GS ECO 2301 CH 2 Trade-offs, Comparative Advantage, and the Market System

Electric cars, though, have struggled to succeed in the marketplace for two key reasons:

(1) The lithium batteries that power electric cars are costly, forcing up the prices of the cars, and (2) the batteries available today need to be recharged every 100 to 300 miles, making the cars impractical for long trips.

Like all economic models, the circular-flow diagram is a simplified version of reality. Figure 2.6 leaves out

(1) the important role of government in buying goods from firms and in making payments, such as Social Security or unemployment insurance payments, to households; (2) the roles played by banks, the stock and bond markets, and other parts of the financial system in aiding the flow of funds from lenders to borrowers; and (3) the fact that some goods and services purchased by domestic households are produced in foreign countries and some goods and services produced by domestic firms are sold to foreign households.

Production possibilities frontier (PPF)

A curve showing the maximum attainable combinations of two goods that can be produced with available resources and current technology.

Households are all the individuals in a home.

A household may consist of one person or several persons. Households are suppliers of factors of production—particularly labor—employed by firms to make goods and services. Households use the income they receive from selling the factors of production to purchase the goods and services supplied by firms.

Circular-flow diagram

A model that illustrates how participants in markets are linked. In factor markets, households supply labor and other factors of production in exchange for wages and other payments from firms. In product markets, households use the payments they earn in factor markets to purchase the goods and services supplied by firms.

Recall that a market is a group of

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

But households own the other factors of production as well, either directly or indirectly, by owning the firms that own these resources.

All firms are owned by households. Small firms, like a neighborhood restaurant, might be owned by one person. Large firms, like Apple, are owned by millions of households that buy shares of stock in them. When firms pay profits to the people who own them, the firms are paying for using the capital and natural resources that are supplied to them by those owners. So, we can generalize by saying that in factor markets, households are suppliers and firms are demanders.

Tesla faces a trade-off: To build one more of its original Model S and Model X cars, it must build one fewer of its new Model 3. The production possibilities frontier illustrates the trade-off Tesla faces. Combinations on the production possibilities frontier—like points A, B, C, D, and E—are efficient because the maximum output is being obtained from the available resources.

Combinations inside the frontier—like point F—are inefficient because some resources are not being used. Combinations outside the frontier—like point G—are unattainable with current resources.

In countries such as Cuba and North Korea, the free market system has been rejected in favor of centrally planned economies with extensive government control over product and factor markets.

Countries that come closest to the free market benchmark have been more successful than countries with centrally planned economies in providing their people with rising living standards.

Households and firms are linked together in a circular flow of production, income, and spending. The blue arrows show the flow of the factors of production. In factor markets, households supply labor, entrepreneurial ability, and other factors of production to firms.

Firms use these factors of production to make goods and services that they supply to households in product markets. The red arrows show the flow of goods and services from firms to households. The green arrows show the flow of funds. In factor markets, households receive wages and other payments from firms in exchange for supplying the factors of production. Households use these wages and other payments to purchase goods and services from firms in product markets. Firms sell goods and services to households in product markets, and they use the funds to purchase the factors of production from households in factor markets.

As the economy moves down the production possibilities frontier, it experiences increasing marginal opportunity costs because increasing automobile production by a given quantity requires larger and larger decreases in tank production.

For example, to increase automobile production from 0 to 200—moving from point A to point B—the economy has to give up only 50 tanks. But to increase automobile production by another 200 vehicles—moving from point B to point C—the economy has to give up 150 tanks Increasing marginal opportunity costs occur because some workers, machines, and other resources are better suited to one use than to another. At point A, some resources that are well suited to producing automobiles—such as workers who have years of experience on automobile assembly lines—are now producing tanks.

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. But going to court to enforce a contract or property rights will be successful only if the court system is independent and judges are able to make impartial decisions on the basis of the law.

Figure 2.5 Gains from Trade When you don't trade with your neighbor, 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)

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). 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 the trade.

Smith argued that such restrictions reduced the income and wealth of a country and its people by restricting the quantity of goods produced. Some people at the time supported the restrictions of the guild system because it was in their financial interest to do so.

If you were a member of a guild, the restrictions served to reduce the competition you faced. But other people believed that the alternative to the guild system was economic disorder. Smith argued that these people were wrong and that a country could enjoy a smoothly functioning economic system if firms were freed from restrictions placed on their operations either by guilds or directly by governments.

When you buy a gasoline-powered car, you probably consider factors such as safety and fuel efficiency. To increase fuel efficiency, automobile manufacturers make some cars that are small and light.

Large cars absorb more of the impact of an accident than do small cars, so people are usually safer driving large cars. What do these facts tell us about the relationship between safety and fuel efficiency?

