ECON 2-2 FREE MARKETS

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Study the introduction above and explain the goals of this lesson. What are you expected to learn?
Also, study the vocabulary words and look for them as you work your way through this lesson.

What do a farmers’ market, a sporting
goods store, the New York Stock
Exchange, and the sign you posted on your
community bulletin board advertising
baby-sitting services have in common? All
are examples of markets. A market is an
arrangement that allows buyers and sellers
to exchange things.

Why Markets Exist
Markets exist because no one is self-sufficient. In other words, none of us produces all we require to satisfy our needs and wants. You probably didn’t grow the plants to make the fibers to weave the cloth to
make the shirt you’re wearing. Instead, you
purchased your shirt at a store, which is an
example of a market. Markets allow us to
exchange the things we have for the things
we want.

You have a small business that sells video games. What do you need to exchange games for money?

a.	a clean environment	c.	a market
b.	water	d.	community laws

Your father is a school teacher. His service as a teacher is converted into _____ that he can trade in the market place for the goods and services our family needs and wants.

a.	money	c.	utilities
b.	daily lessons	d.	health benefits

Specialization
Instead of being self-sufficient, each of us
produces just one or a few products.
A nurse specializes in caring for the sick. A marine mechanic specializes in repairing
machinery aboard sea craft. A baker
specializes in making breads, cakes, and
cookies. Specialization is the concentration of the productive efforts of individuals and firms on a limited number of activities.

Specialization leads to efficient use of resources, including capital, land, and labor. It is easier to learn one task or a few tasks very well than to learn them all.

Buying and Selling
Because each of us specializes in producing just a few products, we need markets to sell what we have and to buy what we want. The typical person earns an income (specializing at a particular job) and uses this income to buy the products that he or she wants to consume. If each person were self-sufficient, producing everything he or she wanted to consume, there would be no need for markets.

Why is specialization necessary for a modern economy to function?

a.	everyone owns shares in the stock market, either directly or indirectly	c.	no one individual can produce all of the land, labor and capital needed to satisfy their needs and wants.
b.	it protects us from global warming	d.	so people can avoid participation in the market

In the 1970’s some college students wanted to divorce themselves completely from modern society so they formed small groups and moved to the desert and other remote locations. They started farms to produced all of the food they needed to survive. Why did these communities fail?

a.	they smoked too much dope	c.	they could not live without their cell phones
b.	college students are stupid	d.	they discovered they could not produce all of the goods and services they wanted and needed

A circular flow model shows the interactions between households and businesses in the free market.

Study the graphic above. What is exchanged in the factor market?

a.	household land, labor and capital for company money	c.	company specialization for company money
b.	company land, labor and capital for household money	d.	household specialization for household money

Study the graphic above. What is exchanged in the product market?

a.	household land, labor and capital for company money	c.	company specialization for company money
b.	company land, labor and capital for household money	d.	household specialization for household money


Free Market Economy Economic systems that are based on voluntary exchanges in markets are called free market economies. In a free market economy, individuals and businesses use markets to exchange money and products. In a free market system, individuals and privately owned businesses own the factors of production, make what they want, and buy what they want. In other words, individuals answer the three key economic questions of what to produce, how to produce it, and who consumes that which is produced. As you might guess, a free market economy functions best in an environment of decentralized decision-making such as enjoyed in the United States.	We can represent a free market economy in a special kind of drawing called a circular flow diagram, or model. A circular flow diagram shows at a glance how individuals and businesses exchange money, resources, and products in the marketplace. Figure 2.3 shows a circular flow diagram of a free market economy. The inner ring of the diagram represents the flow of resources and products. The outer ring represents the flow of money.

