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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
20
Elizabeth
Bread
0
10
10
0
20
Brian Apples
Brian Bread
0
15
30
10
5
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?
Elizabeth
Apples
Elizabeth
Bread
20
0
10
10
0
20
• 10 units
• Opportunity Costs
– 10 Bread = 10 Apples
– 1 Bread = 1 Apple
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?
Brian
Apples
Brian
Bread
0
10
15
5
30
0
• 15 units
• Opportunity Costs
– 5 Bread = 15 Apples
– 1 Bread = 3 Apples
– 1/3 Bread = 1 Apple
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 Gains from
Specialization
and Trade
trade
or Trade
Elizabeth
Bread
Elizabeth
Apples
Brian
Bread
Brian
Apples
Are they better off??
Elizabeth
Bread
Elizabeth
Apples
Brian
Bread
Brian
Apples
No
Specialization Gains from
Specialization
and Trade
trade
or Trade
10
10
5
15
Are they better off??
Elizabeth
Bread
Elizabeth
Apples
Brian
Bread
Brian
Apples
No
Specialization Gains from
Specialization
and Trade
trade
or Trade
10
12
10
12
5
8
15
18
Are they better off??
Elizabeth
Bread
Elizabeth
Apples
Brian
Bread
Brian
Apples
No
Specialization Gains from
Specialization
and Trade
trade
or Trade
10
12
+2
10
12
+2
5
8
+3
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:
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?