Microeconomics
ECON 2302
Spring 2011
Marilyn Spencer, Ph.D.
Professor of Economics
Chapter 2
Quiz 1
Before class on Friday, January 21, send
me an email from the email address
you’ll be using regularly during this
course.
My email address is
marilyn.spencer@tamucc.edu.
4 points
CHAPTER
2
Trade-offs,
Comparative
Advantage, &
the Market
To compete in the
System
automobile market,
the managers of
BMW must make
many strategic
decisions, such as
whether to
introduce new car
models.
CHAPTER
2
Chapter Outline and
Learning Objectives
2.1 Production Possibilities Frontiers and
Opportunity Costs
Use a production possibilities frontier to analyze
opportunity costs and trade-offs.
2.2 Comparative Advantage and Trade
Understand comparative advantage and explain
how it is the basis for trade.
2.3 The Market System
Explain the basic idea of how a market system
works.
Trade-offs, Comparative Advantage,
and the Market System
Scarcity A situation in which unlimited wants exceed
the limited resources available to fulfill those wants.
2.1 LEARNING OBJECTIVE
Use a production possibilities
frontier to analyze opportunity costs
and trade-offs.
Production Possibilities Frontiers
and Opportunity Costs
Production possibilities frontier (PPF)
A curve showing the maximum attainable combinations of
two products that may be produced with available
resources and current technology.
Opportunity cost The highest-valued alternative that
must be given up to engage in an activity.
Production Possibilities Frontiers and
Opportunity Costs, cont.
BMW faces a trade-off: To
build one more roadster, it
must build one less SUV.
The production possibilities
frontier illustrates the tradeoff BMW faces.
Combinations on the
production possibilities
frontier—like points A, B,
C, D, and E—are
technically efficient because
the maximum output is
being obtained from the
available resources.
Combinations inside the
frontier— like point F—are
inefficient because some
resources are not being
used.
Combinations outside the
frontier—like point G—are
unattainable with current
resources.
FIGURE 2-1 BMW’s Production
Possibilities Frontier
Graphing the Production
Possibilities Frontier
Solved Problem
2-1
Drawing a Production Possibilities
Frontier for Rosie’s Boston Bakery
HOURS SPENT MAKING
CHOICE
CAKES
PIES
QUANTITY MADE
CAKES
PIES
A
5
0
5
0
B
4
1
4
2
C
3
2
3
4
D
2
3
2
6
E
1
4
1
8
F
0
5
0
10
Moving from choice D to
choice E increases Rosie’s
production of pies by 2 but
lowers her production of
cakes by 1. Therefore, her
opportunity cost of making
2 more pies is making 1
less cake.
Making
Facing the Trade-offs in
Connection Health Care Spending
the
Spending more on health
care means spending less on
other goods and services.
Although the consequences
of being uninsured can be
severe, particularly if
someone develops a serious
illness, economists are not
surprised that higher prices
for health insurance lead to
less health insurance being
purchased: Faced with
limited incomes, people have
to make choices among the
goods and services they buy.
PPF & Opportunity Costs:
Increasing Marginal Opportunity Costs
As the economy
moves down the
PPF, it experiences
increasing marginal
opportunity costs
because increasing
automobile
production by a
given quantity
requires larger and
larger decreases in
tank production.
FIGURE 2-2
Increasing Marginal
Opportunity Costs
PPF & Opportunity Costs:
Economic Growth
Economic growth The ability of the economy to increase
the production of goods and services.
FIGURE 2-3
2.2 LEARNING OBJECTIVE
Understand comparative advantage and
explain how it is the basis for trade.
Comparative Advantage & Trade
Trade The act of buying and selling
The table shows how many pounds of apples and how many
pounds of cherries you and your neighbor can each pick in
one week.
Comparative Advantage & Trade:
Specialization & Gains from Trade
Panel (a) shows your PPF. If you devote all your time to picking apples
and none of your time to picking cherries, you can pick 20 pounds. If you
devote all your time to picking cherries, you can pick 20 pounds.
FIGURE 2-4 Production Possibilities for You & Your Neighbor, without Trade
Panel (b) shows that if your neighbor devotes all her time to
picking apples, she can pick 30 pounds. If she devotes all her
time to picking cherries, she can pick 60 pounds.
Comparative Advantage & Trade:
Specialization & Gains from Trade
If you specialize in picking apples, you can pick 20 pounds. If your neighbor
specializes in picking cherries, she can pick 60 pounds. If you trade 10 pounds of
your apples for 15 pounds of your neighbor’s cherries, you will be able to
consume 10 pounds of apples and 15 pounds of cherries— point B in panel (a).
FIGURE 2-5
Gains from Trade
Your neighbor can now consume 10 pounds of apples
and 45 pounds of cherries—point D in panel (b). You
and your neighbor are both better off as a result of trade.
Comparative Advantage & Trade:
Specialization & Gains from Trade
TABLE 2-1
A Summary of the Gains from Trade
YOU
YOUR NEIGHBOR
APPLES
CHERRIES
APPLES
CHERRIES
(IN POUNDS) (IN POUNDS) (IN POUNDS) (IN POUNDS)
Production and consumption
without trade
8
12
9
42
Production with trade
20
0
0
60
Consumption with trade
10
15
10
45
2
3
1
3
Gains from trade (increased
consumption)
Comparative Advantage & Trade:
Absolute Advantage v.
