ECON 11202

Chapter 2 · Economics 112 / Core 153

Choices, Production, and Trade

Resources are limited. Economics begins with a precise question: what do we give up when we choose one use instead of another?

Core models
PPF · trade · circular flow
Instructor
Royce Vaughn

02.0

Orientation

The chapter in one idea

Every choice redirects scarce resources. The production possibilities frontier makes that constraint visible; opportunity cost measures the trade-off; comparative advantage shows how specialization and exchange can expand consumption.

  1. Distinguish resources, goods, and factor payments.
  2. Read, construct, and shift a production possibilities frontier.
  3. Calculate opportunity cost with ratios and slopes.
  4. Explain increasing opportunity cost.
  5. Identify absolute and comparative advantage.
  6. Demonstrate gains from trade and trace the circular flow.

02.1

The factors of production

Resources become output

Production converts inputs into goods and services. Economists group those inputs into four broad factors of production.

The categories describe a resource’s role in production—not simply what the resource looks like. A truck used for deliveries is physical capital; the gasoline it burns is a natural resource; the driver’s time and skill are labor.

Factors of production and their conventional payments
FactorWhat it includesPayment to its owner
LandNatural resources: land, water, forests, minerals, energyRent
LaborHuman time, effort, and human capital—the skills embodied in workersWages and salaries
Physical capitalProduced resources used to make other output: tools, buildings, equipmentInterest or rental return
EntrepreneurshipOrganizing production, innovating, and bearing the risk of profit or lossProfit—or loss

Do not confuse physical capital with financial capital. Money can purchase a machine, but the machine—not the money—is the productive resource in this model.

Worked example

A neighborhood bakery

The storefront lot and water are land; the bakers’ time and training are labor; ovens and mixers are physical capital; and the owner’s decision to open, choose a menu, coordinate the inputs, and accept possible losses is entrepreneurship.

Practice 1

Classify the resource

Classify each item and name its usual payment:

  1. Water used by a beverage company
  2. A technician’s time and certifications
  3. A delivery van used by a florist
  4. The florist who chooses the product line and bears the risk of loss

Answer 1 is at the end of the chapter.

02.2

The production possibilities frontier

The edge of what is possible

A production possibilities frontier (PPF) shows the maximum attainable combinations of two outputs given current resources and technology.

It is a boundary, not a forecast. The PPF does not predict what society will produce; it separates attainable combinations from combinations that current productive capacity cannot reach.

Model assumptions

  1. Two output categories so the trade-off fits on a graph.
  2. Fixed resources while we analyze movement along one frontier.
  3. Fixed technology for the same reason.
  4. Full and efficient use is required to produce on the frontier.
One economy’s hourly production possibilities
CombinationPizzasPublic lectures
A020
B2515
C5010
D755
E1000
Linear pizza-and-lecture production possibilities frontierA straight frontier connects A at zero pizzas and 20 lectures to E at 100 pizzas and zero lectures. Points B, C, and D divide the line into equal production steps. The graph also shows one point inside and one point outside the frontier.025507510005101520ABCDEinsideoutsidePizzasPublic lectures
At the chapter values, the linear PPF runs from 100 pizzas to 20 public lectures.
On the frontierAttainable and productively efficient

More of one output requires less of the other.

Inside the frontierAttainable but productively inefficient

Idle or misallocated resources leave output unrealized.

Outside the frontierCurrently unattainable

More or better resources or technology would be required.

Worked example

Read three production points

Use the numbered graph above at its starting maximums: 100 pizzas and 20 lectures. Its five labeled frontier points are A (0, 20), B (25, 15), C (50, 10), D (75, 5), and E (100, 0).

  • Point C: (50 pizzas, 10 lectures) is on the PPF: attainable and productively efficient.
  • (50 pizzas, 6 lectures) is inside: attainable but inefficient.
  • (80 pizzas, 10 lectures) is outside: current capacity cannot produce it.
Practice 2

Locate each point

Use the pre-drawn graph above—not the table alone—to classify each combination as on, inside, or outside. Then state what the classification means.

