Reflexivity means any commodity is as good as any other commodity. There is no difference in consumer satisfaction when any commodity is consumed. For eg x>y≥z, then x>z. the preferences do not change. The consumer prefers a bundle and any bundle is preferred or is indifferent to it. In everyday consumption basket, a consumer often purchases different close substitutes of commodities based on taste, color, shape, size and on their income.

Nonsatiation

Nonsatiation adds more characteristics of a good because it is preferred by a consumer. Each consumer expects something different from the earlier purchased commodity. The consumer always search for something extra above what they usually buy from the market. It's here where the marketing strategies help in breaking the brand loyalty and help the companies make their way into the hearts of the consumers.

Continuation

Consumers always try to switch to different commodities or close substitutes. They get more satisfaction from consuming different commodities at lower prices.But other factors may make them worse off, such as changes in price, size etc. So, they prefer to continue with their earlier choices.

Labor economics

What is Labor Economics?

Labor economics seeks to understand the functioning and dynamics of the market for labor. Labor markets function through the interaction of workers and employers. Labor economics looks at the suppliers of labor services (workers), the demanders of labor services (employers), and attempts to understand the resulting pattern of wages, employment, and income.

Compensation and measurement

Wage is a basic compensation for paid labor, and the compensation for labor per period of time is referred to as the wage rate. Other frequently used terms include:

Wage = payment per unit of time (typically an hour)

Earnings = payment accrued over a period (typically a week, a month, or a year)

Total compensation = earnings + other benefits for labor

Income = total compensation + unearned income

Economic rent = total compensation - opportunity cost

Economists measure labor in terms of hours worked, total wages, or efficiency.

Labor Demand

Labor demand is a derived demand; that is, hiring labor does not desire for its own sake but rather because it aids in producing output, which contributes to an employer's revenue and hence profits. The demand for an additional amount of  depends on the Marginal Revenue Product (MRP) and the marginal cost (MC) of the worker. The MRP is calculated by multiplying the price of the end product or service by the Marginal Physical Product of the worker. If the MRP is greater than a firm's Marginal Cost, then the firm will employ the worker since doing so will increase profit. The firm only employs however up to the point where MRP=MC, and not beyond, in economic theory.

Wage differences exist, particularly in mixed and fully/partly flexible  markets. For example, the wages of a doctor and a port cleaner, both employed by the NHS, differ greatly. There are various factors concerning this phenomenon. This includes the MRP (see above) of the worker. A doctor's MRP is far greater than that of the port cleaner. In addition, the barriers to becoming a doctor are far greater than that of becoming a port cleaner. To become a doctor takes a lot of education and training which is costly, and only those who excel in academia can succeed in becoming doctors. The port cleaner, however requires relatively less training. The supply of doctors is therefore significantly less elastic than that of port cleaners. Demand is also inelastic as there is a high demand for doctors and medical care is a necessity, so the NHS will pay higher wage rates to attract the profession.

The MRP of the worker is affected by other inputs to production with which the worker can work (e.g. machinery), often aggregated under the term "capital". It is typical in economic models for greater availability of capital for a firm to increase the MRP of the worker, all else equal. The education and training noted in the last paragraph are counted as "human capital". Since the amount of physical capital affects MRP, and since financial capital flows can affect the amount of physical capital available, MRP and thus wages can be affected by financial capital flows within and between countries, and the degree of capital mobility within and between countries.

There are two sides to labor economics. Labor economics can generally be seen as the application of microeconomic or macroeconomic techniques in the labor market. Microeconomics techniques study the role of individuals and individual firms in the labor market. Macroeconomic techniques look at the interrelations between the labor market, the goods market, the money market, and the foreign trade market. It looks at how these interactions influence macro variables such as employment levels, participation rates, aggregate income and Gross Domestic Product.

LABOR MARKET

The labor market holds very important place in the world of economics. An important macroeconomic variable is the total amount of labor that is used in certain period of time. The amount of labor and amount of capital are variables for total production and GDP. Amount of labor is related to unemployment rate.

Classification of unemployment

There are different ways of classifying unemployment.

·     Frictional unemployment- 
Individuals are temporarily unemployed while transiting between jobs or just entering the labor market.This kind is typically short in duration and is always present in the economy.

·     Structural unemployment-
Individuals are unemployed because their skills are no longer in demand where they live. This normally leads to longer spells of unemployment and may require the unemployed to acquire new training to survive.

