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The opportunity cost of making the extra 30 million pounds of butter is 37 million guns. That works out to a cost of about 1.2 guns for every pound of butter. If the nation increases its output of butter to 312 million pounds (point 5 on the curve), the opportunity cost of the change would be 63 millions guns, nearly 2 guns for every pound of butter. This increase in the opportunity cost—each additional unit costs more to make than the last—explains why the curve is bow-shaped. ______________ ______________ _____________________________________________________________________________________________________________________________________________________________ _______________ QUICK REFERENCE The law of increasing opportunity costs states that as production switches from one product to another, increasing amounts of resources are needed to increase the production of the second product. Opportunity Cost In the guns vs. butter equation, if more resources are used to make military products, such as stealth bombers, there are fewer resources available for other things, such as butter and other consumer goods. The opportunity cost of making more military products is the other products that cannot be made. The reason for the increasing costs is fairly straightforward. Making butter involves different resources than making guns. Converting from gun production to butter production is not a simple procedure. New machinery must be produced, new factories must be built, and workers must be retrained. The cost of all these actions will be fewer and fewer guns. AP P LI CATION Writing about Economics B. Write a brief paragraph explaining the concepts a PPC shows graphically. The Economic Way of Thinking 21 Changing Production Possibilities The PPC illustrates a country’s present production possibilities as if all resources are fixed. However, a country’s supply of resources is likely to change over time. When additional resources become available, new production possibilities beyond the original frontier become attainable, and the PPC moves outward. EXAMPLE A Shift in the PPC In the late 1700s, the United States occupied a relatively narrow strip of land along the Atlantic Coast. Yet in less than a hundred years, it had expanded to the Pacific Ocean. This additional land provided the United States with an abundance of natural resources. Similarly, successive waves of immigration have added huge numbers of workers to the labor pool. Also, new technology has made the use of land, labor, and capital more efficient. The addition of new resources or the more efficient use of resources already available meant that the United States could produce more goods and services. This is shown on the PPC as a shift of the curve outward, or to the
right, as Figure 1.6 illustrates. Economists refer to this increase in the economy’s total output as economic growth. You’ll learn more about this concept in Chapter 12. FIGURE 1.6 SHIFT IN THE PPC 300 250 200 150 100 50 ) More resources or increased productivity shifts the PPC outward, or to the right, from PPC1 to PPC2. This means that the economy can produce more of both guns and butter and point 4, which was a production impossibility in Figure 1.5 on page 20, now is located on the curve. 1 4 PPC2 PPC1 0 50 100 150 200 250 300 350 Butter (in millions of pounds) ANALYZE GRAPHS 1. If the curve PPC2 represents current production possibilities, what does point 1 represent? 2. What might cause the PPC to shift inward? Use an interactive production possibilities curve at ClassZone.com APPLICATION Applying Economic Concepts C. Identify three developments that would cause the PPC to move outward. 22 Chapter 1 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain how each of these terms is illustrated by the production possibilities curve. a. underutilization b. efficiency 2. On what assumptions is the PPC based? Explain how these conditions do not correspond to the real world. 3. What economic data does a PPC bring together? 4. Why do opportunity costs increase as you make more and more butter and fewer guns? 5. Based on what we learn from PPCs, what does an economy need to be able to produce more of both products on the graph? 6. Using Your Notes Write a one- paragraph summary of this section. Refer to your completed summary chart for the ideas to use in your summary. Analyzing Production Possibilities PPC shows impact of scarcity Use the Graphic Organizer at Interactive Review @ ClassZone.com. Applying Economic Concepts Explain why, in an economy that produces only fish and computers and is working at efficiency, the 500th computer made will cost more in terms of fish than the 450th computer made. 8. Applying Economic Concepts Suppose the owners of a car- manufacturing company are thinking of entering the motorcycle production business. How would a PPC model help them make a decision? 9. Analyzing Cause and Effect If new technology was introduced but there were not enough skilled workers to use it, where would the nation’s production be plotted on the
PPC—inside or outside the curve? Explain your answer. 10. Challenge During a war, a country suffers massive devastation of its industry. How would the country’s PPC change from before the war to after the war? Sketch a PPC to illustrate your answer. Creating a PPC The following information reflects the production possibilities of an economy that makes only corn and television sets. Use the data to create a production possibilities curve. Bushels of Corn (in thousands) Television Sets (in thousands) 10 9 7 4 0 0 1 2 3 4 Label Points on a PPC Use the letters to locate the following points on your PPC: A The point at which the economy makes all TVs and no corn B A point representing efficiency C A point representing underutilization D A point representing an impossible level of production Challenge Use information from your PPC to explain the law of increasing opportunity costs. Use to complete this activity. @ClassZone.com The Economic Way of Thinking 23 S E C T I O N 4 The Economist’s Toolbox TA K I N G N O T E S In Section 4, you will statistics, p. 24 microeconomics, p. 27 macroeconomics, p. 27 positive economics, p. 29 normative economics, p. 29 • demonstrate how and why economists use economic models • understand how and why economists use statistics, charts, tables, and graphs • compare macroeconomics to microeconomics • contrast positive economics with normative economics As you read Section 4, complete a chart to see similarities and differences between key concepts. Use the Graphic Organizer at Interactive Review @ ClassZone.com Concepts Similarities Differences Charts & Tables vs. Graphs Micro vs. Macro Positive vs. Normative Working with Data KEY CONCEPT S An old joke notes that economics is everything we already know expressed in a language we don’t understand. While many economists might disagree with the second part of this joke, they probably would have little argument with the first part. Economics is something that everybody engages in every day, and in that way everyone has knowledge of it. Individuals, business owners, and government officials make economic decisions all the time. Economists study these decisions and look for logical ways to explain why some nations are rich while others are poor, or why some consumers want one kind of product while others want another. Since economists can’t interview every person in every nation about economic choices, they rely on statistics—numerical data or information—to see patterns of behavior
. To help organize and interpret the data they collect, they develop economic models. As you recall from Section 3, an economic model is a simplified representation of complex economic forces. The language of economists—these statistics and models—may sometimes be a little hard to understand. However, it is a more efficient way of explaining economic relationships and interactions than everyday language. Using Economic Models In science class, you may have seen a model of a lunar eclipse, which shows how, with the sun behind it, the earth casts a shadow on the moon. The model assumes certain laws of planetary orbit and simplifies the relationships among the objects in the solar system. However, these assumptions and simplifications make the process of the eclipse quite clear. QUICK REFERENCE Statistics are information in numerical form. 24 Chapter 1 Economic models work in the same way. They are based on assumptions and are simplified because they focus on a limited number of variables. Economists can express their models in words, graphs, or equations. Models help economists explain why things are as they are. In some cases, models can help economists to predict future economic activity. You’ve already learned how economists construct and use one important economic model—the production possibilities curve—in Section 3. You’ll learn about another, the circular flow model, in Chapter 2. FIGURE 1.7 DE VELOPMENT A SSISTANCE Using Charts and Tables Country Economists study statistics in a particular way, looking for trends, connections, and other interesting relationships. They have several tools to help them with this task. Among the most common tools are charts and tables, in which data are arranged and displayed in rows and columns. (See Figure 1.7 above.) By showing numbers in relation to other numbers, charts and tables can reveal patterns in the data. Luxembourg Canada 2,599 236 Aid (in millions of U.S. Dollars) Percentage of Total Economy 0.83 0.27 Source: Organization for Economic Co-operation and Development, 2004 Figures Suppose, for example, you were curious about how much money various developed countries give to help developing countries. In Figure 1.7, if you looked at one set of numbers, you would see that Luxembourg contributed $236 million, while Canada gave more than ten times that, offering nearly $2.6 billion. Your immediate interpretation of these data might be that Canada gives far more in foreign aid than Luxembourg does. But looking at other sets of numbers might suggest a different interpretation. Luxembourg may have contributed far less than
Canada in actual dollar amounts. However, the foreign aid Luxembourg gave represented close to 1 percent of the value of all the goods and services the nation produced. Canada’s contribution, in contrast, was about 0.3 percent of its total economy. After studying these numbers, you might conclude that in relative terms Luxembourg gives more than Canada in foreign aid. Using Graphs When economists are interested in identifying trends in statistics, they often use graphs, or visual representations of numerical relationships. The most common type is the line graph. Line graphs are particularly useful for showing changes over time. Find an update on foreign aid at ClassZone.com Statistics During a debate in the U.S. Senate on the future of Social Security, Senator Charles Grassley of Iowa illustrates a point using statistics in graph form. The Economic Way of Thinking 25 T YPES OF GR APHS FIGURE 1. 8 P C S PER 10 0 PEOPLE I N DE VELOPING COUNTRIES FIGURE 1.9 U. S. COMPUTER AND I N T E R N E T ACC ESS.0 2.5 2.0 1.5 1.0 0.5 0.0 1995 1996 1997 1998 1999 2000 2001 70 6 0 50 40 30 20 10 0 1998 Year 2003 Source: United Nations Source: National Telecommunications and Information Administration Year Computers Internet Access FIGURE 1.10 INTERNE T USERS BY REG ION 3% 1% 5% 21% 70% Developing Countries: Asia and Oceania Developing Countries: Americas Developing Countries: Central and Eastern Europe Developing Countries: Africa Developed Countries Source: United Nations, 2001 figures ANALYZE GRAPHS Graphs show statistics in a visual form. Line graphs (Figure 1.8) are particularly useful for showing changes over time. Bar graphs (Figure 1.9) make it easy to compare numbers or sets of numbers. Pie, or circle, graphs (Figure 1.10) show relationships among the parts of a whole. Use a variety of interactive graphs at ClassZone.com All line graphs use at least two sets of numbers, or variables: one plotted along the horizontal axis, running from left to right, the other plotted along the vertical axis, running from bottom to top. On the line graph in Figure 1.8 above, the range of time from 1995 to 2001 is shown on the horizontal axis. The number of PCs (personal computers) per 100 people in developing countries is shown on the vertical axis. The number of
PCs for each year is plotted on the graph and then these points are joined to form a line. The line may slope upward, showing an upward trend, or downward, showing a downward trend. The line may be straight, keeping the same slope throughout, or it may be curved, having a varied slope. (In later chapters you’ll see that where graphs are used to illustrate economic concepts, lines are referred to as curves whether they are straight or curved.) How would you describe the trend shown in Figure 1.8? A bar graph is especially useful for comparisons. The bar graph in Figure 1.9 above shows information on the percentage of households in the United States that have access to computers and the Internet. The bars vividly illustrate that access to information technology increased dramatically in the United States between 1998 and 2003. A pie graph, often called a pie chart or circle graph, is especially good for representing numbers in relation to a whole. Take a look at the pie graph in Figure 1.10 above. The whole circle represents all the Internet users in the world. The slices of the pie, which represent regions of the world, are drawn in proportion to the percentage of the whole they constitute. APPLICATION Interpreting Graphs A. Look at the pie graph in Figure 1.10 above. Write a generalization based on information in the graph. NEED HELP? Throughout this book, you will be asked to interpret and analyze information in graphs. If you need help with these tasks, see “Interpreting Graphs.” Skillbuilder Handbook, page R29 26 Chapter 1 Microeconomics and Macroeconomics KEY C ONCEPT S For scientists, everything in the earth, air, and water—and beyond—is a source of data to be observed and studied. Yet the data often make little sense until they are seen through the lens of a microscope or telescope. Economic information, as with scientific data, takes on meaning when it is viewed through the most useful lens. Two of the lenses through which economists observe economic behavior are microeconomics and macroeconomics. Microeconomics is the study of the behavior of individual players in an economy, such as individuals, families, and businesses. Macroeconomics is the study of the behavior of the economy as a whole and involves topics such as inflation, unemployment, aggregate demand, and aggregate supply. QUICK REFERENCE Microeconomics is the study of individuals, families, and businesses in an economy. Macroeconomics is the study of the economy as
a whole and is concerned with large-scale economic activity. Microeconomics As the prefix micro-, meaning small, would suggest, microeconomics examines specific, individual elements in an economy. The elements include prices, costs, profits, competition, and the behavior of consumers and producers. Microeconomics can help you understand how the sandwich shop owner arrived at the price of the lunch you bought today, why the neighborhood has several sandwich shops offering the same kinds of food, and why some of these shops flourish while others fail. Microeconomics also can offer explanations for why students decide to work only on the weekends and not on school nights, why some families buy a used car rather than a new car, and why the mom-and-pop grocery store in your neighborhood closed after the superstore opened nearby. Within the field of microeconomics there are areas of specialized concentration. Business organization, labor markets, agricultural economics, and the economics of environmental issues are among the topics that microeconomists might study. You will study the issues of microeconomics in more depth starting in Chapter 4. Macroeconomics Macroeconomics, as its prefix macro-, meaning large, would suggest, examines the economic “big picture.” In other words, macroeconomics is the study of the economy as a whole. While the limited spending power of an unemployed person would be in the realm of microeconomics, the effect of widespread unemployment on the whole nation would be a macroeconomic issue. In a similar way, the rising price of coffee would interest a microeconomist, but a general rise in prices, a sign that the whole economy is experiencing inflation, would be a matter for a macroeconomist. Microeconomics vs. Macroeconomics Changes in coffee prices might interest a microeconomist. A macroeconomist might study general changes in prices. The Economic Way of Thinking 27.11 The Two Branches of Economics Economists Study Macroeconomics The study of the whole economy Microeconomics The study of the individual consumer Units of Study Units of Study • Economic growth • Economic stability • International trade • Consumer markets • Business markets • Labor markets Topics of Interest Topics of Interest • Money, banking, finance • Government taxing and spending policies • Employment and unemployment • Inflation • Markets, prices, costs, profits, competition, government regulation • Consumer behavior • Business behavior ANALYZE CHARTS The division between microeconomics and macroeconomics is not a fixed one. Some topics fall under both areas of study. For example, a
microeconomist might be interested in employment levels in the hotel industry, while a macroeconomist looks at employment levels in the economy as a whole. Identify another topic area that might be of interest to both microeconomists and macroeconomists. While microeconomics considers the individual consumer, macroeconomics studies the consumer sector, also called the household sector. A sector is a combination of all the individual units into one larger whole. Macroeconomics also examines the business sector, and the public, or government, sector—that part of the economy that provides public goods and services. Macroeconomists bring a national or global perspective to their work. They study the monetary system, the ups and downs of business cycles, and the impact of national tax policies on the economy. In addition, they look at such global issues as international trade and its effect on rich and poor nations. You will study macroeconomics in depth beginning in Chapter 10. APPLICATION Categorizing Economic Information B. Which does each of the news headlines relate to—microeconomics or macroeconomics? 1. National Unemployment Figures Rise 4. Cab Drivers on Strike! 2. World Trade Organization Meets 5. Gasoline Prices Jump 25 Cents 3. Shipbuilder Wins Navy Contract 28 Chapter 1 Positive Economics and Normative Economics KEY C ONCEPT S Economics also can be viewed through another pair of lenses. One of those lenses is positive economics, a way of describing and explaining economics as it is, not as it should be. Positive economics involves verifiable facts, not value judgments. The other is normative economics, a way of describing and explaining what economic behavior ought to be, not what it actually is. Normative economics does involve value judgments because it seeks to make recommendations for actions. Positive Economics QUICK REFERENCE Positive economics studies economic behavior as it is. Normative economics involves judgments of what economic behavior ought to be. Positive economics uses the scientific method to observe data, hypothesize, test, refine, and continue testing. Statements made within positive economics can be tested against real-world data and either proved (or at least strongly supported) or disproved (or at least strongly questioned). Suppose, for example, your state is debating the pros and cons of a lottery to raise money for education. In the framework of positive economics, researchers would study data from states with lotteries to see if educational spending increased after the lotteries were begun. Normative Economics Why is this statement about the North American Free Trade Agreement (NAFTA) an
example of normative economics? Normative Economics Normative economics, in contrast, is based on value judgments. It goes beyond the facts to ask if actions are good. Since the values of people differ, so do the recommendations based on normative economics. Consider the issue of using lottery money to fund education. Two economists might agree that the data show that state-run lotteries result in more money for schools, and that many lottery tickets are purchased by people who are poor. Their recommendations, however, might differ because they have different values. One economist might support a lottery because it increases funding for schools. The other might oppose a lottery because it places a burden on the poor. AP P LI CATION Applying Economic Concepts C. Are the following statements examples of positive economics or normative economics? 1. Because of scarcity, everyone must make choices. 2. Americans buy too many cars and do not use mass transit enough. 29 ECO N O M I C S PAC ES E T T E R Adam Smith: Founder of Modern Economics Some 250 years ago, economics as an academic discipline did not even exist. Any discussion of economic issues usually took place in the fields of politics and philosophy. In 1776, however, Adam Smith completely changed this. Seeing the Invisible No other economist has had as much influence as Adam Smith, yet he would not have even considered himself an economist. Smith was born in Kirkcaldy, Scotland, in 1723 and studied, and later taught, literature, logic, and moral philosophy. In 1764 he traveled to France and met many European Enlightenment writers and thinkers. His discussions with them encouraged him to look at the world anew. The result was his groundbreaking work, An Inquiry into the Nature and Causes of the Wealth of Nations, which he published in 1776. In The Wealth of Nations, Smith challenged the idea that mercantilism—a system by which the government of the homeland controlled trade with its colonies— was economically sound. Instead, he argued, a nation would be wealthier if it engaged in free trade. It was in this market where goods could be exchanged freely that Adam Smith saw a new economic relationship. Founder of Economics The Wealth of Nations is considered the founding work of the subject of economics—even though Smith never used the word economics in the book. He reasoned that people behave in ways that satisfy their economic self-interest. A tailor will make clothes as long as people will buy them at a price that satisfies him. If he makes more clothes than customers wish to buy, he will cut
back and make fewer until he finds the balance again. In this way, according to Smith, an “invisible hand” guides the marketplace. In such a free market, both the buyer and the seller benefit from each transaction. Smith’s idea of the “invisible hand,” as well as many other principles he explained in The Wealth of Nations, became the foundation of modern economic theory. APPLICATION Analyzing Effects D. What impact do you think individual self-interest has on the economy as a whole? Illustrate your answer with examples. FAST FACTS Adam Smith Scottish political economist and moral philosopher Born: June, 1723 Died: July 17, 1790 Accomplishment: Laying the foundation for modern economics Other Major Work: The Theory of Moral Sentiments (1759) Famous Quotation: “It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest.” Influenced: Alexander Hamilton Thomas Malthus Karl Marx Defenders of capitalism Critics of capitalism Learn more about Adam Smith at ClassZone.com 30 Chapter 1 S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs: a. statistics economic model b. macroeconomics microeconomics c. positive economics normative economics 2. Why do economists often choose to present statistics in charts, tables, or graphs? 3. Create a simple model to explain how you decide how much time to study and how much time to unwind each evening. You may use words, charts or graphs, or equations. 4. Think of an example of a macroeconomic issue that affects an individual person, family, or business and explain its effect. 5. Explain the value of statistics and other data to positive economics Ford Motor Company assembly line, 1913 and to normative economics. 6. Using Your Notes In what ways was Adam Smith a microeconomist? In what ways a macroeconomist? Refer to your completed comparison and contrast chart. Concepts Similarities Differences Charts & Tables vs. Graphs Micro vs. Macro Positive vs. Normative Use the Graphic Organizer at Interactive Review @ ClassZone.com. Making Inferences How do you think politicians might use normative economics statements? 8. Applying Economic Concepts In which category does each item below belong—microeconomics or macroeconomics? Why? a. Studying statistics to
see how well the economy is doing at creating jobs or increasing exports; b. Studying statistics on gasoline sales and hotel bookings to explore the impact of higher gas prices on vacation plans. 9. Distinguishing Fact from Opinion Consider the example of the state lottery to raise money for education. How might it be possible for two economists to see the same information and arrive at different opinions about what to do? 10. Challenge When you go out shopping, do you often worry that there will be a shortage of something you really want? If so, explain why you think there might be a shortage. If not, explain why there seems to be enough of everything you would want to buy. Using Graphs Graphs are among the most important tools used by economists. Create Graphs Use the following information about Model T Fords (shown above) to create two line or bar graphs. Average price per car 1909 — $904 1911 — $811 1913 — $638 1915 — $626 Number of cars sold 1909 — 12,176 1911 — 40,400 1913 — 179,199 1915 — 355,249 Source: Model T Ford Club of America Challenge As Henry Ford lowered the price of the Model Ts, he potentially reduced his profit—the amount of money he made—on the sale of each car. Why was that a good economic choice? Use to complete this activity. @ ClassZone.com The Economic Way of Thinking 31 Case Study Find an update on this Case Study at ClassZone.com The Real Cost of Expanding O’Hare Airport Background Chicago’s O’Hare airport is one of the busiest airports in the United States. It is a major hub for both domestic and international airlines, and its smooth running is essential if the many airlines that fly in and out of O’Hare are to remain on schedule. However, delays at O’Hare are commonplace, and this sometimes disrupts air travel throughout the United States and abroad. Two main factors are responsible for delays at O’Hare: turbulent Midwestern weather and the layout of O’Hare’s runways. Because all but one of the runways are interconnected, bad weather results in the shutting down of most of the runway system. A modernization plan to improve efficiency at O’Hare was adopted in 2005. This plan generated considerable, and often heated, discussion and debate. What’s the issue? What are the real costs involved in airport expansion? Study these sources to
determine the costs tied to the expansion of O’Hare airport. Chicago O’Hare Airport Expansion The modernization plan is estimated to cost $6.6 billion (in 2001 dollars), which will probably be more like $8 billion by completion.... Supporters of the expansion plan say delays could be cut by 79% and that 195,000 jobs and $18 billion would be put into the local economy. In 2004 the airport played host to 69.5 million arriving, departing and connecting passengers and had total aircraft operations at nearly 929,000, an average of one landing or takeoff every 56 seconds.... The airport has 178 gates on eight connected concourses and one freestanding terminal. The realignment [of the runways] and modernization program could make a great deal of difference to the efficiency of the airport. Overall, delays are expected to drop by 79%. The future airfield will be able to accommodate approximately 1.6 million aircraft operations and 76 million [passengers] per year. Source: Airport-technology.com/projects/chicago Thinking Economically What factors led to the development of the plan to expand O’Hare? What are the projected costs and benefits? A. Online Report This report describes the anticipated benefits of the O’Hare Modernization Plan to redesign the runway system and expand the airport. 32 Chapter 1 B. Political Cartoon Cartoonist Grizelda drew this cartoon about people protesting noise pollution at an airport. Thinking Economically Which opportunity cost does this cartoon address? Explain your answer. Source: www.CartoonStock.com C. Organization Website The Alliance of Residents Concerning O’Hare (AReCo) addresses problems related to the aviation industry. AReCo’s website presents the group’s findings and views regarding the expansion of O’Hare. Area Residents Challenge Wisdom of O’Hare Expansion AReCo cites health hazards, seeks alternatives to enlarging O’Hare. The [aviation] industry and airport expansionists consistently try to minimize the impacts of airports and aircraft. One example of the harm that has been... understated by the federal government... [is the] underreporting [of] the amounts of deadly pollution coming from airports/aircraft. For example, combined aircraft-related amounts of benzene [a known cause of cancer in humans] totaled 20 tons at Logan, Bradley, and Manchester airports in 1999!... Mega airports,
such as Chicago’s O’Hare, operate more aircraft annually than all of the three above-mentioned airports combined, thus emitting even more harmful and even deadly pollution in heavily urban-populated areas.... In the meantime, there are intelligent steps that Chicago (and others) can take that will really modernize the metropolitan air transportation system and retain Chicago’s title of “our nation’s transportation hub.” Such steps include placing a much stronger emphasis on [more than one type of] transportation, such as medium and high-speed rail, that would link O’Hare airport to other airports (becoming a “virtual hub”) and building a new airport in a less populated peripheral area. Source: Areco.org Thinking Economically What alternatives does AReCo cite to O’Hare’s expansion? THINKING ECONOMICALLY Synthesizing 1. Explain the real cost of expanding O’Hare airport. Use information presented in the documents to support your answer. 2. Who are the most likely winners and losers as a result of the O’Hare expansion? Explain your answer. 3. How might supporters of expansion use a production possibilities model to strengthen their case? The Economic Way of Thinking 33 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com CHAPTER 1 Assessment Scarcity: The Basic Economic Problem (pp. 4–11) 1. In what ways does scarcity affect both consumers and producers? 2. What are the four factors of production and how do they relate to scarcity? Economic Choice Today: Opportunity Cost (pp. 12–17) Choose the key concept that best completes the sentence. Not all key concepts will be used. 3. What does the phrase “there’s no such thing as a free lunch” mean in economic terms? consumer economic model economics efficiency factors of production incentive macroeconomics microeconomics opportunity cost producer production possibilities curve scarcity statistics trade-off underutilization utility wants 1 is the fundamental economic problem. It arises because human 2 are limitless, while resources are limited. It affects what a 3 buys and what a 4 makes. It affects what is produced, how it is produced, and who gets what is produced. It affects how the four 5 are put to
