Errol D’Souza

Tradeoffs, Comparative Advantage, & the

Decisions of managers reflect key fact of economic life:
Market System SCARCITY.
AGMP10, 6th August 2022
Scarcity exists because we have unlimited wants and
Errol D’Souza limited resources to satisfy those wants.

Goods and services are scarce as are economic res-

ources or factors of production – workers,
capital, natural resources, entrepreneurial
ability – used to make them.

Scarcity requires trade-offs. Time for instance is scarce.

If you spend an hour studying you have one hour
less to go to the movies. – If Maruti Suzuki decides
to devote some of its scarce workers and machinery
to producing more Swift cars those resources will
Email: errol@iima.ac.in not be available to produce more Baleno cars.
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Errol D’Souza Errol D’Souza

Maruti-Suzuki’s Production Choices
Maruti-Suzuki’s Production Choices
Choice Quantity of Swift cars Quantity of Baleno
Choice Quantity of Swift cars Quantity of Baleno produced cars produced
produced cars produced A 800 0
A 800 0
B 600 200
B 600 200
C 400 400
C 400 400
D 200 600
D 200 600
E 0 800
E 0 800
produced per day
Quantity of Swift

The production possibility frontier is used to analyze trade-

offs that Maruti-Suzuki faces in its production plant.

A production possibility frontier is a curve showing

the maximum attainable combinations of 2 products Quantity of Balenos
that may be produced with available resources. 3
produced per day

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 Quantity of Swift Errol D’Souza Errol D’Souza

produced per day

800 Production possibilities
If the company is producing efficiently and is on the prod-
B frontier showing trade-off
uction possibility frontier the only way to produce
600 between producing Swift
one more of one vehicle is to produce less of the
C and Balenos
other vehicle. – The opportunity cost of producing
400
one more Swift is the number of Balenos the com-
pany will not be able to produce as it has already
devoted those resources to producing Swift cars.

Quantity of Balenos For example, in moving from point B to C, the

200 400 800 produced per day opportunity cost of producing 200 more
Balenos is the 200 fewer Swifts that can
Using all resources the company can produce 800 Swift be produced.
per day or 800 Balenos per day.
If it produces both vehicles, it can produce at B where The opportunity cost of any activity is the highest
600 Swift are produced and 200 Balenos. valued alternative that must be given up
to engage in that activity.
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Errol D’Souza Errol D’Souza

Zero sum charity?

What point on the production possibilities frontier is best?
We cannot tell without further information. If
consumer demand for Swifts is greater than demand
for Balenos the company is likely to choose a point
closer to the horizontal axis.
Tsunami Relief and trade-offs
In Dec 2004 a tsunami flooded coastal areas of Indonesia,
Thailand, Sri Lanka, and other countries bordering
the Indian Ocean. Over 280,000 people died and
trillions of rupees of property were destroyed.

Both governments and individuals face limited

budgets and though there was an increase in total
charitable giving, much of the funds spent on tsu-
nami relief were diverted from other uses. Giving
funds to victims of the tsunami meant fewer funds
were available to aid other good causes such as
health or education.

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 Quantity of Swift Errol D’Souza Errol D’Souza

produced per day

800
B
750

500 C

The downward slope of the production possibilities curve

is a reflection of the scarcity principle – because
resources are limited, having more of one thing
generally means having to settle for less of
Quantity of Balenos
another.
400 800 1,000 produced per day
This production possibility frontier is bowed outward. Increa-
sing Baleno production requires larger and larger When the curve is bowed it means that the opportunity
decreases in Swift production. The company experi- cost of producing Balenos increases as the firm
ences increasing marginal opportunity cost. produces more of them.

This occurs because some workers, machines, and

other resources are better suited to one use than to9 10
another.