Comparative Advantage
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.
TABLE 2-2
Opportunity Costs of Picking Apples and Cherries
OPPORTUNITY COST OF PICKING
1 POUND OF APPLES
OPPORTUNITY COST OF PICKING
1 POUND OF CHERRIES
YOU
1 pound of cherries
1 pound of apples
YOUR NEIGHBOR
2 pounds of cherries
0.5 pound of apples
Comparative Advantage & Trade:
Absolute Advantage v.
Comparative Advantage
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 by trading.
Don’t Let This Happen to YOU!
Don’t Confuse Absolute Advantage and Comparative Advantage
2-2
Solved Problem
Comparative Advantage and
the Gains from Trade
CANADA
UNITED STATES
HONEY
(IN TONS)
MAPLE SYRUP
(IN TONS)
HONEY
(IN TONS)
MAPLE SYRUP
(IN TONS)
0
60
0
50
10
45
10
40
20
30
20
30
30
15
30
20
40
0
40
10
50
0
BEFORE TRADE
AFTER TRADE
HONEY
(IN TONS)
MAPLE SYRUP
(IN TONS)
HONEY
(IN TONS)
MAPLE SYRUP
(IN TONS)
CANADA
30
15
30
20
UNITED STATES
10
40
20
40
Solved Problem
2-2 (continued)
Comparative Advantage and
the Gains from Trade
2.3 LEARNING OBJECTIVE
Explain the basic idea of how
a market system works.
The Market System
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.
The Market System, cont.
Factors of production are divided into four broad categories:
• 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.
The Market System:
The Circular Flow of Income
Two key groups participate in markets:
• A household consists of all the individuals in a home.
• Firms are suppliers of goods and services.
In factor markets, households receive wages and other payments
from firms in exchange for supplying the factors of production.
Households use these wages and other payments to purchase
goods and services from firms in product markets. Firms sell
goods and services to households in product markets, and they
use the funds to purchase the factors of production from
households in factor markets.
Circular-flow diagram A model that illustrates how
participants in markets are linked.
The Market System:
Circular Flow of Income, cont.
Households and firms are
linked together in a circular
flow of (1) production,
(2) income, and (3) spending.
Blue arrows: flow of the
factors of production.
Households supply labor,
entrepreneurial ability, land &
capital. Firms use these factors
of production to make goods
and services for households in
product markets.
Red arrows: flow of goods and
services from firms to
households.
Green arrows: flow of funds.
FIGURE 2-6 The Circular-Flow Diagram
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 System: 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.
Making A Story of the Market System in Action:
the
Connection 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.
All told, an iPod contains about
450 parts, designed and
manufactured by firms around the
world. Many of these firms are not
even aware of which other firms
are also producing components for
the iPod.
The invisible hand of the market
has led these firms to contribute
their knowledge and resources to
the process that ultimately results
in an iPod available for sale in a
store in the United States.
Market System: Role of the Entrepreneur
Entrepreneur Someone who operates a business, bringing
together the factors of production— labor, capital, and
natural resources—to produce goods and services.
The Market System:
Legal Basis of a Successful Market System
Protection of Private Property
Property rights The rights individuals or firms have to
the exclusive use of their property, including the right to
buy or sell it.
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.
Making Property Rights in Cyberspace: YouTube,
the Facebook, and MySpace
Connection
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.
AN INSIDE
LOOK
>> Detroit Challenges Hybrids w/ New Technology
Gas Engines Get Upgrade in Challenge to Hybrids
Choosing between producing hybrids and producing direct-injection cars.
Review: Why is the PPF
usually drawn with a bowedout shape?
What would be the
implications of a different
shape?
Review: Concepts Illustrated by the
Production Possibilities Frontier
Efficiency
Fixed technology
Tradeoffs
Opportunity Cost
Economic Growth
What would it look like if…?
 Not all resources were being used?
 A new, better technology was adopted?
 A war, hurricane or earthquake destroyed some of
the resources?
 People decided they wanted to drive bigger cars?
 More resources were discovered?
 A percentage of the workers became infected with
AIDS?
KEY TERMS
Absolute advantage
Circular-flow diagram
Comparative advantage
Economic growth
Free market
Market
Opportunity cost
Product markets
Entrepreneur
Production possibilities frontier
(PPF)
Property rights
Scarcity
Trade
Factor markets
Factors of production
Quiz #2
 Be prepared for an in-class quiz during our
next class!
 It will consist of 4 multiple choice
questions, from Chapter 2 & Chapter 3.
Questions?
Reality check, to be completed before
we begin Chapter 3:
 Read Chapter 3 introduction and major topic headings.
Read Review Questions: 3rd ed. #1 “In a market system,
who ultimately decides which goods and services will be
produced?” p. 90, 1.2, 1.3, 1.4; p. 91, 2.2; p 92, 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. (2nd
ed. p. 92, 1.2, 1.3, 1.4; p. 93, 2.2; p. 94, 3.1, 3.2,; 1st
edition: 1-8 on pp. 90-91).
Read Problems and Applications: 3rd ed. “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. 90, 1.7; p 91, 2.3; p. 95, 4.15 (2nd ed., p. 92, 1.7;
p. 93, 2.3; p. 96, 4.15; 1st edition: 3, 4, 7, 14 & 21 on pp.
91-93).