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Principles of Economics

Twelfth Edition

PART I
INTRODUCTION TO
ECONOMICS

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Principles of Economics
Twelfth Edition(2 of 2)

Chapter 1
The Scope and
Method of Economics

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Chapter Outline and Learning Objectives


(1 of 2)

1.1 Why Study Economics?


Identify three key reasons to study economics. Think of an example
from your life in which understanding opportunity costs or the
principle of efficient markets could make a difference in your decision
making.

1.2 The Scope of Economics


Describe microeconomics and macroeconomics.

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Chapter Outline and Learning Objectives


(2 of 2)

1.3 The Method of Economics


Think about an example of bad causal inference leading to
erroneous decision making. Identify the four main goals of economic
policy.

Appendix: How to Read and Understand Graphs


Understand how data can be graphically represented.

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Chapter 1 The Scope and Method of


Economics
economics The study of how individuals and societies
choose to use the scarce resources that nature and
previous generations have provided.
The key word in the definition is choose.
Economics is a behavioral, or social, science.
Economics is the study of how people make choices.

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Why Study Economics?


To Learn a Way of Thinking
Economics has three fundamental concepts:
Opportunity cost
Marginalism
Efficient markets

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To Learn a Way of Thinking (1 of 3)


Opportunity Cost
opportunity cost The best alternative that we forgo, or
give up, when we make a choice or decision.
trade-offs as a way of thinking about decision making.
opp. cost arise because resources are scarce (Limited).

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To Learn a Way of Thinking (2 of 3)


Marginalism
marginalism The process of analyzing the additional or
incremental costs or benefits arising from a choice or
decision.

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To Learn a Way of Thinking (3 of 3)


Efficient MarketsNo Free Lunch
efficient market A market in which profit opportunities are
eliminated almost instantaneously.
The study of economics teaches us a way of thinking and
helps us make decisions.

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To Understand Society
Industrial Revolution The period in England during the
late eighteenth and early nineteenth centuries in which
new manufacturing technologies and improved
transportation gave rise to the modern factory system and
a massive movement of the population from the
countryside to the cities.
The study of economics is an essential part of the study of
society.

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To Be an Informed Citizen
To be an informed citizen requires a basic understanding
of economics.

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ECONOMICS IN PRACTICE
iPod and the World
A sticker that says Made in China can often be
misleading.
The iPod is composed of many small parts, and it
is almost impossible to accurately tell exactly
where each piece was produced without pulling it
apart.
From an economics point of view, one often has
to dig deep to see what is really going on.

THINKING PRACTICALLY

1. What do you think accounts for where components of the iPod and Barbie are made?

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The Scope of Economics (1 of 2)


Microeconomics and Macroeconomics
microeconomics The branch of economics that
examines the functioning of individual industries and the
behavior of individual decision-making unitsthat is, firms
and households.
macroeconomics The branch of economics that
examines the economic behavior of aggregatesincome,
employment, output, and so onon a national scale.

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The Scope of Economics (2 of 2)


Microeconomics and Macroeconomics
Microeconomics looks at the individual unitthe
household, the firm, the industry. It sees and examines the
trees.
Macroeconomics looks at the whole, the aggregate. It sees
and analyzes the forest.

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The Method of Economics


Economics deals with two kinds of questions: positive and
normative.
positive economics An approach to economics that
seeks to understand behavior and the operation of
systems without making judgments. It describes what
exists and how it works.
normative economics An approach to economics that
analyzes outcomes of economic behavior, evaluates them
as good or bad, and may prescribe courses of action. Also
called policy economics.

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Theories and Models (1 of 5)


model A formal statement of a theory, usually a
mathematical statement of a presumed relationship
between two or more variables.
variable A measure that can change from time to time or
from observation to observation.
Ockhams razor The principle that irrelevant detail should
be cut away.

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Theories and Models ( 2 of 5)


All Else Equal
ceteris paribus, or all else equal A device used to
analyze the relationship between two variables while the
values of other variables are held unchanged.
Using the device of ceteris paribus is one part of the
process of abstraction.
In formulating economic theory, the concept helps us
simplify reality to focus on the relationships that interest us.

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Theories and Models (3 of 5)


Expressing Models in Words, Graphs, and Equations
Graphs and equations capture the quantitative side of
economic observations and predictions.

