LAPC How the Government Gets

Individual Chapter Assignments:

Chapter 2:

Chapter 2 shows and discusses the gains from trade that can result when individuals, firms, or countries specialize in producing goods for which they have the comparative advantage, and trade those goods with others.

Gains from specialization and exchange can be seen in many situations.  For example, most people that we pay to do things for us (e.g. grow our food, cut our hair, tutor us, etc.) perform the task for a lower opportunity cost than we would bear if we were to do it ourselves.  This is where the gain from trade that benefits both parties comes from, and is why it is rational for you to pay for the service. 

To show that you understand how comparative advantage works in the modern economy, please discuss a good you recently purchased and address the following prompts:

  1. What is the item, and how much did you pay for it?
  2. What is a reasonable estimate of how long it would take you to make the item if you hadn’t been able to buy it?  You need to come up with a number of hours or days or years, or whatever time measurement you want, for how long it would take you.  Don’t try to avoid this.  If you can’t figure it out, pick another good.
  3. Who worked to get the money to pay for the item, and how long did they have to work to get the money?  If your money came from the government, see the how the government gets money page.
  4. Based on your answers to 2 and 3 above, was it rational to buy the good?  Explain.  Make sure you compare the time it would take you to make the good (mentioned in part 2) and the amount of time that had to be worked to get the money (mentioned in part 3).  It is only rational to buy something if you give up less resources working to earn money to pay,  than you would have if you made the good yourself.  If it turned out to be irrational, why did you buy it?

If you want to see an example, check out the “great work” linked above.  But do not copy the example or even the wording.  There are many ways to express these ideas if you understand the material.  Please find your own words or face the consequences of academic dishonesty.

Chapter 3:

In chapter 3 we learn that the supply and demand for a good or service can shift in response to changes in certain variables, and about how supply and demand interact to determine the market equilibrium price. 

  1. Please identify a price change you have observed in the last few years.
  2. Use the supply and demand model to explain why the price changed in 1) above.
  3. Summarize your explanation with one sentence that mentions what you think has happened to both supply and demand,and why, and how this interaction has resulted in the price change you observed. If both curves are moving, you will need to comment on the relative size of each shift to justify the price change you observed.

*Please do not try to explain the price of gas or a cell-phone; please pick something else.

Helpful tip: be sure you discuss both supply AND demand, as they both play a role in determining the price.

Chapter 4a:

In our everyday lives as consumers we purchase many goods and services, and we derive consumers’ surplus for most of them.  With that in mind, please: 

Identify 3 goods or services you have purchased in the last year, and estimate the amount of consumer surplus you enjoy from those purchases.  For each good, please state specifically:

  1. The highest amount you would have been willing to pay.
  2. The price you actually paid.
  3. The amount of consumers’ surplus you received from each item.

Helpful tips: Be sure to state exactly the highest price you would have been willing to pay, and the price you actually paid.  The difference between these two is your consumer’s surplus.  There are different phrases you can use to communicate the highest price you were willing to pay, but note that the following are incorrect:

  1. The price you were willing to pay.  Just because you were willing to pay $20 for a good, doesn’t mean this is the highest you were willing to pay.
  2. The price you expected to pay.  Again, this is not necessarily the highest price you were willing to pay.

Chapter 4b:

We are about one quarter of the way through the course.  How is it going for you?  Are your grades where you want them to be?  If not, what can you do to remedy the situation?  If you want a different result, it is imperative that you change your strategy.

Chapter 5:

This chapter focuses on externalities in the context of producing goods and services, but like many concepts in our course, these ideas are very applicable to our daily lives.  In this discussion, please:

  1. Identify and describe a situation where you have experienced either a positive or negative externality.
  2. State clearly what the external cost or benefit is.
  3. Estimate the dollar value of the externality. You may not be sure how to do this, so consider asking yourself the following: If it’s a positive externality, what is the highest price you would be willing to pay for the external benefit you received? If it’s a negative externality, what is the lowest price you would be willing to accept as compensation for the external cost you are bearing?
  4. How many people in total are affected by this externality? Recommend either a tax or subsidy amount that the externality creator should pay or receive (to “internalize the externality”) based on the number of people affected. You may assume that everyone affected has the same valuation for the externality as you do.

