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The Economic Problem Chapter 3 CHAPTER OUTLINE 1. Explain and illustrate the concepts of scarcity, production efficiency, and tradeoff using the production possibilities frontier. A. Production Possibilities Frontier 1. Attainable and Unattainable Combinations 2. Efficient and Inefficient Production 3.Tradeoffs and Free Lunches 2. Calculate opportunity cost. A.The Opportunity Cost of a Cell Phone B. Opportunity Cost and the Slope of the PPF C. Opportunity Cost Is a Ratio D. Increasing Opportunity Costs Are Everywhere E. Your Increasing Opportunity Cost 3. Explain what makes production possibilities expand. A.Economic Growth 4. Explain how people gain from specialization and trade. A. Absolute and Comparative Advantage B. Comparative Advantage: An Example C.Achieving Gains from Trade What’s New in this Edition? Chapter 3 has been slightly revised for the seventh edition. The “Guns Versus Butter” Eye On has been removed and a new Eye On concerning expanding the PPF for the United States has been added. The introduction of absolute and comparative advantage has been reorganized. © 2015 Pearson Education, Inc.

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Page 1: The Economic Problem

TheEconomicProblem

Chapter

3CHAPTER OUTLINE

1. Explain and illustrate the concepts of scarcity, production efficiency, and tradeoff using the production possibilities frontier.

A. Production Possibilities Frontier1. Attainable and Unattainable Combinations2. Efficient and Inefficient Production3. Tradeoffs and Free Lunches

2. Calculate opportunity cost.A. The Opportunity Cost of a Cell PhoneB. Opportunity Cost and the Slope of the PPFC. Opportunity Cost Is a RatioD.Increasing Opportunity Costs Are EverywhereE. Your Increasing Opportunity Cost

3. Explain what makes production possibilities expand.A. Economic Growth

4. Explain how people gain from specialization and trade.A. Absolute and Comparative AdvantageB. Comparative Advantage: An ExampleC. Achieving Gains from Trade

What’s New in this Edition?Chapter 3 has been slightly revised for the seventh edition. The “Guns Versus Butter” Eye On has been removed and a new Eye On concerning expanding the PPF for the United States has been added. The introduction of absolute and comparative advantage has been reorganized.

Where We AreIn Chapter 3, we use the production possibilities frontier to illustrate the economic problem and cal-culate opportunity cost. We illustrate the effect of

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38 Part 1  .  INTRODUCTION

unemployed resources using the production possibil-ities frontier model. We study how technological change and capital accumulation increase produc-tion possibilities and lead to economic growth. Then we explain how specialization and trade expand pro-duction possibilities.

Where We’ve BeenIn Chapter 2, we described what, how, and for whom goods and services are produced in the United States, thereby motivating the production possibilities frontier model developed in this chap-ter. In Chapter 2 we used the circular flow model to provide a picture of how households and firms inter-act. We described the economic activities of govern-ments in the United States and included govern-ments in the circular flow.

Where We’re GoingThe next chapter introduces the supply and demand model. We will distinguish between quantity de-manded and demand, and explain what determines demand. Likewise we will distinguish between quan-tity supplied and supply, and explain what deter-mines supply. We will explore how demand and sup-ply determine price and quantity in a market, and explain the effects of changes in demand and supply.

IN THE CLASSROOM

Class Time NeededThe material in this chapter can be covered in up to two class ses-sions.

An estimate of the time per checklist topic is:

3.1 Production Possibilities—25 to 40 minutes 3.2 Opportunity Cost—15 to 20 minutes 3.3 Economic Growth—5 to 10 minutes

3.4 Specialization and Trade—25 to 40 minutes

Classroom Activity: You might like to get the students to realize how useful even a simple economic model, such as the PPF model, is for helping us understand and interpret important political events in history. For instance, the PPF model can be used to analyze real-world events such as an “Arms Race” between nations. Draw a PPF for military goods and civilian goods production. Then draw another PPF for a country that is about twice the size of the first, but with the same de-gree of concavity as the PPF for the first country. Now assume that each country considers the other as a mortal “enemy,” and that they engage in a costly arms

