PowerPoint to accompany Chapter 2 Choices and trade-offs in the market

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Learning Objectives 1. Use a production possibility frontier to analyse opportunity costs and trade-offs. 2. Understand comparative advantage and explain how it is the basis for trade. 3. Explain the basic idea of how a market system works. 4. Understand why property rights are necessary for a well-functioning economy.

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Managers making choices at BMW  BMW’s management has faced many decisions which involve trade-offs. For example, whether to concentrate production in Germany, or to build factories in overseas markets.

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia  Production possibility frontier: A curve showing the maximum attainable combinations of two products that may be produced with available resources.  Opportunity cost: The highest-valued alternative that must be given up to engage in an activity. LEARNING OBJECTIVE 1 Production possibility frontiers and real world trade-offs

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia LEARNING OBJECTIVE 1 ChoiceSports cars per day4WDs per day A8000 B C 500 D E0600 BMWs production choices per day Figure 2.1

0 Sports cars produced per day BMWs production possibility frontier: BMW faces a production trade-off between sports cars and 4WDs: Figure 2.1, continued F C 200 G 4WDs produced per day A B D E Inefficient combination Unattainable combination Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

 The bowed out shape of the production possibility frontier illustrates the concept of increasing marginal opportunity costs.  Increasing marginal opportunity costs demonstrate an important economic concept:  The more resources are devoted to any activity, the smaller will be the payoff to devoting additional resources to that activity. LEARNING OBJECTIVE 1 Production possibility frontiers and real world trade-offs

Computers Technological change and the computer industry: Figure Televisions A B C Increasing computer production here by 200 only reduces television production by 50. Increasing computer production here by 200 reduces television production by 150. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

 Economic growth: The expansion of society’s production potential.  Economic growth is usually measured by the rate of growth in real GDP.  Growth can also be illustrated using the production possibility frontier. LEARNING OBJECTIVE 1 Production possibility frontiers and real world trade-offs

0 Televisions Computers Shifting out the production possibility frontier: Economic growth: Figure 2.3(a) A B Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Computers Technological change and the computer industry: Figure 2.3(b) Televisions Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Trade-offs and tsunami relief  More funds for tsunami relief meant less funds for other charities.

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia  We use the production possibility frontier and the concept of opportunity cost to explain the economic gains from specialisation and trade.  Trade: the act of buying or selling a good or service in a market. LEARNING OBJECTIVE 2 Trade

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia  We use a simple example of two people - you and your neighbour.  And two goods, apples and cherries, measure in kilograms (kgs)  We further simplify our example by using straight line production possibility frontiers. LEARNING OBJECTIVE 2 Trade

0 Apples (kg) (a) Your production possibility frontier 20 Production possibilities for you and your neighbour without trade: Figure 2.4 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Cherries (kg) 20 YouYour neighbour ApplesCherriesApplesCherries All time picking apples20 kg0 kg30 kg0 kg All time picking cherries0 kg20 kg0 kg60 kg

0 Apples (kg) (a) Your production possibility frontier 20 Production possibilities for you and your neighbour without trade: Figure 2.4 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia (b) Your neighbour’s production possibility frontier Cherries (kg) 20 Cherries (kg) Apples (kg) YouYour neighbour ApplesCherriesApplesCherries All time picking apples20 kg0 kg30 kg0 kg All time picking cherries0 kg20 kg0 kg60 kg

0 Apples (kg) (a) Your production and consumption after trade 20 Gains from trade: Figure 2.5 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Cherries (kg) 20 Your production with trade Your consumption without trade Your consumption with trade A’ A

0 Apples (kg) (a) Your production and consumption after trade 20 Gains from trade: Figure 2.5 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia (b) Your neighbour’s production and consumption with trade Cherries (kg) 20 Cherries (kg) Apples (kg) Your production with trade Your consumption without trade Your consumption with trade A’ A B’B’ B Your neighbour’s consumption without trade Your neighbour’s consumption with trade Your neighbour’s production with trade

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Absolute and comparative advantage.  Absolute advantage: The ability of an individual, firm or country to produce more of a good or service than competitors using the same amount of resources.  Comparative advantage: The ability of an individual, firm or country to produce a good or service at a lower opportunity cost than other producers. LEARNING OBJECTIVE 2 Trade

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Comparative advantage and the gains from trade.  The basis for trade is comparative advantage not absolute advantage.  Individuals, firms or countries are better off if they specialise in producing goods and services for which they have a comparative advantage and obtain other desirable goods and services by trading. LEARNING OBJECTIVE 2 Trade

A summary of the gains from trade: Table 2.1 You Your Neighbour Apples (kg)Cherries (kg)Apples (kg)Cherries (kg) Production and consumption without trade Production with trade Consumption with trade Gains from trade kg of apples1 kg of cherries You1 kg of cherries1 kg of apples Your neighbour2 kg of cherries0.5 kg of apples Opportunity cost of picking fruit: Table 2.2 Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Gains from specialisation and trade  Suppose Jack and Jenny both live alone on two small deserted islands in the Pacific Ocean. Both produce only two food products, mangoes and fish. If Jack spends all his time fishing he can catch 8 kilograms of fish each week. If he spends all his time picking mangoes he can pick 2 kilograms a week. If Jenny devotes all her time to fishing, she can catch two kilograms of fish a week. If she spends all her time picking mangoes, she can pick 10 kilograms a week. Currently, both devote half their time to fishing and half their time to picking mangoes. LEARNING OBJECTIVE 2

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Gains from specialisation and trade a) Calculate the opportunity cost of fish and mango production for Jack and Jenny. b) Does your calculation in part (a) suggest Jack and Jenny could benefit from specialisation and exchange? If so, who should specialise in the production of each good? c) How will specialisation impact total output. d) Suppose Jack and Jenny both keep half of their total output after specialisation, and trade the other half for the good they do not have. How much will each person gain from this exchange? LEARNING OBJECTIVE 2

