hubbard obrien macroeconomics 2nd edition chapter 02

Chapter 2

Trade-offs, ComparativeAdvantage, and theMarket System

Managers MakingChoices at BMW

When you think of cars that combinefine engineering, high performance,and cutting-edge styling, you are likelyto think of BMW. The BayerischeMotoren Werke, or Bavarian MotorWorks, was founded in Germany in1916. Today, BMW employs morethan 100,000 workers in 23 factoriesin 15 countries to produce eight carmodels. In 2007, it had worldwidesales of nearly 1.5 million cars.

To compete in the automobilemarket, the managers of BMW mustmake many strategic decisions, suchas whether to introduce a new carmodel. In 2006, for example, BMWannounced that it would introduce ahydrogen-powered version of the 7-Series sedan and was also working onfuel-cell powered cars. Another strate-gic decision BMW’s managers face iswhere to focus their advertising. Inthe late 1990s, for example, some ofBMW’s managers opposed advertis-ing in China because they were skepti-cal about the country’s sales potential.

Other managers, however, argued thatrising incomes were rapidly increasingthe size of the Chinese market. BMWdecided to advertise in China, and ithas become the company’s eighth-largest market, with sales increasing bymore than 35 percent in 2007 alone.

Over the years, BMW’s managershave also faced the strategic decisionof whether to concentrate productionin factories in Germany or to buildnew factories in its overseas markets.Keeping production in Germanymakes it easier for BMW’s managers tosupervise production and to employGerman workers, who generally havehigh levels of technical training.Building factories in other countries,however, has two benefits. First, thelower wages paid to workers in othercountries reduce the cost of manufac-turing vehicles. Second, BMW canreduce political friction by producingvehicles in the same country in whichit sells them. In 2003, BMW opened aplant at Shenyang, in northeast China,to build its 3-Series and 5-Series cars.Previously, in 1994, BMW opened aU.S. factory in Spartanburg, SouthCarolina, which currently produces

the Z4 roadster and X5 sports utilityvehicle (SUV) for sale both in theUnited States and worldwide.

Managers also face smaller-scale—or tactical—business deci-sions. For instance, for many years,BMW used two workers to attach thegearbox to the engine in each car.Then BMW engineers developed anew method of attaching the gearboxusing a robot rather than workers. Inchoosing which method to use, man-agers at BMW faced a trade-offbecause the robot method had ahigher cost, but installed the gearboxin exactly the correct position, whichreduces engine noise when the car isdriven. Ultimately, the managersdecided to adopt the robot method. Asimilar tactical business decision mustbe made in scheduling production atBMW’s Spartanburg, South Carolina,plant. The plant produces both the Z4and the X5 models, and each monthmanagers must decide the quantity ofeach model that should be produced.

AN INSIDE LOOK on page 58discusses how BMW managers in theSpartanburg plant prepared to manu-facture a new sports-activity coupe.

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LEARNING ObjectivesAfter studying this chapter, youshould be able to:

2.1 Use a production possibilitiesfrontier to analyze opportunitycosts and trade-offs, page 38.

2.2 Understand comparativeadvantage and explain how it isthe basis for trade, page 44.

2.3 Explain the basic idea of how amarket system works, page 50.

37

Economics in YOUR Life!

The Trade-offs When You Buy a CarWhen you buy a car, you probably consider factors such as safety and gas mileage. To increase gasmileage, automobile manufacturers make cars small and light. Large cars absorb more of the impactof an accident than do small cars. As a result, people are usually safer driving large cars than smallcars. What can we conclude from these facts about the relationship between safety and gasmileage? Under what circumstances would it be possible for car manufacturers to make cars saferand more fuel efficient? As you read the chapter, see if you can answer these questions. You can checkyour answer against those provided at the end of the chapter. >> Continued on page 56


2.1 LEARNING OBJECTIVE

38 PA R T 1 | Introduction

Scarcity The situation in whichunlimited wants exceed the limitedresources available to fulfill thosewants.

In a market system, managers at most firms must make decisions like those made by

BMW’s managers. The decisions managers face reflect a key fact of economic life:

Scarcity requires trade-offs. Scarcity exists because we have unlimited wants but only lim-

ited resources available to fulfill those wants. Goods and services are scarce. So, too, are

the economic resources, or factors of production—workers, capital, natural resources, and

entrepreneurial ability—used to make goods and services. Your time is scarce, which means

you face trade-offs: If you spend an hour studying for an economics exam, you have one less

hour to spend studying for a psychology exam or going to the movies. If your university

decides to use some of its scarce budget funds to buy new computers for the computer labs,

those funds will not be available to buy new books for the library or to resurface the student

parking lot. If BMW decides to devote some of the scarce workers and machinery in its

Spartanburg assembly plant to producing more Z4 roadsters, those resources will not be avail-

able to produce more X5 SUVs.

Many of the decisions of households and firms are made in markets. One key activity

that takes place in markets is trade. Trade involves the decisions of millions of households

and firms spread around the world. By engaging in trade, people can raise their standard of

living. In this chapter, we provide an overview of how the market system coordinates the

independent decisions of these millions of households and firms. We begin our analysis of

the economic consequences of scarcity and the working of the market system by introducing

an important economic model: the production possibilities frontier.

2.1 | Use a production possibilities frontier to analyze opportunity costsand trade-offs.

Production Possibilities Frontiers and Opportunity CostsAs we saw in the opening to this chapter, BMW operates an automobile factory inSpartanburg, South Carolina, where it assembles Z4 roadsters and X5 SUVs. Because thefirm’s resources—workers, machinery, materials, and entrepreneurial skills—are lim-ited, BMW faces a trade-off: Resources devoted to producing Z4s are not available forproducing X5s and vice versa. Chapter 1 explained that economic models can be usefulin analyzing many questions. We can use a simple model called the production possibili-ties frontier to analyze the trade-offs BMW faces in its Spartanburg plant. A productionpossibilities frontier (PPF ) is a curve showing the maximum attainable combinationsof two products that may be produced with available resources and current technology.In BMW’s case, the two products are Z4 roadsters and X5 SUVs, and the resources areBMW’s workers, materials, robots, and other machinery.

Graphing the Production Possibilities FrontierFigure 2-1 uses a production possibilities frontier to illustrate the trade-offs that BMWfaces. The numbers from the table are plotted in the graph. The line in the graph isBMW’s production possibilities frontier. If BMW uses all its resources to produce road-sters, it can produce 800 per day—point A at one end of the production possibilitiesfrontier. If BMW uses all its resources to produce SUVs, it can produce 800 per day—point E at the other end of the production possibilities frontier. If BMW devotesresources to producing both vehicles, it could be at a point like B, where it produces 600roadsters and 200 SUVs.

All the combinations either on the frontier—like A, B, C, D, and E—or inside thefrontier—like point F—are attainable with the resources available. Combinations on

Production possibilities frontier(PPF ) A curve showing themaximum attainable combinations of two products that may be produced with available resources and currenttechnology.

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C H A P T E R 2 | Trade-offs, Comparative Advantage, and the Market System 39

Opportunity cost The highest-valued alternative that must be givenup to engage in an activity.

the frontier are efficient because all available resources are being fully utilized, and thefewest possible resources are being used to produce a given amount of output.Combinations inside the frontier—like point F—are inefficient because maximum out-put is not being obtained from the available resources—perhaps because the assemblyline is not operating at capacity. BMW might like to be beyond the frontier—at a pointlike G, where it would be producing 600 roadsters and 500 SUVs—but points beyondthe production possibilities frontier are unattainable, given the firm’s currentresources. To produce the combination at G, BMW would need more machines ormore workers.

Notice that if BMW is producing efficiently and is on the production possibilitiesfrontier, the only way to produce more of one vehicle is to produce less of the other vehi-cle. Recall from Chapter 1 that the opportunity cost of any activity is the highest valuedalternative that must be given up to engage in that activity. For BMW, the opportunitycost of producing one more SUV is the number of roadsters the company will not beable to produce because it has shifted those resources to producing SUVs. For example,in moving from point B to point C, the opportunity cost of producing 200 more SUVsper day is the 200 fewer roadsters that can be produced.

What point on the production possibilities frontier is best? We can’t tell without fur-ther information. If consumer demand for SUVs is greater than demand for roadsters,the company is likely to choose a point closer to E. If demand for roadsters is greaterthan demand for SUVs, the company is likely to choose a point closer to A.

Quantity ofroadstersproduced

per day

Quantity of SUVsproduced per day

800

600

400

200

200 400 6000

A

B

C

D

E

G

F300

100 500 800

Choice

A

B

C

D

E

Quantity of SUVs Produced

0

200

400

600

800

Quantity of Roadsters Produced

BMW’s Production Choices at Its Spartanburg Plant

800

600

400

200

0

A combination thatis unattainable withcurrent resources

A combination that isinefficient because not allresources are being used

BMW’s productionpossibilities frontiershowing its trade-offbetween producingroadsters and SUVs

Figure 2-1BMW’s Production PossibilitiesFrontier

BMW faces a trade-off: To build one moreroadster, it must build one less SUV. Theproduction possibilities frontier illustratesthe trade-off BMW faces. Combinations onthe production possibilities frontier—likepoints A, B, C, D, and E—are technicallyefficient because the maximum output isbeing obtained from the available resources.Combinations inside the frontier—like pointF—are inefficient because some resources arenot being used. Combinations outside thefrontier—like point G—are unattainable withcurrent resources.



Solved Problem|2-1Drawing a Production Possibilities Frontier for Rosie’s Boston Bakery

Rosie’s Boston Bakery specializes in cakes and pies. Rosiehas 5 hours per day to devote to baking. In 1 hour, Rosie canprepare 2 pies or 1 cake.

a. Use the information given to complete the followingtable:

HOURS SPENT MAKING QUANTITY MADE

CHOICE CAKES PIES CAKES PIES

A 5 0

B 4 1

C 3 2

D 2 3

E 1 4

F 0 5

b. Use the data in the table to draw a production possi-bilities frontier graph illustrating Rosie’s trade-offsbetween making cakes and making pies. Label the verti-cal axis “Quantity of cakes made.” Label the horizontalaxis “Quantity of pies made.” Make sure to label the val-ues where Rosie’s production possibilities frontierintersects the vertical and horizontal axes.

c. Label the points representing choice D and choice E. IfRosie is at choice D, what is her opportunity cost ofmaking more pies?