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Errol D’Souza Errol D’Souza

To increase Baleno production from 0 to 400 the company
has to give up producing 50 Swift cars.
But to increase production by another 400 vehicles
of Baleno it has to give up producing 250
Swift vehicles.
Since increasing production of Baleno requires larger
and larger decreases in the production of the
Swift the company experiences increasing
marginal opportunity costs.
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Increasing marginal opportunity costs implies that the more
resources already devoted to any activity, the smaller
the payoff to devoting additional resources to that
activity.
The more hours you have already spent studying,
the smaller the increase in your test grade
from each additional hour to spend, and the
greater the opportunity cost of using the hour
in that way.
The more funds the government spends cleaning the
environment, the smaller the reduction in
pollution from each additional rupee – and
the greater the opportunity cost of spending
the funds in that way.
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 Errol D’Souza Errol D’Souza

Should Joe Jamail, known as the King of Torts in the legal

Essentially some resources are relatively well suited to profession and the most famous trial lawyer in hist-
producing Swift cars while others are relatively ory write his own will?
well suited for producing Balenos. – As we keep
reassigning workers from Swift to Baleno prod-
uction we are requiring those who are good at
Swift production to work at an activity they are
not as good at.

When resources have different opportunity costs we

should always exploit the resource with the
lowest opportunity cost first.

Principle of Increasing Opportunity Cost – In expanding

the production of any good first employ those
resources with the lowest opportunity cost, and
afterward turn to resources with higher opport-
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unity costs.

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Errol D’Souza Errol D’Souza

Should Joe Jamail, known as the King of Torts in the legal Should Joe Jamail, known as the King of Torts in the legal
profession and the most famous trial lawyer in hist- profession and the most famous trial lawyer in hist-
ory write his own will? ory write his own will?

Writing your own will - 5 hours Writing your own will - 5 hours

Opportunity cost of 5 hours - Rs. 10 lakhs Opportunity cost of 5 hours - Rs. 10 lakhs

Hiring someone to spend 8 hours Hiring someone to spend 8 hours

on your will - Rs. 3 lakhs on your will - Rs. 3 lakhs

Thus, DIY or Do it Yourself when

Opportunity Cost < Hired Cost

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Making the right choice is priceless

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 Quantity of Swift Errol D’Souza Errol D’Souza

produced per day

800
Technological advance makes it possible to produce more
600 goods with the same amount of workers and machi-
B nery, which also shifts outward the production
possibilities frontier.
A

Quantity of Balenos
800 1,000 produced per day

Because resources are scarce producing more Balenos

means producing less Swift cars.
Any increase in available resources – available labour force
or capital stock shifts the production possibilities
frontier outward and makes possible increased
production of both Balenos and Swift cars. – This is17 18
a move from point A to point B.

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Errol D’Souza Errol D’Souza

Specialization and the Gains from Trade

Technological advance makes it possible to produce more
goods with the same amount of workers and machi-
Suppose you and your neighbor both have fruit trees on
nery, which also shifts outward the production
possibilities frontier. your property. – mango and guava trees.

Your neighbor is good at picking mangoes and you

are good at picking guavas. Then it makes
sense if your neighbor concentrates at picking
The ideas of production possibilities frontier and opport- mangoes and you concentrate on picking
unity costs are useful to understand the basic guavas and you can trade some of your
economic activity of trade. – Markets are about guavas for some of your neighbor’s mangoes.
trading or the activity of buying and selling.
But what if your neighbour is better at picking both
Trading makes it possible for people to become mangoes and guavas? Even then there is an
better off by increasing both their prod- advantage to be gained by trading with you.
uction and consumption.

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 Errol D’Souza Errol D’Souza
You Your Neighbour
You Your Neighbour Mangoes Guavas Mangoes Guavas
Mangoes Guavas Mangoes Guavas All time
devoted to 20 kgs. 0 kgs. 30 kgs. 0 kgs.
All time picking
devoted to 20 kgs. 0 kgs. 30 kgs. 0 kgs. mangoes
picking
mangoes All time
devoted to 0 kgs. 20 kgs. 0 kgs. 60 kgs.
All time picking
devoted to 0 kgs. 20 kgs. 0 kgs. 60 kgs. guavas
picking Mangoes Mangoes
guavas (kgs.) (kgs.)

