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establish a smoothly functioning system of exchange so that people can first exploit their
comparative advantages and then acquire what they want to consume? One alternative is
to have a central authority telling people what to do. Adam Smith explained and extolled
yet another way of organizing and coordinating economic activity”markets and prices
can coordinate those activities. Smith noted that people are adept at pursuing their own
self-interests and that a market system harnesses this self-interest remarkably well. As he
A market system is a
form of economic organiza- put it”with clear religious overtones”in doing what is best for themselves, people are
tion in which resource allo- “led by an invisible hand” to promote the economic well-being of society as a whole.
cation decisions are left to
Those of us who live in a well-functioning market economy like that found in the United
individual producers and
States tend to take the achievements of the market for granted, much like the daily rising
consumers acting in their
and setting of the sun. Few bother to think about, say, the reason why Hawaiian pineapples
own best interests without
show up daily in Vermont supermarkets in quantities desired by Vermont consumers. The
central direction.



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Chapter 3 51
The Fundamental Economic Problem: Scarcity and Choice



market deals with this issue
through the profit motive, which
guides firms™ output decisions,
matching quantities produced to
consumer preferences. A rise in the
price of wheat because of increased
demand for bread, for example,
will persuade farmers to produce




SOURCE: © Plush Studios/Blend Images/Jupiterimages
more wheat and devote less of
their land to soybeans. Such a price
system also distributes goods
among consumers in accord with
their tastes and preferences, using
voluntary exchange to determine
who gets what. Consumers spend
their incomes on the things they
like best (among those they can
afford). Vegetarians waste none of
their incomes on beef, and teeto-
talers do not have to spend money on gin. So consumers, by their control of their spending
patterns, can ensure that the bundle of goods they buy at the supermarket is compatible
with their preferences. That is how the market mechanism en-sures that the products of the
economy are divided among consumers in a rational manner, meaning that this distribu-
tion tends to fit in with the preferences of the different purchasers. But there is at least one
problem here; the ability to buy goods is hardly divided equally. Workers with valuable
skills and owners of scarce resources can sell what they have at attractive prices. With the
incomes they earn, they can purchase generous amounts of goods and services. Those who
are less successful in selling what they own receive lower incomes and so can afford to buy
less. In extreme cases, they may suffer severe deprivation.
The past few pages explain, in broad terms, how a market economy solves the three
basic problems facing any society: how to produce any given combination of goods effi-
ciently, how to select an appropriate combination of goods to produce, and how to distrib-
ute these goods sensibly among people. As we proceed through the following chapters,
you will learn much more about these issues. You will see that they constitute the central
theme that permeates not only this text but the work of economists in general. As you
progress through this book, keep in mind two questions:
• What does the market do well?
• What does it do poorly?
There are numerous answers to both questions, as you will learn in subsequent chapters.
Society has many important goals. Some of them, such as producing goods and services
with maximum efficiency (minimum waste), can be achieved extraordinarily well by let-
ting markets operate more or less freely.
Free markets will not, however, achieve all of society™s goals. For example, they often
have trouble keeping unemployment low. In fact, the unfettered operations of markets
may even run counter to some goals, such as protection of the environment. Many
observers also believe that markets do not necessarily distribute income in accord with
ethical or moral norms. But even in cases in which markets do not perform well, there may
be ways of harnessing the power of the market mechanism to remedy its own deficiencies,
as you will learn in later chapters.
Economic debates often have political and ideological overtones. So we will close
this chapter by emphasizing that the central theme we have just outlined is neither
a defense of nor an attack on the capitalist system. Nor is it a “conservative” position.
One does not have to be a conservative to recognize that the market mechanism can
be an extraordinarily helpful instrument for the pursuit of economic goals. Most of
the formerly socialist countries of Europe have been working hard to “marketize” their


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Licensed to:
Part 1
52 Getting Acquainted with Economics



economies, and even the communist People™s Republic of China has made huge strides
in that direction.
The point is not to confuse ends with means in deciding how much to rely on market
forces. Liberals and conservatives surely have different goals. But the means chosen to
pursue these goals should, for the most part, be chosen on the basis of how effective the
selected means are, not on some ideological prejudgments. Even Karl Marx emphasized
that the market is remarkably efficient at producing an abundance of goods and services
that had never been seen in precapitalist history. Such wealth can be used to promote con-
servative goals, such as reducing tax rates, or to facilitate goals favored by liberals, such
as providing more generous public aid for the poor.
Certainly, the market cannot deal with every economic problem. Indeed, we have just
noted that the market is the source of a number of significant problems. Even so, the evi-
dence accumulated over centuries leads economists to believe that most economic prob-
lems are best handled by market techniques. The analysis in this book is intended to help
you identify both the objectives that the market mechanism can reliably achieve and those
that it will fail to promote, or at least not promote very effectively. We urge you to forget
the slogans you have heard”whether from the left or from the right”and make up your
own mind after learning the material in this book.