SOLVING THE PROBLEM:Step 1: Review the chapter material. This problem is about using production pos-

sibilities frontiers to analyze trade-offs, so you may want to review the section “Graphing the Production Possibilities Frontier,” which begins onpage 38.

Step 2: Answer question (a) by filling in the table. If Rosie can produce 1 cake in1 hour, then with choice A, she will make 5 cakes and 0 pies. Because shecan produce 2 pies in 1 hour, with choice B, she will make 4 cakes and 2pies. Using similar reasoning, you can fill in the remaining cells in the tableas follows:

HOURS SPENT MAKING QUANTITY MADE

CHOICE CAKES PIES CAKES PIES

A 5 0 5 0

B 4 1 4 2

C 3 2 3 4

D 2 3 2 6

E 1 4 1 8

F 0 5 0 10

Step 3: Answer question (b) by drawing the production possibilities frontiergraph. Using the data in the table in Step 2, you should draw a graph thatlooks like this:


Trade-offs: Hurricane Katrina,Tsunami Relief, and CharitableGivingWhen Hurricane Katrina hit the Gulf Coast region in August

2005, it resulted in massive flooding that destroyed large sections of New Orleans andother towns in Louisiana, Mississippi, Alabama, and Texas. More than 1,800 people losttheir lives. In response, there was a massive outpouring of charitable donations to aidthe victims. More than two-thirds of Americans donated money to hurricane relief.Although these funds helped to reduce the suffering of many hurricane victims, dona-tions to some other causes actually declined. For instance, the head of the United Way inAlleghany County, Pennsylvania, indicated that it had suffered a decline in donationsduring 2005: “We’re seeing declines this year, not all entirely due to the economy but alsodue to the effect of so much fund raising in August and September for hurricanesKatrina and Rita.” The director of the Women’s Center and Shelter of Great Pittsburgh

More funds for Katrina relief meantless funds for other charities.

|Makingthe

Connection

>> End Solved Problem 2-1


Quantity ofcakes made

Quantityof pies made

5

100

Production possibilities frontiershowing the trade-off betweenmaking cakes and making pies

If Rosie devotes all 5 hours to making cakes, she will make 5 cakes. Therefore,her production possibilities frontier will intersect the vertical axis at 5 cakesmade. If Rosie devotes all 5 hours to making pies, she will make 10 pies.Therefore, her production possibilities frontier will intersect the horizontalaxis at 10 pies made.

Step 4: Answer question (c) by showing choices D and E on your graph. The pointsfor choices D and E can be plotted using the information from the table:

Moving from choice D to choice E increases Rosie’s production of pies by 2but lowers her production of cakes by 1. Therefore, her opportunity cost ofmaking 2 more pies is making 1 less cake.

YOUR TURN: For more practice, do related problem 1.9 on page 61 at the end of this chapter.

Quantity ofcakes made

Quantityof pies made

5

2

1

10860

Choice D

Choice E



had a similar experience: “What they’ve told us is there are so many important causesthat they are aware of that they want to support. The choices are greater than whatthey’ve been faced with before.”

Unfortunately, the trade-off of an increase in charitable giving to one cause result-ing in a decrease in charitable giving to other causes is common following a disaster. InDecember 2004, an earthquake caused a tidal wave—or tsunami—to flood coastal areasof Indonesia, Thailand, Sri Lanka, and other countries bordering the Indian Ocean.More than 280,000 people died, and billions of dollars worth of property was destroyed.Governments and individuals around the world moved quickly to donate to reliefefforts. The U.S. government donated $950 million, and individual U.S. citizens donatedan additional $500 million. Both governments and individuals face limited budgets,however, and funds used for one purpose are unavailable to be used for another pur-pose. Although governments and individuals did increase their total charitable givingfollowing the tsunami disaster, much of the funds spent on tsunami relief appear to havebeen diverted from other uses. A difficult trade-off resulted: Giving funds to victims ofthe tsunami meant fewer funds were available to aid other good causes.

For example, some of the funds provided by the U.S. government for reconstructionin the tsunami-devastated areas came from existing aid programs. As a result, spendingon other aid projects in the region declined. Similarly, nonprofit organizations in NewYork City reported sharp declines in donations to the homeless and the poor, as donorsgave funds for tsunami relief instead. According to a report in the newspaper Crain’sNew York Business, “Some groups such as Bailey House, which helps homeless peoplewho have AIDS, have even started receiving letters from longtime donors warning thatthis year’s gifts are being redirected to the tsunami relief effort.” As one commentatorobserved, “The milk of human kindness is probably flowing at the usual rate in theUnited States. It’s just getting channeled in different directions.”

Source: Steve Levin, "Disaster Aid Is Extra Giving,” Pittsburgh Post Gazette, April 22, 2006; Jacqueline L. Salmon, “KatrinaCompassion Drives Disaster Donations to a Record,” Washington Post, June 19, 2006, p. A05; and Daniel Gross, “Zero-SumCharity,” Slate, January 20, 2005.

YOUR TURN: Test your understanding by doing related problem 1.10 on page 61 at the end

of this chapter.

Increasing Marginal Opportunity CostsWe can use the production possibilities frontier to explore issues related to the economyas a whole. For example, suppose we divide all the goods and services produced in theeconomy into just two types: military goods and civilian goods. In Figure 2-2, we let tanksrepresent military goods and automobiles represent civilian goods. If all the country’s

Tanks

Automobiles

400

200

200 400 5000

C

B

A

350

Increasing automobileproduction by 200 here . . .

. . . reduces tankproduction by only 50.

Increasing automobileproduction by 200 here . . .

. . . reduces tankproduction by 150.

Figure 2-2Increasing MarginalOpportunity Cost

As the economy moves down the productionpossibilities frontier, it experiences increasingmarginal opportunity costs because increasingautomobile production by a given quantityrequires larger and larger decreases in tankproduction. For example, to increaseautomobile production from 0 to 200—moving from point A to point B—theeconomy has to give up only 50 tanks. But toincrease automobile production by another200 vehicles—moving from point B to pointC—the economy has to give up 150 tanks.



Economic growth The ability ofthe economy to produce increasingquantities of goods and services.

resources are devoted to producing military goods, 400 tanks can be produced in oneyear. If all resources are devoted to producing civilian goods, 500 automobiles can beproduced in one year. Devoting resources to producing both goods results in the econ-omy being at other points along the production possibilities frontier.

Notice that this production possibilities frontier is bowed outward rather thanbeing a straight line. Because the curve is bowed out, the opportunity cost of automo-biles in terms of tanks depends on where the economy currently is on the productionpossibilities frontier. For example, to increase automobile production from 0 to 200—moving from point A to point B—the economy has to give up only 50 tanks. But toincrease automobile production by another 200 vehicles—moving from point B to pointC—the economy has to give up 150 tanks.

As the economy moves down the production possibilities frontier, it experiencesincreasing marginal opportunity costs because increasing automobile production by agiven quantity requires larger and larger decreases in tank production. Increasing mar-ginal opportunity costs occurs because some workers, machines, and other resources arebetter suited to one use than to another. At point A, some resources that are well suited toproducing automobiles are forced to produce tanks. Shifting these resources into pro-ducing automobiles by moving from point A to point B allows a substantial increase inautomobile production, without much loss of tank production. But as the economymoves down the production possibilities frontier, more and more resources that are bet-ter suited to tank production are switched into automobile production. As a result, theincreases in automobile production become increasingly smaller, while the decreases intank production become increasingly larger. We would expect in most situations thatproduction possibilities frontiers will be bowed outward rather than linear, as in theBMW example discussed earlier.

The idea of increasing marginal opportunity costs illustrates an important eco-nomic concept: The more resources already devoted to any activity, the smaller the payoffto devoting additional resources to that activity. For example, the more hours you havealready spent studying economics, the smaller the increase in your test grade from eachadditional hour you spend—and the greater the opportunity cost of using the hour inthat way. The more funds a firm has devoted to research and development during agiven year, the smaller the amount of useful knowledge it receives from each additionaldollar—and the greater the opportunity cost of using the funds in that way. The morefunds the federal government spends cleaning up the environment during a given year,the smaller the reduction in pollution from each additional dollar—and, once again, thegreater the opportunity cost of using the funds in that way.

Economic GrowthAt any given time, the total resources available to any economy are fixed. Therefore, ifthe United States produces more automobiles, it must produce less of something else—tanks in our example. Over time, though, the resources available to an economy mayincrease. For example, both the labor force and the capital stock—the amount of physi-cal capital available in the country—may increase. The increase in the available laborforce and the capital stock shifts the production possibilities frontier outward for theU.S. economy and makes it possible to produce both more automobiles and more tanks.Panel (a) of Figure 2-3 shows that the economy can move from point A to point B, pro-ducing more tanks and more automobiles.

Similarly, technological advance makes it possible to produce more goods with thesame amount of workers and machinery, which also shifts the production possibilitiesfrontier outward. Technological advance need not affect all sectors equally. Panel (b) ofFigure 2-3 shows the results of technological advance in the automobile industry thatincreases the quantity of automobile workers can produce per year while leavingunchanged the quantity of tanks that can be produced.

Shifts in the production possibilities frontier represent economic growth becausethey allow the economy to increase the production of goods and services, which ultimatelyraises the standard of living. In the United States and other high-income countries, the




Tanks

Automobiles

(a) Shifting out the production possibilities frontier (b) Technological change in the automobile undustry

400

500

200

450400 6255000

B

A

300

Tanks

Automobiles

400

8005000

automobile industry that increases the quantity of vehicles workers can produce peryear while leaving the maximum quantity of tanks that can be produced unchanged.Shifts in the production possibilities frontier represent economic growth.