use. Since people cannot have everything they want, they have to make choices. Every choice, however, involves a 6, something you have to give up to get what you want. When making an economic decision, you need to consider the 7, the value of the thing you gave up. Economists often use an 8, a simplified representation of reality, to clarify concepts. Economists use such tools in 9, the study of the economic behavior of individual persons, families, and businesses, and in 10, the study of the economy as a whole. One useful model, the 11, shows the maximum amount of goods that an economy can produce. It also shows 12, when not all resources are put to full use. 4. Why is it important to consider marginal benefits and costs when you do a cost-benefit analysis? Analyzing Production Possibilities (pp. 18–23) 5. What are three things a PPC shows? 6. What factors could lead to economic growth? The Economist’s Toolbox (pp. 24–33) 7. What are some tools that economists use to draw meaning from large amounts of data? 8. What are the differences between microeconomics and macroeconomics? A P P LY Look at the bar graph below showing the relationship between educational level and weekly wages. 9. Describe the relationship between education and earnings for males in 1979. 10. Explain why the earnings gap between college and high school graduates might have changed between 1979 and 2004. FIGURE 1.12 EDUCATION AND EARNINGS,200 1,000 800 600 400 200 0 1979 2004 Year Male high school graduates, no college Male college graduates 34 Chapter 1 Source: U.S Bureau of Labor Statistics 11. Creating Graphs Use the following information to create a bar graph showing the weekly wages for females with a high school education and those with a college education in 1979 and 2004. 1979 High school graduates, no college, $424 College graduates, $605 2004 High school graduates, no college, $488 College graduates, $860 Source: U.S. Bureau of Labor Statistics Use to complete this activity. @ ClassZone.com 12. Interpreting Graphs Compare the graph you created with the one on page 34. Identify three differences between the changes over time for women and for men. 13. Evaluating Economic Decisions You plan to open a restaurant that specializes in meals cooked with organic products. You realize that location is very important for this kind of business. You have two options
: you can rent an expensive site downtown or you can buy an inexpensive building in a quiet neighborhood. What are the benefits and the opportunity cost for each option? 14. Conducting Cost-Benefit Analysis You are considering taking a part-time job after school at a local veterinary surgery. Create a decision-making grid to analyze your potential choices. Include alternative jobs you might take and the costs and benefits of each. Similarly, list activities other than working that you might pursue after school. Indicate which alternative you would choose and explain your choice. 15. Challenge You own a small factory that makes widgets and you want to increase production, so you hire new workers. Each new worker increases productivity, but each also must be paid. When will you stop hiring new workers Start a Business Step 1 Team up with a partner or small group of classmates. Step 2 With your partner or group, decide on a business you want to start. This could be anything that has a realistic chance of succeeding: computer technician, T-shirt printer, caramel-corn producer, dog walker, or anything you think may fulfill a want. Step 3 On a chart like the one below, list the factors of production you will need to use to start and run your business. Step 4 Develop a business plan—a way that you can use the factors of production so efficiently that you will be able to make money. Describe your business plan in a paragraph. Step 5 Present your plan to the rest of the class. When all pairs or groups have made their presentations, hold a class vote to select the best plan. Factors of Production Land Labor 1. 2. 3. 1. 2. 3. Capital 1. 2. 3. 1. 2. 3. Entrepreneurship The Economic Way of Thinking 35 Traditional Economy Some economic activities have changed little over time. This farmer in Guizhou Province, China, employs rice-farming methods that the Chinese have used for centuries. 36 CHAPTER 2 SECTION 1 Introduction to Economic Systems SECTION 2 Command Economies SECTION 3 Market Economies SECTION 4 Modern Economies in a Global Age CASE STUDY Contrasting Economies: North Korea and South Korea Economic Systems Scarcity is the situation that exists when there are not enough resources to meet human wants An economic system is the way in which a society uses its scarce resources to satisfy its people’s unlimited wants AT T E R S How does a society decide the ways to use scarce resources to meet unlimited wants? Its economic system determines what to produce, how to produce
, and for whom to produce. Although every country today uses a mixture of economic systems, some mixed systems provide more economic and political freedom and create more wealth than others. More at ClassZone.com FIGURE 2.7 PER C A P I TA GD P Go to ECONOMICS UPDATE for chapter updates and current news on the economies of North Korea and South Korea. (See Case Study, pp. 64–65.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 SOUTH KOREA NORTH KOREA 1994 1996 1998 2000 2002 2004 Year Source: United Nations Statistics Division Go to INTERACTIVE REVIEW for concept review and activities. How do the economies of North Korea and South Korea compare? See the Case Study on pages 64–65. Economic Systems 37 S E C T I O N 1 Introduction to Economic Systems TA K I N G N O T E S In Section 1, you will economic system, p. 38 • identify the three main types traditional economy, p. 38 command economy, p. 39 market economy, p. 39 of economic systems • understand how a traditional economy operates, including its advantages and disadvantages • analyze how modern forces are changing traditional economies As you read Section 1, complete a cluster diagram that provides information on the different kinds of economic systems. Use the Graphic Organizer at Interactive Review @ ClassZone.com traditional economy Economic System Types of Economic Systems QUICK REFERENCE An economic system is the way a society uses resources to satisfy its people’s wants. A traditional economy is an economic system in which people produce and distribute goods according to customs handed down from generation to generation. 38 Chapter 2 KEY CONCEPT S In his book Utopia, 16th-century writer Thomas More describes a society without scarcity, where wants are limited and easily fulfilled. It is no accident, however, that the word utopia means “no place” in Greek. In the real world, scarcity is a fact of life. To address scarcity, societies must answer three questions: • What should be produced? • How should it be produced? • For whom will it be produced? The answers to these questions shape the economic system a society has. An economic system is the way a society uses its scarce resources to satisfy its people’s unlimited wants. There are three basic types of economic systems: traditional economies
, command economies, and market economies. In this chapter you will learn about these economic systems, as well as “mixed” economies that have features of more than one type. TYPE 1 Traditional Economy A traditional economy is an economic system in which families, clans, or tribes make economic decisions based on customs and beliefs that have been handed down from generation to generation. The one goal of these societies is survival. Everyone has a set role in this task. Men often are hunters and herders. Women tend the crops and raise children. The youngest help with everyday chores while learning the skills they will need for their adult roles. There is no chance of deviating from this pattern. The good of the group always takes precedence over individual desires. Traditional The Kavango people of Namibia use fishing techniques passed down from generation to generation. Command Food was scarce and expensive in this store in the former Soviet Union, a command economy. Market Advertisements, like these billboards in New York City, are a common sight in a market economy. T YPE 2 Command Economy In the second type of economic system, a command economy, the government decides what goods and services will be produced, how they will be produced, and how they will be distributed. In a command economy, government officials consider the resources and needs of the country and allocate those resources according to their judgment. The wants of individual consumers are rarely considered. The government also usually owns the means of production—all the resources and factories. North Korea and Cuba are current examples of command economies. Before the collapse of communism in Europe, countries such as the Soviet Union, Poland, and East Germany also were command economies. T YPE 3 Market Economy The third type of economic system, a market economy, is based on individual choice, not government directives. In other words, in this system consumers and producers drive the economy. Consumers are free to spend their money as they wish, to enter into business, or to sell their labor to whomever they want. Producers decide what goods or services they will offer. They make choices about how to use their limited resources to earn the most money possible. In a market economy, then, individuals act in their own self-interest when they make economic choices. However, as they seek to serve their own interests, they benefit others. As a consumer, you choose to buy the products that best meet your wants. However, this benefits the producers who make those products, because they earn money from your purchases. As Adam Smith noted in The Wealth of
Nations (1776), when you make economic decisions you act in your self-interest, but you are “led by an invisible hand” to promote the interests of others. AP P LI CATION Applying Economic Concepts A. How might economic activities within a family with adults, teenagers, and young children represent aspects of traditional, command, and market economies? QUICK REFERENCE A command economy is an economic system in which the government makes all economic decisions. A market economy is an economic system in which individual choice and voluntary exchange direct economic decisions. Find an update on issues in a market economy at ClassZone.com Economic Systems 39 Characteristics of Traditional Economies KEY CONCEPT S In the earliest times, all societies had traditional economies. Such systems serve the main purpose of traditional societies—survival—very well. The traditional economic system, however, tends to be inefficient and does not adapt to change. TRAIT 1 Advantages and Disadvantages The one great advantage of a traditional economy is that it so clearly answers the three economic questions. A traditional society produces what best ensures its survival. The methods of production are the same as they have always been. Systems of distribution are also determined by custom and tradition. In a traditional economy, then, there is little disagreement over economic goals and roles. Traditional economies have several major disadvantages, too. Because they are based on ritual and custom, traditional economies resist change. Therefore, they are less productive than they might be if they adopted new approaches. Further, while traditionally defined roles eliminate conflict, they also prevent people from doing the jobs they want to do or are best suited to do. People who are in the “wrong” jobs are less productive. The lower productivity in traditional economies means that people do not acquire the material wealth that people in other societies do. As a result, people in traditional economies have a much lower standard of living. Forces of Change The use of the cell phone has brought changes to many traditional African societies. TRAIT 2 Under Pressure to Change Around the world, traditional economies are under pressure from the forces of change. The Kavango people of Namibia in southern Africa, for example, have lived as subsistence farmers for centuries. (Subsistence farmers grow just enough to feed their own families.) Modern telecommunications, however, have bombarded the Kavango with images of the world beyond their homeland. As a result, many young Kavango want something more than the life of subsistence farming. Thousands have left their homeland for the cities.
Even the old ways of farming are beginning to change. The vast majority of the Kavango people still make a living from subsistence farming. However, a few have turned to commercial farming, where they grow crops not for their own use, but for sale. APPLICATION Making Inferences B. There are no pure traditional economies today. Why do you think this is so? 40 Chapter 2 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Demonstrate your understanding of the following terms by using each one in a sentence. a. traditional economy b. command economy c. market economy 2. Which is more important in a traditional economy, accumulating individual wealth or honoring tradition? Explain your answer. 3. How are economic decisions made in a command economy? 4. What drives the choices of consumers and producers in a market economy? 5. Does Adam Smith’s “invisible hand” also function in traditional and command economies? Explain your answer. 6. Using Your Notes What do the three kinds of economic systems have in common? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com traditional economy economic system. Drawing Conclusions How might strongly defined economic roles and goals be both a strength and a weakness of traditional economies? 8. Analyzing Cause and Effect What effect might mass media have on the erosion of traditional economies in today’s world? 9. Generalizing from Economic Information You have the following information about an economy: 1) People have little choice in the kinds of jobs they do. 2) Producers are not free to use resources as they wish. 3) People have little, if any, say in how the basic economic questions are answered. What kind of economy might this be? Explain your answer. 10. Challenge Most modern economies are a mixture of the three economic systems described in Section 1. Identify elements of traditional, command, and market economic systems in the American economy. (You will learn more about mixed economies in Section 4.) Market economy in action in Mexico Identifying Economic Systems The three economic systems may be identified by the way they answer the basic economic questions: What to produce? How to produce? For whom to produce? Complete a Table Copy the table below. Complete it by noting how each of the three economic systems answers the basic economic questions. Economic System Answers to the Basic Economic Questions Traditional economy Command economy Market economy Challenge Identify modern countries that have economies that closely resemble each of the three economic systems
. Explain each of your choices. Economic Systems 41 S E C T I O N 2 Command Economies TA K I N G N O T E S In Section 2, you will centrally planned economy, p. 42 • describe the main features of a socialism, p. 43 communism, p. 43 authoritarian, p. 43 command economy • note how socialism and communism differ • identify modern examples of command economies • explain the advantages and disadvantages of a command economy As you read Section 2, complete a hierarchy chart to categorize information about command economic systems. Use the Graphic Organizer at Interactive Review @ ClassZone.com Command Economies government controls command economies today Government Controls KEY CONCEPT S QUICK REFERENCE A centrally planned economy is a system in which central government officials make all economic decisions. In command economies, leaders decide what should be produced and how it should be produced. They also decide for whom it should be produced, in part by setting wages. By determining who earns the highest wages and who the lowest, these leaders decide who has the money to buy available products. A system in which the society’s leaders, usually members of the central government, make all economic decisions is called a centrally planned economy. EXAMPLE Government Planning Think for a moment about how the federal government affects you. If you work, you have to pay taxes. If you’re 18 years old and male, you have to register with the Selective Service System. State and local governments exert somewhat more control over your day-to-day life. State laws set both speed limits and the age at which people can drive. Local laws set standards for cleanliness in food stores and restaurants and for honest business practices. And state and local taxes are collected to support such services as police and fire departments and public education. However, what if the government went further? Suppose that bureaucrats in a government office in Washington, D.C., had the power to decide which businesses could operate in your city. Further, these bureaucrats decided not only what these businesses should produce, but also how much each business should produce each month. Finally, they also decided who could have jobs and set work hours and pay scales for workers. Government controls of this type are a feature of a command, or centrally planned, economy. 42 Chapter 2 E XAMPLE Socialism and Communism Modern societies that have adopted command economies have done so largely because of the influence of Karl Marx, a 19th-century German philosopher, historian, and economist. According to Marx’s analysis
, all of history is a struggle between classes. In his own time, the struggle was between the owners of the great industrial factories and the workers who exchanged their labor for wages. While the industrialists grew rich, the workers remained relatively poor. Marx predicted that in time the workers would overthrow this system and transfer ownership of the factories to public hands. With the means of production owned by the government, the class struggle would be resolved and all citizens would share in the wealth. F I G U R E 2.1 Comparing Economic Systems Communism Socialism Market System Who owns resources? Government Government owns basic resources; the rest are privately owned All resources privately owned How are resources allocated? Government planners decide how resources are used What role does government play? Government makes all economic decisions Government planners allocate basic resources; market forces allocate privately-owned resources Market forces allocate resources Government makes decisions in the basic industries Government’s role limited—mostly to ensure market forces are free to work ANALYZE TABLES Government involvement varies among economic systems. How do communist systems answer the three basic economic questions? Socialism, an economic system in which the government owns some or all of the factors of production, developed from the ideas of Marx. Communism, a more extreme form of socialism in which there is no private ownership of property and little or no political freedom, also grew out of Marx’s thinking. Essentially, it is authoritarian socialism. An authoritarian system requires absolute obedience to authority. Figure 2.1 lists the major characteristics of socialism and communism. Democratic socialism is established through the democratic political process rather than through the violent overthrow of the government. In this form of socialism, the government owns the basic industries, but other industries are privately owned. Central planners make decisions for government-owned industries. Central planners might also control other sectors—health care, for example—to ensure that everyone has access to these important services. AP P LI CATION Comparing and Contrasting A. How are socialism and communism similar yet different? QUICK REFERENCE Socialism is an economic system in which the government owns some or all of the factors of production. Communism is an economic system in which the government owns all the factors of production and there is little or no political freedom. Authoritarian systems require absolute obedience to those in power. Economic Systems 43 ECO N O M I C S PAC ES E T T E R Karl Marx: Economic Revolutionary Millions of lives were affected by the work of Karl Marx. Governments were toppled and new political alliances were forged on the strength of his arguments
. What was it in the thousands of difficult-to-read pages he wrote that fueled revolutions? FAST FACTS A New View of Economics Marx was born in what is now Germany in 1818 and grew up in middle-class comfort. In college, however, he became involved in radical politics. In time, his political activism led to his exile from his homeland. He moved from country to country, eventually settling in London. During his travels, he met Friedrich Engels, the son of a factory owner. Through Engels, Marx became aware of the struggles of the working class and he undertook a deep study of economics. He concluded that the Industrial Revolution had created a system of wage slavery. Factory owners, Marx said, looked upon labor as just another commodity that could be bought. They then used this labor to convert other productive resources into products. The factory owners made a profit by selling products at a higher price than the cost of labor and other resources. By keeping wages low, they could make ever greater profits. The whole industrial system, Marx reasoned, was based on this exploitation of workers. Communism Marx’s writings influenced revolutionary leaders such as V. I. Lenin in Russia and Mao Zedong in China. To Marx, rising tension between worker and owner was an inevitable development in economic history. Over time, more and more wealth would be concentrated in fewer and fewer hands, and dissatisfied workers would revolt and create a new society without economic classes. Marx, assisted by Engels, laid out these ideas in The Communist Manifesto (1848). Marx discussed his economic ideas more fully in his enormous study Das Kapital, which was published in three volumes between 1867 and 1894. Because of the way that communist economies worked in practice and the eventual collapse of communism in the early 1990s, Marx’s theories have fallen into disfavor. Even so, few people had more impact on 20th-century economic and political thinking than Karl Marx. APPLICATION Drawing Conclusions B. What did Marx think was the logical outcome of the struggle between owners and workers? Karl Marx German philosopher, historian, and economist Born: May 5, 1818 Died: March 14, 1883 Major Accomplishment: Detailed analysis of capitalism and foundation for socialist economic theory Famous Quotation: Workers of the world unite; you have nothing to lose but your chains. Influenced: Russian Revolution, 1917 Chinese Revolution, 1949 Learn more about Karl Marx at ClassZone.com 44 Chapter 2 Command Economies Today KEY C ONCEPT S There
are no examples of pure command economies today. The forces that have brought changes to traditional economies are also transforming command economies. However, some countries—North Korea, for example—still have economies with mostly command elements. North Korea Once under the control of China and later Japan, Korea was split into North Korea and South Korea following World War II. North Korea came under communist control. The government controlled every economic decision. For example, it diverted many of the country’s resources to the military, building up an army of more than 1 million soldiers—out of a population of about 22 million. It also developed a nuclear weapons program. However, this military buildup came at the expense of necessities. During the late 1990s and early 2000s, food was so scarce that millions of North Koreans died from hunger and malnutrition. Many North Koreans survived only because of food aid from other countries, most notably South Korea. The failure to provide food and other important products was just one result of a flawed economic plan. For much of the 1990s, North Korea produced less and less each year, and its economy actually shrank. (See Figure 2.2 below.) In 2003, however, central planners relaxed some restrictions on private ownership and market activity. North Koreans hoped that this experiment with free markets would revive the country’s ailing economy. (For more information on North Korea’s economy, see the Case Study on pages 64–65.) FIGURE 2.2 NORTH KOREA: ECONOMIC GROWTH 8 6 4 2 0 -2 -4 -6 - North Korea had a negative growth rate for much of the 1990s. (The red line on the graph marks 0 percent, or no growth.) The average yearly growth rate for all economies during this time period was about 3 percent. 1990 1995 2000 2005 Source: United Nations Year ANALYZE GRAPHS 1. The North Korean economy began to show positive growth after 1999. To what might this development be attributed? 2. During the 1990s, some newspaper reports noted that the North Korean economy was “shrinking.” How is this shown in the graph? Economic Systems 45 Meeting Demand (Left) In communist East Germany, government planners’ decisions left this butcher with just one goose to sell. (Right) In West Germany, a market economy, store shelves were laden with consumer goods. Impact of Command Economies In theory, command economies have some advantages. For example, they seek to provide for everyone, even
the sick and the old who are no longer productive economically. Also, leaders in a command economy can use the nation’s resources to produce items that may not make money in a market economy—certain medicines, for example. In practice, however, the disadvantages of command economies are abundantly clear. To begin with, central planners often have little understanding of local conditions. Because of this, their economic decisions are frequently misguided or wrong. Also, workers often have little motive to improve their productivity, since they know they will be paid the same wages regardless of their output. And because there is no private property, there is no motivation for workers to use resources wisely. Centrally planned economies often set prices well below those that would be established in a market system. As a result, command economies face shortages. One scene repeated in many command economies is people standing in long lines waiting to buy goods. Such shortages often lead to creative behavior. In the former Soviet Union, for example, light bulbs were almost impossible to buy for home use. However, burned-out bulbs in factories were regularly replaced. Some people took and sold these burned-out bulbs. Why? Other people would buy them and use them to switch out with working bulbs in their factories. They then took the working bulbs to light their homes. Perhaps the greatest failing of strict command systems is the great suffering that people living under them endured. Carrying out centrally planned economic policies requires that individual rights—even the right to life—be subordinate to the needs of the state. Millions of people died in the efforts to build huge collective farms in China and the Soviet Union. Millions more were imprisoned for exercising their political or economic rights. Estimates suggest that the deeply flawed policies of command economies are responsible for more deaths than two world wars. APPLICATION Applying Economic Concepts C. Why are consumer goods often in short supply in a command economy? 46 Chapter 2 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Write a brief paragraph explaining the links between the following three terms. a. centrally planned b. socialism c. communism economy 2. Why do communist countries use authoritarian methods to maintain their economic and political system? 3. List and describe some advantages of centrally planned economies. 4. What are some disadvantages of centrally planned economies? 5. What is the relationship between the individual and the state in a communist nation? 6. Using Your Notes Write a sentence that makes a generalization about the nature of command economies. Refer to your completed hierarchy chart to
complete this question. command economies government controls command economies today Use the Graphic Organizer at Interactive Review @ ClassZone.com. Making Inferences Look again at the sentences about Thomas More’s Utopia on page 38. Do you think that Karl Marx, like Thomas More, was trying to imagine a utopia in his writings? Give reasons for your answer. 8. Explaining an Economic Concept How do command societies address the problem of scarcity? Illustrate your answer with examples. 9. Analyzing Cause and Effect Read again the information about the North Korean economy on page 45. What factors caused North Korea’s serious economic problems? What steps has the North Korean government taken to improve the dire economic situation? 10. Challenge Adam Smith used the “invisible hand” as a metaphor for the forces that balance a free market. What might be a good metaphor for the forces at work in a command economy? Explain your answer. Celebration of communism in the Soviet Union Using Graphs Presenting information in a graph shows economic changes more clearly. Create a Graph Use the following data to create a line graph. Household Expenditures in the Soviet Union ($) 1979 1981 1983 1985 1987 1989 825.2 million 934.7 million 966.7 million 1,017.1 million 1,064.7 million 1,152.3 million Source: United Nations Challenge During the 1980s, Soviet leaders introduced market elements into the economy. How might this explain the increase in household expenditures? Use to complete this activity. @ ClassZone.com Economic Systems 47 S E C T I O N 3 Market Economies TA K I N G N O T E S In Section 3, you will • describe what a market is and how it works • identify the main features of a market economy • analyze how the circular flow model represents economic activity in a market economy • explain the advantages and disadvantages of a market economy private property rights, p. 48 market, p. 48 laissez faire, p. 49 capitalism, p. 49 voluntary exchange, p. 49 profit, p. 49 competition, p. 49 consumer sovereignty, p. 50 specialization, p. 50 circular flow model, p. 52 product market, p. 52 factor market, p. 52 As you read Section 3, complete a chart to identify and describe the features of a market economy. Use the Graphic Organizer at Interactive Review @ ClassZone.com Market Economy private property rights Fundamentals of a Market Economy KEY CONCEPT S QUICK REFERENCE
Private property rights are the rights of individuals and groups to own businesses and resources. A market is any place where people buy and sell goods and services. Market economies have several distinct characteristics. Earlier in this chapter you read about the fundamental feature of a market economy—the fact that people’s economic behavior is motivated by self-interest. Self-interested behavior is behind two other features of a market economy. One is private property rights, the rights of individuals and groups to own property. In economic terms, property means everything that an individual owns. This includes factories, offices, clothes, furniture, house, car, and other belongings; money; and even intellectual property, such as songs or ideas developed for inventions. It also includes the labor individuals provide to earn money to buy what they own. The other feature that stems from self-interest is the market, any place or situation in which people buy and sell resources and goods and services. It may be the farmers’ market on Saturdays in the town square, or it may be an enormous cybermarket on the Internet, such as eBay. Large or small, real or virtual, the market is where people can exchange their private property for someone else’s. Private Property Rights In a market economy, people are free to own and use private property— houses, for example. 48 Chapter 2 FEATUR E 1 Private Property and Markets For markets to operate efficiently, private property rights need to be well defined and actively enforced by law. If you have ever bought a car, you know that an essential part of the transaction is getting possession of the title. You need proof that the person you are buying it from actually owns it and has the right to sell it. Since clear ownership is vital to any sale or exchange, private property rights are necessary to make markets work properly. If buyers could not trust that the sellers actually had the right to offer their products on the market, trade would break down. Further, suppose you are a musician but know that your songs can be downloaded for free, depriving you of your right to exchange what you own for money. In such a situation, it is doubtful that you would be motivated to record music. In protecting private property rights so that producers have motivation and consumers have trust, the government performs an important role in a market economy. FEATUR E 2 Limited Government Involvement Sometimes the government’s economic role is to stay out of the marketplace. The principle that the government should not interfere in the economy is called laissez