Chapter 9:

In this chapter on international trade we explained the benefits of trade using the concepts of producer and consumer surplus. We know that trade barriers such as quotas and tariffs cause prices to rise, which reduces consumer surplus, but we also discussed that trade barriers save or create jobs for American workers. In a writing of no more than two pages, please:

  1. identify an imported product that you purchased recently, and estimate the amount of consumer surplus you received from your purchase.
  2. state how much, if any, of your consumer surplus you would be willing to give up if it meant another job could be saved for an American worker.
  3. determine, if you knew that the job saved for the American worker came at the expense of a job for someone in a third-world country, if that would change the amount of consumer surplus (in dollars) you would be willing to give up.
  4. determine, if you knew the surplus you gave up went directly to increase the wage of a worker in a third-world country, if that would change the amount of surplus you would give up.
  5. state whether or not you would change the purchase, and the associated consumer surplus you received, in any way to redistribute the gains you personally received from international trade. If you would have been willing to give up some of the surplus you received if it went directly to the worker in the third world country, would you consider making a donation to a charitable organization benefiting workers that country (this is a way for you to give some of your surplus to the workers)? Why or why not?

Chapter 10 Reflection:

We are a little bit more than half of the way through the course.  How is it going for you?  Are your grades where you want them to be?  If not, what adjustments can you make to improve the situation?  Please respond to these questions in a writing of less than one page (a paragraph may be sufficient).

Chapter 11:

Although most of the concepts developed in chapter eleven pertain to businesses, many of the different notions of cost can be applied to your life.  In a writing of no more than one page, please identify a fixed, variable, marginal, and implicit cost that you have paid in the last few years.

Chapter 12:

Many difficult or important jobs in our society pay surprisingly low wages.  For example, babysitters, social workers, nursing home workers, seasonal lifeguards, and paramedics, all typically make around $15 per hour or less, but provide services that can save lives.                                                                 

This phenomenon can be explained via the supply and demand model we developed back in chapter 3, or from related material we learned here in chapter 12 if we view the worker as a business owner selling their labor services.

We know that if barriers to entry into an industry are low, then businesses cannot expect to earn long-run profits.  This implies that jobs that require little or no training (read: low barriers to entry) should not expect to get paid much.

For this chapter’s learning portfolio assignment, please:

  • Identify a job that you think earns surprisingly little given the task(s) performed
  • Discuss the training necessary to get the job
  • Discuss what you think the job “should” earn, and try to justify it
  • What do you think would happen if the government mandated the wage you suggested above? Please apply the lessons from the material on price floors from chapter 4 in your response

Chapter 13:

Many businesses operate in the “monopolistically competitive” environment.  As we learned in chapter 13, economic profits are possible in this setting, but only to the extent that a firm can continue to differentiate itself from competing firms or produce goods at a lower cost than competitors.  For example, Starbucks recently announced that it plans to offer beer and wine for sale after 4 in the afternoon in some markets.  Certainly this differentiates it from other coffee shops.

For this chapter’s learning portfolio assignment, please:

  • Identify a business operating in the monopolistic competition setting.
  • List the assumptions of monopolistic competition and explain how the business fits in with these assumptions
  • Suggest a way that this business could differentiate itself from its competition

Chapter 15a:

Please name a good or service you or your family has purchased in recent months from a monopolist.  How did the monopoly come to exist?  Do you think you would have benefitted from increased competition in the market for this good or service?  Why or why not?

How the government gets money

The government gets money by charging taxes to your family, friends, neighbors, and everyone else in society. In general, the government has to use the threat of force (fines and jail time) to get people to pay the taxes.

A temporary exception to this is when the government borrows money to pay for current expenditures and programs. In this case, they borrow money by issuing bonds (contractual promises to repay funds later). As bonds are issued on the federal level of government, they accumulate over time to form the national debt.

