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chapter

Economic Activities:
Producing and Trading 2
Setting The following events happened on a day in March.
the Scene

8:2 5 A.M. only produce ‘more time’ the same way 6 : 2 5 P. M .

Two presidential advisors are in the West people produce more watches or more Jayant says to Helena.“What eBay did
Wing of the White House discussing cars. I bet we could sell that for a pretty really wasn’t that hard.” Helena replies,
what Eduard Shevardnadze said in 1990. penny.” “I just wish I had done it.”
Shevardnadze had been the Soviet foreign
minister before the collapse of the Soviet 5 : 5 5 P. M .
Union. He had said the Soviet Union Karen and Larry have been married for
collapsed because of the conflict between eleven years.They have two children: a boy,
the Kremlin and the people.The Kremlin James, nine years old, and a girl, Caroline,
wanted “more guns,” and the people six years old. Every night, Karen cooks the
wanted “more butter,” but it was impossi- dinner and Larry washes the dishes. Fact
ble to get more of both. Something had is, when Karen and Larry first got mar-
to give, and so it did:The Soviet Union ried, they decided to split the households
imploded. tasks “right down the middle.”To them,
this meant that Karen and Larry would
10 : 13 A . M . each do half of everything: Karen would
Bob and Jim are roommates and students do half the cooking, and Larry would do Here are some questions
at the University of Missouri Kansas City.
Bob says,“I have two final exams tomor-
row—biology at 9 and calculus at 2. I
half the cooking; Karen would do half the
cleaning, and Larry would do half the
cleaning. It hasn’t turned out that way,
? to keep in mind as you read
this chapter:

think it’s come down to choosing where though. Each does 100 percent of certain • What does a point on a production
I want to get an A. I don’t have enough tasks. In a way, each has specialized in per- possibilities frontier have to do with
study time tonight to get As in both forming certain tasks around the house. the collapse of the Soviet Union?
courses.” Jim comments,“If we could
• Why can’t Bob get As in both
biology and calculus, and what
does Jim’s desire to produce “more
time”tell us about life?
• What led Karen and Larry to
specialize in doing certain tasks?
• What did eBay do that really
© ASSOCIATED PRESS, AP

wasn’t that hard?

See analyzing the scene at the end of

this chapter for answers to these questions.
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32 Part 1 Economics: The Science of Scarcity

The Production Possibilities Frontier

This section discusses the production possibilities frontier (PPF) and numerous economic
concepts that can be illustrated by it.

The Straight-Line PPF: Constant Opportunity Costs

Assume the following:

1. Only two goods can be produced in an economy: computers and television sets.
2. The opportunity cost of 1 television set is 1 computer.
3. As more of one good is produced, the opportunity cost between television sets and
computers is constant.
Production Possibilities In Exhibit 1(a), we have identified six combinations of computers and television sets
Frontier (PPF) that can be produced in our economy. For example, combination A is 50,000 computers
Represents the possible combinations and 0 television sets, combination B is 40,000 computers and 10,000 television sets, and
of two goods that can be produced in
a certain period of time under the so on. We plotted these six combinations of computers and television sets in Exhibit
conditions of a given state of 1(b). Each combination represents a different point in Exhibit 1(b). For example, the
technology and fully employed combination of 50,000 computers and 0 television sets is represented by point A. The
resources.
line that connects points A–F is the production possibilities frontier. A production
possibilities frontier (PPF) represents the combination of two goods that can be
produced in a certain period of time under the conditions of a given state of technology
and fully employed resources.
The production possibilities frontier is a straight line in this instance because the
exhibit 1 opportunity cost of producing computers and television sets is constant.
Production Possibilities Frontier
(Constant Opportunity Costs) Straight-line PPF  Constant opportunity costs
The economy can produce any of the For example, if the economy were to move from point A to point B, from B to C, and
six combinations of computers and
television sets in part (a). We have so on, the opportunity cost of each good would remain constant at 1 for 1.To illustrate, at
plotted these combinations in part point A, 50,000 computers and 0 television sets are produced. At point B, 40,000 com-
(b). The production possibilities fron- puters and 10,000 television sets are produced.
tier in part (b) is a straight line
because the opportunity cost of pro-
ducing either good is constant: for Point A: 50,000 computers, 0 television sets
every 1 computer not produced, 1 tel- Point B: 40,000 computers, 10,000 television sets
evision set is produced.

Television Point in A
50
Computers (thousands per year)

Combination Computers Sets Part (b) A straight-line PPF

illustrates constant
A 50,000 0 A B opportunity costs.
40
B 40,000 10,000 B
C 30,000 20,000 C C
D 20,000 30,000 D 30

E 10,000 40,000 E
D
F 0 50,000 F 20

E
10
(a)
F

0 10 20 30 40 50
Television Sets (thousands per year)
(b)
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Economic Activities: Producing and Trading Chapter 2 33

We conclude that for every 10,000 computers not produced, 10,000

television sets are produced—a ratio of 1 to 1. The opportunity
cost—1 computer for 1 television set—that exists between points A
Q&A Opportunity cost and PPF seem like
two economic concepts that are
and B also exists between points B and C, C and D, D and E, and E linked together somehow. Are they?
and F. In other words, opportunity cost is constant at 1 computer for
1 television set. Yes. When we move from one point on the PPF to
another point on the PPF, we automatically incur an
The Bowed-Outward (Concave-Downward) PPF: opportunity cost. To illustrate, suppose we move from
Increasing Opportunity Costs point C in Exhibit 1(b) to point D. Notice what hap-
Assume two things: pens: We get more television sets but fewer computers.
What we have to “give up” to get more television sets is
1. Only two goods can be produced in an economy: computers the opportunity cost of those additional television sets.
and television sets.
2. As more of one good is produced, the opportunity cost between
computers and television sets changes.
In Exhibit 2(a), we have identified four combinations of computers and television
sets that can be produced in our economy. For example, combination A is 50,000 com-
puters and 0 television sets, combination B is 40,000 computers and 20,000 television
sets, and so on. We plotted these four combinations of computers and television sets in
Exhibit 2(b). Each combination represents a different point. The curved line that con-
nects points A–D is the production possibilities frontier.
In this case, the production possibilities frontier is bowed outward (concave down-
ward) because the opportunity cost of television sets increases as more sets are produced.
Bowed-outward PPF  Increasing opportunity costs
exhibit 2
Production Possibilities Frontier
To illustrate, let’s start at point A, where the economy is producing 50,000 computers (Increasing Opportunity Costs)
and 0 television sets, and move to point B, where the economy is producing 40,000 The economy can produce any of the
computers and 20,000 television sets. four combinations of computers and
televisions sets in part (a). We have
Point A: 50,000 computers, 0 television sets plotted these combinations in part (b).
The production possibilities frontier
Point B: 40,000 computers, 20,000 television sets in part (b) is bowed outward because
the opportunity cost of producing tel-
evision sets increases as more tele-
vision sets are produced.