faire, a French phrase meaning “leave things alone.” The concept of laissez faire is often paired with capitalism, an economic system that is based on private ownership of the factors of production. Capitalism, the foundation of market economies, operates on the belief that, on their own, producers will create the goods and services that consumers demand. Therefore, according to laissez faire capitalism, there is no need for government involvement in the marketplace. Laissez faire capitalism is a market economy in its pure form. However, there are no pure market economies—all real-world market economies have some degree of government involvement. FEATUR E 3 Voluntary Exchange in Markets When a buyer and seller agree to do business together, they engage in a voluntary exchange, a trade in which the parties involved anticipate that the benefits will outweigh the cost. Both sides in a voluntary exchange believe that what they are getting is worth more than what they are giving up. In a market economy, most trade is based on an exchange of a product for money rather than for another product. Self-interest guides voluntary exchanges. Suppose you buy a new guitar. Even though you spend a good part of your savings, your self-interest is served because you’ve wanted this particular model of guitar. The seller’s self-interest is likely served by profit, a financial gain from a business transaction. If you pay more for the guitar than the seller did, the seller earns money. In voluntary exchange, then, both sides must believe that they are gaining by trading. FEATUR E 4 Competition and Consumer Sovereignty Market economies are also characterized by competition, the effort of two or more people, acting independently, to get the business of others by offering the best deal. You are able to choose today between a Macintosh and a Windows PC operating system because of the competition in the computer market. In the case of these competing systems, each has somewhat different features but mainly performs the same QUICK REFERENCE Laissez faire is the principle that the government should not interfere in the marketplace. Capitalism is an economic system that is based on private ownership of the factors of production. Voluntary exchange is a trade in which both traders believe that what they are getting is worth more than what they are giving up. Profit is a financial gain that a seller makes from a business transaction. Competition involves all the actions sellers, acting independently, do to get buyers to purchase their products. Economic Systems 49 YO U R EC CO M PETITION Where will
you buy your computer? You want to buy a new computer. You could buy a “standard package” from the electronics discount store. The price will be very reasonable, but you won’t be able to customize the software package or the service program. Alternately, you could buy from a computer specialty store. You’ll pay more, but you can choose the extras that you want and the customer support program is excellent.? Electronics discount store Computer specialty store functions as the other. You are free to decide which you prefer based on whatever combination of price and value appeals to you more. When you buy over-the-counter medications, you can also clearly see the competitive aspect of the market. Often next to a well-known brand-name product you will see a product with the same ingredients, similar packaging, but a different name and lower price. The producers of the lower priced item are competing for the business established by the brandname product. If the producers of the brand-name product want to keep your business, they must lower their prices or find a way to add some other value. That’s because you, the consumer, hold the real power in the market place. Consumer sovereignty is the idea that because consumers are free to purchase what they want and to refuse products they do not want, they have the ultimate control over what is produced. Sovereignty means supreme authority, which is what consumers exercise as key economic decision-makers. Let’s look at the over-the-counter medications again. If there were no competition, the brand-name producers could charge higher prices. It would be in their self-interest to charge as much as they possibly could. Competition, however, acts as a control on self-interested behavior, guiding the market toward a balance between higher value and lower prices. Rather than lose your business, the brand-name producers will either lower their prices or raise the value of their product. Because producers must compete for the consumer’s dollar, they have to work at pleasing you, the consumer, while pleasing themselves. FEATURE 5 Specialization and Markets A market economy encourages efficient use of resources by allowing people and businesses to specialize in what they do best. Specialization is a situation in which people concentrate their efforts in the areas in which they have an advantage. This allows people to trade what they can most efficiently produce for goods and services QUICK REFERENCE Consumer sovereignty is the idea that consumers have the ultimate control over what is produced because they are free
to buy what they want and to reject what they don’t want. Specialization is a situation in which people concentrate their efforts in the activities that they do best. 50 Chapter Fundamentals of a Market Economy Private Property Buyers and sellers are free to own and use private property. Specialization Buyers and sellers are able to concentrate their efforts in areas where they have an advantage. Consumer Sovereignty Buyers can exercise their dominance over what is produced by freely deciding whether to buy or not to buy. ANALYZE CHARTS Competition Sellers are free to attempt to get the business of others by offering the best deal. Government Involvement Buyers and sellers must be free to operate with minimal government intervention. Voluntary Exchange When a buyer and seller agree to do business together, each believes that the benefits outweigh the costs. Profit Sellers are free to attempt to maximize their profits. Identify a business in your community. Consider how the fundamentals of a market economy noted in the diagram are illustrated by the operations of that business. Record your ideas in a two-column table. produced more efficiently by others. Specialization removes the need for households to be self-sufficient, and markets allow households to trade for what they need. Suppose one adult in your house is a bank teller and another is a welder. Neither banking nor welding needs to happen within your household, but your household does need groceries. By specializing in what they do best—earning money in their jobs—in a market economy these adults are able to trade the dollars they earn for items and services others specialize in. If, however, they had to grow all the family’s food themselves, they’d be less efficient than those who specialized in farming. Also, with each hour spent on growing food they would lose an hour’s worth of wages from their jobs. Specialization, then, leads to higher-quality yet lower-priced products. AP P LI CATION Applying Economic Concepts A. Which is more important in determining the format in which recordings are offered by the music industry, new technology or consumer sovereignty? Explain. Economic Systems 51 QUICK REFERENCE The circular flow model is a tool that economists use to understand how market economies operate. The product market is the market where goods and services are bought and sold. The factor market is the market for the factors of production—land, labor, capital, and entrepreneurship. Circular Flow in Market Economies KEY CONCEPT S How do all these fundamental characteristics combine to
allow a market economy to function? Economists have developed a model to help them answer this question. Called the circular flow model, it visualizes how all interactions occur in a market economy. The model represents the two key economic decision makers in a market economy—households, which are made up of individuals like you, and businesses. It also shows the two markets where households and businesses meet—that for goods and services, and that for resources. (See Figure 2.4 on the next page.) Product Markets The market for goods and services is called the product market. This is the market you probably know best. The product market isn’t a place as much as it is a set of activities. Whenever or wherever individuals purchase goods or services—at a local mall, a dentist’s office, the phone company, or an online service selling concert tickets—they are doing so in the product market. The suppliers of the product market are businesses, which offer their goods or services for sale and use the money they earn from the sales to keep their businesses going. Factor Markets To run a business, firms must, in turn, purchase what they need from the factor market, the market for the factors of production—land, labor, capital, and entrepreneurship. Individuals own all the factors of production. They own some factors of production outright, such as their own labor and entrepreneurship. Others they own indirectly as stockholders in businesses. In the factor market, businesses are the customers and individuals are the producers. A restaurant buys your labor as a server, for example, to serve meals prepared by chefs whose labor they have also bought. The chefs make the meals from products bought from farmers who own the fields and farm equipment. Circular Flow This set of interactions between businesses and individuals is illustrated in Figure 2.4 on the next page. On the left and right of the model, you can see the two main economic decision makers, businesses and households. At the top and bottom are the two main markets, product and factor. The green arrows represent the flow of money. The blue arrows represent the flow of resources and products. 52 Chapter 2 Circular Flow Individuals, such as restaurant servers, sell their labor to businesses in the factor market The Circular Flow Model Business revenue Product Market Consumer spending Sell goods and services Buy goods and services Businesses Buy productive resources Households (Individuals) Sell land, labor, capital, entrepreneurship Payments for resources Factor Market Income from resources ANALYZE CHARTS The circular flow model is a
tool for understanding the relationships among economic decision makers and various markets. Why do you think that money always flows in one direction, while resources and products always flow in the opposite direction? Use an interactive circular ﬂ ow model at ClassZone.com Find the “Households” box at the right side of the chart. If you follow the green arrow, you see that individuals spend money in the product market to buy goods and services. From the product market, the money goes to businesses as revenue. The businesses spend this in the factor market, paying for the land, labor, capital, and entrepreneurship needed to produce goods and services. The receivers of that money are individuals who own all the factors of production. With the money they receive, individuals can make more purchases in the product market, and so the cycle continues. If you look at the blue arrows, you can follow the route of the resources and products in the circular flow model. Once again, start with individuals. They sell their land, capital, labor, and entrepreneurship in the factor market. Follow the arrows to see that these factors of production are bought by businesses. The businesses then use these productive resources to make goods and services. The goods and services are then sold in the product market and flow to individuals who purchase them. AP P LI CATION Interpreting Economic Models B. Think of a good or a service you have recently bought. Using the circular flow model as a guide, write an explanation of the impact of your purchase on the economy. Economic Systems 53 Impact of Market Economies KEY CONCEPT S Between the late 1940s and the early 1990s, between one-quarter and one-third of the world’s population lived under command economic systems. The Soviet Union and its Eastern European neighbors, China and much of Southeast Asia, Cuba, and North Korea all had centrally planned economies. However, with the collapse of communism in the early 1990s, most of these countries have adopted some form of market economy. Also, as you read in Section 2, even those that have clung to communism and central planning have introduced market-economy measures. Why were these countries so ready to embrace the market system? Advantages On November 9, 1989, the Berlin Wall, a symbol of the division between the communist and democratic worlds, was finally opened. Over the next few days, hundreds of thousands of East Germans began pouring into West Germany through gates and improvised breaches in the wall. What drew these jubilant East Germans to the west?
For most of them, the answer was freedom. Economic and Political Freedom Freedom is one of the chief advantages of a market economy. A market economy requires that individuals be free to make their own economic choices, since it depends on the consumer’s right to buy or refuse products to determine what will be produced. Individuals are also free to develop their interests and talents in work they find satisfying, rather than being assigned to jobs. Also, since the government does not use a heavy hand to control the economy, the political process can be much freer, with a diversity of viewpoints and open elections. Government bureaucracy is generally less cumbersome and costly in a market economy than in a command economy, since there are fewer areas of government involvement. A market economy also can be responsive to changes in conditions and accommodate those changes quickly. Freedom New shopping malls, like this one in Bucharest, Romania, are a common site in many formerly communist countries. Further, individuals in local communities are free to make their own economic choices without the interference of the government. These individuals’ better knowledge of the resources and potential of their area leads to better economic decisions and greater productivity. Profit The profit motive, a key feature of a market economy, insures that resources will be allocated efficiently, since inefficiencies would result in lower profits. It also serves as a reward for hard work and innovation. Knowing you can earn money Find an update about developing market economies in Eastern Europe at ClassZone.com 54 Chapter 2 Competition Competition among dairy companies ensures that there is a wide variety of milk and other dairy products. if you come up with a good idea is an incentive to do so, and the more good ideas people have, the more the economy grows. The incentive to come up with good ideas is related to another advantage of a market economy: it encourages competition, letting consumers have the final say. Competition leads to higher-quality products at lower prices. It also helps to create a diverse product market. Disadvantages Market economies, however, have disadvantages as well. In a pure market economy, the economic good of the individual is the primary focus. A pure market economy has no mechanism for providing public goods and services, such as national defense, because it would not be profitable from a strictly economic viewpoint to do so. Another disadvantage is that a pure market economy cannot provide security to those who, because of sickness or age, cannot be economically productive. Nor can it prevent the unequal distribution of wealth, even though that gap may be the result of unequal opportunities. The industrial
boom in the United States in the late 1800s and early 1900s illustrates the problems that can develop in a market economy with little government regulation. During this time, a few business leaders became very rich. At the same time, most of those who worked for these leaders were paid low—but increasing— wages. Further, most business leaders did little at the time to address the negative consequences of industrialization such as pollution. Issues like these led most industrialized societies to adopt some level of government involvement in the economy. The result was economic systems that mix elements of market and command economies. In Section 4, you’ll learn more about such mixed economies. AP P LI CATION Analyzing Causes C. Why did many societies feel it necessary to adopt some level of government involvement in market economies? Economic Systems 55 For more information on comparing and contrasting information, see the Skillbuilder Handbook, page R19. Comparing and Contrasting Economic Systems Comparing means looking at the similarities and differences between two or more things. Contrasting means examining only the differences between them. To understand economic systems, economists compare and contrast the ways in which societies use their limited resources to meet unlimited wants. TIPS FOR COMPARING AND CONTRASTING Look for subjects that can be compared and contrasted. Economic Systems An economic system is the way in which a society uses its resources to satisfy its people’s needs and wants. Two common economic systems are the market system and the command system. Both systems provide answers to three basic economic questions: What to produce? How to produce? For whom to produce? In a command economy, government economic planners decide what goods and services will be produced, how they will be produced, and for whom they will be produced. Individuals, then, have little or no influence on how economic decisions are made. In contrast, in a market economy the individual plays the major role in answering the basic economic questions. Consumers spend their money on the goods and services that satisfy them the most. In response, producers supply the goods and services that consumers want. Few, if any, “pure” economic systems exist today. Most economic systems are “mixed.” For example, market economies generally have some limited form of government control—a characteristic of command economies. Most command economic systems are likewise mixed in that they have some elements of market economies. Comparison This passage compares two economic systems that have both similarities and differences. Contrast To contrast, look for clue words that show how two things differ. Clue words include however
, in contrast, on the other hand, and unlike. Similarities To find similarities, look for clue words indicating that two things are alike. Clue words include both, similarly, and likewise. T HINKING ECONOMICALLY Comparing and Contrasting 1. How are market and command economic systems similar? 2. In what ways do these two economic systems differ? 3. Read the paragraphs about North Korea under the heading “Command Economies Today” on page 45. Construct a Venn diagram showing similarities and differences between the economy of North Korea and a typical market economy. 56 Chapter 2 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs. a. private property rights c. specialization market b. laissez-faire capitalism profit d. factor market product market 2. What are the essential elements of market economies? 3. What are some advantages of market economies? 4. What are some disadvantages of market economies? 5. How does the profit motive help lead to efficient use of productive resources? 6. Using Your Notes Make charts for a traditional economy and a command economy and compare and contrast them with your completed market economy chart. Market Economy private property rights Use the Graphic Organizer at Interactive Review @ ClassZone.com. Analyzing Cause and Effect Review the circular flow model on page 53. Based on the model, how do businesses benefit from the wages they pay? 8. Creating and Interpreting Economic Models Return to the answer you gave for Application B on page 53. Create a circular flow model to illustrate your answer. 9. Solving Economic Problems How do you think the disadvantages of a market economy can be minimized while its advantages continue to operate? 10. Challenge On August 29, 2005, Hurricane Katrina devastated regions of the Gulf Coast states of Louisiana, Mississippi, and Alabama. Most of New Orleans, for example, was flooded after the levees protecting the city broke. How would a pure market economy respond to the devastation and loss? Employers and employee discuss salary Understanding the Market Economy Market economies can be identified by certain fundamental characteristics. These include self-interested behavior, private property rights, voluntary exchange, profit, competition, consumer sovereignty, specialization, and a limited role for government. Identify Features Each sentence in the chart illustrates one fundamental feature of a market economy. Complete the chart by identifying these features. Feature Description An author secures a copyright for her latest novel. Declining sales signal
the end of production for a model of car. A prospective employee and a business reach an agreement on salary and benefits. Taking advantage of their beautiful natural environment, local planners approve development of new hotels and resorts. Challenge Write sentences illustrating two fundamental features of market economies not illustrated in the sentences above. Economic Systems 57 S E C T I O N 4 Modern Economies in a Global Age TA K I N G N O T E S In Section 4, you will mixed economy, p. 58 • identify the main characteristics nationalize, p. 61 privatize, p. 61 global economy, p. 61 of a mixed economy • understand why most modern economies are mixed economies • explain why modern economies are becoming increasingly global As you read Section 4, complete a cluster diagram to record what you learn about modern economies in a global age. Use the Graphic Organizer at Interactive Review @ ClassZone.com Today’s Mixed Economies Trends in Modern Economies Modern Economies Today’s Mixed Economies KEY CONCEPT S QUICK REFERENCE A mixed economy is an economy that has elements of traditional, command, and market systems. Today, the mixed economy—an economic system that has elements of traditional, command, and market economies—is the most common type of economic system. Even the most strongly market-based modern economies have some elements of central planning. Similarly, market influences have penetrated all of today’s command economies to some extent. Traditional production methods are still followed in some areas of both market and command systems. And traditional economies everywhere are experiencing greater government involvement and growing pressure from market influences. Life in a Mixed Economy Let’s look at a farming family in the rural Midwest of the United States to see how elements of all three economic systems may be present in a mixed economy. The family has owned and operated the farm for many generations. While they use the most modern farming methods, family members still cling to some old customs. At harvest time, for example, everybody works to get in the crops. Even the youngest children have their own special tasks to do. The family’s crops are sold on the market along with those of their neighbors and of farmers throughout the region. Wellmaintained highways connect the farm to the various locations where the crops are sold. Two teenagers in the family attend the public high school. The oldest one works in town at a part-time job during the week, earning the minimum wage. Two grandparents who no longer work full time on the farm each receive a Social Security
check every month. 58 Chapter 2 In this scenario, all three types of economic system are blended. The harvest-time customs the family follows represent the influence of a traditional economy. The command aspects of the economy are reflected in the ways that government has become involved. The well-maintained roads, the public high school, the minimum wage, and the Social Security checks are all examples of government benefits and regulations at the local, state, or national level. (You’ll learn more about government involvement in the economy, including the minimum wage and Social Security, in later chapters.) The market aspects of the economy are represented in the private property rights and entrepreneurship of the family members. They own their land and have figured out the best ways to use it to make a living. Other aspects of a market economy include the competitive market in which their goods are sold, and the voluntary exchange that takes place when the family sells its crops and when one of the teenagers exchanges labor for wages. Elements of Command One way the U.S. government intervenes in the economy is to set safety standards for automobiles and other products. Types of Mixed Economies Although all modern economies are mixed, they often emphasize one type of system or another. In the scenario you just read, which is based on the economy of the United States, the market economy dominates. Even though there are traditional and command elements, the driving forces of the U.S. economy are such features as private ownership and markets. So, the United States essentially has a market economic system. Many European countries have a more even mix of market and command economies. France, for example, tried to find a “middle way” between socialism and capitalism. In the years following World War II, its economy emphasized the command system with government ownership of core industries. In the 1980s, however, many people expressed dissatisfaction with the performance of government-owned industry. As a result, the French government pulled back from its ownership role in the economy, privatizing several industries, most notably banking and insurance. Even so, it still has a controlling share of ownership in a number of industries, including energy, automobiles, transportation, communications, and defense. In addition, it provides an array of social services, including health care and education, to the French people. Sweden, while also a mixed economy, has much greater government involvement. The Swedish government and government-related organizations own about one third of all Swedish companies. In addition, Swedish citizens receive “cradle to grave” social
benefits. These include childcare for children ages 1 through 5, schooling for Economic Systems 59 M AT Calculating Percentages Economists often use percentages to express the level of government involvement in a country’s economy. Step 1: Read the table, which contains data on the total economy and government consumption—the value of all the goods and services government buys—for three countries. Step 2: Using Canada as an example, calculate government consumption as a share of the total economy. Country Canada Nigeria Sweden Total Economy Government Consumption (in billions of U.S. dollars) (in billions of U.S. dollars) 789.8 48.8 259.2 152.4 11.4 72.2 Source: Heritage Foundation Share of economy consumed by government = Government consumption Total economy $152.4 $789.8 = 0.192960243 Step 3: Convert the answer to a percentage by multiplying by 100. 0.192960243 x 100 = 19.2960243% Step 4: Round your answer to a whole number. 19.2960243 rounded to a whole number 19% Comparing Economies To compare government consumption in the economies of two different countries, economists can calculate percentages for each country and compare the percents. NEED HELP? Math Handbook, “Calculating and Using Percents,” page R4 children ages 6 through 16, additional years of school and college for those who choose them, health care, dental care, paid time off for raising families, and generous old-age pensions. In return, however, the Swedish pay very high tax rates, in some cases as high as 60 percent of income. Each country has its own distinct balance of economic types. Namibia, as you read in Section 1, has a large number of people engaged in subsistence farming, following traditional production methods. Since the early 1990s, however, the Namibian government has been encouraging a more market-driven approach, including foreign investment in farming and other businesses. The country’s leaders hope that these efforts will help the economy to grow and provide more economic opportunities for all Namibians. APPLICATION Synthesizing Economic Data A. Look at the Math Challenge above. What level of government involvement in the economy does each country shown have? 60 Chapter 2 Trends in Modern Economies KEY C ONCEPT S Economies have changed, and are always changing, in response to changes in natural, social, and political conditions. In the early 1990s, for example,
some Eastern European economies experienced abrupt change when their command systems broke down after the collapse of communism in the Soviet Union. Many of these economies have been making reforms to introduce more market elements. (You’ll learn more about these economies in Chapter 18.) T RE ND 1 Changes in Ownership Economies in transition often go through predictable processes. Some of the most important relate to changes in ownership. After World War II, some European economies became more centrally planned. For example, the British government, to help the country more effectively recover from the war, nationalized several important industries, including coal, steel, and the railroads. To nationalize means to change from private ownership to government or public ownership. More recently, many economies have moved away from command systems to market systems. In this process, government-owned industries have been privatized. To privatize means to change from government or public ownership to private ownership. Poland, for example, is undergoing a transition from a command to a market economy with an extensive privatization program. Since 1990, Poland has privatized a number of manufacturing, construction, trade, and service industries. The Polish government hoped that private ownership of economic resources would provide incentives for greater efficiency, which, in turn, would help the economy to grow. QUICK REFERENCE To nationalize means to change from private ownership to government or public ownership. To privatize means to change from government or public ownership to private ownership. The global economy refers to all the economic interactions that cross international boundaries. T RE ND 2 Increasing Global Ties One way to help privatize an industry is to open it up to foreign investors. This kind of economic tie between nations is only one example of the global economy. The global economy is all the economic interactions that cross international boundaries. Today, American consumers and businesses are actors in a world economy. Businesses now engage in more foreign trade than ever before, and they depend not only on the products they buy from foreign nations, but also on the foreign markets in which they sell their products. There are several reasons for this surge in economic globalization. One reason is the opening up of the world’s markets to trade. Nations have been discussing ways to open trade for many years. The outcome of these talks has been the signing of agreements that ensure that trade among nations flows as Globalization Some people are opposed to globalization, charging that it results in the loss of national identity. Economic Systems 61 F I G U R E 2. 6 The World Student Backpack Made in Mexico Backpack
Contents Mechanical Pencil Made in South Korea Textbooks Printed and made in the United States MP3 Player Made in China Calculator Designed in the United States, made in Taiwan, powered by batteries made in the United States Cell Phone Designed and made in the United States by a subsidiary of a Finnish company. Shirt Assembled in Honduras from fabric pieces made in the United States Watch Designed in the United States, made in Hong Kong Belt Made in China Jeans Made in Costa Rica Shoes Made in Indonesia ANALYZE CHARTS List all the things that you use in a normal day—the clothes you wear, the foods you eat, the appliances you use, and so on. Identify where each item was made— in the United States or in another country. smoothly and freely as possible. Another reason for the growth of the global economy is the development of faster, safer, and cheaper transportation. Distribution methods have become so efficient that resources and products can be moved around the world relatively inexpensively. In addition, telephone and computer linkages have made global financial transactions quick, inexpensive, and easy. Globalization also has been enhanced by cross-border business partnerships. For example, Ford Motor Company of the United States and Mazda Motor Corporation of Japan have long worked as partners. They design and engineer cars together, use each other’s distribution systems, and share manufacturing plants. Recently, Ford and Mazda have joined with China’s Changan Automotive Group to produce engines for Ford and Mazda cars. Such shared efforts lead to greater efficiency, which results in lower production costs and greater profits. Other global partnerships have grown out of the need to share the enormous costs of researching and developing new technology. For example, Hitachi of Japan has joined with two American companies, Texas Instruments Incorporated and Integrated Device Technology, to develop smaller and more powerful computer memory chips. Such joint efforts are an illustration of today’s economic reality—businesses can cooperate and learn from one another even while pursuing their own interests. Find an update on global partnerships at ClassZone.com APPLICATION Analyzing Effects B. How do global business alliances benefit the U.S. economy? 62 Chapter 2 S E C T I O N 4 Assessment ClassZone.com AC T I C E 1. For each of the following key terms, write a sentence that illustrates its meaning. a. mixed economy c. privatize b. nationalize d. global economy 2. What is a market-driven mixed economy? Illustrate your answer with examples. 3. In the
