Class Notes For Modern Principles: Microeconomics, 4th Edition

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1TheBigIdeasLearningObjectivesAfter completing this chapter students should:>knowthe TenBig Ideas ineconomics.>appreciatethat economics is not just about business and stock markets,but it canhelpthem understand many things they encounter in their everyday lives.>seethateconomicscan be fun!Chapter OutlineThe chapter is organized around 10“BigIdeas”:Big Idea One:IncentivesMatterBig Idea Two:GoodInstitutionsAlign Self-Interest with the Social InterestBig Idea Three:Trade-offs Are EverywhereOpportunity CostBig Idea Four:Thinking on the MarginBig Idea Five:The Power of TradeBig Idea Six:The Importance of Wealth and Economic GrowthBig Idea Seven:Institutions MatterBig Idea Eight:Economic Booms and Busts Cannot Be Avoided but Can BeModeratedBig Idea Nine:InflationIs Caused by Increases in the Supply of MoneyBig Idea Ten:Central Banking Is a Hard Job

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CHAPTER 1•The Big Ideas•2The Biggest Idea of All: Economics Is FunChapterNarrativeThis chapter briefly introduces 10 big ideas in economics that the students will learn morethoroughly in later chapters. Each big idea is explained,and then itsimportance isillustrated by showing how it explains some real-world phenomenon that the studentsshould find interesting. The chapter aims to excite students abouteconomics while givingthem a quick introduction to the big ideas.The chapter opens by explaining how the British government rewarded shipcaptainsfor transporting convicts to Australia in the eighteenth century. At first, thecaptainswerepaid per convict who boarded the ship. The sailorstreated the prisoners inhumanely,andtheir death rates were extraordinarily high. Then, when the government changed thepayment system so that it paidcaptains according to how many prisoners walked off theirship in Australia, rather than how many walked on in England, suddenly theprisoners’survival rate shot up to 99 percent. This illustration leads intothe first big idea: incentivesmatter.BigIdeaOne:IncentivesMatterIncentives are rewardsorpenalties that influence behavior.Changing the incentives changed how the captains treated their prisoners. Under thefirst payment system, there was no monetary reward for delivering the prisoners alive. Infact,if they didn’t feed the prisoners, the captainscould sell the prisoners’ rations and earneven more money. Captains’ incentives were to treat prisoners poorly. Once they were paidaccording to how many healthy passengers they delivered, theirincentives and thus theirbehavior changed for the better.The MRU videoIntroduction to Economicsintroduceseconomics in generaland discusses the importance of incentives in particular using the story ofBritish prisoner transports to Australia. This video might provide a niceopening to your first lecture.Monetary rewards are one major incentive in our society. As Adam Smith said, “It isnot from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner,but from their regard to their own interest.”Teaching Tip:It’s easy to illustrate thisideato students quickly. Glance aroundthe room and see who just recently purchased something, such as a Coke orcoffee. Ask about the transaction.Who sold it? What wasthe seller’sname?Did the seller know the student’s name? Whywas that product available there?What wasthe seller’sincentive? Emphasize the number of things that studentsneed from peoplewho have no incentive to help them other than the monetaryreward.Not all incentives are monetary—fame, power, reputation, sex, and love are allimportant incentives. Emphasize that economics can explain things motivated by theseincentives as well. Students should come away realizing that economics is notlimited toexplaining things that are paid for in money.

