PowerPoint to accompany Chapter 2 Choices and trade-offs in the market

PowerPoint

to accompany

Chapter 2

Choices and trade-offs in the

market

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Learning Objectives

1. Use a production possibility frontier to analyse opportunity costs and trade-offs.

2. Understand comparative advantage and explain how it is the basis for trade.

3. Explain the basic idea of how a market system works.

4. Understand why property rights are necessary for a well-functioning economy.


Managers making choices at BMW

BMW’s management has faced many decisions which involve trade-offs. For example, whether to concentrate production in Germany, or to build factories in overseas markets.


Production possibility frontier: A curve showing the maximum attainable combinations of two products that may be produced with available resources.

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

LEARNING OBJECTIVE 1

Production possibility frontiers and real world trade-offs



Choice Sports cars per day 4WDs per day

A 800 0

B 600 400

C 400 500

D 200 575

E 0 600

BMWs production choices per day Figure 2.1

0

Sports cars produced per day

BMWs production possibility frontier: BMW faces a production trade-off between

sports cars and 4WDs: Figure 2.1, continued

600

300

400

400 500 575 600

800

F

C

200

200

G

4WDs produced per day

A

B

D

E

Inefficient combination

Unattainable combination



The bowed out shape of the production possibility frontier illustrates the concept of increasing marginal opportunity costs.

Increasing marginal opportunity costs demonstrate an important economic concept:

The more resources are devoted to any activity, the smaller will be the payoff to devoting additional resources to that activity.



Computers

Technological change and the computer industry: Figure 2.2

0

400

500

Televisions

350

200

200 400

A

B

C

Increasing computer production here by 200 only reduces

television production by 50.

Increasing computer production here by 200

reduces television production by 150.



Economic growth: The expansion of society’s production potential.

Economic growth is usually measured by the rate of growth in real GDP.

Growth can also be illustrated using the production possibility frontier.



0

Televisions

Computers

Shifting out the production possibility frontier: Economic growth: Figure 2.3(a)

400

200

300

400 450 500 650

500

A

B


Computers

Technological change and the computer industry: Figure 2.3(b)

0

400

500 800

Televisions



Trade-offs and tsunami relief

More funds for tsunami relief meant less funds for other charities.


We use the production possibility frontier and the concept of opportunity cost to explain the economic gains from specialisation and trade.

Trade: the act of buying or selling a good or service in a market.


Trade


We use a simple example of two people - you and your neighbour.

And two goods, apples and cherries, measure in kilograms (kgs)

We further simplify our example by using straight line production possibility frontiers.


Trade

0

Apples (kg)

(a) Your production possibility frontier

20

Production possibilities for you and your neighbour without trade: Figure 2.4


Cherries (kg)

20

You Your neighbourApples Cherries Apples Cherries

All time picking apples 20 kg 0 kg 30 kg 0 kgAll time picking cherries 0 kg 20 kg 0 kg 60 kg

0

Apples (kg)

(a) Your production possibility frontier

20

Production possibilities for you and your neighbour without trade: Figure 2.4


(b) Your neighbour’s production possibility frontier

Cherries (kg)

20

Cherries (kg)

Apples (kg)

0 60

30

You Your neighbourApples Cherries Apples Cherries

All time picking apples 20 kg 0 kg 30 kg 0 kgAll time picking cherries 0 kg 20 kg 0 kg 60 kg

0

Apples (kg)

(a) Your production and consumption after trade

20

Gains from trade: Figure 2.5


Cherries (kg)

20

Your production with trade

Your consumption without trade

Your consumption

with trade108

12

15

A’

A

0

Apples (kg)

(a) Your production and consumption after trade

20

Gains from trade: Figure 2.5


(b) Your neighbour’s production and consumption with trade

Cherries (kg)

20

Cherries (kg)

Apples (kg)

060

30

Your production with trade

Your consumption without trade

Your consumption

with trade108

12

15

A’

A 910

42

45

B’

B

Your neighbour’s consumption without trade

Your neighbour’s consumption

with trade

Your neighbour’s production with trade


Absolute and comparative advantage.

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

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


Trade


Comparative advantage and the gains from trade.

The basis for trade is comparative advantage not absolute advantage.

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


Trade

A summary of the gains from trade: Table 2.1

You Your NeighbourApples (kg) Cherries (kg) Apples (kg) Cherries (kg)

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 2 3 1 3

1 kg of apples 1 kg of cherries

You 1 kg of cherries 1 kg of apples

Your neighbour 2 kg of cherries 0.5 kg of apples

Opportunity cost of picking fruit: Table 2.2



Gains from specialisation and trade

Suppose Jack and Jenny both live alone on two small deserted islands in the Pacific Ocean. Both produce only two food products, mangoes and fish. If Jack spends all his time fishing he can catch 8 kilograms of fish each week. If he spends all his time picking mangoes he can pick 2 kilograms a week. If Jenny devotes all her time to fishing, she can catch two kilograms of fish a week. If she spends all her time picking mangoes, she can pick 10 kilograms a week. Currently, both devote half their time to fishing and half their time to picking mangoes.