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.

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.

The Scottish philosopher Adam Smith is considered the father of modern economics because his book, An Inquiry into the Nature and Causes of the Wealth of Nations, published in 1776, was an early and very influential argument for the free market system.

Smith was writing at a time when extensive government restrictions on markets were common. In many parts of Europe, the guild system prevailed. Under this system, governments would give guilds, or organizations of producers, the authority to control the production of a good.

Two amendments to the U.S. Constitution guarantee property rights:

The Fifth Amendment states that the federal government shall not deprive any person "of life, liberty, or property, without due process of law." The Fourteenth Amendment extends this guarantee to the actions of state governments: "No state . . . shall deprive any person of life, liberty, or property, without due process of law." Similar guarantees exist in every high-income country. Unfortunately, in many developing countries, such guarantees do not exist or are poorly enforced.

Opportunity cost

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

Your neighbor has also benefited from the trade. By specializing in picking only cherries, she can pick 60 pounds. She trades 15 pounds of cherries to you for 10 pounds of apples. She can then consume 10 pounds of apples and 45 pounds of cherries (point D in panel (b) of Figure 2.5).

This combination is 1 more pound of apples and 3 more pounds of cherries than she was consuming before trading with you. She also has moved beyond her PPF. Table 2.1 summarizes the changes in production and consumption that result from your trade with your neighbor. (In this example, we chose one specific rate of trading cherries for apples—15 pounds of cherries for 10 pounds of apples. There are, however, many other rates of trading cherries for apples that would also make you and your neighbor better off.)

copyright protection

Under U.S. law, the creator of a book, film, or piece of music has the exclusive right to use the creation during the creator's lifetime. The creator's heirs retain this exclusive right for 70 years after the death of the creator.

Similarly, technological change makes it possible to produce more goods with the same number of workers and the same amount of machinery, which also shifts the production possibilities frontier outward. Technological change need not affect

all sectors equally. Panel (b) of Figure 2.3 shows the results of technological change in the automobile industry that increases the quantity of automobiles workers can produce per year while leaving unchanged the quantity of tanks they can produce.

Economic Growth At any given time, the total resources available to any economy

are fixed. For example, if the United States produces more automobiles, it must produce less of something else—tanks in our example. The capital stock is the amount of machinery and other physical capital available in an economy.

In fact, economics can be distinguished from other disciplines that study human behavior—such as sociology and psychology—by its emphasis on the

assumption of self-interested behavior. Adam Smith understood—as economists today understand—that people's motives can be complex. But when we analyze people in the act of buying and selling, the motivation of financial reward usually provides the best explanation for the actions people take. suppose that consumers decide that they want to eat less bread, pasta, and other foods that contain gluten. Then the prices firms can charge for gluten-free bread and pasta will increase. The self-interest of firms will lead them to produce more gluten-free bread and pasta and less regular bread and pasta, which, in fact, is what has happened over the past 10 years.

Entrepreneurs put their own funds

at risk when they start businesses. If they are wrong about what consumers want or about the best way to produce goods and services, they can lose those funds. In fact, it is not unusual for entrepreneurs who eventually achieve great success to fail at first.

The production possibilities frontier (PPF) is a curve that shows the maximum

attainable combinations of two goods that can be produced with available resources. The PPF is used to illustrate the trade-offs that arise from scarcity. Points on the PPF are technically efficient. Points inside the PPF are inefficient, and points outside the PPF are unattainable.

We can consider further why both you and your neighbor benefit from specializing in picking only one fruit. First, think about the opportunity cost to each of you of picking the two fruits. We saw from the PPF in Figure 2.4 that if you devoted all your time to picking apples, you would

be able to pick 20 pounds of apples per week. As you move down your PPF and shift time away from picking apples to picking cherries, you have to give up 1 pound of apples for each pound of cherries you pick (the slope of your PPF is −1). Your neighbor's PPF has a different slope, so she faces a different trade-off: As she shifts time from picking apples to picking cherries, she has to give up 0.5 pound of apples for every 1 pound of cherries she picks (the slope of your neighbor's PPF is −0.5). As she shifts time from picking cherries to picking apples, she gives up 2 pounds of cherries for every 1 pound of apples she picks. Therefore, her opportunity cost of picking 1 pound of apples is 2 pounds of cherries, and her opportunity cost of picking 1 pound of cherries is 0.5 pound of apples.

One of the great benefits of trade is that it makes it possible for people to

become better off by increasing both their production and their consumption.

Intellectual property includes

books, films, software, and ideas for new products or new ways of producing products.

