Lecture – 1: Scarcity, Efficiency, Incentives,

Opportunity Cost Formulation of Comparative

Advantage
Dr Soumyatanu Mukherjee.
Ph.D. (University of Nottingham, UK), FHEA.
Associate Professor of Economics, XLRI Delhi-NCR.
Winner: EXIM (Export-Import) Bank of India's International Economic Research Annual (IERA) Award 2018.
External Research Fellow of CREDIT & GEP.
Web: https://sites.google.com/site/smukhnottingham/.
Belong to Alan Deardorff's "Family Tree of Trade Economists" <http://www-personal.umich.edu/~alandear/tree/Z1081.HTM>.
Recap from Last Lecture – Choice under Scarcity

LET US CONSIDER A THE STORE HAS JUST MR. AGARWAL, THE

SIMPLE RETAIL STORE ENOUGH SPACE TO KEEP STORE OWNER OF
SAY SHALIGRAM, THE
CAMPUS STORE AT XLRI
12 CARTONS OF GOODS,
EACH CARTON OF THE
SHALIGRAM IS REQUIRED
TO PAY ALL THAT HE
Table-1: Commission from Different Cartons
JAMSHEDPUR’S SAME VOLUME. EARNS FROM THE
PROBLEM. PROCEEDS OF THE SALE
FROM THE CARTONS TO
THE RESPECTIVE
WHOLESALER.

THE AMOUNT MR.

AGARWAL IS PAID A
COMMISSION PER
CARTON AND THE TOTAL
DEMAND FOR THE ITEM
IS GIVEN IN TABLE 3,
HOW MANY CARTONS OF
EACH SHOULD MR.
AGARWAL HAVE IN HIS
STORE?
 Choice under Scarcity of Space (Contd.)

• We can see in this case, that given that there is no monetary

investment involved on the part of Mr. Agarwal, he should opt for
cartons that give the maximum commission. Table-1: Commission from Different
Cartons
• Hence, it would be easier for him to save space and to keep
maximum commissions for him at the same time through keeping
• 2 Old Spice cartons,
• 8 Lays Chips cartons, and
• 2 Parle Biscuits cartons only

per month.
 • Now let’s assume in addition to the space constraint, Mr
Agarwal also has a cash constraint of Rs. 10000, with which

Scarcity of Space + he has to buy the cartons and then sell it at a profit.
• The amount he has to pay per carton, the net
profit/commission earned per carton, and the total

Budget Constraint demand per item is given in Table 2. The commission

earned is the same as before.
• We now have to answer the same question again. How
many cartons of each should Mr. Agarwal have in his
store?
Scarcity of Space & Money (Contd.)
If we proceed the same way as
before, and stock first Old Spice,
we earn Rs. 2100 of
What about doing the same level
commission/profit, but exhaust
of stocking as before?
Rs. 7000 of cash. It is not possible
to buy the second carton of old
spice.

With the remaining Rs. 3000, we We would now earn a profit of

can buy the next best, that was just Rs. 2850, and space for 10
Lays Chips giving us Rs. 750 of cartons will be left empty due to a
commission. cash constraint.

Yes, let us compute the return on

Is there a better way of stocking
money as done in this new table
up, so that we earn a higher level
from buying each carton and then
of profit?
decide which one to stock first.
Scarcity of Space & Money – More Efficient Choice
• In this case we can see that Parle biscuits give
the maximum return:
✓ On stocking 3 cartons of Parle biscuits, the extra
storage space is 9 cartons,
• However, the remaining income is INR 7000.
• The store owner stocks one carton of ______.
• Why?
• Because Old Spice provides the maximum
return after Parle, and costs INR 7000 for 1
carton.
• Thereby Mr Agarwal now exhausts his income
with extra remaining space for 8 cartons.
• But this bundle maximizes his profits of INR
3300.
• We can see that this is an improvement over
the earlier figure of Rs. 2850.
 How Economists Think
• One can think of another example where a similar situation happens. Often, the last bite of

a sandwich or the last gulp of a 32-ounce coke brings very little utility. Hence, it's not

uncommon to discard the excess of both sandwich & coke.

• Economists call this property the law of diminishing marginal utility, and due to this

reason, we spend our money on all goods be it food, clothing or shelter.

• However, if a man is equally interested in only two goods; alcohol and cigarettes, with

happiness increases at an increasing rate for every additional increase in the total

consumption of both goods, we would then find that he will choose to spend his budget

either completely on alcohol or completely on cigarettes, whichever is cheaper.

The Concept of “Efficiency” in Economics
• Efficiency would imply the best possible use of available resources, and it is a relative
concept.