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CHAPTER 1•The Big Ideas•3Big Idea Two: GoodInstitutions Align Self-Interest with the SocialInterestThe story of how ships’ captains changed their behavior relates to the second big idea.Incentives are not fixed in stone. Different institutions or rules canengenderdifferentincentives and behaviors. An institution is good when it aligns an individual’s self-interestwith society’s interest. An institution is bad, and so are the outcomes, when individuals’incentivesruncounter to society’s interest.Under the right conditions, markets align self-interest and social interest. It’s good thatbusiness people make money by pleasing consumers.Self-intereston their part can be goodfor society.Teaching Tip:Ask students iftheyever worked overtime at a job. Why did theydo it? Get them to explain that they wanted to earn the extra money. They wereacting out of self-interest. But then emphasize howtheir self-interestmade themprovide moreservices tosomeone else thanthey wouldhave otherwise.Be sure to point out thatself-interestisneither good norbad because it is how weprogress as a species.What is important is the institutions.The captains’ greedled to badoutcomes(poorly treated passengers)when institutions were bad.Butthatsamegreed, ordesire for self-interest, led to good outcomes (more passengers making it to Australia)whenthe institutions changed.Greed’s goodness (or usefulness) depends on the institutions.Markets withmutual voluntary interaction make self-interest useful most of the time.Big Idea Three: Trade-offs Are EverywhereStudents are first introduced to opportunity cost (without using that term) by the somewhatshocking conclusion that economists worry that pharmaceutical drugs could be too safe. In2004,Merck withdrew the arthritis drug Vioxx from themarket after a study showed thatit could cause heart attacks and strokes. Yet the FDA had approved the drug five yearsearlier,and millions had used it. Students will be tempted to conclude that the FDA shouldbe more careful studying new drugs so that drugs like Vioxx never reach the market.Making drugs safernecessitatesa trade-off: fewer companies will develop drugsbecause it would be more costly.This is known as drug loss. It will also take longer forgood drugs to make it to market,causing people to miss out on the drug’s beneficial effectin the interim. This is known as drug lag.Ittakes an average of 12 years and $900 millionto bring a new drug to market in the United States. The trade-off society faces for saferdrugs is fewer drugs and getting them more slowly.Such trade-offs are inevitable in a worldof scarcity—that is,when therearenot enough resources to satisfy all of our wants. Howwe use our scarce resources to satisfy as many of our wants as possible is what the authorsrefer to as the “great economic problem.”Scarcity, trade-offs, and the great economicproblem bring us to a key concept in economics: opportunity cost.The opportunity cost ofa choice is the value of theopportunitieslost because of that choice.Teaching Tip:Students are used to thinking of costs as monetary costs.Takesome time to illustrate opportunity costswith examples that they can relate to.For example, what is the opportunity cost of going to a movie one night? Howwould that opportunity cost change if you had an exam the next day?Thetextbookprovides anothernice example:What is the cost of going to college? Tuition, books, lost wages, room and board.Ask students which of theseisnotan opportunity cost. Ask them if they considered lost

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CHAPTER 1•The Big Ideas•4wages when they decided to attend.Then explain why college enrollment is affectedby the business cycle.Teaching Tip:You can have some fun with examples of opportunity cost byasking students questions that relate toeverydaylife. Try askingthe following:>In a social situation, have you ever walked up to two attractive people,looking for a date? You have to choose who to focus on.Theopportunity cost of talking to the person you chose is loss of theopportunity to talk to the other person.(This leads nicely to the joke:an economist was asked how his wife was. He answered, “Comparedto whom?”)>Does anyone play basketball? If you’re on a fast break and you pull upfor a three-pointer,what is your opportunity cost?>If you weren’t here in my class today, what would you be doing?Keep drillingthem with questions until they seem to get it.Big Idea Four: Thinking on the MarginMost choices are made on the margin. Should we do a little more of an activity or a littleless? This concept is introduced in the book with a brief discussion of a driver makingincremental changes to his speed as he travels down the highway. When he hasn’t seen apolice cruiser in a while, he increases his speed a little more. When he finally spots one ashe approaches a big city, he decreases his speed a little. Just like many decisions in life, thedriver’s decision about his speed is not made once andfor all upon starting his car. Rather,when it is beneficial to do so, he speeds up a little, until the benefits of speeding up a littleno longer outweigh the costs (the increased likelihood of a ticket).Teaching Tip:Here is a fun illustration of marginal thinking from students’everyday lives. Ask ifthey haveever chosen to go out with their friends insteadof with their boyfriend or girlfriend and heard theobjection, “You care moreabout them than you do me.”At least one hand will go up.Then explain thatthey now have an answer: “Not in an absolute sense.You are more important,but given that I already spend so much time with you, seeing them tonight ismore important to me only on the margin.”Big Idea Five: The Power of TradeThe benefits of trade go much further than the simple benefits of exchange.Throughspecialization, trade can increase productivity, and higher productivity leads to moreoutput. One way that specialization increases productivity is through the division ofknowledge.Aproducerwhospecializes in the production of just a few goodscan becomean expertinthe production of those goods, learning things that would not have been learnedif every person produced just a small amount of every good for his or her own use.Likewise, specialization allows producers to take advantage of economies of scale, the costsavings that can be achieved when goods are produced in higher quantities.The theory ofcomparative advantagemaintains thatspecialization and trade canbenefiteveryone involved. The key is for producers (individuals, firms,or countries) tofocuson the goodsthey canproducefor thelowest opportunity costand then trade witheach other. The text uses the example of Martha Stewart,who,although likely a very skilledironer, hires someone to do her ironing.The reason?The opportunitycost of her ironing is

