ECON 101 - Chapter 2 Flashcards

Trade-offs, Comparative Advantage, and the Market System

Learning Objectives

• Use a production possibilities frontier to analyze opportunity costs and trade-offs.

• Understand comparative advantage and explain how it is the basis for trade.

• Explain the basic idea of how a market system works.

Production Possibilities Frontiers and Opportunity Costs

• Production Possibilities Frontier (PPF):

  • A curve showing the maximum attainable combinations of two products that may be produced with available resources and current technology.

• Scarcity: This concept requires trade-offs since goods and services and the economic resources used to make them, or factors of production—workers, capital, natural resources, and entrepreneurial ability—are inherently limited.

• Opportunity Cost:

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

Assumptions of the Production Possibilities Frontier

• Full Employment: All available resources are utilized.

• Fixed Resources: The quantity of resources available for production does not change.

• Fixed Technology: Technology remains constant during the analysis.

• Two Goods:

  • Example:

  • Pizzas symbolize consumer goods.

  • Industrial robots symbolize capital goods.

Example Representation of PPF

• Graph Data Points:

  • Pizzas (00,000s): 0, 1, 2, 3, 4

  • Robots (000s): 10, 9, 7, 4, 0

  • Graphically denoted as points A (inefficient), B, C, D, E (unattainable).

  • Axes: Pizzas on horizontal axis (hundred thousands) and Robots on vertical axis (thousands).

The Law of Increasing Opportunity Costs

• Graphical Representation:

  • Amount of Pizzas vs. Robots required as opportunity cost increases as production expands.

• Specific Opportunity Costs:

  • Opportunity cost of first 100,000 pizzas = 1,000 robots.

  • Opportunity cost of second 100,000 pizzas = 2,000 robots.

  • Opportunity cost of third 100,000 pizzas = 3,000 robots.

  • Opportunity cost of fourth 100,000 pizzas = 4,000 robots.

• Shape of the Curve:

  • Concave to the origin indicating increasing opportunity costs as production expands.

• Economic Explanation:

  • Resources are typically better suited to produce one good rather than the other, leading to specialization.

Trade-offs in Health Care Spending

• Real-World Implications: Spending more on health care necessitates spending less on other goods and services (e.g., education, infrastructure).

• Government Budgetary Choices: If taxes are increased for healthcare, individuals will subsequently have less disposable income.

• Decision-Making:

  • Questions arise about budget cuts in other areas, e.g., education or public safety, indicating the need for trade-offs due to resource scarcity.

• Allocative Efficiency: Choosing the best point on the production possibilities frontier reflects optimal resource allocation.

Economic Growth

• Illustrative Figures:

  • Figure 2.3 describes how, with increased economic resources and technological advancements, the economy moves from point A to point B, enabling more operations and car production.

• Understanding Economic Growth:

  • Economic growth is defined as the ability of the economy to increase the production of goods and services.

Comparative Advantage and Trade

• Understanding Trade:

  • Defined as the act of buying and selling of goods and services.

• Benefits of Trade:

  • Enables individuals to improve their state by enhancing both production and consumption capabilities.

Specialization and Gains from Trade

• Your Production Possibilities:

  • Individual PPF shows that dedicating full time either to apples (20 kg) or cherries (20 kg) maximizes fruit picking.

• Neighbor's Production Possibilities:

  • Neighbor can pick 30 kg of apples or 60 kg of cherries, demonstrating different production capabilities.

Opportunity Costs Table

• Comparative Opportunity Costs for Picking Fruits:

  • You:

  • Opportunity Cost of 1 kg of Apples = 1 kg of Cherries.

  • Opportunity Cost of 1 kg of Cherries = 1 kg of Apples.

  • Neighbor:

  • Opportunity Cost of 1 kg of Apples = 2 kg of Cherries.

  • Opportunity Cost of 1 kg of Cherries = 0.5 kg of Apples.

Gains from Trade Example

• Without Trade Example:

  • You consume 8 kg of apples and 12 kg of cherries; Your neighbor consumes 9 kg of apples and 42 kg of cherries.

• Specialization Effects:

  • If you specialize in apples and your neighbor in cherries and trade occurs, you can gain 10 kg of apples and trade for 15 kg cherries, resulting in increased consumption compared to pre-trade levels.

  • You both can achieve unattainable consumption combinations by trading.

Absolute Advantage vs. Comparative Advantage

• Absolute Advantage:

  • The capacity of an individual, firm, or country to produce more of a good or service than competitors, assuming identical resources.

• Comparative Advantage:

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

Importance of Comparative Advantage in Trade

• Specialization Benefits:

  • Comparative advantage underscores the basis for trade.

  • Entities prosper through specialization in their comparative advantage goods, acquiring others through trade.

Examples of Comparative Advantage and Gains from Trade

• Canada and United States Case Study:

  • Demonstrates comparative advantage in video games and nacho chips. Canada has a comparative advantage in video games while the U.S. holds it in nacho chips.

• Scenarios Before and After Trade:

  • Before Trade:

  • Canada: 30 video games, 15 nacho chips.

  • U.S.: 10 video games, 160 nacho chips.

  • After Trade Maximizes Production:

  • Canada specializes in video games and U.S. in nachos, showcasing increased output and consumption benefits.

Market System Overview

• Market Definition: A collective of buyers and sellers of a good or service and the mechanism that facilitates their transactions.

• Types of Markets:

  • Product Market: Exchanges for goods and services.

  • Factor Market: Exchanges for the inputs such as labor and capital.

Factors of Production

• Categories:

  • Labour: All types of work, from part-time jobs to executive positions.

  • Capital: Physical assets (computers, machines, buildings) facilitating the production of goods.

  • Natural Resources: Includes land and raw materials.

  • Entrepreneur: Operates a business and coordinates production inputs.

Circular Flow of Income

• Concept Description: Model illustrating how market participants interact throughout production, income, and expenditures.

• Circular-Flow Diagram Features:

  • The interaction between households and firms represented through blue (factors of production), red (goods/services flow), and green (funds flow) arrows.

Gains from Free Markets

• Characteristics of Free Markets: Markets operate with minimal government restrictions, allowing optimal production and sale of goods and services.

• Market Mechanism:

  • Reflects rational self-interest in market participants, driven by financial incentives; adaptability ensures responding to consumer wants.

Historical Reference

• Adam Smith's Contribution: The concept of the “invisible hand,” representing market forces that guide individual actions to produce societal benefits.

Legal Foundations of a Successful Market System

• Ownership Rights: Ownership enables exclusive control over property and profiting from its use.

• Enforcement of Rights: Ensures efficient market functionality; poorly enforced rights inhibit production capacity.

• Intellectual Property Rights: Patents and copyrights shield creators' rights, incentivizing innovation.

• Government Role: Essential in establishing and upholding a legal framework that facilitates market success.