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Exchange and Markets FERNANDO QUIJANO, YVONN QUIJANO, AND XIAO XUAN XU Macroeconomics: Principles, Applications, and Tools O’Sullivan, Sheffrin, Perez 6/e. 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. P R E P A R E D B Y FERNANDO QUIJANO, YVONN QUIJANO, AND XIAO XUAN XU

A P P L Y I N G T H E C O N C E P T S 1 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 wherever people go? Markets in a Prisoner of War Camp 2 3

COMPARATIVE ADVANTAGE AND EXCHANGE 3.1 COMPARATIVE ADVANTAGE AND EXCHANGE 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.

COMPARATIVE ADVANTAGE AND EXCHANGE 3.1 COMPARATIVE ADVANTAGE AND EXCHANGE  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 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 harvesting coconuts because her opportunity cost of coconuts is 1 fish per coconut, compared to 3 fish per coconut for Fred.

COMPARATIVE ADVANTAGE AND EXCHANGE 3.1 COMPARATIVE ADVANTAGE AND EXCHANGE 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.

COMPARATIVE ADVANTAGE AND EXCHANGE 3.1 COMPARATIVE ADVANTAGE AND EXCHANGE 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.

COMPARATIVE ADVANTAGE AND INTERNATIONAL TRADE 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.

COMPARATIVE ADVANTAGE AND INTERNATIONAL TRADE 3.2 COMPARATIVE ADVANTAGE AND INTERNATIONAL TRADE Outsourcing When a domestic firm shifts part of its production to a different country, we say the firm is outsourcing or offshoring. Some recent studies of outsourcing have reached a number of conclusions: 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.

COMPARATIVE ADVANTAGE AND INTERNATIONAL TRADE 3.2 COMPARATIVE ADVANTAGE AND INTERNATIONAL TRADE Movie Exports  FIGURE 3.2 International Box Office Revenue for U.S. Films, 2004

A P P L I C A T I O N 1 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. Domestic firms used their superior access to consumers to dominate the market. In recent years, the domestic production of candy canes has decreased. 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 domestic sugar industry from foreign competition by restricting sugar imports. As a result, the supply of sugar in the United States is artificially low and the price is artificially high. In this case, the protection of jobs in one domestic industry reduces jobs in another domestic industry.

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.

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 the good. 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 economy respond to scarcity. The market system works by getting each person, motivated by self-interest, to produce products for other people.

3.3 MARKETS 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 suddenly 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.

A P P L I C A T I O N 2 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. Let’s look at this exchange in terms of opportunity cost. Suppose a gamer in the United States is roughly half as productive as a gold farmer in earning gold in the game, getting 12 coins per hour. The gamer can either spend an hour to earn 12 coins or take a shortcut by paying $0.20 per coin, or $2.40. If the gamer’s opportunity cost is greater than $2.40 per hour, buying the coins is sensible.

A P P L I C A T I O N 3 MARKETS IN A PRISONER OF WAR CAMP APPLYING THE CONCEPTS #3: Why do markets develop wherever people go? To illustrate the pervasiveness of exchange, consider the emergence of markets in prisoner of war (POW) camps during World War II, as documented by economist R. A. Radner. During World War II, the International Red Cross gave each Allied prisoner a weekly parcel with the same mix of products—tinned milk, jam, butter, biscuits, corned beef, chocolate, sugar, and cigarettes. In addition, many prisoners received private parcels from family and friends. 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. For example, “cheese for seven” meant that the prisoner was willing to sell a cheese ration for seven cigarettes. In addition to food, the prisoners bought and sold clothing (80 cigarettes per shirt), laundry services (2 cigarettes per garment), and hot cups of coffee (2 cigarettes per cup).

MARKET FAILURE AND THE ROLE OF GOVERNMENT 3.4 MARKET FAILURE AND THE ROLE OF GOVERNMENT 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. Later in the book, we’ll explore several sources of market failure and discuss possible responses by government. Here is a preview of the topics: Pollution. Public goods. Imperfect information. Imperfect competition.

MARKET FAILURE AND THE ROLE OF GOVERNMENT 3.4 MARKET FAILURE AND THE ROLE OF GOVERNMENT 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.

MARKET FAILURE AND THE ROLE OF GOVERNMENT 3.4 MARKET FAILURE AND THE ROLE OF GOVERNMENT 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.

K E Y T E R M S absolute advantage centrally planned economy comparative advantage export import market economy