production Possibilities Frontier, Demand and Supply Analysis

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4008AFE The Economics Environment of Business
Week 2: Production Possibilities Frontier, Demand and
Supply Analysis
Dr Alban Asllani
Lecture Outline
1 Introduction
2 Production Possibilities Frontier
3 Demand and Supply
4 Conclusion
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Intended Learning Outcomes
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After this lecture you should be able to understand and analyse:
How the behaviour of people and their economic interactions
form markets.
How markets work.
Supply and Demand
The Market Equilibrium
Shifts in the Equilibrium
Main Assumptions
The models is based on Adam Smith’s ”invisible hand” (’The
Wealth of Nations’, 1776)
Markets are organized in the most efficient way (i.e. perfect
competition, more on this later!)
Definition
Ceteris Paribus: Latin phrase meaning ”other things equal”
or ”other things held constant”.
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Production Possibilities Frontier
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The production possibilities frontier (PPF) is the boundary
between those combinations of goods and services that can be
produced and those that cannot.
For simplicity, wefocus on two goods, ceteris paribus.
Example
Figure on the left shows the PPF
for two goods: Wheat and
Cotton.
Any point on the frontier such as
A and B and any point inside the
PPF such as C are attainable.
Points outside the PPF are
unattainable.
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Production Efficiency
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We achieve production efficiency if wecannot produce more
of one good without producing less of some other good.
Points on the frontier are efficient.
Any point inside the frontier, such as C, is inefficient.
It is possible to produce more of one good without producing
less of the other good. At C, resources are either unemployed
or misallocated.

PPF and Opportunity Cost
From the PPF wecan understand
the concept of
opportunity cost.
As wemove down along the PPF,
weproduce more Cotton but the
quantity of Wheat decreases.
The opportunity cost of a wheat
is the cotton forgone.
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PPF and Opportunity Cost
Moving from D to E, the
quantity of Cotton produced
increases by 1 ton.
The quantity of wheat produced
decreases by 5 tons.
The opportunity cost of
producing the 4
th ton of cotton is
5 tons wheat. One ton of cotton
costs 5 tons of wheat.
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Efficient Use of Resources
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We are producing at a point on the PPF.
When wecannot produce more of any one good without giving
up some other good, wehave achieved
production efficiency.
When wecannot produce more of any one good without giving
up some other good that wevalue more highly, wehave
achieved
allocative efficiency.
We are producing at the point on the PPF that weprefer
above all other points.

PPF and Opportunity Cost
Moving from D to E, the
quantity of Cotton produced
increases by 1 ton.
The quantity of wheat produced
decreases by 5 tons.
The opportunity cost of
producing the 4
th ton of cotton is
5 tons wheat. One ton of cotton
costs 5 tons of wheat.
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Economic Growth
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The expansion of production possibilities and increase in the
standard of living is called economic growth. Two key factors
influence economic growth:
1 Technological change is the development of new goods and
of better ways of producing goods and services.
2 Capital accumulation is the growth of capital resources,
which includes human capital.
Economic growth is not free. We sacrifice resources in
research and development.
The opportunity cost of economic growth is less current
consumption.

Demand
Law of Demand
The law of demand states a negative relationship between
price and quantity demanded. A higher price leads to a lower
quantity demanded and a lower price leads to a higher quantity demanded.
Demand refers to the amount of some good or service
consumers are willing and able to purchase at each price.
Demand curves (graphs) and demand schedules (tables) are
tools used to summarize the relationship between quantity
demanded and price.
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P O
D Q
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P O
D Q
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Price Quantity
£1 18
£2 15
£3 12
£4 9
£5 6
£6 3

Table: Demand schedule
Factors that influence demand
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Any change in price level represents a movement along the same
demand curve. The demand curve will shift if any other factor that
affects demand changes.
Income.
A change in income will affect the quantity demanded at any
price.
For example, if your income increases your are able to buy
more of the same good at a certain price level.
As a result, the whole demand curve shifts to the right.
Demand and Income
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Demand and Income
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Factors that influence demand
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Tastes and Preferences. If a good becomes a trend more
people will be willing to buy it at a given price level.
Examples?
Prices of other goods (Substitute/complementary). The prices
of related goods may affect the quantity demanded.
Substitute goods are goods which may replace each other in
use. Examples.
Complementary goods are goods which may be consumed
together. Examples.
The nature of the good: normal, inferior, luxury.
Diminishing marginal utility
Law of Diminishing Marginal Utility
The more of a product you consume over a given period of
time, the less additional utility you gain from one more unit.
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Supply
Law of Supply
The law of supply states a positive relationship between price
and quantity demanded. A higher price leads to a higher
quantity supplied and a lower price leads to a lower quantity
supplied.
Supply refers to the amount of some good or service firms are
willing and able to supply at each price.
Supply curves (graphs) and supply schedules (tables) are
tools used to summarize the relationship between quantity
supplied and price.
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Supply curves and schedules
P O
Q
S
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Supply curves and schedules
P O
Q
S
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Price Quantity
£1 3
£2 6
£3 9
£4 12
£5 15
£6 18

