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2 Markets, Governments, and Nations: The Organization of Economic Activity

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Learning Outcomes

After reading this chapter, you should be able to

• Identify the four types of productive resources, or factors of production, and the income paid to each for its role in producing goods and services.

• Understand the basic economic questions that must be addressed by every economic system.

• Use a circular flow model to show the relationships between firms and households in markets in an economy.

• Explain and give examples of the basic functions of government.

• Evaluate the benefits of specialization and exchange based on comparative advantage.

Section 2.1 Limited Resources

Introduction On March 23rd, 2018, Taco Bell surprised everyone in the field of economics by offering col- lege tuition benefits for all 200,000 of its employees, even the part-time employees. In addi- tion, the tuition bills of employees will be paid up front, moving Taco Bell ahead of Starbucks, previously considered to have the best tuition benefits, whose employees have to pay for tuition, take the class, and then submit for reimbursement.

But why would Taco Bell make these costly concessions to its employees? There are no stud- ies that show that as people take more college courses they become better Taco Bell employ- ees. Taco Bell has tapped into a key concept for this chapter, that of externalities.

An externality is the effect a transaction has on a third party who was neither the buyer nor the seller. A commonly discussed negative externality is second-hand smoke. A toddler whose parents smoke around her is neither the buyer nor the seller of the cigarettes, but she is still affected by the harmful smoke. On the other hand, a coworker can experience positive externalities due to other coworkers’ college education, even if he has never taken a course. Studies show that college-educated employees are less likely to be truant and absent, so the buyers (Taco Bell and the employees taking college classes) are affected, and the sellers (the universities) obviously profit from the arrangement, but others are also affected. For example, an employee can use the conflict resolution skills she learned from her online management course to help all of her coworkers, as well as her customers. Taco Bell believes in the power of positive externalities to help their company grow.

2.1 Limited Resources To examine the process of choice, we can begin by identifying the scarce resources that exist. The productive resources are divided into four broad categories: labor, land, capital, and entrepreneurship. All resources used to produce goods and services fit into one of these four categories, or factors of production. Goods are objects that people value. Services are tasks per- formed for people. For example, a hairstylist pro- vides a service of cutting a client’s hair; the scissors and styling products the hairstylist uses are goods.

Labor

Labor is the resource of production with which you are probably most familiar. It is the physical and mental work of human beings. The efforts of a factory worker, a professional basketball player, a university professor, and a financial manager are all labor.

Jack Hollingsworth/DigitalVision/Thinkstock

Why do you think services, such as hairstyling, are a limited resource? Which factors of production are being utilized here?

Section 2.1 Limited Resources

Wages are the payments labor receives for its productive services. Some labor is valued (and paid) more than other labor. Why? One reason is that some labor is more productive. Workers are born with different talents and abilities: Some are more intelligent; others are physically stronger or better coordinated; still others have artistic or musical ability. Laborers can also be made more productive by devoting money and time to improving their skills. Individuals invest in their labor skills by going to college, serving as apprentices, or practicing. Econo- mists refer to this development of labor skills as an investment in human capital. Human capital consists of knowledge and skills that increase labor’s productivity. A large part of wage differences can be explained by differences in human capital.

Land

The second resource is land. Land, to an economist, is not just rocks and soil but all natural resources that can be used as inputs to production. By this definition, land includes minerals, water, air, forests, oil, and even rainfall, temperature, and soil quality. One clear example is the land that farmers use to produce crops such as apples or avocados, but the irrigation of the crops would require water, which would also be considered a land resource. The payments made to this factor of production are called rent.

Capital

The third resource, capital, is defined as all resources used in production that are human inven- tions rather than resources found in nature. As a factor of production, capital includes tools, facto- ries, warehouses, and inventories. When you use a spatula to flip pancakes, the spatula is a capital resource in the production of breakfast. In common usage, capital resources are often confused with financial capital. Financial capital is money lent to individuals and firms to purchase real, physical capital. Economists reserve the term capital for tan- gible inputs to production, not for financial assets.

Capital, like land, receives a flow of income. The payments to capital are called interest. Interest is a payment for giving up present consumption to make resources available for the creation of more capital for future production. Investment is the act of adding to capital. Although the term investment is often used for activities such as buying stocks and bonds, to an economist the term means the creation of real, physical assets, such as machines, factories, or inventories, that can be used to produce other goods and services.

AP Photo/Mark Lennihan

Amazon CEO Jeff Bezos became the richest person in the world in 2018, with an estimated net worth of $112 billion. Microsoft founder Bill Gates came in second at $90 billion.

Section 2.2 Basic Economic Questions

Entrepreneurship

The last factor of production is entrepreneurship, which consists of the activities of combin- ing the other productive resources to produce goods and services, taking risks, and introduc- ing new methods and new products (innovation). Entrepreneurs combine other resources by buying or renting them to produce a saleable product. The reward for innovation, risk taking, and organization is profit.

Profit is difficult to measure in practice because it is whatever is left over after paying for land, capital, and labor. Accountants frequently count profit as the amount of money left after the bills are paid. However, this measure is likely to overlook such opportunity costs as the value of the owner’s labor (wages) or the return to the owner’s capital (interest).

Key Ideas: The Four Factors of Production

• Labor is paid wages. • Land is paid rent. • Capital is paid interest. • Entrepreneurship is paid profit.

2.2 Basic Economic Questions The process of choosing how to allocate scarce resources can be broken down into three broad economic questions:

• What goods and services will be produced and in what quantities? • How will they be produced? (That is, what methods of production and combinations

of inputs will be used?) • For whom will they be produced? (That is, who gets what share of the goods and

services produced?)

Different kinds of economic systems answer these three questions in different ways. How- ever, people in all economic systems are faced with the problem of how to allocate scarce resources among an unlimited number of wants.

The production possibilities curve introduced in Chapter 1 shows attainable levels and com- binations of outputs. It does not, however, explain how to choose among these combinations. What determines whether an economy is at one particular point on the production possibili- ties curve instead of another, and who makes that choice?

Section 2.2 Basic Economic Questions

The market provides at least a partial answer to the three basic questions in many societ- ies. A market is any setting in which buyers and sellers meet to exchange goods, services, or productive resources. A market system is an economic system that relies primarily on market transactions to answer the three basic economic questions.

What, How, and for Whom?

The what question asks exactly what mix of goods and services is to be produced—how many tons of corn, thousands of e-books, hours of entertainment programming, pairs of shoes, and gallons of milk will make up the total national output. It is a difficult enough question in the simple two-product world of the production possibilities curve. With millions of possible combinations of outputs, the what question is extremely complex. In a market system, the answer to the what question is determined by consumers, who “vote” in the marketplace by using their dollars to obtain particular goods and services. In other economic systems, other methods are used to determine what kinds of goods and services are produced and in what amounts.