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Chapter 3  .  The Economic Problem 39

race. Each country picks a point on the PPF that produces an equal level of mili-tary output in absolute terms. What would happen if the larger country decided to increase military produc-tion? Emphasize that while the distance on the military output axis at the point of production is equal for both countries, the resulting distance on the civilian output axis is (by definition) a smaller quantity for the smaller country. The large country can create significant economic and political pressures on the govern-ment of the small country by forcing the small country to match the increase in military production. The PPF reveals how much more additional civilian output is forgone by the citizens of the small economy relative to the citizens of the larger economy. Emphasize also that the opportunity cost of civilian goods is higher for the smaller country.What were the economic repercussions of the Cold War? History and political science majors quickly perceive that these two PPF models reflect the Cold War relationship between the United States and the U.S.S.R. during the early 1980s. The Reagan administration increased U.S. military expenditures during the early 1980s to a post-Vietnam War peak of 6.6 percent of GDP (as compared to about 3.5 percent of GDP in the late 1990s). Many experts agree that this strategy con-tributed to the many political and economic pressures that ultimately lead to the dissolution of the U.S.S.R.“What are the implications for the next fifty years?” China is currently the world’s second largest economy. It is predicted to surpass the U.S. to become the biggest economy in the not-too-distant future. Ask your students how this de-velopment influences the strategic balance and the position of the United States?

Classroom Activity: The PPF model can be used to analyze global environmental agreements between nations. This application of the PPF is a less hawkish and perhaps a more green perspective on a timely international policy issue. Com-pare a rich economy’s PPF to a poor economy’s PPF, each with the same degree of concavity. The production levels are now measured as output per person and the goods are “cleaner air” and “other goods and services.”What if the citizens of each country were required to make equal reductions in per-person greenhouse gas emissions? Show an equal quantity increase in per person output on the clean air axis for both countries’ PPF curve. Show how the opportunity cost of requiring additional pollution reductions (cleaner air) of equal amounts per person is much greater for the citizens of a poorer country than for the citizens of the richer country. This fact has been used to try to per-suade developed countries (like the United States) to accept larger pollution re-duction targets than developing countries (like China, India, and the African na-tions).

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40 Part 1  .  INTRODUCTION

CHAPTER LECTURE

3.1 Production Possibilities

Production Possibilities Frontier The production possibilities frontier (PPF) is the boundary between those

combinations of goods and ser-vices that can be produced and those that cannot.

Consider the production choices for two goods: books and movies. The table with the data for the PPF is below and a figure show-ing the PPF is to the right.

Books MoviesA 0 600B 200 500C 400 300D 600 0

Production points beyond the PPF are not attainable; production points on and within the PPF are attainable.

To make this model useful, it was necessary to simplify. By considering the case where production of all goods other than the illustrated two remain fixed, we can use a relatively simple picture to see how concepts apply to the real world. With three goods, we would have a 3-D frontier surface. With more than 3 goods, it would be impossible to represent the frontier using a graph. Meanwhile, all relevant re-sults of model can be easily illustrated in the simple 2-D case.

Production Efficiency Production is efficient only on the frontier of the PPF. These points are pro-

duction efficient, a situation in more of one good or service cannot be pro-duced without producing less of something else. Points within the PPF, such as point Z, are inefficient.

Tradeoff Along the PPF Moving along the PPF illustrates how scarcity creates the need to make

choices. Producing more books (moving from point A to point B) means pro-ducing fewer movies, and producing more movies (moving from point C to point B) means producing fewer books. These movements reflect a tradeoff, which is an exchange of giving up

one thing to get something else. A free lunch is a gift, getting something without giving up something

else. A movement from point Z to point C is free lunch because more of

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Chapter 3  .  The Economic Problem 41

both books and movies are obtained. When production is efficient – at a point on the PPF – then there will be no opportunity for a free lunch, as attempts to produce more of good requires a tradeoff.

3.2 Opportunity Cost

The opportunity cost of an action is the best thing given up. If the economy is at a production efficient point on the frontier, then the op-

portunity cost of producing more books or movies is the tradeoff along the frontier.

The magnitude of the slope of the PPF measures the opportunity cost of one more unit of the good measured along the horizontal axis. The opportunity cost equals the change in the quantity of the good forgone divided by the change in the quantity of the good that is gained.