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CHAPTER 1•The Big Ideas•5running hercompany (Martha Stewart Living Omnimedia). If the profits from her companythat she foregoes when she spends an hour ironing is greater than thevalueof ironing, thenshe should spend time running her company and use those higher profits to pay someoneto iron her clothes.Big Idea Six: The Importance of Wealth and Economic GrowthSome students will be tempted to discount the importance of wealth and economic growthbecause they associate itonlywith material standards of living. Now’s the time to drivehome the point that increases in wealth give us more of many of the thingswe allvalue.Afew quick examples from the text:>In 2007, more than half a billion peoplearound the worldcontracted malaria,and about1million diedofit. We think of it as a tropical disease,but peopleused to get it in the United States frequently until the 1940s. Better drainage,removal of mosquito breeding sites, and insecticides all contributed to wipingmalaria out. We needed to grow wealthy enough to pay for these things beforemalariacould be eradicated.>In the United States,993in1,000 children born survive until at leastagefiveyears. In Liberia, one of the world’s poorest countries, the survival rate is only765in1,000.Most things people care about—like life expectancy, nutrition, and literacy—are alleasier to get when you are wealthier.It is also helpful topoint out the circular relationship between these ideas. As wealthincreases,there is morefree time to pursue specialization. This specialization leads to moreefficient production methods,which increases economic growth or the ability to producemore goods andservice. This increases wealth,further leading tomore free timeand so on.A good example of this is how better and cheaper sources of light allowed more work pastsunset,leading tomore efficient forms of light generation.Big Idea Seven: Institutions MatterIf wealth is so important,this naturally leads us to ask how to get wealth. This was thefocus of much of Adam Smith’s seminal bookAn Inquiry into the Nature and Causes ofthe Wealth of Nations.Wealthy countries tend to have lots of physical and human capital and usethemwiththe best technologyavailableto produce goods and services more efficiently. But this stillraises the question of why some countries have more than others and why they use it moreefficiently.It all comes back to Big Idea One: Incentives Matter. Entrepreneurs, investors, andsavers need the right incentives to save and invest in physical and human capital,innovation, and efficient organization. The institutions most important in supporting goodincentives for these are property rights, political stability, honest government, a dependablelegal system, and competitive and open markets.Teaching Tip:Ask the students how many of them came to college because theyexpect to earn more. How have the institutions in the United States given them

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CHAPTER 1•The Big Ideas•6the confidence to make that investment in their human capital?North Korea and South Korea provide a striking example of how differentinstitutionsaffectwealth creation.The two countrieshave a common culture and geography and wereequally poor in 1950. South Korea embraced property rights and markets,while NorthKorea did not.Today South Korea has more than 10 times theper capitaincome of NorthKorea.Teaching Tip:If you have access to the Internet in the classroom,pull up asatellite image of the Korean peninsula at night and show them thedifferencein light emissions between the two countries as an indicator ofdevelopment.Big Idea Eight: Economic Booms and Busts Cannot Be Avoided butCan Be ModeratedBooms and busts are part of the normal response to changing economic conditions. Not allbooms and busts are the same, though. The Great Depression was the worsteconomicdownturnthe United Stateshas ever had. Output dropped by 30 percent, unemploymentrose above 20 percent, and the stock market lost a third of its value. This was not anormalrecession. Most economists believe that if the government had acted differently,theDepressionwould have been less severe.Monetary and fiscal policiesaffectthe length and severity ofeconomic booms andbusts. At one time,economists believed thatgovernment policycouldbe used toendtheeconomy’s boom and bust cycle.But mosteconomistsno longer believe that,and we’velearned that when these policies are used poorly,they makerecessions worse and theeconomy more volatile.An example you can useis shipson the ocean. Waveson the oceancannotbe stopped,they are justpart of nature. If you are on a small boat youare constantly being tossed bythese waves. If you are on acruise ship you will likely forget you are on the ocean. Thewaves are still there;however,the builders of the ship have installed technologyto mitigatethe impact of the waves on the ship. Monetary and fiscal policy work in much the sameway by mitigating the impact of the naturalbusiness cycle ontheeconomy.Big Idea Nine:Inflation Is Caused by Increases in the Supply ofMoneyInflation is an increase in the general level of pricesin an economy. Increases in the moneysupplycauseinflation.MiltonFriedmanfamouslysaid,“Inflationisalwaysandeverywhere a monetary phenomenon.”Potential Pitfall:Although inflation comes from increases in the money supply,students are likely to think oil or greedy businessmen causeinflation. It’s worthstressing the monetary causes and how other factorsinfluence relative pricesbut not the general levelof prices.Inflation has negative consequences.Emphasizehowinflationmakes it hard to figureout the real value of goods and services. Most students in the United States have not

