Se, we are economical.  We concentrate on a very simple economy: one with only two factors of production (land and labour), which is only interested in producing and consuming two goods (food (+fibre); clothes (+ shelter)).  These two goods, which can be thought of composites as indicated, comprise all the necessities of life, and are all this simple economy produces, or, for the present, wants to produce.  It is self contained and self-sufficient as a whole. Our economy is a self-contained collection of producers and consumers - everyone is either one or both.

Notice - we are talking of an economy here - which might be a country, or a region, or a community or locality or village, or whatever. In the limit, such an economy could be as small as a self-sufficient, single and subsistence household.  It doesn't matter how big or small it is.  All that matters - for the moment - is that it is self-contained.  We will come to what can happen when two such economies meet and trade with each other below.  For the present, we just consider the logic of this single and simple economy as separate and self contained entity.

What options does our economy have?

• to produce food (and fibre), or clothes, or (more likely) a mixture of the two.
• to consume (use) food and fibre or clothes, or almost certainly a mixture of the two.

How might we do that?  Answer: look at the production possibilities (the supply side) and the consumption preferences (the demand side) for the two goods (which makes up the totality of our simple economy).

The diagram we will use relates production and consumption of one good (food (and fibre)) to the production and consumption of the other (clothes (and shelter)).  So we measure (illustrate) quantities of each good on the two axes:  quantity of clothes on the vertical axis and food on the horizontal axis - though it could just as easily be the other way round, it doesn't matter.  Get a bit of paper and draw this diagram for yourselves now.  Then read the following and trace the argument (logic) out on your diagram as you follow it through.

The supply side:

Consider the production or supply side first.  What options does our economy have?  To use all available production factors (land and labour) to produce food;  or to use all its factors to produce clothes; or to produce some combination of the two goods. And, because our citizens are sensible, they will organise themselves to produce as much as possible of each good.  What?  What about leisure and living?  Don't they take time and effort?  Yes, so our production possibility set will represent the quantities of the two goods our citizens are prepared to, are willing to produce, given that any production involves use of scarce (limited) time and effort, for which there are competing leisure (consumption) and recuperation (investment - see below) demands

So, there is some upper limit to the amount (quantity) of each good our citizens are prepared to produce in this economy.  We can mark these two upper limits (F* and C*) on each of the axes of our diagram of the economy.  Producing F* means that will not produce any C at all, so quantity of C is zero when Food production is at F*, and vice versa. OK?

But neither of these extremes is likely to be a sensible choice for our people - they are much more likely to choose a combination of the two goods.  What are the production possibilities for mixtures of the two goods?  Suppose we start with the economy producing all food and no clothes (at point F*), and now ask ourselves how much clothing this economy could produce if it diverted some of its resources from food to clothes production.  How much food production would have to be given up to produce the first few units of clothes?  Probably not very much, since some factors of production (land and labour) is not very good for food production and would be better at producing clothes.  Furthermore, some of our people would prefer to make clothes than produce food, so are likely to be better at producing clothes than food.

So, to begin with, moving from F* upwards and to the left to produce more clothes and less food, our economy could gain quite a lot of clothes without having to give up much food production.  Eventually, though, as we progressively cut back on food production in order to produce more clothes, we will find that we are having to give up more and more food for each extra unit of clothing production - as the extra resources we need to produce clothes are progressively better at producing food than clothes.  Eventually, we would wind up producing all clothes and no food - at point C*.

So, our production possibility relationship will be curved between F* and C*.  Make sure you follow this logic and the representation of it as the production possibility frontier (PPF) on the diagram .  This should be what you got on your own diagram as you followed the argument through.  If you didn't, why not?  Notice, it is frontier because this curve represents the maximum possible combinations of food and clothes that our citizens are willing to produce, given the land, skills, technologies and work preferences they have.

Notice, too, what this PPF means.  Suppose we start at point C* and then ask how many clothes we have to give up to produce some food.  Move along the PPF, and watch how much extra food we get as we give up limited quantities of clothes. At first, we only have to give up a little clothes for a lot of food - the slope of the PPF is quite flat.  In other words, the supply price (cost) of more food in terms of clothes given up (the opportunity cost, which here is the total cost of food production) is low.

But, as we progress down the PPF, the real cost of food  (its cost relative to everything else in the economy, which in our case is clothes) increases - the slope of the PPF gets steeper.  The cost of food production increases the more food we try and produce - the real supply curve for food slopes upwards.

Repeat this argument (logic) for the price of clothes in terms of food - you will get the same answer - the real supply curve of clothes also slopes upwards: the more we want to produce, the higher the cost in terms of foregone food production - the higher the real (relative) cost of clothes.