Lecture Launcher: Students really do think that while some things are priceless, for everything else there’s MasterCard. Make sure they understand that even if one doesn’t give up money, one must give up something because many of them almost instinctively relate costs to monetary costs. To help them grasp the idea of opportunity cost while moving along the PPF, it is important to get students to realize very early on that thinking only of monetary costs is a narrow view and ignores the most important cost of all—opportunity cost. Demonstrate the fact that opportunity cost does not necessarily involve money by launching your lecture with an example that hits close to home. Ask your stu-dents to take a minute to write down a list of things that qualify as the opportu-nity cost to them of attending your economics class. Expect a fairly wide range of answers from the downright silly to the very thoughtful. Stress that the true opportunity cost of any endeavor is only the one next best thing forgone. The reason is because you can only perform one other activity in place of whatever it is you are doing at present. In other words, you will need to convince your stu-dents that even though they have come up with a fairly long list of items, the op-portunity cost of attending your economics class can only be one of them. This one is the one that will rank above the others as the next best available alterna-tive. Here might be some possible answers: by taking economics your students cannot take biology, physics or chemistry; they might have to give up overtime at work (if they are taking a night class); or the cost could be the forgone extra sleep they could have enjoyed if they are taking an 8:00 a.m. class!

Opportunity Cost Is a Ratio The opportunity cost of producing more of a product is the quantity of the

product forgone divided by the quantity of the product gained. Hence the op-portunity cost of a good or service is a ratio. Being a ratio, the opportunity costs for two goods will be the inverse of each other – the opportunity cost of producing good X in terms of good Y is the inverse of the opportunity cost of good Y in terms of good X.

Increasing Opportunity Cost As more of a product is produced, its opportunity cost increases. In the fig-

ure, moving from point A to point B to point C and so on, the opportunity cost of each additional book increases.

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42 Part 1  .  INTRODUCTION

Increasing opportunity cost is reflected in the bowed-out shape of the PPF.

Opportunity costs increase because resources are not equally productive in all activities. As resources are initially shifted into producing a good, the most productive resources for that good (and least productive for an alternative good) are chosen first – hence the low initial opportunity cost. As more of that good is produced, less productive resources for producing that good (and more productive resources for the alternative good) are shifted towards producing that good – hence the opportunity cost in-creases.

3.3 Economic GrowthEconomic growth is the sustained expansion of production possibilities. Economic growth shifts the PPF outward.

The (Opportunity) Cost of Economic Growth Economic growth requires that resources must be devoted to developing

technology or accumulating capital, which means that current consumption decreases. The decrease in current consumption is the opportunity cost of economic growth. This result demonstrates that economic growth is not “free.”

Countries that devote a higher share of resources to developing technology or accumulating capital are more likely to grow faster.

3.4 Specialization and TradeSpecialization of labor results in greater productivity. Absolute advantage occurs when one person (or nation) is more productive than another (needs fewer inputs or takes less time to produce a good or perform a production task). A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else.

Land Mine: Absolute advantage and comparative advantage are concepts that give students trouble. It flies in the face of intu-ition to say that even though someone has the ability to produce something using fewer resources than someone else, nonethe-less, it still pays for the two to trade. It is an especially difficult concept to grasp when you up the ante by saying that the same would still be true even if that person enjoyed an absolute advan-tage in everything over their trading partner! This might be a good opportunity to use a very concrete example that students should be able to compute right in the classroom. Lay out the fol-lowing scenario: Assume Suzie, a computer consultant, is very good at repairing computers and also happens to be a very good house painter. In fact, she is so good that it turns out she is more productive at both things than her neighbor, Bob, who hap-pens to paint houses for a living. To the right is a ta-ble that shows the amount of time it takes for Suzie

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Time it takes Suzie

Time it takes Bob

Repair a com-puter

2 hours 24 hours

Paint a house 30 hours 48 hours

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Chapter 3  .  The Economic Problem 43

and Bob to perform each of the two activities. In addition, let’s assume that Suzie and Bob earn $100 per computer repaired and Bob and Suzie earn $960 per house painted. Ask the students to compute the opportunity cost for Suzie and Bob repairing a com-puter and painting a house.The new table to the right contains the opportunity costs. (To cal-culate these numbers, take Suzie’s opportunity cost of painting a house. In the 30 hours it takes her to paint a house, she could have repaired 15 computers, so the opportu-nity cost is 15 computers times $100 each, or $1,500.) The table reveals that Suzie has the lower opportunity cost of repairing computers and Bob has the lower opportunity cost of painting houses. What this example demonstrates so pow-erfully is that a person can have an absolute disadvantage in ev-erything, as is the case for Bob, but still manage to have a com-parative advantage in an activity. Point out to students that this logic applies between individuals and also across cities, states, and nations.