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Gains from specialisation and trade Solving the problem:  STEP 1: Review the material. The problem is about the gains from specialisation and trade, covered on pages 40 – 44 of the text. LEARNING OBJECTIVE 2

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Gains from specialisation and trade STEP 2: Answer (a) by calculating the opportunity costs of each good for both individuals. LEARNING OBJECTIVE 2

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Gains from specialisation and exchange LEARNING OBJECTIVE 2

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Gains from specialisation and trade  STEP 3: Answer (b). The individual with the lowest opportunity cost has the comparative advantage in the production of that good.  Jack has the lower opportunity cost and therefore the comparative advantage in fish production.  Jenny has the lower opportunity cost and therefore the comparative advantage in mango production. LEARNING OBJECTIVE 2

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Gains from specialisation and trade  STEP 4: Answer (c). To determine the impact on total output we must compare output prior to specialisation with output post specialisation. In order to make this comparison, we recall that Jenny and Jack both initially spent half their time catching fish and half their time picking mangoes.  This information enables us to construct the table shown on the following slide.  Note: we assume complete specialisation; that is, post specialisation, both Jenny and Jack produce only the good in which they have a comparative advantage. LEARNING OBJECTIVE 2

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Gains from specialisation and trade LEARNING OBJECTIVE 2 Pre-Specialisation and Trade Post Specialisation FishMangoesFishMangoes Jack4180 Jenny15010 TOTAL

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Gains from specialisation and trade  STEP 4: The table shows that production of both goods has increased due to specialisation.  STEP 5: Answer (d). We compare the pre-trade and pre-specialisation consumption and production of Jack and Jenny with their post specialisation consumption. That is, each will keep half their total output and exchange half for the other good. This enables us to construct the table shown on the next slide. The table demonstrates that both individuals have gained in consumption from trade. LEARNING OBJECTIVE 2

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Gains from specialisation and trade LEARNING OBJECTIVE 2 Pre-Specialisation and Trade After Trade FishMangoesFishMangoes Jack 4145 Jenny 1545

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia  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 and services.  Factor markets: Markets for the factors of production, such as labour, capital, natural resources and entrepreneurial ability. LEARNING OBJECTIVE 3 The market system

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia  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.  Adam Smith argued the benefits of a free market system in his famous book – An Inquiry into the Nature and Causes of the Wealth of Nations (published in 1776). LEARNING OBJECTIVE 3 The market system

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia  Smith assumed individuals act in a rational, self-interested way.  If not restricted by government, then firms would be led by the invisible hand of the market to provide consumers with what they wanted.  The price mechanism in the free market leads producers to change supply in accordance with consumer demand. LEARNING OBJECTIVE 3 The market system

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia  Entrepreneurs are central to the working of the market system.  Entrepreneur: Someone who operates a business, bringing together the factors of production to produce goods and services. LEARNING OBJECTIVE 3 The market system

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Story of the market system in action: I, Pencil.  The market coordinates the activities of the many people spread around the world who contribute to the making of a pencil.

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia  Private property rights provide the legal basis of a free market system.  Property rights: The rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it.  To enforce contracts and property rights there must be an independent court system with impartial judges.  Production will fall if property rights are not well enforced – a move inside the PPF. LEARNING OBJECTIVE 4 Property Rights

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Copying movies and music from cyberspace  Apple’s iTunes in conjunction with MP3 players (such as the multi- touch screen iPod shown here), have made a solid attempt at combating unauthorised free downloads of music by offering inexpensive legal downloads.

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia An Inside Look Expansion and production mix at BMW

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Key Terms  Absolute advantage  Comparative advantage  Economic growth  Entrepreneur  Factor markets  Free market  Market  Opportunity cost  Price mechanism  Product markets  Production possibility frontier  Property rights  Scarcity  Trade

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Adam Smith is regarded as the founder of modern economic theory. In consequence, a vast quantity of information is available on his life and writings, both in print and on the internet. Most students studying economics in the 21 st Century do not have the luxury of studying the foundations of this fascinating discipline. However, you can follow the link below to the webpage of the History of Economic Thought, and from there find more information about Adam Smith. Get Thinking!

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Q1. What happens to a country that produces a combination of goods that uses all the resources available in the economy? a. The country is operating on its production possibility frontier. b. The country is maximising its opportunity cost. c. The country has eliminated scarcity. d. All of the above. Check Your Knowledge

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Q1. What happens to a country that produces a combination of goods that uses all the resources available in the economy? a. The country is operating on its production possibility frontier. b. The country is maximising its opportunity cost. c. The country has eliminated scarcity. d. All of the above. Check Your Knowledge

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Q2.Refer to the graph below. Each graph represents one country. Which country in this graph has a comparative advantage in the production of shirts? a. Country A b. Country B c. Neither country d. Both countries Check Your Knowledge

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Q2.Refer to the graph below. Each graph represents one country. Which country in this graph has a comparative advantage in the production of shirts? a. Country A b. Country B c. Neither country d. Both countries Check Your Knowledge

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Q3. According to Adam Smith, which of the following is true? a. Markets work because producers, aided by government, ensure that neither too many nor too few goods are produced. b. Market prices can come to reflect the prices desired by consumers. c. Individuals usually act in a rational, self interested way. d. All of the above. Check Your Knowledge

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia Q3. According to Adam Smith, which of the following is true? a. Markets work because producers, aided by government, ensure that neither too many nor too few goods are produced. b. Market prices can come to reflect the prices desired by consumers. c. Individuals usually act in a rational, self interested way. d. All of the above. Check Your Knowledge