  1. (25 pizzas, 15 lectures)
  2. (60 pizzas, 12 lectures)
  3. (40 pizzas, 8 lectures)

Answer 2 is at the end of the chapter.

02.3

Opportunity cost and slope

Measure what the choice gives up

Ratio methodOC = units forgoneunits gained
Slope methodOCx = OCy =
Linear PPF checkOCx × OCy = 1

The ratio and slope methods are equivalent. For the opportunity cost of the horizontal-axis good, both divide the change in the vertical-axis good by the change in the horizontal-axis good. On a downward-sloping PPF, the slope is negative; opportunity cost reports its absolute value. For the vertical-axis good, reverse the fraction: OCy = |Δx / Δy| = 1 / OCx.

Units prevent inverted answers

“0.2” is incomplete. “0.2 lectures per pizza” says exactly which output was forgone and which was gained. If the units do not answer the question, the ratio is backward.

Slope and opportunity cost

The slope of a downward-sloping PPF is negative. Opportunity cost is reported as a positive sacrifice, so use the absolute value. The slope gives the cost of the horizontal-axis good; its reciprocal gives the cost of the vertical-axis good.

Worked graph

Calculate opportunity cost from a linear PPF

The chapter frontier has fixed intercepts of 100 pizzas and 20 public lectures. Because it is a straight line, its slope and both opportunity costs are constant everywhere on the frontier.

One pizza costs 0.2 lecture; one lecture costs 5 pizzas. The two opportunity costs are reciprocals.

Linear production possibilities frontierA graph with fixed axes from zero to 160 pizzas and zero to 32 lectures. Vertical gridlines are spaced every 25 pizzas and horizontal gridlines every 5 lectures. The labeled frontier combinations are A at zero pizzas and 20 lectures, B at 25 and 15, C at 50 and 10, D at 75 and 5, and E at 100 and zero. Coordinate labels identify the inside point at 50 and 6 and the outside point at 80 and 10. The frontier's slope is negative 0.2 lecture per pizza.025507510012515016005101520253032ABCDEinside (50, 6)outside (80, 10)SLOPE− vertical intercept / horizontal intercept= −20 lectures / 100 pizzas= −0.200 lecture per pizzaPizzasPublic lectures

OCx · one pizza

Ratio method · A → E

20 lectures forgone100 pizzas gained = 0.2 lecture per pizza

Slope method · A → E

= 0.2 lecture per pizza

OCy · one lecture

Ratio method · E → A

100 pizzas forgone20 lectures gained = 5 pizzas per lecture

Slope method · E → A

= 5 pizzas per lecture

Practice 3

Use both methods

On the linear pizza-and-lecture PPF:

Linear pizza-and-lecture production possibilities frontierA straight frontier connects A at zero pizzas and 20 lectures to E at 100 pizzas and zero lectures. Points B, C, and D divide the line into equal production steps.025507510005101520ABCDEPizzasPublic lectures
The highlighted combinations B and D are the two points used in Practice 3.
Points used in Practice 3
PointPizzasLectures
B2515
D755
  1. Move from B (25, 15) to D (75, 5). Find the opportunity cost of one additional pizza using forgone/gained.
  2. Move from D back to B. Find the opportunity cost of one additional lecture.
  3. Confirm both answers using slope and the reciprocal check.

Answer 3 is at the end of the chapter.

Worked graph

Make resources more specialized

When workers and machines differ in their best uses, moving each new group of resources becomes more costly. The frontier bows outward.

Step 10.9 crude-oil unitsStep 24.4 crude-oil unitsStep 39.3 crude-oil unitsStep 415.4 crude-oil units

Each step adds the same 10 natural-gas units.