A market economy may result in choices about the output mix that some economists or policy makers find peculiar or distasteful. Many policy makers may not share the public’s taste for rock videos, gambling palaces, country music, or skateboards. However, unless people’s con- sumption of these items can be shown to be harmful to others, a market society does not pass normative judgment on tastes. Markets produce what people want to buy.

The how question asks what input combination will be used to produce the chosen goods and services. Should levees be produced by combining many workers with a few units of capital or by a more capital-intensive method? Is it better to produce soybeans using a lot of machinery, intensely cultivating a few acres of land, or using more land and workers and relatively little capital? Should college students be taught in large classes by professors (highly skilled labor) or in small sections by teaching assistants (substituting less skilled labor)? Such questions must be answered in a systematic way. In a market system, prices guide suppliers and buyers of resources to decisions that maximize profits or minimize costs.

The for whom question asks who will get the goods and services produced and how much each person will receive. This is a way of asking which of many possible distributions of income will be chosen. Should the distribution be equal or unequal? Should an individual’s share be based on contributions to production, on need, or on some combination of the two? A pure market system answers this question directly: A person’s rewards depend on contributions to production. Other systems, including a mixed market system, use a mixture of guidelines to determine the distribution of income.

The answers to the three questions are not independent of one another. The distribution of income will determine whether there is more demand for bread and milk or luxury yachts. The production process chosen may determine the amount of each kind of output that can be produced.

Section 2.2 Basic Economic Questions

The Types of Economic Systems

Every society has to find a way to answer the three basic economic questions. The study of the different ways of organizing economic activity, or answering these questions, is called comparative economic systems. One way to classify economic systems is by the method used to answer the three basic economic questions. This classification identifies three broad types of economies: the traditional economy, the command (or planned) economy, and the market economy. Of course, no economy fits neatly into any one of these categories. All economies are mixed in that they all contain elements of traditional, command, and market processes.

The Traditional Economy A traditional economy answers the basic economic questions by tradition, or custom. That is, the answers are determined by how the questions have been answered in the past. What is produced is whatever parents have taught their children to produce on the basis of customs. A heavily traditional society is usually not highly sophisticated. Most of people’s efforts are devoted to production of food, clothing, and shelter. Tradition determines what kinds of food are grown, what kinds of clothing are made, and what kinds of houses are built. It also deter- mines what combination of these three is produced in any given period.

The techniques of production (how to produce) are also passed on, with little change, from one generation to the next. In many parts of Asia and Africa, the meth- ods of building houses and of farming have been the same for many generations. Tra- ditional societies also have established answers to the distribution question (for whom): They often have rules on how to divide the spoils of the hunt or the fruits of the harvest. Medieval Europe was a highly traditional society, with shares of crops assigned to various claimants. In such a traditional society, a person’s claim on society’s resources was determined primarily by status in the hierarchy, from a peasant up to a king. You may recognize elements of tradition that persist even in

modern industrial societies. An example of this can be seen in the country of Bosnia and Her- zegovina. Traditionally, Herzegovinians breed goats and sheep for the production of cheese and wool. Because of the country’s economic crisis in the early 2000s, many of Bosnia and Herzegovina’s citizens returned to these traditional ways of production.

AP Photo/Amel Emric

Many Bosnians have returned to traditional ways during economic downturns, seizing the chance to attract other people to buy their ecologically grown and produced food and wares.

Section 2.2 Basic Economic Questions

The Command Economy A command economy, or planned economy, answers the basic economic questions through central command and control. A central planning authority makes all decisions regarding what and how to produce. Individual production units receive detailed plans and orders that carry the weight of law. The question concerning income distribution is answered in the pro- cess of determining what and how to produce. The central planners also set wage rates and levels of production. This planning process was the primary method of organization in the former Soviet Union, as well as in China before the rapid movement toward market econo- mies in the late 1990s and early 2000s. Planned systems are disappearing very rapidly. North Korea and Cuba still make extensive use of central commands, but even these nations seem to be inching toward the use of markets to allocate goods. For example, following President Barack Obama’s visit to Havana in March 2016, the Cuban government began to allow cruise ships to dock at Cuban ports and changed several laws to attract more foreign investment (William Davidson Institute, 2016).

In any economy, people plan. That is, they think about the future and prepare for it. In a tradi- tional society, people plan for a future that will be much like the past. In a command economy, the government plans how to answer the production and consumption questions for society. This kind of planning is very different from the individual planning that goes on in a market economy.

The Market Economy The third type of economic system is the market economy. By definition, a market economy relies on incentives and the self-interested behavior of individuals to direct production and consumption through market exchanges. In practice, consumers are able to “vote” with their dollars in order to determine what is produced and sold in a market.

Suppliers primarily determine how to produce. Since suppliers are self-interested and seek to maximize their profits, they tend to combine resource inputs so as to produce a good or ser- vice at the lowest possible cost. The answer to the how question depends on the prices of pro- ductive resources. Suppliers will use more of abundant resources because they are relatively cheap. In China, for example, the booming population leads to labor being relatively cheap, so manufacturers in China may choose to have products made by hand, instead of using more expensive machinery.

Goods and services are distributed to consumers who have the purchasing power to buy them. Households that have more purchasing power (because they own more valuable pro- ductive resources) receive more goods and services. The quantity and quality of the labor skills an individual sells are the most important determinants of individual income. In 2017 about 51% of personal income in the United States was wages and salaries (Bureau of Eco- nomic Analysis, 2018). People with higher earnings have more “votes” in the form of dollars spent in the marketplace.

Section 2.2 Basic Economic Questions

One essential condition is the institution of legal rights to a specific piece of property, includ- ing the rights to own, buy, sell, or use it in specific ways; these rights are collectively known as property rights. In a command economy, almost all property belongs to the state. In a market economy, however, private property and property rights play an essential role. Markets will only function if individual buyers and sellers possess ownership rights to the goods and ser- vices they want to exchange.

In a market economy, productive resources are owned by individuals. The owners of capital will not invest unless they are certain that they can claim the ownership of that capital and the products that it produces. They also need to be assured that their capital and its interest will not be taken away by the state or by force or violence. Workers will not offer their labor for hire if their right to be paid cannot be enforced or if they know their earnings are likely to be stolen. What a market system needs, then, is a legal system that defines property rights and enforces them against any violations. Defining and enforcing property rights is an important function of government even in a pure market economy.

