Chapter 2 Economic Activities:

Producing and Trading

Chapter 2 Economic Activities:

Producing and Trading

Costs of Trade• Transaction costs

– Time and effort needed to search out, negotiate, and consummate a trade

– May cause trades to not take place• Don’t know about the good• Shipping costs are too high• Don’t like to work with salesperson

• Third-party effects– Impacts of trade on parties not immediately involved

• Second hand smoke (negative externality)

Producing and trading

• Two people: Elizabeth and Brian

• Each produce two goods: Bread and Apples

• Elizabeth 10 loaves of bread and 10 apples

• Brian 5 loaves of bread and 15 apples

Elizabeth Apples

Elizabeth Bread

20 0

10 10

0 20

Brian Apples Brian Bread

0 10

15 5

30 0

Comparative Advantage• Should both produce apples and bread or

should they specialize?

• What does specialize mean?– Produce the good that you do best– Produce at a lower costs than other person(s) can– Called comparative advantage– Looks at opportunity cost

• What was that?• What you have to give up• Give up less?? Have the comparative advantage

What are the opportunity costs?

• Elizabeth– If give up 10 apples how

much more bread can she produce?

• 10 units

– If give up 10 loaves of bread how many more apples can she produce?

• 10 units

• Opportunity Costs– 10 Bread = 10 Apples– 1 Bread = 1 Apple

Elizabeth Apples

Elizabeth Bread

20 0

10 10

0 20

What are the opportunity costs?

• Brian– If give up 15 apples how

much more bread can he produce?

• 5 units

– If give up 5 loaves of bread how many more apples can he produce?

• 15 units

• Opportunity Costs– 5 Bread = 15 Apples– 1 Bread = 3 Apples– 1/3 Bread = 1 Apple

Brian

Apples

Brian

Bread

0 10

15 5

30 0

Should we specialize?• Elizabeth

1 Bread = 1 Apple • Brian

1 Bread = 3 Apples 1/3 Bread = 1 Apple

• Who produces apples cheaper?• What does cheaper mean?

• Lower opportunity cost (give up less)• Brian!!! Give up only 1/3 loaves of bread

• Who produces bread cheaper?• Elizabeth!!! Give up only 1 apple

Here is the deal• Elizabeth produces only bread (20 loaves)

• Brian produces only apples (30 apples)

• Trade 8 loaves of bread for 12 apples

• Breakdown of end result– Elizabeth Bread?

• 12 loaves (20 - 8 traded)

– Elizabeth Apples?• 12 apples (0 + 12 traded)

• Brian Bread– 8 loaves (0 + 8 traded)

• Brian Apples– 18 apples (30 -12 traded)

• Are they better off??

Are they better off??

No Specialization

or Trade

Specialization and Trade

Gains from trade

Elizabeth Bread

Elizabeth Apples

Brian Bread

Brian Apples

Are they better off??No

Specialization or Trade

Specialization and Trade

Gains from trade

Elizabeth Bread

10

Elizabeth Apples

10

Brian Bread

5

Brian Apples

15

Are they better off??No

Specialization or Trade

Specialization and Trade

Gains from trade

Elizabeth Bread

10 12

Elizabeth Apples

10 12

Brian Bread

5 8

Brian Apples

15 18

Are they better off??No

Specialization or Trade

Specialization and Trade

Gains from trade

Elizabeth Bread

10 12 +2

Elizabeth Apples

10 12 +2

Brian Bread

5 8 +3

Brian Apples

15 18 +3

Both are Better off!!

Can you do it??United States United Kingdom

Clothing Food Clothing Food

40 0 60 0

20 20 30 10

0 40 0 20

1. Draw the production possibility curves for both countries. (Clothing on y-axis)

2. Which country has the comparative advantage in clothing? Food?

3. The United States and United Kingdom are negotiating a trade of food and clothing between the countries. If the terms of trade is 25 units of clothing for 15 units of food, should both counties agree?

Economic System• The way in which a society decides to

answer key 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?

Two major economic systems• Capitalism

– An economic system based on private ownership of capital

– Market economy

• Socialism– An economic system based on state ownership

of capital

• Most use pieces of each mixed capitalism

How do they differ

• PPF– Capitalist: Buying behavior of consumers

signal for producers to produce more/less– Socialist: Government sets up how much to

produce

• What good to produce?– Capitalist: Consumers and producers decide– Socialist: Government decides

• How goods will be produced?

– Capitalist: producers decide– Socialist: government decides

• For whom to produce?– Capitalist: Consumers decide if they are able and

willing to purchase the good– Socialist: Government may redistribute funds to get

certain people certain items

• Trade– Capitalist view: Trade benefits both sides– Socialist view: Trade benefits one side at the

expense of the other

• Prices– Capitalism views

• Rations goods and services• Conveys information• Serves as an incentive to respond to information

– Socialism views• Price is set by greedy businesses with much economic

power• Price controls (can’t charge more or less than a certain

price)

Now we want to use these questions for the next chapter

as we look at:

Now we want to use these questions for the next chapter

as we look at: What a market is and how is it

established.

Homework #3

Chapter 2

Questions 1, 5, 12, and 17

Working with Graphs and Numbers: 1, 2, and 5

In-class exercise 3

Do we understand Chapter 2?