c h a p t e r 3 prepared by: fernando and yvonn quijano © 2006 prentice hall business publishing...

C H A P T E RC H A P T E R

3

Prepared by: Fernando and Yvonn Quijano

© 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin

Exchange and Markets

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Comparative Advantageand Exchange

Specialization and the Gains From Trade:

• We can use the principle of opportunity cost to explain the benefits from specialization and trade.

PRINCIPLE of Opportunity CostThe opportunity cost of something is what you sacrifice to get it.

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Specialization & Gains from TradeProduction Possibilities for You

and Your Neighbor, Without Trade

Opportunity cost of picking 1 pound of apples

Opportunity cost of picking 1 pound of cherries

You 1 pound of cherries 1 pound of apples

Your neighbor 2 pounds of cherries .5 pound of apples

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Specialization & Gains from Trade

Gains from Trade

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Specialization & Gains from Trade

A Summary of the Gains from Trade

YOU YOUR NEIGHBOR

Apples(in pounds)

Cherries(in pounds)

Apples(in pounds)

Cherries(in pounds)

Production and consumption without trade

8 12 9 42

Production with trade 20 0 0 60

Consumption with trade 10 15 10 45

Gains from trade (increased consumption)

2 3 1 3

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Absolute Advantage vs. Comparative Advantage

Absolute advantage: The ability of an individual, firm, or country to produce more of a good or service than competitors using the same amount of resources.

Comparative advantage: The ability of an individual, firm, or country to produce a good or service at a lower opportunity cost than other producers.

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Comparative Advantage and the Gains from Trade

The basis for trade is comparative advantage, not absolute advantage.

A country has a comparative advantage in the production of the good for which it has a lower opportunity cost.

To enjoy the gains from trade, a country should specialize in the production of the good for which it has a comparative advantage.

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Specialization and theGains from Trade

• Specialization and exchange makes both people better off, illustrating one of the key principles of economics:

PRINCIPLE of Voluntary ExchangeA voluntary exchange between two people makes both people better off.

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Virtues of Markets

• In a centrally planned economy, a planning authority decides what products to produce, how to produce them, and who gets them.

• Under a market system, prices provide individuals the information they need to make decisions. Prices provide signals about the relative scarcity of a product.

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Virtues of Markets

• The decisions made in markets result from the interactions of millions of people, each motivated by their own interests.

• Adam Smith used the metaphor of the “invisible hand” to explain that people acting in self-interest may actually promote the interest of society as a whole.

c h a p t e r 3 prepared by: fernando and yvonn quijano © 2006 prentice hall business publishing...

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