In a free market economy who answer the three key economic questions of what to produce, how to produce it, and who consumes that which is produced.

a.	the local communities	c.	individuals
b.	the U.S. Government	d.	politicians

In the graphic above, the inner ring shows the flow or _____ and the outer ring shows the flow of _____ .

a.	goods and services - money	c.	stocks and bonds - dividends
b.	money - goods and services	d.	land, labor and capital - savings and investments


Households and Firms The players in the free market economy are households and firms. A household is a person or group of people living in the same residence. Households own the factors of production—land, labor, and capital. Households are also the consumers of goods and services. A business, or firm, is an organization that uses resources to produce a product, which it then sells. Firms transform “inputs,” or factors of production, into “outputs,” or products. Factor Market As you can see from the lower half of the circular flow diagram in Figure 2.3, firms purchase factors of production from households. This arena of exchange is called	the factor market. Firms purchase or rent land (natural resources). They hire workers, paying them wages or salaries for their labor. They also borrow money from households to purchase capital, paying households interest or profits in return. Profit is the financial gain made in a transaction. Product Market Take a close look at the top half of the circular flow diagram in Figure 2.3. You can see that the goods and services that firms produce are purchased by households in the product market. If you follow the rings of the diagram, you will see that households purchase the products made by firms with the money they received from firms in the factor market. The flow between the factor market and the product market is truly circular.

10.

Which item below is not a factor of production?

a.	profit	c.	labor
b.	land	d.	capital

11.

In the diagram above, who owns the factors of production?

a.	households	c.	the government
b.	firms	d.	corporations

12.

What do firms do in the graphic above?

a.	they consume products produced by households	c.	they convert the factors of production into products
b.	they convert capital into land and labor	d.	they convert products into land, labor and capital

The Self-Regulating Nature
of the Marketplace

How is it that firms and households cooperate
to give each other what they want? —factor resources, in the case of firms, and products, in the case of households? As anyone knows who has tried out for the track team, a part in a play, or has applied for a job or to a college, we live in a competitive society. According to Adam Smith, it is, in fact, competition and our own self-interest that keep the marketplace functioning.

Adam Smith

Self-Interest
Adam Smith was a Scottish social philosopher
who, in 1776, published a book titled The Wealth of Nations, in which he described how the market functions. Smith observed that an economy is made up of countless individual transactions. In each transaction, the buyer and seller consider only their self-interest, or their own personal gain. Self-interest, in other words, is the motivating force in the free market.

13.

According to Adam Smith, what keeps the market functioning?

a.	competition among individuals	c.	self sacrifice and altruism
b.	the desire to do good	d.	self sacrifice and competition

14.

According to Adam Smith, what motivates people in a free market?

a.	concern for humanity	c.	love of country
b.	attending to the needs of the rich and poor	d.	self interest

Competition
Consumers (households), in pursuit of their
self-interest, have the incentive to look for
lower prices. An incentive is the hope of
reward or the fear of punishment that
encourages a person to behave in a certain
way. Adam Smith observed that people
respond predictably to both positive and
negative incentives. As for consumers, we
can predict that they will respond to the
positive incentive of lower prices, because
spending less money on a good lowers the
opportunity cost of the purchase.

Firms, meanwhile, seek to make greater
profits by increasing sales. Let’s take, for
example, a shirt manufacturer. The manufacturer finds that striped shirts are far outselling polka-dotted shirts. The manufacturer has the incentive—from more potential sales and profits—to produce more striped shirts. Other manufacturers, observing consumers’ desire for striped shirts, also have the incentive to sell them. With all these manufacturers in the market, consumers have all the striped shirts they want.

Manufacturers also have a second incentive —to make the most profit in selling striped shirts. What keeps manufacturers’ pursuit of profit from causing prices to skyrocket? If one begins charging $30.00 for a striped shirt, another can sell striped shirts for $25.00. If the first manufacturer wants to sell any more striped shirts, he or she had better drop the selling price. Consumers, pursuing their self-interest, will buy the lower-priced shirt. Economists call this struggle among producers for the dollars of consumers competition. While self-interest is the motivating force behind the free market, competition is the regulating force.

Incentives come in two forms. Profit is a
monetary incentive, or an incentive that
rewards in the form of money. Nonmonetary
incentives reward consumers and business in
other ways, such as gifts, services, and other
goods

15.

What lowers the opportunity cost of a purchase?

a.	spending more money on a good or service	c.	correctly estimating the value of a good or service
b.	spending less money on a good or service	d.	postponing the purchase of a good or service

16.

What regulates the free market?

a.	price	c.	government policy
b.	cost	d.	competition

17.