➢Relative in the sense that for a particular score, we mark out who performs best, give
that entity the full score, and other entities are marked as inefficient.

➢The extent of inefficiency is measured by the extent to which it falls short relative to
the one that performs best.

• In Economics, discussions around efficiency centre on mainly two concepts, namely:

➢Productive or Technical efficiency

➢Allocative efficiency
 Technical Efficiency
• The concept of efficiency we would now introduce is attributed to Vilfredo Pareto
(1848-1923) .

• If 5 units of food and 2 units of clothing is currently being produced by Indian

economy, increasing food production to 6 units may imply reducing clothing
production to 1 unit.

• An economy will be said to have achieved technical efficiency, if given the inputs
available, two products X and Y are being produced; it is not possible to increase
the production of X, without sacrificing the production of Y.

• But in both situations then the Indian economy is efficient.

• However, if the same Indian economy produces 2 units of food and 1 unit of
clothing, it is definitely inefficient.
Allocative Efficiency
• Suppose, Indian economy produces 1000 units each of both X and Y, and let there be 100
individuals residing in India.
• An allocation of 10 units to each of X and Y is an equitable allocation, but not necessarily
efficient. Why?
• Of the 100 individuals, let there be one Sam who prefers more X to Y and another Bob who
prefers more Y to X.
• Sam & Bob can exchange X and Y amongst themselves, and after the exchange we have 98
individuals who are as well off as before, while Sam & Bob are clearly better off.
• Hence, for the initial allocation of 10 units, each of X and Y to each individual was surely not
efficient.
 Incentives
Positive Incentives → Incentives promotes/encourages to put extra efforts.

Class Participation & Regularity → 3 Marks. Positive

Incentives → I Expect Better Participation Rates. Is
my promise enough?

Negative incentives discourage action by providing

undesirable consequences
or punishments. (Can you think of some examples?)
Incentives Are Everywhere!
 Incentives Matter (contd.)
• Direct Incentives
• “Here is what I want you to do, and here is what I am
going to do in order to get you to do it.”
• Easy to recognize.
• Example:
(i) Giving a kid a gift if they get straight A’s.
(ii) At Chandni-Chawk Market, if one vendor lowers
its prices, it most likely will get business from
customers who would not usually shop there.
• Indirect Incentives
• A secondary change in behavior brought on by the
original incentive.
• Harder to recognize.
• Example:
(i) To reach the sales quota, the salesperson may
push too hard with some clients or not spend
time with family.
(ii) To avoid the insurance company increasing the
premium in the event of claiming insurance
benefits for a minor accident of your car, you
may not claim it from your insurance, but opt to
pay out of your pocket for repairing.
 Direct & Indirect Incentives
• Unemployment Insurance Scheme in GB: Govt has a direct incentive to alleviate suffering caused by poverty.

• If the amount of UI a person receives is higher than the amount that person can hope to make from a job,

the welfare recipient might decide to stay on UI rather than go to work. – Indirect Incentives

• The indirect incentive to stay on welfare creates an unintended consequence: people who were supposed to

use government assistance as a safety net until they can find a job use it instead as a permanent source of

income.

• But how does a society provide this safety net without taking away the incentive to work?

• Should the UI benefit be higher or lower than the expected income from a basic job?

• If lower, then some people below PL mayn’t have enough to sustain. Solution?

• Target the duration of the scheme.

 Practice What You Know—1
• Which of the following situations
illustrates an incentive?
A. Dave snacks all afternoon and isn’t hungry
for dinner.
B. Dirk’s children misbehave during dinner.
C. Lee gives his children candy if they behave
during dinner.
D. Jaime goes to a restaurant for dinner.
 Opportunity Cost
Opportunity cost: The highest-valued alternative
that must be sacrificed to get something else.

The best possible decision is the one that

minimizes the opportunity cost.

What you’ve given up to be in class? What the

next-best alternative was ?

Why do you think that more students go out on

the weekend rather than on a Monday night or a
night before a test?
15
Opportunity Cost of Going to College
What is the opportunity cost of going to college?

Things to include in opportunity cost:

• Tuition
• Books
• Time (example: Ellen DeGeneres)

Things not to include in opportunity cost:

• Housing
• Food
Practice What You Know—2
The opportunity cost of buying a good is
A. the sum of values of all the other goods you could
have purchased.
B. the value of the next-best alternative you could have
purchased.
C. irrelevant since you will purchase your highest-
valued good.
D. the average of values of all the other goods you could
have purchased.
Production Possibilities Frontier (1/3)
Production possibilities frontier: Model that illustrates the
combinations of outputs a society can produce if all of its
resources are being used efficiently.
• Abbreviated as PPF.