The PPF shows opportunity cost of the goods. In the figure the oppor-tunity cost of a bushel of wheat in Canada is 1/4 of a computer and in Japan it is 1 computer. In Canada the opportunity cost of a computer is 4 bushels of wheat and in Japan it is 1 bushel of wheat. Canada has a comparative advantage in pro-ducing wheat and Japan has a comparative advantage in produc-ing computers.

Achieving Gains from Trade When countries specialize by pro-

ducing the good in which each country has a comparative advan-tage more goods in total can be produced. If Canada and Japan each produce at point A, a total of 8 computers and 16 bushels of wheat are produced. If they specialize accord-ing to comparative advantage, a total of 12 computers and 24 bushels of wheat are produced.

Trade allows consumption to be different than production for each nation, so Canada can trade wheat for computers and Japan can trade computers for wheat. Because more computers and more wheat are produced, both nations can consume more than they can produce on their own.

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Opportunity cost for Suzie

Opportunity cost for Bob

Repair a com-puter

$64 $480

Paint a house $1,500 $200

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44 Part 1  .  INTRODUCTION

Exchange is not a zero-sum game. If it is voluntary, both parties will believe they are better off, by definition (or else they would never agree to the trade in the first place). Imagine what would happen to your consumption if you couldn’t trade and had to be self-sufficient. How would self-sufficiency impact your level of consump-tion of food? Clothing? Transportation? Communications? Entertainment? Health care? Education? The gains from trade explain why an individual, a household, a city, a state, and even a country typically choose not to be entirely self-sufficient. A far greater amount of goods and services can be produced and consumed with spe-cialization and trade than in isolation.

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Chapter 3  .  The Economic Problem 45

USING EYE ON YOUR LIFE

Your Production Possibilities FrontierThe example of a student who must allocate his or her time between studying and other events illustrated in this Eye really strikes home for students and is a truly great example. However, economists gener-ally do not analyze people’s decisions using the PPF. Instead, econo-mists typically use utility functions or indifference curves. It’s proba-bly wise to use this Eye to stress two points to the students: First, there are other ways of analyzing other people’s behavior. Second, the PPF deals with production so, as this Eye shows, we are looking at the production of grades. Students do not know the first point and it is easy for them to overlook the second, so both points are worthwhile.

Your Comparative AdvantageAsk your students what they envision for their future careers. Then ask them why they expect to be successful at this endeavor and tell them to use the concept of comparative advantage in their answer.

USING EYE ON THE ENVIRONMENT

Is Wind Power Free?Use this Eye to help students identify that alternative energy sources, often touted for their environmental friendliness and even as potential sources of economic growth by our elected officials, have opportunity costs associated with them. Relying too heavily on alternative energy sources (such as wind power), can result in an inefficient level of pro-duction. Inefficiency occurs if we must sacrifice other goods and ser-vices without gaining additional electricity when we increase our us-age of these energy sources. It might be the case that increasing the usage of these “greener” sources of energy could lower our current standard of living and hinder overall production on the United States. One moral is to be wary of any politician who promises a cleaner envi-ronment and greater economic growth simultaneously. However, it still may be possible that a productively inefficient point of production now may still be desirable when longer term environmental conse-quences are factored into the costs associated with more traditional energy sources (coal, oil, gas). Ultimately, it comes down to a compar-ison between the value of the current tradeoffs made by switching to alternative energy sources to the potential future environmental bene-fits from using less polluting sources of energy. But, as is often the case, the devil is in the details – calculating those tradeoffs and the value of those environmental consequences is subject to considerable debate and large margins of error, therefore continuing to muddle the desirability of switching to greater usage of alternative energy.