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CHAPTER 1•The Big Ideas•7experienced the chaos of serious inflation, whereas Zimbabwe recentlyhadan inflation rateof over 531 billion percent. Money in that situation becomesvirtuallyworthless and mustbe spent as soon as it’searned, making organized trade harder. In Zimbabwe, people startedbuying things with prepaid cell phoneminutes and gas cards instead of the nationalcurrency.You can highlight this idea byhaving the students assume you hand out envelopes withbetween one and five dollars in them.Now assume you are holding an auction forsomething the students want (such asanswers to the exam) and ask the students whatisthehighestpriceone person can bid. Now assume the envelopes had up to ten dollars in them.Now what is the highest possible bid? Note to the students that the good being auctionedhas not changed, only the price because there is more money.Big Idea Ten: Central Banking Is a Hard JobThe Federal Reservecontrols monetary policy in the United States. But there is a lag—often months—from when the Fed makes a decision to when the effects of that decisionare known. Whenit printstoo much money,weget inflation.Ifit printstoo little,wegetfalling prices. And often as prices and wagesfall,the adjustment doesnot go smoothly. Butbecause of the lag,the Fed isalways shooting at an unknown moving target.Mosteconomists believe the Fed does more good than harm, but when the Fed does itsdifficult job poorly,it can cause great harm.BiggestIdea of All: Economics Is FunThe whole point of the first chapter, and your first lecture of the semester, is to excitestudents about economics. We need to show the students that:>economicsis all around them in their daily lives.>economicsis crucial for understanding the world and how to make it a betterplace.>theseprinciples of economics hold everywhereacross the globe and throughtime.The motto of the book is “See the Invisible Hand. UnderstandYour World.”Chapter 1and your lectures shouldarousea desire in students to do that.

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2The Power of Trade and ComparativeAdvantageLearningObjectivesAfter completing this chapter students should:>understandthat trade makes people better off when preferences differ.>knowthat trade increasesproductivity through specialization and the division ofknowledge.>understandcomparative and absolute advantage and how comparative advantageincreases productivity.>knowthat trade improves the welfare of both low-productivity and high-productivitycountries.Chapter OutlineTrade and PreferencesSpecialization, Productivity, and the Division of KnowledgeComparative AdvantageThe Production Possibility FrontierOpportunity Costs and Comparative AdvantageComparative Advantage and WagesAdam Smith on TradeTrade and GlobalizationTakeaway

