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O’Sullivan • Sheffrin • Perez
Exchange and Markets
© 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez
chapter
1 How many jobs are lost to outsourcing—the shift of production to other countries?
Moving Jobs to Different States and Different Countries
2 Does the protection of one domestic industry harm another?
Candy Cane Makers Move to Mexico for Cheap Sugar
3 Why do markets develop wherever people go?
Markets in a Prisoner of War Camp
© 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez
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chapter
3.1
COMPARATIVE ADVANTAGE AND EXCHANGE
Specialization and the Gains from Trade
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chapter
3.1
COMPARATIVE ADVANTAGE AND EXCHANGE
Specialization and the Gains from Trade
 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.
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3.1
COMPARATIVE ADVANTAGE AND EXCHANGE
Specialization and the Gains from Trade
• Fred has a comparative advantage producing fish because 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 because her
opportunity cost of coconuts is 1 fish per coconut, compared
to 3 fish per coconut for Fred.
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3.1
COMPARATIVE ADVANTAGE AND EXCHANGE
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.
The Division of Labor and Exchange
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.
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3.2
COMPARATIVE ADVANTAGE AND
INTERNATIONAL TRADE
• 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.
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3.2
COMPARATIVE ADVANTAGE AND
INTERNATIONAL TRADE
Movie Exports
 FIGURE 3.2
International Box Office Revenue
for U.S. Films, 2004
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MOVING JOBS TO DIFFERENT STATES AND DIFFERENT COUNTRIES
APPLYING THE CONCEPTS #1: How many jobs are lost to
outsourcing—the shift of production to other countries?
When a domestic firm shifts part of its production to a different country, we say that
the firm is outsourcing or offshoring.
• In the modern global economy, transportation and communication costs are
relatively low.
• With outsourcing and offshoring, a firm can produce its product at a lower
cost, charge a lower price, and sell more output.
Some recent studies of outsourcing have reached a number of conclusions:
• The loss of jobs is a normal part of a healthy economy.
• The jobs lost to outsourcing are at least partly offset by jobs gained through
insourcing.
• The cost savings from outsourcing are substantial, leading to lower prices for
consumers and more output for firms.
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CANDY CANE MAKERS MOVE TO MEXICO FOR CHEAP SUGAR
APPLYING THE CONCEPTS #2: 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.
Why?
• Domestic producers were closer to consumers.
• They had lower transportation costs and lower prices than their
foreign competitors.
The high price of sugar has caused other candy manufacturers to shift their operations
overseas.
• Sugar 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? What does the protection of
this industry do to other industries?
© 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez
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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 of entrepreneurs.
• 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.
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Extra Application 6
THE GREAT WAL-MART OF CHINA
Wal-Mart is looking for new markets and China’s growing middle class has been identified
as that market. While Wal-Mart has had a Chinese presence since 1996, the retailing
giant is ready to take a larger position. The company recently negotiated a deal to
acquire a 100-store rival chain with Chinese government approval expected in the next
few months. The acquisition effectively doubles Wal-Mart’s Chinese retail outlets.
• The current $2.6 billion in annual sales is only a very small fraction of the total
company’s $312 billion in annual sales, but the Chinese exploding middle class has
been targeted as the next generation of Wal-Mart consumers.
• This market is expected to spend more than $860 billion on retail by 2009 and WalMart wants their share of that spending.
Wal-Mart will not receive higher prices but will however
increase revenues, and hopefully profits, by gaining a
larger fraction of this market. The market will continue to
expand as more Chinese enter the middle class.
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3.3
MARKETS
Virtues of Markets
• 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 them.
Under a market system, decisions are made by the thousands of people who already
have information about consumers’ desires, production technology, and resources. These
decisions are guided by prices of inputs and outputs. To illustrate, suppose you buy a wool
coat.
• The farmer knew that the price of wool was high enough to justify raising and
shearing sheep.
• The workers knew that wages were high enough to make their efforts worthwhile.
• The merchant knew that the price of the coat was high enough to make it
worthwhile to acquire the coat in anticipation of selling it.
