3
Exchange and Markets
Chapter Summary
This chapter explores specialization and exchange as well as the virtues and shortcomings of markets. We
also discussed the role of government in a market economy. Here are the main points of the chapter:
• It is sensible for a person to produce the product for which he or she has a comparative
advantage, that is, a lower opportunity cost than another person.
• Specialization increases productivity through the division of labor, a result of the benefits of
repetition, continuity, and innovation.
• A system of international specialization and trade is sensible because nations have different
opportunity costs of producing goods, giving rise to comparative advantages.
• Under a market system, self-interested people, guided by prices, make the decisions about what
products to produce, how to produce them, and who gets them.
• Government roles in a market economy include establishing the rules for exchange, reducing
economic uncertainty, and responding to market failures.
Learning Objectives
1. Use opportunity costs to explain the rationale for specialization and trade.
2. Explain how markets allow specialization and trade.
3. List the roles of government in a market economy.
3.1 Comparative Advantage and Exchange
The concept of comparative advantage is an application of the principle of opportunity cost from Chapter 2.
Principle of Opportunity Cost
The opportunity cost of an item is what you must sacrifice to get the item.
To get more of one item, you must sacrifice some other item. For Fred and Kate in the survivor example,
the opportunity cost of a coconut is the number of fish that could have been produced in the time it takes
to produce one coconut.
Trade is based on comparative advantage, the ability of one person or nation to produce a good at a
lower opportunity cost than another person or nation. If Fred wishes to consume both fish and coconuts
he can either produce both goods, or he can buy one of the goods from Kate. Since Kate can produce
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34 O'Sullivan/Sheffrin/Perez, Macroeconomics, 8e
coconuts at a lower opportunity cost than Fred, he would prefer to buy coconuts from her. Trade
encourages individuals to specialize, and in so doing, increase the total output produced by all parties.
Trade benefits both parties, even if one person can produce more of both goods. We define absolute
advantage as the ability of one person or nation to produce a product at a lower resource cost than
another person or nation. While Fred spends less time producing each coconut than does Kate, he still
wants to buy coconuts from her because she gives up fewer fish to produce a coconut than does Fred.
Fred gives up fewer fish buying coconuts from Kate than he would give up producing coconuts on his
own. This is an example of the principle of voluntary exchange from Chapter 2. As long as Fred and Kate
both agree to the trade, both will be better off as a result of the trade. This is an example of the principle
of voluntary exchange:
Principle of Voluntary Exchange
A voluntary exchange between two people makes both people better off.
Remember
It is important to recognize that we are concerned with opportunity cost, the amount of one
good which must be forgone to produce some other good. Comparative advantage refers to
who has the lowest opportunity cost of producing a certain good. Be sure that you are
comfortable not only understanding the concept of opportunity cost, but calculating
opportunity costs as well.
Trade is based not on who can produce the most of a good, but who can produce a good at
the lowest cost. Thus, trade is based on comparative, not absolute, advantage.
Countries also engage in trade. An import is defined as a good or service produced in a foreign country
and purchased by residents of the home country. An example of an import would be a Hyundai car, which
is produced in Korea and sold in the United States. An export is a good or service produced in the home
country and sold in another country. An example of an export would be agricultural products produced in
the United States and sold in other countries.
Firms take advantage of the principle of comparative advantage to shift production to facilities around the
world. This practice is known as outsourcing or offshoring. Your text notes that the employment effects
of outsourcing are smaller than we may think. Estimates suggest that only 2 percent of layoffs in the first
three months of 2004 were due to job movement overseas. In addition, lower labor costs reduce the prices
that consumers have to pay and allow firms to produce more output.
&
It is also worth remembering that while some U.S. companies are shifting production overseas,
some non-U.S. companies are shifting jobs into the United States. Toyota, BMW, and Mercedes
all have production plants in the United States. From Japan’s perspective, Toyota jobs in Georgetown,
Kentucky, would be viewed as “outsourced.”
