Presentation on theme: "2 Trade-offs, Comparative Advantage, and the Market System"— Presentation transcript:
12 Trade-offs, Comparative Advantage, and the Market System CHAPTERChapter Outline andLearning Objectives2.1Production Possibilities Frontiers and Opportunity Costs2.2Comparative Advantage and Trade2.3The Market System
2Scarcity and trade-offs 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?
3Production Possibilities Frontiers and Opportunity Costs 2.1 LEARNING OBJECTIVEUse a production possibilities frontier to analyze opportunity costs and trade-offs.
4Production possibilities frontier 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”.
5A 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.Figure 2.1
6A 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.Figure 2.1
7Increasing marginal opportunity costs 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.Figure 2.2The more resources already devoted to an activity, the smaller the payoff to devoting additional resources to that activity.
8Economic growth on the PPF 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: the ability of the economy to increase the production of goods and services.
9Technological 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.Figure 2.3
10A straight line, like the PPF for hybrids and SUVs or Making the ConnectionA production possibilities curve for exam gradesSuppose 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 SUVsorA 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…
11Comparative Advantage and Trade 2.2 LEARNING OBJECTIVEUnderstand comparative advantage and explain how it is the basis for trade.
12Interdependence of Goods and Services Hair gel from Cleveland, OHEvery 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.Cell phone from TaiwanDress shirt from ChinaCoffee from Kenya
13Trade can make everyone better off. Trade or ExchangeWhat 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.Why do people trade?Trade can make everyone better off.
14Trade 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.
15Production, 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
16TRADE THROUGH SPECIALIZATION Opportunity CostThe cost of catching one fish (relative to apples) is three times HIGHER for Brian than for Elizabeth !Comparative Advantage: the situation where someone can produce a good or conduct an activity at lower opportunity cost than someone else can.
18Graphical Illustration for Elizabeth and Brian ApplesFishBrianApplesFish3020Exports12•18•Imports1010•155•Imports81012Exports20
19Production, Trade, and Specialization Profit 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.
20Should Tiger Woods become a caddie? World’s #1 GolferShould he do both?World’s #1 CaddieAlthough Tiger Woods has an absolute advantage in both activities, it is still not worth his time to be a caddie.Absolute advantage - the ability to produce more units of a good or service using a given quantity of labor or resource inputs.The opportunity cost of spending one moment as a caddie is too high. He still has a comparative advantage as a golfer.
21When Does Trade Fail to Occur? Opportunity CostsNo 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 qualityTime constraintsTransportation costs
22Trades and Third Parties Third Party Effects: someone other than the parties involved in the exchange was affected.Negative ExternalitiesPositive Externalities
23The answer depends on which country we compare to. Making the ConnectionWhat does the United States have a comparative advantage in?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 aircraftSemiconductorsPassenger carsPharmaceuticalsAutomotive parts and accessoriesSource:
24The Market System Explain the basic idea of how a market system works. 2.3 LEARNING OBJECTIVEExplain the basic idea of how a market system works.
25A basic model of the economy 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 receive payments for these factors by selling them to firms in factor markets.Firms supply goods and services to product markets; households buy these products from the firms.All types of workPhysical capital used to produce other goodsLand, water, oil, ore, raw materials, etc.The ability to bring together factors of production
26The circular flow diagram Households provide factors of production to firms.Firms provide goods and services to households.Firms pay money to households for the factors of production.Households pay money to firms for the goods and services.Figure 2.6
27The 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.
28The 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.
29A Story of the Market System in Action: How Do You Make an iPad? Making the ConnectionA Story of the Market System in Action: How Do You Make an iPad?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.FirmLocation of the FirmiPad Component the Firm SuppliesARMGreat BritainProcessor designBroadcomUnited States (California)Touchscreen controllerInfineon TechnologiesGermanySemiconductorsLG ElectronicsSouth KoreaScreenSamsungFlash memory and processorTexas InstrumentsUnited States (Texas)
30The 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 FordEntrepreneurs make a vital contribution to economic growth, often with considerable personal risk and sacrifice.
31The 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 propertyWhen 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 rightsImportant for transactions across time to occur.An independent court system is critical here.
32Common 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.