Production, Trade, and Market Dynamics in Economics
Production Possibilities and Trade
The Production Possibilities Frontier (PPF) also represents the Consumption Possibilities Frontier.
- Absolute Advantage: The ability to produce a good using fewer inputs than another producer.
- Opportunity Cost: What must be given up to obtain something else.
- Comparative Advantage: The ability to produce a good at a lower opportunity cost than another producer. Whoever forgoes a smaller amount of other goods to produce good X has the lowest opportunity cost of producing that good and is said to possess a comparative advantage in producing that good. Although it is possible for one person to have an absolute advantage in producing both goods, it is impossible to have a comparative advantage in producing both goods. If one person’s opportunity cost in the production of one good is relatively high, their opportunity cost in the production of another good should be relatively low. Comparative advantage reflects the relative opportunity cost. Unless two people have the same opportunity cost, one will have a comparative advantage in one good, and the other in another good.
Comparative Advantage and Trade
The gains from specialization and trade are based not on absolute advantage but on comparative advantage. When each person specializes in producing the good in which they have a comparative advantage, the total output of the economy increases. The principle of comparative advantage makes it possible to benefit from specialization and trade.
Applications of Comparative Advantage
The principle of comparative advantage explains interdependence and the benefits of trade. Just as individuals can benefit from specialization and trade, so can people of different countries. Many of the goods we enjoy are produced abroad, and many of the goods produced in Spain are sold abroad. Goods produced abroad and sold in Spain are called imports. Goods made in Spain and sold abroad are called exports.
Markets and Competition
The terms supply and demand refer to the behavior of people as they interact in competitive markets.
A market is a group of buyers and sellers of a particular good or service. Buyers, as a group, determine the product’s demand, and sellers determine the supply. Markets take many forms. Sometimes they are highly organized. In these markets, buyers and sellers meet at a specific time and place, and an auctioneer helps set prices and arrange sales. More often, markets are less organized. Buyers do not meet at any one time; sellers are in different places and offer somewhat different products.
A competitive market is a market in which there are many buyers and many sellers, so each has a negligible influence on the market price.
Perfect Competition and Other Market Structures
We assume that markets are perfectly competitive. Competitive markets have two main characteristics:
- The goods offered for sale are all exactly the same.
- There are so many buyers and sellers that no single buyer or seller can influence the market price.
Because buyers and sellers in perfectly competitive markets must accept the price the market determines, they are said to be price takers. However, not all goods and services are sold in perfectly competitive markets.
In some markets, there is only one seller, and this seller sets the price. This type of seller is called a monopoly.
An oligopoly has a few sellers that do not always compete aggressively.
Another market structure is the monopolistically competitive market. It contains many sellers, each offering a slightly different product. Because the products are not exactly alike, each seller has some ability to set the price of its own product.
Demand
The Demand Curve: Relationship Between Price and Quantity
The quantity demanded of a good is the amount of a good that buyers are willing and able to purchase. Many factors determine the quantity demanded of a good, but when analyzing how markets work, one factor plays a fundamental role: the price of the good. If the quantity demanded falls when the price rises and rises when the price falls, we say that the quantity demanded is negatively related to the price. This relationship between price and quantity demanded is called the law of demand: ceteris paribus, the quantity demanded of a good falls when the price of the good rises.
Demand schedule: A table that shows the relationship between the price of a good and the quantity demanded.
Demand curve: A graph of the relationship between the price of a good and the quantity demanded.
Market Demand Versus Individual Demand
Market demand is the sum of all individual demands for a particular good or service. The market demand at each price is the sum of the two individual demands. To find the total quantity demanded at any price, we add the individual quantities, which are found on the horizontal axis of the individual demand curves.
Shifting the Demand Curve
The demand curve need not be stable over time. If something happens to alter the quantity demanded at any given price, the demand curve shifts. Any change that increases the quantity demanded at every price shifts the demand curve to the right and is called an increase in demand. Any change that reduces the quantity demanded at every price shifts the demand curve to the left and is called a decrease in demand.
Variables that can shift the demand curve:
- Income: The lower your income, the less you will have to spend in total. If the demand for a good falls when income falls, the good is called a normal good. Normal good: a good for which, ceteris paribus, an increase in income leads to an increase in demand. Not all goods are normal goods. If the demand for a good rises when income falls, the good is called an inferior good. Inferior good: a good for which, ceteris paribus, an increase in income leads to a decrease in demand.
- Prices of Related Goods: When a fall in the price of one good reduces the demand for another good, the two goods are called substitutes. Substitute goods: two goods for which an increase in the price of one leads to an increase in the demand for the other. When a fall in the price of one good raises the demand for another good, the two goods are called complements. Complementary goods: two goods for which an increase in the price of one leads to a decrease in the demand for the other.
- Tastes: The most obvious determinant of your demand is your tastes.
- Expectations: Your expectations about the future may affect your demand for a good or service today.
- Number of Buyers: Because market demand is derived from individual demands, it depends on all those factors that determine the demand of individual buyers, including buyers’ incomes, tastes, expectations, and the prices of related goods.