For the sake of the learning portfolio prompt, you can assume a wage of $30 per hour for whomever was or will be taxed to pay for your item.

Chapter 2: Trade-offs, Comparative Advantage, and the Market System

In chapter 1 we introduced the concept of scarcity, and discussed the related ideas of trade-offs and opportunity costs as consequences of scarcity. We will utilize these ideas to develop something called a production possibilities frontier, which is a graphical representation of the production possibilities and associated trade-offs available to an economy.

PRODUCTION POSSIBILITIES FRONTIER (PPF): A CURVE SHOWING THE MAXIMUM ATTAINABLE COMBINATION OF TWO PRODUCTS THAT CAN BE PRODUCED WITH THE AVAILABLE RESOURCES AND CURRENT TECHNOLOGY.

To motivate our exploration, let’s imagine a simple economy where the citizens only care about production of two goods: bread and cartoons. As a further simplification, let’s assume that the only resource necessary to produce these two goods is human labor. Forget about wheat, yeast, paper, pencils, etc. –the only resource required is labor. As you might imagine, producing bread is easier than producing cartoons. That is, bread requires fewer labor hours than cartoons per unit. This economy could produce all cartoons and no bread, it could produce all bread and no cartoons, or it could produce some of each. Let’s say that if this society wanted to produce all bread and no cartoons, it could produce 50 loaves of bread. If instead the society wants to produce some cartoons, because of scarcity, it will have to forgo some bread. Let’s assume that each cartoon produced requires that 10 loaves of bread be given up. This makes sense because producing cartoons requires workers, and these workers will no longer be able to produce bread. We are starting to identify production possibilities for this society. To be as organized as possible, we should put these production possibilities into a table:

Choice

Bread

Cartoons

A

50

0

B

40

1

C

30

2

D

20

3

E

10

4

F

0

5

In this production possibilities table we can see the exact nature of the trade-offs required in this economy. We see that in order to get one more cartoon, we have to give up 10 loaves of bread, and that to get one more loaf of bread, we have to give up 1/10 of a cartoon. Recall that opportunity cost is the highest valued alternative that must be given up to engage in a course of action. Since this county only produces two goods, the trade-offs we have discussed are actually opportunity costs. Therefore we can say that the opportunity cost of producing 1 cartoon is 10 loaves of bread, and the opportunity cost of producing 1 loaf of bread is 1/10 of a cartoon.

As we’ll do many times throughout this course, we can turn this table into a graph. The table above shows ordered pairs of cartoons and bread. You are probably familiar with the ordered pair (X,Y) from algebra. In algebra, points X and Y can be graphed on an (X,Y) plane, usually with X on the horizontal axis and Y on the vertical axis. We can graph the above production possibilities table in an analogous way, except that instead of using X and Y, we’ll use our variables: cartoons and bread. When we connect the plotted points with a line, we have a graph that appears similar (except with different goods on the axes) to:

A linear PPF is shown, with bread on the vertical axis and cartoons on the horizontal axis.  The PPF hits the bread axis at 50 and hits the cartoons axis at 5.  There are 6 points on the PPF, labeled A, B, C, D, E, and F.

This line we have drawn here represents the data in the production possibilities table, and shows us the maximum attainable combination of the two goods that can be produced in this economy. In other words, we have constructed a PPF.

You should take a minute and be sure you understand what is going on here, since we will be using PPF’s throughout this chapter.

One detail to note about our PPF has to do with its slope. Slope is defined as rise over run. Our PPF has a slope = -10. Since the rise axis is defined to be bread, and the run axis is defined to be cartoons, we see that this slope implies that to “run” positive 1 (e.g. to get one more cartoon), we have to rise -10 (e.g. lose 10 loaves of bread). –This is our opportunity cost information. The conclusion here is that the slope of the PPF tells us what the opportunity cost for production is.

Since our PPF is linear, the slope of the PPF is the same over all levels of production. This is because we assumed that the opportunity cost of a cartoon does not change -that is, over all levels of production, to get one more cartoon, we have to give up exactly 10 loaves of bread. This is called “constant opportunity cost”.