&
To see how “outsourcing” can increase the number of jobs, think about the Jasper Johns example
in Chapter 2. If Jasper Johns earns $5,000 while paying his gardener $1,500 to paint his house,
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Chapter 3: Exchange and Markets 35
Jasper now has an additional $3,500 he can spend on goods and services. In fact, he might decide to spend
some of the extra money hiring a personal chef. The same holds true for companies that move some jobs
overseas. By lowering labor costs in one area, this provides additional resources for the firm to hire other
types of labor.
Remember
Principles of trade are the same whether we are examining individuals, firms, or countries.
Total output increases when individuals or countries specialize in those goods for which
they have a comparative advantage. Voluntary trade between individuals or countries
makes both parties to the trade better off.
Let’s review an Application that answers a key question:
1. What is the rationale for specialization and trade?
APPLICATION 1: ABSOLUTE DISADVANTAGE AND COMPARATIVE
ADVANTAGE IN LATVIA
This Application shows that while Latvia was much less productive than the other nations in the
European Community, Latvia had a comparative advantage in saw timber. Even though the rest
of the EC can produce more saw timber than Latvia, Latvia is able to produce the timber at a
lower opportunity cost. As a result the EC would rather trade grain to Latvia in exchange for saw
timber instead of producing it themselves. Doing so leaves both better off.
3.2 Markets
A market economy is one in which people specialize and exchange goods and services in a market. Most
of us specialize in a few things and exchange our time doing those things for money. We then trade
money for the other goods and services we wish to consume. In this situation, money is a medium of
exchange. At the most basic level, we trade our time for money and use the money to facilitate trades for
other goods.
There are a number of inventions that help markets work better:
• Contracts: Specify terms of exchange and rights and obligations of the parties to the exchange.
• Insurance: Reduces the risk from low probability, random events such as fires.
• Patents: Encourage innovation in new products.
• Accounting rules: Provide a common set of information on the financial status of firms.
In contrast to a market economy, a centrally planned economy is one in which a government
bureaucracy decides how much of each good to produce, how to produce the good, and who gets the
good. In a market system these same decisions are made in a decentralized manner with prices providing
the information about relative scarcity and the incentive to provide goods by means of higher prices for
goods that are relatively scarce.
Markets naturally tend to develop. An example found in your book is that of POW camps. During World
War II, prisoners all received the same goods, regardless of their desire for the goods. Prisoners would
then trade for the goods they desired, using cigarettes as “money.” As a result, tea-drinking British
prisoners were able to trade unwanted coffee for other, more desirable goods.
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36 O'Sullivan/Sheffrin/Perez, Macroeconomics, 8e
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To see the challenges of a centrally planned economy, suppose you were in charge of securing all
the food and clothing needed in your city. Could you imagine the amount of information you
would need to identify all the food products that stores should carry or trying to arrange for the production
of all those products? How much should you pay the workers who produce those goods? Where will those
goods be produced? What about the transportation to bring them to the stores? The market system
answers these questions using prices to convey information to decentralized decision makers. The market
provides incentive for farmers to grow food that people wish to eat, for truckers to transport the food from
the farm to the stores, and for grocery managers to stock the shelves with the food that people want to
buy. As you will see later in the text, profits and losses provide incentives for firms to enter and exit
markets.
Remember
Prices serve an important function in markets. Prices provide information and incentives to
participants in markets to provide the goods and services demanded by the market.
Let’s review an Application that answers a key question:
2. Why do markets develop?
APPLICATION 2: THE MARKET FOR METEORITES
This Application illustrates that markets will develop when there are beneficial trades to be made.
In this case, people find meteorites in the desert and sell them to dealers. The dealers in turn sell
them to collectors and scientists.
3.3 Market Failure and the Role of Government
In general, markets work well and allocate resources to those who most value the resources. There are
some circumstances in which markets don’t do a very good job of allocating resources. These situations
are known as market failure. In these cases, government can intervene in the market and improve
outcomes. Some examples of market failures you will study later in the book are:
• Pollution. What happens when one person’s action negatively impacts someone else? Government
can force polluters to consider the costs they impose on others in the economy. An example would
be a tax requiring polluters to bear the cost that their actions impose on others. The tax provides a
financial incentive for polluters to reduce the amount of pollution they produce.
