Chapter 1 began our study of the basics of economic analysis. Chapter 2 continues the task, introducingto such concepts as marginal choice, efficiency, economic growth, and exchange. This is not exactly a “tools of economics” chapter; instead we look at basic premises that underlie the economic analysis presented in the text.

n CHAPTER OBJECTIVES

After completing this chapter, you should be able to:

1.Identify the purpose of exchange.

2.Discuss the difference between exchange and the terms of exchange.

3.Explain how consumers’ surplus and producers’ surplus can be used in economics.

4.Explain what a production possibilities frontier (PPF) is.

5.Use the PPF framework to discuss choices, opportunity costs, unemployment, economic growth, efficiency, inefficiency, and more.

6.Explain how economic growth can resolve conflicts.

7.Identify the three economic questions every society must answer.

8.Identify the differences between the capitalist vision and the socialist vision.

n KEY TERMS

•production possibilities frontier (PPF) •efficiency

•exchange•transaction costs

•ex ante•ex post

•comparative advantage •consumers’ surplus

•producers’ surplus •terms of exchange

•law of increasing opportunity costs•inefficiency

•technology•economic system

•terms of exchange•law of increasing opportunity costs

•mixed capitalism•vision

nCHAPTER OUTLINE

I.EXCHANGE OR TRADE—Exchange is the process of trading one thing for another, usually money for goods or services. Through exchange we give up one thing for something that we value more.

B.Consumers’ and Producers’ Surplus

1.CONSUMERS’ SURPLUS is the difference between the maximum price a consumer is willing and able to pay and the price actually paid—Consumers’ Surplus = Maximum Buying Price – Price Paid. If a consumer would pay $5 for a sandwich and pays only $3.50, the consumers’ surplus is $1.50. Could be measured in dollars pr utility.

2.PRODUCERS’ SURPLUS is the difference between the minimum price a producer is willing and able to sell a good for and the price actually paid—Producers’ Surplus = Price Paid – Minimum Selling Price. If a consumer pays $3.50 for a sandwich and the seller would have sold it for only $2.50, the producers’ surplus is $1.00.

C.Will a Policy Make You Better or Worse Off?—

Economists often judge the impact of a policy change by the effect it has on consumers’ and producers’ surplus. 

A policy that raises consumers’ surplus makes consumers better off. Policy changes can raise, lower, or not affect consumers’ surplus.

D.Exchange and the TERMS OF EXCHANGE—The terms of exchange refer to how much of one good is traded in terms for another good. If a loaf of bread is $1 and a banana is 25 cents, the terms of exchange are 1 loaf = 4 bananas. 

E.Unexploited Exchanges—Sometimes an exchange does not take place even when the buyer and seller both find the terms of exchange acceptable. For example, suppose the seller of a car wants $15,000 and the potential buyer would be willing to pay $18,000. Favorable terms of exchange exist to make both parties better off, yet the transaction may not take place.

1.Transaction Costs—Transaction costs are the primary reason for these unexploited exchanges. These are the costs associated with the time and effort needed to search out, negotiate, and consummate an exchange. The buyer has to know the good exists. Shopping takes time, advertising products costs money, and so on. The Internet can lower transaction costs by making it easier for potential buyers to shop among competing sellers, and sellers can facilitate sales by making it easier for on-line shoppers to complete the transaction.

F.Turning Potential Exchanges into Actual Exchanges—Lowering transactions costs is one role the entrepreneur plays in facilitating exchanges.

G.Exchanges and THIRD PARTY EFFECTS— Also called EXTERNALITIES Sometimes an exchange between two people can affect a third party, either positively or negatively. 

For example, nonsmokers may be negatively impacted by the smoke of others. These are known as negative externalities.

When we assume that the market is operating efficienly, we assume that the people that make a transaction, make a trade absorb all of the costs and benefits of the trade. When others are inadbvertabtly involved say with pollution or with SUV’s for examples, the market may be inefficient.

H.TradingWithout Money—Trade is a utility-increasing activity in that it increases the utility of both parties to the transaction.

1.COMPARATIVE ADVANTAGE—A person who can produce a good at a lower opportunity cost than another person is said to have a comparative advantage in the production of that good. 

2.If person A can produce 10 shirts or 5 pants in a day, the opportunity costs are 2S = 1P (or 1S = ½P). If person B can produce 10 shirts or 10 pants in a day, the opportunity costs are 1S = 1P. Person A would have the comparative advantage in shirts and person B in pants.

II.THE PRODUCTION POSSIBILITIES FRONTIER—The production possibilities frontier (PPF) illustrates a number of economic concepts: tradeoffs, economic growth, and efficiency. 

TRADE OFF more of one good means less than another

A PPF involves an economy that produces only two goods. 