PPF Conclusions:

• The PPF shows the full employment capacity of the economy: inside it means unemployment; outside it is impossible (unless, that is, we add to the capacity of the economy - see below)
• So, it also shows the maximum real income our economy can generate, in terms of food and clothes mixtures.  Our producers are here not producing these things just for fun, they are producing them because they and their neighbours want them - the products are their income, their return for the work they do.
• The slope of the PPF measures the real supply price (the real cost) of producing both goods.
• The supply curves for both products slope upwards - greater quantities supplied cost more per unit.

• By "investing in human capital" - improving the skills and productivity of our people - the labour, (and the consumers), or simply having more people.
• By investing in land to make it more productive (draining it etc.)
• By improving the effectiveness of our production systems - getting more out for the same level of land and labour input - improving efficiency, which means one or both of better management (ideally less management, since management by itself produces nothing), and better technologies.
• By investing in capital (tools, plant and equipment) which labour can use with the land to produce the goods.
• By combining these things so that work (production) becomes more fun and more respectable, so that people are more willing to work than before (a point seldom, if ever recognised in the textbooks)

What about the consumption or demand side?  Now we have to think about how to represent consumer choices about how much of each (food and clothes) they would like to have and enjoy.  Go back to your paper diagram.  Start with some mix of the two which represents one particular (and observable) choice (F1 of food and C1 of clothes) - a point (x) which will be in the middle of our diagram somewhere - it doesn't really matter exactly where. But, if you are drawing this on the diagram with the PPF on it (which you should now have labelled), you had better put your x somewhere on this frontier, hadn't you?   Why?

Otherwise you will be trying to consume mixes of the two goods you cannot possibly produce (x lies outside the PPF).  Or you will be wasting resources - x lies inside the PPF, which means leaving people and land unemployed when they could be working, and working at something they would like to do, and earning a living, and producing something we want, and thus earning respect.

So, put your x on the PPF - anywhere else is daft, (or, as economists say, inefficient), so we would not expect people to choose it, unless they are so stupid as not to be human.  This point x represents the one the people in our simple economy choose for themselves - it is the one we would observe them at, if we could find this simple economy to look at.

Now ask yourself how the consumers in the economy might judge other combinations or mixes of the two goods that they might have chosen instead of x (F1 and C1)?  How might they compare other possible points on this diagram with x?

Within reason, more of each good would typically be considered preferable to less of each of the two goods, especially as we have included capital in each, - right?  So we can identify the north east quadrant (all points above and to the right of point x) as a preferred set or zone of possible consumption mixes or 'baskets' of goods.  Draw this zone on your diagram now.  And the south west quadrant (all points or good combinations consisting of less and F1 food and C1 clothes) will be considered inferior choices or combinations for our consumer population.  Otherwise they would have chosen one of the points in this zone, and they did not.  Shade in this inferior zone in now.

So, somewhere in the top left (north west) and bottom right (south east) quadrants will lie a boundary which separates the preferred set of consumption mixes from the inferior set, compared with our initial combination x.  There will be a separation between mixes which are preferred and mixes of goods which are considered inferior - a separation zone or boundary along which our citizens cannot make up their minds about which mix is better and which worse - they are, in effect, indifferent between any of the mixes defined by this boundary or indiference zone.

This boundary will (has to) slope downwards and to the right, passing through our reference point, x.  So, draw such a boundary on your diagram.

You have just drawn what economists call an indifference curve (or boundary) (let's label it I2) which indicates all those combinations of food and clothes which the consumers cannot judge to either worse or better than the one they chose initially (x) - they are indifferent between any of the combinations which lie on this boundary or curve.  So, you can now extend the shading of both the preferred zone and the inferior zone up to this boundary. Got that?  If not, go back and re-read the logic and re-draw your own diagram.

You should have got (most of) this diagram.  But you didn't get three curves, you only got I2.  So what are the other curves?  Well, what we are drawing here is a map of consumer preferences.  The further north east we go this map, the more preferable the bundles of goods become - bundles to the north east of x have a higher value to the consumers than bundles to the south west.  The indifference curve we have drawn is a contour line on this preference "hill" - a line joining together all those points (bundles of the two goods) which are considered of equal value by the consumers, the citizens of our economy.  So there are as many other contour lines as we care to draw on this preference map.  I have just drawn in two others, of lower value than I2, so I have labeled them I1 and Io respectively.

Now go back to point x.  Ask yourself how much food our citizens would be willing to give up in exchange for a little more clothes - move upwards and to the left of point x along the indifference curve, I2.

