Ch. 2: Trade, Tradeoffs, and Economic Systems

Del Mar College

John Daly©2003 South-Western Publishing, A Division of Thomson Learning

The Production Possibilities Frontier (PPF)

• The PPF is a graph representing the possible combinations of two goods than an economy can produce in a certain period of time under the conditions of a given state of technology, no unemployed resources and efficient production.

Straight Line PPF: Constant Opportunity Costs

Bowed Outward PPF: Increasing Opportunity Costs

Law of Increasing Opportunity Law of Increasing Opportunity CostsCosts

• In the Real World, most PPF lines are bowed outward.

• For most goods, the opportunity costs the opportunity costs increase as more of the good is producedincrease as more of the good is produced.

Economic Concepts in a PPF Framework

• The economy is efficientefficient if it is producing the maximum output with given resources and technology.

• The economy is inefficientinefficient if it is not producing the maximum output with the given resources and technology.

• Efficiency implies gains are impossible in one area without losses in another area.

Technology

• Technology refers to the body of skills and knowledge concerning the use of resources in production.

• An advance in technology commonly refers to the ability to produce more output with a fixed quantity of resources or the ability to produce the same output with a smaller quantity of resources.

Q & AQ & A• What does a straight-line production possibilities

frontier (PPF) represent? What does a bowed-outward PPF represent?

• Would you expect to see more or fewer political battles in a stagnant economy? What about a growing economy?

• A politician says, “If you elect me, we can get more of everything we want.” Under what conditions is the politician telling the truth?

• In an economy, is there only one combination of goods that is efficient? Explain your answer.

Exchange or Trade

• Why do people trade?

• To make themselves better off.

Time Relevant to Exchange

• Ex Ante: Before the Trade or Exchange has occurred.

• At the Point of Exchange or Trade.

• Ex Post: After the trade has occurred.

Consumers’ and Producers’ Surplus

• Consumers’ Surplus: The difference between the price you paid and the Maximum Price you were willing to pay.

• Producers’ Surplus: The difference between the price received and the Minimum selling price.

Trade and Terms of Trade

• Trade is the process where things (money, goods, services, and so on) are traded or exchanged.

• Terms of Trade refer to how much of one thing is traded for how much of something else.

• Buyers prefer lower prices, sellers prefer higher prices.

Unexploited Trades

• Transaction Costs are the costs associated with searching out, negotiating, and completing an exchange.

• Transaction Costs sometimes keep potential exchanges from turning into actual exchanges.

• One role of the Entrepreneur is to turn potential exchanges into actual exchanges by lowering transaction costs.

Trades and Third Parties• Third Party Effects:

someone other than the parties involved in the exchange was effected.

• If the Third Party Effects had a negative effect on the third party, this exchange effects negative externalities.

Q & A

• What are Transaction Costs? What is the producers’ surplus? The consumers’ surplus?

• Give an Example of an exchange WITHOUT third party effects. Now, give an Example With third party effects. What is the difference in the outcomes?

Production and Trading

• Remember, Trading is a Utility-Increasing Activity!

• Barter is exchanging one good for another: for example, trading apples for bread.

• Comparative Advantage: The situation where someone can produce a good at lower opportunity cost than someone else can.

• Economists have shown that making one product, the trading it for another utility can increase gains for both parties!

Q & A

• If George can produce either (a) 10X and 20Y or (b) 5X and 25Y, what is the opportunity cost to George of producing one more X?

• Harriet can produce either (a) 30X and 70Y or (b) 40X and 55Y; Bill can produce either (c) 10X and 40Y or (d) 20X and 20Y. Who has a comparative advantage in the production of X? In Y? Explain your answers.

Economic Systems

• The way in which society decides what goods to produce, how to produce them, and for whom they will be produced.

Economic Questions

• What goods will be produced?

• How will the goods be produced?

• For whom will the goods be produced?

• Where on the PPF will the economy operate?

• What is the nature of trade?

• What function do prices serve?

Economic Systems and the PPF

• There are hundreds of countries but only two major economic systems.

• We refer to these two major systems as Socialism and Capitalism.

• Most Countries have Chosen Elements from BOTH economic systems.

Mixed Capitalist

Economies

• An economic system characterized by largely private ownership of factors of production, market allocation of resources, and decentralized decision making. Most activities take lace in the private sector in this system, but government plays a substantial and regulatory role.

• The United States has a Mixed Capitalist Economy.

Who or What Should Determine Where the Economy is on the PPF?

• To the Capitalist Thinker:

The Market Decides!• To the Socialist

Thinker:

The Market Does Not Decide; The Government (usually) Decides.

What Goods Will Be Produced?

• This is really asking “Where on the PPF will an economy operate?”

• Capitalist System: The Market will dictate what goods will be produced.

• Socialist System: The Government will have a large role in determining what will be produced.

How Will The Goods Be Produced?

• Under Capitalism, this is decided by private producers.

• Under Socialism, governments play a large part in deciding what is produced.

For Whom Will The Goods Be Produced?

• Under Capitalism, goods will be produced for those persons who are able and willing to pay the prices for the goods.

• Under Socialism, there is more government control over who gets what goods.

Trade

• Under Capitalism, both parties benefit from the trade.

• Under Socialism, Trade is viewed as making one person better off at the expense of another person.

Prices

Under a Capitalist System:

• Prices ration goods and services

• Prices Convey Information

• Prices Serve as an Incentive to Respond to Information

Q & AQ & A

• What are the three economic questions every society must answer?

• How is trade viewed in a Capitalist economic system? In a Socialist system?

• What does an economic system have to do with where on its PPF the economy operates?