Chapter
2
Trade-offs, Comparative
Advantage, and the
Market System
Prepared by:
Fernando & Yvonn Quijano
© 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O’Brien, 2e.
Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Trade-offs, Comparative Advantage, and the
Market System
Scarcity The situation in which
unlimited wants exceed the limited
resources available to fulfill those
wants.
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.1
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.
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.1
Production Possibilities Frontiers
and Opportunity Costs
Graphing the Production Possibilities Frontier
FIGURE 2-1
BMW’s Production
Possibilities Frontier
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Boeing: Defense or Commercial Airlines
But behind the hype, Boeing is facing a more profound
challenge of the strategy it embarked on during the 1990s
to offset jetliner-sales cycles with more stable military
revenue. The logic undergirding that decision is being
tested as military hardware spending is under pressure
globally, at the same time commercial jet orders are
slumping.
http://online.wsj.com/article/SB124501716698213467.html
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.1
Production Possibilities Frontiers
and Opportunity Costs
Graphing the Production Possibilities Frontier
Opportunity cost The highestvalued alternative that must be given
up to engage in an activity.
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.1
Solved Problem
2-1
Drawing a Production Possibilities
Frontier for Rosie’s Boston Bakery
HOURS SPENT MAKING
QUANTITY MADE
CHOICE
CAKES
PIES
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
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.1
Production Possibilities Frontiers
and Opportunity Costs
Increasing Marginal Opportunity Costs
FIGURE 2-2
Increasing Marginal
Opportunity Cost
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.1
Production Possibilities Frontiers
and Opportunity Costs
Economic Growth
FIGURE 2-3
Economic Growth
Economic growth The ability of the economy to
produce increasing quantities of goods and services.
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.2
Comparative Advantage and Trade
Trade The act of buying or selling.
Specialization and Gains from Trade
FIGURE 2-4
Production Possibilities for You and
Your Neighbor, without Trade
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.2
Comparative Advantage and Trade
Specialization and Gains from Trade
FIGURE 2-5
Gains from Trade
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.2
Comparative Advantage and Trade
Specialization and 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)
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.2
Comparative Advantage and Trade
Comparative Advantage versus Absolute Advantage
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 pounds of apples
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.2
Comparative Advantage and Trade
Comparative Advantage versus Absolute 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
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.2
Comparative Advantage and Trade
Comparative Advantage and the Gains from Trade
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
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.3
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.
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.3
The Market System
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.
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.3
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.
Circular-flow diagram A model that
illustrates how participants in markets
are linked.
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.3
The Market System
The Circular Flow of Income
FIGURE 2-6
The Circular-Flow Diagram
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.3
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.
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.3
The Market System
The Market Mechanism
Individuals usually act in a rational, selfinterested 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.
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.3
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—to produce goods and services.
© 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O’Brien, 2e.
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Learning Objective 2.3
The Market System
The 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.
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Chapter 2: Trade-offs, Comparative Advantage, and the Market System
Key Terms
Absolute advantage
Market
Circular-flow diagram
Opportunity cost
Comparative advantage
Product markets
Economic growth
Production possibilities frontier (PPF)
Entrepreneur
Property rights
Factor markets
Scarcity
Factors of production
Trade
Free market
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