A A bowed-outward
Television Point in 50
Computers (thousands per year)

(concave-downward)
Combination Computers Sets Part (b) PPF illustrates
B increasing
A 50,000 0 A 40 opportunity costs.
B 40,000 20,000 B
C 25,000 40,000 C 30
D 0 60,000 D 25
C

20
(a)
10
D

0 10 20 30 40 50 60
Television Sets (thousands per year)

(b)
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34 Part 1 Economics: The Science of Scarcity

What is the opportunity cost of a television set over this range? We see that 20,000 more
television sets are produced by moving from point A to point B but at the cost of only
10,000 computers. This means for every 1 television set produced, 1/2 computer is for-
feited.Thus, the opportunity cost of 1 television set is 1/2 computer.
Now let’s move from point B, where the economy is producing 40,000 computers
and 20,000 television sets, to point C, where the economy is producing 25,000 comput-
ers and 40,000 television sets.
Point B: 40,000 computers, 20,000 television sets
Point C: 25,000 computers, 40,000 television sets

What is the opportunity cost of a television set over this range? In this case, 20,000
more television sets are produced by moving from point B to point C but at the cost of
15,000 computers. This means for every 1 television set produced, 3/4 computer is for-
feited.Thus, the opportunity cost of 1 television set is 3/4 of a computer.
Law of Increasing What statement can we make about the opportunity costs of producing television
Opportunity Costs sets? Obviously, as the economy produces more television sets, the opportunity cost of
As more of a good is produced, the
opportunity costs of producing that
producing television sets increases.This gives us the bowed-outward production possibil-
good increase. ities frontier in Exhibit 2(b).

Law of Increasing Opportunity Costs

We know that the shape of the production possi-
bilities frontier depends on whether opportunity
costs (1) are constant or (2) increase as more of a
good is produced. In Exhibit 1(b), the produc-
tion possibilities frontier is a straight line; in
Exhibit 2(b), it is bowed outward (curved). In the
real world, most production possibilities frontiers
are bowed outward. This means that for most
goods, the opportunity costs increase as more of
the good is produced. This is referred to as the
law of increasing opportunity costs.
But why (for most goods) do the opportu-
nity costs increase as more of the good is pro-
duced? The answer is because people have vary-
ing abilities. For example, some people are better
suited to building houses than other people are.
When a construction company first starts build-
ing houses, it employs the people who are most
skilled at house building. The most skilled per-
sons can build houses at lower opportunity costs
than others can. But as the construction com-
pany builds more houses, it finds that it has
already employed the most skilled builders, so it
must employ those who are less skilled at house
© ASSOCIATED PRESS, AP

building. These (less skilled) people build houses

at higher opportunity costs. Where three skilled
house builders could build a house in a month,
as many as seven unskilled builders may be
required to build it in the same length of time.
Exhibit 3 summarizes the points in this section.
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Economic Activities: Producing and Trading Chapter 2 35

exhibit 3

A Closer
A CLOSER LOOK Look A Summary Statement About
Increasing Opportunity Costs and a
Production Possibilities Frontier That Is
Bowed Outward (Concave Downward)
Many of the points about increasing
opportunity costs and a production
possibilities frontier that is bowed
outward are summarized here.

We start with the When houses are first built, As increasingly more This is the same as saying
assumption that not all only the people who can houses are built, people that as more houses are
people can build houses build them at (relatively) with higher opportunity built, the opportunity cost
at the same opportunity low opportunity costs will costs of building houses of building houses
cost. build them. will start building houses. increases.

And this is why the PPF for

A houses and good X is
100 }5 B bowed outward (concave
95
downward). See diagram
at left.
Good X

C Notice that when we go

50 from building 60 to 70
20 houses (10 more houses),
we forfeit 5 units of good X;
30 D but when we go from
building 110 to 120 houses
(again, 10 more houses),
10 10 we forfeit 20 units of
good X.
0 60 70 110 120
Houses

Economic Concepts Within a PPF Framework

The PPF framework is useful for illustrating and working with economic concepts. This
section discusses seven economic concepts in terms of the PPF framework (see Exhibit 4).

SCARCITY Recall that scarcity is the condition where wants (for goods) are greater than
the resources available to satisfy those wants. The finiteness of resources is graphically
portrayed by the PPF in Exhibit 5. The frontier (itself ) tells us: “At this point in time,
that’s as far as you can go. You cannot go any farther. You are limited to choosing any
combination of the two goods on the frontier or below it.”
The PPF separates the production possibilities of an economy into two regions: (1) an
attainable region, which consists of the points on the PPF itself and all points below it
(this region includes points A–F) and (2) an unattainable region, which consists of the
points above and beyond the PPF (such as point G). Recall that scarcity implies that
some things are attainable and others are unattainable. Point A on the PPF is attainable,
as is point F; point G is not.
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36 Part 1 Economics: The Science of Scarcity

exhibit 4
The PPF Economic Framework
PPF can be
used to
illustrate 7
economic
Scarcity
concepts

Choice

Opportunity Cost

Productive Efficiency

Productive Inefficiency

Unemployment

Economic Growth

exhibit 5
The PPF and Various Economic A
Concepts 55
B
The PPF can illustrate various eco- 50 Unattainable Region
nomic concepts: (1) Scarcity is illus- G
trated by the frontier itself. Implicit in
Television Sets (thousands)

the concept of scarcity is the idea

that we can have some things but not
all things. The PPF separates an C
attainable region from an unattain- 35
able region. (2) Choice is represented
by our having to decide among the
many attainable combinations of the D
28
two goods. For example, will we
choose the combination of goods
represented by point A or by point B? Attainable Region E
(3) Opportunity cost is most easily 15
seen as movement from one point to F
another, such as movement from
point A to point B. More cars are
available at point B than at point A,
but fewer television sets are avail-
able. In short, the opportunity cost
of more cars is fewer television sets. 0 5 15 35 45 52
(4) Productive efficiency is repre- Cars (thousands)
sented by the points on the PPF
(such as A–E ), while productive inef-
ficiency is represented by any point
below the PPF (such as F ). (5) Unem-
ployment (in terms of resources Choice and opportunity cost are also shown in Exhibit 5. Note that within the
being unemployed) exists at any pro- attainable region, individuals must choose the combination of the two goods they want
ductive inefficient point (such as F),
whereas resources are fully to produce. Obviously, hundreds of different combinations exist, but let’s consider only
employed at any productive efficient two, represented by points A and B. Which of the two will individuals choose? They
point (such as A–E ).
can’t be at both points; they must make a choice.
Opportunity cost is illustrated as we move from one point to another on the PPF in
Exhibit 5. Suppose we are at point A and choose to move to point B. At A, we have
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Economic Activities: Producing and Trading Chapter 2 37

economics 24/7
CAN TECHNOLOGY ON THE FARM AFFECT THE NUMBER OF LAWYERS IN THE CITY?