The Mixed Economy

Because of the advantages of the market system, even primarily traditional or command economies incorporate some elements of markets. Conversely, the pure market system is often modified to soften some of the harshness of pure capitalism.

The blend of tradition, command, and market decision methods varies, but most modern industrial countries, such as Canada, Japan, the United States, Australia, and the nations of western Europe, have mixed economies. In a mixed economy, the basic decision method is the market, but some economic choices are made by government. The goal is to leave eco- nomic decisions to the market when it works well but to intervene in the economy when the market outcome is not acceptable. On a macroeconomic level, a high rate of unemployment is an example of an unacceptable market outcome. On a microeconomic level, air pollution caused by coal-fired power plants is an example of an undesirable market outcome. In both instances, some people argue that the government should step in to correct the performance of the market and alter its results.

Governments are much more heavily involved in the economy in, for example, Poland, Swe- den, and France than in the United States and the United Kingdom. The differences in the degree of governmental involvement in economic decisions reflect variety in political sys- tems, national values, and historical experiences.

Comparing Economic Systems

One way to compare the workings of the three types of economic systems is to consider how each responds to change. Suppose an earthquake closes some copper mines, and the supply of copper is suddenly cut in half. A traditional economy would only use copper for jewelry and would probably have rules to ensure that the most respected members of the group had first use of any copper. In a command economy, government officials would decide which uses of copper had the highest priority and make sure that the available copper was distributed properly.

Section 2.3 The Circular Flow of Economic Activity

Contrast these processes with what occurs in a market economy. When the mines close and less copper is available, copper prices will rise. The higher price leads consumers to search for cheaper substitutes. It also attracts a sudden flow of imported copper or scrap copper to the market. The allocation of copper might not meet the traditional economy’s criterion of fairness or the command economy’s priorities. However, the market response is much faster. Substitution and increased supplies occur very quickly, with no need for the government to process and send information. A market system economizes on the amount of costly informa- tion needed to make production and consumption decisions.

The market system has advantages over command and traditional economies in flexibility and capacity for dealing with change. However, the market system also has some drawbacks. Economists often criticize the distribution of income that results from the workings of the market, which can create extremes of wealth and poverty, leading to the common saying “the rich get richer and the poor get poorer.” Market systems have also been criticized for encour- aging self-centered behavior at the expense of community interests.

Key Ideas: Comparing Economic Systems

All economies contain elements of traditional, command, and market processes.

• A traditional economy allows tradition, or custom, to determine the types and com- bination of goods and services produced in any given period.

• In a command (or planned) economy, a central planning authority makes all deci- sions regarding what and how to produce.

• A market economy allows individuals to direct production and consumption through market exchanges to determine which goods and services are bought and sold.

2.3 The Circular Flow of Economic Activity Chapter 1 discussed the use of models with simple descriptions from which wider conclu- sions and inferences can be made. One model that is often used to describe a mixed economy is the circular flow model. The circular flow model is a visual picture of the relationships between the resource market, in which income is earned, and the product market, in which income is used to purchase goods and services.

The Two-Sector Circular Flow Model

In a pure market economy, there are only two kinds of decision makers: households and firms. In reality, sometimes firms and households are one and the same. Family farms fit this description, as do some family-owned grocery stores, day-care centers, and home-based accounting services. To keep it simple, we will assume that households own all resources and that firms produce all goods and services. Firms and households interact in two types

Section 2.3 The Circular Flow of Economic Activity

of markets: the resource and product markets. As shown in Figure 2.1, households purchase goods and services produced by firms, creating a flow of dollars to firms in payment for these goods and services. The individual markets in which these exchanges take place, shown in the upper part of Figure 2.1, make up the product market. Firms buy resources from households (who own all the productive resources) in order to produce the goods and services they sell to the households. The flow of productive resources to firms generates an opposite flow of dol- lar payments (wages, rent, interest, and profits). The total of the individual markets in which these transactions take place, shown in the lower part of Figure 2.1, is the resource market.

Figure 2.1: Circular flow of income

Households purchase goods and services in the production market and supply labor, land, capital, and enterprise in the resource market. Firms buy the services of these inputs in the resource market and supply goods and services in the product market.

Go ods and services

Co ns

um er s

pend ing for goods and servicesP

ROD UCT MARKET

Labor, land, capital, and en

ter pr

is e

Wages, rent, interest, and pro

fit

RESOURCE MAR KE

The circular flow in Figure 2.1 is a highly simplified model of the way a market economy oper- ates. This model is a broad overview of the economy, and we will add some refinements to the model across the rest of this chapter.

Most of macroeconomics focuses on measuring and changing the sizes of the flows of output and income, represented by the sizes of the shaded arrows in Figure 2.1. Most of microeco- nomics is devoted to a closer look at the operation of the individual markets that make up the circular flow and at the behavior of individual decision makers (households, firms, and governments).

Section 2.3 The Circular Flow of Economic Activity

The Circular Flow Model With Savings, Government, and International Trade

We can make the simple circular flow model more realistic in several important ways. To keep things as simple as possible, however, we will limit the model to just the outer flow in each market. The diagrams will show the flow of income payments through the resource market to households and the flow of purchases through the product market to the business sector.

The first adjustment to our model is to relax the assumption that the flow of income from firms to households (the lower half of Figure 2.1) and the flow of payments from households to firms (the upper half of Figure 2.1) are equal. If firms pay out all of their revenues to house- holds, and households spend every dollar they receive on purchases of goods and services, then the flows will be equal. However, if households save part of their incomes, there is a leak- age out of the circular flow. If firms invest (buy new capital equipment), there is an injection into the circular flow. Either an injection or a leakage can change the size of the flow. Figure 2.2 shows a flow of savings out of the income stream and an injection of investment spending into the income stream.

Figure 2.2: Circular flow with saving and investment

If households do not spend their income, some of it will leak out of the circular flow in the form of savings. If business firms borrow in order to invest, their investments will be an injection into the circular flow.

Co ns

um er s

pend ing for goods and services

Payments to resou rce

Business borrowing

to invest

Saving

Investment

Section 2.3 The Circular Flow of Economic Activity

A second adjustment is to add a government sector. You know that local, state, and federal governments produce, or cause the production of, goods ranging from schools and libraries to missiles and post offices. Governments take part of household incomes in taxes—a leak- age out of the spending stream. They also purchase productive inputs from households—an injection, just like investment. Government plays an important microeconomic role because its actions affect the mix of goods and services produced and the distribution of output. At the macroeconomic level, government actions affect the amount of total production, as well as unemployment and economic growth. Figure 2.3 shows a circular flow diagram with a gov- ernment that collects taxes from households and purchases goods and services from firms. Even this model ignores some important government transactions, such as taxes on business, purchases of labor from households, and borrowing.