The frontier (or curve) itself shows all the possible combinations of output that can be produced with a given state of technology, no unemployed resources and efficient production.

A.Straight Line PPF—The straight line PPF represents the state in which the two goods have constant opportunity costs. That is, the rate at which one good can be substituted for the other along the curve is constant.

B.Bowed Outward (Concave Downward) PPF—The PPF drawn concave to the origin indicates increasing opportunity costs. 

This means that as we increase the production of one good, the opportunity costs of making additional units of that good increase. 

C.Law of Increasing Opportunity Costs—When resources are specialized, increased production of one good comes at increased opportunity costs, that is, as the production of one good increases, the (opportunity) cost of producing that good rises faster and faster. 

This is what gives most PPFs their bowed outward curvature.

D.Three Economic Concepts within a PPF Framework—The PPF can be used to explain efficiency, tradeoffs, economic growth, technology, and unemployed resources.

1.Efficiency and Tradeoffs—An economy achieves productive EFFICIENCY when it produces the maximum possible output with given resources and technology.

It is inefficient if less than the maximum output is produced. Efficient production takes place only along the PPF; points below the frontier are always inefficient. 

Efficiency implies that we must give up some of one good to produce more of the other. 

Inefficiency implies that it is possible to produce more of both goods. 

2.Unemployed Resources—One reason that the economy may not be producing at the efficient level is that it may have unemployed resources. 

Along the PPF itself, all resources are employed.

3.Economic Growth—Economic growth refers to increasing the productive capacity of the economy. This is represented by a rightward shift in the PPF.

TECHNOLOGY-

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

An improvement in technology allows existing resources to produce more output, shifting the PPF rightward.

E.Economics and Technology—As farmers have become more productive, fewer farmers are needed to produce the same level of output. Where 32 million farmers worked in the United States in 1910, there are fewer than 5 million farmers today. Technological advances in farming allowed resources to be moved off the farms and into other areas of production without lessening farm production. Therefore, technology changes in one industry can have ripple effects into other unrelated industries.

F.What Can Make Both Conservatives and Liberals Happy?—Rightward shifts in the PPF allow the economy to produce more of all goods simultaneously. Often conservatives and liberals want different output choices. When the PPF is moving to the right (economic growth), it may be possible to produce what both want without having to choose between them.

III.ECONOMIC QUESTIONS AND ECONOMIC SYSTEMS

A.Three Economic Questions Every Society Must Answer

1.What Goods Will Be Produced?—The PPF teaches us that it is impossible to produce as much of every good as we might want, so tradeoffs and choices must be made.

2.How Will the Goods Be Produced?—Resources are also finite and must be allocated to production activities. 

3.For Whom Will Goods Be Produced?—The production must be allocated among consumers, either by a market mechanism or by government action.

C.ECONOMIC SYSTEMS— The way in which society decides to answer key economic questions related to production and trade is its economic system. 

The two major economic systems are capitalism and socialism, but most countries use some combination of the two known as MIXED CAPITALISM. Most economic activities take place in the private sector in the system, but government plays a substabtial economic and regulatory role.

Some economies are closer to capitalism and some to socialism.

E.The Two Systems as they Relate to the Market

1.Prices—The capitalist thinker sees prices as a mechanism that rations goods and services, conveys information, and serves as an incentive to respond to information. A freeze in Florida reduces the orange crop. Orange prices rise, conveying information about a change in the scarcity of oranges that causes both producers and consumers to respond. 

The socialist thinker views prices as being set by greedy businesses with vast economic power, not as a result of the impersonal interaction of supply and demand. If the price of oranges rises suddenly, the government should restrict the price increase to prevent orange growers from exploiting consumers. 

2.Competition—

A capitalist thinker views competition as being omnipresent in the market, whereas the socialist thinker views the market economy as being largely controlled by big business interests that dictate prices and may use manipulative advertising to influence their buying decisions. 

3.Private Property—

The capitalist thinker places a high value on private property because it encourages individuals to make efficient use of resources they own. 

The socialist thinker believes that large private property owners have greater political power and use this power to take advantage of those who have little property. For this reason, it is better to have government ownership than private ownership.

4.Exchange—The capitalist thinker sees an exchange as a mutually beneficial action between consenting market participants whereas the socialist thinker often sees one person benefiting more from the exchange than the other.

F.Economics Around the World—

The Berlin Wall and Soviet Union both came to an end in the late 1980s and early 1990s. One reason is suggested by the PPF. The Soviet Union and its bloc devoted most of its output to military goods, leaving consumers without quality or quantity of goods. 

Economic growth did not occur. 

The result was a dissatisfied population who wanted to shift their country’s resource allocation to a different point on the PPF, and could do so only by replacing their government’s vision.