R.

GLENN

HUBBARD
ANTHONY PATRICK

O’BRIEN

FIFTH EDITION
© 2015 Pearson Education, Inc..
 CHAPTER
CHAPTER

2 Trade-offs, Comparative
Advantage, and the Market System
Chapter Outline and
Learning Objectives
2.1 Production Possibilities
Frontiers and Opportunity
Costs
2.2 Comparative Advantage and
Trade

2.3 The Market System

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Scarcity and Trade-offs
Households, firms and governments continually face decisions about
how best to use their scarce resources.

Scarcity: a situation in which unlimited wants exceed the limited

resources available to fulfill those wants.

Scarcity requires trade-offs. Economics teaches us tools to help make

good trade-offs.

Example: When deciding how to use its scarce workers and

machinery, if Tesla wants to produce more Model X SUVs, those
resources will not be available to produce Model S sedans.

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 Production Possibilities Frontiers and Opportunity
Costs

2.1 LEARNING OBJECTIVE

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

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Production Possibilities Frontier
A production possibilities frontier (PPF) is a curve showing the
maximum attainable combinations of two products that may be
purchases with available resources and current technology.

Question: Is the PPF a positive or normative tool?

Answer: Positive; it shows “what is”, not “what should be”.

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A Production Possibilities Frontier for Tesla
Tesla can produce sedans
and/or SUVs.
If it wants to produce more
sedans, it must reduce the
number of SUVS.
• Points on the PPF are
attainable for Tesla.
• Points below the curve are
inefficient.
• Points above the curve are
unattainable with current
resources.

Figure 2.1 Tesla’s production

© 2015 Pearson Education, Inc. possibilities frontier 6
Tesla Can Trade Off Sedans for SUVs
To produce 20 more SUVs
(e.g. moving from A to B),
Tesla must produce 20 fewer
sedans.
• The 20 fewer sedans is the
opportunity cost of
producing 20 more SUVs.

Opportunity cost: The

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

Figure 2.1 Tesla’s production

© 2015 Pearson Education, Inc. possibilities frontier 7
Increasing Marginal Opportunity Costs
On the previous slide,
opportunity costs were
constant.

But opportunity costs are

often increasing.

Why? Some resources are

better suited to one task than
another. The first resources to
“switch” are the one best
suited to switching.
Figure 2.2 Increasing marginal
opportunity costs
The more resources already devoted to an activity, the smaller
the payoff to devoting additional resources to that activity.
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Economic Growth on the PPF
As more economic resources
become available, the
economy can move from point
A to point B, producing more
tanks and more automobiles.

Shifts in the production

possibilities frontier represent
economic growth.
Figure 2.3a Economic growth

Economic growth: the ability of the economy to increase the

production of goods and services.

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Technological Change in One Industry
This panel shows
technological improvement in
the automobile industry.

The quantity of tanks that can

be produced remains
unchanged.

As in the previous slide, many

previously unattainable Figure 2.3b Economic growth
combinations are now
attainable.

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 Making
the A PPF for Exam Grades
Connection

Suppose you have a limited amount of time to study for two

exams, Economics and Accounting.

What would the production possibilities curve for the exam

grades look like?

A straight line, like the PPF for sedans and SUVs

or
A bowed-outward curve, like the PPF for tanks and
automobiles?

Why? The first hour spent studying Economics

is much more valuable than the last hour…

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 Comparative Advantage and Trade

2.2 LEARNING OBJECTIVE

Describe comparative advantage and explain how it serves as the basis for
trade.

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PPFs for Picking Apples and Cherries
You and your neighbor each
have a limited time to pick
cherries and/or apples.

If you spend your time picking

cherries, you can pick 20
pounds of cherries.

If you spend you time picking

Figure 2.4a Production possibilities for apples, you can pick 20
you and your neighbor, pounds of apples.
without trade

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PPFs for Picking Apples and Cherries—continued
If your neighbor spends all of
her time picking cherries, she
can pick 60 pounds of
cherries.

If your neighbor spends all of

her time picking apples, she
can pick 30 pounds of apples.

Figure 2.4b Production possibilities for

you and your neighbor,
without trade

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Specialization and Trade
What if you and your neighbor decided to specialize and trade?

Trade: The act of buying and selling.

Could your neighbor benefit from trade? She is better at picking both
apples and cherries…

Both of you can benefit from trade, by specializing in what you are
relatively good at. Let’s see how…

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Gains from Specialization and Trade
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).
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Gains from Specialization and Trade—continued
Figure 2.5 Gains from Trade

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 trade.
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Summary of the Gains from Trade

You Your Neighbor

Apples Cherries Apples Cherries

(in pounds) (in pounds) (in pounds) (in pounds)
Production and consumption
without trade 8 12 9 42
Production with trade 20 0 0 60
Consumption with trade 10 15 10 45
Gains from trade (increased
consumption) 2 3 1 3

Table 2.1 A summary of the

gains from trade

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Explaining the Gains from Specialization and Trade
How could both of you benefit from trade, when your neighbor was so
much better than you?
Economists say your neighbor had an absolute advantage in both
cherry- and apple-picking, but you had a comparative advantage in
picking apples.
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.
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.