transition from command to market economies, most economic resources are privatized. What is the expected impact of this action? 4. What forces have contributed to the growth of the global economy? Shopping for shoes 5. How are you, as an individual, affected by the global economy? 6. Using Your Notes Write a foursentence summary of this section, using your completed cluster diagram as a reference. Use the Graphic Organizer at Interactive Review @ ClassZone.com Today’s Mixed Economies Trends in Modern Economies Modern Economies 7. Explaining an Economic Concept Explain, with examples, how the American economy includes elements of traditional, command, and market economic systems. 8. Analyzing Cause and Effect Since the fall of communism in the 1990s, countries in Eastern Europe and the former Soviet Union have abandoned command economies in favor of market economies. How do you think economic life in these countries has changed? 9. Applying Economic Concepts Many nations import U.S. capital and technology by purchasing equipment that U.S. businesses manufacture. Explain how this development can benefit the American people. 10. Challenge How do market forces operate in the global economy? Illustrate your answer with examples. Illustrating the Global Economy How do you participate in the global economy? Study Figure 2.6 opposite and then complete this exercise. Conduct a Survey Make a survey of class members to identify the “Made in” labels in their clothes, shoes, and other items they use every day. Use a chart similar to the one below to list the items and the countries in which they were produced. Product Where Made Sweaters Shirts Pants or dresses Shoes Jackets Backpacks Challenge Write a short explanation of how this list illustrates the global economy. Economic Systems 63 Case Study Find an update on this Case Study at ClassZone.com Contrasting Economies: North Korea and South Korea Background Korea was an independent kingdom for nearly 1,000 years. After World War II, the country was divided into two nations, North Korea and South Korea. Since then, the two countries have developed in vastly different ways. After the Korean War ended in 1953, North Korea’s communist government followed an economic, political, and military policy of isolation. North Korea has a command economy, though elements of a market system are taking root. South Korea, in contrast, is a democracy with a market economy. South Korea has achieved incredible economic growth, in part because of its chaebols (jeh BOLZ), huge technology conglomerates like Samsung and Hyundai that
originated from a single family. Strong government support for businesses has aided the country’s economic success. What’s the issue? How effective are command and market economies? Use these sources to discover how well the economies of North and South Korea function. North Korea South Korea A. Online Article In this article, the United States Institute of Peace (USIP) summarizes the findings of Andrew P. Natsios about the great famine in North Korea. Natsios is the author of The Great North Korean Famine: Famine, Politics, and Foreign Policy (2001). North Korea Suffers Famine Workers in “unproductive” industries die from lack of food According to some estimates,... three million people died in the North Korean famine of the mid-1990s.... Faced with a massive food shortage, the North Korean government “made a choice,” Natsios said. Making the regime’s survival its top priority, the government decided that food would go to the country’s elite and its military forces. Most citizens, especially those who lived in regions or worked in industries that the government deemed “unproductive,” were considered expendable. As many as three million people may have died. Before the famine, North Korea relied on food and oil subsidies, mostly from the former Soviet Union. When that aid declined and a series of natural disasters occurred, the North Korean government cut food rations to farmers. Many people started hoarding and stealing. The system collapsed. In Natsios’ view, North Koreans lost faith in the state. Source: “The North Korean Famine.” Peace Watch Online, June 2002 North Koreans receive contributions of rice from an international humanitarian agency. Thinking Economically What decision described in this document is characteristic of a command economy? Explain your answer. 64 Chapter 2 FIGURE 2.7 PER C A P I TA GD 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 B. Graph This graph compares North Korea’s and South Korea’s per capita GDP— each person’s share of everything produced in the economy—from 1994 to 2004. SOUTH KOREA NORTH KOREA 1994 1996 1998 2000 2002 2004 Year Source: United Nations Statistics Division Thinking Economically What does this graph suggest about productivity in the two nations? C. Magazine Article This article reflects the contributions of corporations like Samsung to South
Korea’s growing economy. Samsung and the “Next Great Tech Revolution” Heading Towards a Digitized Life Lee Jong Jin, 51, is no couch potato. But lounging in his apartment overlooking the mountains of Seoul, the international trader has little reason to leave his sofa. As he watches an interactive game show, he uses the remote to send in answers. In a corner of the 50inch plasma screen, he can link to his online bank or control his air conditioner. Lee is one of thousands of Koreans involved in trials of Samsung Electronics’ Home Network, which allows digital products to talk to each other. If Samsung has its way, millions around the world will be running their homes from the comfort of their couch within a few years.... Over the last decade, [Samsung] has... become the most diverse and profitable consumer-electronics company on the planet. Samsung leads the global market for color televisions, VCRs, liquid crystal displays for electronic devices and digital memory devices.... Since 1999, revenues have doubled, and profits have risen 20 times.... In the digital world all these products will finally be networked to each other... creating the sort of “smart” living space imagined only in science fiction. That’s the idea, anyway. The change, says analyst Keith Woolcock of Westhall Capital in London, will be “the biggest event in technology for the next 10 years.” Source: “Digital Masters,” Newsweek (International Edition), October 18, 2004 Thinking Economically What aspects of a market economy are illustrated by Samsung’s financial success? THINKING ECONOMICALLY Synthesizing 1. Based on documents A and C, in which country does the government appear to be more involved in controlling business and the economy? 2. Based on documents A and C, what can you infer about the effects of government activities on productivity in the two nations? 3. In today’s global economy, is a command economy or a market economy more likely to succeed? Support your answer with information presented in the three documents. Economic Systems 65 CHAPTER 2 Assessment Introduction to Economic Systems (pp. 38–41) 1. What are the three types of economic systems? 2. What are features of a traditional economy? Command Economies (pp. 42–47) 3. What role does the government play in a command economy? 4. What are the advantages and disadvantages
of a command economy? Market Economies (pp. 48–57) 5. What are the features of a market economy? 6. What are the advantages and disadvantages of a market economy? Modern Economies in a Global Age (pp. 58–65) 7. What are the features of a mixed economy? 8. What trends are shaping modern economies? A P P LY Look at the chart below showing statistics for four nations. Answer the following questions. 9. Which country appears to have the most productive economy? 10. Does a high percentage of GDP from agriculture make a country more or less productive? Support your answer with statistics from the chart. FIGURE 2. 8 GROW TH AND PRODUC TIVIT Y Country GDP* Growth Rate PPP** % of GDP from Agriculture North Korea Poland Namibia China 1.0 3.3 4.2 9.2 1,800 30.0 12,700 7,800 6,200 2.8 9.3 14.4 * Gross Domestic Product (value of everything the country produced) ** Purchasing Power Parity (shows a country’s productivity relative to its population) Source: The CIA World Factbook, 2006 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. capitalism centrally planned economy circular flow model command economy competition factor market global economy laissez faire market market economy mixed economy nationalize private property rights privatize product market profit socialism traditional economy voluntary exchange In a 1, the three basic economic questions of what to produce, how to produce, and for whom to produce are answered in the same way they have been for generations. In a 2, in contrast, the government makes most economic decisions. Two systems in which government plays a strong role are communism and 3. In the transition between types of economic systems, the government may 4 industries, taking them out of private ownership. A 5 economy rests on private ownership, however, so 6 guaranteed by the government are vitally important. A market economy also depends on 7 to help produce the highest quality goods at the lowest price. Sellers are motivated by the chance to make a 8, so they try to use their resources as efficiently as possible. The 9 shows the flow of money as well as the flow of products
and resources in the 10 that takes place between buyers and sellers in a market economy. The most common kind of economy today is the 11 which blends elements from all three systems. Each modern economy is also part of the 12, which entails all the economic interactions that cross international borders. 66 Chapter Privatize Your Community’s Recreation Facilities Suppose your community felt that its administration of your park district and recreation facilities—pools, gyms, and so on—had become inefficient. As an exercise to understand the issues involved in moving from a government-owned to a privately-owned enterprise, work through the decisions you would face in privatization. Step 1. With your whole class, divide the recreation facilities into manageable segments. One segment might be park maintenance, another might be fitness classes at the community center, and so on. Then organize pairs or small teams and assign each pair or team one of the segments. Step 2. In your pairs or teams, discuss how to use the elements of a market economy to make your segment of the project as efficient as possible—to provide the lowest priced services at the highest possible quality. Step 3. Draw up a plan describing the privately-owned company you think could take over your segment. Step 4. Share your plans with the teams working on the other segments to see what other ideas came up. Step 5. With your whole class, discuss whether privatizing services like park district facilities is a beneficial step or not. Discuss possible advantages and possible disadvantages. 11. Creating Charts Create a chart showing a continuum of countries with different types of economic systems. At the left will be the nations with the most command elements in their economic systems. On the right will be the nations with the most market elements in their economies. Use the chart below as a model. Country B Country D COMMAND MARKET Country A Country C Country E Begin with the countries listed in the chart on the previous page. Then add other countries mentioned in this chapter, such as France, Sweden, and the United States. Conduct extra research if you have difficulty placing these countries on the continuum. One useful source of information is Economic Freedom of the World Annual Report. 12. Synthesizing Economic Data Look again at Figure 2.8 on page 66. Why do you think Poland and Namibia had relatively high growth rates? In writing your answer, consider the economic changes that have taken place in these countries in recent years. 13. Evaluating Economic Decisions Using information in Figure 2.8, evaluate Poland’s decision to privat
ize a number of its industries, noting whether you think it was a wise or an unwise action. Explain your evaluation. 14. Explaining an Economic Concept In most of the former command economies in Eastern Europe, one of the first economic changes instituted was establishing the right to own private property. Why do you think the leaders of these countries considered this feature of market economies so important? 15. Challenge Write a brief essay explaining how a country’s political system and economic system are intertwined. Economic Systems 67 Free Enterprise In the American free enterprise system, everyone is free to start a business like the couple shown here. Businesses will succeed or fail based on how well they respond to market forces. 68 CHAPTER 3 SECTION 1 Advantages of the Free Enterprise System SECTION 2 How Does Free Enterprise Allocate Resources? SECTION 3 Government and Free Enterprise CASE STUDY The United States: Land of Entrepreneurs The American Free Enterprise System market economy is an economic system based on individual choice, voluntary exchange, and the private ownership of resources Free enterprise system is another name for capitalism, an economic system based on private ownership of productive resources. This name is sometimes used because in a capitalist system anyone is free to start a business or enterprise AT T E R S Free enterprise is all around you, from huge suburban malls to industrial developments to neighborhood corner stores. Think about ways that the American economic system affects your dayto-day life. Consider where you shop, what you buy, where you work, and what you do there. What do you think allows this huge economic engine to run? More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on entrepreneurs in the United States. (See Case Study, pages 92–93). Go to ANIMATED ECONOMICS for interactive versions of diagrams in this chapter. Business revenue Product Market Consumer spending Products Products Products Products Government Businesses Taxes Productive Resources i g n d n e p S Taxes Households (Individuals)) Land, labor, capital, entrepreneurship s e c r u o s e R Payments Factor Market Income Go to INTERACTIVE REVIEW for concept review and activities. How do households, businesses, and government interact in the economy? See Figure 3.4 in Section 2 of this chapter. The American Free Enterprise System 69 S E C T I O N 1 Advantages of the Free Enterprise System TA K I N G N O T E S free enterprise system, p. 70 open opportunity, p. 73 legal equality, p.
73 free contract, p. 73 profit motive, p. 73 In Section 1, you will • explain why the United States is considered to have a capitalist, or free enterprise, system • identify the legal rights that safeguard the free enterprise system • analyze how the profit motive and competition help to make the free enterprise system work As you read Section 1, complete a cluster diagram using information on free enterprise. Use the Graphic Organizer at Interactive Review @ Classzone.com definition detail Free Enterprise detail detail What Is a Free Enterprise System? KEY CONCEPT S QUICK REFERENCE Free enterprise system is another name for capitalism, an economic system based on private ownership of productive resources. As you recall from Chapter 2, the United States has a capitalist economic system. Capitalism is an economic system based on the private ownership of the factors of production. The central idea of capitalism is that producers are free to produce the goods and services that consumers want. Consumers are influenced by the desire to buy the goods and services that satisfy their economic wants. Producers are influenced by the desire to earn profits, the money left over after the costs have been subtracted from business revenues. A capitalist system is also known as a free enterprise system because anyone is free to start a business or enterprise. EXAMPLE United States Let’s take a look at one American who took advantage of that freedom. Monica Ramirez, a makeup consultant for fashion magazines and television, noticed that very few Hispanic women purchased the cosmetics available in stores. She thought that this might present a business opportunity. So, in 2001, she created Zalia Cosmetics, a line of cosmetics specifically for 70 Chapter 3 Latinas. She put her whole savings account into starting the business. Her creativity and energy attracted attention, and she soon had backers willing to invest their money in the business. By 2004, Zalia Cosmetics had sales outlets in the major Hispanic markets of New York, Miami, Dallas, Los Angeles, San Antonio, and Houston. Today, the business continues to grow and Ramirez is sharing her success. She donates a percentage of her profits to organizations that help and encourage Latina entrepreneurs. As you can see in Figure 3.1 below, Zalia Cosmetics was just one of more than 585,000 new businesses started in the United States in 2001. No matter where you go in the United States, you can see similar signs of a free enterprise economy at work. If you walk through a suburban shopping mall you’ll see national and regional chain stores next to small boutiques
and startup shops. Sometimes you’ll even see kiosks in the aisles, competing for business. Similarly, on a stroll through a city neighborhood you’ll observe corner grocery stores, dry cleaners, and barber shops. At an industrial park you’ll see factories that churn out an immense variety of products. In the countryside beyond the city, you’ll notice farms with fields of corn or soybeans, orchards of apples or peaches, or grazing areas for livestock. FIGURE 3.1 NEW FIRMS AND FIRM CLOSURES ( 700 600 500 400 300 200 100 0 This line graph shows the risk involved in starting a new business. Nearly as many businesses close as the number of new businesses that start each year. Less than half of all new businesses survive for four years or more. Find an update on new business firms and business firm closures at ClassZone.com New firms Firm closures * Source: U.S. Small Business Administration Year *Estimated ANALYZE GRAPHS 1. What is notable about 2002 in terms of the relationship between new firms and firm closures? 2. How does this graph illustrate the fact that entrepreneurship involves risk? What do these examples of free enterprise have in common? They are all illustrations of how individual choices are the basis of a market economy. Business owners freely make the choice to start these enterprises. Also, these owners are free to choose how they will use their scarce productive resources. The managers and workers who operate these businesses voluntarily decide to exchange their labor for the pay the owners offer. Finally, consumers make their own choices on which goods and services they will buy. The American Free Enterprise System 71 As you recall, government plays a relatively limited role in the American free enterprise system. The government sometimes takes actions that limit free enterprise. For the most part, however, these actions are designed to protect or encourage competition or to enforce contracts. EXAMPLE Emerging Markets As you read in Chapter 2, most countries today have mixed economic systems with at least some elements of free enterprise. Each economy has its own balance of tradition, free enterprise, and government involvement and its own distinctive ways in which market forces work. To illustrate this, let’s look at the countries of Mexico and Singapore In the Mexican economy, the government plays a much larger role than in the United States. The Mexican government has established many rules and regulations that make starting a new business quite difficult. As a result, an informal market that gets around these barriers has grown up
. In Mexico City, for example, much of the city center is taken up with vendors’ stalls, and people jam the streets to buy imported toys, clothing, shoes, CDs, and more at much lower prices than they could find at regular retail stores. Indeed, the stiff competition from street vendors has driven some of the retail stores out of business. Competition Popular stalls on the streets of Mexico City, selling everything from candy to clothes, provide considerable competition for established stores. The country of Singapore has a thriving free enterprise system. However, the government is so closely involved in the economy that the country is sometimes called Singapore Inc. The government establishes what benefits employers must provide to workers. It also requires all workers to put a percentage of income in the Central Provident Fund, a government savings scheme. The fund is used to pay pensions and to finance public projects, such as education, housing, and health care. Even so, the government is considered very supportive of free enterprise. Many of its policies keep business rents, taxes, and other costs low so that Singaporean companies remain competitive in the world economy. APPLICATION Analyzing Cause and Effect A. What steps can a government take to support free enterprise? 72 Chapter 3 How a Free Enterprise System Works KEY C ONCEPT S You learned in Chapter 2 that the right to private property is one of the most fundamental freedoms in a capitalist economy. With that freedom comes the right to exchange that property voluntarily. This exchange lies at the heart of a free enterprise economy. Another key freedom of this type of economy is open opportunity, the ability of everyone to enter and compete in the marketplace of his or her own free choice. This ensures that the market will reflect a wide range of interests and talents and will provide incentives to everyone to be efficient and productive. Free enterprise also requires legal equality, a situation in which everyone has the same economic rights under the law. In other words, everyone has the same legal right to succeed or fail in the marketplace. Another important element of a market economy is the free contract. For voluntary exchange to work, people must be able to decide for themselves which legal agreements they want to enter into, such as business, job, or purchase commitments. These freedoms assure that people are able to engage in free enterprise. But what motivates people to start a business? For most people, it is the profit motive, the incentive that encourages people and organizations to improve their material wellbeing by seeking to gain from economic activities. Producers, motivated by profit, seek the highest possible price for
their products. Competition offsets the drive to earn profits, since it forces prices down. This helps producers find a price that is not so high that it deters buyers and not so low that it inhibits profits. QUICK REFERENCE Open opportunity is the ability of everyone to take part in the market by free choice. Legal equality is a situation in which everyone has the same economic rights under the law. A free contract is a situation in which people decide which legal agreements to enter into. The profit motive is the force that encourages people and organizations to improve their material well being from economic activities. E XAMPLE Profit in Rocks One memorable example of how the various economic freedoms and the profit motive come together in the free enterprise system is the pet rock. Talking with friends in April 1975, advertising executive Gary Dahl joked that regular pets were too much trouble. Pet rocks, he suggested, were much easier to care for. Dahl’s friends were amused by the idea. In response, he wrote a manual on pet rocks, showing how they could be house trained and taught to do tricks. In August, Dahl began packaging his pet rocks, complete with a care manual, for sale at gift shows. Intrigued, a buyer from a major department store ordered 500. In a matter of weeks, Dahl’s joke had become a national story. Articles appeared in newspapers and magazines and Dahl did several interviews on television. By the end of the year, Dahl had sold more than two tons of pet rocks and had become a millionaire. However, as 1976 began, consumers lost interest, and it quickly became obvious that the pet rock was last year’s fad. Dahl decided to get out of the pet rock business, guided by the same market forces that had brought him into the business and made him rich. Open Opportunity Because of legal rights built into the free enterprise system, Gary Dahl was free to enter the market for pet rocks. The American Free Enterprise System 73 Free Enterprise and Legal Rights Open Opportunity Everyone should have the ability to enter and compete in any marketplace. Open participation serves as an incentive to be efficient and productive. What Legal Rights Are Built into the Free Enterprise System? Free Contract Everyone should have the right to decide for themselves which legal economic agreements they want to enter into. Voluntary exchange, a cornerstone of free enterprise, cannot function without freedom of contract Legal Equality Everyone should have the same economic rights under the law. In other words, the law should not give some people a better chance than others to succeed in the
marketplace. ANALYZE CHARTS The American free enterprise system is based on the idea of freedom—producers and consumers are free to pursue their economic self-interest. Certain legal rights have been established to protect and encourage this freedom. Reread the paragraphs on pet rocks on page 73 and those on books on pages 74–75. How do these examples illustrate the legal rights shown in this chart? EXAMPLE Competition over Books Gary Dahl did face competition from other producers who jumped into the pet rock market. Competition, however, did not drive him out of business. Rather, consumers simply stopped buying pet rocks. The market for books is somewhat different. Demand for books remains high, but booksellers have been going out of business because of new and fierce competition. Before 1995, small chain stores and independent neighborhood booksellers dominated the book market. Around 1995, large chain stores such as Barnes & Noble Inc. and Borders Group Inc. began to compete more aggressively. Because of their huge purchasing volume, the large chain stores could buy their books at greatly discounted prices. They passed the savings on to consumers, lowering prices by anywhere from 10 percent to 40 percent. They also created a warm and welcoming atmosphere in their stores, with comfortable reading areas, cafés, and frequent readings and book signings by authors. 74 Chapter 3 The tactics of the large chain stores caused problems for independent booksellers. In 1991, independent booksellers accounted for more than 30 percent of all book sales in the United States. By 2005, their share of sales had fallen to less than 15 percent. And between 1995 and 2005, about 1,200 independent booksellers went out of business. Soon, however, the large chains faced a challenge themselves: Amazon.com. The online bookseller opened for business in July, 1995 and within a few months had become an important player in the book market. Amazon’s easy-to-use Web site, huge database of titles, quick and reliable delivery, and discounted prices attracted many book buyers. By the end of 2004, Amazon’s sales stood at $134 million a week. Now Amazon, however, is looking over its shoulder at a new challenger. Online competitors such as Overstock.com and Buy.com have undercut Amazon’s prices on hundreds of books by as much as 25 percent while matching Amazon’s level of excellence in service. Consumers have benefited from all of this competition, for they can now easily and conveniently buy books at the lowest prices. Those independent
booksellers who have remained in business cannot match the lower prices offered by the large chains and online sellers. However, they can provide some things that their larger competitors cannot: personal service and a focus on local tastes or specialized subject areas. Consumers benefit from this, too. These independent booksellers who stayed in business illustrate an important aspect of free enterprise. Businesses that keep pace with changes in the market and adjust accordingly thrive. Those that do not eventually fail. YO U R EC FREE ENTERPRISE Where will you open your restaurant? You’ve decided to open a restaurant. You can lease one of two buildings. One is in a busy mall next to a highway exit. However, there are already six restaurants in that mall. The other location is in a small strip mall in a quiet neighborhood with no other restaurants nearby. Consider the chance to make profits and the level of competition, and choose.? Mall food court Neighborhood strip mall AP P LI CATION Analyzing Cause and Effect B. Explain the chain of cause-and-effect reactions since the mid-1990s that led to lower book prices for American consumers. The American Free Enterprise System 75 ECO N O M I C S PAC ES E T T E R Milton Friedman: Promoter of Free Markets At a glittering White House birthday celebration for Milton Friedman in 2002, President George W. Bush declared that the 90-year-old economist “has shown us that... in contrast to the free market’s invisible hand... the government’s invisible foot tramples on people’s hopes.” Economics professors are rarely guests of honor at White House galas. Why did Friedman receive such a tribute? Economic Freedom Personal freedom is at the center of Friedman’s economic theories. Free to Choose Friedman spent most of his career teaching at the University of Chicago, where he helped develop the free-market ideas now linked with what is called the “Chicago School of Economics.” Central to his ideas was the belief that the market should be free to operate in all fields, even such professions as the law and medicine. Easing government restrictions in these fields— lowering licensing standards, for example—would bring more doctors and lawyers into the market. This, in turn, would bring down the cost of legal and medical services. Friedman also put forward the theory that the government’s most important economic role was to control the amount of money in circulation. Without this control of the money supply, Friedman noted,
the economy would experience inflation—a sustained rise in the general level of prices. Friedman’s ideas were very influential. He advised two U.S. presidents and the heads of state of several other countries on economic policy. He gained worldwide recognition in 1976 when he won the Nobel Prize for Economics. Friedman became well known outside the academic world in 1980 when Free to Choose, which he wrote with his wife Rose, became the year’s best-selling nonfiction book in the United States. From 1977 until his death in 2006, Friedman served as a scholar at the Hoover Institution, a conservative public-policy research center at Stanford University. In 1996, he and his wife founded the Milton and Rose D. Friedman Foundation, an organization that promotes school choice. APPLICATION Making Inferences C. How might Milton Friedman have responded to the problems associated with the informal market in Mexico? FAST FACTS Milton Friedman Born: July 31, 1912 Died: November 16, 2006 Important Publications: Capitalism and Freedom (1962) Free to Choose (1980) Bright Promises, Dismal Performance: An Economist’s Protest (1983) Famous Quotation: I am in favor of cutting taxes under any circumstances and for any excuse, for any reason, whenever it’s possible. Major Accomplishments: Economic advisor to Presidents Richard Nixon and Ronald Reagan, and to British prime minister Margaret Thatcher Find an update on Milton Friedman at ClassZone.com 76 Chapter 3 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the differences among the following terms. a. open opportunity b. legal equality c. free contract 2. What is the role of the profit motive in the American free enterprise system? 3. How is a free enterprise system linked to economic freedom? 4. Give examples of three different economic freedoms in a free enterprise system. 5. What force acts as a balance to the profit motive in the American free enterprise system? 6. Using Your Notes Write two or three paragraphs explaining how a free enterprise system works. Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com definition detail Free Enterprise detail detail. Applying Economic Concepts Explain the role of competition in a free market. Illustrate your answer with examples of businesses in your local economy. 8. Comparing and Contrasting Economic Information Monica Ramirez and Gary Dahl both saw business opportunities and started new companies. Compare and contrast Ramirez’s response to the market with that of Dahl.