• Public goods. What if we can’t keep nonpayers from consuming a good, such as a fireworks
display? What if more people could use a good at no additional cost of providing the good? How
do markets respond in these cases? In most cases, markets will not provide an appropriate amount
of public goods, which requires the government to step in and encourage production or in many
cases produce the goods itself. Police protection would be an example of a public good.
• Imperfect information. What happens in a market if the buyers of a product know less about the
product’s condition than the sellers? Government can take steps to provide complete information
so that both sides of the market can make an informed decision. For example, the government
requires that food manufacturers provide nutritional information on labels, so consumers can
know what is contained in the food they are eating.
• Imperfect competition. What happens when only a few firms exist in a market? Think about a
utility that is the only provider of electricity in a particular area. Government will regulate the
prices that the utility can charge so that it can’t exploit its monopoly power.
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Chapter 3: Exchange and Markets 37
The government plays other roles in the market economy as well, including:
• enforcing property rights.
• reducing economic uncertainty and providing social insurance.
• establishing and enforcing rules for market exchange.
Let’s review an Application that answers a key question:
3. What is the role of government in a market economy?
APPLICATION 3: CIVIL LIBERTIES AND EFFICIENCY OF GOVERNMENT
This Application illustrates that nations with relatively strong civil liberties also have high rates
of return on government projects.
Activity
Darrin Hobbes is a very skilled carpenter, though his regular career is practicing law. At the moment,
Darrin is trying to put an addition on his house. He estimates that it would take him three weekends of
work, working eight hours a day on Saturday and Sunday to complete the addition. This means it would
take Darrin 48 hours of time to complete the addition.
WeBuildIt Contractors has provided Darrin with an estimate to complete the addition to his house. They
estimate that they would have two people spend four days at Darrin’s house to complete the addition. This
is a total of 64 hours to complete the addition. WeBuildIt charges $35 per labor hour.
a. Who has the absolute advantage in completing the addition? Why?
b. What would it cost Darrin to pay WeBuildIt to complete the addition? ____________
c. Suppose Darrin earns $60 per hour in his legal practice and can work as many hours as he chooses.
What would it cost Darrin to build the addition himself? ______________
d. Who has the comparative advantage in completing the addition? Why?
Answers
a. Darrin has the absolute advantage because it will take him 48 hours as opposed to 64 hours to do the
same work.
b. It would cost $35(64) = $2,240 to have WeBuildIt complete the addition.
c. It would cost Darrin $60(48) = $2,880 to complete the addition himself.
d. WeBuildIt Contractors has the comparative advantage because the company can do the work at a
lower cost than Darrin.
Key Terms
Absolute advantage: The ability of one person or nation to produce a product at a lower resource cost
than another person or nation.
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38 O'Sullivan/Sheffrin/Perez, Macroeconomics, 8e
Centrally planned economy: An economy in which a government bureaucracy decides how much of
each good to produce, how to produce the goods, and who gets them.
Comparative advantage: The ability of one person or nation to produce a good at a lower opportunity
cost than another person or nation.
Export: A good or service produced in the home country and sold in another country.
Import: A good or service produced in a foreign country and purchased by a resident of the home
country.
Market economy: An economy in which people specialize and exchange goods and services in markets.
Practice Quiz
(Answers are provided at the end of the Practice Quiz.)
1. Which of the following is NOT among the fundamental questions that every economy must solve?
a. What goods and services will be produced?
b. How will the goods and services be produced?
c. At what prices will goods and services be exchanged?
d. Who will receive the goods and services produced?
2. When people participate in markets, they are encouraged to practice
a. self-sufficiency.
b. specialization.
c. restraint in consumption.
d. care in selecting the government officials that run the markets.
3. Which of the following key principles of economics do we use to explore the details of specialization?
a. the nominal-real principle
b. the principle of diminishing returns
c. the principle of opportunity cost
d. the marginal principle
4. Absolute advantage is the ability of an individual, firm, or country to
a. produce more of a good or service than competitors using the same amount of resources.
b. produce a good or service at a lower opportunity cost than other producers.
c. consume more goods or services than others at lower costs.
d. reach a higher production possibilities frontier by raising opportunity costs.
5. We say that a person has a comparative advantage in producing a particular product if he or she
a. is self-sufficient.
b. also has an absolute advantage.
c. has a lower opportunity cost than another person.
d. All of the above define comparative advantage.