Use the data in the table to construct production possibi-

lities frontiers for you and your neighbor.

21 Guavas Guavas
22
(kgs.) (kgs.)

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Errol D’Souza Errol D’Souza

Mangoes Mangoes Mangoes Mangoes
(kgs.) (kgs.) (kgs.) (kgs.)

30 30

20 20

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8 B
A
Guavas
20 60 Guavas 12 20 Guavas 42 60 Guavas
(kgs.) (kgs.) (kgs.) (kgs.)
Your production possibility Your Neighbour’s production
Suppose you don’t trade. You pick and consume 8 kgs of
frontier possibility frontier
mangoes and 12 kgs. of guavas per month – point A.

Your neighbor picks and consumes 9 kgs of mangoes

and 42 kgs of guavas per month – point B.
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 Errol D’Souza Errol D’Souza

Your neighbor now offers you the following: She will trade Your neighbor now offers you the following: She will trade
you 15 kgs. of her guavas for 10 kgs. of your mangoes. you 15 kgs. of her guavas for 10 kgs. of your mangoes.

Should you accept this offer? Should you accept this offer?
Mangoes Mangoes
(kgs.) (kgs.)
You should specialize in
picking only mangoes. This
means you pick 20 kgs. of
mangoes. – You trade 10 kg.
of these for 15 kgs. Of guava
20 20
from your neighbor.
10 10
8 8 You can now consume 10
Guavas Guavas kg. of mangoes and 15 kgs.
12 20 (kgs.) 12 20 (kgs.) of guava.
15 15
You are now better off.
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Errol D’Souza Errol D’Souza

Mangoes
(kgs.)
Absolute advantage is the ability to produce more of a good
or service than competitors using the same amount
30 of resources.

Your neighbor has an absolute advantage over you in pro-

ducing both mangoes and guavas because she can
10 pick more of each fruit than you can in the same
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amount of time.

42 60 Guavas This seems to suggest that your neighbor should

(kgs.) pick her own mangoes and her own guavas.
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Yet we have just seen that she is better off if she

Your neighbor is also better off. By specializing in picking specializes in guava picking and leaves the
guavas she can pick 60 kgs. She trades 15 kg. of these to you mango picking to you. – Why?
for 10 kg. of mangoes.

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 Errol D’Souza Errol D’Souza

Opportunity cost of Opportunity cost of You have to give up 1 kg. of mangoes for each kg. of guavas
picking 1 kg. of picking 1 kg. of you pick as you shift time away from picking mangoes.
mangoes guavas Hence your opportunity cost of picking 1 kg. of mangoes
You
is 1 kg. of guavas.

Your neighbour Your neighbor has a different tradeoff. As she shifts time from
picking mangoes to guavas she has to give up 1 2 kg.
Mangoes of mangoes for every kg. of guavas she picks.
Mangoes
(kgs.) (kgs.)
Alternatively as she shifts time from picking guavas to
picking mangoes she gives up 2 kg. of guavas for every
30 kg. of mangoes she picks.

20

20 Guavas 60 Guavas
29 30
(kgs.) (kgs.)

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Errol D’Souza Errol D’Souza

You have to give up 1 kg. of mangoes for each kg. of guavas Opportunity cost of Opportunity cost of
picking 1 kg. of picking 1 kg. of
you pick as you shift time away from picking mangoes. guavas
mangoes
Hence your opportunity cost of picking 1 kg. of mangoes
is 1 kg. of guavas. You 1 kg. of guavas 1 kg. of mangoes