Table: Supply schedule
Factors that influence supply
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Any change in price level represents a movement along the same
supply curve. The supply curve will shift if any other factor that
affects supply changes.
Cost of the factors of production (land, labour, capital).
Technology.
External shocks, such as weather, war etc.
Number of producers. As the number of firms producing a
product increases, wewould expect more supply to be
available.

Supply and Technology
(0,0) Q
Q
0 Q1
P Advance in Technology
S
S
,
P
D,
D
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Equilibrium
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Equilibrium is the point where the two curves intersect.
The quantity demanded is equal to the quantity the suppliers
are willing to supply.
If anything changes in the market, the price level will adjust to
restore the equilibrium.

Price Mechanism
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Acts as signal: Price adjusts to demonstrate where resources
are required, and where they arenot.
Transmits preference: By their response to price, consumers
send a messageabout theirpreferences.
Ration scarce resources: As resources are scarce, price serves
as a method to ration who receives goods and services.

Equilibrium Analysis
P O
Q
Equilibrium
S D
P
Q
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Equilibrium Analysis
P
(0,0) Q
Income Increase
S D
D
,
P

P
QQ∗∗
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Equilibrium Analysis
(0,0) Q
P
Advance in Technology
S
S
,
P
P∗∗
D
QQ∗∗
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Equilibrium Analysis
P
(0,0) Q
Combined
S D
D
,
S,
P

P
QQ∗∗Q∗∗∗
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Equilibrium Analysis
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When a factor that affects demand changes then the whole
Demand curve shifts. If the change is positive, i.e. increase in
demand, then the curve will shift to the right and vice versa.
When a factor that affects supply changes then the whole
Supply curve shifts. If the change is positive, i.e. increase in
supply, then the curve will shift to the right and vice versa.
Important: If the price changes wemove along the same
curve.
The position of the final equilibrium point will depend on the
magnitude of the changes.

Excess Supply
P O
S D Q
Q

Surplus
Pmin
P
Qd Qs
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Excess Demand
P O
S D Q
Q

Shortage

P
Pmax
Qs Qd
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Further Equilibrium Analysis
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A shortage or excessdemandis a situation in which the
quantity demanded for a product (
QD ) exceeds the quantity
supplied in a market (
QS), i.e. (QD ) > (QS ).
A shortagecan only occur at a price level below the
equilibrium.
A surplus or excesssupply is a situation in which the quantity
supplied (
QS) for a product exceeds the quantity demanded
(
QD ) in a market, i.e. (QD ) < (QS).
A surplus can only occur at a price level above the
equilibrium.

Next time
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To add depth to our analysis wewill talk about elasticity.
What happens to demand when wechange prices ?
Price elasticity: Proportionate change in quantity divided by
proportionate change in price.
There are different types of elasticity.
What We Learned Today
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The allocation of productive resources in an economy is a
matter of trade-off.
PPF illustrates all the possible production points of the
economy.
Efficient production. Production efficiency vs Allocative
efficiency.
Economic Growth is the expansion of the PPF.
What We Learned Today
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Demand refers to the amount of a good that consumers are
willing to purchase at a price level.
It is a downward slope curve because it represents a negative
relationship between price and quantity demanded.
Changes in the price level are illustrated by a movement along
the same demandcurve.
The demand curve will shift if any other factor changes.
What We Learned Today
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Supply refers to the amount of a good that suppliers are
willing to provide at a price level.
It is an upward slope curve because it represents a positive
relationship between price and quantity supplied.
Changes in the price level are illustrated by a movement along
the same supply curve.
The supply curve will shift if any other factor changes.
Conclusion
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Review today’s lesson.
Read the relevant chapters in the book (Including all boxes
and case studies)
Search online for more sources.
Ask questions in seminar if anything is unclear.
Do self-test questions at the end of the chapter and online.
Thank youfor your attention.
Questions?
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