·      Cyclical unemployment-
Unemployment due to recession

·      Classical unemployment-
Unemployment due to real wages being too high.

The natural rate of unemployment is defined as the sum of the rates of frictional, structural, and classical unemployment excluding the cyclical unemployment. We say, we have full employment when the unemployment rate is equal to the natural rate (and cyclical unemployment is zero)

   Please note, cyclical unemployment is zero in a boom. In a recession, the observed unemployment rate exceeds the natural rate by the cyclical unemployment rate.

Diagram

Wages

Nominal wages-The nominal wage is the wage per unit of time in the currency used in the country- commonly called as call wage. Wage is a flow that we typically measure in units of currency per hour.

Wages and income

Wages and income are two distinct variables.Wage means what we typically receive for working an hour, while income is the total revenue from all sources over a longer period of time. Your income depends on the wage as well as the total number of hours you work.

Real wage

Consider the following scenario. You work full time and during January 2014 you make 2000 euro after tax. A particular basket of goods and services costs 100 euro in January, which means you can buy 20 such baskets.

In February, you receive a 10% wage increase and you make 2200 euro after tax. Does this imply that you can buy 10% more baskets, 22 in February? No, Not necessarily.

The number of baskets you can buy in February depends upon the possible changes in price.If the price of the basket increase by 3% to 103 euro, your 2200wage will buy you 2200/103=21.36 baskets of goods, i.e. 7%more than in January. So even though your wage has increased by 10%, you can only increase consumption of baskets by 7%. We say the real wage has increased by 7%.

We define real wage as the nominal wage divided by a price index (CPI). In the above eg, real wage was 20 in january and 21.36 in February. Nominal wage will tell you your wage in units of currency, while real wage will tell you your wage in basket of goods and services.

INTEREST RATES

What is an interest rate?

When you borrow money, you usually have to pay a fee for the loan. This fee is often called interest, particularly if the fee is proportional to the amount you borrow. It is commonly expressed as a percentage of the size of the loan per unit of time. The interest rate may be fixed or floating. If it’s fixed, you will pay the same percentage for the entire duration of the loan. While with floating interest rate, the interest rate will change regularly depending on market conditions.

Market interest rates

The most important interest rates from a macroeconomic point of view are the interest rates that the government pays on loans they use to finance the national debt. The government borrows by issuing government bonds. All such bonds hae fixed nominal amount and a given maturity date. The government promises to pay exactly the nominal amount, to the holder at the maturity date. Some bonds also promise regular coupon payments at regular intervals.

Relationship between the interest rate and bond price

Note that the interest rate depends on the issue price. Higher the issue price, lower will be the interest rate. If the price of a government bond increases, interest rate falls and vice versa. The price of a bond is usually determined by supply and demand which means you can understand movements in the interest rates by analyzing the market. For e.g. if the government needs to borrow more money, supply increases, bond prices fall and interest rates increase.

Yield curve

The yield curve is the graph of interest rates of different maturity (recalculated to yearly rates)at a particular point in time. If the market expects higher interest rates, then slope of the yield curve will increase. The slope of the curve will turn negative if the market expects the interest rates to fall more than the premium on the longer interest rates.

Other interest rates

Lets discuss the other interest rates that’s available in the market. For e.g. You will earn money when you deposit money in a bank account, and you will pay interest when you borrow money. These interest rates depends on the specifics of the deposits and the perceived risk when you borrow money.

Overnight interest rates

Overnight interest rates are rates for loans over a single night. These are shortest of all interest rates. During the day, banks normally have access to interest free loans from the central bank. At the end of the day, all such loans must be cleared with the central bank. For this reason, there is a market for loans overnight between banks and the overnight interest rate is determined by supply and demand in this market.

Central bank overnight interest rates

The overnight interest rate is an important interest rate for a central bank and it has methods of influencing this rate. In United States, this rate is federal funds rate. If the overnight rate steers away from the federal funds rate, the Federal reserve will take desired action to steer it back towards the federal funds rate.In addition to signaling a desired overnight interest rate, most central banks have standing facilities for overnight loans. The ECB has a deposit facility and a marginal lending facility that member banks use for deposits and for lending overnight. The overnight interest rates must therefore be in between the deposit rate and marginal lending rate.