Why along the curve?  Because, if we move upwards and to the right of this curve, we are assuming that our consumers consider themselves to have suddenly become richer.  How come?  Because they can get to a preferred mix of both goods anywhere above and to the right of I2 - (I2 marks the boundary between the preferred set of goods and the set considered inferior.)  They choose x - because they could not get any mix of goods above and to the right (outside) I2.  If they could have, they would have, and x would be in a different place than we supposed. [This sort of analysis is known, in the textbooks as revealed preference theory for this reason - the choices people actually make reveal their preferences for what they want, and about how much effort they are prepared to put in to get it]

Indifference Curve Conclusions:

An indifference curve also shows a constant real income level for our economy, where income is now defined as command over consumption (and investment) mixes ("demand income"), rather than as the returns from production.  Note, again, that this is not a distinction that the textbooks identify.  Why not?  The answer takes us into some even deeper conceptual water than we are already in, and I don't think is necessary here.

So, if we want to know how much food our consumers will be prepared to give up (pay) for an additional quantity of clothes, we had better hold their demand incomes constant - otherwise we will confuse ourselves about why they are willing to pay more or less for more clothes.  So we move up the indifference curve I2.  As we do so, what do we see?  That our consumers are willing to give up progressively less and less food for more and more clothes.  The indifference curve gets steeper.  The more clothes they want, the less food they are prepared to trade (pay) for them, the demand curve for clothes is downward sloping.

Alternatively, move down the indifference curve from point x.  The consumers are willing to give up less and less clothes for more and more food.  The indifference curve gets flatter.  The more food they want the lower the price in terms of clothes (the real price) they are prepared to pay.  The demand curve for food is downward sloping.

The slope of the Indifference Curve shows the real demand prices (the prices consumers are willing to pay) for the two goods. These are indeed real prices - each is priced relative to the other (which is all there is in this economy).

We have already seen the partial answer to this question - the intersection of supply and demand curves in a single-good market. As the markets (the possible trade-offs) for each of the two goods settle down to their equilibrium positions, each will settle on a particular quantity and a particular price - at which the supply cost equals the demand price (where the supply curve and demand curve intersect).  Where will this equilibrium quantity mix (of food and clothes) be on our production possibility frontier (PPF) and consumer preference map (indifference curve map) diagram?  What combinations (quantities) of the two goods would you expect this single economy to choose?  Think, before you read on.

Answer: first, it has to be a mix that our citizens are willing to produce - so the combination has to lie somewhere on the PPF.  But where? Where the consumers think they are getting the best value from their consumption - i.e. as high up the preference map as possible  - on the highest possible indifference contour or curve.  Which is a single unique point (X) as a combination of C1 clothes and F1 food.  This economy, or community, cannot do better than this on its own.

We should expect a sensible, coherent and communicative, and cooperative community to come up with this, given time and no interference from anywhere else.  This is how we would expect people to learn to behave, if left to themselves.  What?  No, you wouldn't expect this?  They will fight and bicker?  They will steal and thieve?  They will behave like children, then?  They won't grow up and be sensible and wise?  Why not, if we leave them alone, wouldn't we expect them to grow up and learn from their mistakes and work out how to do things better?  Isn't this what humans do, if we leave them alone?  If they don't, they will wipe each other out.  These people, in case you hadn't noticed, are our ancestors - so they didn't wipe themselves out.

OK, so I have altered the shape of the PPF here - the reason will become obvious in a minute.  For the present, just notice that this different shape reflects the capacity of the community, and its willingness to work at these particular activities - this one is better at producing clothes than food compared to the previous one.  Why?  because it has more labour and less land, perhaps, and clothing (and shelter) production is more labour intensive and less land intensive than food and fibre production.

At this unique point, this single optimum combination of food and clothes, the indifference curve and the PPF will be tangential to each other - they will have the same slopes.  In other words, at this point, the rate at which consumers are willing to give up one good in terms of the other (the slope of the indifference curve), which is the consumer demand price for each good, will equal the rate at which it is possible to supply one good in terms of the other - the supply cost of each good - the slope of the PPF.  At this point, and this point alone, the production value of the two goods will equal the consumption value.

What are these rates?  They are the real (relative) prices of each good in terms of the other.  The supply prices are equal to the demand prices at this general equilibrium in our two markets.  And the price ratio of one good in terms of the other is the slope of the tangent - the ratio of C0 to F0 in the diagram opposite -  the supply price ratio of the slope of the PPF equals the demand price ratio of the indifference curve.  So, this country's markets will settle down at a general equilibrium of producing and consuming at point X, = C1 of clothes and F1 of food.

