Chapter 2: Trade-offs, Comparative Advantage, and The Market System – Microeconomics Study Notes

Chapter 2: Trade-offs, Comparative Advantage, and The Market System

GPS (Guided Path to Study)

• Scarcity

• Scarcity & Tradeoff Example: Hypothetical Economy

  • Production Possibilities Frontier (PPF)

  • Feasible Output

  • Efficient Output

• Increasing Marginal Opportunity Cost

• Economic Growth

• The Market System

• Trade, Specialization, Exchange, and Comparative Advantage

  • Trade

  • Specialization

  • Absolute Advantage

  • Comparative Advantage

  • Is Specialization & Trade Better Than Self-Sufficiency?

Scarcity

Definition and Fundamental Questions

Scarcity is a central concept in economics, referring to the limited nature of society's resources in contrast to unlimited human wants. This condition forces societies to make choices about resource allocation.

• Three Fundamental Economic Questions:

  1. What to produce?

  2. How to produce?

  3. For whom to produce?

• Trade-offs: Because resources are limited, producing more of one good or service means producing less of another.

• Examples:

  • Individual level: Choosing how to spend 24 hours (sleep, study, socialize) or $100.

  • Societal level: Allocating tax revenue to safe streets or free college education.

Scarcity & Trade-offs

Hypothetical Economy Example

Consider a society that produces two goods (outputs): Candy Bars (C) and Broccoli (B), using two inputs (factors of production): Land (L) and Workers (W). The society has a fixed amount of resources (W = 200, L = 200).

• Trade-off: Allocating resources to produce more of one good means less of the other can be produced.

Production Possibilities Frontier (PPF)

Definition and Interpretation

The Production Possibilities Frontier (PPF) is a graph that shows all possible combinations of two goods or services that can be produced using all available resources efficiently.

• Efficient Output: Points on the PPF represent combinations where resources are fully and efficiently utilized.

• Feasible Output: Points inside the PPF are attainable but inefficient (not all resources are used). Points outside the PPF are unattainable with current resources.

PPF Example

Suppose the PPF for candy bars and broccoli is a straight line from (0, 200) to (100, 0):

• Moving from 0 to 100 broccoli requires giving up 200 candy bars.

• Opportunity Cost: The slope of the PPF ($= -2$) shows the opportunity cost of producing broccoli in terms of candy bars.

Formulas:

• Opportunity cost of 1 Broccoli (B): $\text{OC}_{B} = 2\ \text{Candy Bars}$

• Opportunity cost of 1 Candy Bar (C): $\text{OC}_{C} = 0.5\ \text{Broccoli}$

Efficiency and Feasibility

Definitions

• Productive Efficiency: All points on the PPF are productively efficient; all resources are fully employed.

• Feasible Output: Any combination of goods that can be produced with available resources.

• Unattainable Output: Points outside the PPF cannot be reached with current resources.

Increasing Marginal Opportunity Cost

Why the PPF is Bowed Out

In reality, the PPF is often bowed outward (concave) due to increasing marginal opportunity costs. As more resources are devoted to producing one good, the opportunity cost of producing additional units increases because resources are not perfectly adaptable.

• Example: Shifting resources from military goods to civilian goods increases the opportunity cost as less suitable resources are used.

Economic Growth

Shifting the PPF

Economic growth is the ability of an economy to produce more goods and services over time. Growth shifts the PPF outward, allowing more of both goods to be produced.

• Sources of Growth:

  • Increase in labor force

  • Increase in capital stock

  • Technological innovation

• Selective Growth: Technological improvement in one sector shifts the PPF outward for that good only.

The Market System

Definition and Structure

The market system is a network of buyers and sellers who exchange goods and services. It includes product markets (for goods and services) and factor markets (for resources).

• Factors of Production:

  • Labor: All types of work, from part-time jobs to management.

  • Capital: Physical assets like machinery and tools.

  • Natural Resources: Land, water, minerals.

  • Entrepreneurship: The ability to organize resources and take risks to create goods and services.

Circular Flow of Income

The circular flow diagram illustrates how households and firms interact in product and factor markets, exchanging goods, services, and resources.

The Role of the Entrepreneur

• Entrepreneur: Someone who organizes the factors of production to create goods and services, often introducing innovations and taking risks.

• Impact: Entrepreneurs drive economic growth and improve living standards.

Legal Basis of a Successful Market System

Property Rights and Contracts

• Property Rights: Legal rights to use, buy, or sell property.

• Enforcement: Well-enforced property rights and contracts increase economic efficiency and allow the economy to reach its PPF.

Specialization, Trade, and Comparative Advantage

Definitions and Examples

• Specialization: Focusing production on a limited range of activities to increase efficiency.

• Trade: Exchanging goods and services to obtain what is desired.

• Absolute Advantage: The ability to produce more of a good with the same resources.

• Comparative Advantage: The ability to produce a good at a lower opportunity cost than another producer.

Example Table: Comparative Advantage

Producer	Berries (lbs/day)	Fish (units/day)
Sevi	15	30
Eylem	10	10

• Sevi has an absolute advantage in both berries and fish.

• Comparative advantage is determined by opportunity cost:

  • Sevi's OC of 1 fish = 0.5 berries; OC of 1 berry = 2 fish.

  • Eylem's OC of 1 fish = 1 berry; OC of 1 berry = 1 fish.

  • Sevi has comparative advantage in fish; Eylem in berries.

Formulas:

• Opportunity Cost (OC) = $\frac{\text{Loss in Good Y}}{\text{Gain in Good X}}$

Specialization & Trade vs. Self-Sufficiency

• Specialization and trade allow total production to exceed what is possible under self-sufficiency.

• Each producer specializes in the good for which they have comparative advantage, then trades for other goods.

Example Table: Production with and without Trade

Producer	Berries (Self-sufficiency)	Fish (Self-sufficiency)	Berries (Specialization & Trade)	Fish (Specialization & Trade)
Sevi	8	20	0	30
Eylem	18	6	10	10
Total	26	26	10	40

Conclusion: Specialization and trade increase total output and benefit all parties involved.

Additional info: Some context and examples have been expanded for clarity and completeness, including formulas and tables for opportunity cost and comparative advantage.