Figure 2.3: Circular flow with government

Government is a third decision maker in the circular flow model. It interacts with households and firms in collecting taxes from households and purchasing goods and services from firms. Here households have two leakages not spent on consumption. Firms have three customers for output: households (consumption), other firms (investment), and government.

Co ns

um er s

pend ing for goods and services

Payments to resou rce

Business borrowing

to invest

Saving

Investment

Government purchases

Taxes

Government borrowing

Wages— Government workers

Finally, the simple circular flow model describes a closed economy (one that has no interac- tion with the rest of the world). Most nations are affected by transactions with other countries, so Figure 2.4 adds one final element. Households purchase imported goods and services from the foreign sector (other nations). Firms sell exports to that sector. Imports are a leakage out of the spending stream. Why? Income earned within the country but spent on imports cannot be used to purchase consumer goods from the domestic business sector. Exports represent an injection of spending into the flow because the spending comes from outside the coun- try. Exports often represent a large part of sales and income, especially in small countries. Imports may provide a large share of total consumption. In the United States the percentage

Section 2.3 The Circular Flow of Economic Activity

of exports compared to total output was only 11.9% in 2016. In some smaller countries, this percentage is much higher. Mexico, for example, exported 38% of its output, and Hungary exported 89.5% of what it produced in 2016 (World Bank, 2018b).

Figure 2.4: Circular flow with a foreign sector

Still another source of production and buyer of output is the rest of the world, or the foreign sector. Sales to foreign buyers are exports, and purchases from foreign suppliers are imports.

C on

su me

r sp ending for goods and services

Payments to resou rce

Business borrowing

to invest

Saving

Spending for imports

Foreign spending

on exports

Investment

Government purchases

Taxes

Wages—

Government borrowing

Government workers

In Figure 2.4, the sizes of the arrows labeled “Spending for Imports” and “Foreign Spend- ing on Exports” indicate the size of the foreign sector, or the importance of consumers and suppliers in other countries. If the foreign sector is small, the economy is more like a closed economy. With a large foreign sector, an economy is more likely to affect and be affected by the rest of the world. It is more vulnerable to the effects of inflation or recession in other countries. Since exports are a large share of total output, when export sales fall, the impact is felt throughout the economy.

The larger its land area, population, and total output or income, the less dependent an econ- omy is likely to be on trade. Trade averages 20% to 40% of GDP across the broad range of all countries, but there is tremendous variety within this range. The percentage of exports compared to total output in 2016 was relatively low for large countries such as Brazil (12.5%) and Turkey (22%). Countries that are geographically isolated, such as Australia (18.9% in 2011), also tend to have a lower percentage of trade compared to total output because the cost of shipping is so high. At the other extreme, small countries that produce primary prod- ucts (agricultural or mineral) often have very high percentages of trade compared to total output. The small oil-producing nation of Bahrain exported 96% of its total output in 2016.

Section 2.4 The Economic Role of Government

The share of trade in total output is an indicator of how dependent a nation is on other nations. The higher the trade ratio between exports to total output, the more sensitive a country is to events in foreign markets and the more dependent it is on foreign sources of supply. The benefits of trade are substantial, but one of the opportunity costs of this interdependence is control for policy makers over their own economic fate.

The government sector and the foreign sector are two very important additions to the circu- lar flow model. The government is what makes the economy a mixed economy, where some decisions are made outside the market. The foreign sector makes the economy an open rather than a closed one; actions by the three inside decision makers (households, businesses, and government) will have very different effects from what would occur in a closed economy. We will consider each of these two sectors in turn.

Key Ideas: Components of the Circular Flow Model

The circular flow model illustrates the relationships between the resource market and the product market.

• Households purchase goods and services produced by firms. • Firms buy resources from households. • Governments receive income in taxes from households, purchase productive inputs

from households, and purchase goods and services from firms. • Households purchase imported goods and services from the foreign sector (other

nations).

2.4 The Economic Role of Government All markets work in basically the same way in any economy, as you will see in Chapter 3. Supply and demand determine prices and quantities. In some economies or for some kinds of exchanges, however, the market may not be allowed to perform this function. Then some other decision-making process must be used to answer the three basic economic questions.

The most common method other than the market is to allow choices concerning the use of resources to be made by politicians or other agents of government. The kinds of decisions made through governments and the kinds made through the private sector vary among nations. In the United States health care was largely private until the Affordable Care Act of 2010, with expanded government funding for people who are elderly and people who are poor through Medicare and Medicaid. In Canada health care is publicly financed but privately provided. In most European countries health care is both paid for and provided by govern- ment. Some governments (such as Sweden) use taxes and social welfare programs to greatly modify the market distribution of income. Others (such as Japan) do very little to change the distribution of income that results from market decisions.

Section 2.4 The Economic Role of Government

In the United States most allocation decisions are made through the market. However, there are some things that the market cannot do or cannot do well. Many economists argue that the market does not do a very good job of addressing problems such as poverty, pollution, inflation, unemployment, and the market power of large firms. It is also difficult for private markets to provide enough of certain types of goods and services, such as defense, education, and sewer systems.

Recall that a market system requires clearly defined property rights. That is, someone has to decide who owns what goods and services and to define their rights to use and trade those goods and services. The market cannot define and enforce property rights very well, so this role is usually assigned to governments. Citizens in most modern mixed economies cannot legally drive a car without a license, park in a space reserved for people with disabilities with- out a sticker, or build a fast-food restaurant in a neighborhood zoned as residential. These rules represent government restrictions on property rights. An unrestricted market would allow people to do all of these things, whether or not they were considered desirable by the majority. Even in a pure market economy, government is needed to establish and protect property rights.

The activities of government are grouped into three categories: allocation, redistribution, and stabilization. Stabilization and redistribution are conducted primarily through govern- ments in all economic systems. Allocation is a microeconomic activity that is shared by the government and the market to different extents in different systems. Much of the dispute over what government should or should not do relates to its allocation activities. Also, much of the difference between market and command economies involves how allocation is divided between the market and the agencies of government.

Global Outlook: Privatization in China

The division of economic activity between public and private spheres in a mixed economy is not fixed. In wartime, the share of economic activity commanded by government increases. Also, when there are changes in citizens’ preferences or political philosophy, government’s share of total dollars spent may rise or fall in response. For most western economies, there has been a significant upward trend in the share of government as a percentage of total spending. In the past few decades, however, several mixed economies have tried to reverse that trend and reduce the share of economic activity controlled by government. In particular, there has been a move to spin off some allocation activities of government to the private sector. This change is called privatization. In China, for example, a large part of the economic transition consisted of shifting activities from government to the private sector.

