1. C 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

2. C H A P T E R 3: Exchange and Markets C H A P T E R 3: Exchange and Markets © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 2 of 15 Comparative Advantage and 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 Cost The opportunity cost of something is what you sacrifice to get it.

3. C H A P T E R 3: Exchange and Markets C H A P T E R 3: Exchange and Markets © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 3 of 15 Specialization & Gains from Trade Production Possibilities for You and Your Neighbor, Without Trade Opportunity cost of picking 1 pound of apples Opportunity cost of picking 1 pound of cherries You1 pound of cherries1 pound of apples Your neighbor2 pounds of cherries.5 pound of apples

4. C H A P T E R 3: Exchange and Markets C H A P T E R 3: Exchange and Markets © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 4 of 15 Specialization & Gains from Trade Gains from Trade

5. C H A P T E R 3: Exchange and Markets C H A P T E R 3: Exchange and Markets © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 5 of 15 Specialization & Gains from Trade A Summary of the Gains from Trade YOUYOUR NEIGHBOR Apples (in pounds) Cherries (in pounds) Apples (in pounds) Cherries (in pounds) Production and consumption without trade 812942 Production with trade200060 Consumption with trade10151045 Gains from trade (increased consumption) 2313

6. C H A P T E R 3: Exchange and Markets C H A P T E R 3: Exchange and Markets © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 6 of 15 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.

7. C H A P T E R 3: Exchange and Markets C H A P T E R 3: Exchange and Markets © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 7 of 15 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.

8. C H A P T E R 3: Exchange and Markets C H A P T E R 3: Exchange and Markets © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 8 of 15 Specialization and the Gains from Trade Specialization and exchange makes both people better off, illustrating one of the key principles of economics: PRINCIPLE of Voluntary Exchange A voluntary exchange between two people makes both people better off.

9. C H A P T E R 3: Exchange and Markets C H A P T E R 3: Exchange and Markets © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 9 of 15 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.

10. C H A P T E R 3: Exchange and Markets C H A P T E R 3: Exchange and Markets © 2006 Prentice Hall Business Publishing Economics: Principles and Tools, 4/e O’Sullivan/ Sheffrin 10 of 15 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.