1. Market Economy Free exchange (trade) expands wealth.
Exchange depends on three key things:
Prevention of coercion and fraud.
Property rights.
Contract enforcement.
Money facilitates exchange.
Two key forces expand exchange:
Specialization based on comparative advantage.
Competition.
Prices and profits provide key information.
Exchange expands wealth while preserving liberty.
Specialization and competition: By expanding exchange they expand wealth.

2. Video: Exchange
Through the beautiful miracle of exchange, you could eventually trade a paper clip for a house.

3. Three Key Prerequisites for Exchange
Prevention of coercion and fraud.
Preservation of property rights.
Enforcement of contracts.
Exchange must be voluntary, and people must know what they are getting when they agree to the exchange.
People must be able to claim ownership of the things that they trade and of the things that they obtain through exchange.
No one would want to pay for doughnuts unless they could prevent others from eating them after buying them.
Suppose that cars could not be locked and that they could just be started by pushing a button. The value of cars would go close to 0. The car market would collapse. People would not be willing to exchange very much money for cars. Sellers would not be able to recover the cost of producing them.
Contract enforcement most relevant when exchanges occur over time.
All of those provided by the government. There is a role for government, but it is limited.

4. Money Facilitates Exchange
Money removes the need for a “coincidence of wants”.
Anything can be used for money, as long as everyone agrees on its value.
Money is one the most important inventions ever.
$20 bill has little intrinsic value: Picture of Jackson, eagle, White House; not very attractive at all.
Money, though, greatly expands the opportunities for exchange.
Imagine trying to get a pizza without money. You would have to trade work or some of your possessions. It would be a huge hassle. I could try to offer Pizza Hut an economics lecture on exchange instead of dollars, but that probably wouldn’t work. (But I’ve got a really good one.)
Do you think my mechanic wants an economics lecture in exchange for fixing my car? This would only happen by coincidence. Such coincidences are rare. Money removes the need for rare coincidences.
With money, the college student uses it to buy a pizza; the pizza maker uses the money to buy an oven; the oven maker uses the money to buy metal; the metal worker uses the money to send his son to college so he can buy lots of pizza.
Anything can be used as money, as long as everyone agrees on its value. Different cultures have used stone, shells, cows, cigarettes, beads, and animal skins. The colonists used tobacco. Metal coins are quite useful because they are durable and it is easier to agree on their value. Paper, of course, also works well because it is light weight and easy to produce, much easier than coins.

5. Two Key Forces That Expand Exchange
Specialization
This happens according to the Law of Comparative Advantage.
In addition to expanding exchange, two key implications:
Leads to best use of resources.
Creates economic interdependence.
Competition
Spurs producers to producer at lower costs and allows consumers to buy at lower prices.
This leads to more exchange.
Competition helps the economy make as many beneficial exchanges as possible.
Conventional wisdom: competition does not work in education. Facts:
Much competition for best students at university level in U.S. Result: university system that is the envy of the world
Little competition in government primary and secondary schools. Result: a system that is seen as failing in many ways

6. Specialization Key Terms
Scarcity: Society does not have enough resources to meet everyone’s wants.
 Scarcity creates need for choices, and choices have costs.
Opportunity Cost of a Choice: The value of the best foregone opportunity.
Specializing reduces opportunity costs and expands wealth.
Adam Smith and the “division of labor”.
• Don’t try to do everything! It’s more costly and less efficient.
• Focus your resources on producing only a few goods. It lowers costs and increases efficiency.
Specialization
We naturally try to reduce the opportunity cost of our choices. We can do this by specializing.
Who has an excellent shoe? If you had to make this shoe, how long would it take you? How much did it cost you? How much can you make an hour? So, how many hours did it take you to get this shoe? So, specializing at your job and trading money earned for a shoe allowed you to get this shoe in ____ hours.
I could choose to make my own clothes. It might take me a day to make a shirt, and it would be an ugly one. Or, I can specialize in being an economics professor and make $50 an hour. I can then get a better shirt with just a half hour of work. So, I specialize in one field and exchange the money earned with people who are much better at shirt production for shirts. We specialize in producing things that we can produce at low opportunity cost and then exchange for goods for which our opportunity cost of production is high.
How long would it take you to make a car? In our highly specialized economy, a middle class family can purchase a car with five months of wages.
So specialization expands exchange and produces large gains. In particular, specialization makes it possible to produce complex, valuable items at much lower cost than without specialization.
Without specialization, we would probably all live in tents or caves and walk everywhere. We would be 100% self-sufficient and very poor.
Three ways in which specialization boosts output:
Increase skills: repetition at one task boosts skill in that task.
Increased innovation: this comes more easily as workers performing simple, specialized tasks see more easily how to get machines to do the same thing.
Less time is wasted switching between tasks.

7. Video: Kramer, Shopping Frenzy
Scarcity is a fact of life.
We can’t always get what we want.

8. The Opportunity Cost of Going to College
Tuition 4 Years = $16,000 Books ($1000) 4 Years = $4,000 Misc expenses ($500) 4 Years = $2,000 Foregone Earnings 4 Years = $100,000 Total Opportunity Cost of College = $122,000
Note that, while I am using dollars as a measure of opportunity cost, the actual opportunity cost is the best alternative thing one could do with the money.
Tiger Woods was a student at Stanford. What was the opportunity cost to him of continuing as a full-time student? Is it any wonder that he is a college drop-out?
Rate of Return on college education about 10%:
Lifetime earnings (averages):
HS graduate: $1.2 million
College graduate: $2.1 million 8

9. Video: Eli Herring
He faced a high opportunity cost for following his beliefs.

10. Specialization: “Division of Labor”
Manufacturing assembly line in China

11. Comparative Advantage
Comparative Advantage: Suppose that there are two people, 1 and 2, and two jobs, A and B. If Person 1 has a lower opportunity cost for Job A than Person 2 has for Job A, then Person 1 has a comparative advantage in Job A.
If person 1 has a comparative advantage in Job A, then Person 2 has a comparative advantage in Job B.
You don’t do what you’re best at. You do what has the lowest opportunity cost.

12. Example 1
Output per Day
Mona
Lisa
Food 2 1
Clothing
Question: What are the opportunity costs per unit? 12

13. Example 1 Opportunity Costs per Unit Mona Lisa Food Clothing
0.5 units of Clothing
2 units of Clothing
Clothing
2 units of Food
0.5 units of Food
Thus, Mona is the low-cost farmer; Lisa is the low-cost tailor. So, Mona has a comparative advantage in farming, and Lisa has a comparative advantage in tailoring.

14. Comparative Advantage
Comparative Advantage: Suppose that there are two people, 1 and 2, and two jobs, A and B. If Person 1 has a lower opportunity cost for Job A than Person 2 has for Job A, then Person 1 has a comparative advantage in Job A.
If person 1 has a comparative advantage in Job A, then Person 2 has a comparative advantage in Job B.
Even low-skilled people will have a comparative advantage in something.

15. Example 2
Output per Day
Mona
Lisa
Food 2 3
Clothing 1 6
Question: What are the opportunity costs per unit? 15