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I. CHAPTER OVERVIEW
This chapter introduces a series of fundamental ideas and concepts that define the essence of the economic
problem and the source of economic opportunity for an advanced economy. They are important because they
form the foundation for the analysis of a market economy. The tools and methods that you learn here will be
carried throughout the text and developed in greater detail as you make your way through the course. It is
essential, therefore, that you grasp each of them before you proceed.
After you have read Chapter 2 in your text and completed the exercises in this Study Guide chapter, you should
be able to:
1 Describe what is meant by the term market and describe the process of achieving equilibrium in a
market economy.
2. Use your definition of market equilibrium to address three basic economic problems that confront all
societies.
3. Explain how the price system works as an invisible hand, allocating goods and services in a market
economy.
4. Understand the importance of (a) specialization, (b) the division of labor, (c) money, (d) factors of
production, and (e) capital and property rights in the functioning of a modern economy.
5. Use a circular-flow diagram to illustrate the relationships between agents and markets in a modern
economy.
6. Make a case for government intervention in a mixed market economy in order to promote efficiency,
equity, and macroeconomic growth and stability.
A. What Is a Market?
1. A market economy has at its heart the actions of buyers and sellers who exchange goods and services with
one another. There is no higher authority that directs the behavior of these economic agents; rather, it is the
invisible hand of the marketplace that allocates final goods and services, as well as factors of production.
2. Buyers and sellers receive signals from one another in the form of prices. If buyers want to buy more of a
good, prices rise and sellers respond by supplying more to the marketplace. If buyers want to buy less of a
good, prices fall and sellers respond by supplying less to the marketplace. This is what is meant by the term
invisible hand. Prices rise and fall naturally as people change their behavior; there is no need for a higher
authority. Price signals tell sellers what to do with their production levels.
3. Market equilibrium occurs when the price is such that the quantity that buyers are interested in purchasing
is equal to the quantity that sellers are interested in supplying to the market.
4. The market mechanism allows an economy to simultaneously solve the three economic problems of what,
how, and for whom. Consumers indicate their preferences over what is produced through their willingness to
pay for a good or service. Firms respond to this by considering the mix of final products that will maximize
their own profits, that is, the difference between their revenues from sales and their production costs. This
must involve the question how, since firm production costs are determined by the prices of inputs and
technology used in the production process. Once these questions have been addressed, for whom is found to be
those consumers who have the money to pay for the goods and services produced.
money supply and interest rates) help to move an economy along a stable path, avoiding periods of excessive
inflation and unemployment.
V. HELPFUL HINTS
1. Over the past few years, monumental changes have taken place around the world that have led to the
development of market economies. The Soviet Union collapsed of exhaustion and Russia and the newly-
independent states are in the process of initiating market reforms. China now allows many small farmers to
exchange their products in markets. These large economies, formerly dominated by central economic planning,
found that the old (command) system did a poor job of alleviating the problems of scarcity.
2. Markets do not provide the only solutions to economic problems. In fact, some economies use goodwill
and/or command to motivate resources that are commonly owned by the group. For example, the kibbutz
system in Israel encourages collective consumption as well as joint ownership of the means of production.
These small, intentional communities have provided very efficiently and equitably (according to group
standards) for the needs of their citizens.
3. It is easy to assume that when a market economy is operating efficiently it is also providing an equitable
distribution of income and opportunity. However, this is not always the case. In the United States, some
people inherit wealth and property from their relatives, while others inherit nothing. Likewise, while some
people have the opportunity to attend Harvard University, others are not even able to complete high school
before they must enter the work force. These factors are not always determined by the market and at times may
lead to distributions that seem very unfair to some people.
These questions are organized by topic from the chapter outline. Choose the best answer from the options
available.
A. What Is a Market?
1. Markets can occur:
a. whenever buyers and sellers of the same product can communicate with one another.
b. only if buyers and sellers have some form of currency to use for exchange.
c. only if the government steps in and regulates the behavior of buyers and sellers.
d. all of the above.
e. none of the above.
2. If a commodity such as peanuts becomes overstocked, sellers will:
a. raise their prices in order to make up for the fact that sales are lower.
b. raise their prices in order to increase the demand for peanuts.
c. lower their prices hoping to lure additional buyers into the marketplace.
d. lower their prices in order to encourage competition from rival firms.
e. grow more peanuts next year to make up for losses this year.
3. A market equilibrium is defined as occurring when:
a. government has balanced the forces of demand and supply
b. the price is such that the quantity that buyers want to buy is equal to the quantity that sellers want to
sell.
c. price and quantity are equal.
d. prices are rising.
e. prices are falling.
4. The three economic problems of what, how, and for whom goods shall be produced apply:
a. mainly to totalitarian or centrally planned societies, in which the problem of planning arises directly.
b. only (or principally) to free enterprise or capitalist societies, in which the problem of choice is most
acute.
c. only (or principally) to less developed societies, since development alone is largely a question of
dealing with these three problems.
d. to all societies, regardless of stage of development or form of political organization.
e. to none of the above necessarily, since they are problems for the individual business firm or family not
for society.
