1. © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Fernando & Yvonn Quijano Prepared by: Chapter 2 Trade-offs, Comparative Advantage, and the Market System

2. 2 of 29 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Managers Making Choices at BMW 2.1Use a production possibilities frontier to analyze opportunity costs and trade-offs. 2.2 Understand comparative advantage and explain how it is the basis for trade. 2.3Explain the basic idea of how a market system works. Learning Objectives To compete in the automobile market, the managers of BMW must make many strategic decisions, such as whether to introduce a new car model.

3. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 3 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.

4. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 4 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Production Possibilities Frontiers and 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.

5. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 5 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Production Possibilities Frontiers and Opportunity Costs Learning Objective 2.1 Graphing the Production Possibilities Frontier FIGURE 2-1 BMW’s Production Possibilities Frontier

6. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 6 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Production Possibilities Frontiers and Opportunity Costs Learning Objective 2.1 Graphing the Production Possibilities Frontier Opportunity cost The highest- valued alternative that must be given up to engage in an activity.

7. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 7 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Solved Problem 2-1 Drawing a Production Possibilities Frontier for Rosie’s Boston Bakery Learning Objective 2.1 HOURS SPENT MAKINGQUANTITY MADE CHOICECAKESPIESCAKESPIES A5050 B4142 C3234 D2326 E1418 F05010

8. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 8 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Trade-offs: Hurricane Katrina, Tsunami Relief, and Charitable Giving More funds for Katrina relief meant less funds for other charities. Making the Connection Learning Objective 2.1 More than two-thirds of Americans donated money to hurricane relief. Although these funds helped to reduce the suffering of many hurricane victims, donations to some other causes actually declined.

9. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 9 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Production Possibilities Frontiers and Opportunity Costs Learning Objective 2.1 Increasing Marginal Opportunity Costs FIGURE 2-2 Increasing Marginal Opportunity Cost

10. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 10 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Production Possibilities Frontiers and Opportunity Costs Learning Objective 2.1 Economic Growth FIGURE 2-3 Economic Growth Economic growth The ability of the economy to produce increasing quantities of goods and services.

11. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 11 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Comparative Advantage and Trade Learning Objective 2.2 Trade The act of buying or selling. Specialization and Gains from Trade FIGURE 2-4 Production Possibilities for You and Your Neighbor, without Trade

12. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 12 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 2.2 Specialization and Gains from Trade With the Following Terms of Trade: 10 lb. apples = 15 lb. cherries FIGURE 2-5 Gains from Trade Comparative Advantage and Trade

13. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 13 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 2.2 Specialization and Gains from Trade TABLE 2-1 A Summary of the Gains from Trade Comparative Advantage and Trade YOUYOUR NEIGHBOR APPLES (IN POUNDS) CHERRIES (IN POUNDS) APPLES (IN POUNDS) CHERRIES (IN POUNDS) Production and consumption without trade812942 Production with trade200060 Terms of Trade: 10 lb. apples = 15 lb. cherries Consumption with trade 10151045 Gains from trade (increased consumption)2313

14. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 14 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 2.2 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 In the previous example, which country has an absolute advantage in producing apples? Which country has an absolute advantage in producing cherries? Can specialization and trade be beneficial in this situation? Absolute Advantage versus Comparative Advantage Table 2-2 Opportunity Costs of Picking Apples and Cherries Comparative Advantage and Trade OPPORTUNITY COST OF PICKING 1 POUND OF APPLES OPPORTUNITY COST OF PICKING 1 POUND OF CHERRIES YOU1 pound of cherries1 pound of apples YOUR NEIGHBOR2 pounds of cherries0.5 pounds of apples

15. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 15 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 2.2 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. Absolute Advantage versus Comparative Advantage Comparative Advantage and Trade

16. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 16 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 2.2 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 or want by trading. Comparative Advantage and the Gains from Trade Don’t Let This Happen to YOU! Don’t Confuse Absolute Advantage and Comparative Advantage Comparative Advantage and Trade

17. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 17 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 2.2 Solved Problem 2-2 Comparative Advantage and the Gains from Trade – Terms of Trade: 30 ton honey = 40 ton maple syrup BEFORE TRADEAFTER TRADE HONEY (IN TONS) MAPLE SYRUP (IN TONS) HONEY (IN TONS) MAPLE SYRUP (IN TONS) CANADA30153020 UNITED STATES10402040 CANADAUNITED STATES HONEY (IN TONS) MAPLE SYRUP (IN TONS) HONEY (IN TONS) MAPLE SYRUP (IN TONS) 060050 10451040 20302030 153020 400 10 500

18. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 18 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 2.2 Solved Problem 2-2 Comparative Advantage and the Gains from Trade Terms of Trade: 30 tons of honey = 40 tons of maple syrup

19. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 19 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Market System Learning Objective 2.3 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.

20. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 20 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Market System Learning Objective 2.3 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:

21. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 21 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 2.3 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:

22. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 22 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 2.3 FIGURE 2-6 The Circular-Flow Diagram The Market System The Circular Flow of Income

23. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 23 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Market System Learning Objective 2.3 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

24. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 24 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. The Market System Learning Objective 2.3 The Market Mechanism 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.

25. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 25 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 2.3 Making the Connection A Story of the Market System in Action: How Do You Make an iPod? The market coordinates the activities of the many people spread around the world who contribute to the making of an iPod.

26. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 26 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 2.3 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 The 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.

27. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 27 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Learning Objective 2.3 Making the Connection Property Rights in Cyberspace: YouTube and MySpace 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 and MySpace 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.

28. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 28 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. An Inside LOOK BMW Managers Change Production Strategy Redesigned X5 to lead increase; new coupe to debut in 2008

29. Chapter 2: Trade-offs, Comparative Advantage, and the Market System 29 of 30 © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. K e y T e r m s Absolute advantage Circular-flow diagram Comparative advantage Economic growth Entrepreneur Factor markets Factors of production Free market Market Opportunity cost Product markets Production possibilities frontier (PPF) Property rights Scarcity Trade