Bowed-out production possibilities frontierA bowed-out frontier on numbered axes from zero to 40 natural-gas units and zero to 30 crude-oil units. Gridlines mark every 10 natural-gas units and every 5 crude-oil units. Equal increases in natural-gas production require progressively larger sacrifices of crude oil.010203040051015202530Natural gasCrude oilsmall sacrificelarge sacrifice

Read the bow correctly

Near the vertical intercept the PPF is relatively flat: early units of the horizontal good are inexpensive. Near the horizontal intercept it becomes steep: additional horizontal output requires a larger vertical sacrifice.

On a curved PPF there is no single constant opportunity cost. Name the two points or the specific interval you are measuring.

Worked example

A genuinely bowed frontier

The economy increases natural-gas production from 10 to 20 units, while crude-oil production decreases from 28 to 24 units.

Ten natural-gas units are gained and four crude-oil units are forgone, so the opportunity cost is 0.4 crude-oil unit per natural-gas unit.

Practice 4

Increasing cost

The economy increases natural-gas production from 20 to 30 units, while crude-oil production decreases from 24 to 15 units.

  1. Find the opportunity cost of one additional natural-gas unit.
  2. Compare it with the worked example. What economic fact explains the change?

Answer 4 is at the end of the chapter.

02.4

When the frontier changes

Movements, recovery, and growth

Movement along a frontier

A different output mix. The economy produces more of one good and less of the other. Productive capacity has not changed.

Movement toward the frontier

Idle resources return to use or organization improves. Output rises, but the maximum possible combinations have not changed.

A shift of the frontier

Productive capacity changes because resources or technology change. Growth shifts at least part of the frontier outward; lost resources can shift it inward.

A change that benefits only one industry can pivot the frontier rather than shifting both intercepts equally.

Worked graph

Growth expands the frontier

On the original PPF, point A is attainable but inefficient and point B is attainable and efficient. Point C is outside the original PPF, but growth shifts the frontier outward until C becomes attainable and efficient.

A · Inside: unused productive capacity
B · On the original PPF: efficient production
C · On the growth PPF: greater productive capacity

A changing production possibilities frontierA solid original production possibilities frontier contains point A in its interior and passes through point B. A dotted outward frontier passes through point C, which was outside the original frontier. A small diagonal arrow points from the original frontier toward the growth frontier.A · insideB · on original PPFC · on growth PPFPizzasPublic lecturesoriginal PPFgrowth PPF
Worked example

An improved excavator

Hiring an unemployed excavator operator moves production from inside the current PPF toward it. Inventing an excavator that moves twice as much earth with the same labor and fuel changes technology and shifts the relevant part of the PPF outward.

Practice 5

Movement or shift?

Classify each change as movement along, movement toward, outward shift, inward shift, or pivot. Explain briefly.

  1. Unemployed workers return to their former jobs.
  2. A larger, healthier, better-educated labor force increases capacity across industries.
  3. A new oven raises only pizza output.
  4. A hurricane destroys factories and infrastructure.
  5. On the same PPF, the economy chooses more capital goods and fewer consumer goods.

Answer 5 is at the end of the chapter.

02.5

Comparative advantage and gains from trade

The Gains From Trade Model

Specialize by opportunity cost

Absolute advantageHigher productivity

The ability to produce more of a good with the same resources.

Comparative advantageLower opportunity cost

The ability to produce a good while giving up less of another good.

Absolute advantage tells us who can produce more. Comparative advantage determines specialization. A producer can be best at everything and still gain by allowing another producer to handle the task with the lower relative cost.

