CHAPTER 2
The Power of Markets and the Wealth of Nations
CHAPTER SUMMARY AND TEACHING OBJECTIVES
It is important to understand the underlying fundamentals associate with economic success. One finds
property rights, the freedom to trade, incentives, and the freedom to choose. It will be seen that these
fundamentals are also part of successful management and successful businesses. It is important for
individuals to have incentives to better themselves. Markets, trade and prices guide people toward an
higher level of economic wellbeing.
IMPORTANT TERMS
Property Rights people own things and can do with them pretty much as they wish and they can
exclude others from using the things they own
Absolute Advantage this occurs is a country can simply produce the most of any one good
Comparative Advantage this occurs when a country is relatively more efficient at producing a
product
TOPICS AND TEACHING SUGGESTIONS
1. Why Are Some Countries Rich and Others Dirt Poor
2. Efficiency
A system of markets and prices is the most efficient arrangement for coordinating and organizing
6 Chapter 2: The Power of Markets and the Wealth of Nations
ANSWERS TO EXERCISES
1. What are “gains from trade”? What is the primary benefit of trade? Why is the idea that trade
is beneficial counter-intuitive?
2. What is the difference between “absolute advantage” and “comparative advantage”? How can
a less developed country like Mexico have a comparative advantage relative to the US?
Absolute advantage is based on total productivity. Comparative advantage is based on
3. What is the difference between rich and poor nations? How did they become rich or poor?
4. It has been argued that climate is a predominant explanatory variable in income distribution in
the sense that nations along the equator are poor while those in cooler climates are rich. Can
you explain why this might make sense?
5. Another argument is that the dominance of Catholicism explains economic development. A
third argument is that the form of colonialism is what matters. Try to explain these positions
6. Why might a policy that simply forgives $40 billion of debt not benefit those nations whose
debt is forgiven? Would this policy and the incentives created say anything about the policy
response to the “subprime mortgage” crisis experienced in the US in 2007 and 2008; the
government enacted legislation “forgiving” the debt of some debtors.
Forgiving people for prior bad acts creates a moral hazard. It will encourage people to do
7. What are private property rights? Why are private property rights necessary for markets to
function?
8. Hernando de Soto (a Bolivian economist) argues that property rights are even more important
in the developing world than in rich nations. What is his argument? How could the absence of
well-defined property rights affect economic development? What might the absence of well–
defined property rights mean for illegal immigration? DeSoto has argued that the LDCs fail to
grow primarily because of a lack of private property rights. How does that analysis apply to
the Native American?
9. What does the following statement mean? “Indeed, every decision we make involves some
kind of trade–off.” Under what condition would the statement not be true?
10. It has been said that “Prices are like giant neon billboards that flash important information.”
Describe the types of information that market prices provide.
11. In this and the last chapter it was noted that “Profit opportunities attract firms like sharks to
blood…” Explain
12. “The problem with Asian sweatshops is that there are not enough of them.” — Charles
Wheelan, Naked Economics, p. 20. How is Wheelan’s statement illustrative of the concept
that every market transaction makes all parties better off?
13. What incentives are created by each of the following allocation mechanisms? Market, first
come first served, government.
A first come first serve creates an incentive to get in the front of the line. Government creates
14. Why does market allocation lead to an increased supply whenever a shortage situation exists?
15. The following data represent the production possibilities of two people in solving math and
economics problems. If they devote their total effort and time to math, A can solve 10 math
problems and B can solve 10 math problems. If they devote their total effort and time to
economics, A can solve 10 economics problems and B 5 economics problems.
Percent of Resources Devoted to:
A
B
Math
Economics
Math
Economics
Economics
100
0
10
0
0
0
100
0
10
5
b. Who has the comparative advantage? A also gives up 1 math problem to solve an
c. Assume that each will be self-sufficient and devote half their resources to math and half
to economics. The outcome follows.
A
A
B
B
trade
5
5
5
2.5
Now assume they specialize according to comparative advantage. How much math and economics
will they produce together? What are the gains from trade? A specializes in economics problems