Unfortunately, this is not the most realistic assumption we could make, since underlying this assumption is the unlikely idea that all workers are equally well-suited for production of cartoons and bread. This is unrealistic because we know that people have strengths and weaknesses. For example, it is likely that some workers in the economy are going to be terrible at creating cartoons, but good at baking, while others will be lousy bakers but excellent cartoonists. To see why this makes linear PPFs unrealistic, consider production at the extremes of our possibilities. If the economy is producing only loaves of bread, we are using some people who are bad at baking, who would be better at cartooning. If we decided to come off of this extreme and produce our first cartoon, who would we ask to produce it? -Probably the workers who are lousy bakers but good cartoonists. This means that when we decide to produce our first cartoon, we are likely giving up relatively few loaves of bread, since the workers we assign to produce the first cartoon were bad bakers, and were probably not adding very much to our production of bread. In other words, the opportunity cost of our first cartoon is probably small.

If we decide to produce more cartoons, we will have to give up more loaves of bread. As we increase our production of cartoons, we will eventually have to start using workers who are better bakers than cartoonists. This means that, compared to the first cartoon we produced, we will have to give up more loaves of bread as we produce more cartoons, because we will be using our best bakers, instead of the lousy bakers who were first assigned to cartoon production. Thus, we can say that the opportunity cost of cartoons is increasing as we produce more cartoons. This more realistic notion of opportunity cost is captured in a “bowed-out” PPF, similar to what is shown below:

A PPF is shown on a graph with bread on the vertical axis and cartoons on the horizontal axis.  The shape of the PPF is convex or bowed-out, which means that as society moves down the PPF to produce more cartoons they will have to give up increasing quantities of bread.  Lines on the graph are drawn that show this.

Notice that as we increase the number of cartoons (that is, move down the PPF), we have to give up more and more loaves of bread per cartoon (and the slope of the PPF gets steeper). Going from 1 to 2 cartoons, we have to give up some amount of bread equal to “A”, but to get our 4th cartoon (going from 3 to 4) we have to give up an amount of bread equal to “B”. Since B is bigger than A, we see the increasing opportunity cost of producing one more cartoon as shown by the “bowed out” PPF.

By definition, production possibilities frontiers show us the maximum combinations of two goods or services that can be produced in an economy. These maximum combinations can (and do) change over time. Productive capabilities can be reduced due to government regulations, such as environmental protection laws. More often, though, productive capabilities increase over time. This process is called economic growth.

Economic Growth: The ability of an economy to produce increasing quantities of goods and services over time.

Since 1900, the world has seen a tremendous amount of economic growth. This is important because as we produce more goods and services, we can consume more goods and services. The prodigious economic growth of recent times has enabled many citizens (especially in western countries) to enjoy a dramatically higher standard of living than citizens only a generation or four older.

Economic growth is the single biggest story in economics, and is considered in depth later in macroeconomics. Economic growth comes primarily from two sources: discovery of new resources and improved technology. We can model economic growth using PPF’s.

Growth coming from the discovery of new resources is modeled by an outward shift of a PPF along both axes. The easiest way to see this is to consider production at the extremes on our PPF. Let’s again consider the PPF showing production possibilities for bread and cartoons. Since we assumed that the only input to production of bread and cartoons is human labor, discovery of new resources would be in the form of population growth. If we were producing only bread, and the number of workers in the economy increased, we would be able to produce more bread (move from point A to point B). If, on the other hand, we were producing only cartoons, and the number of workers in our economy increased, we would be able to produce more cartoons (move from point C to point D).

2 PPFs are shown, with one inside the other.  On the vertical axis, the inside PPF hits at point A and the outer PPF hits at point B.  On the horizontal axis, the inside PPF hits at point C and the outer PPF hits at point D.  There are arrows depicting a movement from the inner to the outer PPF to show economic growth.

Thus, to characterize economic growth from new resource discovery, we need to shift the PPF out along both axes since this discovery allows us to produce more of both goods.

Growth coming from improved technology is modeled by an outward shift along only one axis. Again, the easiest way to see this is to consider production at the extremes on our PPF. Imagine that the technological improvement happened in the cartoon production industry. In our example, maybe this means that we have found a new way to train cartoonists that allows them to produce more cartoons. If we were producing only cartoons, obviously we would be able to produce more. Therefore, our production possibilities frontier shifts from point E to point F on the diagram below. On the other hand, imagine that we are producing only bread. Technological change in cartoon production does not affect the bread industry, therefore the new PPF showing this would have to go through the same point G on the bread axis.

2 PPFs are shown.  Both start at point G on the vertical axis, but on the horizontal axis one PPF hits the axis at point E while the other hits at point F, with E being at a lower quantity than F.  There is an arrow along the horizontal axis showing more of the good on that axis could be produced, thus depicting economic growth from improved technology.

Thus, to characterize economic growth from technological change, we see that the new PPF has shifted out only along the axis for the good that has experienced technological improvement.

Although we have argued that a “bowed-out” PPF is more realistic because it shows the more realistic assumption of increasing opportunity costs, we will be using linear PPFs from this point forward. The conclusions we draw will be the same, but the analysis leading to those conclusions is much simpler.

For as long as humans have been living in organized society, we have been trading with one another. We know that people respond to incentives, so this must be because trading partners are better off after the trade. We will show this result, and then try to understand how these gains come to be.

As with many models that we will develop, we will assume a simplified world. As the famous economist David Ricardo described in his 1817 book “On the Principles of Political Economy and Taxation”, we will assume that England and Portugal are producers of wine and cloth. A production possibilities table is below.

England

Portugal

Wine

Cloth

Wine

Cloth

All resources used to produce wine

400

0

600

0

All resources used to produce cloth

0

800

0

600

Let’s say that Portugal and England are initially in autarky –a state where no international trade is taking place. In autarky, a country can only consume what it produces. Let’s say that without trade, England is producing and consuming 200 units of wine, and 400 units of cloth, and Portugal is producing and consuming 250 units of wine, and 350 units of cloth. You may want to verify that these points are in fact on each country’s PPF.

Then, one day, the kings of Portugal and England bump into each other while being fitted for new robes in France. The kings get to talking, and the King of Portugal offers the King of England a trade: 300 units of Portuguese wine for 375 units of English cloth. The English king considers the idea and accepts, because he determines that England will be better off after the trade. The Portuguese king made the offer because he knows that if the trade is accepted, Portugal will also be better off after the trade. Let’s see why.

One item to note is that if England gets its wine from Portugal, it can specialize in cloth production, and that if Portugal gets its cloth from England, it can specialize in wine production. We can keep track of the flow of goods and gains from trade in the following table:

England

Portugal

Wine

Cloth

Wine

Cloth

Production and Consumption without Trade

200

400

250

350

Production with Trade

0

800

600

0

Consumption with Trade

300

425

300

375

Gains from Trade

100

25

50

25

It is often challenging for students (at first) to understand where these numbers come from. Recall that the third row, production and consumption without trade, is given information. The fourth row is relatively straightforward: since England is getting wine from Portugal, it can specialize in cloth. Our production possibilities table (above) shows that if England produces only cloth, it can produce 800 units (and no wine). Similarly, if Portugal is getting cloth from England, it can specialize in wine production, and according to the above production possibilities table, it can produce 600 units of wine (and no cloth).

A country gets to consume whatever is left over after the trade is made. Going from the fourth row to the fifth row just involves imposing the trade. Before the trade takes place, each country has produced quantities in accordance with row 3. The terms of trade are 300 units of wine for 375 units of cloth. England will trade 375 of the 800 units of cloth it produces to Portugal. This leaves England with 425 units of cloth, and Portugal with 375 units of cloth. Portugal will trade 300 of the 600 units of wine it produces to England in exchange for this cloth. This leaves Portugal with 300 units of wine and England with 300 units wine.