Economists have used Adam Smith's metaphor of the invisible hand to

describe how the market leads firms to provide consumers with the goods they want. Firms respond individually to changes in prices by making decisions that collectively end up satisfying the preferences of consumers.

factors of production

economic resources workers, capital, natural resources, and entrepreneurial ability—used to make goods and services.

Factor markets are markets for the

factors of production.

Scarcity requires

trade-offs. Scarcity exists because we have unlimited wants but only limited resources available to fulfill those wants. Goods and services are scarce.

Because consumers often cannot evaluate a new product before it exists, some of the most successful entrepreneurs, such as the late Steve Jobs of Apple, rarely use

focus groups, or meetings with consumers in which the consumers are asked what new products they would like to see. Instead, entrepreneurs think of products that consumers may not even realize they need, such as, in Jobs's case, an MP3 player—the iPod—or a tablet computer—the iPad. Entrepreneurs are important to the economy because they are often responsible for making new products widely available to consumers, as Henry Ford did with the automobile and Steve Jobs did with the iPod.

We are familiar with households as suppliers of labor because most people earn most of their income by

going to work, meaning they are selling their labor services to firms in the labor market.

Firms are suppliers of

goods and services. Firms use the funds they receive from selling goods and services to buy or hire the factors of production needed to make the goods and services.

Product markets are markets for

goods—such as smartphones—and services—such as medical treatment. In product markets, households are demanders and firms are suppliers.

In the United States today, governments at the federal, state, and local levels set or regulate the prices of

only about 10 to 20 percent of goods and services. The prices of other goods and services are free to change as consumer preferences change and as costs of production change.

Table 2.2 summarizes the opportunity costs for you and your neighbor of picking apples and cherries. Note that even though your neighbor can pick more apples in a week than you can, the opportunity cost of picking apples is

higher for her than for you because when she picks apples, she gives up more cherries than you do. So, even though she has an absolute advantage over you in picking apples, it is more costly for her to pick apples than it is for you.

Factors of production are the : Natural resources

include land, water, oil, iron ore, and other raw materials (or "gifts of nature") that are used in producing goods.

Factors of production are the : Labor

includes all types of work, from the part-time labor of teenagers working at McDonald's to the work of senior managers in large corporations.

A key to understanding Smith's argument is the assumption that

individuals usually act in a rational, self-interested way. In particular, individuals take the actions that are most likely to make themselves better off financially. This assumption of rational, self-interested behavior underlies nearly all economic analysis.

Factors of production are the

inputs used to make goods and services. Factors of production are divided into four broad categories: 1. Labor 2. Capital 3. Natural resources 4. An entrepreneur

Factors of production are the : 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.

The relative price

is the price of one good or service relative to the prices of other goods or services. Changes in relative prices provide information, or a signal, to both consumers and firms. For example, consumers worldwide have increased their demand for cattle and poultry. Because corn is fed to cattle and poultry, prices for corn have increased relative to prices for other crops.

Consumers and existing businesses often do not at first realize that the new technology makes

new products feasible. For example, even after the development of the internal combustion engine had made automobiles practicable, Henry Ford remarked: "If I had asked my customers what they wanted, they would have said a faster horse."

Unfortunately, in many low-income countries, business owners are not well protected from having their businesses seized by the government or from having their profits taken by criminals. Where these problems exist

opening a business can be extremely risky. Cash can be concealed easily, but a business is difficult to conceal or move.

An entrepreneur is someone who

operates a business. Entrepreneurs first determine what goods and services they believe consumers want and then decide how to produce those goods and services most profitably, using the available factors of production—labor, capital, and natural resources. Successful entrepreneurs are able to search out opportunities to provide new goods and services. Frequently these opportunities are created by new technology.

Over time, the resources available to an economy may increase because both the labor force and the capital stock increase. When the amount of resources increases, the economy's production possibilities frontier shifts

outward, making it possible to produce both more automobiles and more tanks. Panel (a) of Figure 2.3 shows that over time, the economy can move from point A to point B, producing more tanks and more automobiles.

To protect intellectual property, the federal government grants a

patent that gives an inventor—often a firm—the exclusive right to produce and sell a new product for a period of 20 years from the date the patent was filed.

Markets take many forms: They can be

physical places, such as the pizza parlors in your city or the New York Stock Exchange, or virtual places, such as eBay. In a market, the buyers are demanders of goods or services, and the sellers are suppliers of goods or services.

Comparative advantage is the ability of an individual, a firm, or a country to

produce a good or service at a lower opportunity cost than competitors and is the basis for trade. In picking apples, your neighbor has an absolute advantage over you, while you have a comparative advantage over her. Your neighbor has both an absolute advantage and a comparative advantage over you in picking cherries. As we have seen, you are better off specializing in picking apples, and your neighbor is better off specializing in picking cherries. It is possible to have a comparative advantage in producing a good or service without having an absolute advantage. This is the case with your picking apples.

