Chapter 3: Exchange and Markets – Solved

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Exchange and Markets

Chapter Summary

This chapter explores specialization and exchange as well as the virtues and shortcomings of markets. 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.

Applying the Concepts

After reading this chapter, you should be able to answer these three key questions:
1. Does the protection of one domestic industry harm another?
2. What is the role of opportunity cost in the development of markets?
3. Why do markets develop wherever people go?

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 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 foregone 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.

3.2 Comparative Advantage and International Trade

Countries also engage in trade. An import is defined as a product 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 product 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.

Why do firms move jobs to 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. This Application suggests 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 Tiger Woods example in Chapter 2. If Tiger Woods earns $1,000 while paying his gardener $200 to weed his garden, Tiger Woods now has an additional $800 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.

4. Let’s review an Application that answers a key question we posed at the beginning of the chapter.

1. Does the protection of one domestic industry harm another?

APPLICATION 1:
CANDY CANE MAKERS MOVE TO MEXICO FOR CHEAP SUGAR
To keep the price of sugar high, the U.S. government restricts the amount of sugar which can be imported into the United States. This restriction leads to price disparities for sugar in the U.S. relative to other countries. This Application states that sugar costs six cents per pound in Mexico, but twenty-one cents per pound in the United States. Because of this cost disparity, candy makers have relocated to Mexico to take advantage of lower sugar costs. Since 1998 about 3,000 candy making jobs have left the Chicago area in part because of the difference in sugar prices between the United States and other countries. While the trade restrictions benefit U.S. sugar producers, they harm U.S. workers involved in candy production.

3.3 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 severe storms.
• 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 planning authority decides how much of each good to produce, how to produce the goods, and who gets them. In a market system these same decisions are made in a very 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.

 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 two Applications that answer key questions we posed at the start of the chapter:

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

APPLICATION 2: GOLD FARMING FROM WORLD OF WARCRAFT
Why would you ever pay real money for online game items that you earn “free” in the game? This application points out that for some gamers, it is less expensive to buy gold coins in the World of Warcraft game than it is to earn them. The value of the gamer’s time is what provides the opportunity cost. Suppose a gamer earns $10 per hour at their job. Suppose also that in an hour of playing, they earn 12 gold coins. Would you rather spend an hour earning 12 gold coins or work for that hour, earn $10 and then spend $2.40 for the gold coins. If you play the game for an hour at the end you have 12 gold coins. If you work at the end of an hour you have 12 gold coins, and $7.60.

3. Why do markets develop wherever people go?

APPLICATION 3: MARKETS IN A PRISONER OF WAR CAMP
Markets exist as a way to allocate goods and services to those who desire them. This Application illustrates that principle in 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.” You can see in this example how these trades improved the allocation of goods as tea-drinking British prisoners were able to trade unwanted coffee for other, more desirable goods.

3.4 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 non-payers 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.

The government plays other roles in the market economy as well, including:
• enforcing property rights.
• establishing and enforcing rules for market exchange.
• reducing economic uncertainty and providing social insurance.

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 3 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 an estimate to complete the addition to his house. They estimate that they would have two people spend 4 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, 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.

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

Import: A product 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
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 that has an absolute advantage in the production of all goods.
d. only the party which 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?

Widgets Gadgets
Utopia 500 500
Nirvana 250 125

a. Nirvana has a comparative advantage in both goods.
b. Utopia has a comparative advantage in both goods.
c. Nirvana has a comparative advantage in widgets.
d. Nirvana has a comparative advantage in gadgets.
8. Refer to the table below. Which of the following statements is correct?

Cakes Pies
Jorge 3 6
Rocky 6 9

a. Rocky has the comparative advantage in pies.
b. Jorge has the absolute and comparative advantage in pies.
c. Jorge has a comparative advantage but not an absolute advantage in pies.
d. 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.
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 non-market 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.

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. Country A
b. Country B
c. Neither country
d. 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. Country A
b. Country B
c. Neither country. They both should produce some chips.
d. Both countries should specialize in the production of chips.

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. This question tests your understanding of Application 3 in this chapter: Markets in a prisoner of war camp. Why do markets develop wherever people go?

To illustrate the pervasiveness of exchange, this application illustrates the emergence of markets in prisoner of war (POW) camps in World War II, as documented by economist R. A. Radford. 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.
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.

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.

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