Use a Venn diagram to help you organize your ideas. 9. Predicting Economic Trends Turn back to page 74 and read again the paragraphs about competitive ideas in the bookselling market. What do you think might be the next new idea to compete with discounted books? 10. Challenge In a 1973 magazine interview, Milton Friedman said, What kind of society isn’t structured on greed? The problem of social organization is how to set up an arrangement under which greed will do the least harm; capitalism is that kind of a system. Do you agree with Friedman that societies are structured on greed and that capitalism can reduce the harm caused by greed? Explain your answer. A new business in the United States Analyzing Economic Information The following chart gives data about the rules and time for setting up new businesses in six countries. The rules are measured according to the number of government procedures a new business has to go through before it can begin operating. The time is the number of days it takes to complete the process of registering a new business. Draw Conclusions What is the relationship between the rules and the time for setting up a new business? Rules (Number of Procedures) Time (Number of Days) Country Canada Sweden United States Singapore Germany Mexico China 2 3 5 6 9 9 13 3 16 5 6 24 58 48 Source: World Bank, 2005 Challenge Use the chart and what you know about the economies of the listed countries to write a short paragraph comparing the ease of entry into the marketplace in three countries of your choice. 77 S E C T I O N 2 How Does Free Enterprise Allocate Resources TA K I N G N O T E S In Section 2, you will profit, p. 78 modified free enterprise economy, p. 80 • explain how consumers help determine the way resources are used • explain how producers help determine the way resources are used • analyze a circular flow model of the U.S. economy As you read Section 2, complete a cluster diagram to show how consumers, producers, and the government interact to allocate resources. Use the Graphic Organizer at Interactive Review @ ClassZone.com Profit consumers producers government The Roles of Producers and Consumers KEY CONCEPT S QUICK REFERENCE Profit is the money left over after the costs of producing a good or service have been subtracted from the revenue gained by selling that good or service. In the marketplace, consumers buy products for their personal use from producers who make or provide goods or services. In these exchanges, consumers look to get the best deal for the money they spend. Producers
, on the other hand, are looking to earn the most profit from these transactions. Profit is the money left over after the costs of producing a product are subtracted from the revenue gained by selling that product. Seeking opportunities to earn profits is one way producers help allocate scarce resources in the economy. EXAMPLE Producers Seek Profit A new neighborhood coffee shop illustrates how producers help to allocate resources. The owners of the coffee shop, motivated by the desire to earn profits, charge the highest price consumers are willing to pay. The possibilities for good profits encourage other people to open coffee shops of their own. As a result, productive resources that might have been used in some other kind of business are directed toward the coffee shops. The profit seeking of producers, then, has helped in the allocation of resources. 78 Chapter 3 E XAMPLE Consumers Vote with Their Wallets Consumers also play an important role in allocating resources in a free enterprise system. When consumers choose to buy a product, they are “voting” for their choice against competing products. These “votes” help determine what will be produced in the future, since producers, seeking opportunities to profit, try to provide what consumers want. For example, in the early 2000s, when low-carbohydrate diets were popular, consumers “voted” for low-carb and high-protein foods and against high-carb foods. (Figure 3.3 below illustrates this, showing that between 2002 and 2003 sales of typical low-carb/high-protein products increased, while sales of typical high-carb products fell.) How did food producers respond to these “votes”? They moved some of their productive resources into the low-carb market to try to meet consumer demand. FIGURE 3. 3 SALES OF SELEC TED FOOD PRODUC TS High-Carb Foods Low-Carb/High-Protein Foods Product Unit Sales, 2003 (in millions) Percentage Change Over 2002 Product Unit Sales, 2003 (in millions) Percentage Change Over 2002 Instant Rice 79.1 Bulk Rice 180.2 Cookies 1,839.7 Regular Carbonated Drinks 7,032.5 Dry Pasta 1,227.0 White Bread 1,606.1 Source: ACNielsen –8.2 –4.9 –5.5 –5.9 –4.6 –4.7 Frozen Meat/ Seafood 483.5 Meat Snacks 105.4 +7.7 +7.6 Nuts 6
79.3 +8.8 Diet Carbonated Drinks 2,828.6 +1.0 Cheese 3,424.0 Wheat Bread 873.1 +4.0 +4.0 ANALYZE TABLES 1. Which high-carb item showed the greatest percentage drop in sales between 2002 and 2003? Which low-carb/high-protein item showed the greatest percentage gain? 2. Consumer interest in low-carb diets began to decline after 2004. What differences might you expect to see in a similar table for 2004 and 2005? Interest in low-carb diets peaked early in 2004, but began to fade thereafter. Once again, consumers had cast their votes in the marketplace, buying fewer lowcarb and high-protein products. Producers quickly responded. By the beginning of 2005, some companies had gotten out of the low-carb market completely. Others had significantly cut back production of low-carb products. Consumer actions had caused a reallocation of productive resources. AP P LI CATION Analyzing Cause and Effect A. How would the allocation of resources have been affected if the interest in low-carb diets had continued to increase? The American Free Enterprise System 79 Government in the U.S. Economy KEY CONCEPT S QUICK REFERENCE A modified free enterprise economy is a free enterprise economic system with some government involvement. In Chapter 2 you learned that the United States economy, though based on the market system, is mixed. Government is an important element in the American economic system, but its role is relatively limited. This type of mixed economy, which includes some government protections, provisions, and regulations to adjust the free enterprise system, is sometimes called a modified free enterprise economy. Modified Free Enterprise In Figure 2.4 on page 53, you saw that the economy could be viewed as a stream of resources and products moving in a circular flow between households and businesses. Money also flows between households and businesses, facilitating this exchange of products and resources. Figure 3.4 shows how the government fits into this circular flow. It also shows how government exacts costs and dispenses benefits. Locate the two main economic decision-makers at the right and left of the chart: households (owners of resources) and businesses (makers of products). The two F I G U R E 3. 4 Government in the Circular Flow Model Business revenue Product Market Consumer spending Products Products Products Products Government Businesses Taxes Productive Resources i g n d n e p S Taxes Households (Individuals)) Land, labor, capital
, entrepreneurship s e c r u o s e R Payments Factor Market Income ANALYZE CHARTS This version of the circular flow model shows the flow of resources, products, and money among households, businesses, and the government. Describe the role of government in the economy using information from this chart. Use an interactive circular flow model at ClassZone.com 80 Chapter 3 markets in the economy, the product market (for goods and services) and the factor market (for economic resources), are located at the top and bottom of the chart. The outer green arrows show the flow of money. The inner blue arrows show the flow of resources and products. The government is located in the center of the chart. Like the other key actors in the circular flow, the government is both a consumer and a producer. Look at the arrows that run between government and the two markets. The government is a consumer in the resource market, spending money to buy the factors of production. It is also a consumer in the product market, spending money in exchange for products. Now locate the arrows that run between government and households and government and business firms. Government is a producer here, providing goods and services to both households and businesses. Government collects money from households and businesses, in the form of taxes, as payment for these goods and services. It covers the costs of what it produces with this money. Government also uses this money to make purchases in the resource and product markets, and the cycle continues. FIGURE 3.5 WORKERS ON THE GOVERNMENT PAYROLL FIGURE 3.6 GOVERNMENT CONSUMPTION ) 25 20 15 10 5 0 1996 1998 2000 2002 2004 Year ).50 2.00 1.50 1.00 0.50 0.00 1996 1998 2000 2002 2004 Year Source: U.S. Bureau of Labor Statistics Source: U.S. Department of Commerce ANALYZE GRAPHS 1. About how many workers were on the government payroll in 2005? 2. Based on these two graphs, how is government’s role as a consumer of products and resources changing? Figures 3.5 and 3.6 above show that government is a major consumer of both resources and products. As you can see in Figure 3.5, all levels of government, local, state, and federal, employ almost 22 million workers. This is equal to about 16 percent of the labor force—all the labor resources available in the United States. Further, if you look at Figure 3.6 you
’ll see that government consumption—what all levels of government spend on goods and services—is about two trillion dollars. Find an update on government workers and government consumption at ClassZone.com AP P LI CATION Applying Economic Concepts B. The paycheck that you get for working part-time at the pet store shows what you have earned and how much is withheld for taxes. Explain how the paycheck and the taxes withheld are represented in the circular flow model. The American Free Enterprise System 81 For more on interpreting graphs, see the Skillbuilder Handbook, page R29. Interpreting Graphs: Public Opinion Polls Public opinion polls are a useful tool for gathering information. Economists frequently use information obtained from opinion polls to measure public response to economic conditions. Polls conducted at regular intervals show changes in public opinion over a given period of time. The graph below shows the results of a poll that tracks consumer confidence. The poll, which is conducted monthly, is based on a representative sample of 5,000 households in the United States. Title This indicates the type of data shown. Consumer confidence refers to the way people feel about the economy. Increasing confidence is likely to result in increased purchases of goods. 110 105 100 95 90 85 Consumer Confidence Index April–December 2005 Subtitle This indicates the months and year of data collection. Line on Graph This shows the fluctuations in consumer confidence from month to month. Legend This provides a benchmark for comparison. For example, scores higher than 100 indicate that consumers have more confidence in the economy than they did in 1985. 1985 = 100 A pril M ay Ju n e July Se pte m b er A u g ust O cto b er N ove m b er D ece m b er Source: The Conference Board, December 2005 Consumer Confidence Index According to researchers, consumer confidence in the economy tumbled after Hurricane Katrina hit the Gulf Coast in September 2005. Falling gasoline prices and growth in the job market led to a recovery in confidence in November and December. T HINKING ECONOMICALLY Interpreting 1. During which month was consumer confidence the highest? The lowest? 2. Describe the changes in consumer confidence from August through December. 3. The devastation caused by Hurricane Katrina and resulting increase in gasoline prices led to the abrupt drop in consumer confidence shown in the graph. What other events might cause a decline in consumer confidence? 82 Chapter 3 S E C T I O N 2 Assessment ClassZone.com AC T I C E 1. Why is the U
.S. economy sometimes referred to as a modified free enterprise system? 2. How does the profit motive work to allocate resources? 3. How do households and business firms interact in the product and resource markets? 4. Describe how the government interacts with the product and resource markets. 5. Study the circular flow models on pages 53 and 80. How are the two models different? 6. Using Your Notes Explain how producers, consumers, and the government interact to allocate resources in a free enterprise system. Profit consumers producers government Use the Graphic Organizer at Interactive Review @ ClassZone.com. Applying Economic Concepts Think of several examples in which consumers have voted with their dollars and driven a product from the market or into high demand. Record your ideas in a table like the one below. Consumers Drive Product from the Market Consumers Drive Product into High Demand Analyzing Economic Information Look at the graph below, which shows the sales figures for a company that makes a substance that reduces carbohydrates in baked goods 120 100 80 60 40 20 0 2003 2004 Year 2005 8. Comparing and Contrasting Economic Information Compare and contrast the role of consumers and producers in allocating resources. Which do you think has the greater power? 9 Interpreting Economic Models Use the circular flow chart on page 80 and what you have learned from this section to explain the ways in which government allocates resources. 10. Challenge What industries in today’s world do you think would be wise to make changes given consumers’ preferences? Give reasons for your selections. Interpret Information Write a sentence or two explaining the trend that the graph shows. Challenge If you were the head of the company that made the substance that reduces carbohydrates in baked goods, in what direction would you move your business? How might you reallocate your resources? The American Free Enterprise System 83 S E C T I O N 3 Government and Free Enterprise TA K I N G N O T E S In Section 3, you will • understand that one role of government in the U.S. economy is to address market failures • analyze why governments provide public goods and infrastructure • explain how governments seek to decrease negative externalities and increase positive externalities market failure, p. 84 public goods, p. 84 free rider, p. 85 infrastructure, p. 86 externality, p. 87 negative externality, p. 87 positive externality, p. 87 subsidy, p. 88 safety net, p. 89 transfer payment, p. 89 public transfer payment, p. 89 As you read Section 3
, complete a cluster diagram to show the role of government in free enterprise. Use the Graphic Organizer at Interactive Review @ ClassZone.com providing public goods Government Providing Public Goods KEY CONCEPTS In the American economic system, most production decisions are made in the marketplace through the interactions of buyers and sellers. This is the free enterprise sector of our economy. Other decisions are made by different levels of government. This is the public sector of our economy. How do we decide which sector of the economy should produce a good or service? If all the costs are borne by, and all benefits go to, the buyer and seller, the free enterprise sector produces it. If people who are not part of a marketplace interaction benefit from it or pay part of the costs, there is a market failure. When market failures occur, the government sometimes provides the good or service. Goods and services that are provided by the government and consumed by the public as a group are public goods. Public goods are funded with taxes collected by the government. QUICK REFERENCE Market failure occurs when people who are not part of a marketplace interaction benefit from it or pay part of its costs. Public goods are products provided by federal, state, and local governments and consumed by the public as a group. 84 Chapter 3 Public Goods A city street lighting system is an example of a public good. E XAMPLE Characteristics of Public Goods Public goods have two characteristics. First, people cannot be excluded from the benefits of the product even though they do not pay for it. Second, one person’s use of the product does not reduce its usefulness to others. Perhaps the simplest example of a public good is street lighting. When the street lighting is on, it is impossible to exclude people from using it. In addition, the benefit you receive from the safety and security street lighting provides is not diminished because others receive it too. There is simply no way for a private business to establish a realistic price for street lighting and then collect it from all users. Rather, local governments provide street lighting, paying for it with taxes. Another example of a public good is national defense. Everyone benefits from the country being defended. Further, the security you feel knowing that there is a national defense system in place is not diminished because other people feel secure too. Given these benefits, you would readily pay for this sense of security. However, what if you discovered that your neighbors were not paying for national defense? Would you voluntarily pay then? To avoid this problem, everyone is required to pay
taxes to the national government, which provides national defense. E XAMPLE Free Riders There is no incentive for businesses to produce public goods, because people will not voluntarily pay for them. After all, people receive the benefits of these products whether they pay for them or not. This situation is called the free-rider problem, and it is one type of market failure. A free rider is a person who chooses not to pay for a good or service but who benefits from it when it is provided. QUICK REFERENCE A free rider is a person who avoids paying for a good or service but who benefits from that good or service anyway. Consider a July 4th fireworks display, which can cost $200,000 or more. If you tried to set up a business to put on such displays, you’d immediately run into problems. There is no way to charge people for watching the display, since it is visible from so many locations. Even if you were able to charge a fee to watch from a particularly good location, many people would still be able to watch it from elsewhere without paying. Those people are free riders—they receive the thrill and enjoyment of the fireworks display, but they do not share in the costs of putting it on. Because of them, there is little interest in providing fireworks displays as a business opportunity. One way to address the free-rider problem is for government to provide certain goods and services. The city government, for example, could put on the July 4th fireworks display, using taxes to pay for it. In this way, the costs and benefits are shared throughout the community. Free Riders Free riders will choose not to pay for fireworks displays but will still enjoy the benefits. Because of this, private companies are reluctant to provide such services. The American Free Enterprise System 85 Another example of the free-rider problem is law enforcement. Once a policing system is established, everyone in the community is protected whether they pay for it or not. The best way to ensure that people who benefit from this protection pay a share of the costs is for government to provide the service, paying for it with taxes. Public and Private Sectors—Shared Responsibilities Some goods can be provided by either the public sector or the private sector. These often are toll goods—goods consumed by the public as a group, but people can be excluded from using them. For example, toll ways are open for all people to use, but those who do use them have to pay a toll. Similarly, parks are provided for the
benefit of everyone, but those who want to enjoy this benefit may have to pay an entrance fee. The initial funding for toll goods is often provided by the public sector. Their day-to-day operation is often the responsibility of the private sector. The private and public sectors share the responsibility for the nation’s infrastructure, the goods and services that are necessary for the smooth functioning of society, such as highways; mass transit; power, water, and sewer systems; education and health care systems; and police and fire protection. How important is the infrastructure? Imagine, for example, what the United States would be like without its interstate highways, safe airports and seaports, and passenger and freight train systems. To begin with, the nation’s economy would grind to a halt. Further, the nation would lose its ability to move troops in case of attack or to evacuate people in an emergency. A solid infrastructure, then, is essential to economic health. QUICK REFERENCE The infrastructure consists of all the goods and services that are necessary for the functioning of society. YO U R EC PU BLIC vs. PRIVATE Will you support tax increases to improve recreational facilities? The mayor wants to build a water park to attract visitors, who will spend money at your town’s restaurants and stores. But what you pay in sales tax will rise by about $100 a year to cover the cost. With that money, you could buy a couple of video games. What will you choose—public wants or private wants?? Water park Video game APPLICATION Applying Economic Concepts A. Identify another example in which the free rider problem makes public goods or services the best solution. 86 Chapter 3 Managing Externalities KEY C ONCEPT S Another type of market failure occurs when economic transactions cause externalities. An externality is a side effect of a transaction that affects someone other than the producer or the buyer. A negative externality is an externality that is a negative effect, or cost, for people who were not involved in the original economic activity. For example, a manufacturing company discharges pollution into a nearby river. The costs of the pollution are borne by everyone who lives by the river, even if they have no connection to the manufacturing company. A positive externality, in contrast, is an externality that is a positive effect, or benefit, for people who were not involved in the original economic activity. Another of your neighbors, for example, plants and maintains a beautiful rose garden
. All the surrounding homes benefit from the beauty. E XAMPLE Paying for Negative Externalities One of the most commonly discussed negative externalities is industrial pollution. The owner of a factory that belches filthy smoke in the air, influenced by such Paying for Pollution A 1990 amendment to the Clean Air Act set a limit on the amount of sulfur dioxide that industries could release into the air. The government distributed to those industries only enough “pollution permits” to meet that limit. Instead of using their permits, some companies used cleaner production methods and sold the permits to other companies. As the price of these permits rose, more and more companies developed production methods that did not pollute. FIGURE 3.7 SULFUR DIOXIDE EMISSIONS QUICK REFERENCE An externality is a side effect of a product that affects someone other than the producer or the buyer. A negative externality is an externality that imposes costs on people who were not involved in the original economic activity. A positive externality is an externality that creates benefits for people who were not involved in the original economic activity. 35,000 30,000 25,000 20,000 15,000 10,000 5,000 1970 1975 1980 1985 1990 1995 2000 Source: Environmental Protection Agency Year ANALYZE GRAPHS 1. How would you describe the trend in sulfur-dioxide pollution, especially since changes in government policy in 1990? 2. How did the government take a market approach to the problem of pollution? The American Free Enterprise System 87 market forces as the profit motive and competition, has little incentive in the shortterm to pay the extra money required to reduce the pollution. Everyone living in the surrounding region suffers from this pollution. Not only do they bear the monetary cost of cleaning up the pollution, they suffer other costs too. They are more likely to suffer pollution-related illnesses and, therefore, face higher medical costs. Limiting negative externalities, then, is one important role of the government in the American economy. The government taxes or fines the polluter, and in the process accomplishes two economic purposes. The money it raises through taxation and fines can offset the higher medical costs. In addition, the cost of the tax or fine to the factory owner provides an incentive to reduce pollution. EXAMPLE Spreading Positive Externalities Positive externalities are benefits that extend to people not involved in the original activity. For example, if a new college is built in your town, local
businesses benefit from student purchases of goods and services. Workers benefit too, for as business expands to meet students’ wants, more and more jobs become available. The community as a whole benefits from all the taxes collected from students. Local government is able to spend some of these funds to provide more public goods. In addition, the whole community benefits from the potential contribution a more skilled and knowledgeable population can make to the economy. Positive Externalities The government will try to spread the benefit of a flu vaccination program—a healthier population—as widely as possible. Just as government attempts to limit negative externalities, it tries to increase positive externalities. One way government does this is through subsidies. A subsidy is a government payment that helps cover the cost of an economic activity that is considered to be in the public interest. Since subsidies are paid for with taxes, everyone shares in their cost. Subsidies also spread the benefit of a positive externality as widely as possible. For example, the federal government might provide subsidies to drug companies to develop a new vaccine. This benefits the whole population in the long run because once the vaccine is in use there will be fewer and fewer infected people to spread the disease. Similarly, a local government might subsidize influenza shots for the community. Obviously, those people who take advantage of the free or inexpensive shots benefit because they are protected against infection. Even those people who don’t get the shot still receive a benefit because they are less likely to encounter someone with the flu and therefore less likely to catch it themselves. QUICK REFERENCE A subsidy is a government payment that helps cover the cost of an economic activity that has the potential to benefit the public as a whole. APPLICATION Explaining an Economic Concept B. How might a drunk-driving law address negative externalities? 88 Chapter 3 Public Transfer Payments KEY C ONCEPT S In addition to providing public goods and managing externalities, the government plays another role in the economy. One limitation of free enterprise is that people who are too old or sick to make a full economic contribution do not always have access to all economic opportunities. For these people, and others who are temporarily struggling, there is a public safety net, government programs designed to protect people from economic hardships. Redistributing Income As many as 37 million people in the United States live below the poverty level, which was defined in 2005 as a yearly income of $9,570 for a single person, with $3,260 added for each additional household member. That is more than 12
percent of the nation’s population. However, people move up and down the income ladder in the United States. Many poor families remain poor for a relatively brief time. For example, the median duration of poverty through the 1990s was between four and five months. How does a modern society address economic issues such as poverty? One way is to encourage economic growth. Another is through transfer payments, transfers of income from one person or group to another even though the receiver does not provide any goods or services in return. Some transfer payments are between private individuals. When you receive cash and checks from relatives and friends for your birthday or graduation, you are receiving transfer payments. When someone dies, a transfer payment flows to his or her beneficiaries in the form of inheritance. In both cases, the receiver provides nothing in return for the payment. QUICK REFERENCE The safety net consists of government programs designed to protect people from economic hardship. Transfer payments are transfers of income from one person or group to another even though the receiver does not provide anything in return. A public transfer payment is a transfer payment in which the government transfers income from taxpayers to recipients who do not provide anything in return. A public transfer payment is a payment in which the government transfers income from taxpayers to recipients who do not provide anything in return. Public transfer payments, since they do not reflect exchanges within a marketplace, are not a characteristic of pure market economies. They are more characteristic of command economies, and their presence in the United States is one feature that makes the U.S. economy a mixed economy. Public Transfer Payments Type 2004 Expenditures (in billions of dollars) Social Security benefits Medicare Medicaid Supplemental Security Income Unemployment compensation 517.8 303.3 299.7 37.3 37.1 Public Transfer Payments Social Security is the largest public transfer program. 33.8 Veterans’ benefits Food Stamps Most public transfer payments are in the area of social spending—spending designed to address social issues, such as poverty. Social Security benefits, for example, have significantly reduced poverty among the elderly. This program is funded by the contributions of people currently employed. They pay a social security tax to the federal government, which in turn transfers it to people who are at or past retirement age. The Social Security program also provides income for the disabled. Source: U.S. Department of Commerce Temporary Assistance for Needy Families 25.8 18.5 The American Free Enterprise System 89 Social Spending in Sweden FIGURE 3.8 SOCIAL SPENDING In market economies, all economic
actors—including governments—have to make choices. One economic choice governments must make involves the level of funding for social spending. Sweden’s government, for example, has chosen to spend a significant amount in this area. Close to 30 percent of the country’s total economy is spent on such programs as free public education through college, national health, and retirement and disability pensions. In comparison, social spending in the United States is about 15 percent of the total economy. U.S. social programs are not as comprehensive as Sweden’s. Such generosity, however, comes at a price. Sweden’s workers pay hefty taxes to fund this social spending. Average Swedish workers with two children pay about 22 percent of their income in taxes. In contrast, similar American workers pay only about 9 percent. 28.8% 14.7% Sweden United States Percent of total economy Source: Organization for Economic Co-operation and Development, 2001 figures FIGURE 3.9 HOUSEHOLD TAX BURDEN 21.6% 9.1% CONNECTING ACROSS THE GLOBE 1. Synthesizing Economic Information How do tax levels relate to the amount of resources devoted to social spending? 2. Drawing Conclusions Which country do you think has more of a market economy, Sweden or the United States? Why? Sweden United States Percent of total earnings Source: Organization for Economic Co-operation and Development, 2003 figures The government makes transfer payments to the very poor as well as to the aged and disabled. For many years, the program known as welfare made payments to the needy to assure their well-being. A debate developed about whether such a program fostered dependence on the government and removed incentives to break out of poverty. In response to this debate, the government introduced sweeping reforms in the mid-1990s. The new program, widely known as workfare, stressed the importance of helping welfare recipients enter or re-enter the workforce as quickly as possible. Since these reforms in 1997, 4.7 million Americans have moved from being dependent on welfare to self-sufficiency. Public transfer payments also provide a safety net for people who lose their jobs. Unemployment compensation from a mix of federal and state money tides people over until they can find a new job. While people receive it, they must show that they are making an effort to find another job. (You will learn more about unemployment, poverty, and government social spending in later chapters.) APPLICATION Applying Economic Concepts C. What are the opportunity costs of
public transfer payments? 90 Chapter 3 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Explain the relationship between the terms in each of these pairs: a. market failure free rider c. subsidy positive externality b. negative externality positive externality d. safety net public transfer payment 2. Illustrate the two characteristics of public goods with examples. 3. How is infrastructure linked to the economy? 4. Give an example of a free rider. 5. How can government limit a negative externality? How can it spread a positive one? 6. Using Your Notes Explain how the government gets involved in the economy in a modified free enterprise system. Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com providing public goods Government Cleaning up a toxic dump 7. Categorizing Economic Information Unemployment compensation and payment of living expenses for the disabled are examples of what kind of government involvement in the American economy? 8. Making Inferences After several incidents of hallway disputes among students, the board of a high school decides to hire hallway guards. In economic terms, what is the school board doing? How might this decision affect other programs at the school? 9. Evaluating Economic Decisions As part of the welfare reform of the mid-1990s, the federal government hired 10,000 people who had been dependent on welfare in an initiative called welfareto-work. How does this approach differ from transfer payments? What are the costs and benefits of this approach? 10. Challenge In 2003, Congress passed laws to encourage private charitable organizations to provide social services. They would compete for government funds to carry out community services through their own networks. Do you think this is an effective way to address social issues? Why or why not? Use economic concepts, such as markets, efficiency, and opportunity costs in developing your response. Categorizing Economic Information Externalities are categorized according to their impact, either positive or negative. Identify Externalities Decide whether each of the following is a positive or a negative externality and briefly explain its effect. • A beekeeper establishes a farm next to an apple orchard and the bees move freely into the orchard. • An airport is constructed near a residential neighborhood. • A construction company cleans up a toxic dump near a site it is working on. • Companies pay for programs to help employees get in shape. Challenge Identify and explain a negative externality and a positive externality that affect you.