Privatization can mean a variety of things. It may mean that the government continues to provide a service—for example, garbage collection—but is no longer the producer of that service. Instead, the government collects taxes to pay for the service but contracts with a private firm to actually perform it. Alternatively, the government may get out of the business of providing a service altogether. It will either leave provision completely to the private market or limit its role to subsidizing some buyers or producers. The privatization movement has been an important episode in the continuing search for balance between the public and private sectors.

Section 2.4 The Economic Role of Government

The Allocation Function

Allocation refers to any government activity that affects the quantity and quality of goods and services produced (that is, anything that affects the answer to the what question). Allocation activities in a market-based mixed economy may include providing public education, such as funding education from kindergarten through 12th grade in the United States, or subsidizing higher education as in Argentina and Denmark. Allocation activities may also involve regula- tions, such as taxing cigarettes, limiting factory and auto emissions, and setting safety stan- dards for cars. In a command economy, the array of government allocation activities is much broader. Some, maybe even most, allocation activities also affect the answer to the for whom question because they increase the incomes of some firms and individuals at the expense of others.

Public Goods and Positive Externalities In mixed economies, allocation activities are usually assigned to the public sector only when the good or service is considered a public good or when its production or consumption cre- ates substantial external effects. We will explore each of these criteria in turn.

Economists define public goods as those goods that are nonrival in consumption and not subject to exclusion. What do these technical phrases mean? Nonrival means that a good or service is not used up in consumption. Sunsets and lighthouses are both nonrival in consump- tion. The fact that you are watching a sunset leaves no less sunset for someone else to enjoy. Lighthouses may be used by numerous ships simultaneously as they reach the shoreline, without interrupting the use of the lighthouse by any other ship.

It would be challenging to exclude people from enjoying a beautiful sunset. On the other hand, if a good is excludable, that means that nonpayers, or free riders, can be kept from consuming it. Free riders are people or firms who consume public goods without contributing to the cost of their production. In addition to sunsets and lighthouses, national defense and mosquito spraying are examples of services for which it is very difficult, or at least expensive, to exclude free riders. Because nonpayers cannot easily be excluded, there is not much incentive for a self-interested private firm to produce such goods and services.

The term public goods could even be extended to include goods with weak rivalry or high costs of exclusion. Examples of such “almost” public goods include firefighting, education, and highways. In all these cases, benefits spill over to nonpayers. These spillover benefits to third parties are called positive externalities. Where there are such positive effects, the private market may not produce enough of the good or service because some who benefit can free ride. Note that this broader group of almost public goods can imply an expanded role for government. In fact, all of the services mentioned have at some point been produced in the private sector. Volunteer fire departments in some rural areas still will not put out fires in nonsubscribers’ homes. Higher education in the United States is provided by both the public and private sector. Private toll roads were the earliest form of highways in New England, and toll bridges are still common today.

Keep in mind that the concept of public goods is different from that of goods that are publicly provided. Local and state governments and the federal government may supply goods that are

Section 2.4 The Economic Role of Government

not public goods as we have defined them here. Golf courses are a good example—although some are supplied by the government, many of these require membership or a fee to play. It is also important to note that some goods might be called public even though they are decid- edly private. Public television and public radio are good examples: They refer to themselves as public, but almost all their funds come from private donations. There may be small public subsidies, but private fund-raising efforts pay for public television.

Negative Externalities When people or firms consume certain goods or engage in certain activities, they pass some of the costs of production or consumption along to others. These costs are negative externalities. Those who create noise, litter, hazards, and pollution often do not bear the full cost. If the negative externalities are strong enough and widespread enough, they may constitute public bads. These are negative effects that have an impact on everyone to some degree. Public bads are the opposite of public goods and include broad negative effects such as global warming, depletion of the ozone layer, and extinction of endangered species. Critics of the pure free market argue that many negative externalities and public bads are produced if all decisions are left to private markets and individuals.

The Scope of Allocation by Government Most economists agree that the government does have some responsibility to produce public goods, to encourage the production of goods with positive externalities, and to discourage the production of negative externalities and public bads. But the lines are drawn differently by different individuals within any nation. They are certainly drawn very differently in differ- ent countries. How big do spillovers have to be before government gets involved? Does the government itself have to produce public goods, or can their production be contracted out to the private sector or encouraged through subsidies? Do negative externalities have to be addressed by prohibitions or standards, or can taxes and fines do the job? An individual’s or a nation’s answers to these questions will reflect certain underlying values and ideas about the relative importance of efficiency, equity, and freedom. The answers to these questions also delineate the lines of controversy in almost all debates about public policy.

Figure 2.5 shows a spectrum from public bads through goods with negative externalities to private goods and then to goods with positive externalities, ending with public goods. In almost all economies, it is agreed that the two ends of the spectrum call for government intervention to promote public goods and deter public bads. It is also fairly generally agreed that the market works best in the middle of the spectrum, producing and distributing private goods and nearly private goods. Nations disagree on where to draw the lines on either side of the middle, dividing the private from the public sphere.

Stuart Westmorland/Design Pics/Superstock

The Pebble Beach Golf Links course is an example of a publicly provided good; it’s publicly owned, but if you want to play on this world-class course, you need to pay the fee.

Section 2.4 The Economic Role of Government

Figure 2.5: Public goods, private goods, and public bads

Goods and services fit on a spectrum from pure public goods, to private goods, and then to goods that cause negative external effects to some parties. At the far end of the spectrum are activities that cause widespread public bads.

PRIVATE GOODS

PUBLIC BADS

Goods with negative

externalities

Acid rain Ozone depletion

Noise and litter Oil spills

Cigarette smoke

Food Clothing

Automobiles

PUBLIC GOODS

National defense Mosquito spray Prenatal care

Seat belts/air bags Fire protection

Education

Goods with positive

externalities

The Redistribution Function

The distribution of income in a market economy is based on each person’s contributions to production. There is no denying that the distribution of income determined by the market is quite unequal. Some people are very wealthy, and others are very poor. One way in which economies differ greatly is the extent to which the political process is involved in redistribu- tion. Redistribution means taking income from one group and giving it to another through taxes and transfer payments.