Maximum production with complete specialization · illustrative units
CountryCrude oilNatural gas
United States3040
Venezuela1030

Venezuela

Venezuela production possibilities frontierA production possibilities frontier with natural gas from zero to 40 on the horizontal axis and crude oil from zero to 30 on the vertical axis. The frontier runs from 10 crude oil to 30 natural gas.0102030400102030Closed production (6, 8)Open consumption (10, 10)Natural gasCrude oil

United States

United States production possibilities frontierA production possibilities frontier with natural gas from zero to 40 on the horizontal axis and crude oil from zero to 30 on the vertical axis. The frontier runs from 30 crude oil to 40 natural gas.0102030400102030Closed production (16, 18)Open consumption (20, 20)Natural gasCrude oil
Closed-economy production Open-economy consumption
The matched axes make the relative size of each frontier directly comparable. Circles show closed-economy production; diamonds show one equal-gains allocation of open-economy consumption.
Worked example

United States and Venezuela

The United States has absolute advantage in both goods. Comparative advantage requires opportunity costs:

Cost of one…United StatesVenezuelaLower cost
Natural-gas unitOCng = 30/40 = 0.75 crude-oil unitOCng = 10/30 = 0.33 crude-oil unitVenezuela
Crude-oil unitOCco = 40/30 = 1.33 natural-gas unitsOCco = 30/10 = 3 natural-gas unitsUnited States

Venezuela specializes in natural gas; the United States specializes in crude oil. The pattern follows relative cost, not which country is “better” overall.

Before specialization22 gas · 26 oilU.S. (16 gas, 18 oil) + Venezuela (6 gas, 8 oil)
After specialization30 gas · 30 oilVenezuela makes gas; U.S. makes oil
Additional output+8 gas · +4 oilEqual split shown: each country gains +4 gas and +2 oil

One equal-gains allocation: the United States consumes (20 gas, 20 oil) and Venezuela consumes (10 gas, 10 oil). Each country receives 4 more natural-gas units and 2 more crude-oil units than in the closed economy.

Interactive model

Find a price both sides can accept

The United States exports crude oil; Venezuela exports natural gas. The price is measured in natural-gas units paid for one crude-oil unit.

Both sides can gain at this price.

United States

+0.67natural-gas units gained in value per crude-oil unit exported

Venezuela

+1.00natural-gas units saved in value per crude-oil unit imported

Terms of trade

A mutually beneficial price lies between the two opportunity costs. At an endpoint, one side is indifferent; strictly between them, both can receive more value than the same trade would cost domestically.

1.33 < price < 3 natural-gas units per crude-oil unit

Practice 6

Wendy and Jack

Wendy can make 100 ice creams or 50 loaves of bread. Jack can make 50 ice creams or 30 loaves. Assume linear PPFs.

Wendy

Wendy production possibilities frontierA production possibilities frontier with ice creams from zero to 100 on the horizontal axis and loaves of bread from zero to 50 on the vertical axis. The frontier runs from 50 loaves of bread to 100 ice creams.025507510001020304050Ice creamsLoaves of bread

Jack

Jack production possibilities frontierA production possibilities frontier with ice creams from zero to 100 on the horizontal axis and loaves of bread from zero to 50 on the vertical axis. The frontier runs from 30 loaves of bread to 50 ice creams.025507510001020304050Ice creamsLoaves of bread
Use the intercepts and slopes to compute all four opportunity costs.
  1. Compute all four opportunity costs with units.
  2. Identify absolute advantage in each good.
  3. Identify comparative advantage and the efficient pattern of specialization.
  4. State the open interval of mutually beneficial terms of trade in ice creams per loaf.

Answer 6 is at the end of the chapter.

Practice 7

Test the price

Using Wendy and Jack, decide whether both would accept each price. Explain with opportunity costs.

  1. 1.5 ice creams per loaf
  2. 1.8 ice creams per loaf
  3. 2.5 ice creams per loaf

Answer 7 is at the end of the chapter.

02.6

Follow resources, output, and money

The Circular-Flow Model

The circular-flow model connects production to exchange. In its simplest form, it contains two decision makers and two markets.

Households own productive resources and purchase goods and services. Firms hire resources and sell the resulting output.

Two markets

  1. Markets for goods and services: firms sell; households buy.
  2. Markets for factors of production: households sell resource services; firms buy.

Model diagram

Trace the two loops

The inner black loop carries real flows: goods and services move through the goods market, while factors of production move through factor markets.

The outer red loop carries money flows in the opposite direction.

