Chapter 2

Chapter 2: Trade-offs, Comparative Advantage, and the Market System Production Possibilities Frontier (PPF) ? a curve showing the maximum attainable combinations of two products that may be produced with available resources and current technology 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 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 *the basis for trade is comparative advantage* Example: Napoleon & Pedro produce drawings & cakes to help them get dates. NAPOLEON?S PRODUCTION CHOICES Choice Quantity of drawings produced per day Quantity of cakes produced per day A 0 4 B 1 2 C 2 0 PEDRO?S PRODUCTION CHOICES Choice Quantity of drawings produced per day Quantity of cakes produced per day F 0 12 G 1 8 H 2 4 I 3 0 THE DAILY PRODUCTION POSSIBILITIES FRONTIERS OF NAPOLEON AND PEDRO NAPOLEON PEDRO To increase the production of one good we must decrease the production of another good- this is a trade-off Points ON PPF: attainable, efficient Points INSIDE PPF: attainable, inefficient Points OUTSIDE PPF: unattainable given current resources & tech. Efficiency: the maximum output is being obtained from the available resources AND it is impossible to produce more of one good without producing less of the other Inefficiency: some resources are not being fully employed AND it is possible to produce more of one good without producing less of the other NOTE: The PPF only shows the choices available to an economy, it does not show which production point is best b/c that depends on the wants & preferences of society OPPORTUNITY COST: Napoleon?s marginal opportunity cost of 1 drawing is constant at 2 cakes, and his marginal opportunity cost of 1 cake is constant at ½ a drawing. Pedro?s marginal opportunity cost of 1 drawing is constant at 4 cakes, and his marginal opportunity cost of 1 cake is constant at ¼ a drawing. Where each individual consumes on their PPF depends on that individual's preferences and wants. Let's assume that without trade, Napoleon chooses to produce and consume 1 drawing and 2 cakes (point B), while Pedro chooses to produce and consume 1 drawing and 8 cakes (point G). Pedro has an absolute advantage in the production of both goods. Napoleon has a comparative advantage in the production of drawings, while Pedro has a comparative advantage in the production of cakes. If Napoleon specializes in producing drawings and Pedro specializes in producing cakes, then Napoleon will produce 2 drawings and 0 cakes (point C) and Pedro will produce 0 drawings and 12 cakes (point F). Napoleon produces each of his drawings at an opportunity cost of 2 cakes, so he will not accept fewer than 2 cakes in exchange for each drawing. Let's assume that each individual still wants to consume 1 drawing, so Napoleon gives Pedro 1 drawing and Pedro gives Napoleon 3 cakes. With trade, Napoleon consumes 1 drawing and 3 cakes, while Pedro consumes 1 drawing and 9 cakes. With trade, Napoleon gains 1 cake and Pedro gains 1 cake. Both individuals are now consuming outside their PPF, which illustrates the gains from trade. NAPOLEON PEDRO Quantity of drawings per day Quantity of cakes per day Quantity of drawings per day Quantity of cakes per day Production & consumption without trade 1 2 1 8 Production with trade 2 0 0 12 Trade -1 +3 +1 -3 Consumption with trade 1 3 1 9 Gains from trade (increased consumption) 0 1 0 1 Increasing Marginal Opportunity Cost illustrates an important concept: the more resources already devoted to any activity, the smaller the payoff to (and the greater the opportunity cost of) devoting additional resources to that activity. Economic ? All resources ? Tech. improvement/ Tech. improvement/ ? resources for good X ? resources for good Y Economic growth: the ability of the economy to produce increasing quantities of goods and services -at any given time, resources available in an economy are fixed but over time they may increase Market: a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. Households and firms interact in two types of markets: Product markets: markets for goods (computers) and services (medical treatment) Factor markets: markets for the factors of production, such as labor, capital, natural resources, and entrepreneurial ability Factors of Production Categories Labor- workers Capital-physical capital like computers Natural Resources- land, water, oil, and other raw materials Entrepreneurial ability- ability to bring together the other factors of production to successfully produce and sell goods and services A free market exists when the government places few restrictions on how a good or a service can be produced or sold or on how a factor of production can be employed. Governments in all modern economies intervene more than is consistent with a fully free market. Entrepreneur- someone who operates a business, bringing together the factors of production- labor, capital, and natural resources- to produce goods and services. Legal Basis of a Market System Government has to provide secure rights to private property Government can aid the working of the market by enforcing contracts between private individuals through an independent court system Economists would day that government has a role in facilitating the development of an efficient financial system as well as systems of education, transportation, and communication Property rights- the rights individuals of firms have to the exclusive use of their property, including the right to buy or sell it Property can be tangible (store or factory) or intangible (right to an idea) 5th amendment: The federal government shall not deprive any person of ?life, liberty, or property, without due process of law. 14th amendment: No state shall deprive any person of life, liberty, or property, without due process of law Intellectual property rights include books, films, software, and ideas for new products or new ways of producing products. To protect this intellectual property, the gov. grants a patent or copyright protection.