Trade The act of buying or selling.

Figure 2-3 | Economic Growth

Panel (a) shows that as more economic resources become available and technologicalchange occurs, the economy can move from point A to point B, producing more tanksand more automobiles. Panel (b) shows the results of technological advance in the

market system has aided the process of economic growth, which over the past 200 yearshas greatly increased the well-being of the average person.

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

Comparative Advantage and TradeWe can use the ideas of production possibilities frontiers and opportunity costs tounderstand the basic economic activity of trade. Markets are fundamentally abouttrade, which is the act of buying and selling. Sometimes we trade directly, as when chil-dren trade one baseball card for another baseball card. But often we trade indirectly: Wesell our labor services as, say, an accountant, a salesperson, or a nurse for money, andthen we use the money to buy goods and services. Although in these cases, trade takesplace indirectly, ultimately the accountant, salesperson, or nurse is trading his or her ser-vices for food, clothing, and other goods and services. One of the great benefits to tradeis that it makes it possible for people to become better off by increasing both their pro-duction and their consumption.

Specialization and Gains from TradeConsider the following situation: You and your neighbor both have fruit trees on yourproperty. Initially, suppose you have only apple trees and your neighbor has only cherrytrees. In this situation, if you both like apples and cherries, there is an obvious opportu-nity for both of you to gain from trade: You trade some of your apples for some of yourneighbor’s cherries, making you both better off. But what if there are apple and cherrytrees growing on both of your properties? In that case, there can still be gains from trade.For example, your neighbor might be very good at picking apples, and you might bevery good at picking cherries. It would make sense for your neighbor to concentrate onpicking apples and for you to concentrate on picking cherries. You can then trade someof the cherries you pick for some of the apples your neighbor picks. But what if yourneighbor is actually better at picking both apples and cherries than you are?

We can use production possibilities frontiers (PPFs) to show how your neighborcan benefit from trading with you even though she is better than you are at picking bothapples and cherries. (For simplicity, and because it will not have any effect on the



Apples(pounds)

Cherries(pounds)

Your PPF Your neighbor's PPF

(a) Your production possibilities frontier (b) Your neighbor’s production possibilities frontier

20

200

Apples(pounds)

Cherries(pounds)

30

600

Devote all timeto picking apples

Cherries

0 pounds

Apples

You

20 pounds

Cherries

0 pounds

Apples

Your Neighbor

30 pounds

Devote all timeto picking cherries 20 pounds0 pounds 60 pounds 0 pounds

The table in this figure shows how many pounds of apples and how many pounds ofcherries you and your neighbor can each pick in one week. The graphs in the figureuse the data from the table to construct production possibilities frontiers (PPFs) foryou and your neighbor. Panel (a) shows your PPF. If you devote all your time to pick-

ing apples and none of your time to picking cherries, you can pick 20 pounds. If youdevote all your time to picking cherries, you can pick 20 pounds. Panel (b) shows thatif your neighbor devotes all her time to picking apples, she can pick 30 pounds. If shedevotes all her time to picking cherries, she can pick 60 pounds.

Figure 2-4 | Production Possibilities for You and Your Neighbor, without Trade

conclusions we draw, we will assume that the PPFs in this example are straight lines.)The table in Figure 2-4 shows how many apples and how many cherries you and yourneighbor can pick in one week. The graph in the figure uses the data from the table toconstruct PPFs. Panel (a) shows your PPF. If you devote all your time to picking apples,you can pick 20 pounds of apples per week. If you devote all your time to picking cher-ries, you can pick 20 pounds per week. Panel (b) shows that if your neighbor devotes allher time to picking apples, she can pick 30 pounds. If she devotes all her time to pickingcherries, she can pick 60 pounds.

The production possibilities frontiers in Figure 2-4 show how many apples andcherries you and your neighbor can consume, without trade. Suppose that when youdon’t trade with your neighbor, you pick and consume 8 pounds of apples and 12pounds of cherries per week. This combination of apples and cherries is represented bypoint A in panel (a) of Figure 2-5, on page 46. When your neighbor doesn’t trade withyou, she picks and consumes 9 pounds of apples and 42 pounds of cherries per week. Thiscombination of apples and cherries is represented by point B in panel (b) of Figure 2-5.

After years of picking and consuming your own apples and cherries, supposeyour neighbor comes to you one day with the following proposal: She offers to tradeyou 15 pounds of her cherries for 10 pounds of your apples next week. Should youaccept this offer? You should accept because you will end up with more apples andmore cherries to consume. To take advantage of her proposal, you should specializein picking only apples rather than splitting your time between picking apples andpicking cherries. We know this will allow you to pick 20 pounds of apples. You cantrade 10 pounds of apples to your neighbor for 15 pounds of her cherries. The resultis that you will be able to consume 10 pounds of apples and 15 pounds of cherries(point A' in panel (a) of Figure 2-5). You are clearly better off as a result of tradingwith your neighbor: You now can consume 2 more pounds of apples and 3 morepounds of cherries than you were consuming without trading. You have movedbeyond your PPF !



Absolute advantage The ability ofan individual, a firm, or a country toproduce more of a good or servicethan competitors, using the sameamount of resources.

Apples(pounds)

Cherries(pounds)

(a) Your production and consumption after trade (b) Your neighbor’s production and consumption with trade

20

108

2015120

Apples(pounds)

Cherries(pounds)

30

109

600

A

A'

B

B'

42

Your neighbor’sPPF

Your PPF

45

Your neighbor’sconsumptionwithout trade

Your consumptionwithout trade

Your consumptionwith trade

Your neighbor’sconsumptionwith trade

Your neighbor’sproductionwith trade

Your productionwith trade

When you don’t trade with your neighbor, you pick and consume 8 pounds of applesand 12 pounds of cherries per week—point A in panel (a). When your neighbordoesn’t trade with you, she picks and consumes 9 pounds of apples and 42 pounds ofcherries per week—point B in panel (b). If you specialize in picking apples, you canpick 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’scherries, you will be able to consume 10 pounds of apples and 15 pounds ofcherries—point A' in panel (a).Your neighbor can now consume 10 pounds of applesand 45 pounds of cherries—point B' in panel (b). You and your neighbor are bothbetter off as a result of trade.

Figure 2-5 | Gains from Trade

Your neighbor has also benefited from the trade. By specializing in picking onlycherries, she can pick 60 pounds. She trades 15 pounds of cherries to you for 10 poundsof apples. The result is that she can consume 10 pounds of apples and 45 pounds ofcherries (point B ' in panel (b) of Figure 2-5). This is 1 more pound of apples and 3 morepounds of cherries than she was consuming before trading with you. She also has movedbeyond her PPF. Table 2-1 summarizes the changes in production and consumptionthat result from your trade with your neighbor. (In this example, we chose one specificrate of trading cherries for apples—15 pounds of cherries for 10 pounds of apples.There are, however, many other rates of trading cherries for apples that would also makeyou and your neighbor better off.)

Absolute Advantage versus ComparativeAdvantagePerhaps the most remarkable aspect of the preceding example is that your neighborbenefits from trading with you even though she is better than you at picking both applesand cherries. Absolute advantage is the ability of an individual, a firm, or a country to

TABLE 2-1A 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



produce more of a good or service than competitors, using the same amount ofresources. Your neighbor has an absolute advantage over you in producing both applesand cherries because she can pick more of each fruit than you can in the same amountof time. Although it seems that your neighbor should pick her own apples and her owncherries, we have just seen that she is better off specializing in cherry picking and leavingthe apple picking to you.

We can consider further why both you and your neighbor benefit from specializingin picking only one fruit. First, think about the opportunity cost to each of you of pick-ing the two fruits. We saw from the PPF in Figure 2-4 that if you devoted all your time topicking apples, you would be able to pick 20 pounds of apples per week. As you movedown your PPF and shift time away from picking apples to picking cherries, you have togive up 1 pound of apples for each pound of cherries you pick (the slope of your PPF is−1). (For a review of calculating slopes, see the appendix to Chapter 1.) Therefore, youropportunity cost of picking 1 pound of cherries is 1 pound of apples. By the same rea-soning, your opportunity cost of picking 1 pound of apples is 1 pound of cherries. Yourneighbor’s PPF has a different slope, so she faces a different trade-off: As she shifts timefrom picking apples to picking cherries, she has to give up 0.5 pound of apples for every1 pound of cherries she picks (the slope of your neighbor’s PPF is −0.5). As she shiftstime from picking cherries to picking apples, she gives up 2 pounds of cherries for every1 pound of apples she picks. Therefore, her opportunity cost of picking 1 pound ofapples is 2 pounds of cherries, and her opportunity cost of picking 1 pound of cherries is0.5 pound of apples.

Table 2-2 summarizes the opportunity costs for you and your neighbor of pickingapples and cherries. Note that even though your neighbor can pick more apples in aweek than you can, the opportunity cost of picking apples is higher for her than for youbecause when she picks apples, she gives up more cherries than you do. So, even thoughshe has an absolute advantage over you in picking apples, it is more costly for her to pickapples than it is for you. The table also shows that her opportunity cost of picking cher-ries is lower than your opportunity cost of picking cherries. Comparative advantage isthe ability of an individual, a firm, or a country to produce a good or service at a loweropportunity cost than competitors. In apple picking, your neighbor has an absoluteadvantage over you, but you have a comparative advantage over her. Your neighbor hasboth an absolute and a comparative advantage over you in picking cherries. As we haveseen, you are better off specializing in picking apples, and your neighbor is better offspecializing in picking cherries.

Comparative Advantage and the Gains from TradeWe have just derived an important economic principle: The basis for trade is comparativeadvantage, not absolute advantage. The fastest apple pickers do not necessarily do muchapple picking. If the fastest apple pickers have a comparative advantage in some otheractivity—picking cherries, playing major league baseball, or being industrial engineers—they are better off specializing in that other activity. Individuals, firms, and countries arebetter off if they specialize in producing goods and services for which they have a com-parative advantage and obtain the other goods and services they need by trading. We willreturn to the important concept of comparative advantage in Chapter 8, which is devotedto the subject of international trade.

