Chapter 2 Economics 6th edition Trade-offs, Comparative Advantage, and the Market System April 6, 2017

1.1 Flashback – Three Key Economic Ideas We interact with one another in markets. Market: A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. In analyzing markets, we generally assume:

1.1 Flashback – Three Key Economic Ideas We interact with one another in markets. Market: A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. In analyzing markets, we generally assume: People are rational

1.1 Flashback – Three Key Economic Ideas We interact with one another in markets. Market: A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. In analyzing markets, we generally assume: People are rational People respond to economic incentives

1.1 Flashback – Three Key Economic Ideas We interact with one another in markets. Market: A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade. In analyzing markets, we generally assume: People are rational People respond to economic incentives Optimal decisions are made at the margin

Chapter Outline 2.1 Production Possibilities Frontiers and Opportunity Costs 2.2 Comparative Advantage and Trade 2.3 The Market System

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 deciding how to use its scarce workers and machinery, if Tesla wants to produce more Model X SUVs, those resources will not be available to produce Model S sedans.

Tesla Model X SUV

2.1 Production Possibilities Frontiers and Opportunity Costs A production possibilities frontier (PPF) is a curve showing the maximum attainable combinations of two goods that can be produced with available resources and technology. Question: Is the PPF a positive or normative tool? Answer: Positive; it shows “what is”, not “what should be”.

Figure 2.1 Tesla’s production possibilities frontier (1 of 2)

Figure 2.1 Tesla’s production possibilities frontier (1 of 2) Tesla can produce sedans and/or SUVs. If it wants to produce more sedans, it must reduce the number of SUVS. Points on the PPF are attainable for Tesla. Points below the curve are inefficient. Points above the curve are unattainable with current resources.

Figure 2.1 Tesla’s production possibilities frontier (2 of 2) To produce 20 more SUVs (e.g. moving from A to B), Tesla must produce 20 fewer sedans. The 20 fewer sedans is the opportunity cost of producing 20 more SUVs. Opportunity cost: The highest-valued alternative that must be given up to engage in an activity.

Figure 2.2 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. The more resources already devoted to an activity, the smaller the payoff to devoting additional resources to that activity.

Figure 2.3 Economic growth (panel (a)) 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. Panel (a) shows that as more economic resources become available and technological change occurs, the economy can move from point A to point B, producing more tanks and more automobiles.

“Guns or Butter” 1939–1949

Figure 2.3 Economic growth (panel (b)) This panel shows technological improvement in the automobile industry. The quantity of tanks that can be produced remains unchanged. As in the previous slide, many previously unattainable combinations are now attainable. Panel (b) shows the results of technological change in the automobile industry that increases the quantity of vehicles workers can produce per year while leaving unchanged the maximum quantity of tanks they can produce. Outward shifts in the production possibilities frontier represent economic growth.

What happens to a country that produces a combination of goods that uses all of the resources available in the economy? The country is operating on its production possibilities frontier. The country is maximizing its opportunity cost. The country has eliminated scarcity. All of the above. A

A Combination G Combination F Combinations A or E Refer to the graph below. Which of the following combinations is unattainable with the current resources available in this economy? Combination G Combination F Combinations A or E All of the above. None of the combinations above can be attained with current resources. A

Which of the following best explains why the production possibilities frontier is bowed outward rather than being a straight line? The impact of economic growth on technological change. Diminishing scarcity. Increasing total cost as production increases. Increasing marginal opportunity costs. D

Refer to the graph below Refer to the graph below. Which graph best represents an increase in the economy’s resources? The graph on the left. The graph on the right. Both graphs. Neither graph. A

2.2 Comparative Advantage and Trade Describe comparative advantage and explain how it serves as the basis for trade P R I N C I P L E O F O P P O RT U N I T Y C O S T The opportunity cost of something is what you sacrifice to get it. Comparative Advantage: Fred has an comparative advantage for producing Fish because his opportunity cost for producing fish is less than Kate’s opportunity cost. But, Kate has a comparative advantage for producing coconuts since her opportunity cost of producing a coconut is less than Fred’s opportunity cost. Absolute Advantage: Fred has an absolute advantage for producing both Fish and Coconuts since he can produce more fish in a day or more coconuts in a day than Kate.