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Chapter 3: Exchange and Markets 39
6. According to the theory of comparative advantage, specialization and free trade will benefit
a. only the owner of a monopoly.
b. all trading parties who specialize in the production of the good in which they have a comparative
advantage.
c. only that trading party who has an absolute advantage in the production of all goods.
d. only the party who specializes the most.
7. The table below shows the maximum output of widgets and gadgets for two countries: Utopia and
Nirvana. Which of the following is correct?
Utopia
Nirvana
a.
b.
c.
d.
Widgets
500
250
Gadgets
500
125
Nirvana has a comparative advantage in both goods.
Utopia has a comparative advantage in both goods.
Nirvana has a comparative advantage in widgets.
Nirvana has a comparative advantage in gadgets.
8. Refer to the table below. Which of the following statements is correct?
Jorge
Rocky
a.
b.
c.
d.
Cakes
3
6
Pies
6
9
Rocky has the comparative advantage in pies.
Jorge has the absolute and comparative advantage in pies.
Jorge has a comparative advantage but not an absolute advantage in pies.
Rocky has an absolute advantage but not a comparative advantage in pies.
9. The fact that specialization and exchange make people better off is an illustration of one of these
principles. Which one?
a. the principle of voluntary exchange
b. the principle of diminishing returns
c. the principle of opportunity cost
d. the marginal principle
10. In his 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith noted
that specialization increases productivity. Which of the following was the cause of this phenomenon?
a. increased slavery
b. combining various steps into a single job raised productivity
c. turning small factories into large factories
d. the division of labor
11. A product produced in a foreign country and purchased by residents of the home country is called
a. an import.
b. an export.
c. self-sufficiency.
d. outsourcing.
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40 O'Sullivan/Sheffrin/Perez, Macroeconomics, 8e
12. Which of the following is NOT a reason for the increase in productivity that comes with
specialization?
a. repetition
b. continuity
c. innovation
d. absolute advantage
13. Contracts, insurance, patents, and accounting rules are
a. things that came naturally with the creation of markets.
b. ideas that are unnecessary in a free-market place.
c. inventions that make a market work better.
d. enforced primarily in nonmarket economies, such as centrally planned economies.
14. In what type of economy does the government decide how economic resources will be allocated?
a. in a market economy
b. in a centrally planned economy
c. in both of the above
d. in none of the above (The government does not allocate resources in any type of economy.)
15. In a market system, which of the following provides the information that individuals need to make
decisions?
a. primarily, the government
b. public libraries
c. prices
d. production costs
16. Whenever markets do not produce the most efficient outcomes on their own, we call this phenomenon
a. the invisible hand.
b. market failure.
c. absolute disaster.
d. diminishing returns.
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Chapter 3: Exchange and Markets 41
17. Refer to the figure below. Each graph represents one country. Which country in this graph has a
comparative advantage in the production of shirts?
a.
b.
c.
d.
Country A
Country B
neither country
both countries
18. Refer to the figure below. Each graph represents one country. Which country in this graph should
specialize in the production of chips?
a.
b.
c.
d.
Country A
Country B
Neither country. They both should produce some chips.
Both countries should specialize in the production of chips.
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42 O'Sullivan/Sheffrin/Perez, Macroeconomics, 8e
19. The impact of outsourcing on the domestic economy can be summarized as follows:
a. Outsourcing has resulted in a substantial loss of jobs, insignificant cost savings for outsourcing
companies, higher prices for consumers, and less output for firms.
b. Outsourcing has resulted in a minimal loss of jobs, as well as significant cost savings for
domestic companies, lower prices for consumers, and more output for firms.
c. The results of outsourcing have been mixed. Lower prices for consumers have been
overshadowed by a substantial loss of domestic jobs.
d. The benefits of outsourcing have not outlasted the increases in communication costs and the costs
of the standardization of software necessary to allow firms to outsource business services.
20. The exchange of goods that took place among prisoners of war (POWs) during World War II is an
example of how
a. markets cannot work properly when severe restrictions are imposed on people.
b. markets in restricted places, such as prisoner camps, work poorly because product prices do not
reflect the actual scarcity of goods.
c. even in prisoner camps, the market system can work because people, motivated by self-interest,
rely on exchange to make themselves better off.
d. exchange that takes place through barter does not allow for the emergence of markets. Only
monetary economies can support market exchange.
