Chapter 2: Trade-offs, Comparative Advantage, and the Market System 1 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony

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1 of 30© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.

Trade-offs, Comparative Advantage, and the Market System

Scarcity The situation in which unlimited wants exceed the limited resources available to fulfill those wants.

Scarcity requires trade-offs. Goods and services and the economic resources used to make them, or factors of production—workers, capital, natural resources, and entrepreneurial ability—are scarce.

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Production Possibilities Frontiersand Opportunity Costs

Learning Objective 2.1

Production possibilities frontier (PPF) A curve showing the maximum attainable combinations of two products that may be produced with available resources and current technology.

Opportunity cost The highest-valued alternative that must be given up to engage in an activity.

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Graphing the Production Possibilities Frontier

FIGURE 2-1

BMW’s Production Possibilities Frontier

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Solved Problem 2-1Drawing a Production Possibilities Frontier for Rosie’s Boston Bakery


HOURS SPENT MAKING QUANTITY MADE

CHOICE CAKES PIES CAKES PIES

A 5 0 5 0

B 4 1 4 2

C 3 2 3 4

D 2 3 2 6

E 1 4 1 8

F 0 5 0 10

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Increasing Marginal Opportunity Costs

FIGURE 2-2

Increasing Marginal Opportunity Cost

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Economic Growth

FIGURE 2-3

Economic Growth

Economic growth The ability of the economy to produce increasing quantities of goods and services.

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Comparative Advantage and Trade


Trade The act of buying or selling.

Specialization and Gains from Trade

FIGURE 2-4

Production Possibilities for You and Your Neighbor, without Trade

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Absolute advantage The ability of an individual, a firm, or a country to produce more of a good or service than competitors, using the same amount of resources

Table 2-2

Opportunity Costs of Picking Apples and Cherries

Comparative Advantage versus Absolute Advantage

OPPORTUNITY COST OF PICKING1 POUND OF APPLES

OPPORTUNITY COST OF PICKING1 POUND OF CHERRIES

YOU 1 pound of cherries 1 pound of apples

YOUR NEIGHBOR 2 pounds of cherries 0.5 pounds of apples

Comparative advantage The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors.

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The basis for trade is comparative advantage, not absolute advantage.

Individuals, firms, and countries are better off if they specialize in producing goods and services for which they have a comparative advantage and obtain the other goods and services they need by trading.

Comparative Advantage and the Gains from Trade

Don’t Let This Happen to YOU!Don’t Confuse Absolute Advantage and Comparative Advantage


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FIGURE 2-5

Gains from Trade


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TABLE 2-1

A Summary of the Gains from Trade


YOU YOUR NEIGHBOR

APPLES(IN POUNDS)

CHERRIES(IN POUNDS)

APPLES(IN POUNDS)

CHERRIES(IN POUNDS)

Production and consumption without trade 8 12 9 42

Production with trade 20 0 0 60

Consumption with trade 10 15 10 45

Gains from trade (increased consumption) 2 3 1 3

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Solved Problem 2-2Comparative Advantage and theGains from Trade

BEFORE TRADE AFTER TRADE

HONEY(IN TONS)

MAPLE SYRUP(IN TONS)

HONEY(IN TONS)

MAPLE SYRUP (IN TONS)

CANADA 30 15 30 20UNITED STATES 10 40 20 40

CANADA UNITED STATES

HONEY(IN TONS)

MAPLE SYRUP(IN TONS)

HONEY(IN TONS)

MAPLE SYRUP (IN TONS)

0 60 0 50

10 45 10 40

20 30 20 30

30 15 30 20

40 0 40 10

50 0

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Solved Problem 2-2Comparative Advantage and theGains from Trade

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The Market System


Market A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade.

Product markets Markets for goods—such as computers—and services—such as medical treatment.

Factor markets Markets for the factors of production, such as labor, capital, natural resources, and entrepreneurial ability.

Factors of production The inputs used to make goods and services.

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The Market System


• Labor includes all types of work, from the part-time labor of teenagers working at McDonald’s to the work of top managers in large corporations.

• Capital refers to physical capital, such as computers and machine tools, that is used to produce other goods.

• Natural resources include land, water, oil, iron ore, and other raw materials (or “gifts of nature”) that are used in producing goods.

• An entrepreneur is someone who operates a business. Entrepreneurial ability is the ability to bring together the other factors of production to successfully produce and sell goods and services.

Factors of production are divided into four broad categories:

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Circular-flow diagram A model that illustrates how participants in markets are linked.

The Market System

The Circular Flow of Income

• A household consists of all the individuals in a home.

• Firms are suppliers of goods and services.

Two key groups participate in markets:

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FIGURE 2-6

The Circular-Flow Diagram

The Market System

The Circular Flow of Income

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The Market System


Free market A market with few government restrictions on how a good or service can be produced or sold or on how a factor of production can be employed.

The Gains from Free Markets

Individuals usually act in a rational, self-interested way. Adam Smith understood that people’s motives can be complex.

In a famous phrase, Smith said that firms would be led by the “invisible hand” of the market to provide consumers with what they wanted.

Firms respond individually to changes in relative prices by making decisions that collectively end up satisfying the wants of consumers.

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A Story of the Market System in Action: How Do You Make an iPad?

Makingthe

Connection

Firm Location of the Firm iPad Component the Firm Supplies

ARM Great Britain Processor design

Broadcom United States (California) Touchscreen controller

Infineon Technologies Germany Semiconductors

LG Electronics South Korea Screen

Samsung South Korea Flash memory and processor

Texas Instruments United States (Texas) Touchscreen controller

The invisible hand of the market has led these firms to contribute their knowledge and resources to the process that ultimately results in an iPad available for sale in a store in the United States.

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Property rights The rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it.

The Legal Basis of a Successful Market System

Protection of Private Property

Enforcement of Contracts and Property Rights

If property rights are not well enforced, fewer goods and services will be produced. This reduces economic efficiency, leaving the economy inside its production possibilities frontier.

Patents and copyrights protect intellectual property rights for inventors of ideas for new products or production methods and for creators of books, films, and software.

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Makingthe

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Property Rights in Cyberspace:YouTube

Controlling unauthorized copying is more difficult today than it was when “copying” meant making a physical copy of a book, CD, or DVD. The popularity of YouTube highlights the problem of unauthorized copying of videos and music.

Some recording artists worry that the copyrights for their songs are not being protected on the Internet.

Documents

Chapter 2: Trade-offs, Comparative Advantage, and the Market System 1 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony