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Fascinating economy
Larissa Zaplatinskaia


This book is an academic course in international economics for university students. The study of economics is important because the economy – global, national, local, and personal – effects what you do every day. Economics influences the work you do, where you live, what you eat, how you dress, whether there is gas available for your car, and more. Economics also influences government policy and international relations including wars.





Fascinating economy



Larissa Zaplatinskaia



© Larissa Zaplatinskaia, 2020



ISBNВ 978-5-0051-9933-1

Создано в интеллектуальной издательской системе Ridero




ChapterВ 1



You may never have thought ofВ it this way, but inВ some ways, economics is like aВ game. Games have players and rules. Games involve decisions and actions, and they always have aВ goal. The same is true about economics.



Still, there are some differences. InВ games, you typically get toВ decide whether you want toВ play. But no one ever asks you if you want toВ play the game ofВ economics. InВ this game, you play whether you want toВ or not. That is because the game ofВ economics is going on all the time. It is played at every second ofВ every day inВ all parts ofВ the world.



Since you are already playing the game ofВ economics, you should know what kind ofВ game it is and learn the rules. That way you can play it as well as possible.




Introduction


The study of economics is important because the economy – global, national, local, and personal – effects what you do every day. Economics influences the work you do, where you live, what you eat, how you dress, whether there is gas available for your car, and more. Economics also influences government policy and international relations including wars.



Understanding the basics ofВ economics will help you make good personal financial choices and will help you make wise environmental and political decisions, as well.



We will start byВ learning that economics is not aВ collection ofВ В«otherВ» people but aВ complex system inВ which every individual has roles and goals.



We will also explain the four fundamental questions ofВ economics and how, depending on the way these questions are answered, the game changes. Very soon, you will be well on your way toВ understanding what the economy is all about and how it relates toВ your everyday life.



Some games are similar toВ each other. Take basketball and soccer, for instance. They both have two sides consisting ofВ aВ set number ofВ players. There are specific ways toВ score points. There is aВ winner at the end ofВ aВ set amount ofВ time. So, although basketball and soccer are different games, they have much inВ common.



But what about checkers and soccer? Maybe there are one or two similarities, but the ways to win are very different. In soccer, the team that scores more points wins. In checkers, a player who takes all his or her opponent’s pieces is the winner.



Is there anything that is the same inВ every kind ofВ game?



Playing byВ the Rules



Are there any games that allow players toВ do whatever they want? No. All games have rules. There are important rules inВ economics,В too.



InВ economics, the rules are usually laws. Laws are rules that define what is and is not allowed. For example, you cannot steal from others. That is aВ law, and it is also one ofВ the rules ofВ economics. Another law is that exchanges must be voluntary. Consumers cannot be forced toВ buy things. Voluntary exchange is aВ rule ofВ economics, and it is also aВ law.



Rules and Properties



Games require that people play byВ certain rules, but that is not all there is toВ games. Games are fun precisely because there is more toВ them than just the rules.



InВ tag, we all know toВ avoid the person who is В«it.В» This is not aВ rule. There is no penalty if we do not follow it. But even though it is not aВ rule, it has an effect on how the game is played.



Anything that is not aВ rule but still affects how aВ game is played is called aВ property. The properties ofВ aВ game follow naturally from the rules, but they also add something toВ the game that goes beyond the rules. This is how economics works.



Economic Properties



Like all games, economics has properties inВ addition toВ the rules. These properties affect how the game is played.



Remember: One ofВ the rules ofВ economics is В«no stealing.В» If you want toВ make an exchange, the buyer and seller have toВ agree on the price and then make the exchange. The rule, however, does not tell you how much the price will be. It could be any amount.



This is not true for all games. InВ Monopoly, prices are set byВ the rules. AВ railroad costs $200. But inВ economics, unless there is aВ specific law that sets the price, the amount is up toВ the buyer and seller.



How do prices get set if the rules do not set them? One ofВ the properties ofВ economics helps: Buy low, sell high.



Why is this aВ property ofВ economics? The buyer is giving up something good: money. So, the buyer usually wants toВ pay as little as possible. The seller, on the other hand, wants toВ get as much money as possible. Buyers want lower prices, and sellers want higher prices. Hence, buy low, sell high.



While almost all buyers and sellers play the game like this, it is not aВ rule. You do not go toВ jail if you sell something for aВ lower price than you could have. You are not aВ criminal if you pay more for something than you haveВ to.



InВ economics, there are aВ lot ofВ properties. Sometimes, economists call them В«laws,В» but they are not laws like В«no stealingВ» is aВ law. They are properties, like В«buy low, sell high.В»



One ofВ these properties is called В«The Law ofВ Supply and Demand.В» Despite the name, В«The Law ofВ Supply and DemandВ» is actually aВ property, not aВ law. This property can be complicated, but one part ofВ it states that when the supply ofВ something is low and the demand is high, then the price will be high. Why? It is related toВ the В«buy low, sell highВ» property.



Let us say someone has aВ rare object, like one ofВ the few original copies ofВ the Declaration ofВ Independence. What if you wanted toВ buy that rare object? You cannot steal it. That is aВ rule. And as aВ buyer, you want toВ pay as little as possible.



So, you offer aВ low price. But there are other buyers, too. If you want toВ buy this rare copy ofВ the Declaration ofВ Independence, you have toВ compete with the other buyers. Someone else also wants it badly, so they offer more than you. Now, you cannot go somewhere else toВ buy because it is rare. If you want it, you have toВ offer more. So, you do. But the other person offers more than you again. The price is going higher and higher. Why? Because ofВ the В«Law ofВ Supply and Demand.В»



No one is forced toВ obey this В«law.В» There is no Supply-and-Demand Police making sure this happens, but it happens all the time. Economists call this В«The Law ofВ Supply and DemandВ» instead ofВ В«The Property ofВ Supply and DemandВ» because nearly everyone obeys it even though it is not actually aВ rule.



Outcomes



There is another feature common toВ all games. Every game has an outcome. Outcomes are the real heart ofВ any game.



Outcomes also take place throughout the playing of a game. They result from plays or moves, but the idea is the same – one thing results in another.



Economics has many outcomes. AВ sale is aВ common example. When someone buys something, and the item and money change hands, that is an outcome. Later, we will take aВ look at other economic outcomes.



And the Winner Is – No One?



So far, we have seen that all games have certain features:

• Players

• Rules

• Properties

• Outcomes



It seems as if there is one more thing that is common toВ all games: aВ winner. Does an activity need aВ winner toВ be considered aВ game? Not necessarily.



Consider the game ofВ tag. The players inВ tag are either В«itВ» or В«not it.В» Which one is the winner? Do you win if you are not it? No, you are just one ofВ the players who are not it. And being it does not make you the loser. You are just it until you tag someone else.



Tag has no winner because there is no rule that states when the game has toВ end. AВ game ofВ tag does not end when somebody wins. It lasts until all the players decide toВ stop playing. Technically, aВ game ofВ tag could go on forever. The same is true for economics.



Winners often get medals or trophies toВ show that they haveВ won.



The Features ofВ Games



ToВ study economics, you need toВ understand how the various features ofВ the game work. This means knowing about the different roles ofВ the players and the rules they have toВ obey. It also means knowing about outcomes and understanding the properties that affect the way the game is played.



Economics is like aВ game. It has many ofВ the attributes that all games have inВ common: players, rules, properties, and outcomes. But what kind ofВ game is it? What do the playersВ do?



Surprisingly, the answer is simple: Economics is aВ game inВ which players buy and sell goods and services. It has rules, properties, and outcomes that limit and direct how all that buying and selling takes place.



Goods and Services



Objects that fulfill someone’s needs and wants are called goods. You need food. A sandwich is a good that fulfills that need. Every time you buy a sandwich, you are a player in the game of economics.



What about things you want? Do you want toВ surf the Internet? AВ computer fulfills that want. AВ computer is aВ good. AВ DVD fulfills the want for entertainment, so it is aВ good, too. Just about every object fulfills some need or want.



All foods are goods, even if they do not taste good.



Sometimes our wants and needs cannot be fulfilled byВ goods, or objects. InВ that case, we might require aВ service. Services are actions or other types ofВ assistance that customers need and want.



For example, when you need aВ trim, or you want toВ change your style, you get aВ haircut. But aВ haircut it is not an object. It is aВ service. Someone with aВ specific skill works toВ give you the trim you need or the style you want. Your stylist performs an action, or aВ service. However, he or she makes use ofВ goods, such as scissors and aВ comb, toВ perform the service.



Giving someone aВ haircut is aВ service that requires goods like scissors and aВ comb.



Is Economics About Everything?



Not everything is aВ good or aВ service. For instance, when you pay someone toВ mow your lawn, you are buying aВ service. But when you mow your own lawn, you are just making the grass shorter.



InВ other words, an action that you perform for your own benefit is not aВ service. If you read aВ book, you are not doing anybody aВ service. You may be relaxing or learning. These are good things, but they are not services because you do them for yourself.



On the other hand, if you read aВ book out loud toВ somebody else, you are performing aВ service. AВ service is still aВ service even if someone offers it for free, but services rendered generally involve the exchange ofВ money. The exchange might also be made using the barter system.



What Is Production?



Goods and services need toВ be made. This is known as production. Production is one ofВ the things certain players inВ the game ofВ economics do. AВ player who does this is known as aВ producer.



Production does not just happen. There are required toВ produce goods and services. Something needed for production is called aВ resource.



For example, you need flour toВ make aВ cake. The cake is aВ good, and the flour is aВ resource. Where did the flour come from? Originally, it came from aВ wheat field. So, the wheat field is aВ resource,В too.



What It Takes toВ Make aВ BirthdayВ Cake?



Let us say you want to make a birthday cake for someone. That is a service. It takes action to make a cake, and this action is valued. And it produces a good – a birthday cake. One of the main services in any economy is making goods. This service, called production, requires all kinds of resources. To make a cake, you need a kitchen. A kitchen is a resource.



Of course, you also need the stuff you make the good out of. If you are making a cake, you need flour and eggs and sugar and everything else in the recipe. These are some of the resources you need to make the cake. But you also need bowls, spoons, measuring cups, and a pan. These are resources, too. And finally, you need time and knowledge. In the end, you will put in a lot of effort. All of these things – time, knowledge, and effort – are resources.



Even a genie, who can make a birthday cake out of thin air, has to do something. Maybe the only action they have to take is saying, «Abracadabra.» But that still takes up the genie’s time and requires genie powers. Time and genie powers are resources. Even a genie needs some resources to produce a birthday cake.



Allocation



Resources are essential for production. But very few resources are easily available and ready toВ be used. Resources need toВ be found and set aside toВ produce specific goods. That is known as allocation.



Allocation involves making decisions. If you have aВ bag ofВ flour, you have toВ decide whether you want toВ make cake or bread. That is aВ decision about the allocation ofВ this resource.



Economics is aВ game ofВ constant decision making. AВ lot ofВ these decisions have toВ do with allocation.



Making decisions about how toВ allocate resources is part ofВ many games, not just economics. AВ softball coach allocates players byВ deciding who plays what position and making the batting order.



What will you do with your flour?



Distribution and Consumption



Economics is about the allocation ofВ resources toВ produce goods, but what do we do with these goods once they are produced? We use them, ofВ course.



Using aВ good or aВ service is known as consumption. InВ the game ofВ economics, people consume goods that are produced. When aВ player uses aВ good or service, he or she is known as aВ consumer.



Goods are rarely produced where they are used. If you have aВ piece ofВ clothing with aВ label that says В«Made inВ China,В» it had toВ travel aВ long way toВ get toВ you.



Moving goods toВ consumers is known as distribution. Producers have toВ distribute goods toВ the people who want toВ consume them. Resources get distributed,В too.



Perhaps you want toВ bake aВ friend aВ birthday cake, so you buy aВ bag ofВ flour. Think ofВ all the distribution the flour has toВ go through toВ get toВ you:



It starts out as wheat inВ aВ field far away. After harvest, it is sent toВ aВ flour mill. This takes resources, such as aВ truck, gasoline, and aВ driver. When the milled flour gets loaded onto another truck toВ be shipped toВ aВ warehouse, it takes more resources. From the warehouse, the flour is loaded onto more delivery trucks and taken toВ the store, requiring still more resources. Finally, the bag ofВ flour has arrived at the store for you toВ buy. You become the final stage ofВ distribution when you take the flour from the store toВ your kitchen.



Producing goods takes resources, and so does distributing them. You need trucks and trains and ships, and they need gas and tires and so on. These resources have toВ be allocated, as well. So, inВ addition toВ the allocation ofВ resources for producing goods and services, economics is also about allocating resources for distribution.



Many goods that we use inВ the United States are made inВ other countries.



So, what is Economics About, Again?



You have seen that economics is about producing goods and services for people toВ consume. You have also seen that production requires resources, as well as decisions about the allocation ofВ these resources. Finally, you saw that goods and resources need toВ be distributed from where they are produced toВ where they are used. If you put all ofВ this together, you should have aВ good idea ofВ what the game ofВ economics is about.



Goals are aВ big part ofВ economics. They help us avoid uncertainty. Goals also help us make crucial decisions.



Imagine you are playing softball. You know the rules, but you still have many decisions toВ make. Should you pitch aВ curveball or aВ fastball? Should you swing at aВ ball, or wait for aВ better pitch? Should you steal second base, or wait on first? Without aВ goal, it would be hard toВ answer these questions.



If you have a goal, the answers are obvious. If your goal is to win the game, you know what to do – throw your best pitch, try hard to hit the ball, and steal as many bases as you can without getting thrown out. These are the things that players need to do to win.



Economic Goals



InВ the game ofВ economics, you need goals toВ avoid confusion and toВ know what toВ do with yourself. Different people have different goals, however. You may think the only goal inВ economics is toВ make money, but there are many different goals inВ economics.



Different economic goals affect how people approach making decisions inВ the game ofВ economics. If your goal is efficiency, it is likely that you are going toВ allocate resources for the production and distribution ofВ goods and services differently than aВ person whose goal is security or freedom.

Read through the list toВ see the different economic goals that people pursue. Each will be defined inВ the coming pages.



Goals for Playing the Game ofВ Economics



1.В Efficiency

2. Growth

3. Security

4. Equity

5. Freedom



Efficiency, Growth, and Security



The first three economic goals – efficiency, growth, and security – are goals that make a lot of sense. But that does not mean that everyone agrees these are the proper goals to pursue when deciding how to allocate resources.

• Efficiency refers to the use of resources in a manner that gets as much out of them as possible. Efficiency is a goal producer have, to provide more goods and services for society without using more resources.

• Growth means increasing the size, number, or output of goods or services. It makes sense to want growth, because in the economy, growth means more goods, more jobs, and more money.

• Security is protection against risk or danger. Because life is uncertain and bad things can happen, the economic goal of security encourages us to lessen the dangers we face.



It is NotВ Fair



Another economic goal is equity. Equity means fairness; It is the notion that everyone should be treated equally. If aВ game is not played fairly, then the outcome will be unfair. When aВ game is fair, it has equity.



Still, equity can be aВ tricky concept. Different people might have different ideas about what is fair. Also, it is not always clear what is fair inВ aВ particular situation. Is it fair that one person has aВ lot while someone else has nothing?



Questions ofВ fairness are not always easy toВ answer. Maybe the person with less does not deserve more. Consider the fable ofВ the ant and the grasshopper.



The Ant and the Grasshopper



The ant worked hard all summer, building aВ house, and stocking up on supplies for the winter. The grasshopper danced and played the summer away. When the winter came, the ant had plenty ofВ food toВ survive. The grasshopper had no food and died ofВ starvation.



What is Fair?



Competing ideas about what is fair is aВ common problem when pursuing the goal ofВ equity. This makes equity aВ problematic goal for economics. Although equity is aВ good thing toВ pursue, it is rarely obvious how toВ achieveВ it.



At the end ofВ the story on the previous page, the grasshopper had nothing, and the ant had plenty. Is that fair? It depends on your perspective.



View the Ant and the Grasshopper to hear each side of the story, from the ant’s industriousness to the grasshopper’s cluelessness.



I’m sad that the grasshopper did not know what to do to prepare for winter, but I do not think it is fair to take food from me to help keep him alive. That would be rewarding the grasshopper for his lack of foresight and punishing me for my industriousness. It is not fair to punish someone for doing the right thing.



I do not think it is fair that I should have to starve. I have never seen the winter before, so I did not know what would happen. No one told me I would have to build a house and gather supplies. Do I deserve to die in the cold because I did not know about the harsh conditions I would have to face? Since I did not know, it is not fair to let me die. Would not it be fair to take some of the ant’s food to help me out?



Let FreedomВ Ring



Another important economic goal is freedom. Just like equity, however, freedom is aВ tricky concept. It can mean different things toВ different people.



Freedom inВ economics is defined as the absence ofВ an obstacle or constraint. But what is the obstacle or constraint, and how can it be removed? Different obstacles and constraints present themselves toВ different people inВ innumerable situations.



The Statue ofВ Liberty represents freedom, but not everyone defines freedom the sameВ way.



The Two Faces ofВ Freedom



It is normal for people toВ have different ideas about freedom. Freedom is the absence ofВ an obstacle, but the obstacles people face are not always the same, so their ideas about freedom can be very different.



For a teenager, one obstacle might be rules set by one’s parents. For a parent, an obstacle to freedom might be his or her struggle to earn money for the family.



In the game of economics, different ideas about freedom lead to different ways of looking at the allocation of resources. If you think of freedom in terms of people making their own choices, you might believe that producers should get to decide how goods and services are produced without any constraints. But if you think of freedom as the absence of economic struggle and need, you might believe the government should tell the producers what to make and how much to charge so that everyone’s basic needs can be met. These different views of economic freedom lead to different ideas about how an economy should function.



Conflict Over Goals



With goals that are sometimes incompatible, economics can lead toВ conflict. Do you want efficiency, growth, security, equity, freedom, or some combination? You need toВ have some goals, but someone else will inevitably have different goals. No matter what you want, there are bound toВ be other people who want something else. This can create conflict.



This means that there is more toВ economics than the allocation ofВ resources for the production and distribution ofВ goods and services. Economics is also about setting goals that affect how these allocation decisions are made.



We All Need Goals



You cannot play aВ game without goals. How else can you make important decisions? But people often disagree about the goals they have for playing aВ game.



Things are no different inВ the game ofВ economics. The goals people have for the economy might be different. They might even be incompatible sometimes. Nevertheless, you need goals toВ play this or any game.



Humans have wants and needs that are often greater than what is available. Thus, people face scarcity as aВ basic fact ofВ life.