| SUMMARY |
1. Supplies of all resources are limited. Because resources 7. A firm or an economy that ends up at a point below its
are scarce, an optimal decision is one that chooses the production possibilities frontier is using its resources
best alternative among the options that are possible with inefficiently or wastefully. This is what happens, for
the available resources. example, when there is unemployment.
2. With limited resources, a decision to obtain more of one 8. Economists define efficiency as the absence of waste. It
item is also a decision to give up some of another. The is achieved primarily by the gains in productivity
value of what we give up is called the opportunity cost brought about through specialization that exploits divi-
of what we get. The opportunity cost is the true cost of sion of labor and comparative advantage and by a sys-
any decision. This is one of the Ideas for Beyond the Final tem of exchange.
Exam. 9. Two countries (or two people) can gain by specializing
in the activity in which each has a comparative advantage
3. When markets function effectively, firms are led to use
resources efficiently and to produce the things that con- and then trading with one another. These gains from
sumers want most. In such cases, opportunity costs and trade remain available even if one country is inferior at
money costs (prices) correspond closely. When the mar- producing everything but specializes in producing those
ket performs poorly, or when important, socially costly items at which it is least inefficient. This so-called prin-
ciple of comparative advantage is one of our Ideas for
items are provided without charging an appropriate
Beyond the Final Exam.
price, or are given away free, opportunity costs and
money costs can diverge. 10. If an exchange between two individuals is voluntary,
4. A firm™s production possibilities frontier shows the both parties must benefit, even if no additional goods
are produced. This is another of the Ideas for Beyond the
combinations of goods it can produce, given the current
Final Exam.
technology and the resources at its disposal. The frontier
is usually bowed outward because resources tend to be 11. Every economic system must find a way to answer three
specialized. basic questions: How can goods be produced most effi-
5. The principle of increasing costs states that as the pro- ciently? How much of each good should be produced?
duction of one good expands, the opportunity cost of How should goods be distributed among users?
producing another unit of that good generally increases. 12. The market system works very well in solving some of
6. Like a firm, the economy as a whole has a production society™s basic problems, but it fails to remedy others and
possibilities frontier whose position is determined by its may, indeed, create some of its own. Where and how it
technology and by the available resources of land, labor, succeeds and fails constitute the central theme of this
capital, and raw materials. book and characterize the work of economists in general.




Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:

Chapter 3 53
The Fundamental Economic Problem: Scarcity and Choice



| KEY TERMS |
Resources 40 Inputs 42 Allocation of scarce resources 47
Opportunity cost 41 Production possibilities frontier 43 Division of labor 48
Optimal decision 42 Principle of increasing costs 44 Comparative advantage 49
Outputs 42 Efficiency 47 Market system 50



| TEST YOURSELF |
3. Consider two alternatives for Stromboli in 2007. In case
1. A person rents a house for which she pays the landlord
(a), its inhabitants eat 60 million pizzas and build 6,000
$24,000 per year. The house can be purchased for
pizza ovens. In case (b), the population eats 15 million
$200,000, and the tenant has this much money in a bank
pizzas but builds 18,000 ovens. Which case will lead to a
account that pays 4 percent interest per year. Is buying
more generous production possibilities frontier for
the house a good deal for the tenant? Where does oppor-
Stromboli in 2007?
tunity cost enter the picture?
4. Jasmine™s Snack Shop sells two brands of potato chips. She
2. Graphically show the production possibilities frontier
produces them by buying them from a wholesale supplier.
for the nation of Stromboli, using the data given in the
Brand X costs Jasmine $1 per bag, and Brand Y costs her
following table. Does the principle of increasing cost
$1.40. Draw Jasmine™s production possibilities frontier if
hold in Stromboli?
she has $280 budgeted to spend on the purchase of potato
chips from the wholesaler. Why is it not “bowed out”?
Stromboli™s 2002 Production Possibilities
Pizzas per Pizza Ovens
Year per Year
75,000,000 0
60,000,000 6,000
45,000,000 11,000
30,000,000 15,000
15,000,000 18,000
0 18,000




| DISCUSSION QUESTIONS |
1. Discuss the resource limitations that affect Union. Try to describe how decisions on the number of
chickens to be raised, and the amount of each feed to use
a. the poorest person on earth
in raising them, were made under the old communist
b. Bill Gates, the richest person on earth
regime. If the farm is now privately owned, how does
c. a farmer in Kansas the market guide the decisions that used to be made by
the central planning agency?
d. the government of Indonesia
5. The United States is one of the world™s wealthiest coun-
2. If you were president of your college, what would you
tries. Think of a recent case in which the decisions of the
change if your budget were cut by 10 percent? By 25
U.S. government were severely constrained by scarcity.
percent? By 50 percent?
Describe the trade-offs that were involved. What were
3. If you were to leave college, what things would change
the opportunity costs of the decisions that were actually
in your life? What, then, is the opportunity cost of your
made?
education?
4. Raising chickens requires several types of feed, such as
corn and soy meal. Consider a farm in the former Soviet




Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:




Supply and Demand:
An Initial Look
The free enterprise system is absolutely too important to be left
to the voluntary action of the marketplace.
F LO R IDA CO N G R E S S M A N R I C H A R D K E L LY, 1 9 7 9



I n this chapter, we study the economist™s most basic investigative tool: the mecha-
nism of supply and demand. Whether your econ course concentrates on macro-
economics or microeconomics, you will find that the so-called law of supply and demand
is a fundamental tool of economic analysis. Economists use supply and demand analysis
to study issues as diverse as inflation and unemployment, the effects of taxes on prices,
government regulation of business, and environmental protection. Supply and demand
curves”graphs that relate price to quantity supplied and quantity demanded, respec-
tively”show how prices and quantities are determined in a free market.1
A major theme of the chapter is that governments around the world and throughout
recorded history have tampered with the price mechanism. As we will see, these bouts
with Adam Smith™s “invisible hand” have produced undesirable side effects that often
surprised and dismayed the authorities. The invisible hand fights back!



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