FIC 105: PRINCIPLES OF

ECONOMICS & MANAGEMENT

Unit I
INTRODUCTION TO ECONOMICS
 PART I INTRODUCTION TO ECONOMICS

The Scope and

Method of Economics 1
CHAPTER OUTLIN
E
Why Study Economics?
To Learn a Way of Thinking
To Understand Society
To Be an Informed Citizen
The Scope of Economics
Microeconomics and Macroeconomics
The Diverse Fields of Economics
The Method of Economics
Theories and Models
Economic Policy
An Invitation
Appendix: How to Read and
Understand Graphs

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 economics The study of how individuals and societies choose to use the
scarce resources that nature and previous generations have provided.

The key word in this definition is choose.

Economics is a behavioral, or social, science. In large measure, it is the study

of how people make choices. The choices that people make, when added up,
translate into societal choices.

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 Why Study Economics?

To Learn a Way of Thinking

Three fundamental concepts:

Opportunity cost

Marginalism

Efficient markets

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 Opportunity Cost

opportunity cost The best alternative that we forgo, or give up, when we
make a choice or a decision.

scarce Limited.

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 Marginalism

marginalism The process of analyzing the additional or incremental costs or

benefits arising from a choice or decision.

Efficient Markets—No Free Lunch

efficient market A market in which profit opportunities are eliminated almost

instantaneously.

The study of economics teaches us a way of thinking and helps us

make decisions.

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 To Understand Society

Industrial Revolution The period in England during the late eighteenth and
early nineteenth centuries in which new manufacturing technologies and
improved transportation gave rise to the modern factory system and a
massive movement of the population from the countryside to the cities.

The study of economics is an essential part of the study of society.

To Be an Informed Citizen

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

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 ECONOMICS IN PRACTICE

iPod and the World

A sticker that says “Made in China” can

often be misleading.
Indeed, for the iPod, which is composed of
many small parts, it is almost impossible to
accurately tell exactly where each piece
was produced without pulling it apart.
From an economics point of view, one
often has to dig a little deeper to see what
is really going on.

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

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 The Scope of Economics

Microeconomics and Macroeconomics

microeconomics The branch of economics that examines the functioning

of individual industries and the behavior of individual decision-making units
—that is, firms and households.

macroeconomics The branch of economics that examines the economic

behavior of aggregates—income, employment, output, and so on—on a
national scale.

Microeconomics looks at the individual unit—the household, the firm, the

industry. It sees and examines the “trees.”
Macroeconomics looks at the whole, the aggregate. It sees and analyzes
the “forest.”

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 TABLE 1.1 Examples of Microeconomic and Macroeconomic Concerns
Division
of Economics Production Prices Income Employment
Microeconomics Production/output Prices of individual Distribution of Employment by
in individual goods and services income and individual
industries and wealth businesses and
businesses industries

How much steel Price of medical care Wages in the Jobs in the steel
How much office Price of gasoline auto industry industry
space Food prices Minimum wage Number of
How many cars Apartment rents Executive employees in a firm
salaries Number of
Poverty accountants
Macroeconomics National Aggregate price level National income Employment and
production/output unemployment in
the economy

Total industrial Consumer prices Total wages and Total number of

output Producer prices salaries jobs
Gross domestic Rate of inflation Total corporate Unemployment rate
product profits
Growth of output

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 The Diverse Fields of Economics
TABLE 1.2 The Fields of Economics
Behavioral economics uses psychological theories relating to emotions and social context to help
understand economic decision making and policy. Much of the work in
behavioral economics focuses on the biases that individuals have that affect
the decisions they make.

Comparative economic examines the ways alternative economic systems function. What are the
systems advantages and disadvantages of different systems?

Econometrics applies statistical techniques and data to economic problems in an effort to

test hypotheses and theories. Most schools require economics majors to
take at least one course in statistics or econometrics.

Economic development focuses on the problems of low-income countries. What can be done to
promote development in these nations? Important concerns of development
for economists include population growth and control, provision for basic
needs, and strategies for international trade.

Economic history traces the development of the modern economy. What economic and
political events and scientific advances caused the Industrial Revolution?
What explains the tremendous growth and progress of post-World War II
Japan? What caused the Great Depression of the 1930s?

