Chapter 2: Trade-offs, Comparative Advantage, and the Market System

Production possibilities frontier (PPF)

A curve showing the maximum attainable combinations of two products that may be produced with available resources and current technology. Combinations on the frontier are efficient because all available resources are being fully utilized, and the fewest possible resources are being used to produce a given amount of output.

Market

A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade.

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.

Circular-flow diagrams

A simple economic that can be used to see how participants in markets are linked.

Scarcity

A situation in which unlimited wants exceeds the limited resources available to fulfills those wants. Goods and services are scarce. So are the economic resources, or factors of production - labor (workers), capital, natural resources, and entrepreneurial ability - used to make goods and services.

Increasing Marginal Opportunity Costs

As the economy moves down the production possibilities frontier, it experiences increasing marginal opportunity costs. The more resources already devoted to an activity, the smaller the payoff to devoting additional resources to that activity.

Legal Basis of a Successful Market System

Government has to take active steps to provide a legal environment that will allow the market sustem to succeed.

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 PPF.

Labor

Includes all types of work.

Intellectual Property

Includes books, films, software, and ideas for new products or new ways of producing products. To protect intellectual property, the federal government grants a patent that gives an inventor-which is often a firm-the exclusive rights to produce and sell a new product for a period of 20 years from the date the product was invented. The government grants patents to encourage firms to spend money on the research and development necessary to create new products. Books, films, and software receive copyright protection.

Natural Resources

Includes land, water, oil, iron ore, and other raw materials that are used in producing goods.

Product Markets

Markets for goods and services.

Factor markets

Markets for the factors of production.

Capital

Refers to physical capital that is used to produce other goods.

Adam Smith

The Scottish philosopher that is considered to be the father of modern economics because his book "An Inquiry into the Nature and Causes of the Wealth of Nations." Smith argued that such restrictions (guild system) reduced the income, or wealth, of a country and its people by restricting the quantity of goods produced. Economics can be distinguished from other fields that study human behavior by its emphasis on the assumptions of self-interested behavior. Smith said that firms would be led by the "invisible hand" of the market to provide consumers with what they wanted. Firms would respond to changes in prices by making decisions that ended up satisfying the wants of consumers.

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

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.

Economic growth

The ability of the economy to increase the production of goods and services. Shifts in the PPF represent economic growth, which ultimately raises the standard of living.

Entrepreneurial ability

The ability to bring together the other factors of production to successfully produce and sell goods and services.

Trade

The act of buying and selling.

Comparative Advantage and the Gains from Trade

The basis for trade is comparative advantage, not absolut 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.

Opportunity cost

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

Factors of production

The inputs used to make goods and services. Labor, capital, natural resources, and entrepreneurial ability.

Property rights

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