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

Scarcity

A situation in which unlimited wants exceed the limited resources available to fulfill those wants.

Scarcity and Trade-Offs

Because resources are limited, households, firms, and governments must make choices about how to use them.

Trade-Off

Giving up one thing in order to obtain something else.

Production Possibilities Frontier (PPF)

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

PPF as an Economic Tool

A positive economic tool because it shows what is attainable, not what should be produced.

Point on the PPF

An attainable and efficient combination of production.

Point Inside the PPF

An attainable but inefficient combination because some resources are not fully used.

Point Outside the PPF

An unattainable combination with current resources and technology.

Efficiency on the PPF

Resources are being fully used to produce the maximum attainable output.

Opportunity Cost

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

Opportunity Cost on a PPF

The amount of one good that must be given up to produce more of another good.

Constant Opportunity Cost

Each additional unit of a good requires giving up the same amount of another good.

Increasing Marginal Opportunity Cost

Producing additional units of a good requires giving up increasingly larger amounts of another good.

Why Does Opportunity Cost Often Increase?

Resources are not equally suited to producing every good.

Bowed-Out PPF

A PPF showing increasing marginal opportunity costs.

Straight-Line PPF

A PPF showing constant opportunity costs.

Economic Growth

The ability of an economy to increase its production of goods and services.

Economic Growth on a PPF

Shown by an outward shift of the production possibilities frontier.

What Can Shift a PPF Outward?

More resources or technological improvement.

Technological Improvement in One Industry

Can shift outward only the part of the PPF associated with the good affected by the technology.

Trade

The act of buying and selling.

Specialization

Concentrating production on the good or service for which a person, firm, or country has a comparative advantage.

Gains from Trade

Increases in consumption made possible when people specialize and trade.

Absolute Advantage

The ability to produce more of a good or service than competitors using the same amount of resources.

Comparative Advantage

The ability to produce a good or service at a lower opportunity cost than competitors.

Basis for Trade

Comparative advantage, not absolute advantage.

Who Should Specialize in a Good?

The person, firm, or country with the lower opportunity cost of producing that good.

Can Someone Benefit From Trade Even With an Absolute Advantage in Everything?

Yes. Trade is based on comparative advantage, so both sides can benefit.

Comparative Advantage and Opportunity Cost

The producer with the lower opportunity cost has the comparative advantage.

Opportunity Cost of 1 Unit of a Good

Amount of the other good given up ÷ additional units of the good produced.

Your Apple Opportunity Cost in the Slide Example

1 pound of cherries for 1 pound of apples.

Your Cherry Opportunity Cost in the Slide Example

1 pound of apples for 1 pound of cherries.

Neighbor's Apple Opportunity Cost in the Slide Example

2 pounds of cherries for 1 pound of apples.

Neighbor's Cherry Opportunity Cost in the Slide Example

0.5 pound of apples for 1 pound of cherries.

Who Has Comparative Advantage in Apples in the Slide Example?

You, because your opportunity cost of apples is lower.

Who Has Comparative Advantage in Cherries in the Slide Example?

Your neighbor, because the neighbor's opportunity cost of cherries is lower.

Who Has Absolute Advantage in the Fruit Example?

Your neighbor has an absolute advantage in both apples and cherries.

Why Can Both People Gain From Trade?

Each specializes according to comparative advantage and trades for the other good.

Consumption Possibilities With Trade

Trade can allow people to consume combinations beyond what they could produce individually.

Comparative Advantage and Household Chores

The person with the lower opportunity cost of a chore should specialize in that chore.

Market

A group of buyers and sellers of a good or service and the arrangement through which they trade.

Two Main Groups in the Market System

Households and firms.

Households

Individuals who supply factors of production and buy goods and services.

Firms

Organizations that buy factors of production and use them to produce goods and services.

Factors of Production

Labor, capital, natural resources, and entrepreneurial ability.

Labor

All types of work used to produce goods and services.

Capital

Physical goods such as machines, computers, and buildings used to produce other goods and services.

Natural Resources

Land, water, oil, minerals, and other raw materials used in production.

Entrepreneur

Someone who operates a business and brings together the other factors of production.

Entrepreneurial Ability

The ability to combine labor, capital, and natural resources to successfully produce and sell goods and services.

Factor Market

A market in which factors of production are bought and sold.

Product Market

A market in which goods and services are bought and sold.

What Do Households Sell?

Factors of production to firms in factor markets.

What Do Households Buy?

Goods and services from firms in product markets.

What Do Firms Buy?

Factors of production from households in factor markets.

What Do Firms Sell?

Goods and services to households in product markets.

Circular-Flow Diagram

A model showing how households, firms, product markets, and factor markets are connected.

Real Flow From Households to Firms

Households provide labor, capital, natural resources, and entrepreneurial ability.

Real Flow From Firms to Households

Firms provide goods and services.

Money Flow From Firms to Households

Firms make wages and other payments for factors of production.

Money Flow From Households to Firms

Households spend money on goods and services.

What Is Left Out of the Basic Circular-Flow Model?

Government, the financial system, and foreign buyers and sellers.

Free Market

A market with few government restrictions on how goods or services are produced or sold or how factors of production are employed.

Market Mechanism

The process through which flexible prices and individual decisions help coordinate economic activity.

Flexible Prices

Prices that can change in response to changes in supply, demand, and market conditions.

Price Signals

Changes in prices that communicate information to consumers and firms.

Example of a Price Signal

If consumers want more electric cars, their prices and profitability may rise, encouraging firms to produce more electric cars.

Invisible Hand

Adam Smith's idea that individuals pursuing their own interests can, through markets, contribute to satisfying consumer wants.

Adam Smith

Economist associated with the invisible hand and the advantages of market systems.

The Wealth of Nations

Adam Smith's 1776 work discussing markets and economic organization.

Local Knowledge

Information about particular circumstances known by individuals or firms rather than by everyone.

Why Is Local Knowledge Important?

Individuals use specialized knowledge in making decisions, and market prices help communicate the results throughout the economy.

Markets and Information

Markets help process large amounts of dispersed information through prices and individual decisions.

Market System vs. Central Planning

The slides emphasize that market systems can respond more quickly to local information and changing conditions.

Self-Interest in a Market System

Individuals and firms pursue their own goals, while prices help coordinate their decisions.

Entrepreneurs and Economic Growth

Entrepreneurs contribute to growth by organizing resources and developing products consumers value.

Risk of Entrepreneurship

Entrepreneurs may take substantial personal and financial risks when creating businesses and products.

Private Property

Property owned by individuals or firms rather than collectively by government.

Property Rights

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

Why Are Property Rights Important?

They give households and firms an incentive to work, invest, and conduct economic activity.

Enforcement of Contracts

Government enforcement of agreements that allows transactions, including those extending across time, to occur reliably.

Independent Court System

A court system capable of enforcing property rights and contracts without improper interference.

Legal Basis of a Successful Market System

Protection of private property, enforcement of property rights and contracts, and an independent court system.

Centrally Planned Economy

An economic system in which government plays a central role in directing production and resource allocation.

Karl Marx

The slides describe Marx as arguing that capitalism would eventually be replaced by a communist economy controlled by workers.

Communist Economies in the Slides

The slides state that countries adopting communism instead developed centrally planned systems with strong government control.

Social Democratic Parties

The slides describe these parties as favoring a larger government role in the economy, sometimes including government control or ownership of certain industries.

Social Democracy vs. Marxist Socialism

The slides distinguish modern social democratic policies from socialism in the Marxist tradition.