ECO 2180 Chapter 2

freedom of enterprise

The freedom of firms to obtain economic resources, to use those resources to produce products of the firm's own choosing, and to sell their products in markets of their choice.

freedom of choice

The freedom of owners of property resources to employ or dispose of them as they see fit, of workers to enter any line of work for which they are qualified, and of consumers to spend their incomes in a manner that they think is appropriate.

economic system

a particular set of institutional arrangements and a coordinating mechanism—to respond to the economizing problem. A method of organizing an economy of which the market system and command system are the two general types.The economic system has to determine what goods are produced, how they are produced, who gets them, how to accommodate change, and how to promote technological progress.

Explain the operation of the "invisible hand" and why market economies usually do a better job than command economies at efficiently transforming economic resources into desirable output.

Competition, the primary mechanism of control in the market economy, promotes a unity of self-interest and social interests. As if directed by an invisible hand, competition harnesses the self-interested motives of businesses and resource suppliers to further the social interest. The command systems of the Soviet Union and pre-reform China met their demise because of coordination difficulties caused by central planning and the lack of a profit incentive. The coordination problem resulted in bottlenecks, inefficiencies, and a focus on a limited number of products. The incentive problem discouraged product improvement, new product development, and entrepreneurship.

buisnesses

Economic entities (firms) that purchase resources and provide goods and services to the economy.

households

Economic entities (of one or more persons occupying a housing unit) that provide resources to the economy and use the income received to purchase goods and services that satisfy economic wants.

market system

(1) An economic system in which individuals own most economic resources and in which markets and prices serve as the dominant coordinating mechanism used to allocate those resources; capitalism. Compare with command system. (2) All the product and resource markets of a market economy and the relationships among them.

laissez-faire capitalism

A hypothetical economic system in which the government's economic role is limited to protecting private property and establishing a legal environment appropriate to the operation of markets in which only mutually agreeable transactions would take place between buyers and sellers; sometimes referred to as "pure capitalism."

corporation

A legal entity ("person") chartered by a state or the federal government that is distinct and separate from the individuals who own it.

resource market

A market in which households sell and firms buy resources or the services of resources.

product market

A market in which products are sold by firms and bought by households.

command system

A method of organizing an economy in which property resources are publicly owned and government uses central economic planning to direct and coordinate economic activities; socialism; communism. Compare with market system.

creative destruction

The hypothesis that the creation of new products and production methods destroys the market power of existing monopolies.

circular flow diagram

An illustration showing the flow of resources from households to firms and of products from firms to households. These flows are accompanied by reverse flows of money from firms to households and from households to firms.

sole proprietorship

An unincorporated firm owned and operated by one person.

partnership

An unincorporated firm owned and operated by two or more persons.

market

Any institution or mechanism that brings together buyers (demanders) and sellers (suppliers) of a particular good or service.

medium of exchange

Any item sellers generally accept and buyers generally use to pay for a good or service; money; a convenient means of exchanging goods and services without engaging in barter.

money

Any item that is generally acceptable to sellers in exchange for goods and services.

Explain how the market system deals with risk.

By focusing business risks onto owners, the market system encourages the participation of workers and suppliers who dislike risk while at the same time creating a strong incentive for owners to manage business risks prudently.

Explain how the market system answers the five fundamental questions of what to produce, how to produce, who obtains the output, how to adjust to change, and how to promote progress.

Every economy faces five fundamental questions: (a) What goods and services will be produced? (b) How will the goods and services be produced? (c) Who will get the goods and services? (d) How will the system accommodate change? (e) How will the system promote progress? The market system produces products whose production and sale yield total revenue sufficient to cover total cost. It does not produce products for which total revenue continuously falls short of total cost. Competition forces firms to use the lowest-cost production techniques. Economic profit (total revenue minus total cost) indicates that an industry is prosperous and promotes its expansion. Losses signify that an industry is not prosperous and hasten its contraction. Consumer sovereignty means that both businesses and resource suppliers are subject to the wants of consumers. Through their dollar votes, consumers decide on the composition of output. The prices that a household receives for the resources it supplies to the economy determine that household's income. This income determines the household's claim on the economy's output. Those who have income to spend get the products produced in the market system. By communicating changes in consumer tastes to entrepreneurs and resource suppliers, the market system prompts appropriate adjustments in the allocation of the economy's resources. The market system also encourages technological advance and capital accumulation, both of which raise a nation's standard of living.

residual claimant

In a market system, the economic agent who receives (is claimant to) whatever profit or loss remains (is residual) at a firm after all other input providers have been paid. The residual is compensation for providing the economic input of entrepreneurial ability and flows to the firm's owners.

barter

The direct exchange of one good or service for another good or service.

competition

The effort and striving between two or more independent rivals to secure the business of one or more third parties by offering the best possible terms.

Differentiate between laissez-faire capitalism, the command system, and the market system.

Laissez-faire capitalism is a hypothetical economic system in which government's role would be restricted to protecting private property and enforcing contracts. All real-world economic systems have featured a more extensive role for government. Governments in command systems own nearly all property and resources and make nearly all decisions about what to produce, how to produce it, and who gets the output. Most countries today, including the United States, have market systems in which the government does play a large role, but in which most property and resources are privately owned and markets are the major force in determining what to produce, how to produce it, and who gets it.

dollar votes

The "votes" that consumers cast for the production of preferred products when they purchase those products rather than the alternatives that were also available.

Describe the mechanics of the circular flow model.

The circular flow model illustrates the flows of resources and products from households to businesses and from businesses to households, along with the corresponding monetary flows. Businesses are on the buying side of the resource market and the selling side of the product market. Households are on the selling side of the resource market and the buying side of the product market.

consumer sovereignty

The determination by consumers of the types and quantities of goods and services that will be produced with the scarce resources of the economy; consumers' direction of production through their dollar votes.

List the main characteristics of the market system.

The market system is characterized by the private ownership of resources, including capital, and the freedom of individuals to engage in economic activities of their choice to advance their material well-being. Self-interest is the driving force of such an economy and competition functions as a regulatory or control mechanism. In the market system, markets, prices, and profits organize and make effective the many millions of individual economic decisions that occur daily. Specialization, use of advanced technology, and the extensive use of capital goods are common features of market systems. Functioning as a medium of exchange, money eliminates the problems of bartering and permits easy trade and greater specialization, both domestically and internationally.

private property

The right of private persons and firms to obtain, own, control, employ, dispose of, and bequeath land, capital, and other property.

division of labor

The separation of the work required to produce a product into a number of different tasks that are performed by different workers; specialization of workers.

invisible hand

The tendency of competition to cause individuals and firms to unintentionally but quite effectively promote the interests of society even when each individual or firm is only attempting to pursue its own interests.

specialization

The use of the resources of an individual, a firm, a region, or a nation to concentrate production on one or a small number of goods and services.

self-interest

motivating force. That which each firm, property owner, worker, and consumer believes is best for itself and seeks to obtain.