You might think that there are plenty ofВ goods and services available toВ you. But what would happen if the world stopped producing the thing you need or want? Eventually, the supply would run out. When goods and services become hard toВ find, it leads toВ scarcity.



You saw before that economics is about the allocation ofВ resources for the production and distribution ofВ goods and services. The problem ofВ scarcity is the reason that this is necessary. If there were plenty ofВ goods and services toВ go around, no one would need toВ make allocation decisions. Scarcity is yet another reason why everyone plays economics.



People can face shortages ofВ important goods.



What Is toВ Be Produced?



Because scarcity is aВ fact ofВ life, people have toВ work toВ try toВ increase supply inВ order toВ meet demand. Different people want different goods and services. If there were unlimited resources, people everywhere could have what they wanted.



Since resources are not unlimited everyone has toВ make tough decisions about what toВ do with the resources available. One big question that needs toВ be addressed inВ any economy is this: What is toВ be produced?



Because ofВ scarcity, deciding what is toВ be produced involves also deciding what not toВ produce.



Remember your bag of flour? You can allocate the flour for making bread for sandwiches. But what if it is your friend’s birthday? If you use the flour for bread, you cannot make a birthday cake. Before you start producing something, you have to decide what to produce.



Allocating resources often involves deciding toВ produce one thing instead ofВ another.



Getting Organized



Once it is decided what will be produced, there are still more questions toВ answer. It takes organization toВ produce and distribute goods and services.



There are all kinds ofВ ways toВ organize production. There could be factories, offices ofВ varying sizes, or people working at home. There could be different people who specialize inВ different jobs, or everyone could take turns doing all the different jobs. Production might go on 24В hours aВ day, seven days aВ week, or it could be kept toВ certain working hours.



This is just aВ short list ofВ the different options. There are many methods ofВ organizing production. How do people decide on the best way toВ organize production? The economic goals people have will affect how this question is answered. This can again lead toВ conflict.



The goal ofВ efficiency requires aВ form ofВ organization that has as little waste as possible. One good way ofВ eliminating waste is toВ have different workers specialize inВ different jobs. But if equity is the goal, specialization might not be the way toВ go. When you divide up production into different tasks, some ofВ the tasks might be harder than others. Equity could mean giving each ofВ these workers aВ chance toВ do the easier, cleaner job. But what if freedom is your main economic goal? InВ this case, production would have toВ be organized toВ give workers different choices, and workers would have the freedom toВ decide what jobs toВ take.



Who Gets What and Where?



The questions do not stop once decisions about production have been made. You saw that goods often need toВ be transported from where they are made toВ where they are used. This is distribution. There is more toВ distribution than just transportation, however.



Getting goods toВ the people who use them means making decisions about who gets what. Because ofВ scarcity, some people will not always get what they want. So, the game ofВ economics involves answering aВ third question: How are goods and services toВ be distributed?



InВ other words, how shall we decide who gets what?



If you want equity or security, producers probably need to be told what to produce. Their choices could end up being incompatible with those goals. The government can make sure that everyone is secure, or that goods and services are distributed fairly. But when the government decides how goods and services are distributed, that takes away free choice. Producers are told what to produce and where to send it. A different way to organize distribution is not to organize it at all, to leave it up to people’s free choices to decide what gets produced and how goods and services are distributed. This might result in an unfair distribution, or one that leaves some people insecure, but it would not involve the government telling people what to do.



AВ Variety ofВ Resources



Organizing an economic system involves making decisions about what is going toВ be produced and how it should be distributed. That takes care ofВ most ofВ the game ofВ economics.



Still, there is one final question toВ be answered: What is the most effective allocation ofВ resources?

There are all kinds ofВ resources that go into production and distribution. Remember all the resources needed toВ make aВ birthday cake? There are aВ lot ofВ them: an oven, aВ timer, ingredients, utensils, time, knowledge, and effort.



Production and distribution usually involve aВ long list with very different types ofВ resources. The flour needed for the batter is aВ different type ofВ resource than the oven needed toВ bake the batter, or the time needed for the whole process.



Deciding how toВ allocate resources means you have toВ pay attention toВ where the different resources come from.



It takes many different resources toВ make aВ cake.



The Factors ofВ Production



The types ofВ resources needed for production are known as the factors ofВ production. There are three different factors ofВ production: land (inВ economics, the term land refers toВ any natural resource on, under, or over the land), labor, and capital.



Land is useful for making things. Fields are used to grow food, and water or wind can be used to produce energy. And land is not just what you see on the surface of the Earth. It also includes things that can be found underground. Things like coal and iron – even steam and water come from underground. These natural resources are all useful for producing things.



Some goods spring directly from the Earth, but it takes some work on the part ofВ humans toВ make all goods. Even aВ wild blackberry has toВ be picked byВ someone before it can be eaten. All production requires aВ human touch. Labor is the work that humans do toВ take natural resources and turn them into useful products. Sometimes the labor is physical. Sometimes the labor involves coming up with ideas. Whatever form labor takes, these human resources are just as necessary as natural resources.



Capital is the final type ofВ resource needed for production. Capital resources are goods that have been produced byВ humans toВ make more goods. Capital includes machines like bulldozers and cement trucks. It also includes buildings like factories and other structures such as dams and oil wells.



The term capital also refers toВ the money used toВ pay for other resources. Like other forms ofВ capital, money has been created byВ humans toВ help with the process ofВ production.



You can see that playing the game ofВ economics involves answering aВ lot ofВ different questions. There are four fundamental questions faced byВ people inВ all economic systems.



The way these four questions are answered tells you aВ lot about the way decisions are made inВ different economic systems. When these questions are answered inВ different ways, you end up playing different games.



Another major element inВ economics is the concept ofВ supply and demand. The fundamentals ofВ supply and demand change depending on what type ofВ economic system you are dealing with, however, so this concept cannot be included inВ the fundamental questions ofВ economics, inВ general.



The Four Fundamental Questions



1.В What is toВ be produced?

2. How is production toВ be organized?

3. How are goods and services toВ be distributed?

4. What is the most effective allocation ofВ resources?



You have seen that there are different economic goals that can be pursued: efficiency, growth, security, equity, and freedom. It can be difficult toВ decide among them.



Individual people are not the only ones who choose economic goals. Entire societies also make the same choices. If it is hard enough toВ choose for yourself, imagine how hard it is for aВ whole society toВ agree on its economic goals! ToВ make this decision, it helps toВ understand the different results that occur from pursuing different goals.



For example, what would the game look like if everyone agreed that freedom was the most important goal? ToВ answer this, you can look at how aВ society that values freedom would answer the four fundamental questions ofВ economics. This tells you what aВ free-market system looks like.



The free-market system, sometimes referred toВ as capitalism, is one ofВ the most common economic systems on Earth. Examine how it works.

Free Choice



The first question raised byВ scarcity: What will be produced?



When you are alone, you can answer the question based simply on your personal needs or wants. When an entire society decides what will be produced, however, it raises aВ different question first: Who within society gets toВ make the decision? This question needs toВ be asked and answered before the first fundamental question.



It might seem obvious that the producers themselves should get toВ decide what toВ produce. Their role is toВ produce goods and services, so it makes sense toВ let them choose. This is exactly what happens inВ aВ free-market system: Producers are free toВ choose what toВ produce.



Producers also get toВ choose how toВ organize production, which addresses the second question. InВ fact, producers are free toВ answer all four ofВ the fundamental questions without anyone telling them what they have toВ do. AВ capitalist society is one where allocation, production, and distribution are organized byВ the free choices ofВ the producers.



The Customer Is Always Right



Capitalism leaves production decisions up toВ the producers, but the choices made byВ consumers also play an important role. Producers must eventually sell their goods and services toВ consumers. InВ aВ free-market system, consumers have the freedom toВ choose what toВ buy. This gives them aВ lot ofВ power over producers.



Producers want the goods and services they make toВ be purchased and used. That means producers must pay attention toВ what consumers need and want. If consumers choose not toВ buy the goods and services they produce, the producers have toВ make different decisions.



Because ofВ this, the needs and wants ofВ consumers influence the decisions ofВ producers. InВ aВ free-market economy, the free choices ofВ both producers and consumers determine how the fundamental questions are answered.



Go with theВ Flow



AВ free-market system is based on the free choices ofВ producers and consumers. The choices one group makes affect the other group. Consumers can only consume what producers produce. At the same time, producers want toВ make only what consumers need and want.



Because ofВ this back-and-forth influence, capitalism has aВ circular flow. Influences and inputs move between producers and consumers. Economists call this aВ circular-flow model.



View the Circular-Flow Model below toВ see the circular-flow model ofВ the free-market system.



The Circular Flow Model



The main players in the free-market game are producers and consumers. There is a circular flow of influences and inputs between them. A circle has no beginning and no end, so there is no first influence or input – but we need to begin somewhere, so let us start with the producers. Producers make goods and provide services. These go to the consumers to be used. The consumers purchase these goods and services. Consumers also provide the factors of production by working and investing. Producers pay for the work with wages, and they repay and reward the investments with profits. These things flow back and forth, continuing the cycle as producers and consumers interact and influence each other’s decisions.



Defending Freedom



The free-market system is based on producers and consumers making free choices. But often, consumers and producers have desires that conflict.



Conflict results naturally from people’s desires, and some people try to resolve conflict by using threats to force people to choose in a certain way. This is called coercion. When your desires conflict with someone else, the other person might try to make up your mind for you by using coercion.



Because the free-market system relies on free choices, coercion is usually forbidden in capitalist societies. It is illegal to take away people’s right to choose through coercion. Laws in capitalist societies are designed to defend the freedom of producers and consumers.



The Rules ofВ theВ Game



There are many ways to take away someone’s freedom. Thus, rules are needed to make sure producers and consumers can make free choices. You already know some of these rules. For instance: No stealing.



В«No coercionВ» is another important rule. Coercion can include lying, so В«no lyingВ» is also part ofВ the rules ofВ aВ free-market system.



InВ economics, the rules are laws. That is why the government passes laws against theft, coercion, and fraud. InВ aВ free-market system, the government has toВ make and enforce whatever laws are needed toВ guarantee free choice.



Private Property



Maybe you currently have some amount ofВ financial freedom. Maybe you get an allowance, or you have aВ part-time job that provides aВ bit ofВ spending money. But what if your allowance was taken away or you lost your job? Then you might have toВ ask someone else for money. Since the people you ask are free toВ choose, they can say yes orВ no.



ToВ be free, you need more than protection against coercion. You need toВ have resources, too. If you do not have your own resources, then your ability toВ make free choices is limited.



InВ aВ free-market system, individuals get toВ make free choices about what toВ do with the resources they have. Therefore, rules protecting private property are among the most important rules ofВ aВ capitalist society. These rules are referred toВ as property rights.



Land is one ofВ the resources that helps people be free.



The Resource ofВ Work



Land, money, and capital are resources, but they are not the only resources that allow one to make free choices. Healthy adults who own no property still possess one important resource – their own labor. The ability to work is an important resource in a capitalist system.



The rules ofВ the free-market system protect you against coercion. It is illegal for anyone toВ force you toВ do something. This means that the rules guarantee that you can make free choices about how you sell your labor toВ others.



Labor is an important resource. Almost all production requires some labor. So, everyone who can work has an important resource, the resource ofВ work. Having this resource gives people the ability toВ make free choices.



Competition



The free-market system relies on free choice and private property, but that is not all. Competition is another important part ofВ capitalism.



Competition is needed toВ guarantee freedom. Without competition, people do not have aВ lot ofВ choices. InВ fact, they might have only aВ single choice.

Free-market systems have toВ guarantee that there will be competition. It is one ofВ the rules. Without competition, you would have toВ take the В«freeВ» out ofВ free-market system.



Stock exchange



On the floor ofВ the New York Stock Exchange, traders compete with each other toВ buy and sell shares.



The Importance ofВ Competition



Imagine that you are hungry, and you want aВ sandwich. If there are aВ lot ofВ different sandwich shops inВ competition with each other, then you will have aВ lot ofВ choices. InВ fact, you will probably have fairly good choices. Because you can go toВ someone else, each shop is competing toВ get your business. This kind ofВ competition gives the consumer aВ lot ofВ good choices. They have got aВ lot ofВ things toВ freely choose among.



But what if there were only one sandwich vendor? As a consumer, you would have to go to this one sandwich vendor and take what they had. Maybe they only have tuna fish sandwiches that cost $20. You do not even like tuna fish sandwiches, and you definitely do not want to pay $20 for one. But what other choice do you have? You have to buy the $20 tuna-fish sandwich or go hungry. You can always choose no sandwich and starve, but that is not much of a choice, is it? If your freedom consists solely of choosing between something you do not want – an expensive sandwich you won’t like – and something else you do not want – starvation – then it is hardly worth calling it freedom. Without competition, consumers do not have the freedom they are supposed to have.



The Profit Motive



Free choice, private property, and competition are at the heart ofВ the free-market system. They are so important that there are rules protecting them.



We saw before that games often have properties inВ addition toВ the rules. Such properties are not enforced like rules, but they affect how aВ game is played. Properties ofВ the free-market system are often called market forces.



One important market force in a capitalist system is the profit motive. Producers make a profit by selling a good or service for more than it costs to produce. The difference between the total cost of production and the selling price is the producer’s profit. If the cost is greater, the producer suffers a loss and will struggle to stay in business.



There is no rule that says you have toВ follow the profit motive because there does not need toВ be such aВ rule. It is obvious toВ any producer that aВ profit is better than aВ loss. InВ the free-market system, the profit motive exists without any kind ofВ coercion.



Profit and Competition



The profit motive is extremely important for the free-market system. Because ofВ competition, efficiency and innovation often result from this drive toВ make aВ profit. If you are competing with others, you cannot afford waste. Waste increases costs, which cuts into profit. So producers work hard toВ be as efficient as possible.



Competition keeps prices low, which means that producers cannot just make up for inefficiency byВ raising prices. The incentive toВ be efficient and innovative is an example ofВ market forces.



The profit motive can also work against competition. If you really want toВ make aВ lot ofВ money, it would be better not toВ have any competition. That way, you could sell your goods and services for aВ much higher price and make more profit. Profit seekers have an incentive toВ get rid ofВ competitors, if they can, toВ make more profit. This is another reason it is necessary for the government toВ make laws protecting competition.



What is So Free About aВ Free Market?



You have seen that the free-market system is based on free choice, private property, competition, and the profit motive. These rules and properties create one particular version ofВ the game ofВ economics. It is just one version, but it is the game that most societies play.



Advocates ofВ the free-market system might argue that the most important goal is freedom. Freedom is so desirable, they might say, that it makes it worthwhile toВ sacrifice other goals. Some advocates ofВ the free-market system, however, think that we might not need toВ make these sacrifices. They believe that pursuing freedom allows us toВ reach the other goals as well.



Adam Smith was an early advocate ofВ the free-market system. InВ the same year that the Declaration ofВ Independence was written, he published aВ book called An Inquiry into the Nature and Causes ofВ the Wealth ofВ Nations. It is often simply called The Wealth ofВ Nations.



Modern free-market advocates often cite Adam Smith toВ support their claim that freedom is the most important economic goal. Read some ofВ what Smith said so you can judge the claims ofВ the free-market supporters who agree with his reasoning.



Adam Smith is sometimes called the founder ofВ capitalism.



Read the following excerpt from The Wealth ofВ Nations and think about the things that Adam Smith said about the free-market system.



As every individual, therefore, endeavours as much as he can both toВ employ his capital inВ the support ofВ domestic industry, and so toВ direct that industry that its produce may be ofВ the greatest value; every individual necessarily labours toВ render the annual revenue ofВ the society as great as he can. He generally, indeed, neither intends toВ promote the public interest, nor knows how much he is promoting it. ByВ preferring the support ofВ domestic toВ that ofВ foreign industry, he intends only his own security; and byВ directing that industry inВ such aВ manner as its produce may be ofВ the greatest value, he intends only his own gain, and he is inВ this, as inВ many other cases, led byВ an invisible hand toВ promote an end which was no part ofВ his intention. Nor is it always the worse for the society that it was no part ofВ it. ByВ pursuing his own interest, he frequently promotes that ofВ the society more effectually than when he really intends toВ promote it. IВ have never known much good done byВ those who affected toВ trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed inВ dissuading them fromВ it.



What is the species of domestic industry which his capital can employ, and of which the produce is likely to be of the greatest value, every individual, it is evident, can, in his local situation, judge much better than any statesman or lawgiver can do for him. The statesman who should attempt to direct private people in what manner they ought to employ their capitals would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it ….



The property which every man has in his own labour, as it is the original foundation of all other property, so it is the most sacred and inviolable. The patrimony of a poor man lies in the strength and dexterity of his hands; and to hinder him from employing this strength and dexterity in what manner he thinks proper without injury to his neighbour, is a plain violation of this most sacred property. It is a manifest encroachment upon the just liberty both of the workman, and of those who might be disposed to employ him. As it hinders the one from working at what he thinks proper, so it hinders the others from employing whom they think proper. To judge whether he is fit to be employed, may surely be trusted to the discretion of the employers whose interest it so much concerns. The affected anxiety of the law-giver lest they should employ an improper person, is evidently as impertinent as it is oppressive…



People ofВ the same trade seldom meet together, even for merriment and diversion, but the conversation ends inВ aВ conspiracy against the public, or inВ some contrivance toВ raise prices. It is impossible indeed toВ prevent such meetings, byВ any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people ofВ the same trade from sometimes assembling together, it ought toВ do nothing toВ facilitate such assemblies; much less toВ render them necessary.



The InvisibleВ Hand



An important part of Smith’s theory is the «invisible hand.» He did not believe that a literal hand guides economic outcome. The invisible hand is a metaphor or symbol of market forces in the free-market system that lead to good outcomes without any planning. Because of this invisible hand, pursuing freedom helps realize other economic goals such as efficiency, growth, and security.



Smith clearly did not trust governments toВ direct economic affairs. Individuals pursuing their interests can В«judge much better than any statesman or lawgiver canВ» what is best for the economy. Smith was very suspicious ofВ government intervention inВ the economy.



Smith was also wary of producers since their pursuit of profit might persuade them to work against competition. That is what he meant by «some contrivance to raise prices.» He recognized that the government has a role to play in the game of economics. He believed that the government’s role should be limited to protecting such things as competition, free choice, and private property. The government should not have «folly and presumption enough» to believe it can run the economy directly. According to



Smith The invisible hand is not actually aВ hand.



It is better for everyone if the economy is left inВ the hands ofВ private individuals pursuing their own interests. That is the invisible hand at work.



AВ different ball and different methods ofВ pitching make softball and baseball two different games.