Gains from specialisation and tradea) Calculate the opportunity cost of fish and mango production for Jack and

Jenny.

b) Does your calculation in part (a) suggest Jack and Jenny could benefit from specialisation and exchange? If so, who should specialise in the production of each good?

c) How will specialisation impact total output.

d) Suppose Jack and Jenny both keep half of their total output after specialisation, and trade the other half for the good they do not have. How much will each person gain from this exchange?




Solving the problem:

STEP 1: Review the material. The problem is about the gains from specialisation and trade, covered on pages 40 – 44 of the text.




STEP 2: Answer (a) by calculating the opportunity costs of each good for both individuals.



Gains from specialisation and exchange




STEP 3: Answer (b). The individual with the lowest opportunity cost has the comparative advantage in the production of that good.

Jack has the lower opportunity cost and therefore the comparative advantage in fish production.

Jenny has the lower opportunity cost and therefore the comparative advantage in mango production.




STEP 4: Answer (c). To determine the impact on total output we must compare output prior to specialisation with output post specialisation. In order to make this comparison, we recall that Jenny and Jack both initially spent half their time catching fish and half their time picking mangoes.

This information enables us to construct the table shown on the following slide.

Note: we assume complete specialisation; that is, post specialisation, both Jenny and Jack produce only the good in which they have a comparative advantage.





Pre-Specialisation and Trade

Post Specialisation

Fish Mangoes Fish Mangoes

Jack 4 1 8 0

Jenny 1 5 0 10

TOTAL 5 6 8 10

+3 +4



STEP 4: The table shows that production of both goods has increased due to specialisation.

STEP 5: Answer (d). We compare the pre-trade and pre-specialisation consumption and production of Jack and Jenny with their post specialisation consumption. That is, each will keep half their total output and exchange half for the other good. This enables us to construct the table shown on the next slide. The table demonstrates that both individuals have gained in consumption from trade.





Pre-Specialisation and Trade

After Trade

Fish Mangoes Fish Mangoes

Jack 4 1 4 5

Jenny 1 5 4 5


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 and services.

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


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.

Adam Smith argued the benefits of a free market system in his famous book –

An Inquiry into the Nature and Causes of the Wealth of Nations (published in 1776).


The market system


Smith assumed individuals act in a rational, self-interested way.

If not restricted by government, then firms would be led by the invisible hand of the market to provide consumers with what they wanted.

The price mechanism in the free market leads producers to change supply in accordance with consumer demand.


The market system


Entrepreneurs are central to the working of the market system.

Entrepreneur: Someone who operates a business, bringing together the factors of production to produce goods and services.


The market system


Story of the market system in action: I, Pencil.

The market coordinates the activities of the many people spread around the world who contribute to the making of a pencil.


Private property rights provide the legal basis of a free market system.

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

To enforce contracts and property rights there must be an independent court system with impartial judges.

Production will fall if property rights are not well enforced – a move inside the PPF.


Property Rights


Copying movies and music from cyberspace

Apple’s iTunes in conjunction with MP3 players (such as the multi-touch screen iPod shown here), have made a solid attempt at combating unauthorised free downloads of music by offering inexpensive legal downloads.


An Inside LookExpansion and production mix at BMW


Key Terms Absolute advantage

Comparative advantage

Economic growth

Entrepreneur

Factor markets

Free market

Market

Opportunity cost

Price mechanism

Product markets

Production possibility frontier

Property rights

Scarcity

Trade


Adam Smith is regarded as the founder of modern economic theory. In consequence, a vast quantity of information is available on his life and writings, both in print and on the internet.

Most students studying economics in the 21st Century do not have the luxury of studying the foundations of this fascinating discipline. However, you can follow the link below to the webpage of the History of Economic Thought, and from there find more information about Adam Smith.

http://cepa.newschool.edu/het/

Get Thinking!


Q1. What happens to a country that produces a combination of goods that uses all the resources available in the economy?

a. The country is operating on its production possibility frontier.

b. The country is maximising its opportunity cost.

c. The country has eliminated scarcity.

d. All of the above.

Check Your Knowledge


Q1. What happens to a country that produces a combination of goods that uses all the resources available in the economy?

a. The country is operating on its production possibility frontier.

b. The country is maximising its opportunity cost.

c. The country has eliminated scarcity.




Q2.Refer to the graph below. Each graph represents one country. Which country in this graph has a comparative advantage in the production of shirts?

a. Country A

b. Country B

c. Neither country

d. Both countries



Q2.Refer to the graph below. Each graph represents one country. Which country in this graph has a comparative advantage in the production of shirts?

a. Country A

b. Country B

c. Neither country

d. Both countries



Q3. According to Adam Smith, which of the following is true?

a. Markets work because producers, aided by government, ensure that neither too many nor too few goods are produced.

b. Market prices can come to reflect the prices desired by consumers.

c. Individuals usually act in a rational, self interested way.




Q3. According to Adam Smith, which of the following is true?

a. Markets work because producers, aided by government, ensure that neither too many nor too few goods are produced.

b. Market prices can come to reflect the prices desired by consumers.

c. Individuals usually act in a rational, self interested way.



Documents

PowerPoint to accompany Chapter 2 Choices and trade-offs in the market