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Extra Application 4
DROUGHT PUSHES WHEAT TO 10-YEAR HIGH
Global wheat harvests have been adversely affected by droughts, heat waves, and beetle
infestations at a time when the world stockpile of wheat is at a 20 year low. Wheat traders
warn that another dry spring or summer will worsen the problem and further lower global
wheat stockpiles.
• U.S wheat prices spiked to a ten-year high as a result of the supply impacts and
increasing global demand.
• The price increase is expected to fuel a price increase in a number of food products.
• Most analysts expect consumers to feel the price increases as the producers and
retailers pass along the increased cost.
• Many investors expect problems to continue. The
commodity markets bear evidence of this fact as
traders pushed wheat futures higher based on
expectations of further supply problems.
A drought impacts the wheat market by reducing supply and
graphically shifts the supply curve to the left. The drought alone
will increase prices to some extent. Heat waves and beetle
infestations will also reduce supply and push prices even higher.
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3.3
MARKETS
Virtues of Markets
Prices provide signals about the relative scarcity of a product
and help an economy respond to scarcity.
• The higher price encourages fabric producers to use
the available wool more efficiently and encourages
farmers to produce more of it.
• The higher price also encourages consumers to switch
to coats made from alternative fabrics.
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MARKETS IN A PRISONER OF WAR CAMP
APPLYING THE CONCEPTS #3: Why do markets develop
wherever people go?
During World War II, the International Red Cross gave
each Allied prisoner a weekly parcel, with the same mix of
products.
• The prisoners used barter to exchange one good
for another.
• Cigarettes emerged as the medium of exchange.
The prices of products reflected their scarcity. For example:
• The tea-drinking British prisoners demanded little coffee. Coffee beans sold for just
a few cigarettes in the British compound, but in the French compound, they sold for
dozens of cigarettes.
• Since the Sikhs didn’t eat beef, the excess supply of beef in the Sikh compound led
to low beef prices.
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Extra Application 5
INTEREST RATES: WHAT THE MARKETS MISSED
The most recent interest rate hike announced by the Federal Reserve appears to have
surprised no one but the stock market. The latest quarter-point increase pushed the fed
funds rate to 4.75 percent. The blue chip stocks fell immediately. Since most Fed watchers
anticipated a rate hike, the expectation was that investors had already factored the
increase into stock values
• While the rate hike may have been factored into stock prices, future rate hikes were not.
• Core inflation is currently at 1.8 percent, near the maximum range Bernanke considers
acceptable.
• Bernanke did mention that productivity gains appear
to be keeping labor costs in check and high energy
and commodity costs have not been reflected in
overall prices as of yet.
As interest rates increase, it increases the borrowing cost to
business which leads to lower profits if price increases are
not passed on to consumers. Interest rate changes also
cause investors to reevaluate investment options. Either
scenario would cause an increase in the supply of most
companies’ stocks and a resulting decrease in the price.
© 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez
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3.4
MARKET FAILURE AND THE ROLE OF GOVERNMENT
Although markets often operate efficiently, sometimes they do not.
This phenomenon is known as market failure, which is what happens
when markets fail to produce the most efficient outcomes on their
own. Sources of market failure:
• Pollution
• Public goods
• Imperfect information
• Imperfect competition
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3.4
MARKET FAILURE AND THE ROLE OF GOVERNMENT
The government uses the legal system—police, courts, and prisons—
to enforce property rights. The government has two additional roles to
play in a market economy:
• Establishing rules for market exchange and using its police
power to enforce the rules.
• Reducing economic uncertainty and providing for people who
have lost a job, have poor health, or experience other
unforeseen difficulties and accidents.
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3.4
MARKET FAILURE AND THE ROLE OF GOVERNMENT
Government Enforces the Rules of Exchange
As we’ll see later in the book, the government
uses antitrust policy to foster competition by (a)
breaking up monopolies, (b) preventing firms from
colluding to fix prices, and (c) preventing firms
that produce competing products from merging
into a single firm.
Government Can Reduce Economic Uncertainty
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absolute advantage
export
centrally planned economy
import
comparative advantage
market economy
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