Continued.
..
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 The Diverse Fields of Economics
TABLE 1.2 The Fields of Economics (continued)
Environmental studies the potential failure of the market system to account fully for the
economics impacts of production and consumption on the environment and on natural
resource depletion. Have alternative public policies and new economic
institutions been effective in correcting these potential failures?
Finance examines the ways in which households and firms actually pay for, or
finance, their purchases. It involves the study of capital markets (including
the stock and bond markets), futures and options, capital budgeting, and
asset valuation.
Health economics analyzes the health care system and its players: government, insurers,
health care providers, and patients. It provides insight into the demand for
medical care, health insurance markets, cost-controlling insurance plans
(HMOs, PPOs, IPAs), government health care programs (Medicare and
Medicaid), variations in medical practice, medical malpractice, competition
versus regulation, and national health care reform.

The history of economic which is grounded in philosophy, studies the development of economic ideas
thought, and theories over time, from Adam Smith in the eighteenth century to the
works of economists such as Thomas Malthus, Karl Marx, and John
Maynard Keynes. Because economic theory is constantly developing and
changing, studying the history of ideas helps give meaning to modern theory
and puts it in perspective.

Continued.
..
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 The Diverse Fields of Economics
TABLE 1.2 The Fields of Economics (continued)
Industrial organization looks carefully at the structure and performance of industries and firms
within an economy. How do businesses compete? Who gains and who
loses?
International economics studies trade flows among countries and international financial institutions.
What are the advantages and disadvantages for a country that allows its
citizens to buy and sell freely in world markets? Why is the dollar strong or
weak?
Labor economics deals with the factors that determine wage rates, employment, and
unemployment. How do people decide whether to work, how much to work,
and at what kind of job? How have the roles of unions and management
changed in recent years?
Law and economics analyzes the economic function of legal rules and institutions. How does the
law change the behavior of individuals and businesses? Do different liability
rules make accidents and injuries more or less likely? What are the
economic costs of crime?
Public economics examines the role of government in the economy. What are the economic
functions of government, and what should they be? How should the
government finance the services that it provides? What kinds of government
programs should confront the problems of poverty, unemployment, and
pollution? What problems does government involvement create?
Urban and regional studies the spatial arrangement of economic activity. Why do we have
economics cities? Why are manufacturing firms locating farther and farther from the
center of urban areas?
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 The Method of Economics

positive economics An approach to economics that seeks to understand

behavior and the operation of systems without making judgments.
It describes what exists and how it works.

normative economics An approach to economics that analyzes outcomes

of economic behavior, evaluates them as good or bad, and may prescribe
courses of action. Also called policy economics.

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 Theories and Models

model A formal statement of a theory, usually a mathematical statement of a

presumed relationship between two or more variables.

variable A measure that can change from time to time or from observation to
observation.

Ockham’s razor The principle that irrelevant detail should be cut away.

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 All Else Equal: Ceteris Paribus

ceteris paribus, or all else equal A device used to analyze the relationship
between two variables while the values of other variables are held
unchanged.

Using the device of ceteris paribus is one part of the process of abstraction.
In formulating economic theory, the concept helps us simplify reality to focus
on the relationships that interest us.

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 Expressing Models in Words, Graphs, and Equations

We use both graphs and equations to capture the quantitative side of our
economic observations and predictions.

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 Cautions and Pitfalls

What Is Really Causal?

post hoc, ergo propter hoc Literally, “after this (in time), therefore because
of this.”

A common error made in thinking about causation: If Event A happens before

Event B, it is not necessarily true that A caused B.

The Fallacy of Composition

fallacy of composition The erroneous belief that what is true for a part is
necessarily true for the whole.

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 Testing Theories and Models: Empirical Economics

empirical economics The collection and use of data to test economic

theories.

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 ECONOMICS IN PRACTICE

Does Your Roommate Matter for Your Grades?

If you choose mischievous friends and you misbehave, are your friends causing
your misbehavior or does an inclination toward mischief cause your choice of
friends?
Several recent economics studies of the effect of roommates on college grades
help to sort out causality in peer effects.
Bruce Sacerdote, a professor at Dartmouth college—one of many schools that
randomly assign roommates to freshmen—used data on freshmen academic
and social performance, combined with their background data, to test the peer
effects from different types of roommates.
He found strong roommate effects on grade point average, effort in school, and
fraternity membership.