Playing the game ofВ economics involves answering four fundamental questions. When they are answered differently, different games result.



Think about softball and baseball. They are similar games with aВ few important differences. This is also true for economics. There is more than one way toВ set up the rules. This means there are different versions ofВ the game ofВ economics.



The four all-important questionsВ are



• What will be produced?

• How should production be organized?

• How will goods and services be distributed?

• What is the most effective allocation of resources?



Do What IВ Say and What IВ Do



AВ command economy has less freedom than aВ free-market system. Producers have toВ do what the government says. They do not get toВ decide what toВ make or how toВ make it. Also, people do not get toВ decide where they will work. The government decides that. This is why it is called aВ command economy: The government issues aВ lot ofВ commands.



InВ aВ command economy, the government controls everything related toВ the allocation ofВ resources and the production and distribution ofВ goods and services. InВ order toВ do this, the government owns most ofВ the property. Private property is an important feature ofВ the free-market system, but it gets inВ the way ofВ aВ command economy.



The following is aВ long list ofВ government functions inВ aВ planned economy. The list goes on and on, but these are the fundamental commands issued inВ aВ command economy.



Government Commands



InВ aВ command economy, the government



1.В Assigns production toВ producers.

2. Allocates resources toВ producers.

3. Sets prices for consumers.

4. Decides where people work.

5. Sets wages for workers.

6. Sells goods and services.

7. Decides who gets what and how much.



Your Wish Is the Government’s Command



Why would aВ government do all ofВ this commanding?



There are other economic goals besides freedom and efficiency, and capitalism does not always serve these other goals. The free choices ofВ producers and consumers often result inВ inequality and insecurity. Growth is sometimes strong and sometimes weak. People may be free toВ make choices, but they are often not free from struggle and need.



Command economies exist toВ serve other economic goals, usually equity, security, and freedom from need. These are the main concerns ofВ both socialism and communism. Most nations have some elements ofВ socialism as you will see later, but some countries have attempted complete socialism. Communism combines extreme socialism with political ideology. The former Soviet Union was aВ communist country. Today, China, North Korea, Vietnam, Laos, and Cuba still have communist governments though most have incorporated elements ofВ capitalism. The philosophical goal ofВ aВ command economy is toВ ensure equity and security. But under communism, the reality has been quite different. While some communist economies improved from what they were under previous authoritarian governments, none has achieved true equity or efficiency, and none has reached its economic potential. Some, such as North Korea, have had disastrous economic consequences. Additionally, these governments remain politically repressive.



Making aВ Plan



Free-market systems and command economies have different goals. But the differences do not end there. For one thing, aВ command economy has an extra set ofВ players. There are producers and consumers, as inВ any economic system. There are also government planners. The planners are the ones who issue the commands.



InВ aВ free-market system, outcomes are not planned byВ anybody. They happen because ofВ market forces. The law ofВ supply and demand sets prices. Demand for different types ofВ labor decides where people will work and how much they will make. Voluntary exchanges determine how resources are allocated.



InВ aВ command economy, these things are decided byВ the government instead ofВ byВ market forces. Planners decide how toВ allocate resources for the production and distribution ofВ goods and services. This means they decide what gets produced, they organize production, and they also decide which consumers will receive what and how much. InВ aВ command economy, planners, not producers, answer the four fundamental questions.



Diverting theВ Flow



The free-market system operates with aВ circular flow between producers and consumers. InВ aВ command economy, the flow is different because ofВ the important role played byВ government planners. Their decisions affect almost everything that goes on inВ the economy.



AВ game with three sets ofВ players is obviously very different from aВ game with two sets ofВ players. AВ command economy has aВ flow that involves the planners at almost every step.



Remember how the circular flow model ofВ the free-market system works? Inputs and influences go back and forth between producers and consumers. InВ aВ command economy, government planners get involved. What they do changes the flow. Goods and services are purchased from the government, and the money paid returns inВ the form ofВ wages. Profit is eliminated. Diverting the flow ofВ the free market this way tends toВ slow things down.



In a command economy, planners have to figure out what resources are needed to reach their society’s goals, and they have to figure out how to organize production. Collecting information and coordinating decisions use up a lot of labor, so there are fewer workers to contribute to production. This limits growth. The command economy also cuts down on efficiency and innovation. Planners are focused on organizing resources to meet society’s goals. They do not have much time or incentive to come up with the new products or different ways of doing things.



The Land ofВ the (Mostly) Free Market



You have examined two different economic systems: the free-market system and the command economy. Both ofВ these systems are based on aВ theory about how the economy should be organized. InВ reality, most economies are aВ mixture ofВ both.



The United States has a free-market system – mostly. Almost all decisions are made by the free choices of producers and consumers. Still, there are parts of the U.S. economy that are planned. The government sometimes issues commands that limit the freedom of producers and consumers. These commands serve economic goals other than freedom and efficiency.



For example, minimum wage laws limit the freedom ofВ producers byВ telling them the lowest wage they can pay their workers. The goal ofВ aВ minimum wage is toВ promote economic security and equity byВ protecting workers from exploitation. Not everyone agrees that aВ minimum wage accomplishes this goal, and the value ofВ minimum wage laws is frequently debated.



ToВ many people, the free-market system is an important part ofВ what the American flag represents.



It is inВ theВ Mix



When you mix two things, you can often get the best ofВ both.



Freedom matters inВ the United States, but it is not the only thing that counts. Efficiency is important too, as are equity, security, and growth. This is why the U.S. government issues some commands, which means that the United States has aВ mixed economy. AВ mixed economy uses both free-market and command principles.



In freedom-oriented societies such as the United States, the commands are the exception rather than the rule – but the exceptions are usually quite important. The government limits freedom to serve other economic goals in areas that matter most.



The minimum wage has the goal ofВ promoting security and equity byВ not allowing employers toВ exploit their workers. Experts disagree on its effectiveness.



Retirement is another important feature of a mixed economy. Social Security is a government program designed to ensure that retired workers age 66 or older receive a continuing income after retirement. Social Security was not intended to be a person’s only retirement income and the system faces difficulties.



People are free to, and should, save for retirement inВ other ways inВ the private sector toВ ensure aВ better quality ofВ retired life.



Stay inВ School



One familiar example ofВ government command inВ the United States is the public-school system. This system provides aВ useful service: education. This service is so important for all people that the government does not leave it up toВ producers toВ organize. The states provide this service themselves. While producers may provide education through aВ variety ofВ private schools, government guarantees free education toВ all. InВ fact, all parents have toВ provide their children with either public or private education up toВ at least ageВ 16.



This is an example ofВ the operation ofВ aВ command economy within the United States. But free-market principles also operate. Even though the government guarantees that an education will be provided toВ all, aВ system ofВ private schools exists toВ give parents aВ choice ofВ where toВ send their children. This is not true inВ aВ pure command economy. There were no private schools inВ the Soviet Union.



Take Advantage



Free-market systems and command economies both have advantages and disadvantages. The free-market system serves the goals ofВ freedom and efficiency very well.



Command economies do aВ better job ofВ providing security and equity. There are ups and downs toВ both systems, and no one would try toВ argue that either system is perfect. But is one aВ clear favorite over the other?



The Pros and Cons ofВ the Two Systems



Free-market systems usually provide aВ much greater variety ofВ goods and services. Competition among producers leads toВ innovation as the producers try toВ figure out what consumers need and want. This innovation inspires aВ diversity ofВ goods and services that is not likely toВ exist inВ aВ command economy. Planners do not have much incentive toВ innovate. On the other hand, aВ command economy can make sure that everyone has their basic needs met. Planners can direct the production and distribution ofВ goods and services such as food, medical care, and education toВ guarantee that everyone gets these important things.



Inequality ofВ wealth is one ofВ the disadvantages ofВ the free-market system. When people are given the freedom toВ make different choices, they each get aВ different outcome. Inequality is bound toВ result when wealth is distributed byВ free choices instead ofВ an overall plan. This can lead toВ insecurity, too. AВ command economy can provide greater equality and security but at the cost ofВ efficiency. Planners may be able toВ implement an overall plan that assures that basic needs are met, and wealth is distributed more equally, but the planning required uses up aВ lot ofВ resources. When market forces do the work, resources are not wasted paying, housing, and feeding government planners.



What is Big Brother Doing?



There are important differences between aВ free-market system and aВ command economy. InВ capitalist societies, the government does very little toВ interfere with the economy. Market forces, or the В«invisible handВ» is expected toВ allow the economy toВ function properly.



InВ aВ planned economy, the government takes on the job ofВ the market forces. This uses up aВ lot ofВ resources.



There are advantages and disadvantages toВ both approaches. That is probably why most countries have aВ mixed economy, so they can get some ofВ the advantages ofВ each system and pursue several economic goals at once.



Life is full ofВ decisions. So is the game ofВ economics.



Players decide on economic goals. They decide on the rules ofВ the game. They make allocation and production decisions. They decide what toВ exchange and for how much toВ exchangeВ it.



Making decisions never really ends inВ the game ofВ economics. InВ fact, the economy is primarily just aВ constant stream ofВ decisions and their outcomes.



So how are economic decisions made? Let us take aВ look.



Yogi Berra, one of the greatest baseball players ever, once said about the game, «It ain’t over til it is over.» This is not just true in the game of baseball. It is also true in the game of economics. No economic decision is over until it is over. In other words, you are not done with the decision-making process until you have carried out your decision. Even when you have already decided on a plan, you still have to decide whether to stick to it.



Life is all about personal choices. Sometimes decisions are easy; at other times they are difficult and require aВ lot ofВ thought and maybe even sacrifice. Sometimes our decisions affect other people. This is true inВ baseball as well as inВ economics.



Weighing Pros andВ Cons



Compare going toВ see aВ movie with aВ trip toВ the dentist. Which sounds better: relaxing with aВ bucket ofВ popcorn and aВ soda, or having someone poke around inВ your mouth with aВ metal instrument? If you are like most people, you would probably rather go toВ aВ movie than visit the dentist.



Think about it, however. There are pros, or positive aspects, toВ going toВ the dentist. And there are cons, or negative features, ofВ going toВ the movies. Not even this decision is completely one-sided.



Cost-Benefit Analysis



Making decisions requires weighing the pros and cons. Good decisions can only be made after considering the different choices and picking the one that looks best. That is what players inВ the game ofВ economicsВ do.



Economists call this cost-benefit analysis. When you do aВ cost-benefit analysis, you look for the decision that has the maximum benefit with the minimum cost. InВ other words, the choice with the most pros and the fewest cons is usually the best option.



Be Rational



There is no rule that says you have toВ use cost-benefit analysis, but players who want toВ maximize benefits and minimize costs use it all the time. It is one ofВ the properties ofВ the game ofВ economics.



You do not always have toВ list the pros and cons toВ do cost-benefit analyses. InВ fact, such an analysis happens frequently, and almost automatically. Any time you accept aВ cost, you are looking for aВ benefit. You have probably done aВ cost-benefit analysis ofВ your own, even if you did not sit down toВ make aВ list ofВ pros and cons.



Money Is not Everything



Money is one common way ofВ calculating cost. You see price tags all over the place. It is normal toВ think ofВ cost and price as the same thing, but the cost ofВ aВ decision cannot be measured inВ money alone.



When you buy something with money, there are always additional costs. For instance, the time and effort involved inВ shopping are costs. And whatever you must give up byВ buying one thing instead ofВ another is also aВ cost.



Imagine that you received $200 in birthday money. That is quite a benefit, but spending it involves costs. Maybe you decide to buy a new game console with the money. The price of the console is only one factor. There are hidden costs, too, such as gas for the car or bus fare to get to the store. The time you spend is another cost. So, while it may seem that you are getting something for free – a console bought with someone else’s money – buying it brings certain costs. And maybe you wanted a new backpack and a pair of shoes, too. You are sacrificing those purchases for the game console.



That is Your Opinion



Cost goes beyond money. No price tag reveals the full cost of something. Everyone’s feelings about cost are very personal. The way you calculate the cost of a decision depends very much on your tastes and your situation.



Whenever you buy something, there is a cost in time and effort beyond the price of the purchase. The time and effort spent on a task may be a high cost for one person and a low cost for another. An hour spent shopping probably seems like a low cost for someone who loves to shop – it may even seem like a benefit. But an hour spent shopping may be a very high cost for someone who does not like to shop. Time and effort are non-monetary costs of shopping.



Even monetary costs can vary depending on a person’s situation. If you are a millionaire, paying $10 for a movie is not a big deal. If your job pays $7 an hour, however, that $10 may seem like a lot of money.



Everyone calculates costs and benefits differently. That makes these calculations subjective. In other words, they depend on a lot of factors that vary from one person to another. Because people’s opinions and tastes differ, it affects how they see the costs and benefits of decisions.



Something’s Missing



Unfortunately, not all rational decisions work out the way you might hope. Sometimes you ignore aВ cost, or overestimate the benefits. This does not mean you are irrational. You simply could not think ofВ everything.



Often, it is impossible toВ predict what is going toВ happen. Unexpected costs arise. Benefits turn out toВ be less than you thought. That is normal, because no one can predict the future. That does not mean aВ cost-benefit analysis is useless, though.



Economic Reasoning



Cost-benefit analysis is sometimes called economic reasoning. In many ways, economic reasoning is just like any other kind of reasoning – it is a matter of weighing pros and cons.



Some might call this logic, others common sense. Whether you call it economic reasoning, logic, or common sense, it is all the same thing. It is how people play the game ofВ economics. They make rational decisions hoping for benefits that outweigh costs.



There is no such thing as aВ free lunch, even when someone else is buying.



The economy is not just aВ collection ofВ people. It is like aВ game, except that instead ofВ playing on aВ board or aВ field, the players move within the greater economic system. They follow rules and make decisions, and these decisions result inВ outcomes.



Definition ofВ the Economy



The economy is the total ofВ all the outcomes that result from people participating inВ the economic system.

Economists measure and discuss the strength and performance ofВ the economy. When they use words such as health, vitality, and even stamina, it sounds much like aВ doctor talking about aВ patient. This is not far from the truth.



Economic Indicators



Economists measure the health ofВ the economy byВ comparing and analyzing economic outcomes that result from various activities. Economists use these instruments toВ measure economic activity. These instruments, called economic indicators, include



• Gross domestic product.

• Growth rates.

• Unemployment rates.

• Inflation rates.



Doctors use measurements toВ judge the condition ofВ their patients. Economists measure the health ofВ the economy.



Gross Domestic Product



Some indicators are used quite often toВ measure the health and vitality ofВ the economy. For example, gross domestic product (GDP) is aВ very helpful, and widely used, tool.



The GDP measures the overall size of a country’s economy. It is the monetary value of all goods and services produced in a country during a given time, usually one year. The GDP provides a good overall picture of how much economic activity there is within a country.



UnderstandingВ GDP



Gross domestic product is the sum total ofВ private consumption, government spending, investment, and the net value ofВ exports. The net value ofВ exports, sometimes called the trade balance, is the value ofВ the goods exported minus the goods imported.



The equation can be put more concisely as follows:



GDP = private consumption + government spending + investment + exports – imports



AВ common mathematical formula for measuring GDP looks like this:



GDP = C + G + I + Ex – Im



Private consumption includes all the goods and service purchased or consumed by individuals. Government spending includes all the costs incurred by the government, such as salaries of government employees, military spending, funding for education, and so on. Investment is limited to business investments in capital, and it does not include financial investments such as savings accounts or bonds. Exports are those goods that are produced inside one country and sold in another country. Imports are the reverse – goods made outside the country and purchased within the country. Imports are subtracted from the GDP because they are purchased from other countries before they are sold within the United States. These funds contribute to another country’s GDP.



The GDP is aВ very weighty number for every country inВ the world.



WorldВ GDP



GDP is an important economic indicator. The bigger the GDP, the more activity there is in a country’s economy. For large countries, the GDP numbers are likewise usually very large. Sometimes a country’s GDP is so large that it is hard to comprehend. So what does a GDP number really tell us?



There are aВ couple ofВ ways toВ make the GDP more meaningful. One is toВ make comparisons. For example, inВ 2011, the GDP for the entire world was just under $70В trillion. The same year, the GDP ofВ the United States was about $15В trillion. That means that roughly one-fifth ofВ all economic activity inВ the world took place inВ the United States. That is aВ lot ofВ economic activity for one country.



The United States has the largest GDP inВ the world, as evidenced byВ our many shopping malls.



AnnualВ GDP



You can also compare the GDP from one year to the next, which gives an indication of economic growth on an annual basis, or year by year. For instance, if a country’s GDP grows by 10 percent from one year to the next, the economy is growing rapidly. If its GDP goes down, the economy is weakening. If the GDP stays about the same, the economy is stagnating.



Another way of making the GDP useful is to look at per capita GDP. To do this, you divide a country’s GDP by its population. This tells you the average amount of economic activity contributed by each person in that country.



GrowingВ Up



There are measurements for almost every type ofВ economic activity. These measurements are usually reported as growth rates. Growth rates show how much economic activity there is inВ specific parts ofВ the economy.



There are additional indicators that show how fast the economy is growing (or shrinking) inВ particular areas. There are also dozens ofВ other government statistics that measure economic activity, all ofВ which tell us how well businesses and consumers are doing.



Additional growth indicators include

• Corporate profits.

• Farm income.

• Industrial production.

• New housing construction.

• Personal income.

• Retail sales.



Growth is important for an economy.



Help Wanted



GDP and other growth indicators measure the amount ofВ activity taking place inВ an economy. Another way toВ measure activity is toВ look at inactivity.



One important measure ofВ inactivity is the unemployment rate. This indicator tells us the percentage ofВ workers who are out ofВ work. This is aВ good way toВ measure the health ofВ an economy. When only 5В percent ofВ people are out ofВ work, the economy is much healthier than when the unemployment rate is 10В percent.



As with GDP, comparisons across time provide aВ more useful perspective. If the unemployment rate is declining, that means more people are working. The economy is getting stronger. If the unemployment rate is rising, then the opposite is true.



Did You Know?



A country’s unemployment rate might actually be higher than what is officially listed. This is because many people who are out of work do not report this fact to the government, so they do not get recorded as part of the total percentage of unemployed citizens.



When aВ lot ofВ people are out ofВ work, the economy is not healthy.



The Rising Cost ofВ Living



People from an older generation remember when aВ penny or aВ nickel was worth much more than today. There is aВ reason your grandparents could buy candy for aВ penny, while you have toВ spend close toВ aВ dollar. It is called inflation.



Inflation is aВ feature ofВ economic systems that demonstrates that as time passes, things get more expensive. This might seem unfair if incomes always stayed the same. But usually incomes go up as prices rise. This helps offset increases inВ the cost ofВ living.