Comparative advantage The abilityof an individual, a firm, or a countryto produce a good or service at alower opportunity cost thancompetitors.

TABLE 2-2Opportunity Costs of PickingApples and Cherries

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



Don’t Let This Happen to YOU!Don’t Confuse Absolute Advantage and Comparative Advantage

First, make sure you know the definitions:

• Absolute advantage. The ability of an individual, afirm, or a country to produce more of a good or ser-vice than competitors, using the same amount ofresources. In our example, your neighbor has anabsolute advantage over you in both picking applesand picking cherries.

• Comparative advantage. The ability of an individual,a firm, or a country to produce a good or service at alower opportunity cost than competitors. In ourexample, your neighbor has a comparative advantage

in picking cherries, but you have a comparative advan-tage in picking apples.

Keep these two key points in mind:

1. It is possible to have an absolute advantage in produc-ing a good or service without having a comparativeadvantage. This is the case with your neighbor pickingapples.

2. It is possible to have a comparative advantage in pro-ducing a good or service without having an absoluteadvantage. This is the case with you picking apples.

YOUR TURN: Test your understanding by doing related

problem 2.7 on page 63 at the end of this chapter.

Solved Problem|2-2Comparative Advantage and the Gains from Trade

Suppose that Canada and the United States both producemaple syrup and honey. These are the combinations of thetwo goods that each country can produce in one day:

CANADA UNITED STATES

HONEY MAPLE SYRUP HONEY MAPLE SYRUP(IN TONS) (IN TONS) (IN TONS) (IN TONS)

0 60 0 50

10 45 10 40

20 30 20 30

30 15 30 20

40 0 40 10

50 0

a. Who has a comparative advantage in producing maplesyrup? Who has a comparative advantage in producinghoney?

b. Suppose that Canada is currently producing 30 tonsof honey and 15 tons of maple syrup and the UnitedStates is currently producing 10 tons of honey and 40tons of maple syrup. Demonstrate that Canada andthe United States can both be better off if they spe-cialize in producing only one good and engage intrade.

c. Illustrate your answer to question (b) by drawing a PPFfor the United States and a PPF for Canada. Show onyour PPFs the combinations of honey and maple syrupproduced and consumed in each country before andafter trade.

SOLVING THE PROBLEM:Step 1: Review the chapter material. This problem concerns comparative advantage,

so you may want to review the section “Absolute Advantage versusComparative Advantage,” which begins on page 46.

Step 2: Answer question (a) by calculating who has a comparative advantage ineach activity. Remember that a country has a comparative advantage in pro-ducing a good if it can produce the good at the lowest opportunity cost. When



Canada produces 1 more ton of honey, it produces 1.5 fewer tons of maplesyrup. On the one hand, when the United States produces 1 more ton ofhoney, it produces 1 less ton of maple syrup. Therefore, the United States’sopportunity cost of producing honey—1 ton of maple syrup—is lower thanCanada’s—1.5 tons of maple syrup. On the other hand, when Canada pro-duces 1 more ton of maple syrup, it produces 0.67 ton less of honey. When theUnited States produces 1 more ton of maple syrup, it produces 1 less ton ofhoney. Therefore, Canada’s opportunity cost of producing maple syrup—0.67ton of honey—is lower than that of the United States—1 ton of honey. We canconclude that the United States has a comparative advantage in the produc-tion of honey and Canada has a comparative advantage in the production ofmaple syrup.

Step 3: Answer question (b) by showing that specialization makes Canada andthe United States better off. We know that Canada should specialize where ithas a comparative advantage and the United States should specialize whereit has a comparative advantage. If both countries specialize, Canada will pro-duce 60 tons of maple syrup and 0 tons of honey, and the United States willproduce 0 tons of maple syrup and 50 tons of honey. After both countries spe-cialize, the United States could then trade 30 tons of honey to Canada inexchange for 40 tons of maple syrup. (Other mutually beneficial trades arepossible as well.) We can summarize the results in a table:

BEFORE TRADE AFTER TRADE

HONEY MAPLE SYRUP HONEY MAPLE SYRUP(IN TONS) (IN TONS) (IN TONS) (IN TONS)

CANADA 30 15 30 20

UNITED STATES 10 40 20 40

The United States is better off after trade because it can consume the sameamount of maple syrup and 10 more tons of honey. Canada is better off aftertrade because it can consume the same amount of honey and 5 more tons ofmaple syrup.

Step 4: Answer question (c) by drawing the PPFs.

>> End Solved Problem 2-2

(a) Canada’s PPF

Honey

Maplesyrup

30

40

600 15 20

Canadian productionand consumptionbefore trade

Canadianconsumptionafter trade

Canadianproductionafter trade

(b) The United States’s PPF

Honey

Maplesyrup

50400

20

10

50

U.S. productionand consumptionbefore trade

U.S.consumptionafter trade

U.S.productionafter trade

YOUR TURN: For more practice, do related problems 2.5 and 2.6 on pages 62 and 63 at the end

of this chapter.




Market A group of buyers and sellers of a good or service and theinstitution or arrangement by whichthey come together to trade.

Product markets Markets forgoods—such as computers—andservices—such as medical treatment.

Factor markets Markets for thefactors of production, such as labor,capital, natural resources, andentrepreneurial ability.

Factors of production The inputsused to make goods and services.

2.3 | Explain the basic idea of how a market system works.

The Market SystemWe have seen that households, firms, and the government face trade-offs and incuropportunity costs because of the scarcity of resources. We have also seen that tradeallows people to specialize according to their comparative advantage. By engaging intrade, people can raise their standard of living. Of course, trade in the modern world ismuch more complex than the examples we have considered so far. Trade today involvesthe decisions of millions of people spread around the world. But how does an economymake trade possible, and how are the decisions of these millions of people coordinated?In the United States and most other countries, trade is carried out in markets. Marketsalso determine the answers to the three fundamental questions discussed in Chapter 1:What goods and services will be produced? How will the goods and services be pro-duced? and Who will receive the goods and services?

Recall that the definition of market is a group of buyers and sellers of a good or ser-vice and the institution or arrangement by which they come together to trade. Marketstake many forms: They can be physical places, like a local pizza parlor or the New YorkStock Exchange, or virtual places, like eBay. In a market, the buyers are demanders ofgoods or services, and the sellers are suppliers of goods or services. Households andfirms interact in two types of markets: product markets and factor markets. Productmarkets are markets for goods—such as computers—and services—such as medicaltreatment. In product markets, households are demanders, and firms are suppliers.Factor markets are markets for the factors of production. Factors of production are theinputs used to make goods and services. Factors of production are divided into fourbroad categories:

• Labor includes all types of work, from the part-time labor of teenagers working atMcDonald’s to the work of top managers in large corporations.

• Capital refers to physical capital, such as computers and machine tools, that is usedto produce other goods.

• Natural resources include land, water, oil, iron ore, and other raw materials (or “giftsof nature”) that are used in producing goods.

• An entrepreneur is someone who operates a business. Entrepreneurial ability is theability to bring together the other factors of production to successfully produce andsell goods and services.

The Circular Flow of IncomeTwo key groups participate in markets:

• A household consists of all the individuals in a home. Households are suppliers offactors of production—particularly labor—used by firms to make goods and ser-vices. Households use the income they receive from selling the factors of productionto purchase the goods and services supplied by firms. We are used to thinking ofhouseholds as suppliers of labor because most people earn most of their income bygoing to work, which means they are selling their labor services to firms in the labormarket. But households own the other factors of production as well, either directlyor indirectly, by owning the firms that have these resources. All firms are owned byhouseholds. Small firms, like a neighborhood restaurant, might be owned by oneperson. Large firms, like Microsoft or BMW, are owned by millions of householdswho own shares of stock in them. (We discuss the stock market in Chapter 5.) Whenfirms pay profits to the people who own them, the firms are paying for using thecapital and natural resources that are supplied to them by those owners. So, we cangeneralize by saying that in factor markets, households are suppliers, and firms aredemanders.



Circular-flow diagram A model thatillustrates how participants inmarkets are linked.

Goods

and services

Labor, capita

l, natu

ral r

esou

rces

,

Spending on goods and services

Wages and other payments

Households

Product Markets

Firms

Factor Markets

to the factors of production

and entrepreneuria

l abi

lity

Figure 2-6The Circular-Flow Diagram

Households and firms are linked together in acircular flow of production, income, andspending. The blue arrows show the flow of thefactors of production. In factor markets,households supply labor, entrepreneurialability, and other factors of production tofirms. Firms use these factors of production tomake goods and services that they supply to households in product markets. The redarrows show the flow of goods and servicesfrom firms to households. The green arrowsshow the flow of funds. In factor markets,households receive wages and other paymentsfrom firms in exchange for supplying thefactors of production. Households use thesewages and other payments to purchase goodsand services from firms in product markets.Firms sell goods and services to households inproduct markets, and they use the funds topurchase the factors of production fromhouseholds in factor markets.

• Firms are suppliers of goods and services. Firms use the funds they receive from sell-ing goods and services to buy the factors of production needed to make the goodsand services.

We can use a simple economic model called the circular-flow diagram to see howparticipants in markets are linked. Figure 2-6 shows that in factor markets, householdssupply labor and other factors of production in exchange for wages and other paymentsfrom firms. In product markets, households use the payments they earn in factor mar-kets to purchase the goods and services supplied by firms. Firms produce these goodsand services using the factors of production supplied by households. In the figure, theblue arrows show the flow of factors of production from households through factormarkets to firms. The red arrows show the flow of goods and services from firmsthrough product markets to households. The green arrows show the flow of funds fromfirms through factor markets to households and the flow of spending from householdsthrough product markets to firms.

