economics: principles, applications, and tools, 5th ed

Exchange and Markets

O’Sullivan • Sheffrin • Perez

© 2007 Pearson/Prentice Hall Economics: Principles, Applications, and Tools, 5e O’Sullivan • Sheffrin • Perez

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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

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COMPARATIVE ADVANTAGE AND EXCHANGE3.1Specialization and the Gains from Trade

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COMPARATIVE ADVANTAGE AND EXCHANGE

FIGURE 3.1Specialization and the Gains from Trade

3.1Specialization and the Gains from Trade

• comparative advantageThe ability of one person or nation to produce a good at a lower opportunity cost than another person or nation.

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COMPARATIVE ADVANTAGE AND EXCHANGE3.1

• 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.

Specialization and the Gains from Trade

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COMPARATIVE ADVANTAGE AND EXCHANGE3.1

• absolute advantageThe ability of one person or nation to produce a product at a lower resource cost than another person or nation.

Comparative Advantage Versus Absolute Advantage

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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COMPARATIVE ADVANTAGE AND INTERNATIONAL TRADE3.2

• importA product produced in a foreign country and purchased by residents of the home country.

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

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COMPARATIVE ADVANTAGE AND INTERNATIONAL TRADE3.2

FIGURE 3.2International Box Office Revenuefor U.S. Films, 2004

Movie Exports

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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.

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?

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?

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MARKETS3.3

• market economyAn 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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THE GREAT WAL-MART OF CHINA

• 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 Wal-Mart wants their share of that spending.

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.

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.

Extra Application 6

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MARKETS3.3

Virtues of Markets

• centrally planned economyAn 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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DROUGHT PUSHES WHEAT TO 10-YEAR HIGH

• 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.

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.

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.

Extra Application 4

• 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.

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MARKETS3.3

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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INTEREST RATES: WHAT THE MARKETS MISSED

• 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.

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

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.

Extra Application 5

• 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.

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MARKET FAILURE AND THE ROLE OF GOVERNMENT3.4

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

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.

MARKET FAILURE AND THE ROLE OF GOVERNMENT

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MARKET FAILURE AND THE ROLE OF GOVERNMENT3.4

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

centrally planned economy

comparative advantage

export

import

market economy

economics: principles, applications, and tools, 5th ed

Business

exchange comparative

absolute advantage

candyproduction jobs

exchange specialization

lower cost

lower opportunity cost

opportunity cost of

different states