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sg03 - 3 Exchange and Markets Chapter Summary This chapter...

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3 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. How many jobs are lost to outsourcing—the shift of production to other countries? 2. Does the protection of one domestic industry harm another? 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
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Exchange and Markets 33 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.
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