There is no doubt that an advance in technology affects the Because fewer farmers were needed to produce food, many
industry in which it is developed and used. For example, a tech- farmers left the farms and entered the manufacturing and
nological advance in the car industry will increase the output of service industries. In other words, people who were once
cars; a technological advance in the house-building industry farmers (or whose parents and grandparents were farmers)
will increase the output of houses. began to produce cars, airplanes, television sets, and comput-
ers. They became attorneys, accountants, and police officers.
But can a technological advance in one industry have ripple
effects beyond the industry in which it is developed and What should we learn from this? First, a technological
used? With this question in mind, let’s start with some facts advance in one sector of the economy may make it possible
about farming. The United States had 32.1 million farmers to produce goods in another sector of the economy. Techno-
in 1910, 30.5 million farmers in 1940, 9.7 million farmers in logical advances in agriculture made it possible for fewer
1970, and about 4.8 million farmers in 2000. Farmers farmers to produce more food, thus releasing some farmers
accounted for 34.9 percent of the U.S. population in 1910, to produce other things. In other words, there may be more
23.2 percent in 1940, 4.8 percent in 1970, and only 1.9 services in the world in part because of agriculture’s techno-
percent in 2005. Where did all the farmers go, and why did logical advances.
they leave farming?
Second, technological advances may affect the composition
Many farmers left farming because farming experienced of employment. The technological advances in agriculture
major technological advances during the 20th century. resulted in (1) a smaller percentage of people working in
Where farmers once farmed with minimal capital equip- rural areas on farms and (2) a larger percentage of people
ment, today they use computers, tractors, pesticides, cellu- working in manufacturing and services in the cities and sub-
lar phones, and much more. As a result, more food can be urbs. (Is the growth of the suburbs in the last 50 years due
produced with fewer farmers. in part to technological advances on farms?)

55,000 television sets and 5,000 cars, and at point B, we have 50,000 television sets and
15,000 cars. What is the opportunity cost of a car? Because 10,000 more cars come at a
cost of 5,000 fewer television sets, the opportunity cost of 1 car is 1/2 television set.
Productive Efficiency
PRODUCTIVE EFFICIENCY Economists often say that an economy is productive effi- The condition where the maximum
cient if it is producing the maximum output with given resources and technology. In output is produced with given
resources and technology.
Exhibit 5, points A, B, C, D, and E are all productive efficient points. Notice that all
these points lie on the production possibilities frontier. In other words, we are getting Productive Inefficiency
The condition where less than the
the most (in terms of output) from what we have (in terms of available resources and maximum output is produced with
technology). given resources and technology.
It follows that an economy is productive inefficient if it is producing less than Productive inefficiency implies that
more of one good can be produced
the maximum output with given resources and technology. In Exhibit 5, point F is a without any less of another good being
productive inefficient point. It lies below the production possibilities frontier; it is below produced.
the outer limit of what is possible. In other words, we could produce more goods with
the resources we have available to us. Or we can get more of one good without getting
less of another good.
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38 Part 1 Economics: The Science of Scarcity

To illustrate, suppose we move from inefficient point F to efficient point C. We pro-

exhibit 6 duce more television sets and no fewer cars.What if we move from F to D? We produce
Economic Growth within more television sets and more cars. Finally, if we move from F to E, we produce more
a PPF Framework cars and no fewer television sets. Thus, moving from F can give us more of at least one
An increase in resources or an good and no less of another good. In short, productive inefficiency implies that gains are possi-
advance in technology can increase ble in one area without losses in another.
the production capabilities of an
economy, leading to economic
growth and a shift outward in the UNEMPLOYED RESOURCES When the economy exhibits productive inefficiency, it is not
production possibilities frontier.
producing the maximum output with the available resources and technology. One reason
Economic growth shifts may be that the economy is not using all its resources; that is, some of its resources are
the PPF outward. unemployed, as at point F in Exhibit 5.
When the economy exhibits productive efficiency, it is producing the maximum
output with the available resources and technology.This means it is using all its resources
Military Goods

PPF2 to produce goods; its resources are fully employed, and none are unemployed. At the
productive efficient points A–E in Exhibit 5, there are no unemployed resources.
PPF1
ECONOMIC GROWTH Economic growth refers to the increased productive capabilities of
an economy. It is illustrated by a shift outward in the production possibilities frontier.
Two major factors that affect economic growth are (1) an increase in the quantity of
0 Civilian Goods
resources and (2) an advance in technology.
With an increase in the quantity of resources (e.g., through a new discovery of
resources), it is possible to produce a greater quantity of output. In Exhibit 6, an increase
in the quantity of resources makes it possible to produce both more military goods and
more civilian goods.Thus, the PPF shifts outward from PPF1 to PPF2.
Technology Technology refers to the body of skills and knowledge concerning the use of
The body of skills and knowledge resources in production. An advance in technology commonly refers to the ability to
concerning the use of resources in produce more output with a fixed quantity of resources or the ability to produce the
production. An advance in technology
commonly refers to the ability to same output with a smaller quantity of resources.
produce more output with a fixed Suppose an advance in technology allows more military goods and more civilian
amount of resources or the ability to
produce the same output with fewer
goods to be produced with the same quantity of resources. As a result, the PPF in
resources. Exhibit 6 shifts outward from PPF1 to PPF2. The outcome is the same as when the
quantity of resources is increased.

SELF-TEST
(Answers to Self-Test questions are in the Self-Test Appendix.)
1. What does a straight-line production possibilities frontier (PPF) represent? What does a
bowed-outward PPF represent?
2. What does the law of increasing costs have to do with a bowed-outward PPF?
3. A politician says, “If you elect me, we can get more of everything we want.” Under what
condition(s) is the politician telling the truth?
4. In an economy, only one combination of goods is productive efficient. True or false?
Explain your answer.