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CHAPTER 2•The Power of Trade and Comparative Advantage•2ChapterNarrativeThis chapter illustrates how trade promotes cooperation that allows both highly productivecountries and less productive countries to gain through trading with each other. The chapterprovidesexamples oftrade betweenindividuals andtrade betweencountries.Included isthe famous Adam Smithquotationillustrating thelink between trade amongindividualsandtrade amongcountries: “What is prudence in the conduct of every private family canscarce be folly in that of a great kingdom.”It is important to emphasize to students that thesame principles explain all trade, whether between countries or individuals.The MRU videoThe Big Ideas of Trademotivates the importance of trade ineconomics and explains how trade benefits society. This is a good video toopen the discussion of trade.This video is also useful for illustrating the ideasin the next section of the chapter.Trade and PreferencesThis section tells the story of the founding of eBay. A young computer programmer, PierreOmidyar, finished the code for what would become eBay in 1995. To test it out,he posteda broken laser pointer to the site and asked for a dollar. It sold for $14.83. He was sosurprised that he contacted the buyer to make sure thatheunderstood it was broken. It turnsout that the buyer was a collector of broken laser pointers! Trade transformed somethingthat was worthless toOmidyarto something that was valuable to someone else. Value wasincreasedsimply bya swapbetween people with different preferences. Today eBayoperates in more than 30 countries and earns billions of dollars in revenue. When peoplewith different preferences trade with each other on eBay, each person becomes better off,and so does eBay by facilitating the transaction. The short lesson of this section: tradeincreasesvalue by moving goods from people who value them less to people who valuethem more.Teaching Tip: It is easy to demonstrate to students how trade can increase valueamong individuals. Describe (or actually perform) an exercisein whicheachstudent randomly draws one item from a box containing a mixture of differentcandy bars. Students do not know the brand of candy they will receive until itis drawn from the box,and they must keep the first item selected. Once eachstudent has drawn an item from the box, ask them to rate on a scale from one toten how happy they are with what they received from the random draw. Add upthe total rating for the class. The total rating provides a measure of totalhappiness or value for the class. Then announce that everyone has one minuteto trade their candy bar with anyone else in the class,and they may trade asmany times as they wish during this time.Whenthe trading has ended, askstudents again to rate their happiness,and once again add up the ratings for theclass. The rating should be higher after the trading. Explain to the class that thelevelof happiness,or value,increased through trade, even though no new candywas given. The increase in value simply results frommoving the candy aroundso that it winds up with the people who value it most.

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CHAPTER 2•The Power of Trade and Comparative Advantage•3Specialization, Productivity, and the Division of KnowledgeWhen people trade, it allows them to specialize in producing one thing rather than tryingto produce everything they need. Try asking your students how well they would eat andhowwell-clothed they would be if they had to produce all their own food and clothing.Specialization increases production in two ways. First, by specializing in farming, forexample, farmers learn a lot more about farming than other people,so they become betterat it. Second, they can afford to buy large-scale farming machines thatare more productivebecause they are going to produce in far greater quantities than individualswould producefor their own use.Most instructors are used to emphasizing specialization and the division oflabor.Modern Principlesis different in that this section emphasizes the division ofknowledge.The human brain is limited, and if knowledge is divided across many brains and then tradeoccurs, we can collectively benefit from more knowledge than any one mind could hold. Ifevery person in societyproduced the same thing as the neighbors, the combined knowledgeof a society ofamillion people would barely exceed the knowledge of one brain. In amodern economy, trade allows us to harness far more knowledge through specialization.The book considers a Valentine’s Day rose that may have been grown in Kenya, flown toAmsterdam on a refrigerated airplane, andultimatelytrucked to Topeka by drivers drinkingColumbian coffee. Each person involved understandsonlya small part the whole process,butbecauseoftrade,their collective knowledge is able to deliver the rose.TeachingTip: Toconveytheimportanceof agroupofknowledgeableindividuals rather than one individual,you can highlight the positive aspect ofwikiss orwebcommunities (message boards). Whether it is Wikipdeia.org or asimilarwiki for a television show, video game, or even software, it is thecollective work of individuals with specific knowledge in certain aspects ofsubject coming together in a central location to create an authoritative guide onthe subject solely via trade.Wikis andwebcommunities (or message boards)have become the go-to source to troubleshoot problems. You can also seesimilar ideas in the numerous “How To” video channels on YouTube.Neurosurgeons, heart surgeons,and other medical specialistsall have very specializedknowledge and are able to acquire that knowledgeonlybecause they can trade with otherpeople. If itweren’tfor the cook, housecleaner, and dog walker, these doctors would neverbe able to acquire theirexpertskillsbecause they would be too busy performing all of thesetasks for themselves. The person who specializes as a dog walker is a vital part of theproductive gains from specialization,justasthe neurosurgeonis.When trade increases across larger areas and includes more people,it allows society toharness even more knowledge. The opening of the former communist bloc and Chinabrought billionsof newminds into the international division of knowledge and makes usall more productive.