Still, not every good or service increases inВ price over time. InВ fact, some prices actually decrease over the years. When aВ technology is very new, it is often quite expensive. As technology advances and new ways are discovered toВ produce something more efficiently, the price ofВ an item might actually decrease. Examples ofВ items that have decreased inВ price after first being introduced are radios, televisions, and personal computers.



The average price for aВ gallon ofВ gas rose during aВ relatively short period ofВ time. Think about possible reasons why the price continues toВ rise today.



The Increasing Price ofВ Gas

1977: $0.55

1980: $1.00

1990: $1.25

2000: $1.55

2006: $3.00

2014: $3.56



The InflationВ Rate



TheВ U.S. government measures inflation with something called the Consumer Price Index, or CPI. The CPI is the average price ofВ aВ group ofВ goods and services such as food, transportation, and medical care. As the CPI rises, economists can get an overall picture ofВ how fast prices are rising. This lets them determine what the inflation rateВ is.



The inflation rate is an important economic indicator. It lets people know how fast they should expect prices toВ rise.



The inflation rate can also be used toВ adjust for the effects ofВ inflation. Doing this shows how much something inВ the past would cost today. For example, byВ calculating the inflation-adjusted price, you would find out that something you paid $5В for inВ 1990В would cost $8.90В inВ 2013.



It is easy to see the effect of inflation – did you ever see gas selling so cheaply?



What Your Money CanВ Buy



Prices are always going up, but not all prices rise at the same rate. Some prices go up faster than the inflation rate, while others go up more slowly.



If the actual price and the inflation-adjusted price are about the same, then the price has not really gone up, even though the number on the price tag is bigger.



For example, when gas went from 55В cents per gallon inВ 1977В toВ $1.55В inВ 2000, that was about equal toВ the inflation rate. So, gas cost about the same. But inflation would have made that $1.55В inВ 2000В into only $1.82В byВ 2006. When gas went up toВ $3, it rose faster than inflation.



Often, when prices go up faster than the inflation rate, it is aВ result ofВ high demand. For instance, football is aВ more popular sport today than it was inВ 1975. So prices for tickets toВ the Super Bowl have increased more than three times as fast as the inflation rate. Other areas where prices have outpaced inflation include medical care and college education.



If prices rise at 4% and your income does the same, you are not harmed inВ the short run. But you might be harmed inВ the long run as you try toВ save for college or retirement if your savings cannot keep up with rising costs over aВ long period ofВ time.



As time goes by, aВ dollar buys less and less.



Knowledge Is Power



Decision making is an important part ofВ the game ofВ economics. Making good decisions requires knowledge, skill, and information.



The indicators give economists and others aВ fairly good picture ofВ how the economy is doing.



Economic indicators have an influence on the decision-making process. For instance, the inflation rate is useful for making smart decisions. Imagine that you want toВ buy an expensive new TV. If the inflation rate is high, it might make sense toВ buy the TV now before it gets much more expensive. On the other hand, it might make more sense toВ save the money because your rent and food bills are going toВ go up, too. Economic indicators are like signposts guiding you along an economic path. If read correctly, they can help an economic player arrive at safely at aВ destination.



People who try toВ make money inВ the stock market use all kinds ofВ information toВ make predictions.



Doctoring the Economy



Economists are like doctors who try toВ determine the health ofВ the economy. They use different measures, such as gross domestic product, growth rates, the unemployment rate, and the inflation rate. These indicators provide useful information when it comes toВ making good decisions.



Unfortunately, unlike doctors, economists cannot cure economic sickness. They can diagnose the problems, but they leave it toВ us toВ make our own economic choices.



Economists examine the health ofВ the economy.



Someone born inВ 1950В lived without computers for some 30В years, and then witnessed the evolution ofВ laptops and the Internet. Later, he or she witnessed the invention ofВ the cell phone and then the development ofВ smart phones.



All this technology has drastically changed the way people live. Changes inВ technology affect the economy on aВ large scale, which inВ turn affects how people play the game ofВ economics.



What could be coming next? We do not know exactly, but we do know there is something coming. And it will probably be amazing.



Humans are always striving toВ do things better. Developing technology is one way toВ do this. The advancement ofВ technology leads toВ greater speed, higher production, and increased efficiency.



Many people think ofВ technology as electronic devices such as computers, cell phones, and other wireless tools. These kinds ofВ devices can certainly improve results inВ many areas.



Computers help people work faster byВ making it easier toВ find, organize and reorganize information. Cell phones make it easier toВ get inВ touch with others. Some devices can include aВ calendar, address book, computer, camera, and phone all inВ one.



But technology includes more than just smaller, faster, more powerful electronic devices. Technology is any new advancement inВ or application ofВ science that improves results.



The Power ofВ Machines



For thousands ofВ years, humans have been inventing things toВ make their work easier, faster, and more efficient. Many ofВ the things people have invented are machines that use power toВ replace human or animal effort.



You can get from one place toВ another inВ aВ horse-drawn carriage. But the car, once known as the В«horseless carriage,В» gets you there much faster. The car improves the ride.



The horse-drawn carriage was aВ technological development aВ long time ago. It provided an alternative toВ walking for those who could afford it. With aВ horse-drawn carriage, people could get toВ places much faster and with less effort.



The car increased that speed and reduced that effort even more.



Build aВ Better Mousetrap



New technologies are invented every day. In most cases, today’s devices are not made to replace human or animal effort. Instead, they are designed to replace older, less powerful machines with newer versions.



For example, the telephone replaced the telegram. While the telegram was the fastest way ofВ getting messages from one place toВ another inВ its time, the telephone further increased the speed ofВ communications.



More recently, cell phones are quickly replacing home phones and other so-called В«land lines.В» Home phones make calls fine, but their area ofВ use is limited. Cell phones can go anywhere. This development makes an already powerful technology even more effective.



AВ Method toВ Their Madness



There is more toВ technology than just machines. Smaller, faster, more powerful machines lead toВ improved results. Better results can also be produced byВ organizing time or energy inВ new and different ways. Technological improvement can come from introducing aВ new method.



Methods are all over the place, even if you do not realize it. Nearly everything you do follows aВ method ofВ some sort. How many fingers do you use toВ type, two or 10? That is your method. Do you brush your teeth with aВ side-to-side or swirling motion? Whichever you use is your method.



Some methods can be improved by changing them. These improvements are also technological developments. They improve results and make people’s lives better by increasing speed, efficiency, power, and so on.



Productivity IsВ Up



Producers like toВ improve efficiency. If they can make goods more easily, more quickly, and with less money, they can increase their profits. Producers are always looking for technological improvements toВ increase productivity. Machines can help do this.



Power tools tighten bolts more quickly than regular wrenches. Electric sewing machines enable faster production ofВ clothing than aВ needle and thread. Backhoes haul much larger loads ofВ dirt than shovels.



These are just aВ few examples. Machines are used inВ almost all types ofВ production toВ make things easier and faster for workers. Sometimes, machines even replace workers entirely, eliminating human effort from the production process.



New methods can also increase productivity. One ofВ the most powerful production methods is the assembly line.



The assembly line is aВ simple concept. Instead ofВ having workers move from one production task toВ another, workers line up and each performs just one task as the product moves down the line. Each worker performs aВ different task very quickly as products move along. Also, each task uses just one tool, so no one has toВ put tools down or move toВ aВ different position. This eliminates extra extra motion and increases the speed ofВ production.



The assembly-line method can be used toВ do anything that requires several steps, which is just about everything.



Prices AreВ Down



Improving productivity has major effects on the overall economy. For one thing, increased productivity usually leads toВ lower prices.



According toВ the law ofВ supply and demand, when supply increases, prices drop. When technology makes production more efficient, there is usually more supply. That brings down the price ofВ those goods. When the price ofВ aВ good drops, more people can afford toВ buy the good, so producers make more sales and more profits.



The increased demand because ofВ lower prices would normally raise prices again. But greater productivity helps producers meet rising demand with even more supply, so they can keep pricesВ low.



Greater productivity brings cheaper goods toВ more people and wealth toВ the producer. Producers use some ofВ this wealth toВ develop even better technologies, further increasing productivity.



Increased productivity makes more goods available more cheaply.



The Ripple Effect



Technology increases productivity byВ making it easier and cheaper toВ produce goods and services. This lowers prices and brings more goods and services toВ more people. There is also aВ ripple effect that occurs when goods and services are widely available. When more people have access toВ something, it changes how they behave.



Think ofВ the cell phone. When very few people had aВ cell phone, its usefulness was limited. You could usually only reach people at home because few other people had cell phones.



However, as cell phones became less expensive, more and more people could buy them. Eventually, cell phone owners could reach more people inВ more places. That increased the number ofВ calls. Today, most people can be reached no matter where theyВ are.



Prices came down, more people got cell phones, and the number ofВ conversations went up. That is the ripple effect inВ action.



Although Ransom E. Olds ofВ Oldsmobile invented the original assembly line, Henry Ford introduced conveyor belts toВ the design, which greatly sped up production.



ByВ 1914, the Ford factory was turning out aВ new Model-T every 93В minutes. Because ofВ the speed ofВ production, the Model-T could be made and sold very cheaply. Cars were no longer aВ luxury. Suddenly, millions ofВ people could afford cars, and it did not take long for most families toВ have aВ car.



This had aВ ripple effect on the way people lived. Now that cars were so common, people could live farther from where they worked. This led toВ the development ofВ suburbs. Instead ofВ living inВ crowded cities or distant farms, people had both space and access toВ the city.



Ford’s assembly line changed the place – and the way – many people lived.



Because ofВ the development ofВ suburbs, more highways were needed for people toВ get back and forth toВ work. Soon there were highways connecting different cities all across the country. These highways made it easier toВ go long distances, and that meant that people could take vacations toВ far away places byВ driving there.



The tourism industry became much larger once most Americans had cars. With increases inВ tourism came more motels and amusement parks and restaurants.



The Model-T changed America into aВ car society, and this affected other parts ofВ the American economy. Increases inВ productivity often have this kind ofВ ripple effect.



Make ItВ Fast



Distribution is another area that benefits from technological improvements. If productivity is improved, prices go down and more goods are available toВ consumers. And if goods can be moved around more quickly and inexpensively, the same thing happens.



Technology has been helping improve the distribution ofВ goods since the first horse-drawn cart was piled full ofВ goods toВ be transported elsewhere. InВ the past 50В years, there have been drastic improvements inВ distribution technology.



FedEx changed the package delivery industry byВ introducing aВ new type ofВ system called the hub-and-spoke model.



Strange as it may sound, FedEx sent all ofВ its packages toВ aВ central facility inВ Memphis before shipping them toВ their final destination. Even if you were sending aВ package from New York toВ Boston, it went toВ Memphis first. This is called the hub-and-spoke-model ofВ distribution.



Here’s how Fred Smith, the founder of FedEx, explained the advantage of this method:



If you take any individual transaction, that kind of system seems absurd – it means making at least one extra stop. But if you look at the network as a whole, it is an efficient way to create an enormous number of connections. If, for instance, you want to connect 100 markets with one another and if you do it all with direct point-to-point deliveries, it will take 100 times 99—or 9,900—direct deliveries. But if you go through a single clearing system, it will take at most 100 deliveries. So you are looking at a system that is about 100 times more efficient.



FedEx not only used this new method of shipping packages. They employed new technological devices to make sorting and delivery easier. FedEx used bar codes to sort and track packages, and it put computers in delivery vans to map the driver’s route and continue tracking packages.



Both the hub-and-spoke model and electronic devices led toВ faster deliveries. Soon other delivery companies were imitating Federal Express. Today, fast, and reliable delivery is aВ regular part ofВ life, thanks toВ FedEx and the technological advancements they developed and used.



Simplicity



Technologies do not have toВ be complicated or powerful toВ have aВ major impact on productivity and distribution. Sometimes it is enough just toВ make things simpler, like FedEx did, or toВ standardize methods.



One ofВ the most influential technological advancements inВ the past century did both ofВ these things. The cargo container is just aВ simple rectangular box, but it changed the world ofВ shipping and distribution byВ standardizing and simplifying.



The cargo container is partly responsible for rapid increases inВ global trade.



The RevolutionaryВ Box



Cargo containers are simple metal boxes with aВ wooden floor, 8В 1/2В ft high and either 20В or 40В ft long. Because ofВ their simplicity, the cargo container has increased the efficiency ofВ cargo transportation, making the distribution ofВ goods both faster and less expensive. This has increased the amount ofВ international trade and made it possible for consumers toВ purchase goods more cheaply. There are nearly 15В million ofВ these boxes currently roaming the Earth, and inВ 2005, nearly 8В million containers entered the United States. Their cargo was worth almost $800В billion.



Before containers, cargo was loaded and unloaded byВ dockworkers known as longshoremen. Longshoremen could sometimes use cranes and forklifts, but much ofВ the cargo was contained inВ bags, boxes, and barrels that had toВ be moved piece byВ piece, sometimes byВ hand. This took aВ very long time and was tiring and dangerous. AВ normal ship could take aВ week or more toВ unload, with 20В longshoremen working around the clock. The cost ofВ paying these dockworkers was enormous. Labor costs were at least half ofВ the total cost ofВ shipping goods.



With the use ofВ cargo containers, freight can be loaded and unloaded much more quickly and easily. Special cranes called straddle carriers pick up and drop off containers. The straddle carriers grab containers, wheel them from ship toВ dock or vice versa, and drop them again, transporting aВ large amount ofВ cargo inВ aВ matter ofВ minutes. It now takes less than 10В hours toВ unload the same amount ofВ cargo it once took aВ week toВ unload, and the process requires fewer workers and is less likely toВ involve accidents or breakage.



The cargo container also makes it much easier toВ transport goods from the dock toВ warehouses, distribution centers, and stores. The containers can be put onto flatbed train cars just as easily as they are loaded and unloaded from ships. Or they can be placed on wheels for transport byВ truck. Goods can go nearly the entire length ofВ their journey from factory toВ store inВ the same container. This eliminates all ofВ the wasted time ofВ loading and unloading freight into different carriers.



The increase in speed and reduction in labor costs have made distribution much less expensive, and this makes the prices that consumers pay much lower. Before the cargo container, shipping costs accounted for about one-eighth of the price of goods. The cut that goes to shipping is now less than 1 percent. For example, it costs only 34 cents to ship a pair of shoes from an Asian factory to an American store that can sell the shoes for $45. The shipping costs once would have been $6 or $7. With such high shipping costs, it made more sense to simply make the shoes in America, where they were going to be sold. But many goods can be made more cheaply in other countries, and now that it is inexpensive to ship them to America, they cost much less at the store. This simple technology – the rectangular box – has revolutionized shipping and helped transform the global economy and the American consumer experience.



The Economic Effects ofВ Technology



There is so much technology available today.



Technology can improve production and distribution. The improvements affect the price and availability ofВ goods and services. They also influence how people live their lives.



Technology gives us different options and affects our decisions. When we are looking at the overall economy, we cannot ignore the effects ofВ technology.



Think ofВ all the things you do on the Internet, whether you use aВ desktop computer, aВ laptop, aВ tablet, or aВ handheld device. You can stay inВ touch with friends, catch up on the news, watch your favorite shows, or just check the weather forecast.



But the Internet is not just about getting information or having fun with friends. The Internet is also a key technology that has affected the overall economy. In fact, the Internet is the world’s largest marketplace.



The Communication Explosion



Different technologies have made it easier and easier toВ communicate. The invention ofВ the printing press made it easier toВ print aВ large number ofВ books. The invention ofВ the radio made it possible toВ broadcast stories toВ large audiences.



With the Internet and smart phones, information ofВ all kinds can be shared very efficiently with nearly everyone on Earth. We can send and receive documents, pictures, videos, and audio files over the Internet and over our phones, and we can do it almost instantly.



The ease ofВ sharing information has led toВ aВ huge increase inВ the amount ofВ communication taking place. People are sharing information far more than they ever have. Think about all the e-mails you write, and the texts you send. Would you ever write that many letters?



The Internet does more than increase communication. It affects how people live their lives. Information is necessary for making decisions, so the Internet impacts how people make choices.



Easier, faster communication gives both producers and consumers access toВ aВ greater amount ofВ information. People can learn more toВ help them make better decisions, and they can make these decisions more quickly. Producers can communicate almost instantly with their employees, their suppliers, and everyone else involved inВ making allocation decisions. Meanwhile, consumers have the latest information about prices, availability, and quality, enabling them toВ make the wisest buying decisions.



The amount and speed ofВ information sharing can help improve the way people play the game ofВ economics.



It is easy toВ communicate these days, even on theВ go.



E-Commerce



Access toВ information is not the only way the Internet has affected the economy. The Internet has created an entirely new type ofВ economic activity called e-commerce. It refers toВ online buying and selling ofВ goods and services. E-commerce is the electronic form ofВ retail sales.



E-commerce has changed the way many companies do business. Almost every store has aВ website that sells items people previously had toВ buy inВ their stores. Many companies do not have actual stores at all; they only sell online.



One ofВ the earliest pioneers ofВ e-commerce was Amazon.com, and the company remains one ofВ the largest online retailers. Amazon began byВ selling books on the Internet. After achieving rapid success, the company branched out into other retail areas. Amazon now sells products ranging from electronics and toys toВ clothing, jewelry, tools, and more. Amazon is aВ leader inВ e-commerce, and its business practices have influenced the entire retail industry.



E-commerce allows just about anyone toВ become aВ global seller ofВ goods, services, and information online. Online business gives producers access toВ the largest market available, with over 1.5В billion people who go online on aВ daily basis.



The Internet is getting more popular among shoppers.



The Growth ofВ E-Commerce



E-commerce started taking off inВ the late 1990s. Since 1999, buying and selling online has been the fastest-growing activity inВ the U.S. economy.



Both consumers and producers have gone online toВ buy and sell, and this trend does not seem toВ be stopping. The amount ofВ money spent online has been growing very quickly. InВ 1999, there was $15В billion worth ofВ online sales. The next year, that total had almost doubled toВ $29В billion. Ten years later, U.S. retail e-commerce sales had reached $169В billion inВ 2010. InВ fact, from 2002В toВ 2010В retail e-sales increased at an average annual growth rate ofВ almost 18В percent, compared with 2.6В percent for total retail sales. InВ 2014, e-sales were about 5.9% ofВ total retail sales.



The growth inВ e-commerce has been remarkably fast, but even with the fast growth ofВ e-commerce, online sales represent less than 6В percent ofВ all retail sales inВ the United States. This means that 94В percent ofВ all goods sold are still purchased the old-fashioned way: inВ aВ store.