In the shirt example above, what is the benefit to consumers when buyer and seller compete and act in their own self interests?

a.	fewer shirts but at a price low enough for everyone to afford	c.	higher prices but better shirts
b.	more shirts at a lower price	d.	poorer quality shirts but at a cheaper price

18.

You want to purchase a new Samsung television for Christmas. Best Buy and Walmart offer the same television at about the same price but Walmart is giving away a Christmas turkey with each television purchase. What kind of incentive is Walmart offering?

a.	monetary	c.	discount
b.	non-monetary	d.	profit

The Invisible Hand

Self-interest and competition work together to regulate the marketplace. Self-interest spurs consumers to purchase certain goods and services and firms to produce them. Competition causes more production and moderates firms’ quests for higher prices. The overall result is that consumers get the products they want at prices that closely reflect the cost of producing them. All of this happens without any central plan or direction. Adam Smith called this phenomenon “the invisible hand of the marketplace.”

Eventually the Invisible Hand Will Balance Supply and Demand and bring down the price

Market Forces
The Invisible Hand

19.

In a free market, what motivates companies to keep their prices low?

a.	self-interest	c.	competition
b.	government regulation	d.	altruism

20.

What is the invisible hand?

a.	government control of the free market to maximize productivity that benefits everyone	c.	self regulation of a free market brought about through competition and everyone doing what is best for himself.
b.	the equal distribution of land, labor, capital and money among all citizens	d.	self regulation of a free market brought about by everyone looking out for the interests of others in the market

21.

In the cartoon above, what will eventually bring down the price of gasoline?

a.	competition among the gasoline suppliers	c.	cars that use more gasoline
b.	government price controls	d.	higher demand for gasoline

Advantages of the Free Market
Competition and the pursuit of self-interest
serve the public interest. The free market,
on its own, meets many economic goals.

1. Economic efficiency Because it is self regulating, a free market economy
responds efficiently to rapidly changing
conditions. Producers make only what
consumers want, when they want it, and
generally at prices they are willing to pay.

2. Economic freedom Free market
economies have the highest degree of
economic freedom of any system. This
includes the freedom of workers to work
where they want, of firms to produce
what they want, and of individuals to
consume what they want.

3. Economic growth Because competition
encourages innovation, free markets
encourage growth. Entrepreneurs are
always seeking profitable opportunities,
contributing new ideas and innovations.

4. Additional goals Free markets offer a
wider variety of goods and services than
any other system, because producers
have incentives to meet consumers’
desires. Consumers, in essence, decide
what gets produced. This is called
consumer sovereignty.

Despite its advantages, no pure market
economy exists on any meaningful scale.
The same features that make free markets
attractive also represent the weaknesses of
the free market. The goals of economic
equity and economic security are difficult
to achieve in a pure market system. In
Section 4, you will read about how the free
market system has been modified by
various nations in order to better meet the
entire array of economic goals.

22.

What does the following phrase from the reading above mean? “Competition and the pursuit of self-interest serve the public interest.”

a.	Society benefits if everyone competes and does what is best for themselves.	c.	The public interest is only served when people compete but serve others at the same time
b.	Competition defeats self-interest and therefore helps society	d.	The public is not interested in self-interest and competition

23.

In a free market economy, who decides what is going to be produced?

a.	businesses	c.	the government
b.	consumers	d.	custom and tradition

24.

In a free market economy there is very little waste in the production of goods and services. What is this called?

a.	consumer sovereignty	c.	economic efficiency
b.	economic freedom	d.	economic growth

a.	specialization	d.	market
b.	household	e.	factor market
c.	profit	f.	firm

25.

a person or group of people living in the same residence

26.

the financial gain made in a transaction

27.

an arrangement that allows buyers and sellers to exchange things

28.

an organization that uses resources to produce a product, which it then sells

29.

the concentration of the productive efforts of individuals and firms on a limited number of activities

30.

market in which firms purchase the factors of production from households

a.	product market	d.	self-interest
b.	invisible hand	e.	competition
c.	incentive	f.	consumer sovereignty

31.

the power of consumers to decide what gets produced

32.

one’s own personal gain

33.

the struggle among producers for the dollars of consumers

34.

the market in which households purchase the goods and services that firms produce

35.

term economists use to describe the self regulating nature of the marketplace

36.

an expectation that encourages people to behave in a certain way