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Chapter 3: Exchange and Markets 43
Answers to the Practice Quiz
1. c. The three questions are: What goods and services will be produced? How will the goods and
services be produced? Who will receive the goods and services produced?
2. b. A market is an institution or arrangement that enables people to buy and sell things. The alternative
to buying and selling in markets is to be self-sufficient, with each of us producing everything we need
for ourselves. Rather than going it alone, most of us specialize: We produce one or two products for
others and then exchange the money we earn for the products we want to consume.
3. c. A person specializes in the good for which he or she has a lower opportunity cost. We say that a
person has a comparative advantage in producing a particular product if he or she has a lower
opportunity cost than another person’s marginal cost.
4. a. Absolute advantage is the ability of an individual, firm, or country to produce more of a good or
service than competitors using the same amount of resources.
5. c. The lesson is that those who are self-sufficient have an incentive to specialize and trade. Having an
absolute advantage does not guarantee that a person also has a comparative advantage. We say that a
person has a comparative advantage in producing a particular product if he or she has a lower
opportunity cost than another person.
6. b. According to the theory of comparative advantage, if both nations specialize and trade in the
production of goods/services in which they have a comparative advantage, both nations will be better
off.
7. c. Utopia’s opportunity cost is 1 for either good. Nirvana’s opportunity cost of widgets is 125/250 =
1/2. Since 1/2 < 1, Nirvana has a comparative advantage in widgets.
8. c. Jorge produces fewer pies per hour than Rocky, thus Rocky has an absolute advantage in pies.
Jorge gives up less cake for each pie than Rocky. Thus, Jorge has a comparative advantage.
9. a. The fact that specialization and exchange make both people better off illustrates the key principle
of voluntary exchange.
10. d. Adam Smith explains how the making of a pin is divided into many operations, and then he points
to the very high output that can be produced in that factory through such division of labor.
11. a. An import is a product produced in a foreign country and purchased by residents of the home
country.
12. d. Repetition, continuity, and innovation are the three reasons that cause an increase in productivity
that comes with specialization.
13. c. Although it appears that markets arose naturally, a number of social and government inventions
have made them work better: Contracts, insurance, patents, and accounting rules are part of those
inventions.
14. b. A centrally planned economy is one where the government decides how economic resources will
be allocated.
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44 O'Sullivan/Sheffrin/Perez, Macroeconomics, 8e
15. c. 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. In a market system, prices provide individuals the information
they need to make decisions. Prices provide signals about the relative scarcity of a product and help
an economy respond to scarcity.
16. b. “Market failure” is what happens when markets fail to produce the most efficient outcomes on their
own. The role of government is to correct this problem.
17. b. The opportunity costs are as follows: The opportunity cost of shirts is: 1 chip for country A, and
1/3 chip for country B. The opportunity cost of chips is: 1 shirt for country A and 3 shirts for country
B. Country B has a comparative advantage in the production of shirts because it sacrifices fewer chips
to produce one shirt. Country B should therefore produce shirts.
18. a. The opportunity costs are as follows: The opportunity cost of shirts is: 1 chip for country A, and
1/3 chip for country B. The opportunity cost of chips is: 1 shirt for country A and 3 shirts for country
B. Therefore, country A has a comparative advantage (or lower opportunity cost) in the production of
chips because it sacrifices fewer shirts to produce one chip. Country A should therefore produce
chips.
19. b. According to recent studies, the benefits of outsourcing have significantly outweighed the costs.
Outsourcing has resulted in a minimal loss of jobs, substantial cost savings for domestic companies,
lower prices for consumers, and more output for firms.
20. c. The prisoners used barter to exchange one good for another, and cigarettes emerged as the medium of
exchange. Prisoners wandered through the camp calling out their offers of goods. In addition to food,
the prisoners bought and sold clothing (80 cigarettes per shirt), laundry services (two cigarettes per
garment), and hot cups of coffee (two cigarettes per cup). The prices of products reflected their scarcity.
©2014 Pearson Education, Inc.