The Advantages ofВ E-Commerce



Why is e-commerce becoming more and more popular? Using the Internet toВ buy and sell has advantages for both consumers and producers. That is why online shopping is growing so quickly.



The Internet makes it easy to compare prices. With traditional shopping, it takes multiple trips to different stores to compare their prices. There are Web pages that allow you to see how much dozens of different stores charge for a particular product. Or you can just click from one company’s website to another without having to go anywhere.



Online shopping saves time and money. You do not have toВ go anywhere toВ buy online. You do not have toВ spend time looking for parking, walking into and out ofВ the store, or buying the gas toВ get you there.



Online shopping lets you get things not normally available nearby. With the Internet, the entire world is your store. Wherever something is made or sold, it can be shipped directly toВ you or anyone else.



You can ship gifts without an extra trip toВ the post office. You can do your gift shopping at the last minute and have the box sent right toВ the recipient. Most online stores give you the option ofВ including aВ card and gift wrap.



Consumers like online shopping because ofВ the convenience and availability. E-commerce has advantages for producers too. The Internet makes selling goods and services more efficient for many businesses byВ eliminating unnecessary costs.



Online businesses do not need as many employees. Instead ofВ aВ bunch ofВ salespeople and managers, online businesses only need toВ hire people toВ load goods onto trucks for shipping toВ their customers.



With e-commerce, there are fewer stores toВ run. Some businesses do not even have real stores at all, just warehouses. This saves on rent and labor.



The Internet is an easy form of direct advertising. Instead of putting ads in newspapers and magazines, and on television and the radio, a company’s website is an ad that consumers can look at any time. Advertising on other websites is also less expensive and reaches millions of viewers.



What Sells on the Internet?



E-commerce has done aВ lot for the computer industry. The sale ofВ computers has grown aВ lot since the Internet began taking off. InВ 1990, few people had computers inВ their homes. ByВ the year 2011, over 75% ofВ all-American households had at least one computer.



People with computers are naturally drawn toВ e-commerce for computer products. It is easy toВ buy printers, scanners, wireless routers, and more from online sellers.



What else do you think sells well online? Popular online purchases, with the percentage ofВ total online sales, include

• Computer products: 40%

• Books: 20%

• Travel: 16%

• Clothing: 10%

• Music: 6%

• Gifts: 4%

• Stocks: 4%

• The Internet and Economics



Developments inВ technology have always influenced the overall economy. Through the Internet, people have access toВ more information, which affects their decision-making process. And e-commerce is aВ fast-growing type ofВ economic activity.



Whatever other technological changes are coming, it is likely that the Internet will continue toВ have aВ growing effect on the game ofВ economics.




CHAPTER 1В SUMMARY


The Game ofВ Economics

– Economics is a game played by everyone, in which every player has roles and goals.

– Like other games, the game of economics has rules, properties, and outcomes.

– Unlike other games, economics has no winner. This is mostly because there is no rule that says when the game has to end; in fact, the game of economics never ends.

– Economics is all about the allocation of resources for the production and distribution of goods and services.

– Efficiency, equity, freedom, growth, and security are all goals different players have in the game of economics.

– Although goals are sometimes incompatible with one another, they still must be set in order to play the game of economics.

– Scarcity occurs because resources are limited. This is one reason why allocation decisions are so important.

– The fundamental questions faced by all economic systems are: What will be produced? How should production be organized? How will goods and services be distributed? What is the most effective allocation of resources?




ChapterВ 2



You live inВ aВ world where goods and services are essential. Can you imagine what the world would be like if you could not buy food, use public transportation, or attend classes? The goods and services you use every day are important. Your life would not be the same without them.



InВ the game ofВ economics, different players produce and consume these goods and services. Consumers and producers make the decisions that drive the game ofВ economics. They gather information and weigh options before making aВ choice. They ask themselves certain questions: How much am IВ willing toВ spend? Or how much should IВ produce?



The way people answer these and other important questions determines how they allocate resources. And this inВ turn affects the production, distribution and consumption ofВ goods and services. Economics is powered byВ the many decisions made byВ players. Examine how the various players go about making these important decisions.



Economics is like aВ game. It has rules, properties, outcomes, and players. We all play the game ofВ economics, and ofВ course players are an important part ofВ any game. They make the decisions that drive the action. Economic players make decisions about what toВ produce, sell, andВ buy.



Any time you buy something, you are playing the game ofВ economics. You are participating inВ the economic system. ToВ understand the importance ofВ your role as aВ player inВ the economy, as well as the roles that other people play, examine what the many different playersВ do.



People also have wants – that is, things they desire but could live without, such as concert tickets or the latest basketball shoes. Everyone has needs and wants, and everyone tries to fulfill both, if possible.



Everyone plays the game ofВ economics all the time. Even the simplest actions are economic actions. For instance, if you download aВ ringtone toВ your phone, you are playing the role ofВ aВ consumer. Your cell phone is aВ good.



Consumers make purchases depending on what they need and want. But ofВ course, they must also consider how much money they have toВ spend, and the prices ofВ the things they want. The decisions made byВ consumers send messages. The ring tone is aВ service. Your cell phone provider plays the role ofВ producer.



InВ every type ofВ economic system, there are exchanges between consumers and producers. The decisions that consumers make influence the decisions ofВ producers. Producers decide what and how much toВ produce, depending on the desires ofВ consumers.



Consumers



toВ the other group ofВ players, the producers. Consumers let the producers know what they want toВ buy and the price they are willing toВ pay. Every time aВ consumer decides, it sends this kind ofВ message.



Price has a major effect on a consumer’s decision to buy. If the price of a movie ticket is too high, you might stay home and watch a DVD instead. On the other hand, if the movie theater slashes prices, there will be long lines at ticket office of consumers waiting to see the latest release.



The important role that consumers playВ includes deciding

– What products and services to use and buy.

– How much to buy.

– What price they are willing to pay.



Producers



Consumers make purchasing decisions, but there would not be anything toВ purchase without producers. Producers try toВ satisfy the needs and wants ofВ consumers. They provide consumers with such goods and services as clothing, food, entertainment, and healthcare.



ToВ be successful, producers have toВ determine what consumers want and how much they are willing toВ pay. Producers make all their decisions based upon the decisions made byВ consumers. So, producers are always trying toВ predict what consumers will want next, and how much they will pay forВ it.



Have you ever been toВ aВ water park? How many services do you buy for the price ofВ admission? You can go down aВ variety ofВ slides, swim inВ aВ wave pool, or maybe even watch aВ live show. At aВ water park, producers offer many goods and services inВ one place. ToВ make aВ profit, they must be able toВ anticipate how many consumers will want toВ buy their many goods and services, and what they will be willing toВ pay.



Producers play an important economic role. They decide what to produce, how to produce it, and for whom it will be produced. If they make the right decisions, they will satisfy consumers’ needs and wants.



Workers as Economic Players



Producers produce the things that consumers buy. These things have toВ be made. The people who make the goods and provide the services sold byВ producers play an important role inВ the game ofВ economics. We call these players workers.



Workers create goods and services.



Workers, however, are not aВ third group ofВ economic players. When they make or provide goods and services, they act as producers. But when they purchase things, they act as consumers. Workers play aВ dual role. They are producers and consumers.



Workers as Consumers and Producers



Workers straddle the line between consumer and producer. Sometimes these two roles can be played simultaneously. For example, when aВ restaurant employee is sent out toВ buy potatoes, that worker is both aВ producer (someone making food) and aВ consumer (someone buying food).



Open Workers as Consumers and Producers. Sort the activities into the correct column toВ show when aВ worker is playing the role ofВ aВ consumer, aВ producer, or both.



Businesses as Economic Players



When they make goods or provide services, workers play the role ofВ producer. But it takes more than workers toВ offer those goods and services toВ consumers. For instance, aВ restaurant is more than just aВ group ofВ workers who decide toВ make and serve food toВ people. AВ successful restaurant needs someone toВ apply for the appropriate permits, rent the building, hire employees, buy equipment, and oversee production.



When aВ person or aВ group ofВ partners decides toВ undertake these tasks, they start aВ business. Businesses provide the goods and services the consumers want byВ hiring, organizing, and supplying workers. Nothing would get made without workers. But it is the task ofВ businesses toВ get those things toВ the consumers who want them.



Business Activity



Businesses drive most economic activity. Without businesses, workers would not have anything toВ produce, and they would be unable toВ earn money. Without money, they could not play their other economic role as consumers.



When aВ new business opens, jobs are created for workers. Businesses are producers. But they also provide what the economy needs for consumption. They pay workers what they need toВ consume the goods and services offered byВ producers.



For example, when Dell Inc., aВ computer company, opened aВ factory inВ Austin, Texas, inВ the 1990s, the company provided thousands ofВ jobs for workers inВ the area. The new workers then had money they could spend on goods and services. This boosted local businesses and created even more jobs inВ the area. InВ turn, this led toВ workers earning more money toВ spend on things such as Dell computers. From this example, can you see how aВ big business might help toВ circulate money within aВ community?



Government as an Economic Player



So far, you have seen that most economic decisions inВ the United StatesВ are made byВ individual consumers or businesses. But even under the American free-market system, the government ofВ the United States still plays an important role inВ the economy. TheВ U.S. government tries toВ maintain steady growth, keep prices stable, and provide public goods and services. An example ofВ government action came inВ 2006, when the U.S. government helped stabilize the price ofВ oil byВ ensuring that oil companies could not raise the price ofВ gasoline above aВ certain limit. This enabled consumers toВ continue toВ afford and use gasoline.



This decision also affected the government, because it also buys aВ lot ofВ gas. The government plays the role ofВ consumer even while it is attempting toВ guide and benefit the economy.



Send My Bill toВ the Government



InВ many countries, the government plays aВ more active role inВ the economy. InВ Canada, the government provides universal healthcare toВ all its citizens using taxes paid byВ workers and businesses. InВ this case, the government plays the role ofВ producer.



How Does the Government Play?



The government can fill the role ofВ consumer as well as producer. After all, it takes goods and services toВ run the government. It is helpful, therefore, toВ think ofВ the government as aВ very large, public business.



View How Does the Government Play?, then sort the activities into the correct column toВ show whether the government is playing the role ofВ consumer or producer.



Playing Roles



Consumers and producers play important roles inВ economics. They decide what toВ buy or what toВ produce, and how much ofВ it toВ buy or toВ produce. Other players inВ this game include workers, businesses, and government.



InВ aВ free-market system, people are free toВ decide what toВ buy. But those choices can be influenced byВ others. Sometimes people are influenced byВ family, friends, or advertisements. People are also influenced byВ what is available, how much it costs, and how much money they have. There are many things that can influence the decisions ofВ consumers.



Producers are also affected byВ many influences. What do consumers want? What will they pay for those things? What kinds ofВ advertisements help them decide what toВ buy? These and other questions influence what producers make. Questions about resources influence producers, as well. They need toВ know what resources are available for production, how much they cost, and how far away theyВ are.



Who Has the Power?



Deciding what toВ buy seems simple. You choose what you want and pay someone for it. But the buying and selling ofВ goods and services is much more complicated than that. Part ofВ the reason lies inВ the fact that producers make so many different products. For consumers it can sometimes feel overwhelming. With so much toВ choose from, it can be hard toВ decide.



Why do producers make so much stuff? Producers want toВ sell their goods and services, but not everybody wants toВ buy the same things. If they did, restaurants would have one-item menus and electronics stores would have only one kind ofВ television.



Consumers have the power toВ decide what toВ buy. Producers are aware ofВ this. They make products and services based on what they think consumers will buy. This means producers must pay close attention toВ how consumers behave. ByВ understanding what consumers have done with their money inВ the past, producers try toВ predict what they will be willing toВ buy inВ the future. Because ofВ this, consumers have aВ great influence over the actions ofВ producers. Consumers have aВ great deal ofВ power over producers.



The Power ofВ Producers



Consumers may make the final choice about what toВ buy, but that does not mean producers have no power ofВ their own. The choices made byВ consumers are always limited byВ what is available. Consumers may want toВ buy something, but unless aВ producer makes it, they are out ofВ luck.



Producers determine what is available, and this gives them economic power. For instance, when the quantity ofВ aВ popular product is limited, consumers will often pay aВ higher price. For aВ variety ofВ reasons, including the popularity or rarity ofВ an item, consumers might buy even though the price is high, the quality is not as good, or the choices are limited.



InВ this way, producers have aВ great influence on what is bought.



GuessingВ Game



ToВ sell the things, the goods they make and the services they provide, producers want toВ know what consumers want. What makes them happy? Producers might make an original product that becomes incredibly popular and sell millions. Or they might make an original product that nobody wants and get stuck with aВ full warehouse and aВ lot ofВ unpaid bills. Production sometimes feels like aВ guessing game.



Producers want toВ become masters at this guessing game, and they use aВ variety ofВ methods toВ do so. Surveys or focus groups are used toВ test ideas on small groups ofВ consumers. Based on their reactions toВ new products producers can make better guesses about what the general public willВ buy.



Collecting information on what consumers like and dislike is called market research. If producers can predict what consumers will buy, what products will be popular, or even simply what people need, they can produce aВ lot ofВ it. That allows them toВ sell what they make and grow their business.



Cultural Influences



Producers and consumers influence each other. But the choices made byВ consumers and producers are also affected byВ other factors. Culture plays aВ significant role inВ economic decisions.



InВ most societies, the goods and services produced help distinguish one culture from another. Things like food, art, sports, clothing, and literature differ between cultures. Consumers are influenced byВ their own cultural values and traditions. These traditions influence consumers toВ buy certain kinds ofВ goods and services. They also have an effect on what producers make.



Producers have to be very conscious of what consumers are going to buy, and many consumer decisions are influenced by cultural values. For instance, many cultures value sports. In the U.S., sports such as baseball, football, and basketball are valued very highly. In Europe and Latin America, soccer plays an important cultural role; in some countries, people are even allowed to take time off work to watch a big game or the World Cup. Sports fans all over the world spend millions of dollars every year on tickets and merchandise, but which sports are valued – and therefore potentially valuable to producers – depends on the culture.



Holidays are another important cultural feature. Thanksgiving is aВ big holiday inВ the U.S.В People travel byВ air, car, and train toВ spend time with their families and eat aВ special meal. InВ countries such as Iraq, Lebanon, and Jordan, Eid is aВ very important holiday. Parents buy their children new clothes, shoes, and toys during Eid, which takes place during three days at the end ofВ Ramadan. They also prepare and share special dishes and take time toВ visit with family and friends.



InВ Asian countries such as China, Korea, and Vietnam, the Lunar New Year is the most important holiday ofВ the year. InВ China, for example, the festivities begin on the first full moon ofВ the year and can last for up toВ 25В days. The New Year is aВ time ofВ renewal. Families spend time together eating rich foods and paying respect toВ ancestors and elders.



Different holidays lead toВ different consumption decisions, and these consumption decisions affect producers. AВ producer inВ China is not going toВ be very successful trying toВ sell turkeys inВ November, but aВ producer inВ the U.S. would be wise toВ go into the turkey business around Thanksgiving.



Peer Pressure



Consumers do not always buy goods and services because ofВ aВ need or aВ want. Sometimes consumers make purchases because they feel pressured. Sometimes people buy products simply because others are. This is known as peer pressure.



Peer pressure influences consumer behavior, and it does not just apply toВ young people. People ofВ all ages feel peer pressure. For example, an adult might feel pressure toВ buy aВ luxury car, aВ boat, or some other expensive item simply because that is what other successful adultsВ do.



Because peer pressure can convince consumers toВ buy things they might not otherwise purchase, producers like it. Producers cannot control peer pressure, but often try toВ start aВ trend inВ the hopes ofВ creating peer pressure. Producers try toВ anticipate what the next trend will be, especially during aВ holiday season like Christmas. They can make aВ lot ofВ money if they produce the right product at the right time.



Scarce Resources and the Environment



The decisions made byВ consumers and producers are also affected byВ the availability ofВ resources. Today, many resources are becoming scarce at the same time that the needs and wants ofВ consumers are increasing. Meeting those needs and wants is aВ big challenge for any society.



Goods and services can become scarce as a result of limited availability of natural resources. Environmental changes can also lead to scarcity. For example, farmers who experience drought or floods might lose their crops – an important resource. Big cities can lose electricity, another kind of resource, during heat waves.



AВ Game ofВ Influences



InВ economics, the players all make free choices, but these free choices are not completely free from influence. Consumers and producers influence each other with the decisions they make. Culture, peer pressure, price, and environmental changes also affect these decisions.



View AВ Game ofВ Influences, and match each economic situation listed inВ the left column with the type ofВ influence it corresponds toВ inВ the right column.



Over the years, the quantity and variety ofВ goods and services available toВ consumers has greatly increased. Consumers have many more choices today than ever before.



On one hand, this makes consumers’ choices easier because they can usually find something that they want to buy. However, at the same time it also makes consumer decisions harder. With so many choices, consumers have to sift through many options to find the one that suits them. This takes time and energy.



Consumers use different decision-making methods based on personal values and outside influences. ToВ understand how consumers, participate inВ economics, we need toВ understand how they make decisions and what factors influence these decisions.



Over the years, the quantity and variety ofВ goods and services available toВ consumers has greatly increased. Consumers have many more choices today than ever before.



On one hand, this makes consumers’ choices easier because they can usually find something that they want to buy. However, at the same time it also makes consumer decisions harder. With so many choices, consumers have to sift through many options to find the one that suits them. This takes time and energy.



Consumers use different decision-making methods based on personal values and outside influences. ToВ understand how consumers, participate inВ economics, we need toВ understand how they make decisions and what factors influence these decisions.



Like everyone else, you make decisions every day. But do your decisions always make sense? You certainly hope so. When it comes toВ buying, we all try toВ use rational choice before we make aВ decision.



When consumers make aВ purchase, they try toВ make rational, or wise, decisions. Often, economic decisions are made after thinking about price, quantity, need, and sacrifice. But sometimes economic decisions are irrational, or unwise. Irrational economic decisions can lead toВ trouble.



Like everyone else, you make decisions every day. But do your decisions always make sense? You certainly hope so. When it comes toВ buying, we all try toВ use rational choice before we make aВ decision.



When consumers make aВ purchase, they try toВ make rational, or wise, decisions. Often, economic decisions are made after thinking about price, quantity, need, and sacrifice. But sometimes economic decisions are irrational, or unwise. Irrational economic decisions can lead toВ trouble.



Cost-Benefit Analysis



To make rational choices, we need lots of information. In fact, making wise decisions usually involves cost-benefit analysis. A rational choice will seek to maximize benefits while minimizing costs. Costs and benefits differ from one consumer to the next, so each person’s rational choice will be different as well.