Entrepreneurs Cinder Flounder

What is Cinder’s opportunity cost for producing a smoothie?   Lattes/hour Smoothies /hour Cinder 4 2 Flounder 15 3 What is Cinder’s opportunity cost for producing a smoothie? What is Flounder’s opportunity cost for producing a latte?  Who has the absolute advantage in the production of smoothies?  Who has the comparative advantage in the production of smoothies?  Assuming each individual specializes in producing a single good, what would Cinder and Flounder produce?   2 lattes (4 lattes/2 smoothies) 1/5 smoothie (3 smoothies/15 lattes) Flounder Cinder Cinder – Smoothie; Flounder - Latte

2.2 Comparative Advantage and Trade Describe comparative advantage and explain how it serves as the basis for trade You and your neighbor each have a limited time to pick apples and/or cherries. The table shows the amount of each fruit that you could each pick, by devoting all of your time to that fruit.

Figure 2.4 Production possibilities for you and your neighbor, without trade If you spend all of your time picking cherries, you can pick 20 pounds of cherries; or if you spend all your time picking apples, you can pick 20 pounds of apples. Your neighbor can similarly pick 60 pounds of cherries or 30 pounds of apples.

Specialization and trade What if you and your neighbor decided to specialize and trade? Trade: The act of buying and selling. Could your neighbor benefit from trade? She is better at picking both apples and cherries… Both of you can benefit from trade, by specializing in what you are relatively good at. Let’s see how…

Figure 2.5 Gains from trade (1 of 3) When you don’t trade with your neighbor, let’s say you pick and consume 8 pounds of apples and 12 pounds of cherries per week—point A in panel (a). When your neighbor doesn’t trade with you, she picks and consumes 9 pounds of apples and 42 pounds of cherries per week—point C in panel (b).

Figure 2.5 Gains from trade (2 of 3) 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 (3 of 3) 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. Note that your neighbor benefits from trade even though she could produce more of either fruit than you could.

Table 2.1 A summary of the gains from trade Both you and your neighbor are able to consume more with trade than without.

Explaining the gains from specialization and trade How could both of you benefit from trade, when your neighbor was so much better than you? Economists say your neighbor had an absolute advantage in both cherry- and apple-picking, but you had a comparative advantage in picking apples. 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 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.

Making the Connection: Comparative advantage and housework People living together have to divide up household chores. Basic economic concepts like comparative advantage can provide useful insight in the division of labor. Suppose Jack is faster than Jill at both cooking and laundry. However: Jack is MUCH faster at preparing tasty meals, while Jack is only a little faster at doing laundry Jack’s comparative advantage is in cooking—to cook a tasty meal, he gives up the opportunity to perform less laundry than Jill—so he should specialize in this, while Jill specializes in laundry.

Who has a comparative advantage for producing apples? You Your Neighbor You and your neighbor None of the above A

If you have a comparative advantage in the production of apples, what point would best represent your production with trade? A A’ C D B

Consider the figure below. Which country has a comparative advantage? Country A has a comparative advantage in the production of both goods. Country B has a comparative advantage in the production of both goods. Country A has a comparative advantage in the production of food. Country B has a comparative advantage in the production of food. C

Each graph represents one country Each graph represents one country. Which country should specialize in the production of shirts? B Country A Country B Neither country. They both should produce some chips. Both countries should specialize in the production of chips.

EC201 Students Survey Born in Oregon? (Yes or No) Where live currently? (Corvallis, Albany, Lebanon, Sweet Home, Other) Do you work in addition to being student? (Yes or No) How many credits will you take this term? (for example, 12 credits) Do you identify as a Ducks fan, Beavers fan, Both, or Other?

Born in Oregon?

Born in Oregon?

Where do you live currently?

Where do you live currently?

Do you work (in addition to being a student)?

Do you work (in addition to being a student)?

2.3 The Market System Explain the basics of how a market system works Two key groups participate in the modern economy: Households & Firms 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.

Figure 2.6 The Circular-flow Diagram (1 of 2) Circular-flow diagram: A model that illustrates how participants in markets are linked. Households provide factors of production to firms. 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.

Figure 2.6 The Circular-flow Diagram (2 of 2) Like all economic models, the circular flow diagram is a simplified version of reality: No government No financial system No foreign buyers and sellers of goods We will explore these sectors in later chapters.

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.

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 self-interest. 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.

Making the Connection: How do you make an iPad? How do you make an iPad? Although Apple engineers designed the iPad, Apple does not manufacture iPad components, nor does it assemble the final product. Hundreds of firms are involved; many probably don’t even know their products will be used in an iPad. But guided by their own self-interest, they all contribute to the final product—without any desire to enrich Apple or provide enjoyment for iPad purchasers.

The role of the entrepreneur An entrepreneur is someone who operates a business, bringing together the factors of production—labor, capital, and natural resources—to produce goods and services. 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.

Table 2.3 Important Products Introduced by Entrepreneurs at Small Firms Entrepreneurs make a vital contribution to economic growth by Responding to consumer demand Introducing new products Government policies encouraging entrepreneurship are likely to increase economic growth and raise standards of living.

