MacroEcomonics principles, application, and tools 7th edition by sullivan chapter 03

His opportunity cost of fish is one-third coconut per fish, compared to 1 coconut per fish for Kate • Kate has a comparative advantage in coconuts.. Her opportunity cost of coconuts i

C H A P T E R 3

Exchange and Markets

Exchange and Markets

Mattel’s Barbie, the most profitable doll in history, is sold in 140

countries around the world at a rate of two dolls per second.

CHAPTER

3

C H A P T E R 3

Exchange and Markets

Does the protection of one domestic industry harm another?

Candy Cane Makers Move to Mexico for Cheap Sugar

What is the role of opportunity cost in the development of markets?

Gold Farming for World of Warcraft

Why do markets develop?

The Shakers and the Market for Garden Seeds

A P P L Y I N G T H E C O N C E P T S 1

2 3

C H A P T E R 3

Exchange and Markets COMPARATIVE ADVANTAGE

AND EXCHANGE

3.1

Specialization and the Gains from Trade

P R I N C I P L E O F O P P O RT U N I T Y C O S T

The opportunity cost of something is what you sacrifice to get it.

C H A P T E R 3

Exchange and Markets COMPARATIVE ADVANTAGE

AND EXCHANGE (cont’d)

3.1

 FIGURE 3.1

Specialization and the Gains

from Trade

● comparative advantage

The ability of one person or

nation to produce a good at a

lower opportunity cost than

another person or nation

• Fred has a comparative advantage in

producing fish.

His opportunity cost of fish is

one-third coconut per fish, compared to 1

coconut per fish for Kate

• Kate has a comparative advantage in

coconuts

Her opportunity cost of coconuts is 1

fish per coconut, compared to 3 fish

per coconut for Fred.

C H A P T E R 3

Exchange and Markets COMPARATIVE ADVANTAGE

AND EXCHANGE (cont’d)

3.1

P R I N C I P L E O F V O L U N T A R Y E X C H A N G E

A voluntary exchange between two people makes both people better off.

Comparative Advantage versus Absolute Advantage

● absolute advantage

The ability of one person or nation to produce a product at

a lower resource cost than another person or nation

C H A P T E R 3

Exchange and Markets COMPARATIVE ADVANTAGE

AND EXCHANGE (cont’d)

3.1

The Division of Labor and Exchange

In his 1776 book, An Inquiry into the Nature and Causes of the Wealth of

Nations, Adam Smith noted that specialization actually increased productivity

through the division of labor

Smith listed three reasons for productivity to increase with specialization, with

each worker performing a single production task:

1 Repetition The more times a worker performs a particular task, the more

proficient the worker becomes at that task

2 Continuity A specialized worker doesn’t spend time switching from one

task to another This is especially important if switching tasks requires a change in tools or location

3 Innovation A specialized worker gains insights into a particular task that

lead to better production methods

C H A P T E R 3

Exchange and Markets COMPARATIVE ADVANTAGE AND

INTERNATIONAL TRADE

The lessons of comparative advantage and

specialization apply to trade between nations.

3.2

● import

A product produced in a foreign country and purchased by residents of the home country

● export

A product produced in the home country and sold in another country

C H A P T E R 3

Exchange and Markets COMPARATIVE ADVANTAGE AND

INTERNATIONAL TRADE (cont’d)

3.2

Outsourcing

When a domestic firm shifts part of its production to a different

country, we say the firm is outsourcing or offshoring.

1 The loss of domestic jobs resulting from outsourcing is a normal

part of a healthy economy, because technology and consumer preferences change over time

2 The jobs lost to outsourcing are at least partly offset by jobs

gained through insourcing, jobs that are shifted from overseas to

the United States

3 The cost savings from outsourcing are substantial, leading to

lower prices for consumers and more output for firms The jobs gained from increased output at least partly offset the jobs lost

to outsourcing

Some recent studies of outsourcing have reached a number of

conclusions:

C H A P T E R 3

Exchange and Markets

CANDY CANE MAKERS MOVE TO MEXICO FOR CHEAP SUGAR

APPLYING THE CONCEPTS #1: Does the protection of one domestic

industry harm another?

•About 90 percent of the world’s candy canes are consumed in the United States, and until recently most were produced domestically

•In 2003, Spangler Candy Company of Bryan, Ohio, shifted half its production to Mexico because the cost of sugar, the key ingredient in candy, is only $0.06 per pound in Mexico, compared to $0.21 in the United States

•Since 1998, the Chicago area, the center of the U.S confection industry, has lost about 3,000 candy-production jobs

•Why is the price of sugar in the United States so high? The government protects the

A P P L I C A T I O N 1

C H A P T E R 3

Exchange and Markets 3.3 MARKETS

● market economy

An economy in which people specialize and exchange goods and services in markets

Although it appears that markets arose naturally, a number of social and

government inventions have made them work better:

• Contracts specify the terms of exchange, facilitating exchange between

strangers

• Insurance reduces the risk entrepreneurs face.