General Equilibrium Conclusion:
Markets can achieve the best of all possible worlds, in the real world in which we live. This is a fact of logic not just an assertion or an assumption.  It is true in principle.  And we, as humans, are uniquely capable of turning our principles into practice - that is what we do that makes us different from the animals.  If the real world does not live up to this principle in its practice, then we will work to understand why, and then work to fix it.  This is science and reason.  Anything else is idle speculation or fantasy.  Simple, isn't it?  Tough, isn't it?  Is this why people don't like economics?

Implication:
The market system rewards the owners of the factors of production - those who have the most land, the most capital and the labour skills best fitted, most well matched to the wants of society (the consumer) will earn the most production income, and thus get to exercise the most money votes about what is produced.   If you (land, labour, capital, or management) are useless, you won't get paid in this system, and you won't get the chance to exercise your consumption income. To him that hath shall be given - from those who are most able, but not (necessarily) to those who are considered most deserving.

So we would also expect our sensible human community to show some humanity and seek to soften the harsh realities of natural selection (since that is what this system really is).  Our community will also develop governance and redistribution (care) systems alongside its market systems.  Why? Because, some form of government is an essential complement to this trading system - the long arm of the law is necessarily attached to Adam Smith's invisible hand of the market - to outlaw theft, enforce contracts and protect property rights (whether these are common rights or private rights).  Once in place, such governments will also become responsible for managing the natural selection of the market - including acting as judge to redistribute losses and gains, and protect or support the less well off.  The humane economy will naturally develop gifts from those who have to those who have not, which will be outside the system of exchange portrayed here. But not independent of it, since the capacity to give depends on the resources one can accumulate and incomes one can generate.

We have not concentrated on either the sociology or the politics of our economy, our community, here - because this is an economics course.  But it is nonsense to pretend that these aspects of humanity do not exist, or that economics is fundamentally different and separated from them.  They have to fit, and the way they fit is through the governance (or management, if you prefer) of the market system.

Finally - the benefits of Trade.
Now, at last, we are in a position to look at the benefits from trade.  Suppose, now, we have another community (or country, if you prefer).  This second country - country 2 - is practically identical to country 1 except that it has more land and less labour.  Otherwise the mix of skills and preferences are identical.  The PPF for country 2 shows that the country is better at food production and not so good at clothing production as country 1.  But the preference maps are identical for the two countries.  On its own, then, country 2 would choose to produce and consume C2 clothes and F2 food, at a real price ratio of C3/F3.

Now suppose you are a trader. You have an opportunity to do business between these two countries.  What are you going to do?  Buy clothes where they are cheap and sell them where they are expensive, and the same thing for food.  And where is food cheap?  In country 2 - you don't have to pay a much in clothes in country 2 as you do in country 1.  And clothes are cheap in country 1.  So there is money to be made shipping food from country 2 to 1 and clothes from 1 to 2 - right?  Just think about the meaning of the slopes of the "price lines" in each country - they show the price of one good in terms of the other.

And what happens when we start to trade - exporting food from 2 to 1 and clothes from 1 to 2?  Remember the results of the last session?  The price of food will rise in country 2 (the food exporter), and thus the price of clothes will fall in 2.  Country 2's "price line" (C3 to F3) will get steeper.  The opposite will happen in country 1 - the line C0 - F0 will get flatter.

And what will limit this process of price changes as a consequence of trade between to two countries?  Again, from the previous session - the free trade or "world price" will be the same in each country - the slopes of the price lines will be the same, flatter than 1's and steeper than 2's.  The trading price line will lie between the price lines of the two countries, as in the figure below (Ce - Fe). I have omitted the previous no-trade price lines from these diagrams, to make them clearer.  But you should be able to re-draw these for yourselves.

So what? At this price ratio, country 1's optimum consumption point is now C1c of clothes and C1f of food.  This is where the trade price line touches the highest possible indifference curve. A higher indifference curve than it can possibly get to without trade - a higher consumer or demand income - so it is definitely better off with trade.

How does it manage to consume this amount of food (which is more than it could possibly produce itself in this diagram - C1f lies outside the PPF)?  Answer - it imports food, and pays for these imports with exports of clothes.

How much food and clothes would it pay country 1 to produce?  Where the trade price line is the same slope as (lies tangential to) the PPF - since the slope of the PPF shows the supply price ratio of the two goods - the price ratio which matches the opportunity costs of producing each of the goods.  So, country 1 produces P1c of clothes, and P1f of food, and trades (P1c - C1c) clothes for (C1f - P1f) food.