By gains from trade, we just mean increased consumption. Specifically, how much more of each good each country gets to consume when it trades, relative to when it is in autarky. Before the trade, England got to consume 200 units of wine, and after the trade they consume 300 units of wine. Thus their gain from trade is 100 units of wine. Similarly, before the trade Portugal got to consume 350 units of cloth, and after the trade they consume 375 units of cloth. Their gain from trade is then 25 units of cloth. The other “gains from trade” cells can be computed analogously.

We can see that both parties get to consume more after the trade takes place, and so they are both better off. This is nice, but we should try to understand where these gains from trade come from. It turns out that these gains from trade come from the fact that England and Portugal have different opportunity costs for production. There is more than way to calculate opportunity cost. We saw in our exploration of PPFs that opportunity cost can be inferred from the slope of the PPF. Using this method, one needs to be able to calculate the slope and interpret it. This exercise should be performed, and will be left to the reader.

The other method for calculating opportunity cost utilizes the production possibilities table. Upon examination, we note that England could produce 400 units of wine. If it chooses this option, it gives up the ability to produce as much as 800 units of cloth. In other words, for England, the opportunity cost of 400 units of wine is 800 units of cloth. If we put this into a mathematical equation, we can do some simple manipulation that will benefit us:

England: Opportunity cost of 400 wine = 800 cloth.

The equals sign allows us to manipulate the equation into a more usable format. Dividing each side by 400 yields:

England: Opportunity cost of 1 wine = 2 cloth, which implies

England: Opportunity cost of 2 cloth = 1 wine, which implies

England: Opportunity cost of 1 cloth = (1/2) wine.

This implies that, using its own production technology, England would have to give up 600 units of cloth if it wanted 300 units of wine. England benefits from the trade with Portugal because it gets 300 units of wine by giving up only 375 units of cloth.

From the production possibilities table we see that Portugal is capable of producing 600 units of cloth. If it chooses to do this, it gives up the ability to produce 600 units of wine. In other words, for Portugal, the opportunity cost of 600 units of wine is the 600 units of cloth it must give up. Putting this into a mathematical equation yields:

Portugal: Opportunity cost of 600 cloth = 600 wine, which implies

Portugal: Opportunity cost of 1 cloth = 1 wine, which implies

Portugal: Opportunity cost of 1 wine = 1 cloth.

This implies that, using its own production technology, if Portugal wanted 375 units of cloth it would have to give up 375 units of wine. Portugal benefits from trade with England because it gets 375 units of cloth by giving up only 300 units of wine.

Because the two countries have different opportunity costs, there is room to make a mutually beneficial trade. Please pause for a few moments here and make sure that you understand this point and this example.

This is an illustrative example, but it shows a more general result. In this example, England specialized in cloth, where its opportunity cost for 1 unit of cloth is (1/2) a unit of wine. Portugal’s opportunity cost for 1 unit of cloth is 1 unit of wine. Therefore, England is specializing in the good for which it has the lower opportunity cost. Similarly, Portugal specialized in wine, where its opportunity cost for 1 unit of wine is 1 unit of cloth. England’s opportunity cost for 1 unit of wine is 2 units of cloth. Therefore Portugal is also specializing in the good for which it has a lower opportunity cost.

For both parties to gain from trade with one another, it is necessary for each party to specialize in the good for which they have the lower opportunity cost. This is the fundamental notion of comparative advantage.

COMPARATIVE ADVANTAGE: THE ABILITY OF AN INDIVIDUAL, FIRM, OR COUNTRY TO PRODUCE A GOOD OR SERVICE AT A LOWER OPPORTUNITY COST THAN COMPETITORS.

In our example, we would say that England has the comparative advantage in cloth, and Portugal has the comparative advantage in wine. In order for mutually beneficial trade to be possible, each party must specialize in the good for which they have the comparative advantage.

Our study of comparative advantage shows us that gains from trade are possible when two trading partners have different opportunity costs. This realization explains how a country like Germany, which is excellent at producing many goods, can benefit from trading with a relatively less productive country like Romania. Although Germany can probably produce more of every good than Romania can, Germany can benefit from trade because they likely have different opportunity costs. Differing opportunity cost is the key requirement in order for two parties to specialize in production and make a mutually beneficial trade.

