Chapter 6 slides

Chapter 6: Comparative Advantage and Gains from Trade

Chapter Objectives

• Learn how markets generate gains from trade.

1. Gains from Trade: Understand the role of markets in reallocating resources to better uses.

2. Comparative Advantage: Use comparative advantage to allocate tasks to those with the lowest opportunity cost.

3. The Power of Prices: Understand the role that prices play in coordinating economic activity.

4. How Managers Can Harness Market Forces: Be prepared to harness market forces in your own life.

Key Terms

• Absolute advantage

• Comparative advantage

• Gains from trade

• Internal markets

• Knowledge problem

• Prediction market

• Specialization

Chapter Summary

• Presents key advantages of markets, specifically gains from trade through specialization and exchange.

• Explores the role of prices in coordinating economic activity.

Chapter Outline

• 8.1. GAINS FROM TRADE

• 8.2. COMPARATIVE ADVANTAGE

  • Introducing Comparative Advantage

  • Comparative Advantage in Action

  • Markets Facilitate Gains from Trade

  • Comparative Advantage Drives International Trade

• 8.3. THE POWER OF PRICES

  • Role 1: A Price Is a Message

  • Role 2: A Price Is an Incentive

  • Role 3: A Price Aggregates Information

• 8.4. HOW MANAGERS CAN HARNESS MARKET FORCES

  • Internal Markets Allocate Resources

8.1. Gains from Trade

• Learning Objective: Understand the role of markets in reallocating resources to better uses.

• Gains from trade refer to benefits from reallocating resources, goods, and services effectively.

• Markets facilitate allocation by allowing buying and selling of labor, assigning tasks efficiently.

8.2. Comparative Advantage

• Learning Objective: Use comparative advantage to allocate tasks to those with the lowest opportunity cost.

• Everyday decisions involve allocating tasks efficiently within families and across organizations.

• Absolute Advantage: Ability to perform a task using fewer inputs; doesn’t reflect who should perform the task.

• Example: Stephen Curry has absolute advantages in basketball and teaching but must allocate his time wisely based on comparative advantage.

Understanding Opportunity Cost

• Comparative Advantage: Focuses on opportunity cost; tasks should be allocated to maximize output based on who has the lower opportunity cost.

• Trade-off: Choosing one task means giving up the potential output of another task.

• Calculating Opportunity Costs: To find comparative advantage, calculate potential outputs for alternative tasks.

Example of Household Task Allocation

• Jamie and Helen’s Case:

  • Jamie Vacuums: Takes 4 hours (4 meals).

  • Helen Vacuums: Takes 4 hours (2 meals).

  • Jamie’s cost of a meal = Vacuuming ¼ of a house.

  • Helen’s cost = Vacuuming ½ of a house.

  • Conclusion: Allocate tasks based on who has the lower opportunity cost to maximize efficiency.

8.3. The Power of Prices

• Learning Objective: Understand the role that prices play in coordinating economic activity.

Roles of Prices

1. Price as a Message:

   • Indicates how much buyers value goods (marginal benefit) and how expensive it is for sellers to produce more (marginal cost).

   • Assists in coordinating market outcomes.

2. Price as an Incentive:

   • High prices encourage suppliers to produce more and buyers to consume less.

   • Example: High pharmaceutical prices promote R&D and drug availability.

3. Price Aggregates Information:

   • Prices reflect collective information and help in making informed decisions, impacting demand and supply effectively.

   • Example: Prediction markets aggregate and broadcast information improving forecast accuracy.

8.4. How Managers Can Harness Market Forces

• Learning Objective: Be ready to harness market forces in your own life.

Internal Markets

• Internal markets in organizations function similarly to regular markets, allocating scarce resources effectively.

• Knowledge Problem: Lack of complete knowledge prevents optimal decision-making; markets can bridge this gap.

• Examples:

  • Google utilizes internal markets for resource allocation across teams.

  • NASA used an internal market to allocate scientific resources efficiently.

Prediction Markets in Organizations

• Internal prediction markets enhance forecast accuracy; provide better insights for decision-making.

• Example: Ford achieved 25% better sales forecasts through employee-driven prediction markets.