Exchange or Trade
Exchange (Trade) Exchange or trade is the process of giving up one thing for something else. Usually,
The process of giving up one thing for money is traded for goods and services. Trade is all around us; we are involved with it
something else. every day. Few of us, however, have considered the full extent of trade.
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Economic Activities: Producing and Trading Chapter 2 39

economics 24/7
LIBERALS, CONSERVATIVES, AND THE PPF

Liberals and conservatives often pull in different eco-

nomic directions. To illustrate, suppose our economy is
currently at point A in Exhibit 7, producing X2 of good X
and Y2 of good Y. Conservatives prefer point C to point A Through economic growth,
and try to convince the liberals and the rest of the nation shown here by a shift from
PPF1 to PPF2, both liberals
to move to point C. Liberals, however, prefer point B to and conservatives can get
point A and try to persuade the conservatives and the more of what they want.
rest of the nation to move to point B. Thus, we have a D
B
political tug of war. Y3

Is there a way that both groups can get what they want?

Good Y
Yes, if there is economic growth so that the production
possibilities frontier shifts outward from PPF1 to PPF2 . A
Y2
On the new production possibilities frontier, PPF2 , point
D represents the quantity of X that conservatives want
and the quantity of Y that liberals want. At point D, con- C PPF2
servatives have X3 units of good X, which is what they Y1
would have had at point C, and liberals have Y3 units of
good Y, which is what they would have had at point B.
Through economic growth, both conservatives and liber- PPF1
als can get what they want. The political tug of war will
cease—at least for a while. 0 X1 X2 X3
We say “for a while” because even at point D, there is Good X
scarcity. The wants of liberals and conservatives are both
greater than the resources available to satisfy those
wants. Starting at point D, liberals might push for a exhibit 7
movement up the production possibilities frontier and
Economic Growth May End Political Battles, for a While
conservatives for a movement down it.
The economy is at point A, but conservatives want to be at point C and
Question to ponder: Does an increase in a family’s liberals want to be at point B. As a result, there is a political tug-of-war.
income have the same effect as economic growth in a Both conservatives and liberals can get the quantity of the good they
society? Does it eliminate or reduce the family tug of want through economic growth. This is represented by point D on PPF2.
war—at least for a while?

Periods Relevant to Trade

There are three time periods relevant to the trading process. We discuss these relevant
time periods next.

BEFORE THE TRADE Before a trade is made, a person is said to be in the ex ante position. Ex Ante
For example, suppose Ramona has the opportunity to trade what she has, $2,000, for Phrase that means “before,” as in
something she does not have, a big-screen television set. In the ex ante position, she before a trade.
wonders if she will be better off with (1) the television set or with (2) $2,000 worth of
other goods. If she concludes that she will be better off with the television set than with
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40 Part 1 Economics: The Science of Scarcity

$2,000 worth of other goods, she will make the trade. Individuals will make a trade only
if they believe ex ante (before) the trade that the trade will make them better off.

AT THE POINT OF TRADE Suppose Ramona now gives $2,000 to the person in possession
of the television set. Does Ramona still believe she will be better off with the television
set than with the $2,000? Of course she does. Her action testifies to this fact.

Ex Post AFTER THE TRADE After a trade is made, a person is said to be in the ex post position.
Phrase that means “after,” as in after Suppose two days have passed. Does Ramona still feel the same way about the trade as
a trade. she did before the trade and at the point of trade? Maybe. Maybe not. She may look
back on the trade and regret it. She may say that if she had it to do over again, she
would not trade the $2,000 for the big-screen television set. In general, though, people
expect a trade to make them better off, and usually, the trade meets their expectations.
But there are no guarantees that a trade will meet expectations because no one in the
real world can see the future.

Trade and the Terms of Trade

Trade refers to the process whereby “things” (money, goods, services, etc.) are given up to
Terms of Trade obtain something else. The terms of trade refer to how much of one thing is given up
How much of one thing is given up for for how much of something else. For example, if $30 is traded for a best-selling book, the
how much of something else. terms of trade are 1 bestseller for $30. If the price of a loaf of bread is $2.50, the terms
of trade are 1 loaf of bread for $2.50. Buyers and sellers can always think of more advanta-
geous terms of exchange. Buyers prefer lower prices, whereas sellers prefer higher prices.

Thinking like Costs of Trades

A person buys a pair of shoes for
AN ECONOMIST $100. Later that day, the person
As always, economists consider both benefits and costs.They want to
determine what costs are involved in a trade and whether the costs
says that he was “ripped off” by the shoe store owner; may prevent a trade from taking place.
specifically, he says he paid too much for the shoes. Is
this person arguing against trade or against the terms UNEXPLOITED TRADES Suppose Smith wants to buy a red 1965 Ford
of trade? The economist knows that sometimes what Mustang in excellent condition.The maximum price she is willing and
able to pay for the Mustang is $30,000.Also suppose that Jones owns a
sounds like a person arguing “against trade” is really
red 1965 Ford Mustang in excellent condition. The minimum price
his argument against the “terms of trade.” Everyone can
he is willing and able to sell the Mustang for is $23,000. Obviously,
think of better terms of trade for himself.You buy a Smith’s maximum buying price ($30,000) is greater than Jones’s min-
book for $40. Are there better terms of trade for you? imum selling price ($23,000), so a potential trade or exchange exists.
Sure, you would have rather paid $30 for the book Will the potential trade between Smith and Jones become an
instead of $40. Sometimes, when it sounds as if we are actual exchange? The answer to this question may depend on the
arguing against trade, what we are really saying is transaction costs. Transaction costs are the costs associated with
the time and effort needed to search out, negotiate, and consummate
this: “I wish I could have bought the good or service at
a trade. To illustrate, neither Smith nor Jones may know that the
better terms of trade than I did.”
other exists. Suppose Smith lives in Roanoke, Virginia, and Jones
lives 40 miles away in Blacksburg, Virginia. Each needs to find the
other, which may take time and money. Perhaps Smith can put an ad
Transaction Costs in the local Blacksburg newspaper stating that she is searching for a 1965 Ford Mustang
The costs associated with the time in mint condition. Alternatively, Jones can put an ad in the local Roanoke newspaper
and effort needed to search out, stating that he has a 1965 Ford Mustang to sell. The ad may or may not be seen by the
negotiate, and consummate an
exchange. relevant party and then acted upon. Our point is a simple one: Transaction costs some-
times keep potential trades from turning into actual trades.
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Economic Activities: Producing and Trading Chapter 2 41

Consider another example. Suppose Kurt hates to shop for clothes because shopping
takes too much time. He has to get in his car, drive to the mall, park the car, walk into
the mall, look in different stores, try on different clothes, pay for the items, walk to and
get back in his car, and drive home. Suppose Kurt spends an average of 2 hours when he
shops, and he estimates that an hour of his time is worth $30. It follows, then, that Kurt
incurs $60 worth of transaction costs when he buys clothes. Usually, he is not willing to
incur the transaction costs necessary to buy a pair of trousers or a shirt.
Now, suppose we ask Kurt if he would be more willing to buy clothes if shopping
was easier. Suppose, we say, the transaction costs associated with buying clothes could be
lowered from $60 to less than $10. At lower transaction costs, Kurt says that he would be
willing to shop more often.
How can transaction costs be lowered? Both people and computers can help lower
the transaction costs of trades. For example, real estate brokers lower the transaction costs
of selling and buying a house. Jim has a house to sell but doesn’t know how to find a
buyer. Karen wants to buy a house but doesn’t know how to find a seller. Enter the real
estate broker, who brings buyers and sellers together. In so doing, she lowers the transac-
tion costs of buying and selling a house.
As another example, consider e-commerce on the Internet. Ursula can buy a book
by getting in her car, driving to a bookstore, getting out of her car, walking into the
bookstore, looking at the books on the shelves, taking a book to the cashier, paying for
it, leaving the store, getting back in her car, and returning home. Or Ursula can buy a
book over the Internet. She can click on one of the online booksellers, search for the
book by title, read a short description of the book, and then click on 1-Click Buying.
Buying on the Internet has lower transaction costs than shopping at a store because
online buying requires less time and effort. Before online book buying and selling, were
there potential book purchases and sales that weren’t being turned into actual book pur-
chases and sales? There is some evidence that there were.

TURNING POTENTIAL TRADES INTO ACTUAL TRADES Some people are always looking for
ways to earn a profit. It would seem that one way to earn a profit is to turn potential
trades into actual trades by lowering transaction costs. Consider the following example.
Buyer Smith is willing to pay a maximum price of $400 for good X; Seller Jones is will-
ing to accept a minimum price of $200 for good X. Currently, the transaction costs of
the exchange are $500, evenly split between Buyer Smith and Seller Jones.
Buyer Smith thinks, “Even if I pay the lowest possible price for good X, $200, I will
still have to pay $250 in transaction costs, bringing my total to $450. The maximum
price I am willing to pay for good X is $400, so I will not make this purchase.”
Seller Jones thinks, “Even if I receive the highest possible price for good X, $400, I
will still have to pay $250 in transaction costs, leaving me with only $150.The minimum
price I am willing to accept for good X is $200, so I will not make this sale.”
This potential trade will not become an actual trade unless someone can lower the
transaction costs. One role of an entrepreneur is to try to turn potential trades into actual
trades by lowering transaction costs. Suppose Entrepreneur Brown can lower the transaction
costs for Buyer Smith and Seller Jones to $10 each, asking $60 from each person for ser-
vices rendered. Also, Entrepreneur Brown negotiates the price of good X at $300. Will
the potential exchange become an actual exchange?
Buyer Smith thinks, “I am willing to pay a maximum of $400 for good X. If I pur-
chase good X through Entrepreneur Brown, I will pay $300 to Seller Jones, $10 in trans-
action costs, and $60 to Brown.This is a total of $370, leaving me better off by $30. It is
worthwhile for me to purchase good X.”
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42 Part 1 Economics: The Science of Scarcity

Seller Jones thinks, “I am willing to sell good X for a minimum

Thinking like In the example just given, Buyer of $200. If I sell good X through Entrepreneur Brown, I will receive
AN ECONOMIST Smith and Seller Jones were $300 from Buyer Smith and will have to pay $10 in transaction costs
made better off by Entrepreneur Brown. Keep in mind
and $60 to Brown. That will leave me with $230, or $30 better off.
It is worthwhile for me to sell good X.”
that it was profit that motivated Entrepreneur Brown
Thus, an entrepreneur can earn a profit by finding a way to lower
to turn a potential exchange into an actual exchange transaction costs. As a result, a potential exchange turns into an
and, in the process, make both Smith and Jones better actual exchange.
off. Simply put, the desire for profit (to help ourselves)
can often prompt us to assist others. Trades and Third-Party Effects
Consider two trades. In the first, Harriet pays 80 cents to Taylor for
a pack of chewing gum. In this trade, both Harriet and Taylor are
made better off (they wouldn’t have traded otherwise), and no one is
made worse off.
In the second trade, Bob pays $4 to George for a pack of cigarettes. Bob takes a cig-
arette, lights it, and smokes it. It happens that he is near Caroline when he smokes the
cigarette, and she begins to cough because she is sensitive to cigarette smoke. In this
trade, both Bob, who buys the cigarettes, and George, who sells the cigarettes, are made
better off. But Caroline, who had nothing to do with the trade, is made worse off. In
this exchange, a third party, Caroline, is adversely affected by the exchange between
George and Bob.
These examples show that some trades affect only the parties involved in the
exchange, and some trades have third-party effects (someone other than the parties involved
in the exchange is affected). In the cigarette example, the third-party effect was negative;
there was an adverse effect on Caroline, the third party. Sometimes economists call
adverse third-party effects negative externalities. A later chapter discusses this topic in detail.

SELF-TEST
1. What are transaction costs? Are the transaction costs of buying a house likely to be
greater or less than those of buying a car? Explain your answer.
2. Smith is willing to pay a maximum of $300 for good X, and Jones is willing to sell good X
for a minimum of $220. Will Smith buy good X from Jones?
3. Give an example of a trade without third-party effects. Next, give an example of a trade
with third-party effects.

Production, Trade, and Specialization

The first section of this chapter discusses production; the second section discusses trade.
From these two sections, you might conclude that production and trade are unrelated
activities. However, they are not: Before you can trade, you need to produce something.
This section ties production and trade together and also shows how the benefits one
receives from trade can be affected by how one produces.

Producing and Trading

To show how a change in production can benefit traders, we eliminate anything and
everything extraneous to the process.Thus, we eliminate money and consider a barter, or
moneyless, economy.
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Economic Activities: Producing and Trading Chapter 2 43

