MicroeconomicsECON 2302May 2011

Marilyn Spencer, Ph.D.

Professor of Economics

Chapter 2

Quiz 1Before class on Tuesday, May 17, 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 System

To compete in the automobile market, the managers of BMW

must make many strategic decisions, such as whether to

introduce new car models.

2.1 Production Possibilities Frontiers and Opportunity CostsUse a production possibilities frontier to analyze opportunity costs and trade-offs.

2.2 Comparative Advantage and TradeUnderstand comparative advantage and explain how it is the basis for trade.

2.3 The Market SystemExplain the basic idea of how a market system works.

Chapter Outline and Learning Objectives

CHAPTER 2

Trade-offs, Comparative Advantage, and the Market System

Scarcity A situation in which unlimited wants exceed the limited resources available to fulfill those wants.

Use a production possibilities frontier to analyze opportunity costs and trade-offs.

2.1 LEARNING OBJECTIVE

Production Possibilities Frontiersand 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.

FIGURE 2-1 BMW’s Production Possibilities Frontier

BMW faces a trade-off: To build one more roadster, it must build one less SUV. The production possibilities frontier illustrates the trade-off 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.

Graphing the Production Possibilities Frontier

Solved Problem 2-1Drawing a Production Possibilities Frontier for Rosie’s Boston Bakery

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.

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

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.

Facing the Trade-offs in Health Care Spending

Makingthe

Connection

PPF & Opportunity Costs: Increasing Marginal Opportunity Costs

FIGURE 2-2 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 2-3

Economic growth The ability of the economy to increase the production of goods and services.

PPF & Opportunity Costs: Economic Growth

Comparative Advantage & Trade

Understand comparative advantage and explain how it is the basis for trade.

2.2 LEARNING OBJECTIVE

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

FIGURE 2-4 Production Possibilities for You & Your Neighbor, without 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.

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.

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

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).

TABLE 2-1 A Summary of the Gains from Trade

YOU YOUR NEIGHBOR

APPLES(IN POUNDS)

CHERRIES(IN POUNDS)

APPLES(IN POUNDS)

CHERRIES(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

Gains from trade (increased consumption) 2 3 1 3

Comparative Advantage & Trade: Specialization & Gains from Trade

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.

OPPORTUNITY COST OF PICKING1 POUND OF APPLES

OPPORTUNITY COST OF PICKING1 POUND OF CHERRIES

YOU 1 pound of cherries 1 pound of apples

YOUR NEIGHBOR 2 pounds of cherries 0.5 pound of apples

TABLE 2-2 Opportunity Costs of Picking Apples and Cherries

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.

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

Comparative Advantage & Trade: Absolute Advantage v. Comparative Advantage

Solved Problem 2-2Comparative Advantage and the Gains from Trade

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

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

Solved Problem 2-2 (continued)Comparative Advantage and the Gains from Trade

Quiz #2Quiz #2 Be prepared for an in-class quiz during

our next class!

It will consist of 5 multiple choice questions, from Chapter 2 & Chapter 3.

The Market System

Explain the basic idea of howa market system works.

2.3 LEARNING OBJECTIVE

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.

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.

The Market System: The Circular Flow of Income

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.

FIGURE 2-6 The Circular-Flow DiagramHouseholds 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.

The Market System: Circular Flow of Income, cont.

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 Gains from Free Markets

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 Market Mechanism

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.

A Story of the Market System in Action: How Do You Make an iPod?

Makingthe

Connection

Entrepreneur Someone who operates a business, bringing together the factors of production— labor, capital, and natural resources—to produce goods and services.

Market System: Role of the Entrepreneur

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

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.

Enforcement of Contracts and Property Rights

The Market System: Legal Basis of a Successful Market System

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.

Property Rights in Cyberspace: YouTube, Facebook, and MySpace

Makingthe

Connection

Some recording artists worry that the copyrights for their songs are not being protected on the Internet.

Detroit Challenges Hybrids w/ New Technology

Gas Engines Get Upgrade in Challenge to Hybrids

AN INSIDE LOOK >>

Choosing between producing hybrids and producing direct-injection cars.

Review: Why is the PPF usually drawn with a bowed-

out shape?

What would be the implications of a different

shape?

Review: Concepts Illustrated by theProduction 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?

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

KEY TERMS

Questions?

Reality check, to be completed before our next class:

Read Chapter 1 of Hubbard & O’Brien and be able to answer:

3rd edition Review Questions:

p. 20, 1.2; p. 21, 2.1 & 2.3; p. 22, 3.1 & 3.3 (2nd edition: p. 20, 1.2; p. 21, 2.1 & 2.3; p. 22, 3.1 & 3.3 ; 1st edition: p. 19, 1, 3, 5, 6 & 8)

3rd edition: Problems and Applications:

p. 22, 2.7; p. 23, 3.8 (2nd edition: p. 22, 2.7; p. 23, 3.8 ; 1st edition: p. 20, 13 and 15)

Reality check, to be completed before our next class: Read Chapter 2 and be able to answer:

3rd edition Review Questions:

p. 58, 1.2, 1.3; p. 60, 2.2; p. 62, 3.1 (2nd edition: p. 60, 1.2, 1.3; p. 62, 2.2; p. 63, 3.1; 1st edition: pp. 56-57, 2, 3, 5, 6 & 11).

3rd edition Problems and Applications:

p. 58-59, 1.4 & 1.8; p. 60, 2.4 (2nd edition: p. 60-61, 1.4 & 1.8; p. 62, 2.4 ; 1st edition: pp. 57 & 59, 1, 5 and 11).

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).

Reality check to have been completed before we begin Ch. 4: Pre-read Ch. 4, including:

Review Questions:Consumer surplus is used as a measure of a consumer’s net

benefit from purchasing a good or service. Explain why consumer surplus is a measure of net benefit.

Why would economists use a term like “deadweight loss” to describe the impact on consumer and producer surplus from a price control?”

Problems and Applications:3rd ed., p. 130, 4A.5, 4A.6, 4A.7 & 4A.8; (2nd ed., p. 134,

4A.5, 4A.6, 4A.7 & 4A.8; 1st edition: 1-4 on p. 129).

Quiz 1Before class on Tuesday, May 17, 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

Quiz #2Quiz #2 Be prepared for an in-class quiz during

our next class!

It will consist of 5 multiple choice questions, from Chapter 2 & Chapter 3.