Like all economic models, the circular-flow diagram is a simplified version of real-ity. For example, Figure 2-6 leaves out the important role of government in buyinggoods from firms and in making payments, such as Social Security or unemploymentinsurance payments, to households. The figure also leaves out the roles played by banks,the stock and bond markets, and other parts of the financial system in aiding the flow offunds from lenders to borrowers. Finally, the figure does not show that some goods andservices purchased by domestic households are produced in foreign countries and somegoods and services produced by domestic firms are sold to foreign households. The gov-ernment, the financial system, and the international sector are explored further in laterchapters. Despite these simplifications, the circular-flow diagram in Figure 2-6 is usefulfor seeing how product markets, factor markets, and their participants are linked



together. One of the great mysteries of the market system is that it manages to success-fully coordinate the independent activities of so many households and firms.

The Gains from Free MarketsA free market exists when the government places few restrictions on how a good or aservice can be produced or sold or on how a factor of production can be employed.Governments in all modern economies intervene more than is consistent with a fullyfree market. In that sense, we can think of the free market as being a benchmark againstwhich we can judge actual economies. There are relatively few government restrictionson economic activity in the United States, Canada, the countries of Western Europe,Hong Kong, Singapore, and Estonia. So these countries come close to the free marketbenchmark. In countries such as Cuba and North Korea, the free market system hasbeen rejected in favor of centrally planned economies with extensive government con-trol over product and factor markets. Countries that come closest to the free-marketbenchmark have been more successful than countries with centrally planned economiesin providing their people with rising living standards.

The Scottish philosopher Adam Smith is considered the father of modern econom-ics because his book An Inquiry into the Nature and Causes of the Wealth of Nations, pub-lished in 1776, was an early and very influential argument for the free market system.Smith was writing at a time when extensive government restrictions on markets werestill very common. In many parts of Europe, the guild system still prevailed. Under thissystem, governments would give guilds, or organizations of producers, the authority tocontrol the production of a good. For example, the shoemakers’ guild controlled whowas allowed to produce shoes, how many shoes they could produce, and what price theycould charge. In France, the cloth makers’ guild even dictated the number of threads inthe weave of the cloth.

Smith argued that such restrictions reduced the income, or wealth, of a country andits people by restricting the quantity of goods produced. Some people at the time sup-ported the restrictions of the guild system because it was in their financial interest to doso. If you were a member of a guild, the restrictions served to reduce the competition youfaced. But other people sincerely believed that the alternative to the guild system was eco-nomic chaos. Smith argued that these people were wrong and that a country could enjoya smoothly functioning economic system if firms were freed from guild restrictions.

The Market MechanismIn Smith’s day, defenders of the guild system worried that if, for instance, the shoemakers’guild did not control shoe production, either too many or too few shoes would be pro-duced. Smith argued that prices would do a better job of coordinating the activities ofbuyers and sellers than the guilds could. A key to understanding Smith’s argument is theassumption that individuals usually act in a rational, self-interested way. In particular, indi-viduals take those actions most likely to make themselves better off financially. Thisassumption of rational, self-interested behavior underlies nearly all economic analysis. Infact, economics can be distinguished from other fields that study human behavior—suchas sociology and psychology—by its emphasis on the assumption of self-interested behav-ior. Adam Smith understood—as economists today understand—that people’s motivescan be complex. But in analyzing people in the act of buying and selling, the motivation offinancial reward usually provides the best explanation for the actions people take.

For example, suppose that a significant number of consumers switch from buy-ing regular gasoline-powered cars to buying gasoline/electric-powered hybrid cars,such as the Toyota Prius, as in fact happened in the United States during the 2000s.Firms will find that they can charge relatively higher prices for hybrid cars than theycan for regular cars. The self-interest of these firms will lead them to respond to con-sumers’ wishes by producing more hybrids and fewer regular cars. Or suppose thatconsumers decide that they want to eat less bread, pasta, and other foods high incarbohydrates, as many did following the increase in popularity of the Atkins andSouth Beach diets. Then the prices firms can charge for bread and pasta will fall. The

Free market A market with fewgovernment restrictions on how agood or service can be produced orsold or on how a factor of productioncan be employed.


A Story of the Market System inAction: How Do You Make an iPod?The iPod is a product of Apple, which has its headquarters inCupertino, California. It seems reasonable to assume that

iPods are also manufactured in California. In fact, Apple produces none of the compo-nents of the iPod, nor does it assemble the components into a finished product. Far frombeing produced entirely by one company in one place, the iPod requires the coordinatedactivities of thousands of workers and dozens of firms, spread around the world.

Several Asian firms, including Asustek, Inventec Appliances, and Foxconn, assemblethe iPod, which is then shipped to Apple for sale in the United States. But the firmsdoing final assembly don’t make any of the components. For example, the iPod’s harddrive is manufactured by the Japanese firm, Toshiba, although Toshiba actually assem-bles the hard drive in factories in China and the Philippines. Apple purchases the con-troller chip that manages the iPod’s functions from PortalPlayer, which is based in SantaClara, California. But PortalPlayer actually has the chip manufactured for it by TaiwanSemiconductor Manufacturing Corporation, and the chip’s processor core was designedby ARM, a British company. Taiwan Semiconductor Manufacturing Corporation’s fac-tories are for the most part not in Taiwan, but in mainland China and Eastern Europe.

All told, the iPod contains 451 parts, designed and manufactured by firms aroundthe world. Many of these firms are not even aware of which other firms are also produc-ing components for the iPod. Few of the managers of these firms have met managers ofthe other firms or shared knowledge of how their particular components are produced.In fact, no one person from Steve Jobs, the head of Apple, on down possesses the knowl-edge of how to produce all of the components that are assembled into an iPod. Instead,the invisible hand of the market has led these firms to contribute their knowledge to theprocess that ultimately results in an iPod available for sale in a store in the United States.Apple has so efficiently organized the process of producing the iPod that you can ordera custom iPod with a personal engraving and have it delivered from an assembly plant inChina to your doorstep in the United States in as little as three days.

Hal Varian, an economist at the University of California, Berkeley, has summarizedthe iPod story: “Those clever folks at Apple figured out how to combine 451 mostlygeneric parts into a valuable product. They may not make the iPod, but they created it.”

Sources: Hal Varian,“An iPod Has Global Value. Ask the (Many) Countries That Make It,” New York Times, June 28, 2007;and Greg Linden, Kenneth L. Kraemer, Jaon Dedrick, “Who Captures Value in a Global Innovation System? The Case ofApple’s iPod,” Personal Computing Industry Center, June 2007.


of this chapter.

The Role of the EntrepreneurEntrepreneurs are central to the working of the market system. An entrepreneur is some-one who operates a business. Entrepreneurs must first determine what goods and servicesthey believe consumers want, and then they must decide how to produce those goods andservices most profitably. Entrepreneurs bring together the factors of production—labor,capital, and natural resources—to produce goods and services. They put their own funds

The market coordinates the activitiesof the many people spread aroundthe world who contribute to themaking of an iPod.

|Makingthe

Connection


self-interest of firms will lead them to produce less bread and pasta, which in fact iswhat happened.

In the case where consumers want more of a product, and in the case where theywant less of a product, the market system responds without a guild or the governmentgiving orders about how much to produce or what price to charge. In a famous phrase,Smith said that firms would be led by the “invisible hand” of the market to provide con-sumers with what they wanted. Firms would respond to changes in prices by makingdecisions that ended up satisfying the wants of consumers.

Entrepreneur Someone whooperates a business, bringing togetherthe factors of production—labor,capital, and natural resources—toproduce goods and services.



Property rights The rightsindividuals or firms have to theexclusive use of their property,including the right to buy or sell it.

at risk when they start businesses. If they are wrong about what consumers want or aboutthe best way to produce goods and services, they can lose those funds. In fact, it is notunusual for entrepreneurs who eventually achieve great success to fail at first. Forinstance, early in their careers, both Henry Ford and Sakichi Toyoda, who eventuallyfounded the Toyota Motor Corporation, started companies that quickly failed.

The Legal Basis of a Successful Market SystemIn a free market, government does not restrict how firms produce and sell goods andservices or how they employ factors of production, but the absence of governmentintervention is not enough for a market system to work well. Government has to pro-vide secure rights to private property for a market system to work at all. In addition,government can aid the working of the market by enforcing contracts between privateindividuals through an independent court system. Many economists would also say thegovernment has a role in facilitating the development of an efficient financial system aswell as systems of education, transportation, and communication. The protection ofprivate property and the existence of an independent court system to impartiallyenforce the law provide a legal environment that will allow a market system to succeed.

Protection of Private Property For a market system to work well, individuals must bewilling to take risks. Someone with $250,000 can be cautious and keep it safely in a bank—or even in cash, if the person doesn’t trust the banking system. But the market system won’twork unless a significant number of people are willing to risk their funds by investing themin businesses. Investing in businesses is risky in any country. Many businesses fail every yearin the United States and other high-income countries. But in the high-income countries,someone who starts a new business or invests in an existing business doesn’t have to worrythat the government, the military, or criminal gangs might decide to seize the business ordemand payments for not destroying the business. Unfortunately, in many poor countries,owners of businesses are not well protected from having their businesses seized by the gov-ernment or from having their profits taken by criminals. Where these problems exist, open-ing a business can be extremely risky. Cash can be concealed easily, but a business is difficultto conceal and difficult to move.

Property rights are the rights individuals or firms have to the exclusive use of theirproperty, including the right to buy or sell it. Property can be tangible, physical property,such as a store or factory. Property can also be intangible, such as the right to an idea.

Two amendments to the U.S. Constitution guarantee property rights: The 5thAmendment states that the federal government shall not deprive any person “of life, lib-erty, or property, without due process of law.” The 14th Amendment extends this guar-antee to the actions of state governments: “No state . . . shall deprive any person of life,liberty, or property, without due process of law.” Similar guarantees exist in every high-income country. Unfortunately, in many developing countries, such guarantees do notexist or are poorly enforced.