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Theories and Models (4 of 5)


Cautions and Pitfalls
Economists are interested in cause and effect, but sorting
out causality from correlation is not always easy.
post hoc, ergo propter hoc Literally, after this (in time),
therefore because of this. A common error made in
thinking about causation: If Event A happens before Event
B, it is not necessarily true that A caused B.

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Theories and Models (5 of 5)


Testing Theories and Models: Empirical Economics
empirical economics The collection and use of data to
test economic theories.

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ECONOMICS IN PRACTICE
Does Your Part-time Job Matter for Your Academic Performance?

Several studies of the effect of part-time jobs


on college grades help to sort out causality in
part-time job effects.
One study used data on final-year journalism
students academic achievements and wellbeing along with their employment reasons
and working hours to test the part-time
employment effects.
The overall results revealed strong negative
employment effects.

THINKING PRACTICALLY
1. Would the academic outcomes of university juniors change as they become university
seniors if they continuously pursue similar types of employment?

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Economic Policy ( 1 of 3)
Four criteria are important in judging economic outcomes:
1. Efficiency
2. Equity
3. Growth
4. Stability

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Economic Policy (2 of 3)
Efficiency
efficiency In economics, allocative efficiency. An efficient
economy is one that produces what people want at the
least possible cost.
Equity
equity Fairness.

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Economic Policy ( 3 of 3)
Growth
economic growth An increase in the total output of an
economy.
Stability
stability A condition in which national output is growing
steadily, with low inflation and full employment of
resources.

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An Invitation
You cannot begin to understand how a society functions
without knowing something about its economic history and
its economic system.
Learning to think in this very powerful way will help you
better understand the world.
This book proceeds step-by-step, each section building on
the last.
Make sure you understand where it all fits in the big
picture.

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REVIEW TERMS AND CONCEPTS

ceteris paribus, or all else equal

economic growth

economics

efficiency

efficient market

empirical economics

equity

Industrial Revolution

macroeconomics

Marginalism

microeconomics

model

normative economics
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CHAPTER 1 APPENDIX:
How to Read and Understand Graphs
graph A two-dimensional representation of a set of
numbers or data.
Time Series Graphs
time series graph A graph illustrating how a variable
changes over time.

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TABLE 1A.1 Total


Disposable Personal
Income in the United
States, 19752014 (in
Billions of Dollars)

Year
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994

Total
Disposable
Personal
Income
1,219
1,326
1,457
1,630
1,809
2,018
2,251
2,425
2,617
2,904
3,099
3,288
3,466
3,770
4,052
4,312
4,485
4,800
5,000
5,244

Year
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014

FIGURE 1A.1 Total Disposable Personal


Income in the United States: 19752014 (in
Billions of Dollars)

Total
Disposable
Personal
Income
5,533
5,830
6,149
6,561
6,876
7,401
7,752
8,099
8,466
9,002
9,401
10,037
10,507
10,994
10,943
11,238
11,801
12,384
12,508
12,981

Source: U.S. Department of Commerce, Bureau of Economic Analysis.

Source: See Table 1A.1.

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Graphing Two Variables


X-axis The horizontal line against which a variable is
plotted.
Y-axis The vertical line against which a variable is plotted.
origin The point at which the horizontal and vertical axes
intersect.
Y-intercept The point at which a graph intersects the
Y-axis.
X-intercept The point at which a graph intersects the
X-axis.

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Plotting Income and Consumption Data


for Households
positive relationship A relationship between two
variables, X and Y, in which a decrease in X is
associated with a decrease in Y and an increase
in X is associated with an increase in Y.
negative relationship A relationship between two
variables, X and Y, in which a decrease in X is
associated with an increase in Y and an increase
in X is associated with a decrease in Y.

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FIGURE 1A.2 Household


Consumption and Income
TABLE 1A.2 Consumption
Expenditures and Income, 2012

Bottom fifth
2nd fifth
3rd fifth
4th fifth
Top fifth

Average
Income
Before Taxes

Average
Consumption
Expenditures

$ 9,988
27,585
47,265
75,952
167,010

$ 22,154
32,632
43,004
59,980
99,368

Source: Consumer Expenditures in 2012, U.S. Bureau


of Labor Statistics.

Source: See Table 1A.2.