People often confuse differing opportunity costs, and the implication it has on trade, with a more basic notion about production capacity… Many people mistakenly think that the absolute quantity that a country can produce has an effect on that country’s trade patterns, when actually it is all about differing opportunity cost and comparative advantage. The ability to produce more than a competitor is called the:

ABSOLUTE ADVANTAGE: THE ABILITY OF AN INDIVIDUAL, FIRM, OR COUNTRY TO PRODUCE MORE OF A GOOD OR SERVICE THAN COMPETITORS.

In our example, we say that England has the absolute advantage in cloth production and Portugal has the absolute advantage in wine production. ­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­­

______________________________________________________________________________

In chapter 1, we talked about different types of economic systems. We noted that the United States has a mixed economy, in which the majority of decisions about the allocation of resources are made by households and firms interacting in markets. In the coming sections, we will be exploring how the private incentives of market participants –firms and households- interact to (usually) determine the socially efficient allocation of resources. We begin our pursuit of this lofty goal by taking a broad look at how the resources required for production, and the goods and services that are produced with these resources, are traded in markets in exchange for money. The definition of a market is here:

MARKET: A GROUP OF BUYERS AND SELLERS OF A GOOD OR SERVICE AND THE INSTITUTION OR ARRANGEMENT BY WHICH THEY COME TOGETHER TO TRADE.

Markets can be physical places like a grocery store, a stock exchange, or a flower stand. But they can also be virtual places like Amazon.com, EBay, or Craigslist. Usually when we think of markets, the types of markets that typically come to mind are markets for goods and services. We call these product markets.

PRODUCT MARKETS: MARKETS FOR GOODS AND SERVICES, LIKE SHOES AND AUTO REPAIR, RESPECTIVELY.

In product markets, households are buyers and firms are sellers. Firms gather the resources necessary to create goods and services, then sell those goods and services to households. Firms acquire the resources necessary for production by purchasing them from what are called factor markets.

FACTOR MARKETS: MARKETS FOR THE FACTORS OF PRODUCTION, SUCH AS LABOR, CAPITAL, NATURAL RESOURCES, AND ENTREPRENEURIAL ABILITY.

FACTORS OF PRODUCTION: THE INPUTS USED TO MAKE GOODS AND SERVICES.

In factor markets, firms are buyers and households are sellers. The easiest way to see this is by considering the labor market. Labor is a crucial input to the production of goods and services. When members of households go to work, they are selling their labor to firms in exchange for wages (money).

So we have two types of markets, product and factor, and two types of market participants, households and firms. Firms acquire inputs to production from households in factor markets, and then convert those inputs into goods and services which are then sold to households in product markets. Households get payments from firms for the factors of production (like wages), and use those payments to buy goods and services from firms in product markets. The firms then take payments from product markets and spend them again in factor markets, and the cycle continues. A diagram, called a “circular flow diagram” illustrates this idea:

A diagram is shown with 4 bubbles arranged in a diamond shape, and a bunch or arrows between them showing flows of money and resources.  2 bubbles represent each firms and households, and two other bubbles represent product and factor markets, respectively.  The arrows show that households get money from firms through factor markets and pay money to firms in product markets, and also that firms obtain resources from households in factor markets and provide goods and services to them in product markets.

This diagram shows how factors, products, and payments move through a market economy. Although the government is not mentioned here, it does play a crucial role in sustaining the vitality of a market economy. The government promotes a healthy market economy by enforcing property rights and contracts. Without this, markets could not function efficiently.

If property rights were not enforced, and individuals were not discouraged from stealing one another’s possessions, consumers would have less incentive to purchase goods and services, and economic activity would be suppressed. If market participants were permitted to default on contracts, there would be no reason to enter into a contract. Since a significant portion of economic activity is based on contracts, failure to enforce contracts would suppress economic activity.

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