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Trade-offs, Comparative Advantage, and the Market System C

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2Chapter Outline andLearning Objectives

2.1 Production Possibilities Frontiers and Opportunity Costs

2.2 Comparative Advantage and Trade

2.3 The Market System

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Households, firms and governments continually face decisions about how best to use their scarce resources.

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

Scarcity requires trade-offs. Economics teaches us tools to help make good trade-offs.

Example: When buying a car, will you favor a larger, safer car, or a smaller, more fuel-efficient one?

Scarcity and trade-offs

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Use a production possibilities frontier to analyze opportunity costs and trade-offs.

2.1 LEARNING OBJECTIVE

Production Possibilities Frontiers and Opportunity Costs

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A production possibilities frontier (PPF) is a curve showing the maximum attainable combinations of two products that may be purchases with available resources and technology.

Question: Is the PPF a positive or normative tool?

Answer: Positive; it shows “what is”, not “what should be”.

Production possibilities frontier

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Figure 2.1

A production possibilities frontier for BMW

BMW can produce hybrid cars and/or SUVs.

If it wants to produce more hybrids, it must reduce the number of SUVS.

Points on the PPF are attainable for BMW.

Points above the curve are not attainable.

Points below the curve are inefficient.

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Figure 2.1

A production possibilities frontier for BMW

To produce 200 more SUVs (e.g. moving from A to B), BMW must produce 200 fewer hybrids.

The 200 fewer hybrids is the opportunity cost of producing 200 more SUVs.

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

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Figure 2.2

On the previous slide, opportunity costs were constant.

But opportunity costs are often increasing.

Why? Some resources are better suited to one task than another. The first resources to “switch” are the one best suited to switching.

The more resources already devoted to an activity, the smaller the payoff to devoting additional resources to that activity.

Increasing marginal opportunity costs

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Figure 2.3As more economic resources become available, the economy can move from point A to point B, producing more tanks and more automobiles.

Shifts in the production possibilities frontier represent economic growth.

Economic growth on the PPF

Economic growth: the ability of the economy to increase the production of goods and services.

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Figure 2.3

Technological change in one industry

This panel shows technological improvement in the automobile industry.

The quantity of tanks that can be produced remains unchanged.

As in the previous slide, many previously unattainable combinations are now attainable.

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A production possibilities curve for exam gradesMaking

the

Connection

Suppose you have a limited amount of time to study for two exams, Economics and Accounting.

What would the production possibilities curve for the exam grades look like?

A straight line, like the PPF for hybrids and SUVs

or

A bowed-outward curve, like the PPF for tanks and automobiles?

Why? The first hour spent studying Economics is much more valuable than the last hour…

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Comparative Advantage and Trade

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

2.2 LEARNING OBJECTIVE

Interdependence of Goods and Services

Every day you rely on

many people from around the world,

most of whom you do not know,

to provide you with the goods and services

you enjoy.Coffee from

Kenya

Dress shirt from China

Cell phone from

Taiwan

Hair gel from Cleveland, OH

Trade or Exchange

Why do people trade?

Trade can make everyone better off.

What is trade?Trade is the process of giving up one thing (money, goods, services, etc.) for something else.

The mechanism that allows trade is called a market.

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Trade and Terms of Trade

Terms of Trade: how much of one thing is traded for how much of something else.

Buyers prefer lower prices, sellers prefer higher prices.

Production, Trade, and Specialization

Terms of Trade: how much of one item is traded for how

much of another item.

Absolute price – in terms of moneyRelative price – in terms of other goods

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TRADE THROUGH SPECIALIZATION

Comparative Advantage: the situation where someone can produce a good or conduct an activity at lower opportunity cost than someone else can.

The cost of catching one fish (relative to apples) is three times HIGHER for Brian than for Elizabeth !

Opportunity Cost

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The Gains From Specialization Through Trade

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5

•

Elizabeth

Apples

Fish0

15 10

Brian

Apples

Fish0

2030

20 10

Graphical Illustration for Elizabeth and Brian

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Imports

Exports

Exports

18

8Imports1

2

• •

10

•

Production, Trade, and SpecializationProfit and a Lower Cost of Living

The desire for Profit and an Easier Life guided the decisions of Elizabeth and Brian.