In any economy, when the government taxes individuals with high incomes, they have less incen- tive to work, save, and invest to increase output in future years. On the other hand, some indi- viduals cannot earn an income through the market. They may be too old, too young, sick, or unable to find employment for other reasons. Some people may work as hard as they can with the skills and resources at their disposal but still not earn enough to get by. There is some private redistribution, but private charity itself is subject to a free-rider problem. (Many people will not contribute because they know others will.) Such free-riding behavior makes income redistribu- tion more or less a public good that falls within the domain of government.

How much income should be redistributed? To whom should it go? How can redistribution be managed to minimize the negative effects on work incentives? These are difficult questions to answer. In general, there is more redistribution and greater equality of income in countries at the middle of the spectrum, with more mixed economies, than in countries at either the com- mand or the market extreme.

In the United States, for example, transfer payments are income received by individuals with- out any work being done; they take the form of Social Security benefits, food stamps, and wel- fare payments. Taxes that collect relatively more from people who are rich than from people who are poor, such as the U.S. federal income tax, mean that people who are rich pay more than do people who are poor for the same level of public services. This difference is a form of redistribution.

These transfer payments are primarily financed by the federal government rather than state governments. The states administer the programs and pay part of the cost. Redistributing income at the federal level makes it possible to reduce inequality between rich and poor

Section 2.5 The Role of the Foreign Sector

states, as well as between rich and poor individuals within states. In any economy, however, how much redistribution is enough, from whom it should come, and to whom it should go are very difficult policy questions.

The Stabilization Function

The last and most recently developed task of government is stabilization. Stabilization refers to government policy actions to reduce changes in output, employment, and prices. Market economies tend to go through severe ups and downs in output, employment, and prices, as seen in recent history. It is now clear, however, that unemployment and inflation are problems for command economies such as North Korea as well.

Stabilization is mainly a macroeconomic function. However, the ways in which stabilization policies are carried out also affect the mix of goods produced (allocation) and the distribution of costs and benefits (redistribution). Government attempts to stabilize the economy consist of increasing spending or cutting taxes to increase output and employment, or cutting spend- ing and increasing taxes to control inflation. In addition, changes in the money supply are used to expand or contract economic activity.

Economists disagree about how stable a market economy would be if it were left alone. His- torically, in the U.S. economy (and most market economies), there have been periods of high unemployment combined with low inflation or occasionally even deflation (falling price level). These downturns have alternated with periods of more rapid inflation (increasing price level) and lower unemployment in a cyclical pattern. Although such cycles have been less severe since World War II, the most recent recession of 2007–2009 demonstrated that the need for stabilization is still present even in today’s economy.

Key Ideas: Types of Government Activities

Government economic activities can be grouped into three categories: allocation, redistribution, and stabilization.

• Allocation activities may include producing public education, subsidizing higher education, and building highways.

• Redistribution is when the government taxes individuals with high incomes and gives that money to another group through transfer payments.

• Stabilization refers to policy actions aimed at reducing ups and downs in output, employment, and prices.

2.5 The Role of the Foreign Sector The last of the four sectors is the foreign sector. All nations engage in trade with other nations to some extent because there are goods and services they cannot produce for themselves or can produce only at a very high cost. In most nations, there is also some inflow and out- flow of the productive resources—labor, capital, land, and entrepreneurship. Some nations,

Section 2.5 The Role of the Foreign Sector

including the United States, allow goods and resources to flow relatively freely across their borders. Others, such as China and Russia, restrict the movement of one or both with tariffs, quotas, immigration restrictions, capital controls, and exchange controls.

The Benefits and Costs of International Trade

In general, a nation benefits from trade in both goods and resources. Trade enables house- holds to consume goods that are not produced domestically or would be much more costly to produce there. Trade enables firms to produce for larger markets, often lowering their aver- age costs of production. Trade also forces firms to respond to competitors in other countries that are producing products that are cheaper, more appealing, or safer. A flow of labor or capital may help a country overcome its shortages in certain resources.

Those who work for or own firms whose products compete with imports, as well as work- ers who compete directly with immigrant workers, may not have a positive attitude toward such trade. These groups are likely to lobby for tariffs and other forms of protection in order to shield themselves from the effects of foreign competition. In addition, an economy that depends on international trade to market its products or supply needed goods and services will be affected by the actions of other countries. Interdependence with other countries reduces the amount of control that a government can exert over domestic economic activities.

For a nation as a whole, however, there are substantial gains from trade with other nations. Let us explore one of the main benefits of such trade, the gains that result from specializing on the basis of comparative advantage.

Specialization and Comparative Advantage

A major benefit of international trade is that it permits a nation to go beyond its production possibilities curve without acquiring more resources or improving technology. A nation can attain larger combinations of output through specialization and exchange. Specialization, or the division of labor, means that individuals will produce more than they intend to consume of one or more items and will trade the excess for other things they want.

Specialization allows individuals to take the fullest advantage of their unique talents and skills. Some people who are strong and agile can become professional athletes. Some people who are intelligent and gifted talkers can become lawyers. Specialization allows individu- als to concentrate on what they do best and to produce more than they could if they tried to engage in a variety of production activities. For people with very valuable specialized skills, such as basketball stars or brain surgeons, the opportunity cost of using their time for other purposes is very high. Think about the value of the time brain surgeons spend when cooking their own dinner or mowing their lawn!

Nations, states, and regions also specialize. The phrase banana republic used to refer to small Central American countries that were heavily specialized in producing bananas for export. These countries used the earnings from bananas to import and consume a wide variety of products that they did not produce. Other small countries are highly specialized in oil, coffee,

Section 2.5 The Role of the Foreign Sector

cocoa, sugar, and other agricultural products and raw materials. Within the United States pine- apples come from Hawaii, oranges from Florida, avocados from California, corn and wheat from the Midwest and plains states, and peaches from Georgia and South Carolina. Nations, states, and regions also specialize in certain types of goods and services. Japan is famous for small cars and electronic products, Switzerland for watches and banking, and France and Italy for their fine wines.

By specializing, individuals, regions, and nations can produce greater total output without any increase in resources or breakthroughs in tech-

nology. Thus, specialization improves a nation’s standard of living. Small countries especially can consume more goods and enjoy a wider range of goods and services through specializa- tion and trade than if they were limited to what they produced.

Rudenkoi/iStock/Thinkstock

For centuries Switzerland has specialized in watchmaking. Even today Swiss watches are world renowned.

Policy Focus: The Problem With Level Playing Fields

The one policy issue that almost all economists agree on is the benefit of free trade based on the principle of comparative advantage. Yet free trade is often not a politically popular position. Many politicians propose the extension of free trade agreements to foreign countries. Take the North American Free Trade Agreement, designed to dramatically increase international trade between the United States, Mexico, and Canada. The debate was heated. The agreement was negotiated during the George H. W. Bush administration and narrowly enacted by Congress in 1993 with support from President Bill Clinton.