A graph is a simple two-dimensional geometric representation of data. The graph in Figure 1A.2
displays the data from Table 1A.2.
Along the horizontal scale (X-axis), we measure household income. Along the vertical scale (Y-axis), we
measure household consumption.
Note: At point A, consumption equals $22,154 and income equals $9,988. At point B, consumption
equals $32,632 and income equals $27,585.
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Slope
slope A measurement that indicates whether the
relationship between variables is positive or negative
and how much of a response there is in Y (the variable
on the vertical axis) when X (the variable on the
horizontal axis) changes.

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FIGURE 1A.3 A Curve with (a) Positive Slope and


(b) Negative Slope

A positive slope indicates that increases in X are associated with increases in Y and that
decreases in X are associated with decreases in Y.
A negative slope indicates the oppositewhen X increases, Y decreases; and when X
decreases, Y increases.
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FIGURE 1A.4 Changing Slopes along Curves

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APPENDIX REVIEW TERMS AND


CONCEPTS

graph

negative relationship

origin

positive relationship

Slope

time series graph

X-axis

X-intercept

Y-axis

Y-intercept

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Principles of Economics
Twelfth Edition

Chapter 2
The Economic
Problem: Scarcity and
Choice

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Chapter Outline and Learning Objectives


2.1 Scarcity, Choice, and Opportunity Cost
Understand why even in a society in which one person is better than
a second at all tasks, it is still beneficial for the two to specialize and
trade.

2.2 Economic Systems and the Role of Government


Understand the central difference in the way command economies
and market economies decide what is produced.

Looking Ahead

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Chapter 2 The Economic Problem:


Scarcity and Choice ( 1 of 2)
On the surface, economic issues seem quite different from
one another.
But the fundamental concern is choice in a world of
scarcity.
Individuals choices determine three key features of
society:
What gets produced?
How is it produced?
Who gets what is produced?

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Chapter 2 The Economic Problem:


Scarcity and Choice ( 2 of 2)
capital Things that are produced and then used in the
production of other goods and services.
factors of production (or factors) The inputs into the
process of production. Another term for resources.
production The process that transforms scarce resources
into useful goods and services.
inputs or resources Anything provided by nature or
previous generations that can be used directly or indirectly
to satisfy human wants.
outputs Goods and services of value to households.
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FIGURE 2.1 The Three Basic Questions

Every society has some system or process that transforms its scarce resources into useful
goods and services.
In doing so, it must decide what gets produced, how it is produced, and to whom it is
distributed.
The primary resources that must be allocated are land, labor, and capital.
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Scarcity, Choice, and Opportunity Cost


Scarcity and Choice in a One-Person Economy
Nearly all the same basic decisions that characterize
complex economies must also be made in a simple
economy.
A person must decide what to produce and how and when
to produce it.

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Scarcity and Choice in a One-Person


Economy
Opportunity Cost
The concepts of constrained choice and scarcity are
central to the discipline of economics.
opportunity cost The best alternative that we give up, or
forgo, when we make a choice or decision.

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ECONOMICS IN PRACTICE
Nannies and Opportunity Costs
The increase in demand for nannies in the
Middle East with an increase in per capita
income is a good example of the role of
opportunity costs in our lives.
From the point of view of policy implication,
the lower opportunity cost of hiring nannies
helps the countries of both the expatriates
and the nanny to generate more income
and higher levels of economic growth.

THINKING PRACTICALLY
1. Under what circumstances could
measuring opportunity costs prevent
you from making a rational decision?

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Scarcity and Choice in an Economy of


Two or More (1 of 2)
Specialization, Exchange, and Comparative Advantage
theory of comparative advantage Ricardos theory that
specialization and free trade will benefit all trading parties,
even those that may be absolutely more efficient producers.
absolute advantage A producer has an absolute advantage
over another in the production of a good or service if he or
she can produce that product using fewer resources (a lower
absolute cost per unit).
comparative advantage A producer has a comparative
advantage over another in the production of a good or service
if he or she can produce that product at a lower opportunity
cost.
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FIGURE 2.2 Comparative Advantage and the Gains from Trade

Panel (a) shows the best Colleen and Bill


can do each day, given their talents and
assuming they each wish to consume an
equal amount of food and wood.
Notice that Colleen produces by splitting
her time equally during the day, while Bill
must devote two thirds of his time to
wood production if he wishes to equalize
his amount produced of the two goods.
Panel (b) shows what happens when
both parties specialize. Notice that more
units of each good are produced.

