ECO 202 Module 2: Trade-offs, Comparative Advantage, and the Market System

production possibilities frontier

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

• used in positive analysis, shows what is, not what should be

• the more resources devoted to an activity, the smaller the payoff to devoting additional resources to the activity (opportunity cost increases)

economic growth

the ability of the economy to increase the production of goods and services

• shifts in the PPF represent economic growth

trade

the act of buying and selling

• can benefit from trade by specializing in what you’re relatively goof at

  • can consume more with trade than without

absolute advantage

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

ability of an individual, firm, or country to produce a good or service at a lower opportunity cost than competitors

• the basis for trade is comparative advantage

households

consist of individuals who provide the factors of production (labor, capital, natural resources, and other inputs used to make goods and services)

firms

purchase the factors of production and use them to create goods and services

four factors of production

• labor: all types of work

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

• natural resources: land, water, oil, iron ore, and other raw materials that are used in producing goods

• entrepreneur: someone who operates a business

entrepreneurial ability

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

factor market

market for the factors of production

product market

market for goods - such as computers - or services - such as medical treatment

circular flow diagram

model that illustrates how participants in markets are linked

• households provide factors of production to firms

• firms provide goods and services to households

• firms pay money to households for the factors of production

• households pay money to firms for the goods and services

free market

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

• countried closest to the free market benchmark have been more successful than those with centrally planned economies in providing their people with rising living standards

how does the market mechanism work?

suppose many consumers switch from buying gas-powered cars to buying electric cars

• firms will find they can charge more for electric cars

• the self-interest of these firms will lead them to produce more electric cars, since these are now more profitable

• we don’t need anyone (such as the government) to be in charge of decision-making, it will happen organically

• however, we need flexible prices in order for the correct price signals to reach firms. flexible prices allow collective actions of households and firms to signal the relative worth of goods and services

protection of private property

without protection, people have little incentive to work hard

property rights

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

enforcement of contracts and property rights

independent court system is critical for transactions to occur across time

social democratic parties

favor large role of government in the economy, sometimes including government ownership or control of some large industries