CHAPTER
2
Trade-offs, Comparative Advantage,
and the Market System
Chapter Outline and
Learning Objectives
2.1 Production Possibilities
Frontiers and Opportunity
Costs
2.2 Comparative Advantage
and Trade
2.3 The Market System
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Scarcity 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?
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Production Possibilities Frontiers and Opportunity
Costs
2.1 LEARNING OBJECTIVE
Use a production possibilities frontier to analyze opportunity costs and
trade-offs.
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Production 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”.
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A 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
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A 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
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Increasing 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 2.2
The more resources already devoted to an activity, the smaller
the payoff to devoting additional resources to that activity.
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Economic growth on the PPF
Figure 2.3
As 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.
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Technological change in one industry
This panel shows
technological improvement in
the automobile industry.
Figure 2.3
The quantity of tanks that can
be produced remains
unchanged.
As in the previous slide, many
previously unattainable
combinations are now
attainable.
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Making
the
A production possibilities curve for exam grades
Connection
Suppose 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 SUVs
or
A 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…
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Comparative Advantage and Trade
2.2 LEARNING OBJECTIVE
Understand comparative advantage and explain how it is the basis for
trade.
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Interdependence of Goods and Services
Every 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.
Hair gel from
Cleveland, OH
Cell phone
from Taiwan
Dress shirt
from China
Coffee from
Kenya
Trade or Exchange
 What is trade?
Trade is the process of giving up one thing (money,
goods, services, etc.) for something else.
 Why do people trade?
The mechanism that allows trade is called a market.
Trade can make everyone better off.
Trade 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.
14
Production, Trade, and Specialization
Terms of Trade: how much of one item is traded for how
much of another item
.
Absolute price – in terms of money
Relative price – in terms of other goods
TRADE THROUGH SPECIALIZATION
Opportunity
Cost
The 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.
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The Gains From Specialization Through Trade
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Graphical Illustration for Elizabeth and Brian
Apples
Apples
Elizabeth
Brian
30
20
Exports
•
•
12
10
18
15
• •
Imports
0
101
20
Exports
2
Fish
0
5 8 10
Imports
Fish
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Production, 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.
Should Tiger Woods become a caddie?
World’s #1 Golfer
Should he do both?
World’s #1
Caddie
Although 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
Thegood
opportunity
cost
of spending
one moment
as aorcaddie
is
or service
using
a given quantity
of labor
resource
too high.
inputs
. He still has a comparative advantage as a golfer.
When Does Trade Fail to Occur?
Opportunity Costs
No 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 quality
Time constraints
Transportation costs
Trades and Third Parties
Third Party Effects:
someone other than the
parties involved in the
exchange was affected.
Negative Externalities
Positive Externalities
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Making
the
Connection
What 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 aircraft
• Semiconductors
• Passenger cars
• Pharmaceuticals
• Automotive parts and accessories
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The Market System
2.3 LEARNING OBJECTIVE
Explain the basic idea of how a market system works.
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A 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 work
Physical capital used
to produce other
goods
Land, water, oil, ore,
raw materials, etc.
The ability to bring
together factors of
production
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The circular flow diagram
Households provide
factors of production to
firms.
Figure 2.6
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.
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The 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.
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The 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 selfinterest.
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.
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Making
the
Connection
A 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.
Firm
Location of the Firm
iPad Component the Firm Supplies
ARM
Great Britain
Processor design
Broadcom
United States (California)
Touchscreen controller
Infineon Technologies
Germany
Semiconductors
LG Electronics
South Korea
Screen
Samsung
South Korea
Flash memory and processor
Texas Instruments
United States (Texas)
Touchscreen controller
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The 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 Ford
Entrepreneurs make a vital contribution to economic growth,
often with considerable personal risk and sacrifice.
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The 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 property
• When 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 rights
• Important for transactions across time to occur.
• An independent court system is critical here.
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Common 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.
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