In any modern economy, intellectual property rights are very important.Intellectual property includes books, films, software, and ideas for new products ornew ways of producing products. To protect intellectual property, the federal govern-ment grants a patent that gives an inventor—which is often a firm—the exclusiveright to produce and sell a new product for a period of 20 years from the date theproduct was invented. For instance, because Microsoft has a patent on the Windowsoperating system, other firms cannot sell their own versions of Windows. The govern-ment grants patents to encourage firms to spend money on the research and develop-ment necessary to create new products. If other companies could freely copyWindows, Microsoft would not have spent the funds necessary to develop it. Just as anew product or a new method of making a product receives patent protection, books,films, and software receive copyright protection. Under U.S. law, the creator of a book,film, or piece of music has the exclusive right to use the creation during the creator’slifetime. The creator’s heirs retain this exclusive right for 50 years after the death ofthe creator.


Property Rights in Cyberspace:YouTube and MySpaceThe development of the Internet has led to new problems inprotecting intellectual property rights. People can copy and

e-mail songs, newspaper and magazine articles, and even entire motion pictures andtelevision programs or post them on Web sites. Controlling unauthorized copying ismore difficult today than it was when “copying” meant making a physical copy of a book,CD, or DVD. The popularity of YouTube and MySpace highlights the problem of unau-thorized copying of videos and music. YouTube, founded in 2005, quickly became anenormous success because it provided an easy way to upload videos, which could then beviewed by anyone with an Internet connection. By 2008, thousands of new videos werebeing uploaded each day, and the site was receiving more than 20 million visitors permonth. YouTube earned substantial profits from selling online advertising. Unfor-tunately, many of the videos on the site contained copyrighted material.

At first, YouTube’s pol-icy was to remove any videocontaining unauthorizedmaterial if the holder of thecopyright complained. ThenYouTube began to negotiatewith the copyright holdersto pay a fee in return forallowing the copyrightedmaterial to remain on thesite. For music videos,YouTube was usually able toobtain the needed permis-sion directly from therecording company. Things were more complicated when videos on YouTube usedcopyrighted songs as background music. In those cases, YouTube needed to obtain per-missions from the songwriters as well as the record company, which could be a time-consuming process. Obtaining permission to use videos that contained material fromtelevision shows or movies was even more complicated because sometimes dozens ofpeople—including the actors, directors, and composers of music—held rights to thetelevision show or movie. YouTube’s vice president for business development wasquoted as saying, “It’s almost like technology has pushed far beyond the business prac-tices and the law, and now everything needs to kind of catch up.” In November 2006,YouTube agreed to be purchased by Google for $1.65 billion, which made the youngentrepreneurs who started the company very wealthy. The willingness of YouTube’sowners to sell their company to Google was motivated at least partly by the expectationthat Google had the resources to help them resolve their copyright problems.

MySpace had similar problems because many Web pages on the site contained copy-righted music or videos. Universal Music sued MySpace after music from rapper Jay-Z’slatest album started appearing on the site even before the album was released. In its law-suit, Universal claimed that the illegal use of its copyrighted music had “created hun-dreds of millions of dollars of value for the owners of MySpace.”

Music, television, and movie companies believe that the failure to give the full pro-tection of property rights to the online use of their material reduces their ability to sellCDs and DVDs.

Sources: Kevin J. Delaney, Ethan Smith, and Brooks Barnes, “YouTube Finds Signing Rights Deals Complex, Frustrating,”Wall Street Journal, November 3, 2006, p. B1; and Ethan Smith and Julia Angwin, “Universal Music Sues MySpace ClaimingCopyright Infringement,” Wall Street Journal, November 18, 2006, p. A3.


of this chapter.

|Makingthe

Connection


Some recording artists worry that the copyrights for theirsongs are not being protected on the Internet.


>> Continued from page 37


Enforcement of Contracts and Property Rights Much business activity involvessomeone agreeing to carry out some action in the future. For example, you may borrow$20,000 to buy a car and promise the bank—by signing a loan contract—that you will payback the money over the next five years. Or Microsoft may sign a licensing agreement witha small technology company, agreeing to use that company’s technology for a period of sev-eral years in return for a fee. Usually these agreements take the form of legal contracts. For amarket system to work, businesses and individuals have to rely on these contracts being car-ried out. If one party to a legal contract does not fulfill its obligations—perhaps the smallcompany had promised Microsoft exclusive use of its technology but then began licensing itto other companies—the other party could go to court to have the agreement enforced.Similarly, if property owners in the United States believe that the federal or state govern-ment has violated their rights under the 5th or 14th Amendments, they can go to court tohave their rights enforced.

But going to court to enforce a contract or private property rights will be successfulonly if the court system is independent and judges are able to make impartial decisionson the basis of the law. In the United States and other high-income countries, the courtsystems have enough independence from other parts of the government and enoughprotection from intimidation by outside forces—such as criminal gangs—that they areable to make their decisions based on the law. In many developing countries, the courtsystems lack this independence and will not provide a remedy if the government violatesprivate property rights or if a person with powerful political connections decides to vio-late a business contract.

If property rights are not well enforced, fewer goods and services will be produced.This reduces economic efficiency, leaving the economy inside its production possibilitiesfrontier.

Economics in YOUR Life!

At the beginning of the chapter, we asked you to think about two questions: Whenbuying a new car, what is the relationship between safety and gas mileage? and Underwhat circumstances would it be possible for car manufacturers to make cars safer andmore fuel efficient? To answer the first question, you have to recognize that there is atrade-off between safety and gas mileage. With the technology available at any partic-ular time, an automobile manufacturer can increase gas mileage by making a carsmaller and lighter. But driving a lighter car increases your chances of being injured ifyou have an accident. The trade-off between safety and gas mileage would look muchlike the relationship in Figure 2-1. To get more of both safety and gas mileage, automo-bile makers would have to discover new technologies that allow them to make the carlighter and safer at the same time. Such new technologies would make points like G inFigure 2-1 attainable.



ConclusionWe have seen that by trading in markets, people are able to specialize and pursue theircomparative advantage. Trading on the basis of comparative advantage makes all partic-ipants in trade better off. The key role of markets is to facilitate trade. In fact, the marketsystem is a very effective means of coordinating the decisions of millions of consumers,workers, and firms. At the center of the market system is the consumer. To be successful,firms must respond to the desires of consumers. These desires are communicated tofirms through prices. To explore how markets work, we must study the behavior of con-sumers and firms. We continue this exploration of markets in Chapter 3, when wedevelop the model of demand and supply.

Before moving on to Chapter 3, read An Inside Look on the next page to learn howBMW managers reallocate scarce resources in the firm’s South Carolina plant to prepareto manufacture a new sports-activity coupe.


An Inside LOOK

58

KNIGHT RIDDER TRIBUNE BUSINESS NEWS, JANUARY 25, 2007

BMW Managers ChangeProduction Strategy

c

b

a

Redesigned X5 to lead increase;new coupe to debutin 2008BMW expects production to rise 58percent this year, nearly reaching itsrecord production of 2002 and endingthe string of production declines sincethen. The plant’s 4,500 workers [basedin Spartanburg, South Carolina] areexpected to make 165,000 vehicles thisyear, up from 104,632 in 2006,spokesman Bob Nitto said Wednesday.The redesigned X5 sport utility vehicleis expected to drive the increase, withits production nearly doubling toabout 130,000 vehicles. Production ofthe Z4 and related coupes is expectedto decline slightly to 35,000 cars, downfrom 38,756 last year.

And in 2008, the plant is expectedto add a new coupe to the productionline, one that BMW now refers to as asports-activity coupe. The term is avariation of the moniker BMWadopted in 1999 for the X5—a sports-activity vehicle. The automotive pressis referring to the new car as the BMWX6, the crossover vehicle companyofficials have said previously would bebuilt at Greer.

But even with a third vehicle,plant employment is not likely toincrease substantially, plant spokes-woman Bunny Richardson said. Pro-duction workers at the plant earnabout $25 to $26 per hour.

Richardson and Nitto spoke withabout a dozen area journalists allowedto see the plant for the first time sinceNovember 2005. That winter, thefacility was shut down for two monthsas its separate assembly lines for theX5 and Z4 were merged into a singleline.

One reason for the change wasthe increasing imbalance in produc-tion. The Z4s are smaller cars withfewer parts than the large, complexX5s. Also, Z4 sales have flattened,while X5 sales have risen. As a result,X5s are expected to account for 80percent of the cars made at the plantthis year.

The plant continues to becomemore dense. When it opened in 1994,aisles were wide and heavy equipmentthin. Now many parts move over-head, and robots have become morenumerous.

The appearance has changed asthe plant’s production has climbed:

• At the end of 1995, the first fullyear of production, the plant had1,556 workers and made 13,943cars, or about nine cars per worker.

• At the end of 2000—the first fullyear of production of the originalX5—the plant had 4,058 workersand made 83,672 vehicles, about21 vehicles per worker.

• Production peaked in 2003, whenthe plant’s work force swelled to4,700, making 166,090 vehicles,or about 35 per worker.

• This year, the plant is expected toexceed 2003 in productivity, withproduction of 37 cars per worker.

This will be all the more challeng-ing because of the size and complexityof the new X5, which first reachedU.S. dealers in November, and is beingrolled out to the European market thisyear. The X5 is filled with gizmosdesigned to allow it to shift from tripsto the grocery store to fording creeks.Even the tires are complex: Run-flattires now are standard equipment.Those supplied by Michelin are madeat its Lexington plant, Richardsonsaid.

Journalists were allowed to testthe cars driving on a test track and off-road trail near the plant. Some ver-sions carried an option that BMWcalls Active Steering, a form of powersteering that varies response depend-ing on speed.

In a parking lot, only a slightmotion is needed to steer into a space,while at higher speeds, sharp turnsrequire more turning.

“You don’t want to sneeze andchange lanes,” said Larry Parmele, a55-year-old former race car driver andinstructor at BMW’s PerformanceCenter test tracks in Greer.