Your neighbour 2 kg. of guavas 1

2 kg. of mangoes
Your neighbor has a different tradeoff. As she shifts time from
picking mangoes to guavas she has to give up 1 2 kg. Even though your neighbor can pick more mangoes a month
of mangoes for every kg. of guavas she picks. than you, the opportunity cost of picking mangoes is
higher for her than for you because when she picks
Alternatively as she shifts time from picking guavas to mangoes she gives up more guavas than you do.
picking mangoes she gives up 2 kg. of guavas for every
kg. of mangoes she picks. So even though she has an absolute advantage over
you in picking mangoes, it is more costly for her to
Opportunity cost of Opportunity cost of pick mangoes than it is for you. – However, her opp-
picking 1 kg. of picking 1 kg. of ortunity cost of picking guavas is lower than your
mangoes guavas
opportunity cost of picking guavas.
You 1 kg. of guavas 1 kg. of mangoes Comparative advantage is the ability of an individual, firm,
or country to produce a good or service at a lower
Your neighbour 2 kg. of guavas 1
2 kg. of mangoes
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opportunity cost than other producers.

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 Errol D’Souza
You are better off specializing in picking mangoes and your
neighbor is better off specializing in picking guavas.
Even though she can pick 1 12 times as many mang-
oes as you can in a month she can pick 3 times as
many guavas. So by specializing in picking guavas
she is spending her time in activity where her abs-
olute advantage over you is the greatest.
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Errol D’Souza
This is an important economic principle: The basis for trade
is comparative advantage, not absolute advantage.
The fastest mango pickers do not necessarily do mango
picking. If the fastest mango pickers have a comparat-
ive advantage in some other activity they are better off
specializing in that other activity.
Individuals, firms, and countries are better off if they speci-
alize in producing goods or services for which they
have a comparative advantage and obtain the other
good or service they need by trading.
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Errol D’Souza
Absolute advantage – The ability of an individual, firm, or
country to produce more of a good or service than
competitors using the same amount of resources.
- In the example your neighbor has an absolute
advantage over you in both picking mangoes and in
picking guavas.
Comparative advantage – The ability of an individual, firm,
or country to produce a good or service at a lower
opportunity cost than other producers. – In the
example your neighbor has a comparative advantage
in picking guavas but you have a comparative
advantage in picking mangoes.
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Errol D’Souza
Trade allows people to specialize according to their comp-
arative advantage. By engaging in trade people can
raise their standard of living.
Trade is carried out in markets. – a group of buyers and
sellers of a good or service and the institution or
arrangement by which they come together to trade.
Households and firms interact in two types of markets:
product markets and factor markets.
In product markets households are demanders and
firms are suppliers
Factor markets are markets for factors of production
such as labour, capital, natural resources,
and entrepreneurial ability. In this market
households are suppliers and firms are 36
demanders.
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Product
The previous diagram is a simplified version of reality. It
Markets leaves out the role played by government in making
payments such as subsidies and buying goods from
firms.

It also leaves out the role played by banks, the stock

Firms Households markets and bond markets in the financial
system in aiding the flow of funds from lenders
to borrowers.

It does not show that some goods and services are

Factor
produced in foreign countries and some of
Markets
the output of domestic firms are sold to foreign
households.

The Circular Flow of Income and Product

Output = Income = Expenditure 37 38

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Errol D’Souza Errol D’Souza

“Economics is a science which studies human behavior as
a relationship between given ends and scarce means which
have alternative uses”
-Lionel Robbins
An Essay on the Nature and Significance of Economic Science, 1932
“Economics is a science which studies human behavior as
a relationship between given ends and scarce means which
have alternative uses”
-Lionel Robbins
An Essay on the Nature and Significance of Economic Science, 1932

“Economics is the study of how societies use scarce

resources to produce valuable commodities and dist-
ribute them among different people”
-Paul Samuelson & William Nordhaus
Economics, 18th edition