Real flowMoney flow
Circular-flow model with households at the top, firms at the bottom, the market for goods and services on the left, and factor markets on the right. Goods and services flow from firms through the goods market to households. Factors of production flow from households through factor markets to firms. Money flows in the opposite direction around the outside of the diagram.
Households supply factors and buy output. Firms buy factors and sell output. Every real exchange has a payment moving the other way.

Why this model matters

Three questions every economy answers

The circular-flow model links the economy’s purpose—turning scarce resources into output—to the institutions that determine production and distribution.

01

What is produced?

Household demand and firms’ production decisions meet in markets for goods and services.

02

How is it produced?

Firms combine labor, land, physical capital, and entrepreneurship obtained through factor markets.

03

Who gets it?

Income earned from supplying resources gives households purchasing power; goods and services flow to the buyers who use that income.

Worked example

One student, two markets

When a student works at a café, the household is a seller in the factor market and the café is a buyer; labor flows to the firm and wages flow to the household. When the same student buys coffee, the household is a buyer in the goods market and the café is a seller; coffee flows to the household and spending flows to the firm.

Practice 8

Trace both sides of the exchange

  1. A graphic designer works for a software firm. Identify the market, buyer, seller, real flow, and money flow.
  2. The designer uses part of the wage to buy a laptop. Identify the market, buyer, seller, real flow, and money flow.
  3. Name three important sectors omitted from the basic two-sector model.

Answer 8 is at the end of the chapter.

02.7

Put the models together

Additional practice

Practice 9

Work and leisure

You have eight hours. Each hour of work earns $20; every hour not worked is leisure.

  1. Construct the endpoint combinations and graph earnings vertically.
  2. Find the slope.
  3. Find the opportunity cost of one leisure hour.
  4. Find the opportunity cost of one dollar of earnings.
  5. Why is the PPF linear? Give one change that would make it bowed.

Answer 9 is at the end of the chapter.

Practice 10

Kelly and Jack on an island

Per hour, Kelly can gather 10 coconuts or 12 fish. Jack can gather 10 coconuts or 15 fish.

  1. Graph both PPFs with fish vertically.
  2. Compute every opportunity cost.
  3. Identify absolute and comparative advantage.
  4. State the efficient specialization pattern.

Answer 10 is at the end of the chapter.

Practice 11

Spot every error

“Venezuela produces less crude oil and natural gas, so it has nothing useful to offer the United States. The United States should make both goods. Any trade must make Venezuela poorer.”

Identify and correct every distinct economic error.

Answer 11 is at the end of the chapter.

Practice 12

A changing economy

For each event, name the PPF change and one circular-flow effect.

  1. A recession leaves workers and machines idle.
  2. A technical college raises worker skills across local industries.
  3. A flood destroys roads, stores, and equipment.

Answer 12 is at the end of the chapter.

02.8

Check reasoning, units, and vocabulary

Answer key

An answer is complete only when the reasoning and units are clear. Equivalent wording is acceptable when the economics is precise.

1 · Classify the resource

  1. Land; rent.
  2. Labor, including human capital; wages or salary.
  3. Physical capital; interest or rental return.
  4. Entrepreneurship; profit or loss.

2 · Locate each point

  1. (25, 15) is on the PPF: attainable and productively efficient.
  2. At 60 pizzas the frontier allows 8 lectures, so (60, 12) is outside and currently unattainable.
  3. At 40 pizzas the frontier allows 12 lectures, so (40, 8) is inside: attainable but productively inefficient.
Linear pizza-and-lecture production possibilities frontierA straight frontier connects A at zero pizzas and 20 lectures to E at 100 pizzas and zero lectures. Points B, C, and D divide the line into equal production steps.025507510005101520ABCDEa (25, 15)b (60, 12)c (40, 8)PizzasPublic lectures
The answer graph plots all three requested combinations against the chapter PPF.