Source: Jim Duplessis, “BMW Expects Turn-around,” Knight Ridder Tribune Business News,January 25, 2007, p.1. Reprinted by permissionof the Permissions Group.


changed. Managers introduced moremachinery and workers and changed thelayout of the factory. Moving the X5 and Z4to the same assembly line so the plant canproduce the new sports-activity coupemodel is just the latest in a long line ofchanges that the managers have made.These changes provide the plant with moreresources for producing BMW cars. Weshow this by shifting out the productionpossibilities frontier in Figure 2. You shouldalso notice that as output at the plantexpanded, BMW increased employmentand the number of robots. As output at afirm or a plant expands, BMW tends to usemore of all types of inputs, including labor.

Thinking Critically1. Launching the new sports-activity coupe

may require that the BMW managersshut down the Spartanburg plant forsome period. Besides the direct costs ofinstalling a new assembly line and newmachinery, what would be the costs toBMW of shutting down the plant for aperiod of months? If shutting down theplant is costly, why would BMW do it?

2. Some BMWs are made in Germany,some in South Carolina, and some inother places. Should the United Statesgovernment encourage the domesticproduction of BMWs by banning importsof BMWs?

59

Quantityof coupesproduced

per day

Quantity of X5SUVs produced

per day

Final quantityof X5s

Initial quantityof X5s

0

Initial quantityof coupes

Final quantityof coupes

Figure 1. The increase in production at the plant in 2008.

Quantityof coupesproduced

per day

0

PPF1995

PPF2007

B

1. The increased numberof inputs like robots andworkers shifts out the PPFto the right . . .

Quantity of X5SUVs produced

per day

2. . . . making outputcombinations like B—that were not possiblein 1995—possible in2007.

Figure 2. The effect of increasing inputs on output at the plant.

Key Points in the ArticleThe article discusses the trade-offs thatBMW managers face when making produc-tion decisions, given the size of the manu-facturing plant and the technology used atthe plant. The article also points out thatthese production decisions depend on thecharacteristics of the cars being produced,the number of workers at the plant, thetechnology of production, and the sales ofthe different car models.

Analyzing the NewsBMW plans to produce about 60,000more automobiles at the Spartanburg,

South Carolina plant during 2007. Eventhough the total number of automobiles pro-duced is going to increase, BMW is going tocut back on the production of the Z4 andother coupes. Figure 1 shows the increase intotal production as a movement toward theproduction possibilities frontier. Notice thateven though BMW is producing more auto-mobiles, it is choosing to produce fewercoupes, so total production of coupes isdeclining as the production at the plant ismoving toward the frontier.

a

Production at plantsfrequently responds to

changes in the marketplace. Ifsales of one model decline, then

automobile companies often reduce pro-duction of that model and expand produc-tion of the models that are selling. At thisplant, production of the Z4 model is declin-ing, while production of the X5 model isexpanding. These changes in productiondecisions are a direct response to changesin the sales of these models. In addition,managers sometimes have to stop produc-tion so that they can retool the plant. In thiscase, managers closed the plant for twomonths during 2005, so that they couldintroduce a new assembly line that pro-duced both the X5 and Z4 models. Thisallowed the managers to expand produc-tion at the plant and make it easier to intro-duce a new “sports-activity coupe” modelthat will begin production in 2008. The man-agers may have to close the plant again toprepare for production of the new sports-activity couple. In effect, the managerswould be giving up production of existingmodels in 2007 while the plant is closed sothat they can increase production of thenew model in the future. Sometimes thetrade-offs that managers face are trade-offsbetween the present and the future.

As the demand for BMW models hasincreased, the automobile factory has

c

b



Key TermsAbsolute advantage, p. 46

Circular-flow diagram, p. 51

Comparative advantage, p. 47

Economic growth, p. 43

Entrepreneur, p. 53

Factor markets, p. 50

Factors of production, p. 50

Free market, p. 52

Market, p. 50

Opportunity cost, p. 39

Product markets, p. 50

Production possibilitiesfrontier (PPF), p. 38

Property rights, p. 54

Scarcity, p. 38

Trade, p. 44

2.1 LEARNING OBJECTIVE 2.1 | Use a production possibilities frontier to analyze opportunity costs and trade-offs,

pages 38–44.

Production Possibilities Frontiers and Opportunity Costs

Summary

The production possibilities frontier (PPF) is a curve thatshows the maximum attainable combinations of two productsthat may be produced with available resources. The PPF isused to illustrate the trade-offs that arise from scarcity. Pointson the frontier are technically efficient. Points inside the fron-tier are inefficient, and points outside the frontier are unattain-able. The opportunity cost of any activity is the highest valuedalternative that must be given up to engage in that activity.Because of increasing marginal opportunity costs, productionpossibilities frontiers are usually bowed out rather thanstraight lines. This illustrates the important economic conceptthat the more resources that are already devoted to any activity,the smaller the payoff to devoting additional resources to thatactivity is likely to be. Economic growth is illustrated by shift-ing a production possibilities frontier outward.

Visit www.myeconlab.com to complete these exercisesonline and get instant feedback.

Review Questions

1.1 What do economists mean by scarcity? Can you thinkof anything that is not scarce according to the eco-nomic definition?

1.2 What is a production possibilities frontier? How can weshow economic efficiency on a production possibilitiesfrontier? How can we show inefficiency? What causes aproduction possibilities frontier to shift outward?

1.3 What does increasing marginal opportunity costsmean? What are the implications of this idea for theshape of the production possibilities frontier?

Problems and Applications

1.4 Draw a production possibilities frontier that showsthe trade-off between the production of cotton andthe production of soybeans.a. Show the effect that a prolonged drought would

have on the initial production possibilities frontier.

b. Suppose genetic modification makes soybeansresistant to insects, allowing yields to double.Show the effect of this technological change on theinitial production possibilities frontier.

1.5 [Related to the Chapter Opener on page36] One of the trade-offs BMW faces is betweensafety and gas mileage. For example, adding steel to acar makes it safer but also heavier, which results inlower gas mileage. Draw a hypothetical productionpossibilities frontier that BMW engineers face thatshows this trade-off.

1.6 Suppose you win free tickets to a movie plus all youcan eat at the snack bar for free. Would there be a costto you to attend this movie? Explain.

1.7 Suppose we can divide all the goods produced by aneconomy into two types: consumption goods andcapital goods. Capital goods, such as machinery,equipment, and computers, are goods used to pro-duce other goods.a. Use a production possibilities frontier graph to

illustrate the trade-off to an economy betweenproducing consumption goods and producingcapital goods. Is it likely that the production pos-sibilities frontier in this situation would be astraight line (as in Figure 2-1 on page 39) orbowed out (as in Figure 2-2 on page 42)? Brieflyexplain.

b. Suppose a technological advance occurs thataffects the production of capital goods but notconsumption goods. Show the effect on the pro-duction possibilities frontier.

c. Suppose that country A and country B currentlyhave identical production possibilities frontiersbut that country A devotes only 5 percent of itsresources to producing capital goods over each ofthe next 10 years, whereas country B devotes 30percent. Which country is likely to experiencemore rapid economic growth in the future?Illustrate using a production possibilities frontiergraph. Your graph should include production pos-sibilities frontiers for country A today and in 10years and production possibilities frontiers forcountry B today and in 10 years.



Capitalgoods

Consumptiongoods

0

A

B

C

D

E

1.8 Use the production possibilities frontier for a countryto answer the following questions.

decide whether the federal government should spendmore on research to find a cure for heart disease. Heasks you, one of his economic advisors, to prepare areport discussing the relevant factors he should con-sider. Discuss the main issues you would deal with inyour report.

1.11 Lawrence Summers served as secretary of the trea-sury in the Clinton administration and later as thepresident of Harvard University. He has been quotedas giving the following moral defense of the eco-nomic approach:

There is nothing morally unattractiveabout saying: We need to analyze whichway of spending money on health care willproduce more benefit and which less, andusing our money as efficiently as we can. Idon’t think there is anything immoralabout seeking to achieve environmentalbenefits at the lowest possible costs.

Would it be more moral to reduce pollution withoutworrying about the cost or by taking the cost intoaccount? Briefly explain.

Source: David Wessel, “Precepts from Professor Summers,” Wall StreetJournal, October 17, 2002.

1.12 In The Wonderful Wizard of Oz and his other booksabout the Land of Oz, L. Frank Baum observed that ifpeople’s wants were modest enough, most goodswould not be scarce. According to Baum, this was thecase in Oz:

There were no poor people in the Land ofOz, because there was no such thing asmoney. . . . Each person was given freelyby his neighbors whatever he required forhis use, which is as much as anyone mayreasonably desire. Some tilled the landsand raised great crops of grain, whichwas divided equally among the wholepopulation, so that all had enough. Therewere many tailors and dressmakers andshoemakers and the like, who madethings that any who desired them mightwear. Likewise there were jewelers whomade ornaments for the person, whichpleased and beautified the people, andthese ornaments also were free to thosewho asked for them. Each man andwoman, no matter what he or she pro-duced for the good of the community,was supplied by the neighbors with foodand clothing and a house and furnitureand ornaments and games. If by chancethe supply ever ran short, more was takenfrom the great storehouses of the Ruler,which were afterward filled up againwhen there was more of any article thanpeople needed. . . .

a. Which point(s) are unattainable? Briefly explainwhy.

b. Which point(s) are efficient? Briefly explain why.c. Which point(s) are inefficient? Briefly explain

why.d. At which point is the country’s future growth rate

likely to be the highest? Briefly explain why.1.9 [Related to Solved Problem 2-1 on page

40] You have exams in economics and chemistrycoming up and five hours available for studying.The following table shows the trade-offs you face inallocating the time you will spend in studying eachsubject.

HOURS SPENT STUDYING MIDTERM SCORE

CHOICE ECONOMICS CHEMISTRY ECONOMICS CHEMISTRY

A 5 0 95 70

B 4 1 93 78

C 3 2 90 84

D 2 3 86 88

E 1 4 81 90

F 0 5 75 91

a. Use the data in the table to draw a production pos-sibilities frontier graph. Label the vertical axis“Score on economics exam” and label the horizon-tal axis “Score on chemistry exam.” Make sure tolabel the values where your production possibili-ties frontier intersects the vertical and horizontalaxes.

b. Label the points representing choice C and choiceD. If you are at choice C, what is your opportunitycost of increasing your chemistry score?

c. Under what circumstances would A be a sensiblechoice?

