Trade-offs, Comparative Advantage, Market System Chapter 2

Ch. 2: Trade-offs, Comparative Advantage, and Market System 1.The scarcity and OC concepts can be explained in terms of the production possibilities schedule (PPS), or curve (PPC), frontier (PPF) PPS or PPC (PPF)  a table or graph showing alternative combinations of two goods that could be produced with available resources and technology

2. An Example of Production Possibilities Schedule (PPS)- a Case of Increasing OC

PPC –Curve zBread TV Set 20 5 B A C D E F PPC

3. Constant vs Increasing OC zA constant OC is a case where the amount we give up to get something remains the same (2 Hotdogs for 1 Ham). PPC is a straight line. zIt implies perfect substitution of resources. zIncreasing OC occurs when we have to give up more and more to get each additional unit (More and more Bread units for a TV Set). PPC is a Curve zIt implies an imperfect resource substitution- realistic

4. Law of Increasing OC This law suggests that the opportunity cost of each additional TV set continues to increase (realistic). It also implies that there is a trade-off between the production of TV and Bread i.e. getting more TV Sets comes at the expense of giving up more and more of bread units.

PPC Assumptions z5a. Assumption of PPC are : z -Full employment of resources z -Fixed technology z -Finite resources at given point in time z b. A point (X )inside the PPC implies z underutilization of resources. z c. a point (Y) outside the frontier implies z unattainable combination z d. A point on the PPC implies full employment and use of best technology or method of production.

PPC Applications z6. Some Applications of the PPC or PPF z - illustrates scarcity, choice, OC. z - shows economic growth as reflected by the shift in the PPC or PPF. 7. An economy is considered to be efficient when the forces of demand and supply determine prices of goods and services The function of price is to allocate resources to their best use.

8. Why Do We Trade? zThere are mutual gains from trade zTrade improves the welfare of trading partners

zThe rancher and the farmer are both able to produce beef and potatoes. zOunces (Meat and Potatoes) Produced in 8 Hours Work Per Day z Meat Potatoes OC OC’ zFarmer8oz32oz 1M=4P 1P=1/4M zRancher24oz48oz 1M=2P 1P=1/2M 9. An Example  the rancher and the farmer

10. Absolute VS Comparative Advantage zQuestion: Who is more productive in both goods in absolute terms? zThe rancher is said to have an Absolute Advantage (AA). z7. What is AA? – The comparison among producers according to productivity. zIt implies that the rancher should produce both meat and potatoes. Hence AA does not establish the basis for trade. zQuestion: Who can produce meat at a relatively cheaper cost? Who can produce potatoes at a relatively cheaper cost? zIt depends on who has a Comparative Advantage (CA) in what good based on OC.

Absolute VS Comparative Advantage zQuestion: Who has a CA in the production of Meat? Look at the table – the rancher, because the OC of 1M = only 2P to the rancher, whereas it is 4P to the farmer. z11. CA – the comparison among producers according to opportunity cost. zWho has a CA in Potatoes? – the farmer, of necessity. Why? Because the OC of 1P is only ¼M to the farmer, whereas it is ½ M of meat to the rancher.

Absolute VS Comparative Advantage z12. CA implies that each must specialize in what it does best and trade for what it does not have. Therefore, CA establishes the basis of trade. z13. For this to happen, there must be a difference in the exchange ratio between the Farmer and Rancher, i.e. 1:4 and 1:2=> limits to terms of trade (domestic exchange ratios). zIn order for trade to be beneficial to both, the terms of exchange must always be between the exchange ratio for each individual, say 1M = 3P. zQuestion: How does a 1M = 3P benefit both? Notice that the rancher only used to get 2P for 1M before trade. Since it does not produce potatoes after specialization in meat, the rancher is happy to get 3P for 1M.

Absolute VS Comparative Advantage zThe farmer is also happy to get 1/3 M for 1P after trade than the pre-trade of only ¼ M for 1P. Thus, trade based on CA benefits both trading partners. zCA advantage leads individuals or countries to specialize in what they do best. zCubans in cigars, Germans in cameras, Japanese in HDTV’s, etc. zComment: zTrade is based on CA → Specialization → Division of Labor → Efficiency → Increased production → Increased consumption → Trade is beneficial to both. zQuestion: Should Tiger Wood mow his lawn? No. Explain why? The OC of mowing his lawn is too high than to hire someone.

14. Specialization and Trade zIndividuals and countries will be better off by specializing in what they do best and trading with their neighbors. zThe result is that scarce resources are used most efficiently and the collective material well- being is improved.

zA model that shows how participants in markets (buyers and sellers) are linked (Hubbard-O’Brien) z A visual model of the economy that shows how dollars flow through markets among households and firms (Mankiw) 15. The Circular-Flow Diagram

Households Businesses

The Circular-Flow Diagram. Households Businesses Inputs or Factors of Production Products and Services The Flow of Goods and Services

The Circular-Flow Diagram. Households Businesses Wages, Rent, Interest and Profits Payments for Products and Services The Flow of Dollars $ $ $ $

The Circular-Flow Diagram. Households Businesses Market for Factors of Production Product Market $ $ $ $

Circular-flow diagram zA model that shows how participants in markets are linked (HO) z A visual model of the economy that shows how dollars flow through markets among households and firms (Mankiw)

Efficiency "An efficient economy utilizes all of its available resources and produces the maximum amount of output that its technology permits."