The American Free Enterprise System 91 Case Study Find an update on this Case Study at ClassZone.com The United States: Land of Entrepreneurs Background The free enterprise system and the belief that everyone has the right to pursue economic success through lawful means is the backbone of American society. Many people achieve that success through working for an employer who provides a place to work, a paycheck, and other benefits. However, an increasing number of people are working for themselves, and for a variety of reasons. These reasons include a desire to market their own products, or to have more freedom. What’s the issue? What are some of the options for opening your own business? Study these sources to learn how others found their way, and the obstacles and opportunities they faced. A. Magazine Article This article discusses the development of Fizzy Lizzy, a new soft drink, from initial concept through launch, and introduces the entrepreneur who came up with the idea. A Business Idea in a Bottle Getting Fizzy Lizzy Bubbling [Elizabeth] Marlin... got into the beverage business in the summer of 1996, when she set out for a long bicycle ride.... Not long into her trip, she realized that her favorite refreshment, which she had packed into a saddlebag—a half-gallon carton of grapefruit juice and a liter bottle of seltzer, which she’d mix together—was not only inconvenient, it was also slowing her down. “Juice and seltzer is so simple,” Marlin said. “I thought, Why can’t I buy this is in a bottle?” She... was fixated on the idea of creating a carbonated juice, and began researching the beverage industry. She soon discovered she would need to hire a food scientist to help her.... Although Marlin planned to devote her entire checking account to startup costs, that amount was nowhere near what [Abe] Bakal (consultant with 30 years’ experience) was asking for R & D alone.... [B]ut he was so impressed by her enthusiasm that he offered to consult in return for a 20-percent stake in the business.... Bakal recalled recently, “... one of the things I’ve learned in product development is that sometimes—not always, but sometimes—you can compensate with enthusiasm and commitment for money.” Source: “The Industry: Message in a
Bottle,” New York Times, June 26, 2005 Thinking Economically How did Elizabeth Marlin and Abe Bakal use their productive resources to start this enterprise? 92 Chapter 3 B. Chart These statistics show the number of self-employed entrepreneurs and their businesses relative to sizes of firms with paid employees. FIGURE 3.10 BUSI NESS ENTERPRISES BY EM PLOYMEN T SIZE Number of Employees No employees 1–9 employees 10–99 employees 100–499 employees 500+ employees Number of Firms 770,229 3,759,630 1,135,443 84,829 16,926 Total Employment 0 12,500,539 28,516,802 16,430,229 55,950,473 All 5,767,127 113,398,043 Source: Statistical Abstract of the United States, 2003 figures Thinking Economically What is the percentage of entrepreneurial firms with no employees? What percentage of paid employees work in companies with 100 or more workers? C. Newspaper Article This article discusses franchises, businesses that offer entrepreneurs an option to start their own business by buying into an established company with an existing business model. Being The Boss With Backup The Costs and Benefits of Franchising In Maryland, there were more than 13,000 franchises employing about 179,000 [people] in 2001, according to [a] study, which was commissioned by the International Franchise Association. More than two dozen of those franchises are headquartered in the state, including Educate Inc., with more than 1,000 Sylvan tutoring center franchises worldwide and MaggieMoos’s International with 184 ice cream shops, according to the association. Opening such a business might be just the right fit for Phil Clark, a mortgage consultant from Elkridge. The mortgage business tends to fluctuate, Clark said. A franchise would give Clark more control over his future, a prospect he finds exciting. “A franchise gives me something more stable,” he said.... But it comes at a price. The cost of opening a franchise can vary from $25,000 to millions of dollars. For some, franchising can mean economic empowerment and a chance at the American dream. But buyer beware: There is no guarantee of success, and a franchise requires the same amount of commitment, sacrifice and sweat equity as any independent business.... Source: “Growing Occupation: Being Your Own Boss,” Baltimore Sun, April 21, 2006 Thinking Economically If you were to start your own business, would you
buy a franchise or build a new enterprise based on your own ideas? What factors would help you in making your decision? THINKING ECONOMICALLY Synthesizing 1. How do the legal rights built into the free enterprise system affect the businesses in A and C? 2. Which of these two businesses do you feel would provide more stability for its owner? Why? 3. Do you think entrepreneurs make up a large percentage of the work force? Why are entrepreneurs important to the economy? The American Free Enterprise System 93 Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. capitalism externality free contract free enterprise system infrastructure legal equality modified free enterprise economy negative externality open opportunity positive externality profit profit motive public goods public transfer payments safety net subsidy transfer payments 1 is another name for capitalism. Three features of this type of economy are open opportunity, legal equality, and 2, or the right to enter into agreements of one’s choice. The 3 is a driving force in a free enterprise system, urging entrepreneurs to enter the market. The market allocates resources through the activities of both producers and consumers. Producers, seeking 4, move their resources into the most productive areas. Consumers, through their dollar votes, help determine which products succeed and which fail. Left on its own, however, a free market cannot address many social issues. The United States has a 5, mixing government involvement and market forces. One role for the government is to provide 6, such as national defense. Without a strong 7 in place, modern economies cannot function. The government also addresses problems created by a 8, such as the pollution from a factory that affects all those living nearby. It furthers a 9, such as better health through vaccinations, by offering a 10 for inoculations. The government also makes direct 11 in the form of social security, unemployment compensation, and disability coverage. 94 Chapter 3 CHAPTER 3 Assessment Advantages of the Free Enterprise System (pp. 70–77) 1. What is a free enterprise system? 2. What are some of the rights that must be protected for a free enterprise system to work? How Does Free Enterprise Allocate Resources? (pp. 78–83) 3. What are the roles of consumers and producers
in allocating resources? 4. What role does the government play in the economy’s circular flow? Government and Free Enterprise (pp. 84–93) 5. What problem makes public goods necessary? 6. Besides providing public goods, what two purposes can a government serve in a market economy? A P P LY Use the information in the table to answer the following questions about changes in the nation since the passage of the Clean Air Act in 1970. Since the passage of the Clean Air Act: • Nitrogen oxide emissions have declined by 17% • Sulfur dioxide emissions have declined by 49% • Lead emissions have declined by 98% • Carbon monoxide emissions have declined by 41% • Particulate emissions caused by combustion have declined by 82% At the same time: • U.S. population grew by 42% • Overall energy consumption grew by 43% • Total U.S. employment grew by 95% • The number of registered vehicles grew by 111% • The economy grew by 175% Source: Foundation for Clean Air Progress 7. How would you use these statistics to argue that the government has effectively managed a negative externality? 8. Recently, there has been pressure to loosen clean air standards. Use economic arguments to support or oppose this proposed action. Creating Graphs Use the statistics below to create a graph titled Businesses in the United States, 1997–2003. Use information from your graph and from Figure 3.1 on page 71 to write a generalization about businesses in the American free enterprise system. Year 1997 1999 2001 2003 Number of Businesses (in millions) 21.0 21.8 22.6 22.7 Source: U.S. Small Business Administration Use to complete this activity. @ ClassZone.com 10. Distinguishing Fact from Opinion Look again at the information on changes in the United States after the passage of the Clean Air Act. Which of the following statements represents a fact? Which is an opinion? Explain why. • Pollution has decreased since 1970. • Pollution has decreased as a result of the Clean Air Act. • The government can ease restrictions now that pollution is lower. 11. Applying Economic Concepts In the 1990s, efforts were made to reform the healthcare system in the United States so that much of it came under government control. Explain in terms of economic concepts you have learned in this chapter why these efforts failed. 12. Challenge Milton Friedman wrote, Many people want the government to protect the consumer. A much more urgent problem is to protect the consumer
from the government. Explain what you think Friedman meant by this. Illustrate your answer with examples. Conducting an Economic Impact Study A manufacturing company has announced plans to open a factory in your town. The plant will consist of a manufacturing area and a warehouse area and will employ about 500 people. Production will be on a 24-hour basis, with workers working one of three 8-hour shifts. At the same time, a national megastore chain wants to open a store on the outskirts of town. The store will employ 60 people, be open 18 hours a day, and have a 200-car parking lot. Imagine that you have been asked by local government authorities to conduct an economic impact study to identify the positive and negative externalities that the factory or megastore might create. Step 1 Form a group with three or four classmates. Conduct research on how a factory or a megastore operates—the materials they use, the byproducts they create, and so on. Then do research to discover the impact a new factory or megastore might have on a community. Step 2 In your group, review your findings and identify the positive and negative externalities of the factory or megastore. Record the information in a chart similar to the one below. Externalities Created by the Factory/Megastore Positive Negative Step 3 Use your chart to write your economic impact report. Note the major externalities and suggest steps that the local government might take to limit negative externalities and to encourage positive externalities. The American Free Enterprise System 95 Microeconomics U n i t 2 Market Economies at Work 96 CHAPTER 4 SECTION 1 What Is Demand? SECTION 2 What Factors Affect Demand? SECTION 3 What Is Elasticity of Demand? CASE STUDY Fueling Automobile Demand Demand This computer store customer meets the two requirements of demand—the customer is willing to buy and is able to pay. Demand Microeconomics is the study of the economic behaviors and decisions of small units, such as individuals and businesses Demand is the willingness to buy a good or service and the ability to pay for it AT T E R S The concept of demand is demonstrated every time you buy something. List the last five goods or services that you purchased. Rate each one with a number from 1 (not important to you) to 4 (very important). Which of the goods or services would you stop buying if the price rose sharply? Describe the relationship between your ratings and your willingness to buy at a higher price. More at ClassZone.com Go to E
CONOMICS UPDATE for chapter updates and current news on demand in the automobile industry. (See Case Study, pages 124–125.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. What caused more people to demand hybrid cars? See the Case Study on pages 124–125. Demand 97 S E C T I O N 1 What Is Demand TA K I N G N O T E S In Section 1, you will demand, p. 98 • define demand and outline law of demand, p. 99 what the law of demand says • explain how to interpret and create demand schedules and describe the role of market research in this process • explain how to interpret and create demand curves demand schedule, p. 100 market demand schedule, p. 100 demand curve, p. 102 market demand curve, p. 102 As you read Section 1, complete a cluster diagram like this one for each key concept. Use the Graphic Organizer at Interactive Review @ ClassZone.com Demand The Law of Demand KEY CONCEPT S In Chapter 3, you learned that the United States has a free enterprise economy. This type of economic system depends on cooperation between producers and consumers. To make a profit, producers provide products at the highest possible price. Consumers serve their own interests by purchasing the best products at the lowest possible price. The forces of supply and demand establish the price that best serves both producers and consumers. In this chapter, you’ll learn about the demand side of this equation. QUICK REFERENCE Demand is the willingness to buy a good or service and the ability to pay for it. 98 Chapter 4 Demand is the desire to have some good or service and the ability to pay for it. You may want to take a round-the-world cruise or to rent a huge apartment that overlooks the ocean. Or you may want to buy a brand-new sports car or a state-of-the-art home entertainment center. However, you may not be able to afford any of these things. Therefore, economists would say that you have no actual demand for them. Even though you want them, you don’t have the money needed to buy them. Conversely, you may want the latest CDs by several of your favorite bands. And, at a price of between $12 and $15 each, you can afford them. Since you have both the desire for them and the ability to pay for them, you do
have demand for CDs. Price is one of the major factors that influence demand. The law of demand states that when the price of a good or service falls, consumers buy more of it. As the price of a good or service increases, consumers usually buy less of it. In other words, quantity demanded and price have an inverse, or opposite, relationship. This relationship is graphically illustrated in Figure 4.1 below. QUICK REFERENCE Law of demand states that when prices go down, quantity demanded increases. When prices go up, quantity demanded decreases. E XAMPLE Price and Demand Let’s take a look at an example of demand in action. Cheryl, a senior at Montclair High School, loves movies and enjoys collecting them on DVD. She and Malik, a friend from school, sometimes meet downtown at Montclair Video Mart to look through the DVD stacks. Rafael, the owner of the video mart, often jokes that Cheryl and Malik spend so much time at his store that he might have to give them jobs. Actually, Cheryl already has a job—stocking shelves at her neighborhood supermarket. She worked so many hours this summer that she has extra money to spend. Let’s see how DVD prices at Montclair Video Mart affect her spending decisions. Cheryl has been saving to buy the DVD boxed set of the original Star Wars trilogy, one of her favorite series of movies. The set costs $69.95, and Cheryl has the money to buy it this weekend. When Cheryl goes to the Montclair Video Mart, she is disappointed to learn that the Star Wars set is sold out and a new shipment won’t arrive for a week. She decides to buy some other DVDs so that she won’t go home empty-handed, but she also decides to save roughly half of her money toward a future purchase of Star Wars. As she looks through the movie DVDs, she sees that most of those she wants sell for $15. How many will she buy at that price? Let’s say she decides to buy three and keep the rest of her money for the Star Wars trilogy. But what if each of the DVDs she wants costs just $5? Cheryl might decide that the price is such a good deal that she can buy seven. As you can see, the law of demand is more than just an economic concept. It’s also a description of how consumers behave. AP P LI CATION Applying Economic Concepts A. You have $50 and want to buy some CDs
. If prices of CDs rose from $5 each to $10, how would your quantity demanded of CDs change? Find an update on the demand for CDs and DVDs at ClassZone.com Demand 99 Demand Schedules KEY CONCEPT S QUICK REFERENCE Demand schedule is a listing of how much of an item an individual is willing to purchase at each price. Market demand schedule is a listing of how much of an item all consumers are willing to purchase at each price. Price and Demand Storeowners often offer products at sale prices to encourage consumers to make more purchases. A demand schedule is a table that shows how much of a good or service an individual consumer is willing and able to purchase at each price in a market. In other words, a demand schedule shows the law of demand in chart form. A market demand schedule shows how much of a good or service all consumers are willing and able to buy at each price in a market. EXAMPLE Individual Demand Schedule A demand schedule is a two-column table that follows a predictable format. The left-hand column of the table lists various prices of a good or service. The right-hand column shows the quantity demanded of the good or service at each price. Cheryl’s demand for DVDs can be expressed in a demand schedule. Let’s take a look at the price list in Figure 4.2 below. How many DVDs will Cheryl buy if they cost $20 each? How many will she buy when the price stands at $10? Your answers to these questions show one thing very clearly. Cheryl’s demand for DVDs depends on their price. Price per DVD ($) Quantity Demanded a b 30 25 20 15 10 $5 0 1 2 3 4 7 a At the top price of $30, Cheryl is not willing to buy any DVDs. b At $10, she will buy four DVDs. Notice that when the price falls, the number of DVDs Cheryl will buy rises. When the price rises, the number she will buy falls. So quantity demanded and price have an inverse, or opposite, relationship. ANALYZE TABLES 1. How many DVDs will Cheryl be likely to buy if the price is $15? 2. What is the relationship between Cheryl’s demand for DVDs and various quantities demanded shown on this table? Use an interactive demand schedule at ClassZone.com 100 Chapter 4 E XAMPLE Market Demand Schedule The demand schedule in Figure 4.2 shows how many DVDs an individual, Cheryl, is willing and able to buy at
each price in the market. The schedule also shows that the quantity of DVDs that Cheryl demands rises and falls in response to changes in price. Sometimes, however, an individual demand schedule does not give business owners enough information. For example, Rafael, who owns Montclair Video Mart, needs information about more than just one consumer before he can price his merchandise to gain the maximum number of sales. He needs a market demand schedule, which shows the quantity demanded by all the people in a particular market who are willing and able to buy DVDs. Take a look at the DVD market demand schedule below. Notice that it’s similar to the individual demand schedule except that the quantities demanded are much larger. It also shows that, like individual demand, market demand depends on price. Price per DVD ($) Quantity Demanded a b c 30 25 20 15 10 5 50 75 100 125 175 300 a At the top price of $30, Rafael’s customers will buy 50 DVDs. b At the middle price of $15, the quantity demanded of DVDs is 125. c At the low price of $5, the quantity demanded rises to 300. So, markets behave in the same way as individual consumers. As prices fall, the quantity demanded of DVDs rises. As prices rise, the quantity demanded falls. ANALYZE TABLES 1. How does the quantity demanded of DVDs change when the price drops from $25 to $10? 2. How does this market demand schedule illustrate the law of demand? CONNECT TO MATH How would a merchant use this schedule to decide on a price? First, the merchant would calculate the total revenue at each price. To ﬁ gure out total revenue, multiply the price per DVD by the quantity demanded. $30.00 50 Price Quantity $1,500.00 Total Revenue How did Rafael create a market demand schedule? First, he surveyed his customers, asking them how many DVDs they would buy at different prices. Next, he reviewed his sales figures to see how many DVDs he sold at each price. Techniques such as these for investigating a specific market are called market research. Market research involves the gathering and evaluating of information about customer preferences. (You’ll learn more about market research in Chapter 7.) By tabulating the results of his market research, Rafael created his market demand schedule. AP P LI CATION Applying Economic Concepts B. Imagine that you have discovered a restaurant that makes the best pizza you have ever tasted. Create a demand schedule showing how many pizzas a month
you would buy at the prices of $25, $20, $15, $10, and $5. Demand 101 Demand Curves KEY CONCEPT S QUICK REFERENCE Demand curve graphically shows the data from a demand schedule. Market demand curve graphically shows the data from a market demand schedule. A demand curve is a graph that shows how much of a good or service an individual will buy at each price. In other words, it displays the data from an individual demand schedule. Creating a demand curve simply involves transferring data from one format, a table, to another format, a graph. A market demand curve shows the data found in the market demand schedule. In other words, it shows the quantity that all consumers, or the market as a whole, are willing and able to buy at each price. A market demand curve shows the sum of the information on the individual demand curves of all consumers in a market. EXAMPLE Individual Demand Curve Study the demand curve (Figure 4.4 below) created from Cheryl’s demand schedule. How many DVDs will Cheryl buy at the price of $15? How will Cheryl’s quantity demanded change if the price rises by $5 or falls by $5? Find the answers to these questions by running your finger along the curve. As you can see, the demand curve is a visual representation of the law of demand. When prices go up, the quantity demanded goes down; when prices go down, the quantity demanded goes up. You should note that this demand curve and the schedule on which it is based were created using the assumption that all other economic factors except price remain the same. You’ll learn more about these factors and how they affect demand in Section 2. FIGURE 4.4 CHERYL’ S DVD DEMAND CURVE CONNECT TO MATH One common mistake people make is to look at the downward-sloping graph and think it means that quantity demanded is decreasing. However, if you move your ﬁ nger downward and to the right on the demand curve, you’ll notice that the quantity demanded is increasing 30 25 20 15 10 5 0 102 Chapter 4 Price per DVD ($) Quantity Demanded a The vertical axis of the 30 25 20 15 10 5 0 1 2 3 4 7 graph shows prices, with the highest at the top. b The horizontal axis shows quantities demanded, with the lowest on the far left. c Notice that demand curves slope downward from upper left to lower right. a b c 2 1
6 Quantity demanded of DVDs 3 5 4 7 ANALYZE GRAPHS 1. How many DVDs will Cheryl buy when the price is $10? 2. How does this demand curve illustrate the law of demand? Use an interactive demand curve at ClassZone.com E XAMPLE Market Demand Curve Like Cheryl’s individual demand curve, the market demand curve for Montclair Video Mart shows the quantity demanded at different prices. In other words, the graph shows the quantity of DVDs that all consumers, or the market as a whole, are willing and able to buy at each price. Despite this difference, the market demand curve for Montclair Video Mart (Figure 4.5) is constructed in the same way as Cheryl’s individual demand curve. As in Figure 4.4, the vertical axis displays prices and the horizontal axis displays quantities demanded. FIGURE 4.5 DVD MARKET DEMAND CURVE ) 30 25 20 15 10 5 0 Price per DVD ($) Quantity Demanded 30 25 20 15 10 5 50 75 100 125 175 300 100 150 50 Quantity demanded of DVDs 200 250 300 Notice that market demand curves slope downward from upper left to lower right, just as individual demand curves do. The main difference between the two types of demand curves is that the quantities demanded at each price are much larger on a market demand curve. This is because the curve represents a group of consumers (a market), not just one consumer. NEED HELP? Throughout this chapter, you will be asked to create and to analyze demand curves. If you need help with those activities, see “Interpreting Graphs.” Skillbuilder Handbook, page R29 ANALYZE GRAPHS 1. At which price will Montclair Video Mart sell 175 DVDs? 2. Cheryl was unwilling to buy any DVDs at $30. Montclair Video Mart can sell 50 DVDs at that price. How do you explain the difference? Look at Figure 4.5 above one more time. What is the quantity demanded at the price of $15? How will quantity demanded change if the price increases by $5 or drops by $5? Once again, find the answers to these questions by running your finger along the curve. As you can see, the market demand curve—just like the individual demand curve—vividly illustrates the inverse relationship between price and quantity demanded. If price goes down, the quantity demanded goes up. And if price goes up, the quantity demanded goes down. Also, like the individual demand curve, the market demand curve