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CHAPTER 2•The Power of Trade and Comparative Advantage•4The MRU videoHow the Division of Knowledge Saved My Son’s Lifeprovides a real-world example of how the division of knowledge andspecialization are intimately related to trade and how we all benefit from theresulting increase in productivity.Comparative AdvantageThe third reasonfortrade is to take advantage of people’sdiffering abilitiesrelative to eachother. The book contrasts absolute advantage with comparative advantage using theexample of Martha Stewart. An absolute advantage in production exists when a country orperson can produce the same good using fewer inputs than another country or person. Butcomparativeadvantage exists when a countryorperson can produce the same good at alower opportunity cost. Martha Stewart doesn’t do her own ironing. She may be the world’sbest ironer. But she can do her ironingonlyat the expense of time away from running herbusiness. Her blouses might look slightly better if she did them herself, but the gain wouldbe small compared to the losses thatwouldresult from having someone else run herbusiness while she irons. She has an absolute advantage in ironingandrunning a businessbut a comparative advantage onlyatrunning her business.The MRU videoComparative Advantageintroduces the idea of comparativeadvantage in general terms and explains how it makes both parties in a tradebetter off.The MRU videoAnother Look at Comparative Advantageprovides a moredetailedlookatcomparativeadvantage.Thedistinctionbetweencomparative advantage and absolute advantage is explained early in thevideo. The video concludes with a homework problem that students can dofor themselves. Production possibilities frontiers are not used in the video.The MRU videoComparative Advantage Videoprovides the answer to thehomework problem presented at the end of the previous video and illustrateshow trade based on comparative advantage makes both parties in the tradebetter off.The Production Possibility FrontierThe production possibilities frontier(PPF)shows all of the combinations of goods that acountry can produce given its productivity and supply of inputs. The book plotsa PPFfor

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CHAPTER 2•The Power of Trade and Comparative Advantage•5the United States and Mexicoin Figure 2.1.Figure 2.1: Production and Consumption in Mexico and the United StatesWithout TradePotential Pitfall:Students will be confused throughout the discussion of tradeif they do not understand the basics of the PPF. Take the time to explain the keypoints of working with these graphs. Explain that producing combinations ofgoods outside the PPF is impossiblewith given resources and technology.Points inside the PPF are inefficientbecause you are leaving resources unused.Points on the PPF are efficient. Then explain how the slope of the PPF relatesto the opportunity costs of producing eachgood. Do not move on until studentscan take a PPF and calculate the opportunity costs of producing both goods inboth countries, as shown in Table 2.1 in the text. It may be worthwhile toprovide your own example for students to work for themselves.Emphasize that even though Mexico is less productive than the United States,it stillhas a comparative advantage in producing shirts,as shown in Table 2.1. The theory of

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CHAPTER 2•The Power of Trade and Comparative Advantage•6comparative advantage says that to increase its wealth,a country should produce the goodsit can make at low cost and buy the goods that it can make only at high costrelative to othercountries. The book illustrates this by supposing that the United States and Mexico eachdevote 12 units of labor to producing shirts and 12 units to producing computers. Find thespots on their respective PPFs.The book then moves 12 units of Mexico’s labor out of computers and into shirtproduction and two units of U.S. labor out of shirt production and into computerproduction. This allows Mexico to trade three shirts to the United States for one computer.Youcan illustrate that they both reach a point outside of their original PPF. You mightwant to trace some more points outside of the PPF that Mexico and the United States couldachieve with specialization and trade.Teaching Tip:Students sometimes have a hard time understanding that thegains from trade come from the fact that one country isalwaysa lower-costproducer ofsomegood. I like to tell a story from Steven Landsburg’sTheArmchair Economist. Suppose there are two ways to make cars. One is the wayyou are familiar with on an assembly line in Detroit. The other is to grow cropsin Iowa and then truck them to this fancy new machine parked in an Oakland,California, harbor. You put the crops inthe machine and push it outof viewoffshore and three months later it pulls back up to the docks and spits out cars.Which method should you use to make cars? Obviously, whichever islessexpensive. That fancy machine is a boat that trades the crops to Japan for cars.Trade is justlikea production technology that can lower costs.Figure 2.2: Production and Consumption in Mexico and the United States with Trade