THINKING PRACTICALLY
THINKING PRACTICALLY
1.Would you expect college seniors who choose their own roommates to have more or
1.Would you expect college seniors who choose their own roommates to have more or
less similar grades than college freshmen who are assigned as roommates?
less similar grades than college freshmen who are assigned as roommates?
Why or why not?
Why or why not?

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 Economic Policy

Four criteria in judging economic outcomes:

1.Efficiency

2.Equity

3.Growth

4. Stability

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 Efficiency

efficiency In economics, allocative efficiency. An efficient economy is one that

produces what people want at the least possible cost.

Equity

equity Fairness.

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 Growth

economic growth An increase in the total output of an economy.

Stability

stability A condition in which national output is growing steadily, with low

inflation and full employment of resources.

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 An Invitation

You cannot begin to understand how a society functions without knowing

something about its economic history and its economic system.

Learning to think in this very powerful way will help you better understand
the world.

As you proceed, it is important that you keep track of what you have
learned in earlier chapters. This book has a plan; it proceeds step-by-step,
each section building on the last. Make sure you understand where it all fits
in the big picture.

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 REVIEW TERMS AND CONCEPTS

ceteris paribus, or all else equal microeconomics

economic growth model
economics normative economics
efficiency Ockham’s razor
efficient market opportunity cost
empirical economics positive economics
equity post hoc, ergo propter hoc
fallacy of composition scarce
Industrial Revolution stability
macroeconomics variable
marginalism

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 CHAPTER 1 APPENDIX

How to Read and Understand Graphs

A graph is a two-dimensional representation of a set of numbers, or data.

Time Series Graphs

A time series graph shows how a single measure or variable changes over
time.

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 TABLE 1A.1 Total Disposable Personal  FIGURE 1A.1 Total Disposable Personal Income in the
Income in the United States, 1975–2012 United States: 1975–2012 (in billions of dollars)
(in billions of dollars)
Total Total
Disposable Disposable
Personal Personal
Year Income Year Income
1975 1,187.3 1994 5,184.3
1976 1,302.3 1995 5,457.0
1977 1,435.0 1996 5,759.6
1978 1,607.3 1997 6,074.6
1979 1,790.8 1998 6,498.9
1980 2,002.7 1999 6,803.3
1981 2,237.1 2000 7,327.2
1982 2,412.7 2001 7,648.5
1983 2,599.8 2002 8,009.7
1984 2,891.5 2003 8,377.8
1985 3,079.3 2004 8,889.4
1986 3,258.8 2005 9,277.3
1987 3,435.3 2006 9,915.7
1988 3,726.3 2007 10,423.6
1989 3,991.4 2008 11,024.5
1990 4,254.0 2009 10,772.4
1991 4,444.9 2010 11,127.1
1992 4,736.7 2011 11,549.3
1993 4,921.6 2012 11,930.6

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 Graphing Two Variables

X-axis The horizontal line against which a variable is plotted.

Y-axis The vertical line against which a variable is plotted.

origin The point at which the horizontal and vertical axes intersect.

Y-intercept The point at which a graph intersects the Y-axis.

X-intercept The point at which a graph intersects the X-axis.

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 Plotting Income and Consumption Data for Households

TABLE 1A.2 Consumption Expenditures

and Income, 2008
Average Average
Income Consumption
Before Taxes Expenditures
Bottom fifth $ 10,263 $ 22,304
2nd fifth 27,442 31,751
3rd fifth 47,196 42,659
4th fifth 74,090 58,632
Top fifth 158,652 97,003

 FIGURE 1A.2 Household Consumption and Income

A graph is a simple two-dimensional geometric representation of data.
This graph displays the data from Table 1A.2.
Along the horizontal scale (X-axis), we measure household income.
Along the vertical scale (Y-axis), we measure household consumption.
Note: At point A, consumption equals $22,304 and income equals $10,263.
At point B, consumption equals $31,751 and income equals $27,442.

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

negative relationship A relationship between two variables, X and Y, in which

a decrease in X is associated with an increase in Y and an increase in X is
associated with a decrease in Y.

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 Slope

slope A measurement that indicates whether the relationship between

variables is positive or negative and how much of a response there is in Y
(the variable on the vertical axis) when X (the variable on the horizontal axis)
changes.

Y Y2  Y1

X X 2  X 1

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

A positive slope indicates that A negative slope

increases in X are associated indicates the opposite—
with increases in Y and that when X increases, Y
decreases in X are associated decreases; and when X
with decreases in Y. decreases, Y increases.

