chap2pp

© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.

Fernando & Yvonn Quijano

Prepared by:

Chapter

2

Trade-offs, Comparative Advantage, and the Market System

2 of 29© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.

Managers Making Choices at BMW

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

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

2.3 Explain the basic idea of how a market system works.

Learning Objectives

To compete in the automobile market, the managers of BMW must make many strategic decisions, such as whether to introduce a new car model.

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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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Production Possibilities Frontiersand Opportunity Costs

Learning Objective 2.1

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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Graphing the Production Possibilities Frontier

FIGURE 2-1

BMW’s Production Possibilities Frontier

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Graphing the Production Possibilities Frontier

Opportunity cost The highest-valued alternative that must be given up to engage in an activity.

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Solved Problem 2-1Drawing 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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Trade-offs: Hurricane Katrina, Tsunami Relief, and Charitable Giving

More funds for Katrina relief meant less funds for other charities.

Makingthe

Connection


More than two-thirds of Americans donated money to hurricane relief. Although these funds helped to reduce the suffering of many hurricane victims, donations to some other causes actually declined.

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Increasing Marginal Opportunity Costs

FIGURE 2-2

Increasing Marginal Opportunity Cost

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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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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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FIGURE 2-5

Gains from Trade


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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

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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

Absolute Advantage versus Comparative Advantage

Table 2-2

Opportunity Costs of Picking Apples and Cherries


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 pounds of apples

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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.

Absolute Advantage versus Comparative Advantage


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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.

Comparative Advantage and the Gains from Trade

Don’t Let This Happen to YOU!Don’t Confuse Absolute Advantage and Comparative Advantage


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Solved Problem 2-2Comparative Advantage and theGains from Trade

BEFORE TRADE AFTER TRADE

HONEY(IN TONS)

MAPLE SYRUP(IN TONS)

HONEY(IN TONS)

MAPLE SYRUP (IN TONS)

CANADA 30 15 30 20UNITED 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

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Solved Problem 2-2Comparative Advantage and theGains from Trade

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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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The Market System


• 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.

Factors of production are divided into four broad categories:

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Circular-flow diagram A model that illustrates how participants in markets are linked.

The Market System

The Circular Flow of Income

• A household consists of all the individuals in a home.

• Firms are suppliers of goods and services.

Two key groups participate in markets:

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FIGURE 2-6

The Circular-Flow Diagram

The Market System

The Circular Flow of Income

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The Market System


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 Gains from Free Markets

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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.

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Makingthe

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A Story of the Market Systemin Action: 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.

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

The Role of the Entrepreneur

The Market System

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Property rights The rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it.

The Legal Basis of a Successful Market System

The Market System

Protection of Private Property

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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Makingthe

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Property Rights in Cyberspace:YouTube and MySpace

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.

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An Inside LOOK BMW Managers Change Production Strategy

Redesigned X5 to lead increase; new coupe to debut in 2008

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K e y T e r m s

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

chap2pp

Documents

production possibilities frontier

production possibilities frontiers

trade comparative advantage

2 comparative advantage

comparative advantage

learning objective 2

3 property rights

maple syrup