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CHAPTER 2•The Power of Trade and Comparative Advantage•7Teaching Tip:Emphasize to students that consumption must equal productionwhen there is no trade. In other words, when you don’t trade, you can consumeonlywhat you produce yourself. But with trade, consumption can exceedproduction. That is, trade allows a country to move beyond its PPF. You canmake a big deal out of this—even refer to it as the “magic” of trade—since itallowsyou to reach points that were previously considered out of reach. It isworthwhile to emphasize, however, that we still are not producing beyond thePPF;we are only consuming at points beyond the PPF.Potential Pitfall:Many students will be concerned that there are no gains fromtrade for a high-productivity country when it trades with a low-productivitycountry.Emphasizethat unless each country can produce every good at theexact same opportunity costs,there will always be gains from trade. The key isthatthe difference in opportunity costs allows each country to producesomething more cheaply than the other. The same way it makes sense forMartha Stewart to trade with a housekeeper, it makes sensefor productivenations to trade with less productive ones.Comparative Advantage and WagesAnother common fear is that rich countries can’t compete with poor countries thatpaylowwages. The book deals with this fear by incorporating wages into theexample of tradebetween theUnited States and Mexico.Assume a computer sells for $300 and shirts for$100 (consistent with the 3-to-1 trade).The value of Mexican consumption is 1×$300 plus6×$100 for $900 total divided by 24 workers, whichequals an average wage of $37.50.In the United States, 12×$300 plus 9×$100 equals $4,800 divided by 24 workers for anaverage wage of $200.Despite the fact that Mexico is a low-wage nation and the United States a high-wagenation, they both still gain from trade. After trade, the book’s example shows that Mexicogets 1×$300 plus 9×$100 for $1,200, or an average wage of $50, while theU.S.wagerises to $216.67. The fact that productivity is lower in Mexico is what causesMexicanwages to be lower. Specialization and trade letall workersimprove their wage regardlessof their initial level of productivity.Adam Smith on TradeThe book briefly introduces students to Adam Smith, who reinforces the concept thatspecialization and trade make sense for countries for the same reasonthey makesense forindividuals.Trade and GlobalizationThe Roman Empire had plenty of trade. The Dark Ages saw a decrease in long-distancetrade,and the Renaissance saw it expand again. Global trade was common in the nineteenthcentury as well. Technology changes what goods are traded globally, but globalizationitself is not new. Global trade isn’t fundamentally differentfromdomestic trade. The bookintroduces Don Boudreaux’s quote, “Globalization is the advance of human cooperation

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CHAPTER 2•The Power of Trade and Comparative Advantage•8across national boundaries.”TakeawayTrade makes peoplebetter off when their preferences differ. Trade also increasesproductivity through specialization and the division of knowledge. When countriesspecialize and trade according to comparative advantage, they produce the goods they canproduce at low cost and trade for the goods they can produce only at high cost. Everyoneand every country hasa comparative advantage in something, so all can gain from trade.The logic of trade for individuals is relatively easy for students to accept, but they likelyhave tons of myths in their head when it comes to international trade. It will probably takesome time to dispel these myths andhelp themunderstand the logic of trade. I suggest oneexercise to get you started.In-and Out-of-ClassActivitiesTohave your students internalize how trade between two countries benefits both countriesand how many misconceptions surround the topic, you canask each student to bring in anews article critical of international trade. Ask them to identify why the author of the articlethinks international trade in the particular case isn’t beneficial. Ask the students to assessthe merit of the objection. Then use each criticism and student response as the basis for abrief class discussion. It may be helpful to provide students with an online resource forfinding articles.For students having trouble in the following sections ofthis chapter, MRU videos areavailable for additionaloutside-of-class instruction:For Problems in the Section:Watch the MRUVideo:Trade and PreferencesTheBig Ideas of TradeSpecialization, Productivity, andthe Division of KnowledgeHow the Division ofKnowledge Saved MySon’s LifeComparative AdvantageComparative AdvantageComparative AdvantageAnother Look atComparative AdvantageComparative AdvantageComparative AdvantageHomework

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