1.10 [Related to the Making the Connection onpage 41] Suppose the president is attempting to



2.2 LEARNING OBJECTIVE 2.2 | Understand comparative advantage and explain how it is the basis for trade,

pages 44–49.

Comparative Advantage and Trade

Summary

Fundamentally, markets are about trade, which is the act ofbuying or selling. People trade on the basis of comparativeadvantage. An individual, a firm, or a country has acomparative advantage in producing a good or service if itcan produce the good or service at the lowest opportunitycost. People are usually better off specializing in the activityfor which they have a comparative advantage and trading forthe other goods and services they need. It is important notto confuse comparative advantage with absolute advantage.An individual, a firm, or a country has an absolute advan-tage in producing a good or service if it can produce more ofthat good or service from the same amount of resources. It ispossible to have an absolute advantage in producing a goodor service without having a comparative advantage.


Review Questions

2.1 What is absolute advantage? What is comparativeadvantage? Is it possible for a country to have a com-parative advantage in producing a good without alsohaving an absolute advantage? Briefly explain.

2.2 What is the basis for trade? What advantages are thereto specialization?


2.3 Look again at the information in Figure 2-4 on page45. Choose a rate of trading cherries for apples differ-ent than the rate used in the text (15 pounds of cher-ries for 10 pounds of apples) that will allow you andyour neighbor to benefit from trading apples andcherries. Prepare a table like Table 2-1 on page 46 toillustrate your answer.

2.4 Using the same amount of resources, the UnitedStates and Canada can both produce lumberjackshirts and lumberjack boots, as shown in the follow-ing production possibilities frontiers.

a. Who has a comparative advantage in producinglumberjack boots? Who has a comparative advan-tage in producing lumberjack shirts? Explain yourreasoning.

b. Does either country have an absolute advantage inproducing both goods? Explain.

c. Suppose that both countries are currently produc-ing three pairs of boots and three shirts. Show thatboth can be better off if they specialize in produc-ing one good and then engage in trade.

2.5 [Related to Solved Problem 2-2 on page 48]Suppose Iran and Iraq both produce oil and olive oil.The following table shows combinations of bothgoods that each country can produce in a day, mea-sured in thousands of barrels.

IRAQ IRAN

OIL OLIVE OIL OIL OLIVE OIL

0 8 0 4

2 6 1 3

4 4 2 2

6 2 3 1

8 0 4 0

Quantityof shirts

made

Quantityof boots

made

United States

430

12

3

Quantityof shirts

made

Quantityof boots

made

Canada

630

6

3

>> End Learning Objective 2.1

You will know, by what I have told youhere, that the Land of Oz was a remarkablecountry. I do not suppose such an arrange-ment would be practical with us.

Do you agree with Baum that the economic system inOz wouldn’t work in the contemporary UnitedStates? Briefly explain why or why not.

Source: L. Frank Baum, The Emerald City of Oz, pp. 30–31. First editionpublished in 1910.




a. Who has the comparative advantage in producingoil? Explain.

b. Can these two countries gain from trading oil andolive oil? Explain.

2.6 [Related to Solved Problem 2-2 on page 48]Suppose that France and Germany both produceschnitzel and wine. The following table shows combi-nations of the goods that each country can produce ina day.

FRANCE GERMANY

WINE SCHNITZEL WINE SCHNITZEL (BOTTLES) (POUNDS) (BOTTLES) (POUNDS)

0 8 0 15

1 6 1 12

2 4 2 9

3 2 3 6

4 0 4 3

5 0

a. Who has a comparative advantage in producingwine? Who has a comparative advantage in pro-ducing schnitzel?

b. Suppose that France is currently producing 1 bottleof wine and 6 pounds of schnitzel, and Germany is

currently producing 3 bottles of wine and 6 poundsof schnitzel. Demonstrate that France and Germanycan both be better off if they specialize in producingonly one good and then engage in trade.

2.7 [Related to Don’t Let This Happen to You! onpage 48] In the 1950s, the economist Bela Balassacompared 28 manufacturing industries in the UnitedStates and Britain. In every one of the 28 industries,Balassa found that the United States had an absoluteadvantage. In these circumstances, would there havebeen any gain to the United States from importingany of these products from Britain? Explain.

2.8 In colonial America, the population was spread thinlyover a large area, and transportation costs were veryhigh because it was difficult to ship products by roadfor more than short distances. As a result, most of thefree population lived on small farms where they notonly grew their own food but also usually made theirown clothes and very rarely bought or sold anythingfor money. Explain why the incomes of these farmerswere likely to rise as transportation costs fell. Use theconcept of comparative advantage in your answer.

2.9 During the 1928 presidential election campaign,Herbert Hoover, the Republican candidate, arguedthat the United States should only import those prod-ucts that could not be produced here. Do you believethat this would be a good policy? Explain.

2.3 LEARNING OBJECTIVE 2.3 | Explain the basic idea of how a market system works, pages 50–56.

The Market System

Summary

A market is a group of buyers and sellers of a good or serviceand the institution or arrangement by which they cometogether to trade. Product markets are markets for goodsand services, such as computers and medical treatment.Factor markets are markets for the factors of production,such as labor, capital, natural resources, and entrepreneurialability. A circular-flow diagram shows how participants inproduct markets and factor markets are linked. Adam Smithargued in his 1776 book The Wealth of Nations that in a freemarket where the government does not control the produc-tion of goods and services, changes in prices lead firms toproduce the goods and services most desired by consumers. Ifconsumers demand more of a good, its price will rise. Firmsrespond to rising prices by increasing production. If con-sumers demand less of a good, its price will fall. Firmsrespond to falling prices by producing less of a good. Anentrepreneur is someone who operates a business. In a mar-ket system, entrepreneurs are responsible for organizing the

production of goods and services. A market system will workwell only if there is protection for property rights, which arethe rights of individuals and firms to use their property.


Review Questions

3.1 What is the circular-flow diagram, and what does itdemonstrate?

3.2 What are the two main categories of participants inmarkets? Which participants are of greatest impor-tance in determining what goods and services areproduced?

3.3 What is a free market? In what ways does a free marketeconomy differ from a centrally planned economy?

3.4 What is an entrepreneur? Why do entrepreneurs playa key role in a market system?




3.5 Under what circumstances are firms likely to producemore of a good or service? Under what circumstancesare firms likely to produce less of a good or service?

3.6 What are private property rights? What role do theyplay in the working of a market system? Why areindependent courts important for a well-function-ing economy?


3.7 Identify whether each of the following transactionswill take place in the factor market or in the productmarket and whether households or firms are supply-ing the good or service or demanding the good orservice:a. George buys a BMW X5 SUV.b. BMW increases employment at its Spartanburg

plant.c. George works 20 hours per week at McDonald’s.d. George sells land he owns to McDonald’s so it can

build a new restaurant.3.8 [Related to the Making the Connection on

page 53] In The Wealth of Nations, Adam Smithwrote the following (Book I, Chapter II): “It is notfrom the benevolence of the butcher, the brewer, orthe baker, that we expect our dinner, but from theirregard to their own interest.” Briefly discuss what hemeant by this.

3.9 In a commencement address to economics graduatesat the University of Texas, Robert McTeer, Jr., whowas then the president of the Federal Reserve Bank ofDallas, argued, “For my money, Adam Smith’s invisi-ble hand is the most important thing you’ve learnedby studying economics.” What’s so important aboutthe idea of the invisible hand?

Source: Robert D. McTeer, Jr., “The Dismal Science? Hardly!” Wall StreetJournal, June 4, 2003.

3.10 Evaluate the following argument: “Adam Smith’sanalysis is based on a fundamental flaw: He assumesthat people are motivated by self-interest. But thisisn’t true. I’m not selfish, and most people I knowaren’t selfish.”

3.11 Writing in the New York Times, Michael Lewis arguedthat “a market economy is premised on a system of

incentives designed to encourage an ignoble humantrait: self-interest.” Do you agree that self-interest isan “ignoble human trait”? What incentives does amarket system provide to encourage self-interest?

Source: Michael Lewis, “In Defense of the Boom,” New York Times,October 27, 2002.

3.12 An editorial in BusinessWeek magazine offered thisopinion: “Economies should be judged on a simplemeasure: their ability to generate a rising standard ofliving for all members of society, including people atthe bottom.” Briefly discuss whether you agree.

Source:“Poverty: The Bigger Picture,”BusinessWeek, October 7, 2002.

3.13 An estimated 400 million to 600 million peopleworldwide are squatters who live on land to whichthey have no legal title, usually on the outskirts ofcities in developing countries. Economist Hernandode Soto persuaded Peru’s government to undertake aprogram to make it cheap and easy for such squat-ters to obtain a title to the land they had been occu-pying. How would this creation of property rightsbe likely to affect the economic opportunities avail-able to these squatters?

Source: Alan B. Krueger, “A Study Looks at Squatters and Land Title inPeru,”New York Times, January 9, 2003.

3.14 [Related to the Making the Connection onpage 55] A columnist for the Wall Street Journalargued that most copyright holders are not damagedby having their material shown on YouTube:

It’s [laughable] to suggest that contentowners are hurt by videos of teenagerslip-synching to hip-hop songs, that themarket for sports DVDs is destroyed byfans being allowed to relive a team’s greatmoment, or that artists reusing footageof famous televised events destroys inter-est in documentaries.

Do you agree with the argument that the copyrightowners of the material mentioned should not be paida fee if their material is on YouTube? Are there othertypes of material not mentioned by this columnistwith which the copyright holders might suffer signif-icant financial damages by having their materialavailable on YouTube?

Source: Jason Fry, “The Revolution May Be Briefly Televised,” Wall StreetJournal, November 13, 2006.


hubbard obrien macroeconomics 2nd edition chapter 02

Economy & Finance

bmw managers

managers of bmw mustmake

decisions managers

series cars

ofbmws managers

bybmws managers

cars small

small cars