Assumptions (ceteris paribus):

• Technology fixed.
• Quantity of resources fixed.
• Society produces only two goods.
Production Possibilities Frontier (2/3)
Downward sloping:
• must give up one good to increase production
of another.

The slope of the PPF will equal the negative value

of the opportunity cost of producing good Y in
terms of good X.
Production Possibilities Frontier (3/3)
Practice What You Know—3
With regard to the PPF, an efficient point is a point that is
A. impossible to reach.
B. inside the PPF.
C. outside the PPF.
D. on the PPF.
PPF and Opportunity Cost (1/2)
PPF and Opportunity Cost (2/2)
PPF and Economic Growth (1/3)
Economic growth
• enables a society to produce
more output;
• is shown by an outward shift.

Factors:
• new resources
• technology

24
PPF and Economic Growth (2/3)
PPF and Economic Growth (3/3)
Practice What You Know—4
True or false: Point A represents the amounts
of cars and bicycles that will be sold. False
Practice What You Know—5
True or false: Movement along the curve from point A
to point C shows us the opportunity cost of producing
more bicycles.
True
Practice What You Know—6
True or false: If we have high unemployment, False
then the curve shifts in.
Practice What You Know—7
True or false: If an improved process for manufacturing
cars is introduced, society will be able to produce more
cars and more bicycles.
True
Practice What You Know—8
Suppose there is high unemployment. With respect to the
PPF, what will happen?
A. The PPF will shift inward.
B. The PPF will shift outward.
C. We will produce at a point inside the PPF.
D. We will produce at a point outside the PPF.
 Market Determined Opportunity Cost – An Illustrative Example

What is the Market Determined Opportunity Cost of

Candy?
Specialization and Trade (1/2)
• Like an increase in resources and
improvements in technology,
specialization and trade also generate
gains for society.

• Specialization: The limiting of one’s

work to a particular area.
Practice What You Know—9
We often think of specialization and trade occurring
between countries. However, it can occur on much smaller
levels as well.

Examples . . .
• within a home
• at a gathering of friends and/or family
Specialization and Trade (2/2)
Assumptions (ceteris paribus):
• Technology is fixed.
• Quantity of resources is fixed.
• Society produces only two goods.
• Two people that have different abilities in the
production of the two goods.
Absolute and Comparative Advantage: David Ricardo (1817),
Gottfried Haberler (1930)

Absolute Advantage Comparative Advantage

• One producer’s • The ability to make a
ability to make more good at a lower
than another opportunity cost
producer with the than another
same quantity of producer.
resources.

Differences in producers’ ability to produce goods

allows them to specialize in what they have a
comparative advantage in and trade for other
goods that they want.
Advantages from Trade (1/4)
Who has absolute advantage on pizzas? And on wings?
Should the same person produce both pizzas and wings?
Who has comparative advantage on pizzas? And on wings?
Daily Production
Person Pizzas Wings
Gwen 60 120
Blake 24 72
Advantages from Trade (2/4)
Advantages from Trade (3/4)

Without Trade With Trade

Person Good Produc- Consump- Produc- Consump-
tion tion tion tion
Gwen Pizza 40 40 60 41
Wings 40 40 0 47
Blake Pizza 18 18 0 19
Wings 18 18 72 25

With specialization and trade, each person can

consume more than they otherwise could have.
Advantages from Trade (4/4)

• Gwen and Blake continue to

produce at their PPF but
through specialization and
trade, they can now consume
outside of it.
 Finding the Price for Trading
• How did we know that Gwen and Blake would both be Person Opportunity Cost Ratio

willing to trade 19 pizzas for 47 wings? 1 pizza equals 2

Gwen 1:2 = 0.50
wings
• Terms of trade (ToT) 19 pizzas for 47
Terms of trade 19:47 = 0.40
wings
• The relative prices or exchange rate of goods.
1 pizza equals 3
Blake 1:3 = 0.33
wings
• We can express this as a ratio (pizza:wings).
The mutually agreed trade-off ratio/ the ToT/ exchange
• For Gwen, the maximum rate at which she can give 1
rate is 19:47 (= 0.40) falls b/n Gwen’s and Blake’s
pizza to Blake is 2 wings, (viz., her opportunity cost of
opportunity cost ratios and is therefore advantageous to
producing 1 pizza)
both.
• Similarly for Blake, the maximum rate at which he’s As long as the terms of trade are between the
agreed to accept 1 pizza from Gwen is 3 wings (his OC). opportunity costs of the trading partners, the trade
benefits both sides.