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Comparative Advantage and the Gains from Trade

Opportunity Cost of Picking Opportunity Cost of Picking

1 Pound of Apples 1 Pound of Cherries
You 1 pound of cherries 1 pound of apples

Your Neighbor 2 pounds of cherries 0.5 pound of apples

Table 2.2 Opportunity costs of

picking apples and
cherries

The basis for trade is comparative advantage, not absolute

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.

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 Making
the Comparative Advantage and Housework
Connection
People living together have to divide up household chores.

Basic economic concepts like comparative advantage can provide

useful insight in the division of labor.

Suppose Jack is faster than Jill at both cooking and laundry.

However:
• Jack is MUCH faster at preparing tasty meals, while
• Jack is only a little faster at doing laundry

Jack’s comparative advantage is in cooking—to cook a tasty meal, he

gives up the opportunity to perform less laundry than Jill—so he
should specialize in this, while Jill specializes in laundry.

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 The Market System

2.3 LEARNING OBJECTIVE

Explain the basic idea of how a market system works.

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The Two Key Groups in a Modern Economy

Two key groups participate in the All types of work

modern economy:
• Households consist of individuals
who provide the factors of Physical capital used
production: labor, capital, natural to produce other
goods
resources, and entrepreneurial
ability.
• Households receive Land, water, oil, ore,
payments for these factors raw materials, etc.
by selling them to firms in
factor markets.
The ability to bring
• Firms supply goods and services together factors of
to product markets; households production
buy these products from the firms.
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The Circular-Flow Diagram
Circular-flow diagram: A 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.

Figure 2.6 The circular-flow

© 2015 Pearson Education, Inc. diagram 24
The Circular-Flow Diagram—a Simplified Model
Like all economic models,
the circular-flow diagram is
a simplified version of
reality:
• No government

• No financial system

• No foreign buyers and

sellers of goods

We will explore these

sectors in later chapters.

Figure 2.6 The circular-flow

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The Gains from Free Markets
A free market is one 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.

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

This concept is not new: Adam Smith argued for free markets in his
1776 treatise, An Inquiry into the Nature and Causes of the Wealth of
Nations.

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The Beauty of the Market Mechanism
It is not immediately obvious that markets will do better than centrally-
planned systems for satisfying human desires.

After all, individuals are acting only in their own rational self-interest.

But markets with flexible prices allow the collective actions of

households and firms to signal the relative worth of goods and
services.

In this way, the “invisible hand” allows individual responses to

collectively end up satisfying the wants of consumers.

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 Making
the A Story of the Market System in Action
Connection
How do you make an iPad?

Although Apple engineers designed the

iPad, Apple does not manufacture iPad
components, nor does it assemble the
final product.

Hundreds of firms are involved; many

probably don’t even know their
products will be used in an iPad.

But guided by their own self-interest,

they all contribute to the final product—
without any desire to enrich Apple or
provide enjoyment for iPad purchasers.
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The Role of the Entrepreneur
An entrepreneur is someone who brings together the factors of
production—land, labor, and capital—to produce goods and services.

The best entrepreneurs create products that consumers never even

knew they wanted.

“If I had asked my customers what they wanted, they

would have said a faster horse.”
- Henry Ford

Entrepreneurs make a vital contribution to economic growth, often

with considerable personal risk and sacrifice.

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Selected Products and Their Inventors
Entrepreneurs make a vital Product Inventor
contribution to economic Air conditioning William Haviland Carrier
growth by Airplane Orville and Wilbur Wright

• Responding to consumer Automobile, mass produced Henry Ford

demand Biomagnetic imaging Raymond Damadian
• Introducing new products Biosynthetic insulin Herbert Boyer

DNA fingerprinting Alec Jeffries

Government policies … …

encouraging entrepreneurship Vacuum tube Philo Farnsworth

are likely to increase Zipper Gideon Sundback
economic growth and raise
standards of living.

Table 2.3 Important products

introduced by
entrepreneurs

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The Legal Basis of a Successful Market System
In a free market, government does not restrict how firms produce and
sell goods, or how they employ factors of production.

However governments must provide a sound legal environment that

will allow the market system to succeed, including:

Protection of private property

• When criminals can take your wages or profits, households and
firms 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—
are essential here.
Enforcement of contracts and property rights
• Important for transactions across time to occur.
• An independent court system is critical here.
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 Making
the Who Owns The Wizard of Oz?
Connection
Copyrights and patents protect
the intellectual property of
creators and inventors, in order
to encourage innovation.

But sometimes they work

against innovation; for
example, when Disney wanted
to remake the classic 1939
movie The Wizard of Oz, they
had to change many details to
avoid infringing on Warner
Bros’ copyright.

While copyrights provide essential protections, these do not come

without costs.
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Common Misconceptions to Avoid
The production possibilities frontier should never bow inward (why?).

The PPF tells us what can be produced, not what should be

produced.

Just because someone is better or worse at everything, doesn’t mean

trade with them cannot be beneficial.
• The basis for trade is comparative advantage, not absolute
advantage!

Free markets raise the standard of living; but that doesn’t mean there
is no role for governments.
• Governments must provide a sound legal environment to allow the
market system to succeed.

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