The arguments against free trade are usually couched in terms of wanting all people in all countries to be on a “level playing field.” In fact, during the 2008 presidential campaign, candidate Hillary Clinton said, “We are the best traders in the world, but we are tired of being treated like patsies. We are going to have reciprocal trade, or we’re not going to let our markets be open when other markets are not” (Postman, 2008).

There are several policy problems with the concept of a level playing field. First, there is the political problem. When trade takes place, some people (the ones who would have had the business in the absence of international trade) in both countries are hurt. But as we saw, the aggregate benefits exceed the costs. The level playing field argument is a political effort by those who would be damaged by international trade to get government protection. For example, the United Automobile Workers may ask the government for protection from foreign automakers. Second, you should also keep in mind that there is no such thing as a level playing field. Mexico may have cheap labor, but the United States is rich in natural resources. Finally, the most important point about the level playing field argument is that our theory tells us that even if the fields are not level, both countries still gain from specialization and trade.

Section 2.5 The Role of the Foreign Sector

Specialization and Exchange The benefits of specialization require that people or nations engage in exchange. If you choose to specialize, you will have to engage in trade because you will give up producing other goods and services that you need. If you are concentrating on what you do well, you do not have time to spend cutting your own hair, growing your own vegetables, or repairing your own car. You certainly do not have time to build your house or manufacture your car! One thing that distinguishes modern industrial societies from developing countries is the extent of special- ization and exchange. The average American produces very little of what he or she consumes. Instead, individuals specialize in one or two products or services and purchase everything else in the market.

Comparative Advantage How do individuals, regions, or nations decide what products to produce for exchange? Sometimes the answer is obvious, determined by climate or other resources. In general, the answer lies in the principle of comparative advantage. This principle states that each per- son, group, or country should specialize in that product or service for which the opportunity cost of production is lowest. If this principle is followed, the total output of a group of people, an entire economy, or for that matter, the entire world will be maximized. Higher total output will result, with no increase in resources or improvement in technology.

Figure 2.6 illustrates comparative advantage using two linear production possibilities curves. Both Milo and Carmen can produce various combinations of cookies and hamburgers with their available resources, as the curves illustrate. Before specializing, Carmen is producing 30 hamburgers and 10 dozen cookies a month for her own consumption (point A). Milo is producing 10 hamburgers a month and 40 dozen cookies for himself (point R). Carmen, who has had some experience working in a restaurant, is better at making hamburgers. Each ham- burger she makes requires that she give up production of only half a dozen cookies. Milo’s hamburgers cost him 2 dozen cookies each. Carmen has a lower opportunity cost for ham- burgers, which means that Milo must have a lower opportunity cost for cookies. It seems they should specialize and trade.

If they decide to specialize, Carmen will produce 50 hamburgers (point B). Milo will turn out 60 dozen cookies (point S). Total output increases by 10 hamburgers and 10 dozen cookies. All that remains is to divide up the gains. One combination that makes both better off is to split the increase equally. Thus, Carmen consumes at point C and enjoys 35 hamburgers and 15 dozen cookies. Milo consumes at point T, with 15 hamburgers and 45 dozen cookies. Both have gained, because they are consuming more than before. There is more total output with- out any new resources or improvement in technology!

Section 2.5 The Role of the Foreign Sector

Figure 2.6: Specialization and exchange

When Carmen and Milo specialize, total output increases from 40 hamburgers and 50 dozen cookies to 50 hamburgers and 60 dozen cookies. After exchange, both can consume more than before. Carmen is at point C instead of A, and Milo is at point T instead of R.

Hamburgers/ month

0 0

10 15

40 45 60

10 15 25 Dozens of cookies/month

Dozens of cookies/month

Carmen

S R

Milo

Key Ideas: The Benefits of Specialization and Trade

• All nations engage in trade with other nations to obtain goods and services they can- not produce for themselves or can produce only at a very high cost.

• A nation can attain larger combinations of output through specialization and exchange.

• The principle of comparative advantage states that each person, group, or country should specialize in that product or service for which the opportunity cost of pro- duction is lowest.

• If the principle of comparative advantage is followed, the total output of a group of people, an entire economy, or the entire world will be maximized.

The principle of comparative advantage means that both trading partners gain when individ- uals and nations specialize in the products for which their opportunity cost is lower and trade for what others produce more efficiently. Comparative advantage is the basis of all trade, not just international trade.

Conclusion

Conclusion Suppose you were hired by Raúl Castro to advise him on how he should organize produc- tion in Cuba. What would you advise his government to do, and what things should he let markets do? What goods should the government produce or subsidize, if any? Should the Cuban people be allowed to buy goods from foreign firms? How should Castro decide what goods should be imported and what goods should be exported? Transitioning the Cuban economy appears to be very complicated. The concepts in this chapter should have helped you develop an understanding of how countries such as Cuba face these economic ques- tions. You have a better understanding of the problems he faces. Trying to gradually transi- tion a planned economy that did not engage in international specialization and exchange is not an easy task. It seems clear that the Cuban leader will not adopt a pure market economy, but how much government planning should he retain in the system? What is the appropriate size of the public sector? Perhaps it is better to ask Castro how much market interaction he wants to introduce and how fast.

Key Ideas

1. Productive resources consist of labor, land, capital, and entrepreneurship. Labor receives wages, land receives rent, capital receives interest, and entrepreneurship receives profit.

2. Every economy must address three basic economic questions: what to produce, how to produce it, and for whom to produce it.

3. A traditional economy answers the basic economic questions by tradition, or custom. In a command economy, a central planning authority makes all decisions regarding what and how to produce. A market economy relies on incentives and the self-interested behavior of individuals to direct production and consumption through market exchanges. Consumers vote with their dollars and determine what is produced. In different degrees, industrial nations have tried to answer the basic economic questions by using mixed economies, where the market is the primary method but with government officials often intervening in the marketplace in an attempt to improve economic performance.

4. The circular flow model is a useful overview of the relations among resources and products in a market economy. The basic model shows the interactions of house- holds and businesses in the resource and product markets. More realistic versions add savings and investment, government, and a foreign sector.