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46 Part 1  .  INTRODUCTION

USING EYE ON THE U.S. ECONOMY

Expanding Our Production PossibilitiesThis Eye can make an interesting combination with the Eye on the En-vironment in the previous section. While “green” energy sources such as wind, hydro, and solar are often touted, they require sacrifices in other areas of production in order to generate the same level of elec-tricity as other energy sources (such as natural gas). While the envi-ronmental impact of fracking has become a matter of intense debate (and something your students may have strong opinions about), the production benefits associated with fracking technology have been tremendous. Technological advancements in fracking allow the United States to generate more electricity without having to cut back produc-tion in other areas. If it does turn out that fracking has severely nega-tive environmental consequences though, it may result in a lower standard of living. Given what we see with the PPF in this Eye On, ask your students how it might be possible for the United States to expand electricity generation without compromising other areas of production and while still protecting the environment. Hopefully they should identify that technology is ultimately what will determine if “green” energy sources can meet our electricity needs in the future without requiring production sacrifices. If “green” technology can advance enough, it can unequivocally improve our standard of living by allow-ing greater production to take place while simultaneously maintaining a quality environment.

No One Knows How to Make a PencilAdapt this Eye as either in-class, small group work or an out-of-class research assignment (depending on what fits your course best). Select a good that is indicative of the region of the country in which your col-lege is located. Ask students to identify all of the factors of production used to produce that good and try to trace those components back to their original sources. It should only take going through this process for one good for students to gain an understanding and appreciation for the astonishing power of specialization and trade.

USING EYE ON THE GLOBAL ECONOMY

Hong Kong’s Rapid Economic GrowthThis Eye makes an excellent launching pad for a discussion of the de-sirability of economic growth and its opportunity cost. Ask your stu-dents what—and how much—they are willing to sacrifice for more rapid economic growth. You can also engage them in a discussion of whether another nation’s rapid growth is good or bad for the United States.

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HoursFish

(pounds)

Fruit(pounds)

0 0 or 01 4 or 72 7 or 133 9 or 194 10 or 245 11 or 28

PossibilityFish

(pounds)

Fruit(pounds)

A 0 28B 4 24C 7 19D 9 13E 10 7F 11 0

Chapter 3  .  The Economic Problem 47

ADDITIONAL EXERCISES FOR ASSIGNMENT

Questions Checkpoint 3.1 Production PossibilitiesIn the winter, both fish and fruit are harder to find and Robinson Crusoe can work only 5 hours a day. The table shows the quantities that Crusoe can produce in winter. Use this ta-ble for the next 4 problems.

1. Use these numbers to make Crusoe’s PPF in winter.

2. Based on Crusoe’s PPF, Which combina-tions (pounds of each) are attainable and which are unattainable: (i) 9 fish and 13 fruit, (ii) 10 fish and 13 fruit, (iii) 7 fish and 18 fruit?

3. Which combinations (pounds of each) use all of Crusoe's available 5 hours a day: (i) 11 fish and 0 fruit, (ii) 10 fish and 7 fruit, (iii) 4 fish and 20 fruit?

4. Which combinations provide Crusoe with a free lunch and which confront him with a tradeoff when he increases fish by 1 pound: (i) 10 fish and 7 fruit, (ii) 4 fish and 2 fruit?

Checkpoint 3.2 Opportunity CostThe table shows Robinson Crusoe’s PPF in the winter. Use it for the next 4 problems.

5. Calculate Crusoe’s opportunity cost of a pound of fruit. Make a table that shows Cru-soe's opportunity cost of a pound of fruit as he increases the time he spends picking fruit and decreases the time he spends fishing.

6. If Crusoe currently catches 7 pounds of fish and picks 13 pounds of fruit a day, calculate his opportunity cost of a pound of fruit and of a pound of fish. Explain your answer.

7. If Crusoe increases the fish caught from 7 to 9 pounds and de-creases the fruit picked from 19 to 13 pounds, what is his oppor-tunity cost of a pound of fish? Explain your answer.

8. Does Crusoe's opportunity cost of a pound of fruit increase as he spends more time picking fruit? Explain why or why not.

Checkpoint 3.4 Specialization and Trade9. Bob is a lawyer with a large law firm. He is very good at prepar-

ing briefs and also is very good at typing. Bob's legal assistant Tom can prepare 1 legal brief in two hours and Bob can prepare 1 legal brief in one hour. In one hour Tom can type 6 pages and

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PossibilityFish

(pounds)

Fruit(pounds)

A 0 and 28B 4 and 24C 7 and 19D 9 and 13E 10 and 7F 11 and 0

48 Part 1  .  INTRODUCTION

Bob can type 9 pages. Which person has the absolute advantage in preparing briefs and which has the comparative advantage in typing? Which person has the comparative advantage in prepar-ing briefs and which in typing?