5. There cannot be a problem of what goods to produce if:
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a. the supply of a productive resource is very small, so it must be devoted to the production of goods
selected from a set of essential necessities.
b. production has not yet reached the stage at which the law of diminishing returns begins to operate.
c. the supply of productive resources is sufficiently large to make possible the production of some luxury
goods.
d. each productive input is so specialized that it can be used only in the production of one good and no
other.
e. production can be carried on under conditions of decreasing or constant cost, rather than increasing
cost.
6. The “invisible hand” refers to:
a. the role of government in the marketplace.
b. a system of taxation that redistributes wealth from the rich to the poor.
c. the fact that individuals, pursuing their own self-interest, achieve the best good for all when operating
in a market economy.
d. a production system whereby each individual performs the task to which he or she is best suited.
e. a production system whereby each country produces the products that best suit each particular resource
base.
The following problems are designed to help you to apply the concepts that you learned in this chapter.
A. What Is a Market?
1. Determine whether the following events would lead to store shelves that are understocked or overstocked,
and explain the effect of this on prices in a market economy.
a. Flooding in the midwest destroys a large portion of the corn crop. Will store shelves tend to be
understocked or overstocked with corn? Prices will go (up / down).
b. Your college wins the NCAA basketball championship. Will bookstore shelves tend to be
understocked or overstocked with sweatshirts? Prices will go (up / down).
c. Scientists find that much of the popcorn sold at movie theaters is bad for our health. Will theaters
tend to be understocked or overstocked with popcorn? Prices will go (up / down).
2. Draw a circular-flow diagram in the space below, showing the interaction between households and firms in
goods markets and in input markets. Use your diagram to show how this market economy would answer the
what, how, and for whom questions that face all societies.
Figure 2-1
b. As this economy produces increasingly more military goods, what happens to the PPF? Carefully
explain. Given this information, why might you have predicted the eventual demise of the Soviet Union?
Explain.
d. The Federal Reserve takes actions to decrease the money supply, thereby increasing interest rates.
(Toward / Away from)
e. The government requires all auto manufacturers to install safety belts in newly produced automobiles.
(Toward / Away from)
f. The FTC breaks up Microsoft, on the grounds that the company has too much monopoly power.
(Toward / Away from)
Answer the following questions, making sure that you can explain the work you did to arrive at the answers.
1. For the past several decades, governments have been taking steps to preserve the environment. Recently, a
new policy initiative has emerged that uses basic economic concepts to provide incentives for polluters.
Markets have emerged in which pollution “rights” are traded between “owners” of these rights. Government
authorities establish maximum amounts of pollutants that firms can emit into the air on a region-by-region
basis. They then dole these rights out to firms in the area, who are allowed to emit pollutants only as long as
they own the rights to emit them.
a. Using this information, explain how markets for pollution rights emerge. How are property rights
established, and why is it important to establish these property rights?
b. Why might this policy fail to provide incentives for firms to limit pollution to the greatest extent
possible? Explain.
2. If money is not categorized as capital by economists, why do we use money in an economic system at all?
What purpose does it serve? Explain.
3. Discuss the pros and cons of promoting laissez-faire in an economic system. Would you be in favor of
such a policy? Why or why not?
4. Define what is meant by the term equity. Why is it difficult for economists to come up with a definitive
definition of an equitable distribution of resources? Explain.
5. Define what is meant by the term progressive taxation. How might this help to provide a more equitable
distribution of income?
3. a. Resources are not equally suited to the production of both commodities. Starting at point A in Figure
2-1, a relatively large amount of capital equipment is produced as society gives up military equipment.
However, as more and more capital equipment is produced, the resources that are left are less and less
suited to the production of them. Consequently, more and more military equipment must be given up.
b. As the Soviet economy produced more and more military goods, less and less capital equipment was
available for its firms. Furthermore, some of the resources that were being used to produce military goods
were much better suited to the production of other commodities. It became increasingly more difficult to
efficiently and equitably distribute the capital equipment, that was available. Finally, the economy
collapsed.
Figure 2-1
4. a. away from
b. away from
c. toward
d. away from
e. away from
f. away from
Cons: No program of economic stabilization; no provision for the production of public goods; less
consumer protection; no oversight of externalities.
4. Equity deals with fairness. Economists have difficulty with this concept because we all have different
tastes and preferences as well as different needs and abilities. Should individuals be rewarded according to their
efforts or according to their needs? The answer to this question entails subjective evaluation.
5. Progressive taxation occurs when the percent of income that is paid in taxes increases with increases in
income. The very wealthy would pay the highest percentage of their income in taxes. These tax revenues
could be redistributed by the government to the poorest families. This would make the distribution of
income more equitable.
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