is constructed on the assumption that all other economic factors remain constant—only the price of DVDs changes. AP P LI CATION Applying Economic Concepts C. Look back at the demand schedule for pizzas you created for Application B on page 101. Use it to create a demand curve. Create a demand curve at ClassZone.com Demand 103 ECO N O M I C S PAC ES E T T E R Vera Wang: Designer in Demand In this section, you’ve learned about the law of demand. You’ve also seen demand in action in some hypothetical situations. The story of fashion designer Vera Wang, however, provides a real-world example of demand at work. When they married, Mariah Carey, Jennifer Lopez, and several other stars turned to Wang for their wedding dresses. What explains the demand for this one woman’s gowns? Responding to Demand Vera Wang had worked in the fashion industry for more than 15 years by the time she started planning her own wedding in 1989. So she was frustrated when she couldn’t find the type of sophisticated bridal gown she wanted. She knew that many modern brides were savvy career women who preferred designer clothing. Yet, no one was making wedding dresses for those women. Changing Styles Vera Wang wanted to change traditional wedding dress styles that, she thought, made brides look “like the bride on top of a cake, very decorated.” The next year, Wang decided to fill that unmet demand. She created her own line of gowns featuring elegant sleeveless styles rather than the hooped skirts, puffed sleeves, and lace flounces that had dominated weddingdress designs before. Soon celebrities such as Uma Thurman were choosing Vera Wang wedding gowns. This generated publicity, and demand for Wang’s creations grew. In response, other designers began to create sleeker wedding dresses, and the style spread. Vera Wang is now considered to be one of the country’s most influential designers of wedding gowns. Demand for the sophisticated Wang style has spread beyond weddings. In recent years, Wang has expanded her product line to include ready-to-wear dresses, perfume, accessories, and home fashions. APPLICATION Analyzing Cause and Effect D. In what ways did Vera Wang respond to consumer demand? In what ways did she generate consumer demand? FAST FACTS Vera Wang Title: Chairman and CEO of Vera Wang Ltd. Born: June 27, 1949, New York, New York Major Accomplishment:
Designer of high-fashion wedding gowns Other Products: Clothing, perfume, eyewear, shoes, jewelry, home fashions Books: Vera Wang on Weddings (2001) Price Range for Vera Wang Wedding Gowns: about $2,000 to $20,000 Find the latest on Vera Wang’s business at ClassZone.com 104 Chapter 4 S E C T I O N 1 Assessment ClassZone.com AC T I C E 1. Explain the differences between the terms in each of these pairs: a. demand law of demand b. demand schedule demand curve c. market demand schedule market demand curve 2. Look at Figure 4.1 on page 99. Write a caption for the figure that explains the law of demand. 3. Review the information on Vera Wang on the opposite page. Why is it unlikely that most brides will have demand for an original Vera Wang gown? 4. How might an owner of a bookstore put together a market demand schedule for his or her store? 5. Why does the demand curve slope downward? 6. Using Your Notes How are price and quantity demanded related? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com demand 7. Drawing Conclusions List three products that you are familiar with and the approximate price of each. Which of the products, if any, do you have a demand for? Consider the two requirements of demand as you answer this question. 8. Making Inferences Why might Rafael’s market demand schedule and curve not be an accurate reflection of the actual market? To answer this question, consider the assumption that was made when the schedule and curve were created. 9. Applying Economic Concepts Return to the demand schedule for pizzas you created for Application B on page 101. Assume that your class is the market for pizzas. Tabulate these individual demand schedules to create a market demand schedule. Then use that schedule to draw a market demand curve. 10. Challenge Does quantity demanded always fall if the price rises? List several goods or services that you think would remain in demand even if the price rose sharply. Why does demand for those items change very little? (You will learn more about this topic in Section 3.) Making a Market Demand Curve Suppose that you own a store that sells athletic shoes. You survey your customers and analyze your sales data to see how many pairs of shoes you can expect to sell at various prices. Your research enables you to make the following market demand schedule. Price per Pair of
Shoes ($) Quantity Demanded 175 150 125 100 75 50 0 10 20 40 70 110 Create a Demand Curve Use this market demand schedule to create a market demand curve. Challenge Write a caption for your market demand curve explaining what it shows. Use to complete this activity. @ClassZone.com Demand 105 S E C T I O N 2 What Factors Affect Demand TA K I N G N O T E S In Section 2, you will • determine a change in quantity demanded • explain the difference between change in quantity demanded and change in demand • determine a change in demand • analyze what factors can cause change in demand law of diminishing marginal utility, p. 106 income effect, p. 107 substitution effect, p. 107 change in quantity demanded, p. 108 change in demand, p. 109 normal goods, p. 110 inferior goods, p. 110 substitutes, p. 112 complements, p. 112 As you read Section 2, complete a chart that shows each factor that causes change in demand. Use the Graphic Organizer at Interactive Review @ ClassZone.com Factor That Changes Demand Reason Why Demand Changes More About Demand Curves KEY CONCEPT S The demand schedules and demand curves that you studied in Section 1 were created using the assumption that all other economic factors except the price of DVDs would remain the same. If all other factors remain the same, then the only thing that influences how many DVDs consumers will buy is the price of those DVDs. The demand curve graphically displays that pattern. Now think about the shape of demand curves. Why do they slope downward? The reason is the law of diminishing marginal utility, which states that the marginal benefit from using each additional unit of a good or service during a given time period tends to decline as each is used. Recall that utility is the satisfaction gained from the use of a good or service. Suppose it is a hot day, and you have just gulped down a glass of lemonade. Would you gain the same benefit from drinking a second glass? How about a third? In all likelihood, you’d find the second glass less satisfying than the first, and the third glass less satisfying than the second. Because consumers receive less satisfaction from each new glass of lemonade they drink, they don’t want to pay as much for additional purchases. So, they will buy QUICK REFERENCE Law of diminishing marginal utility states that the marginal benefit of using each additional unit of a product during a given period will decline. 106 Chapter 4 two glasses only if the lemonade is offered at
a lower price, and they will buy three only if the price is even lower still. This pattern of behavior, which holds true for most consumer goods and services, creates the downward slope of the demand curve. For another example, see Figure 4.6 below, which displays the demand that a young man named Kent has for video games. FIGURE 4.6 DIMINISHING MARGINAL UTILITY ) 90 75 60 45 30 15 0 1 2 3 4 5 6 7 Quantity demanded of video games This graph displays the demand for video games by a high school senior named Kent. The demand curve slopes downward because of the law of diminishing marginal utility, which states that the marginal benefit of using each additional unit of a product during a given period will decline. Because of that declining satisfaction, Kent will buy additional games only at lower prices. ANALYZE GRAPHS How many video games is Kent willing to buy at a price of $45? How does the law of diminishing marginal utility explain his refusal to buy more games at that price? Why do consumers demand more goods and services at lower prices and fewer at higher prices? Economists have identified two patterns of behavior as causes: the income effect and the substitution effect. The income effect is the term used for a change in the amount of a product that a consumer will buy because the purchasing power of his or her income changes—even though the income itself does not change. For example, you can buy more paperback books if they are priced at $7 than if they are priced at $15. If you buy a $7 book, you will feel $8 “richer” than if you buy a $15 book, so you are more likely to buy another book. The income effect also influences behavior when prices rise. You will feel $8 “poorer” if you buy a $15 book instead of a $7 one, so you will buy fewer books overall. The substitution effect is the pattern of behavior that occurs when consumers react to a change in the price of a good or service by buying a substitute product— one whose price has not changed and that offers a better relative value. For example, if the price of paperback books climbs above $10, consumers might decide to buy fewer books and choose instead to buy $4 magazines. AP P LI CATION Drawing Conclusions A. Malik goes to the mall to buy a $40 pair of blue jeans and discovers that they are on sale for $25. If Malik buys two pairs,
is this an example of the income effect or the substitution effect? Explain your answer. QUICK REFERENCE Income effect is the change in the amount that consumers will buy because the purchasing power of their income changes. Substitution effect is a change in the amount that consumers will buy because they buy substitute goods instead. Demand 107 Change in Quantity Demanded KEY CONCEPT S Remember that each demand curve represents a specific market situation in which price is the only variable. A change in the amount of a product that consumers will buy because of a change in price is called a change in quantity demanded. Each change in quantity demanded is shown by a new point on the demand curve. A change in quantity demanded does not shift the demand curve itself. EXAMPLE Changes Along a Demand Curve Let’s look again at Cheryl’s demand curve for DVDs (Figure 4.7 below). Note the quantities demanded at each price. Notice that as quantity demanded changes, the change is shown by the direction of the movement right or left along the demand curve. FIGURE 4.7 CHANGE IN QUANTITY DEMANDED ) 30 25 20 15 10 Quantity demanded of DVDs A change in quantity demanded doesn’t shift the demand curve. The change refers to movement along the curve itself. Each point on the curve represents a new quantity demanded. a As you move to the right along the curve, the quantity demanded increases. b As you move to the left, the quantity demanded decreases. ANALYZE GRAPHS 1. What is the change in quantity demanded when the price drops from $20 to $10? 2. What is the direction of the movement along the demand curve when the quantity decreases? Use an interactive demand curve to see changes in quantity demanded at ClassZone.com Figure 4.7 shows change in quantity demanded for one person. A market demand curve provides similar information for an entire market. However, market demand curves have larger quantities demanded and larger changes to quantity demanded because they combine data from all individual demand curves in the market. APPLICATION Applying Economic Concepts B. Why do increases or decreases in quantity demanded not shift the position of the demand curve? QUICK REFERENCE Change in quantity demanded is an increase or decrease in the amount demanded because of change in price. 108 Chapter 4 Change in Demand KEY C ONCEPT S Consider what might happen if you lose your job. If you aren’t earning money, you aren’t likely to buy many CDs or movie tickets or magazines—no matter how low
the price. Similarly, when national unemployment rises, people who are out of work are more likely to spend their limited funds on food and housing than on entertainment. Fewer people would be buying DVDs at every price, so market demand would drop. This is an example of a change in demand, which occurs when a change in the marketplace such as high unemployment prompts consumers to buy different amounts of a good or service at every price. Change in demand is also called a shift in demand because it actually shifts the position of the demand curve. QUICK REFERENCE Change in demand occurs when something prompts consumers to buy different amounts at every price. FIGURES 4.8 AND 4.9 CHANGE IN DEMAND FIGURE 4.8 DECREASE IN DEMAND FIGURE 4.9 INCREASE IN DEMAND 60 50 40 30 20 10 a D2 D1 60 50 40 30 20 10 b 0 1 2 3 4 5 6 7 Quantity demanded of baseball cards Quantity demanded of baseball cards ANALYZE GRAPHS 1. In Figure 4.8, how has demand for baseball cards changed at each of these prices: $20, $30, and $40? 2. In Figure 4.9, how has demand for baseball cards changed at each of these prices: $30, $40, and $50? Use an interactive version of shifting demand curves at ClassZone.com Six factors can cause a change in demand: income, market size, consumer tastes, consumer expectations, substitute goods, and complementary goods. An explanation of each one follows. FACT OR 1 Income If a consumer’s income changes, either higher or lower, that person’s ability to buy goods and services also changes. For example, Tyler works at a garden center. He uses his earnings to buy baseball cards for his collection. In the fall, people garden less and buy fewer gardening products, so Tyler works fewer hours. His smaller paycheck means that he has less money to spend, so he demands fewer baseball cards at every price. Figure 4.8 shows this change. The entire demand curve shifts to the left. When a change in demand occurs, the demand curve shifts. a As Figure 4.8 shows, a shift to the left (D2) indicates a decrease in demand. D1 D3 b As Figure 4.9 shows, a shift to the right (D3) indicates an increase in demand. Demand 109 QUICK REFERENCE Normal goods are goods that consumers demand more of when their incomes rise
. Inferior goods are goods that consumers demand less of when their incomes rise. Suppose, however, that Tyler is promoted to supervisor and receives a raise of $2 an hour. Now he has more money to spend, so his demand for baseball cards increases and his demand curve shifts to the right—as shown in Figure 4.9 on page 109. As you might guess, changes in income also affect market demand curves. When the incomes of most consumers in a market rise or fall, the total demand in that market also usually rises or falls. The market demand curve then shifts to the right or to the left. Increased income usually increases demand, but in some cases, it causes demand to fall. Normal goods are goods that consumers demand more of when their incomes rise. Inferior goods are goods that consumers demand less of when their incomes rise. Before his raise, Tyler shopped at discount stores for jeans and T-shirts. Now that he earns more, Tyler can afford to spend more on his wardrobe. As a result, he demands less discounted clothing and buys more name-brand jeans and tees. Discounted clothing is considered an inferior good. Other products that might be considered inferior goods are used books and generic food products. YO U R EC NORMAL GOODS AND IN FE RIOR GOODS If your income rises, which car will you choose? Most people prefer to buy a new car if they can afford it. Used cars are an example of inferior goods—demand for them drops when incomes rise because people prefer new-car quality to getting a bargain.? ▲ New car ▲ Used truck FACTOR 2 Market Size If the number of consumers increases or decreases, the market size also changes. Such a change usually has a corresponding effect on demand. Suppose that the town of Montclair is on the ocean. Each summer, thousands of tourists rent beachfront cottages there. As a result, the size of the population and the market grows. So what do you think happens to the market demand curve for pizza in Montclair in the summer? Check the two graphs at the top of the next page. Population shifts have often changed the size of markets. For example, in the last 30 years, the Northeast region of the United States lost population as many people moved to the South or the West. The causes of the population shift included the search for a better climate, high-tech jobs, or a less congested area. 110 Chapter 4 FIGURES 4.10 AND 4.11 IMPACT
OF CHANGES IN MARKET SIZE FIGURE 4.10 MONTCLAIR’ S POPULATION DURING TOURIST SEASON FIGURE 4.11 CHANGE IN PIZZA MARKET DEMAND CURVE 20 15 10 Apr. May June July Aug. Sept. 28 24 20 16 12 August D2 May D1 50 100 150 200 250 300 Months Quantity demanded of pizzas ANALYZE GRAPHS 1. During what month was the population of Montclair at its highest? What happened to the demand for pizzas during that month? Explain. 2. What would you expect to happen to the market demand curve in September? Explain. One economic result of the migration is that the overall market size of the Northeast has shrunk, while the market size of the South and the West has grown. This change in market size has altered the demand for many products, from essentials such as homes, clothing, and food to nonessentials such as movie tickets. Demand for most items will grow in booming regions and decrease in regions that are shrinking. FACT OR 3 Consumer Tastes Because of changing consumer tastes, today’s hot trends often become tomorrow’s castoffs. When a good or service enjoys high popularity, consumers demand more of it at every price. When a product loses popularity, consumers demand less of it. Advertising has a strong influence on consumer tastes. Sellers advertise to create demand for the product. For example, some people stop wearing perfectly good pants that still fit because advertising convinces them that the style is no longer popular and that a new style is better. Think about your own closet. Doesn’t it contain some item of clothing that you just had to have a year ago, but would never pay money for now? You’ve just identified an instance of consumer taste changing demand. Consumer tastes also affect demand for other products besides clothing. When was the last time you saw someone buying a telephone that had to be attached to the wall by a cord? FACT OR 4 Consumer Expectations Your expectations for the future can affect your buying habits today. If you think the price of a good or service will change, that expectation can determine whether you buy it now or wait until later. When a change in market size occurs, it often causes a change in demand. a Figure 4.10 shows how the population of Montclair changed during the last tourist season. Notice which month had the highest population. b Notice that the market demand curve (D2)
shifts to the right between May and August. Find an update on changing consumer tastes at ClassZone.com Demand 111 QUICK REFERENCE Substitutes are goods and services that can be used in place of each other. Let’s look at one example of how consumer expectations shape demand. Automobiles usually go on sale at the end of summer because dealers want to get rid of this year’s models before the new models arrive. Would you expect demand for new cars to be higher in May, before the sales, or in August, during the sales? It is higher in August because consumers expect the sales and often choose to wait for them. FACTOR 5 Substitute Goods Goods and services that can be used in place of other goods and services to satisfy consumer wants are called substitutes. Because the products are interchangeable, if the price of a substitute drops, people will choose to buy it instead of the original item. Demand for the substitute will increase while demand for the original item decreases. People may also turn to substitutes if the price for the original item becomes too high. Again, demand for the substitute rises while demand for the original item drops. Substitutes can be used in place of each other. For example, when gasoline prices are high, some people decide to commute to school by bus or train. When gasoline prices are low, a higher number of people choose to drive instead of to take public transportation. As you can see from that example, when the price of one good rises, demand for it will drop while demand for its substitute will rise. YO U R EC SU BSTITUTE SERVIC ES How would you decide whether to take a cab or a bus? Taxis have certain advantages; they will take you to a speciﬁ c place at a speciﬁ c time. But if taxi fares rise, you might give up the convenience and go by bus instead.? Taxi City bus FACTOR 6 Complementary Goods When the use of one product increases the use of another product, the two products are called complements. An increase in the demand for one will cause an increase in the demand for the other. Likewise, a decrease in demand for one will cause a decrease in demand for the other. In contrast to substitutes, complements are goods or services that work in tandem with each other. An increase in demand for one will cause an increase in demand for the other. One example is CDs and CD players. Consumers who bought CD players QUICK REFERENCE Comple
ments are goods that are used together, so a rise in demand for one increases the demand for the other. 112 Chapter 12 Factors That Cause a Change in Demand Income Increased income means consumers can buy more. Decreased income means consumers can buy less. Complements When the use of one product increases the use of another product, the two are called complements. Substitutes Substitutes are goods and services that can be used instead of other goods and services, causing a change in demand. What Causes a Change in Demand? Market Size A growing market usually increases demand. A shrinking market usually decreases demand. Consumer Tastes The popularity of a good or service has a strong effect on the demand for it, and in today’s marketplace, popularity can change quickly. Consumer Expectations What you expect prices to do in the future can influence your buying habits today. ANALYZE CHARTS Choose a product used by most consumers, and create a hypothetical demand curve showing demand for that product in a town of 1,000 people. Label it A. On the same graph, add a demand curve showing demand if the population drops to 700. Label it B. Which factor on the chart does the shift in the demand curve represent? also demanded CDs to play on them. And, as CDs became more popular, demand for CD players grew until they began to appear in places they had never been before, such as in the family minivan. Therefore, with complements, if the price of one product changes, demand for both products will change in exactly the same way. If the price for one product rises, demand for both will drop. Conversely, if the price for one product drops, demand for both will rise. AP P LI CATION Categorizing Information C. Choose one of the following products: soda, hamburgers, pencils, or tennis rackets. On your own paper, list as many substitutes and complements for the product as you can. Compare your lists with those of a classmate. Demand 113 For more on analyzing political cartoons, see the Skillbuilder Handbook, page R26. Analyzing Political Cartoons Political cartoons often deal with economic themes. Because of this, you will find that the skill of interpreting political cartoons helps you to understand the economic issues on people’s minds. TECHNIQUES USED IN POLITICAL CARTOONS Political cartoonists use many techniques to deliver their message. The techniques used in this cartoon include: Exaggeration The cartoonist has shown the automobile as towering over
shoes that you created on page 105. Add a new curve showing how demand would be changed if the most popular basketball player in the NBA endorses a brand of shoes that your store does not sell. Share your graph with a classmate and explain your reasoning. 10. Challenge Do you think changes in consumer taste are most often initiated by the consumers themselves or by manufacturers and advertisers? Explain your answer, using real-life examples. Explaining Changes in Demand Think about different types of bicycles: road bikes, mountain bikes, hybrid bikes. What factors affect demand for bicycles? Identify Factors Affecting Demand The table below lists examples of a change in demand in the market for bicycles. For each example, identify which factor that affects demand is involved. Example of Change in Demand Factor That Affected Demand Electric scooter sales rise, and bike sales fall. The cost of aluminum alloy bike frames is about to rise; consum– ers buy bikes now. Using a folding bicycle becomes a fad among commuters. Sales of this type of bike boom. The U.S. birth rate declined for 10 years in a row, eventually causing a drop in sales of children’s bikes. Challenge Identify the two factors affecting demand that do not appear on this table. Provide examples of how these factors might affect demand for bicycles. Demand 115 S E C T I O N 3 What Is Elasticity of Demand TA K I N G N O T E S In Section 3, you will elasticity of demand, p. 117 • define elasticity of demand • identify the difference between elastic and inelastic demand • define unit elastic • determine how total revenue is used to identify elasticity elastic, p. 117 inelastic, p. 117 unit elastic, p. 118 total revenue, p. 122 total revenue test, p. 122 As you read Section 3, complete a cluster diagram using the key concepts and other terms. Use the Graphic Organizer at Interactive Review @ ClassZone.com Elasticity of Demand Elasticity of Demand KEY CONCEPT S You have learned that there are many factors that influence the demand for a product. However, those factors alone are not the only influences on the sales of goods and services. How does the owner of an electronics store know how to price his or her goods so that the entire inventory of PDAs, or personal digital assistants, are sold? Store owners know that consumers are responsive to changes in price. Let’s examine the relationship between price and demand, and how it affects consumers’ buying habits.