It is YourВ Call



Think, for example, ofВ trying toВ make aВ wise decision about which cell provider toВ use. One company offers 5,000В minutes for $50. Another gives 2,000В minutes for $45. The extra benefit is 3,000В more minutes for aВ cost ofВ only $5. It seems like aВ good deal, right? If you regularly use 3,000В minutes per month, it is aВ good deal. But what if you never use more than 1,500В minutes per month? There is no need toВ pay for extra minutes if you will never use them.



ByВ using information about the two plans and your own needs, you would be able toВ make aВ cost-benefit analysis and come up with aВ rational decision.



Financial Planning



Cost-benefit analysis is helpful when it comes toВ making decisions, but it is not the only tool used byВ consumers. Consuming usually involves money, and most ofВ us need toВ plan ahead and keep track ofВ our money toВ make sure there is enough when we need it. This involves financial planning, which is the creation ofВ aВ strategy toВ pay for necessities and save for future goals.



Give Me aВ Break



Imagine that you have saved some money and now you are ready toВ choose how toВ spend it. Some ofВ your friends are planning toВ go toВ the beach on the weekend. You would like toВ join them, but if you spend your money on aВ day at the beach, you will not have any left. Do you need or want that money for something else? AВ financial plan can help you answer the second question.



As with rational choice, financial planning requires information and an understanding ofВ your financial goals. Financial planning is another form ofВ rational choice. You decide whether the benefits ofВ aВ purchase now are worth the cost ofВ not having the money for aВ different purchase later.



The Benefits ofВ aВ Budget



One tool that some consumers use toВ help with financial planning is aВ budget. AВ budget allows aВ person toВ control how much money is coming inВ and how much is goingВ out.



The main idea behind aВ budget is toВ have enough money toВ pay for the thing you want and need. AВ consumer with aВ budget knows whether he or she can afford toВ go on aВ beach vacation without spending money needed for rent or bills. AВ budget can also help consumers reach their financial goals. AВ budget can help you save for the future byВ keeping your expenses below your income. This leads toВ savings now for spending later.



Top Five Benefits ofВ aВ Personal Budget



Know how much money you are making.

Know how much money you are spending.

Know how much money you are saving.

Plan for future expenses.

Plan for future savings.



Fixed and Flexible Expenses



Expenses are part ofВ life. AВ budget helps monitor and control them.



There are two main types ofВ expenses: fixed expenses and flexible expenses. Fixed expenses, such as rent, aВ car payment, or tuition, are necessary and generally do not change from month toВ month. Flexible expenses, such as buying video games, paying for car repairs, or purchasing new clothes, are non-necessary or unplanned spending. Sometimes, flexible expenses can be adjusted or eliminated. At other times, however, they cannot be avoided.



Fixed expenses must be taken into account inВ aВ budget, because they rarely change and usually cannot be eliminated. Once the fixed expenses are paid for, there may or may not be much left for flexible expenses.



Short-Term Expenses



Fixed expenses cannot be avoided. They are part ofВ life. The financial planning that takes care ofВ these expenses is known as short-term planning. Short-term planning involves keeping track ofВ and covering all fixed expenses such as food and rent.



Most consumers do not limit their budget to just the necessities. They also try to plan for flexible expenses like entertainment, gifts, trips, and unforeseen circumstances that are a regular part of nearly every consumer’s spending habits. Short-term planning allows consumers to have enough money to do some of this discretionary spending.



Securing Your Future



Short-term planning takes care ofВ expenses for necessities and some luxuries. But most people have financial goals that go beyond just meeting their day-to-day expenses.



ToВ prepare for spending inВ the years toВ come, many people employ long-term planning. This kind ofВ planning involves looking into the future toВ make wise decisions.



Long-term planning can seem aВ bit overwhelming. It can be hard toВ plan for spending that you will not do until 20В years have passed. But long-term planning has many important benefits. Wise consumers try toВ think about the long-term plan even though it can be difficult toВ predict the future.



What is Your Plan?



How about you? Have you considered your long-term expenses? Have you started saving money for college, or maybe for aВ down payment on aВ car? These are two common reasons for long-term planning.



Assets and Income



When consumers plan for the future, they pay attention toВ assets and income. An asset is anything aВ person owns that has monetary value. Personal assets can include cars, computers, jewelry, or aВ savings account. Income is the money aВ person gets, whether as aВ gift, aВ salary, or earnings from an investment.



Knowing your assets and income is necessary inВ helping you plan your budget. This, inВ turn, will affect the way you spend your money. For example, you could decide toВ invest inВ stocks this year. Five years from now, you may show aВ profit on this investment. That extra money can help pay for tuition. This is an example ofВ how long-term planning can be effective. You can plan now for how your assets and income might grow inВ the future.



View Assets and Income. Sort each example into the appropriate column toВ show whether it is an asset or aВ form ofВ income.



Financial Planning and Decision Making



Consumers engage inВ both short-term and long-term planning. Without short-term planning, you might have fixed expenses that go unmet. Without long-term planning, you cannot move toward your bigger goals such as going toВ college, owning aВ home, and eventually retiring.



Both short-term and long-term planning affect how consumers make decisions. What consumers spend now often depends on their plans for the next month, the next year, and the distant future.



View Financial Planning and Decision Making. Sort the following financial goals into the correct column below toВ make sure you understand the difference between short- and long-term planning.



Consumers inВ the economy are aВ bit like runners inВ aВ race. The runners each have aВ different reason for competing. Some may be happy just toВ be inВ the race at all. Others may be intent on achieving aВ personal best, while for others only winning the race will do. All the runners take part inВ the race toВ achieve some sort ofВ satisfaction. They run toВ find fulfillment. Consumers buy goods and services for just the same reason. They want toВ find satisfaction when they participate inВ the economy.



What makes someone satisfied? OfВ course, the answer is different for everyone. Some people are content with little, while others can never seem toВ get enough. As one ofВ the richest men inВ the world, Henry Ford was once asked, В«How much is enough?В» He answered, В«Just aВ little bit more.В»



Some want toВ win, while others are happy toВ participate.



Utility



Satisfaction cannot be easily measured. But because nearly all economic decisions involve consumers in search of satisfaction, economists try to understand it. They call a person’s economic satisfaction utility. Utility is the amount of personal satisfaction consumers get from the goods and services they purchase.



For instance, if you buy aВ new CD and find that you really like the music on it, then you are satisfied. Your utility is high. If you do not like the music, however, you are not so satisfied. Your utility is low. The concept ofВ utility applies toВ every decision you make when buying goods and services. It is an important factor toВ consider when looking at how consumers make decisions.



Remember that your measure ofВ utility is quite different from that ofВ others. Your utility depends on your personal tastes and preferences, your goals, and your individual situation. Someone else might love aВ CD that you did not like very much. Utility levels differ from person toВ person.



Some things can be weighed easily, but satisfaction is not one ofВ them.



Utility and the Cost-Benefit Analysis



You already know that consumers use the cost-benefit analysis to make economic decisions. Costs and benefits can be measured in monetary or nonmonetary terms. Ultimately, costs are measured in satisfaction, or utility. Since each person’s utility is different, different people make different decisions in the same situation.



Consider this example. Mike and Emily are inВ the same physics class. They are both having aВ hard time understanding the material, so the teacher offers toВ help them catch up after school. The cost toВ each ofВ them is aВ few hours at the end ofВ the school day. While the time commitment is the same for both, their utility may be quite different. Emily has other after-school activities that she does not want toВ miss. Mike has no other plans after school. The cost ofВ this time is different toВ each ofВ them. Their utility is different.



Different decisions result from different tastes and preferences.



The Road Not Traveled



When you make decisions as aВ consumer, you do not consider just one possibility. For instance, if you are thinking about going toВ aВ movie, you are weighing two different options: going and not going. Not going leaves you other options: reading aВ book, taking aВ walk, or playing aВ game with aВ friend. Every decision involves following one path and not following all the other possible paths.



So, aВ decision is not just about selecting something that has more benefits than costs. It is about selecting the option that gives the greatest amount ofВ utility from among all the available opportunities. Consumers have toВ consider the benefits lost as aВ result ofВ their decisions.



Think ofВ aВ farmer who decides toВ grow corn on his land. His opportunity cost is the alternative crop that might have been grown. What if he decided toВ grow wheat instead ofВ corn? Would he have made more profit? Since he decided toВ grow corn, he gave up the alternative toВ grow wheat. He considered both options before making his decision, and inВ the end, he thought that it would be more profitable toВ grow corn.



Utility and Incentive



ToВ maximize utility, consumers and producers look at incentives. These are the factors that motivate or influence human behavior.



Incentives can be monetary or nonmonetary. If you work very hard at your job, you might get rewarded with a bonus or a pay raise. Your employer is giving you a monetary incentive to work hard. If your hard work earns an extra week of vacation instead, that is a nonmonetary incentive. Because utility is a person’s satisfaction, an incentive can raise utility whether it is monetary or nonmonetary.



Incentives increase the possible benefits ofВ aВ decision. As such, they affect the cost-benefit analysis aВ consumer might make.



Most people would agree that aВ bonus is aВ better incentive than aВ pat on the back.



What DrivesВ You?



When you look at opportunity costs, you consider monetary and nonmonetary incentives.



If you reduce your part-time work hours toВ do volunteer work inВ your field ofВ study, you will decrease your monetary benefits but probably increase your nonmonetary benefits. The volunteer work helps others and makes you feel good. This decision could also have aВ monetary effect; the experience you get from volunteering might help you get aВ better paying job inВ the future.



Untangling and calculating the monetary and nonmonetary incentives can be tricky. As aВ consumer, you do it all the time when you make decisions.



Marginal Analysis



Consumers try toВ boost their utility byВ making decisions that maximize satisfaction, or benefits, while minimizing costs. You have seen that cost-benefit analysis and paying attention toВ opportunity costs help consumers figure out what decision will be best.



Consumers also use marginal analysis when they make decisions. Marginal analysis helps answer an important question: What happens if the situation changes byВ one unit ofВ something? Economic players ask themselves this question inВ one way or another all the time.



Consider this situation: The latest summer blockbuster has gotten some pretty bad reviews but seeing it will give you aВ chance toВ do something with your friends. Besides, tickets for aВ matinee are only $5. The utility you will receive from that purchase seems high.



But what if you get toВ the theater and discover that the ticket prices have been raised byВ $1? It might still seem worth it toВ go. But it is also possible that the extra dollar pushes the cost higher than the benefit. If that is true, then your utility has decreased, and you likely will choose not toВ go.



Will you see the movie for $6? How about $7? What about $8? At aВ certain point, the price will rise high enough that the cost outweighs the benefit, and your decision would change. That is marginal analysis.



Producers Thinking Like Consumers



Even though they may be unaware ofВ it, consumers use marginal analysis when they make economic decisions. For every good or service, there is aВ point at which consumers change their minds about making aВ purchase if the price gets too high. Consumers are not necessarily aware ofВ the fact that it was marginal analysis that led toВ that decision.



Producers, on the other hand, pay close attention toВ marginal analysis. They hope toВ maximize profits, which means they want as many customers as possible toВ pay the highest price possible. ToВ achieve this, they try toВ predict consumer behavior. Producers ask themselves questions such as, В«Will raising ticket prices byВ $1В drive away moviegoers, or will most consumers be willing toВ pay that much more?В»



Producers use marginal analysis all the time. When producers can increase the utility ofВ consumers, they sell more goods and services. When they can get the most out ofВ consumers, they will maximize profits.



Producers study consumers toВ see how they make decisions.



More Than Price



Marginal analysis can be applied toВ other questions as well. Any time one more unit ofВ something can be added, the question ofВ whether it is beneficial toВ do this must be asked and answered.



AВ bank manager looks aВ bit worried. Her customers seem toВ be waiting aВ bit too long before they are served byВ aВ teller. What if she hired one more teller? The waiting time would decrease, and her customers would be more satisfied. If the customers do not have toВ wait very long, it is highly possible they will return toВ the same branch.



AВ hungry customer has already eaten three plates ofВ sushi. He is considering ordering one more plate and uses marginal analysis toВ compare the pros and cons ofВ doing so. He knows that he might not enjoy the fourth plate ofВ sushi as much as he enjoyed the first three. And he does not want toВ get sick from overeating. InВ the end, his marginal analysis tells him toВ forgo that fourth plate.



David is aВ city council member. The council needs toВ vote on aВ one cent increase toВ aВ local tax. David and another city council member want toВ vote inВ favor ofВ the tax increase. The extra money will allow the city toВ replace aВ worn-out playground at aВ neighborhood park, which would be beneficial toВ local residents with children. AВ third council member is against the tax increase, because not all residents will benefit from the new park, and she thinks the money could be spent inВ aВ better way. Marginal analysis is different from person toВ person because everyone has individual goals and values.



Everyone is unique. It is what makes people separate individuals, each with their own likes and dislikes. In the game of economics, this uniqueness means that consumers have different tastes and different preferences when it comes to buying goods and services. Look at all the brands and types of cereals in a grocery store. That should give you some idea of how diverse consumers’ tastes are.



Consumer decisions are influenced byВ many factors. Taste is just one ofВ them. See the list below for some ofВ the nonmonetary factors that influence consumers.



– Taste

– Culture

– Beliefs

– Values



Beyond Money



Culture, family traditions, and personal values all affect consumer decisions. These factors are nonmonetary incentives.



When a family celebrates Thanksgiving, they make economic decisions that might be influenced by the desire to cook the perfect meal. So, they might ignore other factors, like price, because they gain more utility from the feast itself than from cutting costs. The nonmonetary incentive of hosting a great Thanksgiving meal outweighs monetary incentives – at least to a point.



The combination ofВ cultures, beliefs, and values leads toВ different kinds ofВ decisions being made byВ different consumers, even when they face the same situation.



Working together as aВ family offers incentives that go beyond money.



Culture Matters



The desire for particular goods and services is often influenced by a person’s culture.



Part ofВ the culture ofВ the United States is Independence Day, or the Fourth ofВ July. Thanksgiving is also important inВ the United States. Because ofВ these features ofВ the culture, consumers buy aВ lot ofВ fireworks inВ early July and aВ lot ofВ turkeys inВ late November.



How Culture Influences Consumerism



As we learned before, our economic decisions are based on what culture or cultures we belong to. Culture is more than just holidays and sports, though. For instance, the rock-and-roll culture is highly present inВ many countries around the world. People who belong toВ this culture enjoy dressing like rockers, buying and listening toВ rock music, attending concerts given byВ their favorite bands, and collecting memorabilia.



Traditional Native American cultures consider humans an integral part ofВ the environment, not aВ dominating force. They are closely tied toВ natural resources and events, and they value and respect nature. For example, they avoid over-consumption ofВ water or lumber inВ order toВ protect lakes and forests. They also value self-sufficiency, and often produce their own goods and services through gathering, hunting, and fishing.



We do not necessarily have to be part of a culture to celebrate it. For example, St. Patrick’s Day is an important holiday in Ireland, but it is also widely celebrated all over the world. On March 17 of every year, people of all different cultures can be found wearing green and making merriment. Producers take advantage of the universal appeal of St. Patrick’s Day to market and sell specific products, such as green clothing, festive decorations, and even green food. In this case, St. Patrick’s Day has become an adopted culture for many.



Values and Beliefs



Culture is more than just holidays and traditions. Different cultures have different values and beliefs that influence their members’ behavior.



Values and beliefs are linked. If you value aВ clean environment, then recycling is likely toВ be aВ part ofВ your value system. Your behavior is guided byВ that value. If you believe that free trade is the best kind ofВ system, then you would not mind buying leather shoes from Brazil or aВ pair ofВ jeans imported from Italy. If you believe inВ supporting local businesses, on the other hand, you might buy only locally grown fruits and vegetables.



Producers try to understand consumers’ values and beliefs when allocating resources, because values and beliefs affect the way consumers make economic decisions.



For example, recycling is an integral part ofВ South Korean culture. The government makes sure that recycling bins are available across the country, and it employs officers who routinely check toВ make sure people put their refuse inВ the correct bin. Because this is an important value among South Koreans, producers there try toВ make eco-friendly products toВ increase the sense ofВ utility among consumers.



How green areВ you?



Risk Aversion



Every economic decision aВ person makes contains some sort ofВ risk. Some decisions are less risky than others. If aВ college student puts $5В inВ aВ savings account, there is little risk, but also very little reward. Her money is safe, but it will not grow fast. If, on the other hand, she uses the $5В toВ buy aВ lottery ticket, she is taking aВ big risk, with the possibility ofВ aВ great reward. Most likely, she has lost the $5В forever. But there is aВ slight chance she will win millions.



Many people play the lottery. Many others do not. This is because everyone has aВ unique level. Some people will always choose the less risky option, even if the possible reward is small. Other people will go with something far riskier inВ the hope that they will get aВ big reward.



It is common for people toВ have aВ high level ofВ risk aversion. Security is an important value toВ many people. But many people have low levels ofВ risk aversion. These risk takers make very different decisions than people who prefer toВ play it safe.



Here is one example ofВ risk aversion. Suppose you loaned aВ friend $300В last month. Today, he offers toВ pay it all back, or toВ invest it inВ his Internet company. You have aВ high level ofВ risk aversion if you prefer that he pay you the $300В now. You are not sure how profitable his business will be, so toВ you it is not worth taking the risk. You have aВ low level ofВ risk aversion if you decide toВ let the $300В ride and see if you end up with more inВ the longВ run.



There is no such thing as aВ safeВ bet.



Let us Talk AboutВ You



Cultures, values, beliefs, and risk aversion all play aВ part inВ the economic decisions that people make. People do not even have toВ be consciously aware ofВ these factors. They just do what seems right. This does not mean these factors are not influential. It just means that many consumers are not conscious ofВ their influence.



You can see the influence these factors have more clearly if you think about your own views. Do you know what your value and belief system is? Do you ever think twice about making an economic decision based on what you believeВ in?



The media has all sorts ofВ messages for us. At times it can feel like aВ constant bombardment from the television, the phone, and the Internet, not toВ mention the radio, magazines, mail, billboards, and all the other ways that words and pictures are hurled at us. It is almost impossible toВ escape the media.



Think ofВ the many advertisements for products and services you see inВ just one day. Could you even count them all? InВ addition, you get warnings, instructions, questions, information, and all kinds ofВ other messages.



Communication is an important feature of human behavior, and the media’s primary focus is communicating one message or another to consumers.



Types ofВ Media



Companies use the mass media toВ communicate information about their products and services toВ aВ large number ofВ people. Producers are aware that consumers are the ultimate decision makers inВ the game ofВ economics. Producers, however, also know that the mass media can be aВ powerful method ofВ persuading consumers toВ buy their goods and services. Take aВ closer look at how this works.