Absolute advantage is 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. Your neighbor has an absolute advantage over you in picking both apples and cherries because she can pick more of each fruit than you can in the same amount of time. Although it seems that your neighbor should pick her own apples and her own cherries, we have just seen that she is better off specializing in picking cherries and leaving picking apples to you. It is possible to have an absolute advantage in producing a good or service without having a comparative advantage. This is the case with your neighbor picking apples.

Factors of production are the : Capital

refers to physical capital, such as computers, office buildings, and machine tools, used to produce other

The business professors advising Feeding American proposed changing the food allocation system to one that

resembled a market. Each food program was given a number of "shares" that they could use in bidding against other food programs for the types of food that best met the needs of the low-income people using their program. In addition, any local program that had surplus food was allowed to sell it to other local programs in exchange for shares.

In a free market, government does not

restrict how firms produce and sell goods and services or how they employ factors of production. But the absence of such government restrictions is not enough for the market system to succeed in providing people with a high standard of living. Government has to take active steps to provide a legal environment that will allow markets to operate efficiently.

But the market system won't work unless a significant number of people are willing to

risk their funds by investing them in businesses. Investing in businesses is risky in any country. Many businesses fail every year in the United States and other high-income countries. But in high-income countries, someone who starts a new business or invests in an existing business doesn't have to worry that the government, the military, or criminal gangs might decide to seize the business or demand payments for not destroying it.

We can use production possibilities frontiers (PPFs) to show how your neighbor can benefit from trading with you even though

she is better than you are at picking both apples and cherries.

The government grants patents to encourage firms to

spend money on the research and development necessary to create new products. If other companies could freely copy Siri, Apple would not have spent the funds necessary to develop it.

Markets are fundamentally about trade, which is the

the act of buying and selling. Sometimes we trade directly, as when children trade one baseball card for another baseball card. But often we trade indirectly: We sell our labor services as, say, an accountant, a salesperson, or a nurse for money, and then we use the money earned to buy goods and services.

Property rights are the rights individuals or firms have to

the exclusive use of their property, including the right to buy or sell it. Property can be physical property, such as a store or factory. Property can also be intangible, such as the right to an idea.

A free market exists when

the government places few restrictions on how goods and services can be produced or sold or on how factors of production can be employed. Governments in all modern economies intervene more than is consistent with a fully free market. In that sense, we can think of the free market as being a benchmark against which we can judge actual economies.

The idea of increasing marginal opportunity costs illustrates an important economic concept: The more resources already devoted to an activity,

the smaller the payoff to devoting additional resources to that activity. The more hours you have already spent studying economics, the smaller the increase in your test grade from each additional hour you spend—and the greater the opportunity cost of using the hour in that way. The more funds a firm has devoted to research and development during a given year, the smaller the amount of useful knowledge it receives from each additional dollar spent—and the greater the opportunity cost of using the funds in that way. The more funds the federal government spends cleaning up toxic waste dumps during a given year, the smaller the reduction in pollution from each additional dollar spent—and, once again, the greater the opportunity cost of using the funds in that way.

Feeding America's managers have used the knowledge of which types of foods local food programs prefer to guide

the types of food they ask companies to donate. For instance, in addition to fruits and vegetables, programs are willing to pay more shares for peanut butter and frozen chicken because these foods are easy to store. Even many critics of using a market mechanism to allocate food donations eventually embraced the system, including the director of one Michigan food program whose initial reaction was: "I am a socialist. That's why I run a food bank. I don't believe in markets."

Entrepreneurs make vital contributions to economic growth through

their roles in responding to consumer wants and introducing new products. Government policies that encourage entrepreneurship are also likely to increase economic growth and raise the standard of living. In the next section, we consider the legal framework required for a successful market in which entrepreneurs can succeed.

Outward shifts in the production possibilities frontier represent economic growth because

they allow the economy to increase the production of goods and services, which ultimately raises the standard of living. In the United States and other high-income countries, the market system has aided the process of economic growth, which over the past 200 years has greatly increased the well-being of the average person.

Note that for the market mechanism to work in response to changes in consumers'

wants, prices must be flexible.

For the market system to work well, individuals must be

willing to take risks. Someone with $250,000 can be cautious and keep it safely in a bank—or even in cash, if the person doesn't trust banks.

In providing copyright protection for only a limited time, Congress provides economic incentives to creators while eventually

—after the period of copyright has ended—allowing the creators' works to be freely available to others. The longer the period of copyright, the longer the creator (or the creators' family) can restrict others from using the work.

Two key groups participate in markets:

• households and • firms