In this economy, there are two individuals, Elizabeth and Brian. They live near each
other, and each engages in two activities: baking bread and growing apples. Let’s suppose
that within a certain period of time, Elizabeth can produce 20 loaves of bread and no
apples, or 10 loaves of bread and 10 apples, or no bread and 20 apples. In other words,
three points on Elizabeth’s production possibilities frontier correspond to 20 loaves of
bread and no apples, 10 loaves of bread and 10 apples, and no bread and 20 apples. As a
consumer, Elizabeth likes to eat both bread and apples, so she decides to produce (and
consume) 10 loaves of bread and 10 apples.
Within the same time period, Brian can produce 10 loaves of bread and no apples,
or 5 loaves of bread and 15 apples, or no bread and 30 apples. In other words, these
three combinations correspond to three points on Brian’s production possibilities fron-
tier. Brian, like Elizabeth, likes to eat both bread and apples, so he decides to produce
and consume 5 loaves of bread and 15 apples. Exhibit 8 shows the combinations of
bread and apples that Elizabeth and Brian can produce.
Elizabeth thinks that both she and Brian may be better off if each specializes in pro-
ducing only one of the two goods and trading it for the other. In other words, Elizabeth
should produce either bread or apples but not both. Brian thinks this may be a good
idea but is not sure which good each person should specialize in producing.
An economist would advise each to produce the good that he or she can produce at
a lower cost. In economics, a person who can produce a good at a lower cost than another
person is said to have a comparative advantage in the production of that good. Comparative Advantage
Exhibit 8 shows that for every 10 units of bread Elizabeth does not produce, she can The situation where someone can
produce 10 apples. In other words, the opportunity cost of producing 1 loaf of bread (B) produce a good at lower opportunity
cost than someone else can.
is 1 apple (A):
Opportunity costs for Elizabeth: 1B  1A
1A  1B

As for Brian, for every 5 loaves of bread he does not produce, he can produce 15
apples. So, for every 1 loaf of bread he does not produce, he can produce 3 apples. It fol-
lows, then, that for every 1 apple he chooses to produce, he forfeits 1/3 loaf of bread.
Opportunity costs for Brian: 1B  3A
1A  1⁄ 3B

Comparing opportunity costs, we see that Elizabeth can produce bread at a lower
opportunity cost than Brian can. (Elizabeth forfeits 1 apple when she produces 1 loaf of
bread, whereas Brian forfeits 3 apples when he produces 1 loaf of bread.) On the other
hand, Brian can produce apples at a lower opportunity cost than Elizabeth can.We con-
clude that Elizabeth has a comparative advantage in the production of bread, and Brian
has a comparative advantage in the production of apples.
Suppose each person specializes in the production of the good in which he or she
has a comparative advantage.This means Elizabeth produces only bread and produces 20
loaves. Brian produces only apples and produces 30 apples.

Elizabeth Brian
exhibit 8
Production by Elizabeth and Brian
Bread Apples Bread Apples
This exhibit shows the combinations
20 0 10 0 of goods each can produce individu-
10 10 5 15 ally in a given time period.
0 20 0 30
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44 Part 1 Economics: The Science of Scarcity

economics 24/7
JERRY SEINFELD, THE DOORMAN, AND ADAM SMITH

Oh, I get it. Why waste time making small talk with This observation is not unique to us. It goes back to Adam
the doorman? I should just shut up and do my job, Smith, who said that there is a direct relationship between
opening the door for you. the degree of specialization and the size of the market.
—The doorman, speaking to Jerry, Smith said:
in an episode of Seinfeld There are some sorts of industry, even of the low-
In a Seinfeld episode, Jerry comes across a doorman (played est kind, which can be carried on nowhere but in a
by actor Larry Miller) who seems to have a chip on his great town. A porter, for example, can find employ-
shoulder. While waiting for the elevator, Jerry sees the door- ment and subsistence in no other place. A village is
man reading a newspaper. Jerry looks over and says, “What by much too narrow a sphere for him; even an ordi-
about those Knicks?” (a reference to the New York Knicks nary market town is scarce large enough to afford
professional basketball team). The doorman’s response is, him constant occupation.1
“What makes you think I wasn’t reading the Wall Street Smith’s observation that “some sorts of industry . . . can be
page? Oh, I know, because I’m the uneducated doorman.” carried on nowhere but in a great town” seems true. Some
This exchange between the doorman and Jerry would be occupations and some goods can only be found in big cities.
unlikely if Jerry had not lived in New York City or in some Try to find a doorman in North Adams, Michigan (population
other large city. That’s because doormen are usually found 514) or restaurant chefs who only prepare Persian, Yugosla-
only in large cities. If you live in a city with a population less vian, or Caribbean entrées in Ipswich, South Dakota (popu-
than 100,000, you may not find a single doorman in the lation 943).
entire city. There are few doormen even in cities with a pop- 1An
Inquiry into the Nature and Causes of the Wealth of Nations, Adam
ulation of 1 million. Smith. Ed. Edwin Cannan, New York: Modern Library, 1965.

Thinking like Now suppose that Elizabeth and Brian decide to trade 8 loaves
We see many people specializing of bread for 12 apples. In other words, Elizabeth produces 20 loaves
AN ECONOMIST in the world in which we live.
of bread and then trades 8 of the loaves for 12 apples. After the
One person only works at accounting services, another trade, Elizabeth consumes 12 loaves of bread and 12 apples. Com-
only styles hair, a third only writes songs. Why do peo- pare this situation with what she consumed when she didn’t special-
ple specialize? Largely, it is because individuals have ize and didn’t trade. In that situation, she consumed 10 loaves of
found that they are better off specializing in producing
bread and 10 apples. Clearly, Elizabeth is better off when she special-
izes and trades than when she does not. But what about Brian?
one good or service, selling that good or service for
Brian produces 30 apples and trades 12 of them to Elizabeth for
money, and then using the money to buy what they 8 loaves of bread. In other words, he consumes 8 loaves of bread and
want. It is simply our story of Elizabeth and Brian 18 apples. Compare this situation with what he consumed when he
occurring repeatedly with different pairs of individuals. didn’t specialize and didn’t trade. In that situation, he consumed 5
loaves of bread and 15 apples. Thus, Brian is also better off when he
specializes and trades than when he does not.
Exhibit 9 summarizes consumption for Elizabeth and Brian. It shows that both Eliz-
abeth and Brian make themselves better off by specializing in the production of one
good and trading for the other.
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Economic Activities: Producing and Trading Chapter 2 45

No Specialization Specialization Gains from

and and Specialization
No Trade Trade and Trade
Consumption
of Loaves of Bread 10 12 +2
Elizabeth
Consumption
exhibit 9
of Apples 10 12 +2 Consumption for Elizabeth
and Brian With and Without
Specialization and Trade
Consumption
of Loaves of Bread 5 8 +3 A comparison of the consumption of
bread and apples before and after
Brian specialization and trade shows that
Consumption both Elizabeth and Brian benefit from
producing the good in which each
of Apples 15 18 +3 has a comparative advantage and
trading for the other good.