Traditionally, news media is aВ subset ofВ mass media with its own content and purpose. InВ recent years, however, the lines between general mass media and news have blurred.



Influencing Consumer Behavior



Television, magazines, and other media can be highly influential. Popular sitcoms create images ofВ consumption that inform our own consumer behavior.



Consciously or not, some people adopt the styles, fashions, and even attitudes ofВ their favorite TV characters. Some consumers make decisions based on their desire toВ look or live inВ aВ way that resembles the lifestyles they see onВ TV.



Magazines can have a big effect on consumer behavior, as well. Fashion magazines influence some women’s perception of beauty and influence the products they buy. Men’s magazines also influence how men see themselves. They have articles that include news, sports, men’s fashion, and even lists of the top outfits men should have in their closets.



Some people adopt the styles they see on their favorite shows.



Mass Media



Mass media has aВ big effect on how consumers view themselves.

Companies advertise their products and services inВ all forms ofВ media. This is done indirectly through product placement and directly through advertising.



Advertising is the biggest method used byВ producers toВ influence consumer behavior.



There are many methods and techniques ofВ advertising. You are probably familiar with most ofВ them already. TV commercials, magazine ads, billboards, and even signs on the sides ofВ buses all infiltrate our lives on aВ daily basis.



On the Internet, most Web pages contain advertising, often including pop-up screens and animations. You can get advertising delivered directly toВ your cell phone,В too.



It pays toВ advertise.



Over the years, the sophistication ofВ advertising techniques has advanced, as have breakthroughs inВ communication technology. Many people use the Internet every day and depend on it toВ get information. This makes the Internet an enticing vehicle for advertisers. Unlike radio, television, and print sources, the Internet is aВ nonlinear form ofВ media, making it possible toВ advertise inВ various ways. Banner ads, pop-up windows, corporate Web pages, and bulk e-mails are some ofВ the methods used.



Advertising Strategies



The main purpose ofВ advertising is toВ get consumers toВ demand more goods and services. There are many ways toВ do this. One is toВ create aВ need for aВ product byВ emphasizing the connection between aВ product and aВ certain aspect ofВ life.



For example, most people want toВ be clean. Soap and shampoo are needed toВ be clean, but is that all? If advertising can convince consumers that they also need deodorant and conditioner toВ feel clean, then more people will buy deodorant and conditioner.



Advertisers can also succeed at increasing demand by getting people to see luxuries as necessities. This is usually just a perception – you think you cannot live without something when, in fact, you probably can.



The Brand-NameВ Game



InВ our fast-paced world, producers know that consumers like toВ find what they need quickly and conveniently. Today, you can order aВ product online from anywhere inВ the world and have it delivered toВ your house inВ aВ matter ofВ days.



This leads to a lot of competition among producers who want consumers to buy their stuff. This is another purpose of advertising – to get people to choose a specific product or service instead of the same thing provided by a competitor.



One method used by companies to get people to buy their products instead of someone else’s is branding. Branding gets people to recognize a particular company’s product and associate it with quality and popularity. Some brands can even succeed in becoming common names for the products they sell, such as Kleenex or Band-Aids.



Branding is not the only method that advertisers use. Advertisers know that consumers are more likely toВ buy products that they identify with, so they make ads that appeal toВ people byВ telling aВ story or connecting the consumer toВ the product.



Some brands are so familiar that we use their names generically.



Adverse Advertising



People get their news mostly from TV, newspapers, the Internet, and the radio. When it comes toВ informing the public on goods and services, the news media can be an effective and powerful tool ofВ communication. When aВ new product comes out, like the latest car, gadget, or toy, the news media will likely discuss it, providing another form ofВ free advertising.



News stories also alert the public toВ defects, dangers, and recalls. This kind ofВ negative exposure also influences consumers byВ getting them toВ avoid certain goods and services and toВ beware ofВ dangers inВ general.



Producers Influencing Consumers



Consumers make the final choice inВ all purchases, but producers do not want toВ leave all ofВ the deciding up toВ consumers. They want consumers toВ demand more goods and services, and they want consumers toВ choose their products over those offered byВ someone else. Producers try toВ influence what consumers think and do toВ increase demand for their products so they can beat out the competition.



Consumers are the driving force ofВ the economy, but they cannot do it alone. Without producers, there would not be anything toВ consume. ToВ have consumption, there needs toВ be production. That is why businesses are important.



Businesses come inВ all shapes and sizes, from small home businesses run byВ one person toВ large international corporations that employ thousands ofВ people inВ dozens ofВ countries.



InВ many ways, businesses are like consumers. But there are important differences too. You will study some ofВ these key differences and learn more about the role ofВ businesses inВ the economic system.



Producers make all kinds ofВ economic decisions. Just like consumers, they use rational choice when they do. InВ fact, producers are often more likely than consumers toВ pay close attention toВ the rationality ofВ their decisions.



Usually, there is aВ lot more risk for producers when it comes toВ decisions. As aВ result, producers have significant incentive toВ use cost-benefit analysis and other tools ofВ financial management. If they do not make good decisions, they will not make money. If they do not make money, they will go out ofВ business.



Producers try toВ be as rational as possible, so they can keep playing their role inВ the economy.



Producers and Rational Choice



Remember that rational choice is aВ decision-making process that compares the benefits and costs ofВ an action. Rational choice is aВ way ofВ looking at several potential choices and deciding which choice is the best.



You have seen how consumers do this. Producers do the same thing, though there are some important differences. For one thing, businesses consider benefits and costs just as aВ consumer does, but only the monetary costs and benefits are relevant toВ their calculations. Consumers often take into account non-monetary things when doing cost-benefit analysis.



For instance, aВ farmer decides which crops toВ grow just like aВ consumer decides what toВ eat for dinner. But while the consumer might consider nonmonetary factors, the farmer is going toВ focus on monetary considerations.



Consumers might think about what is cost-effective when planning dinner, but they probably also prioritize nonmonetary considerations, such as what they like toВ eat or how healthy the foodВ is.



Farmers do not think about what they like to eat when deciding which crops to grow. A farmer’s food preference does not affect production decisions. What farmers do pay attention to is how much money it will cost to plant various crops and how much they can expect to earn by selling those crops. Whichever crop will have the highest expected return is the crop the farmer will plant. It is the rational choice in monetary terms.



Profit



Monetary calculations are central to any producer’s decision-making process because making money is the reason businesses exist in the first place. In a market economy, businesses are free to make as much money as they can.



To make a profit, a business must have more revenue than costs. This means a business must earn more from the sale of its goods and services than it spends producing those goods and services. Here’s a simple formula that shows how to calculate profit:



Revenue – Costs = Profit



Profit is often called «the bottom line» because it is at the bottom of the calculation. The calculation of profit can be a bit more involved than simply subtracting costs from revenue. There are different types of expenses – production costs, administrative costs, taxes, and so on – that are calculated and subtracted in different ways.



For example, imagine aВ lemonade stand that rings up $30В inВ sales on aВ particularly hot day. Making and distributing the lemonade cost $7. You can calculate profits with aВ simple equation:

$30 (revenue) – $7 (costs) = $23 (profit)

The lemonade stand made $23В profit.



The Profit Motive



Making profit is not just something businesses like toВ do. It is something theyВ haveВ toВ do.



Every producer must make aВ profit inВ order toВ remain inВ business. Without profits, businesses disappear. This gives producers the profit motive, which tells them that they have toВ minimize costs and maximize monetary benefits. This is not exactly aВ law ofВ economics, but it is so universally followed that it might as wellВ be.



The profit motive is aВ necessity. Producers who choose toВ ignore profit end up going out ofВ business. Only those businesses that have the profit motive will remain inВ business. You can easily say that all businesses are driven byВ the profit motive because they do not have any other choice.



Profits and Losses



A free-market economy is driven by businesses’ desire to make a profit. Businesses make production, pricing, and hiring decisions based on that goal. A business that keeps costs low and brings in more money than it spends makes a profit.



If costs and revenues are equal, the business is just breaking even. And when costs are higher than revenue the business is running at aВ loss. AВ business can break even or run at aВ loss for only so long before going out ofВ business.



Even when aВ company is making aВ profit, the profit motive is an incentive. Because ofВ competition, there can be pressure toВ make greater profits the next year. When other companies are increasing their profits, aВ business can fall behind even if its revenues are above its costs.



Imagine that you own aВ small bakery. You manage toВ sell enough cakes, rills, and doughnuts so that your revenues are greater than your costs. You can pay the rent, buy supplies, and pay your employees, and still earn aВ profit at the end ofВ each month.



But what if your rent goes up? ToВ break even at the end ofВ the month, you increase the price ofВ your goods. InВ this case, your revenues are equal toВ your costs. You are not making aВ profit, but you can continue with your business.



If you want toВ continue making aВ profit at the end ofВ the month, you have toВ increase the price ofВ your goods even more. Unfortunately, your customers might choose toВ stop buying your baked goods. InВ this case, you experience an economic loss because your costs are greater than your revenues.



The profit motive drives businesses toВ do two things:

– Reduce costs whenever possible

– Increase sales whenever possible



Inputs and Outputs



Profit is revenue minus cost. Simple. But what brings inВ revenue? And what counts as cost?



Revenue is all ofВ the money aВ business brings inВ byВ selling its goods and services. InВ other words, it is the money derived from its output. For aВ business toВ have output, it needs input.



Inputs are what go into production. They can include the land, labor, and capital that are needed toВ produce any good or service.



Inputs cost money such as wages for workers, rent for land or capital for raw materials and equipment. They involve monetary costs for businesses. A producer’s costs account for all of the inputs necessary for production.



Opportunity Costs



Because profit dominates a producer’s thinking, businesses have to pay close attention to inputs and outputs. This involves making rational production decisions.



Consumers consider opportunity costs toВ make rational decisions. Businesses do the same. Remember that this is the cost ofВ opportunities that are passed up when deciding toВ do one thing instead ofВ another.



Business decisions about opportunity costs involve determining inputs and outputs. For example, if you have decided to open a bicycle factory, you have to decide what kinds of bicycles to make. You also have to decide what to use to make your bikes. Say you decide to make aluminum mountain bikes. The opportunity cost of that decision is what you could earn making steel mountain bikes, aluminum children’s bikes, or any of the various combinations available.



Production Possibilities Frontier



Businesses do not just try toВ guess about opportunity costs. Guesses are often wrong, and wrong answers lead toВ losses, not profits. Producers need aВ better tool ofВ analysis. One tool is the production possibilities frontier, also known as theВ PPF.



AВ production possibilities frontier is aВ graph that shows producers how toВ set up production inВ an efficient manner. Efficient production allows aВ producer toВ maximize profit.



Production Possibilities Frontier



Businesses do not just try toВ guess about opportunity costs. Guesses are often wrong, and wrong answers lead toВ losses, not profits. Producers need aВ better tool ofВ analysis. One tool is the production possibilities frontier, also known as theВ PPF.



AВ production possibilities frontier is aВ graph that shows producers how toВ set up production inВ an efficient manner. Efficient production allows aВ producer toВ maximize profit.



Working With theВ PPF



This graph represents the PPF ofВ aВ bicycle-making business. The red line shows how many ofВ each bike can be made with the inputs available, such as workers, aluminum, plastic, and other supplies inВ the factory. The points A, B, and C represent the points at which production ofВ mountain bikes and racing bikes is the most efficient.



This table shows when production is the most efficient. Points A, B, and C show some ofВ the many possibilities ofВ producing bicycles where production is maximized. AВ maximum ofВ 150В racing bikes and 200В mountain bikes can be produced given the set ofВ inputs available.



Let us aВ look at that PPF graph again for an example ofВ inefficient production. Point X shows an inefficient use ofВ inputs. ByВ making only 100В ofВ each bike, the available workers and materials are not being used efficiently. No producer would want toВ choose aВ level ofВ output that falls below the PPF. As long as the points ofВ production stay on the red line, production is maximized.



How can you decide whether A, B, or C – or any other point on the PPF – is the best one? They are all equally efficient. However, unless mountain bikes and racing bikes sell for the same amount, one decision could lead to more revenue than another. To make a fully rational decision, the prices for each bike must be taken into consideration. The PPF cannot predict price so its usefulness is limited, but it is

still an important tool for creating efficient production.



Market Research



The PPF shows a producer how to maximize efficiency, but there is more to making a rational decision than efficiency. Getting the most output from your inputs – productive efficiency – gives you the possibility of maximum revenue with minimum cost.



Consider the previous example. The PPF tells us that any ofВ the three mixes ofВ production will be efficient.



But which one will generate the greatest revenue? Rational choice always requires information. ToВ get this kind ofВ information, producers do market research.



Producers can decide which type ofВ efficient production will also be profit-maximizing productionВ by

– Researching the price of competing goods in the market.

– Finding out what consumers are willing to pay.

– Determining whether consumers want or need what is being offered.



Getting the Profit Motive



Profits drive producers. After all, making aВ profit is the reason people start aВ business inВ the first place. Producers make decisions that are aimed at maximizing efficiency and profits. Making these decisions requires aВ lot ofВ information about production and the potential market.



InВ aВ free-market system, producers are free toВ make decisions. This freedom creates competition among businesses as they pursue the same goal ofВ selling goods or services.



AВ typical example ofВ competition is the long-running contest between soda products Coca-Cola and Pepsi. The two companies that produce these popular beverages have engaged inВ direct competition with each other for over 100В years. OfВ course, there are lots ofВ other drinks available, too, and Coke and Pepsi compete against all the available options for the biggest share ofВ the multibillion dollar soda market.



Businesses want as big aВ share as possible inВ order toВ maximize profit. They clash inВ the free market toВ get consumers toВ purchase their goods and services instead ofВ those offered byВ their rivals. Competition pushes businesses toВ be as efficient as possible so they can offer the lowest prices. It also drives them toВ develop new products and services inВ order toВ keep attracting new customers.



InВ aВ free-market system, producers are free toВ make decisions. This freedom creates competition among businesses as they pursue the same goal ofВ selling goods or services.



AВ typical example ofВ competition is the long-running contest between soda products Coca-Cola and Pepsi. The two companies that produce these popular beverages have engaged inВ direct competition with each other for over 100В years. OfВ course, there are lots ofВ other drinks available, too, and Coke and Pepsi compete against all the available options for the biggest share ofВ the multibillion dollar soda market.



Businesses want as big aВ share as possible inВ order toВ maximize profit. They clash inВ the free market toВ get consumers toВ purchase their goods and services instead ofВ those offered byВ their rivals. Competition pushes businesses toВ be as efficient as possible so they can offer the lowest prices. It also drives them toВ develop new products and services inВ order toВ keep attracting new customers.



What Kind ofВ Competition?



Competition is aВ clash ofВ rivals pursuing the same goal, but not all competitions are the same. The way rivals compete depends on their goals and the number ofВ competitors.



InВ aВ football game, for instance, two teams compete toВ score the most points. InВ aВ 100-meter race, on the other hand, there might be as many as nine runners competing against each other, and also the clock. While there is no victory for finishing inВ second place inВ aВ football game, inВ aВ foot race there is. You may not be the very fastest if you place second or even third, but you have beaten many competitors.



Businesses compete toВ make as much profit as possible. The amount ofВ profit they can make depends on the kind ofВ competition they face. The nature ofВ competition faced byВ different businesses inВ different markets is known as the market structure.



Different markets are like different sports. The nature ofВ the competition depends on the number ofВ competitors. The competitors are always trying toВ maximize revenue and profit, but the number ofВ other businesses selling the same things varies.



Economic competition comes inВ two different types: competition among the few and competition among the many. InВ aВ market with only aВ few producers making aВ specific thing, each producer has some control over the price. The distinction between aВ few producers and many producers tells us about the basic market structure.



But we can be even more specific about the types ofВ competition. One extreme type ofВ market structure is called aВ monopoly. When only aВ single producer sells aВ good or service, there is no competition at all. That is aВ monopoly. InВ aВ monopoly, the consumer is stuck with whatever decisions the producer makes, because there is no rival product toВ choose.



Oligopoly is another market structure characterized byВ few sellers. There are more producers than inВ aВ monopoly, but the range ofВ businesses is very limited, and consumers have toВ choose from aВ short list ofВ providers. Oligopoly offers some competition, but producers do not have toВ worry very much about competition.



At the other end ofВ the spectrum ofВ market structures is pure competition. InВ aВ purely competitive market, there are numerous businesses, and there is aВ wide variety ofВ products sold. InВ aВ purely competitive market, consumers have aВ wide range ofВ choices, and producers have toВ find ways toВ beat out their rivals. All this competition results inВ aВ lot ofВ innovation, incentives toВ be efficient, and lower prices.








Pure Competition



The market structure that works best for consumers is pure competition. Pure competition is an ideal market structure that does not actually exist anywhere inВ the real world. We can, however, use pure competition as aВ standard for analyzing the market structures that do exist.



AВ purely competitive marketВ has

– A large number of small businesses.

– Identical or easily substituted products.

– Freedom of entry into and exit out of the industry.

– Perfect knowledge of prices and technology.



Even though pure competition does not actually exist inВ the real world, there are places where it is close. The company eBay, an online retailer, created aВ marketplace on the Internet that functions with aВ market structure that comes quite close toВ pure competition.



Consumers can buy almost anything on eBay inВ aВ pure competition market structure. Pure competition exists when identical products are sold.



The sellers or producers on eBay set aВ minimum price for their goods. The consumer can then bid for the goods ofВ his or her choosing. InВ this case, we have pure competition because everyone has perfect knowledge ofВ the pricesВ set.



Monopoly



Pure competition and monopoly are two extreme types ofВ market structure.

While pure competition allows for perfect competition among aВ large number ofВ sellers, aВ monopoly creates aВ total lack ofВ competition. The monopoly has complete control over its market. This gives the producer complete control over what products toВ provide and what prices toВ charge.



The characteristics ofВ aВ monopolyВ are

– A single producer.

– A unique product with no close substitutes.

– A price controlled by the producer.

– Entry is blocked to competitors.



The Near Monopoly



A pure monopoly is nearly as rare as pure competition. Most actual monopolies, such as a city’s utility provider, are heavily regulated by the government.



But there are some companies that control aВ particular market so thoroughly that they come close toВ creating aВ monopoly.



Microsoft is one of these near monopolies. While Microsoft is not a monopoly by definition – Apple also creates operating-system software – Microsoft dominates the market so effectively that it has been accused of acting like a monopoly.



The Microsoft Monopoly



Bill Gates and his company Microsoft control the market when it comes toВ operating systems, such as Windows 95, Office 2003, and other software applications.