Both acted in their own self-interests.

Both gained from specialization and trade.

Adam Smith: Eighteenth-century economist (the father of modern economics) spoke about an invisible hand that guided individual actions toward a positive outcome that he/she did not intend.

Should Tiger Woods become a caddie?

World’s #1 Golfer

World’s #1 Caddie

Should he do both?

Absolute advantage - the ability to produce more units of a good or service using a given quantity of labor or resource inputs.

Although Tiger Woods has an absolute advantage in both activities, it is still not worth his time to be a caddie.

The opportunity cost of spending one moment as a caddie is too high. He still has a comparative advantage as a golfer.

When Does Trade Fail to Occur?

Opportunity Costs

No Comparative Advantage exists if the opportunity costs are the same.

Transaction Costs: costs associated with searching out, negotiating, and completing an exchange.

Cost of item is not always the principle determinant of whether the transaction occurs.

Uncertainty of quality

Time constraints

Transportation costs

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Trades and Third Parties

Third Party Effects: someone other than the parties involved in the exchange was affected.

Negative Externalities

Positive Externalities

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What does the United States have a comparative advantage in?

Makingthe

Connection

The answer depends on which country we compare to.

However in general, since we know countries will specialize and trade in whatever they have a comparative advantage in, we can look at what the US exports to answer this question.

Top US exports:• Civilian aircraft• Semiconductors• Passenger cars• Pharmaceuticals• Automotive parts and accessories

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The Market System

Explain the basic idea of how a market system works.

2.3 LEARNING OBJECTIVE

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Two key groups participate in the modern economy:

• Households consist of individuals who provide the factors of production: labor, capital, natural resources, and entrepreneurial ability.

• Households receivepayments for these factorsby selling them to firms in factor markets.

• Firms supply goods and services to product markets; households buy these products from the firms.

A basic model of the economy

All types of work

Physical capital used to produce other goods

Land, water, oil, ore, raw materials, etc.

The ability to bring together factors of production

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Figure 2.6Households provide factors of production to firms.

Firms provide goods and services to households.

Firms pay money to households for thefactors of production.

Households pay money to firms for the goods and services.

The circular flow diagram

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The gains from free markets

A free market is one 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.

Countries that come closest to the free market benchmark have been more successful than those with centrally planned economies in providing their people with rising living standards.

This concept is not new: Adam Smith argued for free markets in his 1776 treatise, An Inquiry into the Nature and Causes of the Wealth of Nations.

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The beauty of the market mechanism

It is not immediately obvious that markets will do better than centrally-planned systems for satisfying human desires.

After all, individuals are acting only in their own rational self-interest.

But markets with flexible prices allow the collective actions of households and firms to signal the relative worth of goods and services.

In this way, the “invisible hand” allows individual responses to 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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The role of the entrepreneur

Entrepreneurs bring together the factors of production, combining them into useful products for consumers.

The best entrepreneurs create products that consumers never even knew they wanted.

“If I had asked my customers what they wanted, they would have said a faster horse.”

- Henry Ford

Entrepreneurs make a vital contribution to economic growth, often with considerable personal risk and sacrifice.

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The legal basis of a successful market system

In a free market, government does not restrict how firms produce and sell goods, or how they employ factors of production.

However governments must provide a sound legal environment that will allow the market system to succeed, including:

Protection of private property• When criminals can take your wages or profits, households

and firms have little incentive to work hard.• Property rights, including intellectual property, are key.

Enforcement of contracts and property rights• Important for transactions across time to occur.• An independent court system is critical here.

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Common misconceptions to avoid

The production possibilities frontier should never bow inward.

The PPF tells us what can be produced, not what should be produced.

Just because someone is better or worse at everything, doesn’t mean trade with them cannot be beneficial.• The basis for trade is comparative advantage, not absolute

advantage!

Free markets raise the standard of living; but that doesn’t mean there is no role for governments.• Governments must provide a sound legal environment to allow

the market system to succeed.