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 Errol D’Souza
“Economics is the study of how people make choices
under conditions of scarcity and of the results of
those choices for society.”
Robert H. Frank and Ben S. Bernanke
Principles of Economics
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Errol D’Souza
Entrepreneurs are central to the working of the market
system. An entrepreneur is someone who operates
a business.
Entrepreneurs decide what goods they believe con-
sumers want, and then decide how those goods
might be produced most profitably.
They bring together the factors of production – land
labour, capital, and natural resources – to produce
goods and services.
They put their own funds at risk when they start
businesses. – It is not unusual for entreprenurs
who eventually achieve great success to fail at
first. Early in his career Sakichi Toyoda whose
company eventually became Toyota Motor Corp
started a company that quickly failed. 43
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Errol D’Souza
“Economics is the study of how people make choices
under conditions of scarcity and of the results of
those choices for society.”
Robert H. Frank and Ben S. Bernanke
Principles of Economics
“Economics is the study of how society manages its
scarce resources…. Economists therefore study how
people make decisions: how much they work, what
they buy, how much they save, and how they invest
their savings.”
N. Gregory Mankiw
Principles of Macroeconomics
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Errol D’Souza
The Legal Basis of a Successful Market System
The absence of government intervention is not enough for
a market system to work well. – Governments have to
provide secure rights to private property for a market
system to work at all.
In addition government can aid the working of the
market by enforcing contracts between private
individuals through an independent court
system.
The protection of private property and the existence
of an independent court system to impartially
enforce the law provide a legal environment
that will allow a market system to succeed.
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In many poor countries owners of businesses are not well
protected from having their businesses seized by
government or from having their profits taken by
criminals and the mafia. – Where such problems
exist opening a business can be extremely risky
and this reduces the gains from trading in the
market place.
Property rights refer to the rights individuals have to exc-
lusive use of their property, including the right to
buy or sell it. – Property can be tangible, physical
property, such as a factory. It can also be intangible,
such as the right to an idea.
In a modern economy intellectual property rights are
very important – rights to books, films, soft-
ware, and ideas for new products or new ways 45
of producing products.
The development of the internet has led to new problems in
protecting intellectual property rights. Songs, news-
paper and magazine articles, and entire motion pic-
tures can be copied and e-mailed from one computer
to another.
Unauthorized copying of music became particularly severe
in 1999 when Napster created software that allowed
people to download music from the Web without the
authorization of the copyright holders. – A sharp
decline in music CD sales occurred.
Record companies and some artists – heavy metal band
Metallica – sued Napster for copyright infringe-
ment. A federal court in the US ordered the
firm to stop its activities.
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Errol D’Souza Errol D’Souza

Using the same amount of resources, Bangladesh and Viet-

nam can both produce shirts and shoes as shown in ▪ Who has a comparative advantage in producing shirts and
the following production possibilities frontiers: who in producing shoes? – Explain your reasoning.
Quantity Quantity
Of shirts Bangladesh Of shirts Vietnam ▪ Does either country have an absolute advantage in produ-
cing both goods?
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▪ Suppose that both countries are currently producing 3
pairs of shoes and 3 shirts. Show that both can be
better off if they specialize in producing one good and
6
then engage in trade.

3 3

3 4 Quantity 6 Quantity
3
Of shoes Of shoes

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 Errol D’Souza Errol D’Souza

Opportunity cost of Opportunity cost of

producing a shirt producing a pair of Problem: An estimated 600 million or more people world-
shoes
wide are squatters who live on land to which they have
Bangladesh 1 pair of shoes 3 shirts no legal title. Economist Hernando de Soto persuaded
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Peru’s government to undertake a program to make
Vietnam 1 1 it cheap and easy for squatters to obtain a title to the
land they had been occupying.
Bangladesh has a comparative advantage of producing shirts
- its opportunity cost is lower. Vietnam has a comp- How would this creation of property rights be likely to
arative advantage of producing shoes. affect the economic opportunities available to these
squatters?

See: Alan B Krueger, “A Study Looks at Squatters and

Land Title in Peru”, New York Times, January 9, 2003.

https://www.nytimes.com/2003/01/09/business/economic-scene-a-study-looks-at-squatters-and-land-titles-in-peru.html

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Problem: During the 1928 presidential election camp-

aign, Herbert Hoover, the Republican candidate,
argued that the US should only import those
products that could not be produced in the country.
Do you believe this would be a good policy?

Analyze the Make in India policy of the Indian gov-

ernment.

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