3 · Use both methods

B→D gains 50 pizzas and forgoes 10 lectures: 10/50 = 0.2 lectures per pizza. D→B gains 10 lectures and forgoes 50 pizzas: 50/10 = 5 pizzas per lecture. Slope = (5−15)/(75−25) = −0.2 lecture per pizza; its absolute value and reciprocal confirm the answers. 0.2 × 5 = 1.

Linear pizza-and-lecture production possibilities frontierA straight frontier connects A at zero pizzas and 20 lectures to E at 100 pizzas and zero lectures. Points B, C, and D divide the line into equal production steps.025507510005101520ABCDEPizzasPublic lectures
B (25, 15) and D (75, 5) are highlighted on the correctly drawn linear PPF.

4 · Increasing cost

Moving from (20, 24) to (30, 15) gains 10 natural-gas units and forgoes 9 crude-oil units: 0.9 crude-oil unit per natural-gas unit. That exceeds the earlier 0.4 because resources moved later are less suited to natural-gas production.

Bowed production possibilities frontier for Practice 4A bowed frontier passes through 10 natural-gas units and 28 crude-oil units, 20 and 24, and 30 and 15. The segment from 20 and 24 to 30 and 15 is highlighted.0102030400152430(10, 28)(20, 24)(30, 15)Natural gasCrude oil
The highlighted segment gains 10 natural-gas units and gives up 9 crude-oil units.

5 · Movement or shift?

  1. Movement toward the existing PPF.
  2. Outward shift.
  3. Pivot outward on the pizza axis.
  4. Inward shift.
  5. Movement along the existing PPF.
a · Recoveryinside → frontierGood XGood Y

a · Recovery

b · Outward shiftGood XGood Y

b · Outward shift

c · Pizza-axis pivotGood XGood Y

c · Pizza-axis pivot

d · Inward shiftGood XGood Y

d · Inward shift

e · Along the PPFalong frontierGood XGood Y

e · Along the PPF

Each panel shows the correctly drawn movement or change in productive capacity.

6 · Wendy and Jack

WendyJack
OC of one loaf100/50 = 2 ice creams50/30 = 1.67 ice creams
OC of one ice cream50/100 = 0.5 loaf30/50 = 0.6 loaf

Wendy has absolute advantage in both goods. Jack has comparative advantage in bread; Wendy has comparative advantage in ice cream. Specialize accordingly. Mutually beneficial terms are 1.67 < price < 2 ice creams per loaf.

Wendy

Wendy production possibilities frontierA production possibilities frontier with ice creams from zero to 100 on the horizontal axis and loaves of bread from zero to 50 on the vertical axis. The frontier runs from 50 loaves of bread to 100 ice creams.025507510001020304050Ice creamsLoaves of bread

Jack

Jack production possibilities frontierA production possibilities frontier with ice creams from zero to 100 on the horizontal axis and loaves of bread from zero to 50 on the vertical axis. The frontier runs from 30 loaves of bread to 50 ice creams.025507510001020304050Ice creamsLoaves of bread
Each player is shown on a separate graph with matched axes; the intercepts and slopes produce the opportunity costs in the table.

7 · Test the price

  1. At 1.5, Jack refuses: a loaf costs him 1.67 ice creams to make.
  2. At 1.8, both accept: Jack receives more than 1.67 and Wendy pays less than 2.
  3. At 2.5, Wendy refuses: she can make a loaf herself for 2 ice creams.

Wendy

Wendy production possibilities frontierA production possibilities frontier with ice creams from zero to 100 on the horizontal axis and loaves of bread from zero to 50 on the vertical axis. The frontier runs from 50 loaves of bread to 100 ice creams.025507510001020304050Ice creamsLoaves of bread

Jack

Jack production possibilities frontierA production possibilities frontier with ice creams from zero to 100 on the horizontal axis and loaves of bread from zero to 50 on the vertical axis. The frontier runs from 30 loaves of bread to 50 ice creams.025507510001020304050Ice creamsLoaves of bread
Each player is shown on a separate graph with matched axes; the slopes show the domestic costs that bound acceptable prices.