10. If you were seeking out a trading partner, would you choose someone whose tastes are similar to yours or different? Explain your answer.

Answers Checkpoint 3.1 Production Possibilities1. Crusoe’s production possibilities frontier in

the winter is given in the table to the right. The production possibilities frontier is illus-trated in Figure 3.1.

2i. Attainable

2ii. Not attainable. After spending 4 hours pro-ducing 10 fish, Crusoe has only one hour left to devote to picking fruit, which yields him 7 fruit, not 13.

2iii. Attainable

3i. The combination uses all Crusoe’s avail-able 5 hours a day.

3ii. The combination uses all Crusoe’s avail-able 5 hours a day.

3iii. The combination does not use all of Crusoe’s time.

4i. The combination of 10 fish and 7 fruit confront Crusoe with a tradeoff because it is a point on his production possibilities frontier.

4ii. The combination of 4 fish and 2 fruit gives Crusoe a free lunch because it is in-side his production possibilities frontier. Crusoe could increase fish by 1 and si-multaneously increase his fruit.

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Move from

Increase in fruit picked

(pounds)

Decrease in fish caught

(pounds)

Opportunitycost of fruit(pounds of

fish)F to E 7.0 1.0 0.14E to D 6.0 1.0 0.17D to C 6.0 2.0 0.33C to B 5.0 3.0 0.60B to A 4.0 4.0 1.00

Chapter 3  .  The Economic Problem 49

Checkpoint 3.2 Opportunity Cost5. Crusoe’s opportunity cost

of a pound of fruit is the pounds of fish he forgoes. To calculate the opportu-nity cost, start by comput-ing the increase in fruit picked as he increases the time he spends picking fruit. Also calculate the de-crease in the fish he catches. Then, divide the decrease in fish by the increase in fruit to get the opportunity cost per pound of fruit. The table shows the increase in pounds of fruit picked, the decrease in pounds of fish caught, and the oppor-tunity cost as we move along the production possibilities frontier.

6. His opportunity cost of a pound of fruit and a pound of fish are both zero. The reason is that he is operating inside his production possibilities frontier. He could pick 6 more pounds of fruit without giving up any fish or alternatively catch 2 more pounds of fish without giving up any fruit. Crusoe is in a position to reap a free lunch.

7. When Crusoe increases his fish caught by 2 pounds, from 7 pounds to 9 pounds, he decreases the quantity of fruit from 19 pounds to 13 pounds. His opportunity cost of a pound of fish is 6 pounds of fruit ÷ 2 pounds of fish, which is 3 pounds of fruit.

8. Crusoe’s opportunity cost of a pound of fruit increases as he spends more time picking fruit. This result is shown in the table above. As Crusoe spends more time picking fruit, so that he moves from spending no time at point F to one hour at point E to two hours at point D and so on, his opportunity cost of a pound of fruit rises from 0.14 pounds of fish to 0.17 pounds of fish to 0.33 pounds of fish, and so forth.

Checkpoint 3.4 Specialization and Trade9. Bob has an absolute advantage in preparing briefs and typing be-

cause he uses fewer resources than Tom for each. Comparative advantage is a different matter. When Bob prepares one brief in one hour, his opportunity cost is 9 pages of typing. When Tom prepares one brief in two hours, his opportunity cost is 12 pages of typing. Bob has the comparative advantage in preparing briefs because his opportunity cost is less. With regard to typing the op-portunity costs are reversed. If Bob spends one hour typing he gives up one brief that he could have prepared. If Tom spends one hour typing he gives up only 1/2 of a brief he could have pre-pared. Tom has the comparative advantage in typing because his opportunity cost is less.

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50 Part 1  .  INTRODUCTION

10.Someone with different tastes would most likely have more expe-rience in the production of different goods and services. And by specializing in the production of other goods and services they would most likely have a lower opportunity cost. So we could both benefit by specializing and trading the goods in which we have a comparative advantage.

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