The exports [production minus consumption] of clothes pays for the imports (consumption minus production) of food, at the trading price ratio between the two products.  And country 1 is clearly better off with trade than without it, since it can now consume above (beyond) the limits of its production possibilities.  The same arguments apply to country 2.  Follow them through for country 2 for yourselves.

Conclusions from Trade:

• Country 1 is said to have a comparative advantage in clothing production - it can produce clothes relatively cheaply in terms of food, whereas country 2 has a comparative advantage in food production.  Notice, importantly, that one of these countries could be absolutely better at producing both goods - able to produce both more food and more clothes per person or per hectare.  But this would make absolutely no difference to its comparative advantage.  Unless both countries are absolutely identical (in which case their real prices would also be identical, and there would be no gain from trade, and thus no trade) , one must have a comparative advantage in one good and the other must have a comparative advantage in the other good - fact of logic; mathematical certainty; law of human nature - call it what you like.
• In particular - there is no way that one country can possibly have a comparative advantage in the production of both goods.  Having a comparative advantage in one good automatically means that the country has  comparative disadvantage in the other.  This result is perfectly general - it holds however many goods we might like to consider - any country will have a comparative advantage in something - something which it is relatively good at compared with all the other things it might be able to do.
• Trade allows these countries to exploit their comparative advantages, buying (importing) things which are relatively cheap from elsewhere and paying for these imports with exports of things which are relatively cheap in this country, and thus relatively expensive elsewhere.
• It will pay countries to specialise in the things which they are relatively good at - the things in which they have a comparative advantage.  Country 1 here specialises in clothes - producing more than it is willing to consume, and country 2 specialises in food (& fibre) production.
• Trade prices equalise between countries as trade occurs, which encourage the appropriate supply and demand responses to exploit these opportunities for specialisation
• The results of this logical analysis are unambiguous - trade pays and is of benefit to everyone.  There is no doubt about this - it is a fact of logic - it stands to reason.  Not believing this is exactly equivalent to not believing that the earth is round and goes round the sun - it is daft, nonsensical, illogical, without foundation.
• It is also, I argue, a fact of life as well as a fact of logic - because the principle of specialisation and trade according to comparative advantage is a basic principle of evolution and natural selection.  Rabbits don't try to be wolves - they get better at being rabbits, and working better with the resources and conditions in which they find themselves. This is how natural ecosystems work, as well as how markets work.  But this is another story.

• Demand for sterling (= supply of forex) depends on exports of goods and services, and on inward flows of investment funds from abroad (capital inflows)
• Supply of sterling (= demand for forex) depends on imports of goods and services, and on outward flows of investment funds from the UK to foreign countries (capital outflows)
• Balance of Payments (BoP) records all these transactions:
• Current Account  (Exports vs. Imports)
• balance of visible trade
• balance of invisible trade (services, tourism travel etc.)
• Capital Account (flows of investment (financial) funds into and out of the country
• Official Financing - change in the Central Bank (BoE in the UK) forex reserves.

• Increasing Income shifts Sf right (increasing demand for imports) -> e.r. depreciation or BoP deficit (the typical UK condition prior to 1971 - when under fixed exchange rates)
  
• Increasing Interest rates shift Sf left (discouraging capital outflows), and Df right (encouraging capital inflows -> e.r. appreciation or BoP surplus (the typical German condition prior to 1971 under fixed exchange rates)
  

• Increases Y
• Reduces r
• depreciates e.r -> more expensive imports, more competitive exports -> further expansionary effect.
• more likely to generate inflation

• Any currency which is viewed by the market as being vulnerable is subject to considerable short term capital outflows, which makes the currency even more vulnerable and liable to devaluation of fixed rate or depreciation of a floating rate. Speculative bubbles (either bull or bear) are frequent in Forex markets for currencies which governments seek to control, especially but not only for the lesser currencies (can even affect the major currencies - euro, $, yen, £)
• rapid growth from Foreign Direct Investment (FDI) - direct, because it refers to actual purchases of goods and services and physical investment) tends to lead to currency appreciation as a result of the capital inflows, as does an increase in the price of raw materials and fuels, for net exporters of these goods (sometimes called the Dutch disease, after the experience of the Netherlands when North Sea Oil was first discovered and exploited). This e.r appreciation puts major pressure on the domestic economy - making imports more competitive and exports more difficult to sell, tending to contract the domestic economy. The domestic economy needs to be both robust and flexible (sensible banks and stock markets) to cope with this pressure.

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