Microeconomics ECON 2302 Spring 2010 Marilyn Spencer, Ph.D. Professor of Economics Chapter 2

Announcement 4 I have to cancel my office hours Thursday, January 21, because I have a department meeting. 4 Please phone or for an appointment if you need to meet with me before my Tuesday, January 26 office hours.

Quiz 1 Before class on Thursday, January 28, send me an from the address you’ll be using regularly during this course. My address is 4 points

After studying this chapter, you should be able to: Use a production possibilities frontier to analyze opportunity cost and trade- offs. Understand comparative advantage and explain how it is the basis for trade. Explain the basic idea of how a market system works. LEARNING OBJECTIVES 1 2 3

Economists generally use a scientific approach: 4 Scientific method 4 Making assumptions 4 Constructing economic models ÜAbstract ÜSimplified

Why economists don’t all agree: Different assumptions, which lead to and/or arise from: 4 Different models (positive analysis) 4 Different values (normative analysis)

Positive v. Normative Analysis:  Positive statements are statements that describe the world as it is. ÜCalled descriptive analysis  Normative statements are statements about how the world should be. ÜCalled prescriptive analysis

The Role of Assumptions 4 Economists make assumptions in order to make the world easier to understand. 4 The art in scientific thinking is deciding which assumptions to make. 4 Economists use different assumptions to answer different questions.

Production Possibilities Frontier The production possibilities frontier is a graph showing the various combinations of output that the economy can possibly produce given the available factors of production and technology.

Production Possibilities Frontiers and Real-world Trade-offs Graphing the Production Possibilities Frontier BMW’s Production Possibilities Frontier

 Drawing a Production Possibilities Frontier for Rosie ’ s Boston Bakery LEARNING OBJECTIVE 1 Hours Spent MakingQuantity Made ChoiceCakesPiesCakesPies A5050 B4142 C3234 D2326 E1418 F05010

Production Possibilities Frontiers and Real-world Trade-offs Increasing Marginal Opportunity Costs As the economy moves down the production possibilities frontier, it experiences increasing marginal opportunity costs because increasing automobile production by a given quantity requires larger and larger decreases in aircraft carrier production. More funds for bank and automobile bailouts means less funds for other worthy recession – ending programs. Trade-offs and government funding to help end the recession 2 - 1

Review: Why is the PPF drawn with this particular shape? What would be the implications of a different shape?

Production Possibilities Frontiers and Real-world Trade-offs Economic Growth Economic Growth The ability of the economy to produce increasing quantities of goods and services Economic Growth

Concepts Illustrated by the Production Possibilities Frontier 4 Efficiency 4 Fixed technology 4 Tradeoffs 4 Opportunity Cost 4 Economic Growth

What would it look like if…? 4 Not all resources were being used? 4 A new, better technology was adopted? 4 A war, hurricane or earthquake destroyed some of the resources? 4 People decided they wanted to drive bigger cars? 4 More resources were discovered? 4 A percentage of the workers became infected with AIDS?

Trade LEARNING OBJECTIVE 2 Trade The act of buying or selling. Specialization and Gains from Trade Production Possibilities for You and Your Neighbor, Without Trade

Trade Specialization and Gains from Trade Gains from Trade

Trade Absolute Advantage Versus 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. 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 cherries.5 pound of apples Don’t Confuse Absolute Advantage and Comparative Advantage

Trade Comparative Advantage and the Gains from Trade The basis for trade is comparative advantage, not absolute advantage. A country has a comparative advantage in the production of the good for which it has a lower opportunity cost. To enjoy the gains from trade, a country should specialize in the production of the good for which it has a comparative advantage.

The Market System LEARNING OBJECTIVE 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 good—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.

The Market System The Circular-Flow Diagram The Circular-Flow Diagram Households and firms are linked together in a circular flow of production, income, and spending. Circular-flow diagram A model that illustrates how participants in markets are linked.

The Market System The Circular Flow Diagram Two key groups participate in markets:  A household is all the individuals in a home.  Firms are suppliers of goods and services.

The Market System The Gains from Free Markets 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 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.

The Market System The Role of the Entrepreneur Entrepreneur Someone who operates a business, bringing together the factors of production—labor, capital, and natural resources—in order to produce goods and services. The market coordinates the activities of the many people spread around the world who contribute to the making of a pencil. Story of the Market System in Action: “I, Pencil” 2 - 2

The Market System The Legal Basis of a Successful 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. PROTECTION OF PRIVATE PROPERTY Metallica sued to stop copyright infringement of their songs on the Internet. Property Right in Cyberspace: Napster, Kazaa, iTunes 2 - 3

Review 4 Positive v. normative analysis 4 Role of assumptions 4 Circular-Flow Model 4 Production Possibilities Frontier ÜTrade-offs Ü Known amount of resources Ü Given level of technology Ü Changes in the amount of resources or technology

Review, continued 4 Definitions: Üfree market Üentrepreneur Üproperty rights

Reminder: Quiz 1 Before class Thursday, January 28, send me an from the address you’ll be using regularly during this course. My address is 4 points

Questions?

Reality check, to be completed before class January 28:  Read Chapter 3 introduction and major topic headings. ÜRead Review Questions #1 “In a market system, who ultimately decides which goods and services will be produced? And also p. 92, 1.2, 1.3, 1.4; p. 93, 2.2; p. 94, 3.1, 3.2, and also: What happens to the equilibrium price in a market if the demand curve shifts to the right? Draw a demand and supply graph to illustrate your answer. (1 st edition: 1-8 on pp ). ÜRead Problems and Applications: Is it possible for a good to be an inferior good for one person and a normal good for another? If yes, cite some examples, and p. 92, 1.7; p. 93, 2.3; p. 96, 4.15 (1 st edition: 3, 4, 7, 14 & 21 on pp ).