Profit and a Lower Cost of Living

The last column of Exhibit 9 shows the gains from specialization and trade. One way to
view these gains is in terms of Elizabeth and Brian being better off when they specialize
and trade than when they do not specialize and do not trade. In short, specialization and
trade make people better off.
Another way to view these gains is in terms of profit and a lower cost of living. To
illustrate, let’s look again at Elizabeth. Essentially, Elizabeth undertakes two actions by
specializing and trading. The first action is to produce more of one good (loaves of
bread) than she produces when she does not specialize. The second action is to trade, or
“sell,” some of the bread for a “price” higher than the cost of producing the bread.
Specifically, she “sells” 8 of the loaves of bread (to Brian) for a “price” of 12 apples. In
other words, she “sells” each loaf of bread for a “price” of 1 1/2 apples. But Elizabeth
can produce a loaf of bread for a cost of 1 apple. So she “sells” the bread for a “price” (1
1/2 apples) that’s higher than her cost of producing the bread (1 apple).The difference is
her profit.
Many people think that one person’s profit is another person’s loss. In other words,
because Elizabeth earns a profit by specializing and trading, Brian must lose. But we
know this is not the case.The cost to Brian of producing a loaf of bread is 3 apples. But
he “buys” bread from Elizabeth for a “price” of only 1 1/2 apples. In other words, while
Elizabeth is earning a profit, Brian’s cost of living (what he has to forfeit to get a loaf of
bread) is declining.

A Benevolent and All-Knowing Dictator Versus the Invisible Hand

Suppose a benevolent dictator governs the country where Brian and Elizabeth live. We
assume that this benevolent dictator knows everything about almost every economic
activity in his country. In other words, he knows Elizabeth’s and Brian’s opportunity
costs of producing bread and apples.
Because the dictator is benevolent and because he wants the best for the people
who live in his country, he orders Elizabeth to produce only loaves of bread and Brian
to produce only apples. Next, he tells Elizabeth and Brian to trade 8 loaves of bread for
12 apples.
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46 Part 1 Economics: The Science of Scarcity

Afterward, he shows Exhibit 9 to Elizabeth and Brian. They are both surprised that
they are better off having done what the benevolent dictator told them to do.
Now in the original story about Elizabeth and Brian, there was no benevolent, all-
knowing dictator.There were only two people who were guided by their self-interest to
specialize and trade. In other words, self-interest did for Elizabeth and Brian what the
benevolent dictator did for them.
Adam Smith, the 18th-century Scottish economist and founder of modern eco-
nomics, spoke about the invisible hand that “guided” individuals’ actions toward a positive
outcome that they did not intend. That is what happened in the original story about
Elizabeth and Brian. Neither intended to increase the overall output of society; each
intended only to make himself or herself better off.

SELF-TEST
1. 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 ?
2. 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 ? of Y ? Explain your answers.

a r eAa R
d eeard ear sAkssk .s . ... . . .
H ow Wi l l E c o n o m i c s H e l p M e I f I ’ m a H i s t o r y M a j o r ?

I ’ m a h i s t o r y m a j o r t a k i n g m y fi r s t c o u r s e people trade and about money. If you study the Boston

i n e c o n o m i c s . B u t q u i t e f r a n k l y, I d o n ’ t s e e Tea Party, you will need to know about government
h ow e c o n o m i c s w i l l b e o f m u c h u s e i n m y grants of monopoly and about taxes.
s t u d y o f h i s t o r y. A n y t h o u g h t s o n t h e Economics can also be useful in another way. Sup-
subject? pose you learn in your economics course what can and
cannot cause inflation. We’ll say you learn that X can
Economics often plays a major role in historical events. cause inflation and that Y cannot. Then, one day, you
For example, many social scientists argue that econom- read an article in which a historian says that Y caused
ics played a large role in the collapse of communism. If the high inflation in a certain country and that the high
communism had been able to produce the quantity and inflation led to a public outcry, which was then met
variety of goods and services that capitalism produces, with stiff government reprisals. Without an understand-
perhaps the Soviet Union would still exist. ing of economics, you might be willing to accept what
Fact is, understanding economics may help you the historian has written. But with your understanding
understand many historical events or periods. If, as a of economics, you know that events could not have
historian, you study the Great Depression, you will happened as the historian reports because Y, which the
need to know something about the stock market, tar- historian claims caused the high inflation, could not
iffs, and more. If you study the California Gold Rush, have caused the high inflation.
you will need to know about supply, demand, and In conclusion, a good understanding of economics
prices. If you study the history of prisoner-of-war will not only help you understand key historical events
camps, you will need to know about how and why but will also help you discern inaccuracies in recorded
history.
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Economic Activities: Producing and Trading Chapter 2 47

! analyzing the scene

What does a point on a production possibilities frontier to accomplish all his goals. More resources mean more goals
have to do with the collapse of the Soviet Union? can be met and fewer tradeoffs will be incurred.
The former Soviet foreign minister said the Soviet Union had What led Karen and Larry to specialize in doing certain
collapsed because of a conflict between the Kremlin and the tasks?
Soviet people.What was the conflict? The conflict concerned
where the economy of the Soviet Union chose to be located In the chapter we showed (numerically) how two people
on its PPF. The Kremlin wanted a point that represented (Elizabeth and Brian) could make themselves better off by
“more guns” (more military goods) and “less butter” (fewer specializing and trading.What holds for Elizabeth and Brian
civilian or consumer goods), whereas the people wanted a also holds for Karen and Larry.
point that represented “fewer guns” and “more butter.” In
other words, the Kremlin wanted to be at one point on the What did eBay do that really wasn’t that hard?
PPF while the people wanted to be at another. It’s unlikely
On any given day, 16 million items in 27,000 different cate-
the Soviet Union would have collapsed had the people and
gories are listed for sale on eBay.com.What does eBay do?
the Kremlin agreed on the point on the PPF to be at.
It brings buyers and sellers together.
Consider the situation years ago when the World Wide
Why can’t Bob get As in both biology and calculus, and
Web did not exist. Suppose a person in London found an
what does Jim’s desire to produce “more time”tell us
old Beatles’ record in his attic and decided he wanted to sell
about life?
it. Unbeknownst to him, a person in Los Angeles wanted to
Bob says he has to choose between an A in biology and an buy exactly that old Beatles’ record. But alas, the record never
A in calculus.To make that statement, Bob must be thinking changed hands because neither the seller nor the buyer knew
in terms of his PPF for “producing grades.” His “grades PPF” how to find the other or even if the other existed. In short,
would look like the straight line in Exhibit 1. Bob’s likely the transaction costs of completing the trade were just too
biology grade is on the vertical axis (starting with an F at the high.
origin and moving up to an A), and his calculus grade is on Years later, the Web came along, and with it, eBay.What
the horizontal axis (again starting with an F at the origin and eBay actually did was use the Web to lower the transaction
moving across to an A).When Bob says that he must choose costs of trading. eBay basically told the world: If you’re a seller
where he wants to get an A, he is saying that there is no point and want a buyer or if you’re a buyer and want a seller, come
on his “grades PPF” that represents an A in both courses to us.
(given his resources, such as time, and his state of technology, Today, the London seller of the old Beatles’ record can
such as his ability to learn the material). In other words, the inexpensively be matched with the Los Angeles buyer. eBay
point that represents two As is in his unattainable region, and and the Web are the “matchmakers.”The potential traders go
the point that represents one A and, say, one B, is in his attain- online to eBay where they become actual traders. eBay
able region. charges a small fee for creating the place where buyer and
Jim’s desire to produce “more time” tells us that he feels seller can find each other.
there is not enough of a particular resource (time) in which