• Patents increase the profitability of inventions, encouraging firms to develop

new products and production processes

• Accounting rules provide potential investors with reliable information about

the financial performance of a firm

C H A P T E R 3

Exchange and Markets 3.3 MARKETS (cont’d)

● centrally planned economy

An economy in which a government bureaucracy decides how much of each good to produce, how to produce the good, and who gets the good

Virtues of Markets

Under a market system, decisions are made by the millions of people who already have information about consumers’ desires, production

technology, and resources These decisions are guided by prices of inputs and outputs

Prices provide signals about the relative scarcity of a product and help an

C H A P T E R 3

Exchange and Markets 3.3 MARKETS (cont’d)

The Role of Entrepreneurs

Entrepreneurs play a key role in a market economy

▪ Prices and profits provide signals to entrepreneurs about what to produce

▪ If a product becomes popular, competition among consumers to obtain it will increase its price and increase the profits earned by firms producing it

▪ Entrepreneurs will enter the market and increase production to meet the higher demand, switching resources from the production of other products

▪ As entrepreneurs enter the market, they compete for customers, driving the price back down to the level that generates just enough profit for them to remain

in business

C H A P T E R 3

Exchange and Markets

GOLD FARMING FOR WORLD OF WARCRAFT

APPLYING THE CONCEPTS #2: What is the role of opportunity

cost in the development of markets?

As an example of a market that results from comparative advantage, consider the market for virtual currency

▪ Firms in China pay workers (called gold farmers) to play the online game World of Warcraft

(WoW) In the game, workers earn virtual currency in the form of gold coins by killing monsters

▪ In the real world, firms pay the workers a piece rate of about $0.0125 per coin, which translates into a wage of about $0.30 per hour

▪ The firm sells the coins to an online retailer for about $0.03 per coin, and the retailer then sells the coins to consumers for about $0.20 per coin

▪ The consumers in this market are WoW gamers in the United States, who are willing to pay

cash for game shortcuts—they use the purchased coins to buy the equipment and magic spells required to battle virtual monsters and move to the next level of the game.

A P P L I C A T I O N 2

C H A P T E R 3

Exchange and Markets

THE SHAKERS AND THE MARKET FOR GARDEN SEEDS

APPLYING THE CONCEPTS #3: Why do markets develop?

In 1802, a new market developed in the US – garden seeds sold in Small packets The Shakers, a religious grouped developed the Market

The Shakers packaged seeds for peas, beets, onions, and lettuce and distributed them throughout the country

They dominated the market through hard work and comparative advantage

Their comparative advantage:

▪ They were committed to work as an expression of their religious beliefs

▪ Their operations were much larger than traditional farms, using five times as

much land and capital

A P P L I C A T I O N 3

C H A P T E R 3

Exchange and Markets MARKET FAILURE AND

THE ROLE OF GOVERNMENT

3.4

Although markets often operate efficiently on their own, sometimes they do not.

Market failure happens when a market doesn’t

generate the most efficient outcome.

There are several sources of market failure and possible responses by government Here is a preview of the topics:

• Pollution.

• Public goods.

C H A P T E R 3

Exchange and Markets MARKET FAILURE AND

THE ROLE OF GOVERNMENT (cont’d)

3.4

Government Enforces the Rules of Exchange

• To facilitate exchange, the government helps to enforce contracts by maintaining a legal system that punishes people who violate them

This system allows people to trade with the confidence that the terms of the contracts they enter will be met

• In the case of consumer goods, the implicit contract is that the product is safe to use The government enforces this implicit contract through product liability or tort law

• The government disseminates information about consumer products

• The government uses antitrust policy to foster competition

C H A P T E R 3

Exchange and Markets MARKET FAILURE AND

THE ROLE OF GOVERNMENT (cont’d)

3.4

Government Can Reduce Economic Uncertainty

• Given the uncertainty of market economies, most governments fund

a “social safety net” that provides for citizens who fare poorly in markets

• Of course, there are private responses to economic uncertainty For example, we can buy our own insurance to cover losses

• Some types of insurance, however, are unavailable in the private insurance market As a result, the government steps in to fill the void

C H A P T E R 3

Exchange and Markets

K E Y T E R M S

absolute advantage

centrally planned economy

comparative advantage

export import market economy