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  FIGURE 1A.4 Changing Slopes Along Curves

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 Some Precautions

TABLE 1A.3 Aggregate National Income

and Consumption for the
United States, 1930–2012
(in billions of dollars)
Aggregate Aggregate
National Income Consumption
1930 82.9 70.1
1940 90.9 71.3
1950 263.9 192.2
1960 473.9 331.8
1970 929.5 648.3
1980 2433.0 1,755.8
1990 5059.8 3,835.5
2000 8938.9 6,830.4
2005 11,273.8 8,803.5
2006 12,031.2 9,301.0
2007 12,396.4 9,772.3
2008 12,609.1 10,035.5
2009 12,132.6 9,845.9
2010 12,811.4 10,215.7
2011 13,358.9 10,729.0
2012 13,720.9 11,119.5

 FIGURE 1A.5 National Income and Consumption

It is important to think carefully about what is represented by points in the space defined by the axes of a graph.
In this graph, we have graphed income with consumption, as in Figure 1A.2, but here each observation point is
national income and aggregate consumption in different years, measured in billions of dollars.
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 APPENDIX REVIEW TERMS AND CONCEPTS

graph time series graph

negative relationship X-axis

origin X-intercept

positive relationship Y-axis

slope Y-intercept

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 The Economic
Problem: Scarcity 2
and Choice
CHAPTER OUTLIN
E
Scarcity, Choice, and
Opportunity Cost
Scarcity and Choice in a One-Person
Economy
Scarcity and Choice in an Economy
of Two or More
The Production Possibility Frontier
The Economic Problem
Economic Systems and the Role
of Government
Command Economies
Laissez-Faire Economies: The Free
Market
Mixed Systems, Markets, and
Governments
Looking Ahead

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  FIGURE 2.1 The Three Basic Questions
Every society has some system or process that transforms its scarce resources into
useful goods and services. In doing so, it must decide what gets produced, how it is
produced, and to whom it is distributed.

The primary resources that must be allocated are land, labor, and capital.

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 capital Things that are produced and then used in the production of other
goods and services.

factors of production (or factors) The inputs into the process of production.
Another term for resources.

production The process that transforms scarce resources into useful goods
and services.

inputs or resources Anything provided by nature or previous generations that

can be used directly or indirectly to satisfy human wants.

outputs Goods and services of value to households.

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 Scarcity, Choice, and Opportunity Cost

Scarcity and Choice in a One-Person Economy

Nearly all the same basic decisions that characterize complex economies must
also be made in a simple economy.

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 Opportunity Cost

The concepts of constrained choice and scarcity are central to the discipline
of economics.

opportunity cost The best alternative that we give up, or forgo, when we
make a choice or decision.

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 ECONOMICS IN PRACTICE

Frozen Foods and Opportunity Costs

The growth of the frozen dinner entrée

market in the last 50 years is a good
example of the role of opportunity costs
in our lives.
Many entrepreneurs find that the simple
tools of economics—like the idea of
opportunity costs—help them anticipate
what products will be profitable for them
to produce in the future.

THINKING PRACTICALLY
THINKING PRACTICALLY
1.Many people think that soda consumption leads to increased obesity, and many
1.Many people think that soda consumption leads to increased obesity, and many
schools have banned the sale of soda in vending machines. Use the idea of opportunity
schools have banned the sale of soda in vending machines. Use the idea of opportunity
costs to explain why some people think these bans will reduce consumption.
costs to explain why some people think these bans will reduce consumption.
Do you agree?
Do you agree?

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 Scarcity and Choice in an Economy of Two or More

Specialization, Exchange, and Comparative Advantage

theory of comparative advantage Ricardo’s theory that specialization and

free trade will benefit all trading parties, even those that may be “absolutely”
more efficient producers.

absolute advantage A producer has an absolute advantage over another in

the production of a good or service if he or she can produce that product using
fewer resources (a lower absolute cost per unit).

comparative advantage A producer has a comparative advantage over

another in the production of a good or service if he or she can produce that
product at a lower opportunity cost.

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  FIGURE 2.2 Comparative
Advantage and the Gains
from Trade
Panel (a) shows the best
Colleen and Bill can do
each day, given their
talents and assuming they
each wish to consume an
equal amount of food and
wood.
Panel (b) shows what
happens when both
parties specialize. Notice
more units are produced
of each good.