chapter summary
An Economy’s Production Possibilities Frontier Increasing and Constant Opportunity Costs
• An economy’s production possibilities frontier (PPF) • A straight-line PPF represents constant opportunity
represents the possible combinations of two goods that costs: Increased production of one good comes at con-
the economy can produce in a certain period of time stant opportunity costs.
under the conditions of a given state of technology and • A bowed-outward (concave-downward) PPF represents
fully employed resources. the law of increasing opportunity costs: Increased produc-
tion of one good comes at increased opportunity costs.
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48 Part 1 Economics: The Science of Scarcity

The Production Possibilities Frontier and Various example, how much money ($25,000? $30,000?) is
Economic Concepts traded for one car.

• The PPF can be used to illustrate various economic

concepts. Scarcity is illustrated by the frontier itself. Transaction Costs
Choice is illustrated by our knowing that we have to
locate at some particular point either on the frontier or • Transaction costs are the costs associated with the time
below it. In short, of the many attainable positions, one and effort needed to search out, negotiate, and consum-
must be chosen. Opportunity cost is illustrated by a mate a trade. Some potential exchanges are not realized
movement from one point on the PPF to another point because of high transaction costs. Lowering transaction
on the PPF. Unemployed resources and productive inef- costs can turn a potential exchange into an actual
ficiency are illustrated by a point below the PPF. Pro- exchange.
ductive efficiency and fully employed resources are • One role of an entrepreneur is to try to lower transac-
illustrated by a point on the PPF. Economic growth is tion costs.
illustrated by a shift outward in the PPF.

Comparative Advantage and Specialization

Exchange or Trade
• Individuals can make themselves better off by specializ-
• The three time periods relevant to the trading process ing in the production of the good in which they have a
are (1) the ex ante period, which is the time before the comparative advantage and then trading some of that
trade is made; (2) the point of trade; and (3) the ex post good for other goods. A person has a comparative
period, which is the time after the trade has been made. advantage in the production of a good if he or she can
• There is a difference between trade and the terms of produce the good at a lower opportunity cost than
trade. Trade refers to the act of giving up one thing for another person can.
something else. For example, a person may trade money • Individuals gain by specializing and trading. Specifically,
for a car. The terms of trade refer to how much of one they earn a profit by specializing in the production of
thing is traded for how much of something else. For the goods in which they have a comparative advantage.

key terms and concepts

Production Possibilities Productive Efficiency (Exchange) Trade Terms of Trade
Frontier (PPF) Productive Inefficiency Ex Ante Transaction Costs
Law of Increasing Technology Ex Post Comparative Advantage
Opportunity Costs

questions and problems

1 Describe how each of the following would affect the scarcity condition; (b) choice; (c) opportunity cost;
U.S. production possibilities frontier: (a) an increase in (d) productive efficiency; (e) unemployed resources.
the number of illegal immigrants entering the country; 3 What condition must hold for the production possibili-
(b) a war; (c) the discovery of a new oil field; (d) a ties frontier to be bowed outward (concave downward)?
decrease in the unemployment rate; (e) a law that to be a straight line?
requires individuals to enter lines of work for which
they are not suited. 4 Give an example to illustrate each of the following:
(a) constant opportunity costs and (b) increasing oppor-
2 Explain how the following can be represented in a PPF tunity costs.
framework: (a) the finiteness of resources implicit in the 5 Why are most production possibilities frontiers for
goods bowed outward (concave downward)?
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Economic Activities: Producing and Trading Chapter 2 49

6 Within a PPF framework, explain each of the follow- 9 “A nation may be able to live beyond its means, but
ing: (a) a disagreement between a person who favors the world cannot.” Do you agree or disagree? Explain
more domestic welfare spending and one who favors your answer.
more national defense spending; (b) an increase in the 10 Use the PPF framework to explain something in your
population; (c) a technological change that makes everyday life that was not mentioned in the chapter.
resources less specialized.
11 Describe the three time periods relevant to the trading
7 Some people have said that during the Cold War, the process.
Central Intelligence Agency (CIA) regularly estimated
(a) the total quantity of output produced in the Soviet 12 Are all exchanges or trades beneficial to both parties in
Union and (b) the total quantity of civilian goods pro- the ex post position? Explain your answer.
duced in the Soviet Union. Of what interest would these 13 A person who benefits from a trade can be disgruntled
data, or the information that might be deduced from over the terms of trade. Do you agree or disagree?
them, be to the CIA? (Hint:Think in terms of the PPF.) Explain your answer.
8 Suppose a nation’s PPF shifts inward as its population 14 Give an example of a negative third-party effect (nega-
grows. What happens, on average, to the material stan- tive externality).
dard of living of the people? Explain your answer.

working with numbers and graphs

1 Tina can produce any of the following combinations of 5 In the preceding figure, which graph depicts a change
goods X and Y: (a) 100X and 0Y, (b) 50X and 25Y, and in the PPF that is a likely consequence of war?
(c) 0X and 50Y. David can produce any of the follow- 6 If PPF2 in the following graph is the relevant produc-
ing combinations of goods X and Y: (a) 50X and 0Y, (b) tion possibilities frontier, then which points are unat-
25X and 40Y, and (c) 0X and 80Y. Who has a compara- tainable? Explain your answer.
tive advantage in the production of good X? of good
Y? Explain your answer.
J
2 Using the data in Problem 1, prove that both Tina and
PPF3
David can be made better off through specialization D I
E
and trade.
3 Exhibit 6 represents an advance in technology that A B PPF2
made it possible to produce more of both military and F
civilian goods. Represent an advance in technology that
Guns

makes it possible to produce more of only civilian

goods. Does this indirectly make it possible to produce
more military goods? Explain your answer. PPF1
4 In the following figure, which graph depicts a techno-
logical breakthrough in the production of good X only?
Y Y Y Y
C G H
0
Butter

7 If PPF1 in the preceding figure is the relevant produc-

tion possibilities frontier, then which point(s) represent
productive efficiency? Explain your answer.
0 X 0 X 0 X 0 X