3.1 COMPARATIVE ADVANTAGEAND EXCHANGE (4 of 4)The Division of Labor and ExchangeIn his 1776 book, An Inquiry into the Nature and Causes of the Wealth of Nations, Adam Smith noted that specialization actually increasedproductivity through the division of labor.Smith listed three reasons for productivity to increase with specialization, with each worker performing a single production task:1. Repetition. The more times a worker performs a particular task, the more proficient the worker becomes at that task.2. Continuity. A specialized worker doesn‘t spend time switching from one task to another. This is especially important if switching tasks requires a change intools or location.3. Innovation. A specialized worker gains insights into a particular task that lead to better production methods.

Absolute Disadvantage and Comparative Advantage in LatviaAPPLYING THE CONCEPTS #1: What is the rationale for specialization and trade?

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Latvia in the 1990s was much less productive than nations in the European Community. The question is, Why would a member of the EC, whose workersare more productive than Latvian workers in the production of all goods, buy any products from Latvia?

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Although the EC has an absolute advantage in both products, it has a comparative advantage (a lower opportunity cost) in grain: the opportunity cost ofone unit of grain is 6 units of saw timber in the EC, compared to 20 units of saw timber in Latvia. Latvia has a comparative advantage in saw timber: theopportunity cost is 1/20 units of grain in Latvia, compared to 1/6 units of grain in the EC.

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Based on the notion of comparative advantage, we know that both the EC and Latvia can be made better off if the EC produces grain in exchange for sawtimber produced by Latvia.

Market economyAn economy in which people specialize and exchange goods and services in markets.

Although it appears that markets arose naturally, a number of social and government inventions have made them work better:

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Contracts specify the terms of exchange, facilitating exchange between strangers.Insurance reduces the risk entrepreneurs face.Patents increase the profitability of inventions, encouraging firms to develop new products and production processes.Accounting rules provide potential investors with reliable information about the financial performance of a firm.

Centrally planned economyAn economy in which a government bureaucracy decides how much of each good to produce, how to produce the good, and who gets the good.

Under a market system, decisions are made by the millions of people who already have information about consumers’ desires, production technology, andresources. These decisions are guided by prices of inputs and outputs.Prices provide signals about the relative scarcity of a product and help an economy respond to scarcity.The market system works by getting each person, motivated by self-interest, to produce products for other people.

The Role of EntrepreneursEntrepreneurs play a key role in a market economy.▪ Prices and profits provide signals to entrepreneurs about what to produce.▪ If a product becomes popular, competition among consumers to obtain it will increase its price and increase the profits earned by firmsproducing it.▪ Entrepreneurs will enter the market and increase production to meet the higher demand, switching resources from the production of otherproducts.▪ As entrepreneurs enter the market, they compete for customers, driving the price back down to the level that generates just enough profitfor them to remain in business.

The Market for MeteoritesAPPLYING THE CONCEPTS #2: Why do markets develop?

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When a meteoroid, a chunk of debris in the solar system, enters the earth’s atmosphere it becomes a meteor, and if a meteor reaches the ground andsurvives impact, it becomes a meteorite.

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The market for meteorites is highly organized. Meteorites have been hitting the earth for millions of years, and they can still be found in many desert areas.In Morocco, people bring meteorites picked up in the desert to local dealers, who then sell them to the public through websites and eBay. And there areprofessional meteorite hunters, who listen for news of meteorite showers and then travel to the landfalls to gather fresh meteorites.

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The market price of meteorites varies from a few dollars per gram for the most common types to Hundreds of dollars per gram for the rarest, includingobjects that originated from Mars and the moon.

To facilitate exchange, the government helps to enforce contracts by maintaining a legal system that punishes people who violate them. This systemallows people to trade with the confidence that the terms of the contracts they enter will be met.

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In the case of consumer goods, the implicit contract is that the product is safe to use. The government enforces this implicit contract through productliability or tort law.

Property Rights and Urban SlumsAPPLYING THE CONCEPTS #3: What is the role of government in a marketeconomy?o

One role of government is to About 10 percent of the world’s population lives in urban squatter settlements, with little security in housing. A household that occupies public landcould be relocate at any time, and would lose all f its immobile possessions including a dwelling.

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One policy option is property titling, that is, granting ownership of a dwelling to its occupant. The person who owns a dwelling reaps all the benefits of regular repair andmaintenance, including any increase in market value.