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 play a critical role by providing a sound legal environment that will allow the market system to succeed. 1. Protection of private property When criminals can take your wages or profits, households and firms have little incentive to work hard. Property rights: the rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it. 2. Enforcement of contracts and property rights Important for transactions across time to occur. An independent court system is critical for this.

Making the Connection: An elementary case of copyright Copyrights and patents protect the intellectual property of creators and inventors, in order to encourage innovation. In 2011, a publisher sued the estate of Sherlock Holmes creator Sir Arthur Conan Doyle for free access to his characters for new stories (instead of $5,000 use fee). Federal Appeals Judge (and economist) Richard Posner granted access to the characters without payment. What are the consequences of this?

Which of the following refers to markets where goods, such as computers, or services, such as medical treatment, are offered? Product markets. Essential markets. Factor markets. Competitive markets. A

In which markets are factors of production, such as labor, capital, natural resources, and entrepreneurial ability traded? In product markets. In essential markets. In factor markets. In competitive markets. C

Which of the following are the two key groups of participants in the circular flow of income? Product markets and factor markets. Government and the financial sector. Households and firms. Buyers and sellers. C

Which of the following is critical for the success of a market system? To allow individuals or firms to have exclusive use of their property. To prevent individuals from buying or selling their property depending on the circumstances. Either choice above. Whatever people are allowed to do with their property makes no difference to the functioning of free markets. To allow the government to determine the optimal use of private property. A

Which point or points are attainable? Which point or points are efficient? Which point or points are inefficient? At which point is the country’s future growth rate likely to be the highest? A, B, C, D B, C, D A E

France Who has a comparative advantage in producing wine? Who has comparative advantage in producing schnitzel? Suppose that France is currently producing 1 bottle of wine and 6 lbs of schnitzel, and Germany is currently producing 3 bottles of wine and 6 lbs of schnitzel. Demonstrate that France and Germany can both be better off if they specialize in producing only one good and then trade for the other. Germany If specialization the following could occur: France = 1 bottle of wine and 7 lbs of Schnitzel and Germany, 3 bottles of wine and 8 Schnitzel

In colonial America, the population was spread thinly over a large area, and transportation costs were very high because it was difficult to ship products by road for more than short distances. As a result, most of the free population lived on small farms, where they not only grew their own food but also usually made their own clothes and very rarely bought or sold anything for money. Explain why the incomes of these farmers were likely to rise as transportation costs fell. Use the concept of comparative advantage in your answer. When transportation costs fell, each region could specialize in the goods that they had comparative advantage and trade for other goods. Consequently, specialization made it possible to consume more goods. The ability to purchase more goods is effectively an increase income.

Use the concepts of comparative and absolute advantage to discuss this quote by Emily Oster: “No, you shouldn’t always unload the dishwasher because you’re better at it.” You should only unload the dishwasher if you have a comparative advantage at doing so. Emily was incorrect and based her decision on absolute advantage.

In many parts of Europe during the mid-1770’s, governments gave guilds, or organizations of producers, the authority to control who was allowed to produce a good, the amount of the good produced, and the price charged for the good. Would you expect more competition among producers in a guild system or in a market system? Was the consumer or the producer at the center of the guild system, and which is at the center of the market system? How would the two systems compare over time in terms of innovation of new products and technologies? Market System Producer Consumer Mostly likely the market system would be more innovative in order to adapt to changes in consumer preferences over time.

Briefly explain the idea and the importance of the invisible hand. In a speech at the New York University Law School, Federal Reserve Chairman Ben Bernanke stated: “Writing in the 18th century, Adam Smith conceived of the free-market system as an “invisible hand” that harnesses the pursuit of private interest to promote the public good. Smith’s conception remains relevant today, notwithstanding the enormous increase in economic complexity since the Industrial Revolution.” Briefly explain the idea and the importance of the invisible hand. If people act in a rational, self-interested way the price they pay for goods will act as a signal to producers to produce the goods that they want at the lowest possible cost and the economy will be allocatively and productively efficient.

Entrepreneurs Cinder Flounder

Ch. 2 Class Quiz Birds/Day Mice/Day Cinder 2 4 Flounder 8   Birds/Day Mice/Day Cinder 2 4 Flounder 8 What is Cinder’s opportunity cost/day for producing a bird? What is Flounder’s opportunity cost/day for producing a mouse? Who has the absolute advantage in the production of birds? Who has the comparative advantage in the production of birds? Assuming each entrepreneur specializes in producing a single good, what would Cinder and Flounder produce?