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FIGURE 2.3 Production Possibilities with and without Trade

This figure shows the combinations of food and wood that Colleen and Bill can each generate in one day
of labor, working by themselves. Colleen can achieve independently any point along line ACB, while Bill
can generate any combination of food and wood along line DFE.
Specialization and trade would allow both Bill and Colleen to move to the right of their original lines, to
points like C and F. In other words, specialization and trade allow both people to be better off than they
were acting alone.
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Scarcity and Choice in an Economy of


Two or More (2 of 2)
Weighing Present and Expected Future Costs and
Benefits
We trade off present and future benefits in small ways all
the time.
Capital Goods and Consumer Goods
consumer goods Goods produced for present
consumption.
investment The process of using resources to produce
new capital.

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The Production Possibility Frontier (1 of 7)


production possibility frontier (ppf) A graph that shows
all the combinations of goods and services that can be
produced if all of societys resources are used efficiently.

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FIGURE 2.4 Production Possibility Frontier

The ppf illustrates a number of economic concepts. One of the most important is opportunity cost.
The opportunity cost of producing more capital goods is fewer consumer goods.
Moving from E to F, the number of capital goods increases from 550 to 800, but the number of
consumer goods decreases from 1,300 to 1,100.
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The Production Possibility Frontier (2 of 7)


Negative Slope and Opportunity Cost
marginal rate of transformation (MRT) The slope of the
production possibility frontier (ppf).
The negative slope tells us how much society has to give
up of one output to get a unit of another output.

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The Production Possibility Frontier (3 of 7)


The Law of Increasing Opportunity Cost
FIGURE 2.5 Corn and Wheat Production in Ohio and Kansas
The ppf illustrates that the opportunity
cost of corn production increases as we
shift resources from wheat production to
corn production. Moving from point E to D,
we get an additional 100 million bushels
of corn at a cost of 50 million bushels of
wheat.
Moving from point B to A, we get only 50
million bushels of corn at a cost of 100
million bushels of wheat. The cost per
bushel of cornmeasured in lost wheat
has increased.

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TABLE 2.1 Production Possibility Schedule for Total Corn and


Wheat Production in Ohio and Kansas

Total
Corn Production
(Millions of Bushels per
Year)

Total
Wheat Production
(Millions of Bushels per
Year)

700

100

650

200

510

380

400

500

300

550

Point on ppf

The ppf illustrates that the opportunity cost of corn production increases as we shift resources from
wheat production to corn production. Moving from point E to D, we get an additional 100 million
bushels of corn at a cost of 50 million bushels of wheat.
Moving from point B to A, we get only 50 million bushels of corn at a cost of 100 million bushels of
wheat. The cost per bushel of cornmeasured in lost wheathas increased.
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The Production Possibility Frontier (4 of 7)


Unemployment
During economic downturns or recessions, industrial plants
run at less than their total capacity.
When there is unemployment of labor, we are not
producing all that we can.

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The Production Possibility Frontier (5 of 7)


Inefficiency
Waste and mismanagement are the results of a firm
operating below its potential.
Sometimes inefficiency results from mismanagement of
the economy instead of mismanagement of individual
private firms.

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FIGURE 2.6 Inefficiency from Misallocation of Land in Farming

Inefficiency always results in a combination of production shown by a point inside the ppf, like point A.
Increasing efficiency will move production possibilities toward a point on the ppf, such as point B.

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The Production Possibility Frontier (6 of 7)


The Efficient Mix of Output
To be efficient, an economy must produce what people
want.
Output efficiency occurs when the economy is operating at
the right point on the ppf.

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The Production Possibility Frontier (7 of 7)


Economic Growth
economic growth An increase in the total output of an
economy. Growth occurs when a society acquires new
resources or when it learns to produce more using existing
resources.
Growth shifts the ppf up and to the right.

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TABLE 2.2 Increasing Productivity in Corn and Wheat Production in


the United States, 19352009
Corn

19351939
19451949
19551959
19651969
19751979
19811985
19851990
19901995
1998
2001
2006
2007
2008
2009
a

Wheat

Yield per
Acre
(Bushels)

Labor Hours
per 100
Bushels

Yield per Acre


(Bushels)

Labor Hours
per 100
Bushels

26.1
36.1
48.7
78.5
95.3
107.2
112.8
120.6
134.4
138.2
145.6
152.8
153.9
164.9

108
53
20
7
4
3
NAa
NAa
NAa
NAa
NAa
NAa
NAa
NAa

13.2
16.9
22.3
27.5
31.3
36.9
38.0
38.1
43.2
43.5
42.3
40.6
44.9
44.3

67
34
17
11
9
7
NAa
NAa
NAa
NAa
NAa
NAa
NAa
NAa

Data not available.