Did you know that 90% of the world’s personal computers run on Microsoft software from the minute they are turned on? Microsoft has managed to automatically set up its operating systems in most computers being sold in the world. It has a monopoly, because its products are unique, and its rivals cannot compete against it. Microsoft is also able to control the price of its operating systems because there are no similar products on the market.



InВ 1998, aВ court case was filed against Microsoft Corporation. Microsoft rivals accused Microsoft ofВ abusing its monopoly inВ the way it sold its operating systems and web browsers. The main issue was whether Microsoft was allowed toВ sell its Internet Explorer web browser software with its Microsoft Windows operating system.



Many technology companies have fought legally against Microsoft’s monopoly, including Apple Computer, Netscape, and Sun Microsystems. However, Microsoft still holds the majority of the market of operating software. It has the monopoly, because it has blocked the entry or has made it very difficult for competitors to enter the same market.



Monopolistic Competition



Monopolistic competition is aВ market structure that includes many producers providing products or services that are almost the same, but not quite identical.



AВ market structure ofВ this sort allows some price control. But businesses generally accept the prices charged byВ rivals, ignoring the impact ofВ their own costs. Monopolistic competition resembles pure competition except that different producers are selling similar products.



Oligopoly



InВ aВ system ofВ monopolistic competition, there are aВ large number ofВ small businesses. InВ an oligopoly, there are aВ small number ofВ large businesses dominating aВ particular market. Businesses keep aВ close eye on the decisions made byВ the few other businesses inВ the industry.



Because there is not much competition, businesses inВ this type ofВ market do not change prices often. InВ order toВ attract customers away from the small number ofВ competitors they face, businesses inВ an oligopoly offer incentives, including bonuses and rebates.



The characteristics ofВ an oligopolyВ are

– An industry dominated by a small number of large businesses.

– Businesses sell either identical or slightly differentiated products.

– Businesses give incentives instead of changing prices.

– Significant barriers exist to enter industry.



Oligopoly Models



Oligopoly is aВ common market structure because many industries are difficult toВ break into. Anyone can open aВ lemonade stand with just aВ few dollars, but it takes millions and millions toВ build and operate aВ car factory. As aВ result, lemonade is aВ pretty competitive market, while the automobile industry is an oligopoly.



The automobile industry is considered an oligopoly because it is dominated byВ aВ small number ofВ large companies. These companies all sell similar cars, such as four-door sedans, minivans, and SUVs.



Another good example ofВ an oligopoly is the airline industry. This industry is dominated byВ aВ small number ofВ large companies. These businesses offer their customers similar products. However, certain airlines go toВ certain cities, while others do not. Airline companies also have incentives toВ attract customers, such as ticket upgrades or free air miles.



Considering Competition



Businesses compete with each other as they pursue the profit motive, but they take into account the type ofВ competition they face before they make decisions.



The four different market structures you have examined show the differences between the competitive situations faced byВ producers operating inВ different markets.



Remember that the level ofВ competition varies depending on the number and size ofВ competitors, the type and quality ofВ their products and services, and their degree ofВ market control over price.








The continuum ofВ market structures



Market Structure Review



From the largest corporation toВ the humblest small business, participating successfully inВ the free-market system requires aВ good plan, lots ofВ determination, and the willingness toВ take some risks. AВ person who starts aВ new business is aВ risk taker. We call these people entrepreneurs. An entrepreneur is an individual who begins, manages, and bears the risks ofВ aВ business.



Entrepreneurs play an important role inВ economics byВ offering consumers new ideas, new products, or new services. They compete inВ existing markets and sometimes create entirely new markets. Entrepreneurship is difficult and risky because many new businesses fail. But when successful, entrepreneurship contributes toВ the growth and prosperity ofВ the overall free-market economy. Entrepreneurs create jobs and encourage aВ greater exchange ofВ goods and services.



An Entrepreneur’s Motivation



There are many reasons why entrepreneurs decide toВ start aВ business. Henry Ford wanted toВ produce cars more efficiently; Oprah Winfrey wanted toВ help people make their lives better; Steve Jobs wanted toВ provide customers with user-friendly personal computers and new entertainment ideas. These are just three examples ofВ innovative and successful entrepreneurs. Entrepreneurs often share common motivations. The also share common characteristics.



Motivations and Characteristics ofВ Entrepreneurs



– Autonomy: Entrepreneurs like to work for themselves.

– Profits: Entrepreneurs are driven by their quest for profits. Successful entrepreneurs can create wealth rapidly.

– Risk: Entrepreneurs have a low level of risk aversion, since investing money in their own businesses is very risky.

– Innovation: Entrepreneurs need innovation in the product, service, or business process in order to be successful.



Innovation



One key to becoming a successful entrepreneur is innovation. The development of new devices, ideas, or ways of doing things helps entrepreneurs sell more goods or provide more services. Innovation is how businesses create new solutions to satisfy their customers’ needs and wants. Innovation includes the creation of more effective products, systems, services, or technology.



Entrepreneurs’ Innovations



Entrepreneurs innovate byВ creating

– New products.

– New production methods.

– New markets.

– New sources of supply.



The InnovationВ Game



Entrepreneurs innovate byВ introducing new means ofВ production, new products, and new forms ofВ organization. Innovations consist ofВ inventions, discoveries, and new methods ofВ production. Sometimes, innovations can change the entire economy.



One ofВ the biggest business sectors inВ the world is the media industry. The media provide aВ service that nearly every person consumes inВ one way or another.

Because the media are a part of nearly every consumer’s life, they are important to producers. Businesses use the media to advertise their message to potential customers. Almost every business relies on the media in some way to stay in business.



Unlike some businesses with a specialized customer base, media companies can sell to everyone – consumers and producers alike.



If aВ satellite turns inВ the desert and there is no one there toВ see it, does it still reach thousands ofВ viewers?



Advertising Dollars



Media companies can make money byВ selling magazines, newspapers, televisions subscriptions, Internet services, and more directly toВ consumers. But for most media companies, the bulk ofВ their profits come from selling advertisements. InВ fact, the mass media and news media make 90В percent ofВ their revenues from advertising. If it were not for advertising, most media companies would not exist.



Businesses spend aВ lot ofВ money on advertising. InВ 2012, companies spent more than $152В billion on advertising inВ the United States and more than $490В billion worldwide.



What Advertisers Are Buying



Advertisers pay a lot of money to media companies, but what exactly are they buying? In one sense, they are simply purchasing time or space: ink on a page, pixels on a screen, or 30 seconds of time. But what advertisers are really paying for is the audience – viewers, listeners, readers, browsers, or whoever might be exposed to the ads. Advertising is all about buying access to an audience.



Media companies provide content – shows, articles, information – to attract an audience so that they can turn around and sell that audience to advertisers. In the world of the media, the consumers are also the product.



How Visible IsВ It?



Because they pay high prices toВ advertise their goods and services, businesses want as many people as possible toВ see their ads. Visibility is an important measurement.



Businesses try toВ advertise inВ places where they feel they will have high visibility inВ front ofВ aВ large audience.



Visibility is determined byВ aВ few factors. One is the size ofВ the advertisement. AВ full-page image attracts more attention than aВ half-page image, so aВ full-page advertisement costs more. AВ one-minute commercial is more expensive than aВ 30-second commercial because it has greater visibility.



Another important factor is popularity. Popularity determines the rate for aВ specific amount ofВ advertising space. If aВ lot ofВ people read aВ particular magazine, then aВ full-page ad will be expensive. If only aВ few people read it, that same page will be much less expensive.



Expensive Advertising Slots



The Super Bowl regularly has the most expensive advertising on television. A 30-second commercial during Super Bowl XLI costs $2.4 million – that is $80,000 per second. Because of the high cost and high visibility of these ads, advertisers often use the Super Bowl to show innovative or unusual commercials or to launch new ad campaigns.



The Olympics is another sporting event with high visibility. Ad rates vary depending on the time ofВ day, but the average cost ofВ aВ 30-second commercial during the 2006В Olympics was $700,000. That is aВ lot less than aВ Super Bowl ad, but NBC made aВ total ofВ $900В million selling ads during that Olympics.



Popular TV series also command high ad rates. American Idol, one ofВ the top-rated shows inВ recent years, charges as much as $700,000В for aВ single 30-second commercial. The same 30-second ad on CSI costs only $465,000. Survivor and The Apprentice each get $350,000В for aВ 30-second spot. As ratings drop, ad rates drop, too. ER charged $440,000В for aВ 30-second commercial inВ 2004, but its ratings went down the following year, so the rates went down toВ $400,000.



Measuring the Audience



The cost of advertising depends on the size of the audience and the size of the advertisement. The bigger the audience, the more it will cost a business to advertise to that audience. Advertisers buy access to the audience’s attention, and more audience members means more sales, which means more money.



But how can advertisers know how big the audience is going toВ be?



What is the Medium?



The method ofВ measurement ofВ the audience size depends on the medium. It is easy toВ measure consumers on the Internet. AВ Web page can count the number ofВ times aВ page has been viewed.



InВ other forms ofВ media, the count needs toВ be estimated. For print sources, circulation counts the number ofВ magazines or newspapers that are printed and distributed. Not every magazine or newspaper will actually get read byВ somebody, and some will get read more than once. However, circulation is still aВ pretty good measurement ofВ the size ofВ the potential audience. For TV and radio, audience size is measured byВ aВ ratings system.



Advertising Outlets



Media companies are not limited toВ aВ single way ofВ selling advertisements. InВ fact, the more ways they can sell ads, the more money they can make. Most media companies use aВ variety ofВ methods toВ advertise.



Magazines and newspapers, for instance, have traditionally sold advertising toВ raise revenues while also charging subscription fees toВ people who receive the publication inВ the mail. With the advent ofВ the Internet, many magazines and newspapers have continued toВ enjoy advertising revenues but have struggled toВ find ways toВ charge subscription fees, because so many websites are available for free.



American Media



People get the information they need toВ make decisions primarily from the media. People watch TV, browse the Internet, read newspapers and magazines, and listen toВ the radio. What they see, read, and hear affects how they think and choose.



There are thousands ofВ media sources for people toВ choose from, but aВ large number are owned byВ aВ few large companies. These companies are known as media conglomerates. Their dominance ofВ the media industry creates aВ market structure that closely resembles an oligopoly because aВ few large companies control nearly all the media industry.



Global Media Giants



The centralized global media system is aВ very recent development. Until the 1980s, the basic broadcasting systems and newspaper industries were domestically owned and regulated. Starting inВ the 1980s, the U.S. government, along with its Federal Communications Commission (FCC), began toВ deregulate, or remove the legal restrictions that had been inВ place on media and communication systems.



With the rise ofВ satellite and digital technologies, deregulation resulted inВ the success ofВ global media giants. There are only aВ few global media giants today.



The Internet Media Revolution



The Internet operates differently from other forms ofВ media. Because it is relatively easy and inexpensive toВ build an Internet site, it is easy for many different producers toВ have an Internet presence.



Millions ofВ people contribute toВ the information available on the Internet. The popularity ofВ blogging, instant messaging, and social media sites means that more and more people get their information and entertainment from sources that are not controlled byВ large media companies.



Despite the possibilities ofВ the Internet, many ofВ the most popular websites today belong toВ large media conglomerates. While it may always remain inexpensive toВ put information on the Internet, the most popular websites will likely come from large global corporations.



The Business ofВ Media Review



Media companies are unique types ofВ producers. They create content for people toВ consume, but these consumers are themselves something that is sold toВ other producers who buy advertisements.



Media companies play an important role inВ the game ofВ economics. They provide information that affects the decisions ofВ consumers, and they provide advertising services that nearly every producer needs toВ purchase.



People start new businesses every day. It requires aВ lot ofВ planning and organizing, not toВ mention hard work and determination. It also takes money. Potential business owners can use their own money. They can borrow it from the bank, take on aВ business partner, or have aВ third party, sometimes called aВ venture capitalist, invest what it takes toВ open for business.



There are many kinds ofВ businesses. Some businesses only have one owner. Others have multiple partners who own the company together. InВ the end, all businesses try toВ accomplish the same goals: providing goods and services toВ satisfy the needs and wants ofВ consumers.



The first thing any aspiring business owner has toВ do is decide which goods or services toВ offer for sale. The variety ofВ goods and services available from businesses is wide, and new entrepreneurs are always trying toВ come up with new ideas about what toВ sell and how toВ sellВ it.



Sole Proprietorships



One way toВ start aВ business is toВ operate alone, with little or no help from anyone else. This kind ofВ business is called aВ sole proprietorship. The owner ofВ aВ sole proprietorship is completely inВ charge ofВ the operation ofВ the business. If there are other employees, the owner is the boss. The owner receives all the profits but also bears all the financial risks (that is, the losses).



Many entrepreneurs prefer toВ open aВ new business as aВ sole proprietorship. It is the most common type ofВ business, and it is also the easiest type toВ build. Almost all small businesses are sole proprietorships. Many medium-sized businesses and large businesses begin as sole proprietorships but grow with success and add partners and investors.



The Risks and Rewards ofВ aВ Sole Proprietorship



With aВ sole proprietorship, aВ business is much like an extension ofВ the business owners. It has no separate existence.



There are many benefits toВ aВ sole proprietorship. For instance, business owners can make their own decisions without having toВ consult other people.



Another advantage is that business owner pay personal income taxes, not corporate taxes, on profits. This makes accounting much simpler. And, ofВ course, business owners also get toВ keep all the profits.



But there are also downsides. AВ sole proprietor has unlimited liability. That means that the business owner is responsible for all the debts and financial losses ofВ the business. If the business fails, the owner can lose all assets. This includes not just business assets like equipment and supplies, but also personal assets like real estate and savings.



Sole proprietors also need toВ have enough money toВ start the business inВ the first place. Some potential business owners borrow money from aВ bank toВ start aВ company, but this is risky because ofВ unlimited liability. The bank can collect personal assets if an owner defaults on aВ small-business loan.



Partnerships



Another way toВ organize aВ business is toВ form aВ partnership with others. AВ partnership is aВ contract inВ which business partners agree toВ operate the company together byВ combining their money, knowledge, and time. Partners share profits based on their contributions.



There are two main ways ofВ organizing aВ business partnership: as aВ general partnership and as aВ limited partnership.



AВ general partnership is much like aВ sole proprietorship except that each partner is fully responsible for the debts ofВ the business, including debts incurred byВ the other partners. Every partner has an equal voice inВ running the business, and the partners have toВ consult one another toВ make decisions related toВ their business.



InВ aВ limited partnership, on the other hand, each partner has limited liability. The most each partner can lose is the amount he or she has contributed toВ the partnership. InВ aВ limited partnership, the business is managed byВ one or more ofВ the partners, while the other partners are investors who rarely take part inВ any business decisions.



Failed Partnerships



Two partners decide toВ start aВ restaurant. Each contributes $10,000В toВ fix up an old building, hire servers and cooks, and buy supplies. After the first year, the business is failing. The restaurant is $40,000В inВ debt byВ the time it closes its doors. Under aВ general partnership, each partner is fully responsible for this debt. If one partner only has $5,000В inВ her savings account while the other partner has $50,000, the partner with more savings can be made toВ pay $35,000В ofВ the debt.



If this same restaurant had been aВ limited partnership, each partner would be responsible for only 50% ofВ the debt. So, the richer partner only has toВ pay back $20,000В ofВ that $40,000. If the other partner can only pay $5,000, some ofВ the debt might go unpaid. This can happen inВ aВ limited partnership. Investors generally prefer limited partnerships so that they are not held fully responsible if the business incurs too much debt.



Pros and Cons ofВ Partnerships



There are many advantages toВ aВ business partnership. First ofВ all, partnerships are fairly easy toВ establish. Also, partnerships typically make it easier toВ raise money that can be invested inВ the business. That is why partnerships are the preferred type ofВ business for some small companies. Instead ofВ going toВ the bank and borrowing money, business owners can ask people toВ be partners and invest their money. Another advantage toВ aВ partnership is that there are rarely any extra taxes toВ file, just personal income taxes on any profit made.



Being held individually responsible for all the company’s debts is one of the major disadvantages to a general partnership. General partnerships can also be difficult to operate because partners need to work together and agree on business decisions. What might be a simple decision with just one person in charge can become much more complicated with two or more people trying to agree. This difficulty is lessened within a limited partnership because business decisions are made only by the managing partner. Still, the lack of input into business decisions by the «silent» partners takes away control, leaving their investment in the hands of the managing partners.



Corporations



Another type ofВ business is aВ corporation. Corporations are like partnerships inВ that they are funded and operated byВ more than one person. But aВ corporation has many people who invest, and few investors have as much direct control or responsibility inВ the business operations as they would inВ aВ partnership.



The investors inВ aВ corporation are not partners but stockholders. AВ stockholder is someone who owns aВ share inВ the corporation inВ the form ofВ stock. Unlike partners, stockholders do not make the business decisions themselves, unless they own aВ majority ofВ all available stocks. Usually, aВ corporation is run byВ aВ board ofВ directors, who are elected byВ stockholders. The board ofВ directors is responsible for managing the business and making the daily decisions required toВ operateВ it.



Stockholders



When compared toВ forming aВ business partnership, investing inВ aВ corporation is much easier and safer. Stockholders do not need toВ help make day-to-day business decisions the way partners do. Those business decisions are left up toВ the board ofВ directors. If stockholders do not agree with the decisions made byВ the board, they can vote for new members or simply sell their stock and invest inВ another corporation.



Because stockholders own the shares ofВ aВ corporation, many businesses inВ the United States face aВ situation known as В«double taxation.В» The government taxes both corporate profits as well as the personal income ofВ all the shareholders when they receive dividends or distributions ofВ corporate profits.



Investors who buy stock in profitable corporations usually receive dividends. A dividend is a portion of the company’s profit paid on each share of stock. Investors who own a lot of stock receive large dividend payments.



Stockholders are also protected if a corporation fails. Unlike sole proprietors or partners, stockholders are not responsible for any of the corporation’s debts.



Benefits ofВ Being aВ Stockholder



AВ corporation is aВ legal entity. It has rights toВ buy, sell, trade, and own property. It must also pay corporate taxes. AВ corporation has many advantages for its owners and stockholders. One ofВ those advantages is limited liability. As aВ stockholder, you cannot lose more than you initially invest.



When a company is doing well and paying high dividends, there are always other investors who want to buy that company’s stock. This drives the price up. Stockholders can earn money in two ways: through dividends and by selling their shares for more than the original purchase price.



Still, investing byВ purchasing stock inВ aВ corporation can be risky. People who invest inВ stocks often lose money because they choose the wrong company.




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