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 A Graphical Presentation of the Production Possibilities and Gains from
Specialization

 FIGURE 2.3 Production Possibilities with and without Trade

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

We trade off present and future benefits in small ways all the time.

Capital Goods and Consumer Goods

consumer goods Goods produced for present consumption.

investment The process of using resources to produce new capital.

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 The Production Possibility Frontier

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

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 All points below and to the left
of the curve (the shaded area)
represent combinations of
capital and consumer goods
that are possible for the society
given the resources available
and existing technology.
Points above and to the right of
the curve, such as point G,
represent combinations that
cannot be reached.
If an economy were to end up
at point A on the graph, it would
be producing no consumer
goods at all; all resources
would be used for the
production of capital.
If an economy were to end up
at point B, it would produce
only consumer goods.

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 Although an economy may be
operating with full employment
of its land, labor, and capital
resources, it may still be
operating inside its ppf, at a
point such as D. The economy
could be using those resources
inefficiently.
Periods of unemployment also
correspond to points inside the
ppf, such as point D.
Moving onto the frontier from a
point such as D means
achieving full employment of
resources.

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  FIGURE 2.4 Production
Possibility Frontier

The ppf illustrates a number

of economic concepts.
One of the most important is
opportunity cost.
The opportunity cost of
producing more capital
goods is fewer consumer
goods.
Moving from E to F, the
number of capital goods
increases from 550 to 800,
but the number of consumer
goods decreases from
1,300 to 1,100.

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 Negative Slope and Opportunity Cost

marginal rate of transformation (MRT) The slope of the production

possibility frontier (ppf).

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 The Law of Increasing Opportunity Cost

 FIGURE 2.5 Corn and Wheat Production in Ohio and Kansas

The ppf illustrates that the opportunity cost of corn production increases as we shift
resources from wheat production to corn production. Moving from point E to D, we
get an additional 100 million bushels of corn at a cost of 50 million bushels of wheat.
Moving from point B to A, we get only 50 million bushels of corn at a cost of 100
million bushels of wheat. The cost per bushel of corn—measured in lost wheat—
has increased.

TABLE 2.1 Production Possibility Schedule

for Total Corn and Wheat
Production in Ohio and Kansas
Total Total
Corn Production Wheat Production
Point (Millions of (Millions of
on ppf Bushels per Year) Bushels per Year)

A 700 100
B 650 200
C 510 380
D 400 500
E 300 550

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 Unemployment

During economic downturns or recessions, industrial plants run at less than

their total capacity. When there is unemployment of labor and capital, we are
not producing all that we can.

Inefficiency

Waste and mismanagement are the results of a firm operating below its
potential.

Sometimes inefficiency results from mismanagement of the economy instead of

mismanagement of individual private firms.

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 Unemployment

During economic downturns or recessions, industrial plants run at less than

their total capacity. When there is unemployment of labor and capital, we are
not producing all that we can.

Inefficiency

Waste and mismanagement are the results of a firm operating below its
potential.

Sometimes inefficiency results from mismanagement of the economy instead of

mismanagement of individual private firms.

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  FIGURE 2.6 Inefficiency from
Misallocation of Land in Farming

Society can end up inside its

ppf at a point such as A by
using its resources
inefficiently.
If, for example, Ohio’s climate
and soil were best-suited for
corn production and those of
Kansas were best suited for
wheat production, a law
forcing Kansas farmers to
produce corn and Ohio
farmers to produce wheat
would result in less of both. In
such a case, society might be
at point A instead of point B.

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 The Efficient Mix of Output

To be efficient, an economy must produce what people want.

Economic Growth

economic growth An increase in the total output of an economy. Growth

occurs when a society acquires new resources or when it learns to produce
more using existing resources.

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 TABLE 2.2 Increasing Productivity in Corn and Wheat Production
in the United States, 1935–2009
Corn Wheat
Yield per Acre Labor Hours per Yield per Acre Labor Hours
(Bushels) 100 Bushels (Bushels) per 100 Bushels
1935–1939 26.1 108 13.2 67
1945–1949 36.1 53 16.9 34
1955–1959 48.7 20 22.3 17
1965–1969 78.5 7 27.5 11
1975–1979 95.3 4 31.3 9
1981–1985 107.2 3 36.9 7
1985–1990 112.8 NAa 38.0 NAa
1990–1995 120.6 NAa 38.1 NAa
1998 134.4 NAa 43.2 NAa
2001 138.2 NAa 43.5 NAa
2006 145.6 NAa 42.3 NAa
2007 152.8 NAa 40.6 NAa
2008 153.9 NAa 44.9 NAa
2009 164.9 NAa 44.3 NAa
a
Data not available.