8 · Trace the exchange

  1. Factor market: the household/designer sells labor; the firm buys. Design labor flows to the firm; wages flow to the household.
  2. Goods market: the computer firm sells and the household buys. The laptop flows to the household; spending/revenue flows to the firm.
  3. Common omissions: government, the financial system, and the rest of the world.

9 · Work and leisure

Endpoints are (0 leisure, $160 earnings) and (8 leisure, $0 earnings). Slope = (0−160)/(8−0) = −$20 per leisure hour. One leisure hour costs $20 of earnings; one dollar of earnings costs 0.05 leisure hour. The PPF is linear because every work hour earns the same wage. Fatigue, changing productivity, or an overtime premium could make the trade-off nonlinear.

Leisure hours and Earnings ($) production possibilities frontierA straight frontier connects zero leisure hours and 160 earnings ($) to 8 leisure hours and zero earnings ($).0024048061208160Leisure hoursEarnings ($)
The straight line connects the two endpoint combinations: (0, $160) and (8, $0).

10 · Kelly and Jack

KellyJack
OC coconut12/10 = 1.2 fish15/10 = 1.5 fish
OC fish10/12 = 0.83 coconut10/15 = 0.67 coconut

Neither has absolute advantage in coconuts; Jack has absolute advantage in fish. Kelly has comparative advantage in coconuts; Jack has comparative advantage in fish. Kelly should specialize relatively toward coconuts and Jack toward fish.

Kelly

Kelly production possibilities frontierA production possibilities frontier with coconuts from zero to 10 on the horizontal axis and fish from zero to 15 on the vertical axis. The frontier runs from 12 fish to 10 coconuts.02.557.51003691215CoconutsFish

Jack

Jack production possibilities frontierA production possibilities frontier with coconuts from zero to 10 on the horizontal axis and fish from zero to 15 on the vertical axis. The frontier runs from 15 fish to 10 coconuts.02.557.51003691215CoconutsFish
Each player is shown on a separate graph with matched axes. Both can gather 10 coconuts; Jack's higher fish intercept gives him absolute advantage in fish.

11 · Spot every error

  1. Absolute disadvantage does not imply no gains from trade; comparative advantage determines specialization.
  2. Venezuela’s opportunity cost of natural gas is lower, so it has comparative advantage in natural gas.
  3. If the United States produces natural gas, it gives up crude oil at a higher rate than Venezuela does.
  4. Under the model, voluntary trade at mutually beneficial terms can make both countries better off; Venezuela is not forced to accept a harmful price.

Venezuela

Venezuela production possibilities frontierA production possibilities frontier with natural gas from zero to 40 on the horizontal axis and crude oil from zero to 30 on the vertical axis. The frontier runs from 10 crude oil to 30 natural gas.0102030400102030Closed production (6, 8)Open consumption (10, 10)Natural gasCrude oil

United States

United States production possibilities frontierA production possibilities frontier with natural gas from zero to 40 on the horizontal axis and crude oil from zero to 30 on the vertical axis. The frontier runs from 30 crude oil to 40 natural gas.0102030400102030Closed production (16, 18)Open consumption (20, 20)Natural gasCrude oil
Closed-economy production Open-economy consumption
Closed production is on each PPF; the equal-gains open-consumption bundles lie beyond each country's PPF.

12 · A changing economy

  1. The economy moves inside the unchanged PPF. Lower production reduces firms’ revenue, factor purchases, and household income.
  2. Better human capital shifts the PPF outward. More productive labor can raise output, wages, sales, and income flows.
  3. Destroyed physical capital and infrastructure shift the PPF inward. Production, factor demand, household income, and goods-market exchange may fall.
a · Recessioninside → frontierGood XGood Y

a · Recession

b · Better skillsGood XGood Y

b · Better skills

c · Flood damageGood XGood Y

c · Flood damage

A recession changes the economy's position; education and flood damage change the frontier itself.