Source: U.S. Department of Agriculture, Economic Research Service, Agricultural Statistics, Crop Summary.

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FIGURE 2.7 Economic Growth Shifts the PPF Up and to the Right

Productivity increases have enhanced the ability of the United States to produce both corn and wheat.
As Table 2.2 shows, productivity increases were more dramatic for corn than for wheat.
Thus, the shifts in the ppf were not parallel.
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FIGURE 2.8 Capital Goods and Growth in Poor and Rich Countries

Rich countries find it easier


than poor countries to
devote resources to the
production of capital, and
the more resources that
flow into capital production,
the faster the rate of
economic growth.
Thus, the gap between
poor and rich countries has
grown over time.

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ECONOMICS IN PRACTICE
Trade-Offs among High and Middle-Income Countries in the Middle East
In all societies resources are limited and unable to
satisfy unlimited needs and wants.
The real gross domestic product (GDP or income) of
the UAE is approximately 11 times that of Jordan.

In Jordan, consumers spend around 16 percent of


their income on housing, rent, and related expenses
as opposed to UAEs 36 percent. UAE is an oil
exporting country, attracting a large number of foreign
investors and labor, which creates a large demand on
housing. In any economy, people are making their

own economic decisions based on their priorities.

THINKING PRACTICALLY
1.

In what ways do you think the prices of goods are related to the law of
increasing opportunity cost?

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The Economic Problem


Recall the three basic questions facing all economic
systems:
What gets produced?
How is it produced?
Who gets it?
Given scarce resources, how do large, complex societies
go about answering the three basic economic questions?

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Economic Systems and the Role of


Government (1 of 7)
Command Economies
command economy An economy in which a central
government either directly or indirectly sets output targets,
incomes, and prices.
Laissez-Faire Economies: The Free Market
laissez-faire economy Literally from the French: allow
[them] to do. An economy in which individual people and
firms pursue their own self-interest without any central
direction or regulation.

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Economic Systems and the Role of


Government (2 of 7)
market The institution through which buyers and sellers
interact and engage in exchange.
Some markets are simple and others are complex, but
they all involve buyers and sellers engaging in exchange.
The behavior of buyers and sellers in a laissez-faire
economy determines what gets produced, how it is
produced, and who gets it.

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Economic Systems and the Role of


Government (3 of 7)
Consumer Sovereignty
consumer sovereignty The idea that consumers
ultimately dictate what will be produced (or not produced)
by choosing what to purchase (and what not to purchase).
The mix of output is dictated by consumers who vote by
buying or not buying.

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Economic Systems and the Role of


Government (4 of 7)
Individual Production Decisions: Free Enterprise
Under a free market system, individual producers must
determine how to organize and coordinate their production.
In a free market economy, production decisions are made
by private organizations acting in their own interest.

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Economic Systems and the Role of


Government (5 of 7)
Distribution of Output
A households income affects the amount of output it can
get.
Income is the amount that a household earns each year. It
comes in a number of forms, such as wages, salaries, and
interest.
You may be able to increase your income by getting more
education or training.

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Economic Systems and the Role of


Government (6 of 7)
Price Theory
In a free market system, the basic economic questions are
answered without the help of a central government plan or
directives.
This is what the free in free market meansthe system
is left to operate on its own, with no outside interference.
Individuals pursuing their own self-interest will go into
business and produce the products and services that
people want.

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Economic Systems and the Role of


Government (7 of 7)
Price Theory
Other individuals will decide whether to acquire skills;
whether to work; and whether to buy, sell, invest, or save
the income that they earn.
The basic coordinating mechanism is price.

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Mixed Systems, Markets, and


Governments
The differences between command economies and
laissez-faire economies in their pure forms are enormous.
In fact, these pure forms do not exist in the world.
All real systems are in some sense mixed.

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REVIEW TERMS AND CONCEPTS


absolute advantage
capital
command economy
comparative advantage
consumer goods
consumer sovereignty
economic growth
factors of production (or factors)
inputs or resources
investment
laissez-faire economy
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