5. There are some necessary functions that the market cannot perform or cannot per- form well. These include defining and protecting property rights, providing public goods and correcting for external effects, bringing about a more equal distribution of income, and stabilization. Allocation by government includes not only the production of public goods and the reduction of public bads but also any activities that affect private decisions about production and consumption. These activities include impos- ing taxes, providing subsidies, and enacting regulation. Different societies make different choices about how much allocation is carried out by government. Redis- tribution changes the unequal distribution of income that results from the market. Redistribution occurs mainly through taxes and transfer payments, but any action of government will have redistributive effects. Stabilization refers to the activities of government aimed at creating full employment, stable prices, and a satisfactory rate

Conclusion

of economic growth. These actions include changes in taxes, transfer payments, and spending, as well as changes in the size of the money supply.

6. International trade in goods, services, and resources benefits both trading partners. Some workers and firms in a nation experience losses because of foreign competi- tion. The gains usually exceed the losses, but the losers may succeed in persuading the government to restrict trade for their own protection. Individuals and nations can gain a higher standard of living with the same resources and technology if they engage in specialization and exchange. Total output will be larger if individuals, regions, and nations produce those goods for which their opportunity costs are low- est and trade for other things. This is the principle of comparative advantage.

Critical-Thinking Questions

1. Is your college education an investment in human capital? What is the opportunity cost of your degree?

2. How are macroeconomic problems handled in a mixed economy? 3. In what ways are resource markets and product markets similar? In what ways are

they different? 4. List all the leakages and all the injections you have observed in circular flow

diagrams. 5. Which of the following institutions or actions represent traditional, command, or

market processes? a. the military draft b. the volunteer army c. encouraging daughters to become teachers and nurses d. requiring women to be teachers and nurses e. offering financial incentives to anyone who becomes a teacher or nurse f. five generations of farmers tilling the same land g. prohibiting the sale of marijuana h. taxing the sale of alcoholic beverages

6. Classify each of the following government actions as primarily allocation, redistribu- tion, or stabilization: a. cutting taxes to end a recession b. making Social Security payments to the elderly c. paying farmers not to produce corn d. putting restrictions on the amount of sulfur dioxide that factories are allowed to

emit into the air e. buying paper shredders for government offices

7. Why is specialization necessary for exchange, and vice versa? 8. Angela and Jose have been assigned the tasks of filing folders and grading papers.

Angela can file 50 folders an hour and grade 20 papers. Jose can file 25 folders per hour and grade 25 papers. The total output for these two work–study students is to file 200 folders and grade 100 papers. How long will it take if they divide the task equally? How long will it take if they specialize based on the principle of comparative advantage? How much time do they gain by specializing?

9. In Question 8, what is Angela’s opportunity cost for filing in terms of grading not done? What is Jose’s? How does this information help you determine comparative advantage?

Conclusion

10. Use the information in the table on the production of bushels of peaches and toma- toes in two countries, Upland and Downland. Plot a pair of production possibilities curves like those in Figure 2.6. Before trade, each country is producing 20 bushels of peaches and 30 bushels of tomatoes. Locate the countries’ initial production combinations on the graphs. Determine who should specialize in what, locate the production points after specialization, and determine how much the total output will increase.

Upland Downland

Peaches Tomatoes Peaches Tomatoes

40 0 50 0

30 15 40 10

20 30 30 20

10 45 20 30

0 60 10 40

0 50

11. Suppose you own a farm with buildings and machinery, all five members of your family work on the farm, and you take the risks and manage the production. Identify all the productive resources involved and classify them correctly.

12. What should be the role of government in providing education? Should it produce, subsidize, or get out of education altogether? Why do you suppose that education through the 12th grade is “free” (actually paid for through taxes) but only subsidized beyond that level? Does it have anything to do with who gets the benefits?

13. Can you find examples of services produced in the public sector in your area that are produced in the private sector elsewhere, or vice versa? Can you explain why the choice might not be the same in different sections of the country or in communities of different sizes?

14. Where would you put each of the following items on the spectrum in Figure 2.5? Would you expect any of them to be produced by government as opposed to being public goods? Why? a. hospital wastes that wash up on beaches b. noise from a student apartment complex that bothers the neighbors c. highways d. holiday decorations that make a house more attractive e. flu shots

15. Individuals as well as nations have comparative advantages, which can change. How will going to college and getting a degree change your comparative advantage?

Conclusion

Key Terms allocation Any activities by a government or its agents that affect the distribution of resources and the combination of goods and services produced.

capital The durable inputs into the produc- tion process created by people. Machines, tools, and buildings are examples of capital.

circular flow model A visual repre- sentation of the relationships between the resource market (in which income is obtained) and the product market (in which income is used to purchase goods and services).

command economy An economy in which the three basic questions are answered through central planning and control (also called a planned economy).

comparative economic systems The study of the different ways of organizing economic activity.

entrepreneurship Combining the produc- tive resources of land, labor, and capital to produce goods and services; taking risks; and introducing new methods and new products (innovation).

free riders People or business firms that consume collective goods without contribut- ing to the cost of their production.

goods Objects that people value.

human capital The investment made to improve the quality of people’s labor skills through education, training, health care, and so on.

interest The return to capital, one of the productive resources.

labor The physical and mental exertion that human beings put into production activities.

land Natural resources that can be used as inputs to production.

market A place where buyers and sellers meet to exchange goods, services, and pro- ductive resources.

market economy An economy in which the three basic questions are answered through the market by relying on self-interested behavior and incentives.

mixed economy An economy in which the three basic questions are answered partly by market forces and partly through government.

negative externalities Harmful spillovers to third parties that result from production or consumption of certain goods.

positive externalities Spillover benefits to third parties (free riders) that result from production or consumption of certain goods.

principle of comparative advantage The idea that output will be maximized if people specialize in producing those goods or services for which their opportunity costs are lowest and engage in exchange to obtain other things they want.

product market The set of markets in which goods and services produced by firms are sold.

profit The return to entrepreneurship, one of the productive resources of production. Profit is whatever remains after all other resources have been paid.

property rights The legal rights to a spe- cific piece of property, including the rights to own, buy, sell, or use in specific ways. Mar- kets can exist and exchanges can occur only if individuals have property rights to goods, services, and productive resources.

Conclusion

public bads Negative external effects of production or consumption that impact a large number of individuals; for example, acid rain.

public goods Goods that are nonrival in consumption and not subject to exclusion.

redistribution Actions by government that transfer income from one group to another.

rent The return to land, one of the produc- tive resources.

resource market The set of markets in which owners of productive resources sell these to producers.

services Tasks that are performed for people.

specialization Limiting production activi- ties to one or a few goods and services that one produces best in order to exchange for other goods.

stabilization Actions by the government to reduce changes in output, employment, and prices.

traditional economy An economy in which the three basic questions are answered by custom, or how things have been done in the past.

wages The return to labor, one of the pro- ductive resources.