Consumer demand is not limitless. It is highly dependent on price. But as you know, demand is seldom fixed. As a result, price is also seldom fixed. Generally, people assume that if prices rise consumers will buy less, and if prices drop consumers will buy more. However, this isn’t always the case. The relationship between price and demand is somewhat more complicated than you might think. Change in consumer buying habits is also related to the type of good or service being produced and how important the good or service is to the consumer. The marketplace certainly is very sensitive to changes in price—but not all increases in price will result in a decrease in demand. 116 Chapter 4 Economists use the term elasticity of demand to describe how responsive consumers are to price changes in the marketplace. Economists describe demand as being either elastic or inelastic. Demand is elastic when a change in price, either up or down, leads to a relatively larger change in the quantity demanded. The more responsive to change the market is, the more likely the demand is elastic. On the other hand, demand is inelastic when a change in price leads to a relatively smaller change in the quantity demanded. For this reason, elastic goods and services are often said to be price sensitive. So, in the case of inelastic demand, changes in price have little impact on the quantity demanded. Another way to think about elasticity is to imagine that a rubber band represents quantity demanded. When the quantity demanded increases by a marked amount, the demand is elastic and the rubber band stretches. If the quantity demanded barely changes, demand is inelastic and the rubber band stretches very little. QUICK REFERENCE Elasticity of demand is a measure of how responsive consumers are to price changes. Demand is elastic if quantity demanded changes signiﬁ cantly as price changes. Demand is inelastic if quantity demanded changes little as price changes. E XAMPLE Elasticity of Demand for Goods and Services Let’s look at an example of elastic demand. Suppose that a certain brand of PDAs goes on sale. If the price of that brand goes down 20 percent, and the quantity demanded goes up 30 percent, then demand is elastic. The percentage change in quantity demanded is greater than the percentage change in price. Goods that have a large number of substitutes fall into the elastic category, since if the prices change, consumers can choose other products. Now think about a completely different type of good—the medicine insulin. Many diabetics
require daily insulin injections to regulate their blood sugar levels. Even if the price of insulin were to rise sharply, diabetics would still need the same amount of insulin as they did before. If the price were to drop, they would not need any more insulin than their required dosage. As a result, the demand for insulin is inelastic because the quantity demanded remains relatively constant. YO U R EC EC ESSIT Y O R C HOIC E Which of these services could you give up? Most people consider getting a cavity ﬁ lled to be a necessity. Having your teeth whitened is a service that can be postponed or eliminated without harm. As a result, the demand for whitening is more elastic than the demand for ﬁ llings.? ▲ Cosmetic whitening ▲ Filling a cavity Demand 117 Over time the elasticity of demand for a particular product may change. If more substitutes for a product become available, the demand may become more elastic. For example, the cost of cell phones and their service has become more elastic as more providers enter the market. On the other hand, in the case of prescription drugs, if a product is withdrawn from the market and there are fewer choices for the consumer, the demand may become inelastic. The data for elastic demand and the data for inelastic demand produce demand curves that look very different from each other. Compare Figure 4.13 and Figure 4.14 below. Notice that the inelastic demand curve has a steeper slope than the elastic demand curve does. The reason for this difference is that the changes along the vertical axis (the price) are proportionally greater than the changes along the horizontal axis (the quantity demanded). FIGURE 4.13 ELASTIC DEMAND CURVE FIGURE 4.14 INELASTIC DEMAND CURVE ) 12 10 300 250 200 150 100 50 b 4 8 12 16 20 0 20 40 60 80 100 120 a In Figure 4.13, elastic demand curves have gradual slopes. They are more horizontal than vertical because of the greater changes in quantity demanded. b In Figure 4.14, inelastic demand curves have steep slopes. They are more vertical than horizontal because quantity demanded changes very little. Quantity demanded of movie tickets (in thousands) Quantity demanded of fillings ANALYZE GRAPHS 1. In Figure 4.13, what happens to the quantity demanded when price drops from $10 to $8? 2. In Figure 4.14, what is
the difference in quantity demanded between the most expensive and least expensive filling? Use elastic and inelastic demand curves at ClassZone.com QUICK REFERENCE Demand is unit elastic when the percentage change in price and quantity demanded are the same. Demand is said to be unit elastic when the percentage change in price and quantity demanded are the same. In other words, a 10 percent increase in price would cause exactly a 10 percent drop in quantity demanded, while the reverse would be true. No good or service is ever really unit elastic. Instead, unit elasticity is simply the dividing point between elastic and inelastic demand. It is a useful concept for figuring out whether demand is elastic or inelastic. APPLICATION Drawing Conclusions A. Decide how elastic demand is for the following item. Explain your reasoning. When a grocery store sells soup at $1.09 per can, it sells 1,500 cans per week. When it dropped the price to $0.75, it sold an additional 1,000 cans. 118 Chapter 4 What Determines Elasticity? KEY C ONCEPT S Just as there are factors that cause a change in demand, there are also factors that affect the elasticity of demand. The factors that affect elasticity include the availability of substitute goods or services, the proportion of income that is spent on the good or service, and whether the good or service is a necessity or a luxury. FACT OR 1 Substitute Goods or Services Generally speaking, if there is no substitute for a good or service, demand for it tends to be inelastic. Think back to the consumers who need insulin to regulate their blood sugar levels. No substitute exists for insulin, so consumers’ demand is inelastic even when the price goes up. If many substitutes are available, however, demand tends to be elastic. For example, if the price shoots up for beef, consumers can eat chicken, pork, or fish. In this case, demand is elastic. FACT OR 2 Proportion of Income The percentage of your income that you spend on a good or service is another factor that affects elasticity. Suppose that photography is your hobby, and you spend about 10 percent of your income on a digital camera, memory cards, software programs, and lenses. If the price for any of these rises even slightly, your demand will likely fall because you just don’t have any more money to spend on your hobby. Your demand is elastic. At the same time, demand for products that cost little of your income
tends to be inelastic. For example, if the cost of pencils or ballpoint pens rose, would you buy fewer pencils and pens? Probably not. You spend so little on these items that you could easily pay the increase. Find an update on factors affecting elasticity at ClassZone.com YO U R EC PROPORTION OF INCO M E How much would you invest in a hobby? This amateur photographer spends about 10 percent of her income to pay for her digital camera and supplies. If the costs of taking photographs rise sharply, she won’t be able to increase her demand by an equal amount because she won’t have enough money to pay for the additional expenses.? Demand 119 If the level of your income increases, you are likely to increase your demand for some goods or services. Suppose you ordinarily see one movie per month. If your income increases, you may choose to attend the movies several times a month. FACTOR 3 Necessities Versus Luxuries A necessity is something you must have, such as food or water. Demand for necessities tends to be inelastic. Even if the price rises, consumers will pay whatever they can afford for necessary goods and services. But that doesn’t mean that consumers will buy the same quantities no matter what the price. If the price of a necessity such as milk rises too much, consumers may choose to buy a substitute, such as a cheaper brand of milk or powdered milk. The quantity demanded of milk will change as the law of demand predicts; however, the change in quantity demanded is smaller than the change in price, so demand is inelastic. In contrast, a luxury is something that you desire but that is not essential to your life, such as a plasma television. The demand for luxuries tends to be elastic. Consumers will think twice about paying a higher price for something they don’t truly need. The change in quantity demanded is much greater than the change in price. F I G U R E 4.15 Estimating Elasticity By examining the three factors that affect elasticity, you can often estimate whether demand for a certain good or service will be elastic or inelastic. Products Table Salt Ice Cream Sports Car Gasoline Insulin Braces on Teeth no yes yes no no no small small large small small large necessity luxury luxury necessity necessity luxury Are there good substitutes? yes = elastic no = inelastic What proportion of income does it use? large = elastic small = inelastic Is it
a necessity or a luxury? luxury = elastic necessity = inelastic Conclusion inelastic elastic elastic inelastic inelastic elastic ANALYZE TABLES What patterns can you see in the factors that affect elasticity? Write a sentence summarizing your answer. APPLICATION Evaluating B. Create a chart like the one above for the following products: mountain bikes, airplane tickets, and home heating oil. Determine if the products are elastic or inelastic. 120 Chapter 4 Calculating Elasticity of Demand KEY C ONCEPT S Businesses find it useful to figure the elasticity of demand because it helps them to decide whether to make price cuts. If demand for a good or service is elastic, price cuts might help the business earn more. If demand is inelastic, price cuts won’t help. To determine elasticity, economists look at whether the percentage change in quantity demanded is greater than the percentage change in price. To calculate that relationship, economists use mathematical formulas. One such set of formulas is shown below. Another way to determine elasticity is shown on page 122. M AT 16 Calculating the Elasticity of Demand Step 1: Calculate percentage change in quantity demanded. (If the final result is a negative number, treat it as positive.) Original quantity – New quantity Original quantity 100 = Percentage change in quantity demanded Example Calculations 2,000 – 6,000 2000 100 = 200% Step 2: Calculate percentage change in price. (If the final result is a negative number, treat it as positive.) Original price – New price Original price 100 = Percentage change in price 10 – 8 10 100 = 20% Step 3: Calculate elasticity. Percentage change in quantity demanded Percentage change in price = Elasticity 200% 20% = 10 Step 4: After doing your calculations, if the final number is greater than 1, demand is elastic. If the final number is less than 1, demand is inelastic. Advanced Calculations Economists use a more complex version of these formulas. In Step 1, instead of dividing the change in quantity demanded by the original quantity demanded, they divide it by the average of the original and new quantities. In Step 2, they divide change in price by an average of the original price and new price. NEED HELP? Math Handbook, “Calculating and Using Percents,” page R4 AP P LI CATION Applying Economic Concepts C. Choose two points on the demand curve shown in Figure 4.13 and determine
the price and quantity demanded for each point. Then use that data to calculate elasticity of demand. Demand 121 Total Revenue Test KEY CONCEPT S Businesses need to know about elasticity of demand because it influences the amount of revenue they will earn. Economists measure elasticity of demand by calculating a seller’s total revenue, the amount of money a company receives for selling its products. Total revenue is calculated using the following formula, in which P is the price and Q is the quantity sold: TOTAL REVENUE = P Q. You can measure elasticity by comparing the total revenue a business would receive when offering its product at various prices. This method is the total revenue test. If total revenue increases after the price of a product drops, then demand for that product is considered elastic. Why? Because even though the seller makes less on each unit sold, the quantity demanded has increased enough to make up for the lower price. For example, if a hot dog stand sells 100 hot dogs for $2.50 each, the total revenue is $250 for the day. However, if the price of hot dogs drops to $2.00 each and 150 are sold, the total revenue for the day will be $300. The demand is elastic. But if the total revenue decreases after the price is lowered, demand is considered inelastic. If the hot dog stand lowers its price to $1.00 each and sells 200 hot dogs, it makes $200 in total revenue. Clearly, the price reduction has caused only a modest increase in quantities sold, which is not enough to compensate for lower revenues. EXAMPLE Revenue Table Let’s look at an example of demand for movie tickets. In Figure 4.17, you can see how total revenues show whether demand is elastic or inelastic. Price of a Movie Ticket ($) Quantity Demanded per Month Total Revenue ($) a b 12 10 8 6 4 1,000 2,000 6,000 12,000 20,000 12,000 20,000 48,000 72,000 80,000 a At $10 a ticket, the quantity demanded is 2,000. Total revenue is $20,000. b When the price drops to $8, the quantity demanded rises to 6,000. Total revenue rises to $48,000. So, demand is elastic. ANALYZE TABLES When the price range changes from $8 to $6, is demand elastic or inelastic? Explain. APPLICATION Creating Tables D. Use the information
from Figure 4.14 to estimate prices to make a total revenue table. QUICK REFERENCE Total revenue is a company’s income from selling its products. Total revenue test is a method of measuring elasticity by comparing total revenues. 122 Chapter 4 S E C T I O N 3 Assessment ClassZone.com AC T I C E 1. Use each of the terms below in a sentence that gives an example of the term: a. elastic b. inelastic c. total revenue 2. How is total revenue related to elasticity of demand? 3. Why are elastic goods and services said to be price sensitive? 4. What are the factors that affect elasticity of demand and how does each affect elasticity? 5. Analyze the factors that determine elasticity to explain why utilities companies never offer sale prices on their services. 6. Using Your Notes How does the concept of unit elasticity relate to the concepts of elasticity and inelasticity? Refer to your completed cluster diagram. Use the Graphic Organizer at Interactive Review @ ClassZone.com elasticity of demand 7. Analyzing Causes In early 2004, news articles reported that prescription drug prices were rising almost three times faster than the prices of other products. Identify the factors that explain why the drug companies were able to raise prices so sharply. 8. Analyzing Data In June, Snead’s Snack Bar sold 1,000 fruit smoothies at a price of $2.50 each. In July, they sold 1,300 fruit smoothies at a price of $2.00. Is the demand for fruit smoothies elastic or inelastic? Use the formula on page 121 to decide. Show the math calculations to support your answer. 9. Applying Economic Concepts Suppose the company that runs concession stands at a local sports arena wants to increase revenue on sales of soft drinks. The manager believes the only solution is to charge higher prices. As a business consultant, what advice would you give the manager? Use economic thinking to support your answer. 10. Challenge You learned in this section that no product ever has demand that is unit elastic. What possible reasons can you give for that? Draw on what you know about utility, demand, and elasticity as you formulate your answer. Calculating Elasticity Determine the elasticity of bottled water by calculating elasticity and using the revenue table below. Use the information on pages 121 and 122 to help you. Number of Bottles Sold Price ($) 35 75 100 120 2.00 1.
50 1.25 1.00 Write a Summary After you have determined whether bottled water is elastic or inelastic, think about what factors affect the demand for bottled water. Write a summary of your conclusions explaining whether demand is elastic or inelastic and why, and what factors affect the elasticity of water. Challenge What effect might the introduction of a new energy drink have on the demand for bottled water? Use economic thinking to support your answer. Demand 123 Case Study Find an update on this Case Study at ClassZone.com Fueling Automobile Demand Background Automobiles make up a huge portion of the American economy. In recent years the demand for automobiles and all the services connected with them has accounted for approximately one-fifth of all retail sales. Over the past decade, the total number of automobiles, including light trucks and SUVs (Sport Utility Vehicles), sold has been over 16 million units. Car dealers are constantly looking for ways to sustain and increase demand for their product. Paul Taylor, chief economist of the National Automobile Dealers Association, observed, “The key to sales of 16.9 million will be the continued strong economy and sustained incentives.” Incentives are awards designed to lure potential buyers into an automobile showroom and encourage sales. Manufacturers have tried everything from giving away mountain bikes to zero percent financing. What’s the issue? How does demand affect your selection of a vehicle? Study these sources to discover how the law of demand and the factors that affect demand shape the market. A. Online Article Most car dealers offer some sort of incentive. This article discusses Volkswagen’s new approach in dealer incentives to car buyers. Text not available for electronic use. Please refer to the text in the textbook. Thinking Economically Do incentives described in this document change the demand for automobiles or the quantity demanded? Explain your answer. 124 Chapter 4 B. Political Cartoon Brian Duffy, a cartoonist with the Des Moines Register, drew this cartoon about the rising price of gasoline. Thinking Economically Which of the factors that cause a change in demand does this cartoon address? Explain your answer. C. Online Report An auto-buying service linking buyers and sellers examines demand for hybrid automobiles. Hybrid cars get power from a combination of batteries and a gaspowered engine. The Year of the Hybrid Stellar Fuel Efficiency, Low Emissions, and More Power Why do we think 2005 will be The Year of the Hybrid? We can sum it up in two words: Power and SUV. There’s something reassuring about how auto
manufacturers are helping Americans have their cake and eat it too by offering up more fuel-efficient SUVs. Let’s face it, America’s love affair with the SUV shows no sign of waning. Yet... we can’t live in denial that the SUV has a fat appetite for gasoline. And then there’s the power argument. Despite the crowd pleasing fuel efficiency standards offered by hybrids, there was still the complaint that they lacked juice, or horsepower.... 2005’s hybrids will appeal to those of us... who absolutely demand a lot of horsepower. As if overcompensating for being picked on when they were little, 2005’s hybrids are coming out with more horsepower than their gas-only counterparts. Though hybrids tend to be more expensive than their gas- or diesel-only powered cousins, the savings in fuel (and sometimes in taxes) can more than offset this difference in the long run. Source: Invoicedealers.com Thinking Economically Which of the factors affecting demand is evident in this article? Use evidence from the article to support your answer. THINKING ECONOMICALLY Synthesizing 1. How would the demand for automobiles be affected by information presented in each of these documents? Support your answer with examples from the documents. 2. Identify and discuss the factors that affect elasticity of demand illustrated in these documents. 3. Explain how Documents B and C illustrate a cause and effect relationship in the demand for SUVs. Use evidence from these documents to support your answer. Demand 125 CHAPTER 4 Assessment What Is Demand? (pp. 98–105) 1. What two things are necessary for a consumer to have demand for a good or service? 2. What do economists mean when they say that quantity demanded and price have an inverse relationship? What Factors Affect Demand? (pp. 106–115) 3. What is the difference between change in quantity demanded and change in demand? 4. How do consumer expectations affect demand? What Is Elasticity of Demand? (pp. 116–125) 5. Explain the difference between elastic and inelastic demand. 6. What are two methods for calculating elasticity of demand? A P P LY Look at the graph below showing personal spending for two types of products: computers and stationery. 7. What is the general trend of how spending for each of these product types has changed? Are the two trends alike or different? 8. In what way might these products be
complements? In what way might they be substitutes? FIGURE 4.18 PERSONAL SPENDING ON COMPUTERS AND STATIONERY STATIONERY COMPUTERS 50 40 30 20 10 1993 1995 1997 1999 2001 2003 Year Source: U.S. Department of Commerce, Bureau of Economic Analysis Review this chapter using interactive activities at ClassZone.com • Online Summary • Quizzes • Vocabulary Flip Cards • Graphic Organizers • Review and Study Notes Complete the following activity either on your own paper or online at ClassZone.com Choose the key concept that best completes the sentence. Not all key concepts will be used. change in demand change in quantity demanded demand demand curve demand schedule elastic elasticity of demand income effect inelastic inferior goods law of demand market demand curve market demand schedule normal goods substitutes substitution effect total revenue total revenue test unit elastic 1 is the desire for a product and the ability to pay for it. According to the 2, when price decreases, demand rises, and when price increases, demand falls. Demand can be displayed in a table called a 3 or on a graph called a 4. A 5 is a table that shows how much demand all consumers in a market have. When that same information is displayed on a graph, it is called a 6. The different points on a demand curve show a 7. A 8 occurs when consumers are willing to buy different amounts of a product at every price. The six factors that change demand are income, market size, consumer expectations, consumer taste, complement, and 9. The term 10 describes how responsive consumers are to price changes. Demand that changes significantly when prices change is 11. Demand that doesn’t change significantly when prices change is 12. The dividing line between the two is where demand is 13. 14 is calculated by multiplying price by quantity sold. 126 Chapter. Creating Graphs A tornado destroys a town. Think of three goods for which demand will rise in the weeks after the storm and three goods for which demand will fall. For each good, create a graph with two demand curves: curve A representing demand before the storm and curve B representing demand after the storm. Under each graph, write a caption explaining the change in demand. Use to complete this activity. @ ClassZone.com 10. Identifying Causes A certain stuffed toy is popular during the holiday season, but sells for half the listed price after the holidays. Which factor in change in demand is at work here? Explain. 11. Identifying Causes In the last few decades, demand for ketchup has dropped
in the United States, while demand for salsa has risen. Which factors that affect demand account for this? 12. Using Economic Concepts Airlines give discounts to travelers who book in advance and stay over a weekend. Travelers who book at the last minute and do not stay over a weekend usually pay fullprice. How does the concept of elasticity explain the difference between the two groups’ demand for tickets and the airlines’ pricing decisions? 13. Challenge Suppose that you read the following article in the newspaper: Meteorologists announced today that this has been the warmest winter in 57 years. The unusual weather has affected local businesses. According to Pasha Dubrinski, owner of Pasha’s Outerwear, sales of winter parkas are 17 percent lower than last year. Dubrinski said, “Instead of buying down-filled parkas, people have been buying substitute items such as leather coats.” Across town, Michael Ellis, owner of Home Hardware, said that his sales of snow blowers are also down. “Next week, I will cut the price. That will increase demand.” Are these two storeowners correct in the way they use economic terms? Explain your answer Equip Your Team Step 1 Choose a partner. Imagine you are equipment managers for your school’s baseball team. You must equip the nine starters with a budget of $5,000. The equipment supplier sends you the list of prices shown in column A of the table below. Create a list telling how many of each item you will buy. SP ORTING GOODS PRICES Prices (in dollars) Item Bat Baseball Glove or Mitt Catcher’s Mask Full Uniform Jersey Only Cleats Sunglasses Team Jacket A 130 2 80 80 65 30 25 20 50 B 170 3 130 90 100 60 60 30 75 C 200 4 160 100 135 90 90 40 100 Step 2 When you call in the order, you learn that a big sporting goods factory has burned. Prices have risen to those shown in column B. You must redo your order using the new prices but the same budget. Step 3 The economy is hit with sudden and severe price hikes. Redo your order using the prices in column C. Step 4 Share your three purchasing lists with the class. As a class, use the collected data to create a market demand curve for each item. Step 5 Use the collected data to calculate elasticity for each item. (You may use either method explained in this chapter.) Then as a class discuss your results. What factors
influenced elasticity? Use to complete this activity. @ ClassZone.com Demand 127 Supply The cost of raw materials, the wages paid to workers, and the production decisions made by managers all affect the supply of televisions. 128 CHAPTER 5 SECTION 1 What Is Supply? SECTION 2 What Are the Costs of Production? SECTION 3 What Factors Affect Supply? SECTION 4 What Is Elasticity of Supply? CASE STUDY Robots— Technology Increases Supply Supply Demand is the willingness to buy a good or service and the ability to pay for it Supply is the willingness and ability of producers to offer goods and services for sale AT T E R S You may not think of yourself as a producer, but you are. You offer your labor when you do chores around the house or work at a parttime job. If you have a car, you sometimes provide transportation for your friends. Also, if you belong to a sports or academic team, you supply your skills and knowledge. List five things that you supply. Then list the costs you incur and the rewards you receive for supplying them. How would your willingness and ability to supply these things be affected if these costs and rewards changed? More at ClassZone.com Go to ECONOMICS UPDATE for chapter updates and current news on the use of robots in industry. (See Case Study, pp. 158–159.) Go to ANIMATED ECONOMICS for interactive lessons on the graphs and tables in this chapter. Go to INTERACTIVE REVIEW for concept review and activities. How does the use of robots affect the supply of goods and services? See the Case Study on pages 158–159. Supply 129 S E C T I O N 1 What Is Supply TA K I N G N O T E S In Section 1, you will supply, p. 130 • define supply and outline what law of supply, p. 131 the law of supply says • explain how to create and interpret supply schedules • explain how to create and interpret supply curves supply schedule, p. 132 market supply schedule, p. 132 supply curve, p. 134 market supply curve, p. 134 As you read Section 1, complete a cluster diagram like the one shown using the key concepts and other helpful words and phrases. Use the Graphic Organizer at Interactive Review @ ClassZone.com Supply law of supply supply schedule The Law of Supply KEY CONCEPT S In Chapter 4, you learned about the demand side of market interactions and how consumers serve their interests by purchasing the best products at the lowest possible price. You also discovered that

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