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

Productivity increases have

enhanced the ability of the United
States to produce both corn and
wheat.
As Table 2.2 shows, productivity
increases were more dramatic for
corn than for wheat. Thus, the
shifts in the ppf were not parallel.

Note: The ppf also shifts if the amount

of land or labor in corn and wheat
production changes. Although we
emphasize productivity increases
here, the actual shifts between years
were due in part to land and labor
changes.

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 Sources of Growth and the Dilemma of Poor Countries

 FIGURE 2.8 Capital Goods and

Growth in Poor and Rich
Countries
Rich countries find it easier
than poor countries to devote
resources to the production
of capital, and the more
resources that flow into
capital production, the faster
the rate of economic growth.
Thus, the gap between poor
and rich countries has grown
over time.

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 ECONOMICS IN PRACTICE

Trade-Offs among the Rich and Poor

In all societies, for all people, resources

are limited relative to people’s demands.
In 1990, the World Bank defined the
extremely poor people of the world as
those earning less than $1 a day. Even
for the poorest consumers, however,
biological need is not all determining.
In societies with very few entertainment
outlets, we may see more demand for
festivals, indicating that even in
extremely poor societies, household choice plays a role.

THINKING PRACTICALLY
THINKING PRACTICALLY
1.Why might we see a greater demand for festivals in poor countries than in rich ones?
1.Why might we see a greater demand for festivals in poor countries than in rich ones?
How might this be affected by choices available?
How might this be affected by choices available?

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 The Economic Problem

Recall the three basic questions facing all economic systems:

(1) What gets produced?

(2) How is it produced?

(3) Who gets it?

Given scarce resources, how do large, complex societies go about

answering the three basic economic questions?

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 Economic Systems and the Role of Government
Command Economies

command economy An economy in which a central government either directly

or indirectly sets output targets, incomes, and prices.

Laissez-Faire Economies: The Free Market

laissez-faire economy Literally from the French: “allow [them] to do.” An

economy in which individual people and firms pursue their own self-interest
without any central direction or regulation.

market The institution through which buyers and sellers interact and engage in
exchange.

Some markets are simple and others are complex, but they all involve
buyers and sellers engaging in exchange.
The behavior of buyers and sellers in a laissez-faire economy determines
what gets produced, how it is produced, and who gets it.

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 Consumer Sovereignty

consumer sovereignty The idea that consumers ultimately dictate what will
be produced (or not produced) by choosing what to purchase (and what not to
purchase).

Individual Production Decisions: Free Enterprise

free enterprise The freedom of individuals to start and operate private

businesses in search of profits.

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 Distribution of Output

The amount that any one household gets depends on its income and wealth.

Income is the amount that a household earns each year. It comes in a number
of forms: wages, salaries, interest, and the like.

Wealth is the amount that households have accumulated out of past income
through saving or inheritance.

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 Price Theory

In a free market system, the basic economic questions are answered without
the help of a central government plan or directives. This is what the “free” in
free market means—the system is left to operate on its own with no outside
interference. Individuals pursuing their own self-interest will go into business
and produce the products and services that people want. Other individuals will
decide whether to acquire skills; whether to work; and whether to buy, sell,
invest, or save the income that they earn.
The basic coordinating mechanism is price.

Mixed Systems, Markets, and Governments

The differences between command economies and laissez-faire economies in

their pure forms are enormous. In fact, these pure forms do not exist in the
world; all real systems are in some sense “mixed.”

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 Looking Ahead

This chapter described the economic problem in broad terms. We outlined the
questions that all economic systems must answer. We also discussed very
broadly the two kinds of economic systems. In the next chapter, we analyze the
way market systems work.

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 REVIEW TERMS AND CONCEPTS

absolute advantage investment

capital laissez-faire economy

command economy marginal rate of transformation (MRT)

comparative advantage market

consumer goods opportunity cost

consumer sovereignty outputs

economic growth production

factors of production (or factors) production possibility frontier (ppf)

free enterprise theory of comparative advantage

inputs or resources

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