CHAPTER
3
Markets in the Global
Economy
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
1
Markets in the Global Economy

A market is an arrangement that allows
buyers and sellers to exchange things.

A market system facilitates the
exchange of money and products.

Markets exist because individuals are
not self-sufficient but instead consume
many products produced by others.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
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.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Specialization and the Gains From
Trade

Each of us specializes in producing just a
few products and uses the market to
exchange goods and services.

Why do we specialize?

Because output for society as a whole will
increase if the task of producing something is
assigned to the country or person who can
produce it more efficiently.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Absolute Versus Comparative
Advantage

Consider this
productivity table.
Brenda can produce
more bread or shirts
per hour than Sam.
Therefore, she has an
absolute advantage
over Sam.

However, the decision as to who should
specialize in the production of one good or the
other is based not on absolute but on
comparative advantage.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Opportunity Cost and
Comparative Advantage



Brenda sacrifices 3 loaves of bread for each shirt she produces.
Sam sacrifices one loaf of bread for each shirt he produces.
Sam should specialize in the production of shirts because
he faces a lower opportunity cost in that activity.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Opportunity Cost and
Comparative Advantage


Comparative advantage is the ability of
one person or nation to produce a good
at an opportunity cost that is lower than
the opportunity cost of another person or
nation.
Specialization is beneficial if there are
differences in opportunity cost that
generate a comparative advantage.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Circular Flow Diagram

The circular flow diagram is a schematic
representation of output and input
markets, and the role of participants in
those markets, mainly households and
business firms.
• Factor, or input markets allow owners of
land, labor and capital to sell these resources
to organizations that will transform them into
goods.
• Product, or output markets allow
organizations to sell their goods and services
to consumers.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Households and Firms

A household is an individual or group
of people who live in the same housing
unit.

A firm is an organization that uses
resources to produce a product for
sale.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Interaction Between Buyers and
Sellers in the Circular Flow


© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
In labor markets,
households sell their labor
to firms for wages. About
75% of income is earned by
households.
In capital markets,
households provide savings
that firms use to purchase
physical capital.
Households receive interest
or a share of the firm’s
profits in return (about 20%
of income).
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O’Sullivan & Sheffrin
Interaction Between Buyers and
Sellers in the Circular Flow

In natural resource
markets, households
sell natural resources
to firms.

In product, or output
markets, households
purchase goods and
services produced by
firms.
11
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Interaction Between Buyers and
Sellers in the Circular Flow

Inputs flow from
households into factor
markets where they are
purchased by firms and
then transformed into
products. Then, products
flow from firms to product
markets where they are
purchased by
households.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Global Economy

Exports are goods produced in this country
and sold elsewhere. Imports are goods
produced elsewhere and sold in this country.

Trade among countries is based on the same
principles of trade between individuals.
Specialization based on comparative
advantage results in gains for all participants.

Smaller nations rely more on trade because
they have fewer opportunities for
specialization within their borders.
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
13
Currency Markets and Exchange
Rates

Foreign exchange markets allow
people to exchange one currency for
another. The exchange rate is the
price of one currency in terms of
another.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Currency Markets and Exchange
Rates

The exchange rate of the dollar in terms of
yen is expressed as follows:
¥
Yen necessary to
Yen per dollar =
 113.64
buy one dollar.
US$
US$
Dollars necessary
Dollars per Yen =
 0.0088
¥
to buy one yen.
Example:
Hotel room in Japan: ¥ 9,000
Exchange rate: 113.64 ¥ $
Cost of the hotel in dollars: $79.20
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Role of Government

Providing public goods and services such as
streets, education, parks, public safety, national
defense, and space exploration

Redistributing income to the poor

Taxation to support spending programs

Regulation of business practices to control
pollution, encourage competition, and improve the
safety of consumer goods

Trade policy to control international trade, to
promote or to restrict some types of trade
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Government Regulation of
Economic Activity
The government establishes a legal system to
enforce property rights. Regulation exists at three
levels of government:

Federal regulatory agencies include the Securities
and Exchange Commission (SEC), Federal Trade
Commission (FTC), FCC, FDA, OSHA, and EPA

State regulation includes pollution, banking,
transportation, education, land use, licensing

Local regulation includes zoning and building codes
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Alternative Economic Systems —
Centrally Planned Economies

The United States has a mixed economy because it
combines a free-market system with extensive
government interaction.

An alternative to a market system is a centrally
planned economy in which production and
consumption choices are made by a central
government rather than by markets.

Most of the formerly centrally planned economies
have been making a transition to a market system.
This is a difficult process that requires privatization
of previously state-owned firms and resources.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Protectionist Policies
Trade barriers are rules that restrict the free
flow of goods between nations. They include:
 Tariffs or taxes on imports

Quotas or limits on the quantity of imports

Voluntary export restraints or agreements
between governments to limit imports

Nontariff trade barriers or subtle practices
that hinder trade
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Tariff and Trade Agreements

GATT, the General Agreement on Tariffs
and Trade, was initiated in 1947 by the
United States and 23 other countries to
lower tariff barriers among participants. It
has over 100 members today.

WTO, the World Trade Organization, is
an organization that oversees GATT and
other international trade agreements.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Tariff and Trade Agreements

NAFTA, the North American Free Trade Agreement,
which took effect in 1994, lowers barriers between
the United States, Mexico, and Canada.

EU, the European Union, has reduced trade barriers
within Europe; 15 nations are members.

APEC, the Asian Pacific Economic Cooperation, is
an 18-member organization of Asian nations that
attempts to reduce trade barriers.
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© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin