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In medieval times, the aristocracy and town guilds directed much of the eco-nomic activity in Europe and Asia. However, about two centuries ago, govern-ments began to exercise less and less power over prices and production meth-

ods. Feudalism gradually gave way to markets, or what we call the “marketmechanism” or “competitive capitalism.”

In most of Europe and North America, the nineteenth centurybecame the age of laissez-faire. This doctrine, which translates

as “leave us alone,” holds that government should interfereas little as possible in economic affairs and leave economic

decisions to the private marketplace. Many governmentsespoused this economic philosophy in the middle of

the nineteenth century.Nevertheless, by the end of the century, the

unbridled excesses of capitalism led the UnitedStates and the industrialized countries of West-

ern Europe to retreat from full laissez-faire.Government’s role expanded steadily as it reg-ulated monopolies, levied income taxes, andbegan to provide a social safety net with sup-port for the elderly. This new system, calledthe welfare state, is one in which marketsdirect the detailed activities of day-to-dayeconomic life while government regulatessocial conditions and provides pensions,health care, and other necessities for poorfamilies.

Then, around 1980, the tides shiftedagain, as conservative governments inmany countries began to reduce taxes andderegulate government’s control over theeconomy. Particularly influential was the“Reagan revolution” in the United States,which changed public attitudes about taxes

and government and reversed the trends inU.S. federal spending on civilian programs.

Even Democratic president William Clintonheld that “the era of big government is over.”The most dramatic turn toward the market

came in Russia and the socialist countries of East-ern Europe. After decades of extolling the advan-

tages of a government-run command economy, thesecountries scrapped central planning and made the dif-

ficult transition to a decentralized, market economy.China, while still run by the dictatorship of the Commu-

nist party, has enjoyed an economic boom in the last twodecades by allowing competition to operate within its borders.

Developing countries like Taiwan, Singapore, and Chile have en-joyed rapid income growth by embracing capitalism and reducing the

role of government in their economies.This capsule history of the shifting balance between state and market raises

many questions. What exactly is a market economy, and what makes it so pow-erful? What is the “capital” in “capitalism”? What government controls are

Markets andGovernment in aModern Economy

Every individual endeavors to employhis capital so that its produce may be of

greatest value. He generally neitherintends to promote the public interest,

nor knows how much he is promoting it.He intends only his own security, only

his own gain. And he is in this led by aninvisible hand to promote an end which

was no part of his intention. Bypursuing his own interest he frequently

promotes that of society more effectuallythan when he really intends to promote

it.

Adam Smith, The Wealth of Nations (1776)

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2C H A P T E R

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Not Chaos, but Economic OrderThe market looks like a jumble of different sellersand buyers. It seems almost a miracle that food isproduced in suitable amounts, gets transported tothe right place, and arrives in a palatable form at thedinner table. But a close look at New York or othereconomies is convincing proof that a market systemis neither chaos nor miracle. It is a system with itsown internal logic. And it works.

A market economy is an elaborate mechanismfor coordinating people, activities, and businessesthrough a system of prices and markets. It is a com-munication device for pooling the knowledge andactions of billions of diverse individuals. Withoutcentral intelligence or computation, it solves prob-lems of production and distribution involving bil-lions of unknown variables and relations, problemsthat are far beyond the reach of even today’s fastestsupercomputer. Nobody designed the market, yetit functions remarkable well. In a market economy,no single individual or organization is responsiblefor production, consumption, distribution, andpricing.

How do markets determine prices, wages, andoutputs? Originally, a market was an actual placewhere buyers and sellers could engage in face-to-facebargaining. The marketplace—filled with slabs of but-ter, pyramids of cheese, layers of wet fish, and heapsof vegetables—used to be a familiar sight in manyvillages and towns, where farmers brought theirgoods to sell. In the United States today there arestill important markets where many traders gathertogether to do business. For example, wheat andcorn are traded at the Chicago Board of Trade, oiland platinum are traded at the New York MercantileExchange, and gems are traded at the Diamond Dis-trict in New York City.

In a general sense, markets are places wherebuyers and sellers interact to set prices and ex-change goods and services. There are markets foralmost everything. You can buy artwork by old mas-ters at auction houses in New York, or pollutionpermits at the Chicago Board of Trade, or legaldrugs from delivery serivces in many large cities.A market may be centralized, like the stock mar-ket. It may be decentralized, as in the case of labor. Or it may exist only electronically, as is increasingly the case with “e-commerce” on the Internet.

26 CHAPTER 2 MARKETS AND GOVERNMENT IN A MODERN ECONOMY

needed to make markets function effectively? Whydo societies redefine the roles of government andmarket from time to time? The time has come to un-derstand the principles that lie behind the marketeconomy and to review government’s role in eco-nomic life.

A. WHAT IS A MARKET?

In a country like the United States, most economicdecisions are resolved through the market, so we be-gin our systematic study there. Who solves the threefundamental questions—what, how, and for whom—in a market economy? You may be surprised to learnthat no one individual or organization or government isresponsible for solving the economic problems in a marketeconomy. Instead, millions of businesses and con-sumers engage in voluntary trade, intending to im-prove their own economic situations, and their ac-tions are invisibly coordinated by a system of pricesand markets.

To see how remarkable this is, consider the cityof New York. Without a constant flow of goods intoand out of the city, New Yorkers would be on theverge of starvation within a week. For New York tothrive, many kinds of goods must be provided. Fromthe surrounding counties, from 50 states, and fromthe far corners of the world, goods travel for daysand weeks with New York as their destination.

How is it that 10 million people can sleep easilyat night, without living in mortal terror of a break-down in the elaborate economic processes uponwhich they rely? The surprising answer is that, with-out coercion or centralized direction by anyone,these economic activities are coordinated throughthe market.

Everyone in the United States notices how muchthe government does to control economic activity: itplaces tolls on bridges, polices the streets, regulatesdrugs, levies taxes, sends armies to Europe, and soforth. But we seldom think about how much of ourordinary economic life proceeds without govern-ment intervention. Thousands of commodities areproduced by millions of people every day, willingly,without central direction or master plan.

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A market is a mechanism through which buyersand sellers interact to set prices and exchange goodsand services.

In a market system, everything has a price, whichis the value of the good in terms of money (the roleof money will be discussed in Section B of this chap-ter). Prices represent the terms on which people andfirms voluntarily exchange different commodities.When I agree to buy a used Ford from a dealer for$4050, this agreement indicates that the Ford is worthat least $4050 to me and that the $4050 is worth atleast as much as the Ford to the dealer. The used-carmarket has determined the price of a used Ford and,through voluntary trading, has allocated this good tothe person for whom it has the highest value.

In addition, prices serve as signals to producersand consumers. If consumers want more of any good,the price will rise, sending a signal to producers thatmore supply is needed. When a terrible disease re-duces beef production, the supply of beef decreasesand raises the price of hamburgers. The higher priceencourages farmers to increase their production ofbeef and, at the same time, encourages consumersto substitute other foods for hamburgers and beefproducts.

What is true of the markets for consumer goodsis also true of markets for factors of production, suchas land or labor. If more computer programmers areneeded to run Internet businesses, the price of com-puter programmers (their hourly wage) will tend torise. The rise in relative wages will attract workersinto the growing occupation.

Prices coordinate the decisions of producers andconsumers in a market. Higher prices tend to reduceconsumer purchases and encourage production.Lower prices encourage consumption and discour-age production. Prices are the balance wheel of themarket mechanism.

Market Equilibrium. At every moment, some peopleare buying while others are selling; firms are invent-ing new products while governments are passing lawsto regulate old ones; foreign companies are openingplants in America while American firms are sellingtheir products abroad. Yet in the midst of all this tur-moil, markets are constantly solving the what, how,and for whom. As they balance all the forces operat-

ing on the economy, markets are finding a marketequilibrium of supply and demand.

A market equilibrium represents a balance among allthe different buyers and sellers. Depending upon theprice, households and firms all want to buy or selldifferent quantities. The market finds the equilib-rium price that simultaneously meets the desires ofbuyers and sellers. Too high a price would mean aglut of goods with too much output; too low a pricewould produce long lines in stores and a deficiencyof goods. Those prices for which buyers desire to buyexactly the quantity that sellers desire to sell yield anequilibrium of supply and demand.

How Markets Solve the ThreeEconomic Problems

We have just described how prices help balance con-sumption and production (or demand and supply)in an individual market. What happens when we putall the different markets together—beef, cars, land,labor, capital, and everything else? These marketswork simultaneously to determine a general equilib-rium of prices and production.

By matching sellers and buyers (supply and de-mand) in each market, a market economy simulta-neously solves the three problems of what, how, andfor whom. Here is an outline of a market equilibrium:

1. What goods and services will be produced is de-termined by the dollar votes of consumers—notevery 2 or 4 years at the polls, but in their dailypurchase decisions. The money that they pay intobusinesses’ cash registers ultimately provides thepayrolls, rents, and dividends that consumers, asemployees, receive as income.

Firms, in turn, are motivated by the desire tomaximize profits. Profits are net revenues, or thedifference between total sales and total costs.Firms abandon areas where they are losing prof-its; by the same token, firms are lured by highprofits into production of goods in high de-mand. Some of the most profitable activities to-day are producing and marketing legal drugs—drugs for depression, anxiety, impotence, and allother manner of human frailty. Lured by thehigh profits, companies are investing billions inresearch to come up with yet more new and im-proved chemicals.

WHAT IS A MARKET? 27

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Congress and the president? Or the advertisingmoguls from Madison Avenue? All these entities canaffect us, but the core determinants of the shape ofour economy are the dual monarchs of tastes and tech-nology. Innate and acquired tastes—as expressed inthe dollar votes of consumer demands—direct theuses of society’s resources. They pick the point onthe production-possibility frontier (PPF ).

But consumers alone cannot dictate what goodswill be produced. The available resources and tech-nology place a fundamental constraint on theirchoices. The economy cannot go outside its PPF. Youcan fly to Hong Kong, but there are no flights toMars. An economy’s resources, along with the avail-able science and technology, limit the candidates forthe dollar votes of consumers. Consumer demandhas to dovetail with business supply of goods. So busi-ness cost and supply decisions, along with consumerdemand, help determine what is produced.

You will find it helpful to recall the dual monar-chy when you wonder why some technologies failin the marketplace. From the Stanley Steamer—acar that ran on steam—to the Premiere smokelesscigarette, which was smokeless but also tasteless,history is full of products that found no markets.How do useless products die off ? Is there a gov-ernment agency that pronounces upon the valueof new products? No such agency is necessary.Rather, they become extinct because there is noconsumer demand for the products at the goingmarket price. These products earn losses ratherthan profits. This reminds us that profits serve asthe rewards and penalties for businesses and guidethe market mechanism.

Like a farmer using a carrot and a stick to coaxa donkey forward, the market system deals out prof-its and losses to induce firms to produce desiredgoods efficiently.

A Picture of Prices and MarketsWe can picture the circular flow of economic life inFigure 2-1 on page 29. The diagram provides anoverview of how consumers and producers interactto determine prices and quantities for both inputsand outputs. Note the two different kinds of marketsin the circular flow. At the top are the product mar-kets, or the flow of outputs like pizza and shoes; atthe bottom are the markets for inputs or factors ofproduction like land and labor. Further, see how de-


2. How things are produced is determined by thecompetition among different producers. Thebest way for producers to meet price competitionand maximize profits is to keep costs at a mini-mum by adopting the most efficient methods ofproduction. Sometimes change is incrementaland consists of little more than tinkering with themachinery or adjusting the input mix to gain acost advantage, which can be very important ina competitive market. At other times there aredrastic shifts in technology, as with steam enginesdisplacing horses because steam was cheaper perunit of useful work, or airplanes replacing rail-roads as the most efficient mode for long-distance travel. Right now we are in the midst ofjust such a transition to a radically different tech-nology, with computers revolutionizing manytasks in the workplace, from the checkoutcounter to the drafting table.

3. For whom things are produced—who is consum-ing and how much—depends, in large part, onthe supply and demand in the markets for fac-tors of production. Factor markets (i.e., marketsfor factors of production) determine wage rates,land rents, interest rates, and profits. Such pricesare called factor prices. The same person may re-ceive wages from a job, dividends from stocks, in-terest on a bond, and rent from a piece of prop-erty. By adding up all the revenues from factors,we can calculate the person’s market income.The distribution of income among the popula-tion is thus determined by the quantity of factorservices (person-hours, acres, etc.) and the pricesof the factors (wage rates, land rents, etc.).

Be warned, however, that incomes reflectmore than the rewards for sweaty labor or fru-gal living. High incomes can come from largeinheritances, good luck, and skills highly prizedin the marketplace. Those with low incomes areoften pictured as lazy, but the truth is that lowincomes are generally the result of poor edu-cation, discrimination, or living where jobs arefew and wages are low. When we see someoneon the unemployment line, we should remem-ber, “There, but for the grace of supply and de-mand, go I.”

Monarchs of the MarketplaceWho rules a market economy? Do giant companieslike Microsoft and AT&T call the tune? Or perhaps

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cisions are made by two different entities, consumersand businesses.

Consumers buy goods and sell factors of pro-duction; businesses sell goods and buy factors of pro-duction. Consumers use their income from the saleof labor and other inputs to buy goods from busi-nesses; businesses base their prices of goods on thecosts of labor and property. Prices in goods marketsare set to balance consumer demand with business

supply; prices in factor markets are set to balancehousehold supply with business demand.

All this sounds complicated. But it is simply thetotal picture of the intricate web of interdependentsupplies and demands, interconnected through amarket mechanism to solve the economic problemsof what, how, and for whom. Look at Figure 2-1 care-fully. A few minutes spent studying it will surely helpyou understand the workings of a market economy.

WHAT IS A MARKET? 29

Product markets

Demand Supply

Supply Demand

What

How

For whom

Factor markets

Prices onproduct markets

Prices onfactor markets(wages, rents,

interest)Capital goods

Land

Labor

Capital goods

Land

Labor

Shoes

Housing

Consumer $votes

CONSUMERS

Ownershipof inputs

BUSINESSES

Productivityof factors

Pizzas

Shoes

Housing

Pizzas

$ Costs ofproduction

FIGURE 2-1. The Market System Relies on Supply and Demand to Solve the Trio of Economic Problems

We see here the circular flow of a market economy. Dollar votes of consumers (households,governments, and foreigners) interact with business supply in the product markets at top,helping to determine what is produced. Business demand for inputs meets the supply of la-bor and other inputs in the factor markets below to help determine wage, rent, and inter-est payments; incomes thus influence for whom goods are delivered. Business competition tobuy factor inputs and sell goods most cheaply determines how goods are produced.

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In summary:

Adam Smith discovered a remarkable property ofa competitive market economy. Under perfect com-petition and with no market failures, markets willsqueeze as many useful goods and services out of theavailable resources as is possible. But where monop-olies or pollution or similar market failures becomepervasive, the remarkable efficiency properties of theinvisible hand may be destroyed.


The Invisible HandThe order contained in a market economy was firstrecognized by Adam Smith. In one of the most fa-mous passages of all economics, quoted from TheWealth of Nations at the opening of this chapter, Smithsaw the harmony between private profit and publicinterest. He argued that even though every individ-ual “intends only his own security, only his own gain,. . . he is led by an invisible hand to promote an endwhich was no part of his intention. By pursuing hisown interest he frequently promotes that of societymore effectually than when he really intends to pro-mote it.”

Pause for a moment to consider these paradoxi-cal words, written in 1776. That same year was alsomarked by the American Declaration of Indepen-dence. It is no coincidence that both ideas appearedat the same time. Just as the American revolutionar-ies were proclaiming freedom from tyranny, AdamSmith was preaching a revolutionary doctrine eman-cipating trade and industry from the shackles of afeudal aristocracy. Smith held that in this best of allpossible worlds, government interference with mar-ket competition is almost certain to be injurious.

Smith’s insight about the functioning of the mar-ket mechanism has inspired modern economists—both the admirers and the critics of capitalism. Eco-nomic theorists have proved that under limited con-ditions a perfectly competitive economy is efficient(remember that an economy is producing efficientlywhen it cannot increase the economic welfare of any-one without making someone else worse off).

After two centuries of experience and thought,however, we recognize the limited scope of this doc-trine. We know that there are “market failures,”that markets do not always lead to the most effi-cient outcome. One set of market failures concernsmonopolies and other forms of imperfect compe-tition. A second failure of the “invisible hand”comes when there are spillovers or externalitiesoutside the marketplace—positive externalitiessuch as scientific discoveries and negative spilloverssuch as pollution.

A final reservation comes when the income dis-tribution is politically or ethically unacceptable.When any of these elements occur, Adam Smith’s invisible-hand doctrine breaks down and govern-ment may want to step in to mend the flawed invis-ible hand.

Adam Smith: Founding father of economics“For what purpose is all the toil and bustleof this world? What is the end of avarice and

ambition, of the pursuit of wealth, of power, andpre-eminence?” Thus wrote Adam Smith (1723–

1790), of Scotland, who glimpsed for the social world ofeconomics what Isaac Newton recognized for the physicalworld of the heavens. Smith answered his questions in TheWealth of Nations (1776), where he explained the self-reg-ulating natural order by which the oil of self-interest lubri-cates the economic machinery in an almost miraculousfashion. Smith believed that the toil and bustle had theeffect of improving the lot of the common man andwoman. “Consumption is the sole end and purpose of all production.”

Smith was the first apostle of economic growth. Atthe dawn of the Industrial Revolution, he pointed to thegreat strides in productivity brought about by specializa-tion and the division of labor. In a famous example, hedescribed the specialized manufacturing of a pin factory inwhich “one man draws out the wire, another straightens it,a third cuts it,” and so it goes.This operation allowed 10people to make 48,000 pins in a day, whereas if “allwrought separately, they could not each of them maketwenty, perhaps not one pin a day.” Smith saw the result ofthis division of labor as “universal opulence which extendsitself to the lowest ranks of the people.” Imagine what hewould think if he returned today to see what two morecenturies of economic growth have produced!

Smith wrote hundreds of pages railing against count-less cases of government folly and interference. Considerthe seventeenth-century guild master who was attemptingto improve his weaving.The town guild decided,“If a clothweaver intends to process a piece according to his owninvention, he should obtain permission from the

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B. TRADE, MONEY, ANDCAPITAL

Since the time of Adam Smith, market economieshave evolved enormously. Advanced capitalisteconomies, such as the United States, Western Eu-rope, and Japan, have three distinguishing features:trade and specialization, money, and capital.

� An advanced economy is characterized by anelaborate network of trade, among individualsand countries, that depends on great specializa-tion and an intricate division of labor.

� Modern economies today make extensive use ofmoney, or the means of payment. The flow ofmoney is the lifeblood of our system. Money pro-vides the yardstick for measuring the economicvalue of things and for financing trade.

� Modern industrial technologies rest on the useof vast amounts of capital: precision machinery,large-scale factories, and stocks of inventories.Capital goods leverage human labor power intoa much more efficient factor of production andallow productivity many times greater than thatpossible in an earlier age.

TRADE, SPECIALIZATION, ANDDIVISION OF LABOR

As compared to the economies of the 1700s, today’seconomies depend heavily on the specialization ofindividuals and firms, connected by an extensive net-work of trade. Western economies have enjoyedrapid economic growth as increasing specializationhas allowed workers to become highly productive inparticular occupations and to trade their output forthe commodities they need.

Specialization occurs when people and countriesconcentrate their efforts on a particular set of tasks—it permits each person and country to use to its bestadvantage its specific skills and resources. One of thefacts of economic life is that, rather than have every-one do everything in a mediocre way, it is better toestablish a division of labor—dividing production intoa number of small specialized steps or tasks. A divi-sion of labor permits tall people to play basketball,numerate people to teach, and persuasive people tosell cars. It sometimes takes many years to receive thetraining for particular careers—it usually takes 14postgraduate years to become a certified neurosur-geon.

Capital and land are also highly specialized. Landcan be specialized, as in the vineyard lands of Cali-fornia and France, which it has taken decades to cul-tivate. The computer software that went along withthe labor to write this textbook took over a decadeto be developed, but it is useless at managing an oilrefinery or solving large numerical problems. Oneof the most impressive examples of specialization isthe computer chip that manages automobiles, in-creases their efficiency, and can even serve as a “blackbox” to record accident data.

The enormous efficiency of specialization allowsthe intricate network of trade among people and na-tions that we see today. Very few of us produce a sin-gle finished good; we make but the tiniest fractionof what we consume. We might teach a small part ofone college’s curriculum, or empty coins from park-ing meters, or separate the genetic material of fruitflies. In exchange for this specialized labor, we willreceive an income adequate to buy goods from allover the world.

The idea of gains from trade forms one of the cen-tral insights of economics. Different people or coun-tries tend to specialize in certain areas; they then

TRADE, MONEY, AND CAPITAL 31

judges of the town to employ the number and length ofthreads that he desires after the question has been con-sidered by four of the oldest merchants and four of theoldest weavers of the guild.” Smith argued that suchrestrictions—whether imposed by government or bymonopolies, whether on production or on foreign trade—limit the proper workings of the market system and ulti-mately hurt both workers and consumers.

None of this should suggest that Smith was an apologistfor the establishment. He had a distrust of all entrenchedpower, private monopolies as much as public monarchies. Hewas for the common people. But, like many of the great econ-omists,he had learned from his research that the road to wasteis paved with good intentions.

Above all, it is Adam Smith’s vision of the self-regulat-ing “invisible hand” that is his enduring contribution tomodern economics.

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engage in the voluntary exchange of what they pro-duce for what they need. Japan has grown enor-mously productive by specializing in manufacturinggoods such as automobiles and consumer electron-ics; it exports much of its manufacturing output topay for imports of raw materials. By contrast, coun-tries which have tried the strategy of becoming self-sufficient, attempting to produce most of what theyconsume, have discovered that this is the road to stag-nation. Trade can enrich all nations and increaseeveryone’s living standards.

To summarize:

Advanced economies engage in specializationand division of labor, which increase the productiv-ity of their resources. Individuals and countries thenvoluntarily trade goods in which they specialize forothers’ products, vastly increasing the range andquantity of consumption and having the potential toraise everyone’s living standards.

The plastic and hair come from Taiwan and Japan.Assemblyused to be done in those countries but has now migratedto lower-cost locations in Indonesia, Malaysia, and China.Themolds themselves come from the United States, as do thepaints used in decorating. China supplies labor and the cot-ton cloth used for dresses.The dolls sell for $10, of which35 cents covers Chinese labor, 65 cents covers foreign ma-terials, $1 covers Hong Kong profits and transportation, andthe rest is Mattel profit, marketing, and transportation ex-penses in the United States.1

Evidence indicates that this process of slicing up theproductive process is typical of manufacturing activities inthe United States and other high-income countries.

A second component of globalization is the increas-ing integration of financial markets. Financial integration isseen in the accelerated pace of lending and borrowingamong nations as well as in the convergence of interestrates among different countries. The major causes of fi-nancial market integration have been the dismantling of re-strictions on capital flows among nations, cost reductions,and innovations in financial markets, particularly the use ofnew kinds of financial instruments.

Financial integration among nations has undoubtedlyled to gains from trade, as nations with productive usesfor capital can borrow from countries with excess saving.In the last two decades, Japan has served as the world’smajor lending country. Surprisingly, the United States hasbeen the world’s largest borrower—partly because of itslow national savings rate and partly because of the tech-nological dynamism of its computer, telecommunication,and biotechnology industries.

Integration of goods and financial markets has pro-duced impressive gains from trade in the form of lowerprices, increased innovation, and more rapid economicgrowth. But these gains have been accompanied by painfulside effects.

One consequence of economic integration is the un-employment and lost profits that occur when low-cost foreign producers displace domestic production. The unemployed textile worker, the bankrupt soybean farmer—they find little solace in the fact that consumers are enjoying lower prices for food and clothing.Those who losefrom increased international trade have become tireless advocates of “protectionism” in the form of tariffs and quotas on international trade.

GlobalizationYou can hardly open a newspaper todaywithout reading about the most recenttrends in “globalization.” What exactly does

this term mean? How can economics contributeto understanding the issues?

Globalization is a popular term that is used to denotean increase in economic integration among nations. Increas-ing integration is seen today in the dramatic growth in the flows of goods, services, and capital across nationalborders.

One major component of globalization is the spec-tacular increase in the share of national output devoted toimports and exports. With a continuous drop in trans-portation and communication costs, along with decliningtariffs and other barriers to trade, the share of trade inU.S. national output has more than doubled over the lasthalf-century. Domestic producers now compete with pro-ducers from around the world in their prices and designdecisions.

The increased share of trade has been accompaniedby increased specialization in the production process itselfas different stages of production are “outsourced” to dif-ferent countries. A typical example is the production ofBarbie dolls:

1 See Feenstra in the Further Reading section at the end ofthis chapter.

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gine. It can grow out of control and cause a hyper-inflation, in which prices increase very sharply. Whenthat happens, people concentrate on spending theirmoney quickly, before it loses its value, rather thaninvesting it for the future. That’s what happened toseveral Latin American countries in the 1980s, andmany former socialist economies in the 1990s, whenthey had inflation rates exceeding 1000 percent oreven 10,000 percent per year. Imagine getting yourpaycheck and having it lose 20 percent of its valueby the end of the week!

Money is the medium of exchange. Proper man-agement of the money supply is one of the major is-sues for government macroeconomic policy in allcountries.

CAPITAL

An advanced industrial economy like the UnitedStates uses an enormous number of buildings, ma-chines, computers, software, and so on. These arethe factors of production called capital—a producedfactor of production, a durable input which is itselfan output of the economy.

Most of us do not realize how much our daily ac-tivities depend upon capital, including our houses,the highways on which we drive, and the wires thatbring electricity and cable TV to our homes. The to-tal net private capital stock in the U.S. economy ismore than $19 trillion—including government-owned, business, and residential capital. On average,this is $70,000 per person.

As we have seen, capital is one of the three ma-jor factors of production. The other two, land andlabor, are often called primary factors of production.That means their supply is mostly determined bynoneconomic factors, such as the fertility rate andthe country’s geography. Capital, by contrast, has tobe produced before you can use it. For example,some companies build textile machinery, which isthen used to make shirts; some companies build farmtractors, which are then used to help produce corn.

Use of capital involves time-consuming, round-about methods of production. People learned longago that indirect and roundabout production tech-niques often are more efficient than direct methods

MONEY: THE LUBRICANT OF EXCHANGE 33

A second consequence comes when financial inte-gration triggers international financial crises. In the late1990s, problems in Thailand, Mexico, and Russia spilledover into stock and bond markets around the world.Thecontagion arising from small disturbances is a direct re-sult of closely linked markets. American investors puttheir funds into Thailand, seeking higher returns. Butthese same investors are likely to pull out their fundswhen they smell trouble, and that can lead to a financialcrisis as countries attempt to prop up exchange ratesor financial institutions in the face of a massive specula-tive attack.

Globalization raises many new issues for policymak-ers. Are the gains from trade worth the domestic costsin terms of social disruption and dislocation? Should coun-tries prevent investors from moving funds in and out sorapidly that domestic markets are threatened? Does in-tegration lead to greater inequality? Should internationalinstitutions become lenders of last resort for countriesin financial difficulties? These questions are on the mindsof policymakers around the world who are attempting todeal with globalization.

MONEY:THE LUBRICANT OF EXCHANGE

If specialization permits people to concentrate onparticular tasks, money then allows people to tradetheir specialized outputs for the vast array of goodsand services produced by others. What is money?Money is the means of payment—the currency andchecks that we use when we buy things. But more thanthat, money is a lubricant that facilitates exchange.When everyone trusts and accepts money as paymentfor goods and debts, trade is facilitated. Just imaginehow complicated economic life would be if you hadto barter goods for goods every time you wanted tobuy a pizza or go to a concert. What services couldyou offer Sal’s Pizza? And what about your educa-tion—what could you barter with your college for tu-ition that it needs? Because everyone accepts moneyas the medium of exchange, the need to match sup-plies and demands is enormously simplified.

Governments control the money supply throughtheir central banks. But like other lubricants, moneycan get overheated and damage the economic en-

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Capital and Private PropertyIn a market economy, capital typically is privatelyowned, and the income from capital goes to indi-viduals. Every patch of land has a deed, or title ofownership; almost every machine and building be-longs to an individual or corporation. Property rightsbestow on their owners the ability to use, exchange,paint, dig, drill, or exploit their capital goods. Thesecapital goods also have market values, and peoplecan buy and sell the capital goods for whatever pricethe goods will fetch. The ability of individuals to ownand profit from capital is what gives capitalism its name.

However, while our society is one built on privateproperty, property rights are limited. Society deter-mines how much of “your” property you may be-queath to your heirs and how much must go in in-heritance and estate taxes to the government. Societydetermines how much your factory can pollute andwhere you can park your car. Even your home is notyour castle: you must obey zoning laws and, if nec-essary, make way for a road.

Interestingly enough, the most valuable eco-nomic resource, labor, cannot be turned into acommodity that is bought and sold as private prop-erty. Since the abolition of slavery, it has been againstthe law to treat human earning power like other cap-ital assets. You are not free to sell yourself; you mustrent yourself at a wage.


of production. For example, the most direct methodof catching fish is to wade into a stream and grab fishwith your hands, but this yields more frustration thanfish. By using a fishing rod (which is capital equip-ment), fishing time becomes more productive interms of fish caught per day. By using even more cap-ital, in the form of nets and fishing boats, fishing be-comes productive enough to feed many people andprovide a good living to those who operate the spe-cialized nets and equipment.

Growth from the Sacrifice of Current Consump-tion. If people are willing to save—to abstain frompresent consumption and wait for future consump-tion—society can devote resources to new capitalgoods. A larger stock of capital helps the economygrow faster by pushing out the PPF. Look back at Fig-ure 1-5 to see how forgoing current consumption infavor of investment adds to future production possi-bilities. High rates of saving and investment help ex-plain how Taiwan, China, and other Asian countrieshave grown so fast over the last three decades. Bycomparison, many poor countries save and invest lit-tle—they start the economic race at the back and fallfurther behind because they cannot accumulate pro-ductive capital.

Is there no limit to the amount of useful capital?Should we continue to boost productivity by addingmore capital, by replacing all direct processes withmore productive, roundabout ones and all round-about processes with still more roundaboutprocesses? While this seems sensible, it has a highcost because too much roundabout investmentwould cause too great a reduction in today’s con-sumption. Investing resources to give every workeran advanced degree, to remove 99.9 percent of pol-lution, and to build a subway system under everytown and hamlet would certainly increase produc-tivity. But the payoff would not be worth the enor-mous cost in reducing consumption.

We summarize as follows:

Economic activity involves forgoing current con-sumption to increase our capital. Every time we in-vest—building a new factory or road, increasing theyears or quality of education, or increasing the stockof useful technical knowledge—we are enhancingthe future productivity of our economy and increas-ing future consumption.

Property rights for capital and pollutionProperty rights define the ability of individu-als or firms to own, buy, sell, and use the cap-ital goods and other property in a

market economy. These rights are enforcedthrough the legal framework, which constitutes

the set of laws within which an economy operates. An effi-cient and acceptable legal framework for a market econo-my includes the definition of property rights, the laws ofcontract, and a system for adjudicating disputes.

As the ex-communist countries are discovering, it isvery difficult to have a market economy when there are nolaws enforcing contracts or guaranteeing that a company can keep its own profits. And when the legalframework breaks down, as in the former Yugoslavia or indrug-producing countries like Colombia, people begin tofear for their lives and have little time or inclination to

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government intervention. In the real world, however,no economy actually conforms totally to the ideal-ized world of the smoothly functioning invisiblehand. Rather, every market economy suffers fromimperfections which lead to such ills as excessive pol-lution, unemployment, and extremes of wealth andpoverty.

For that reason, no government anywhere inthe world, no matter how conservative, keeps itshands off the economy. In modern economies gov-ernments take on many tasks in response to theflaws in the market mechanism. The military, thepolice, the national weather service, and highwayconstruction are all typical areas of government ac-tivity. Socially useful ventures such as space explo-ration and scientific research benefit from govern-ment funding. Governments may regulate somebusinesses (such as banking and drugs) while sub-sidizing others (such as education and healthcare). Governments also tax their citizens and re-distribute some of the proceeds to the elderly andneedy.

How do governments perform their functions?Governments operate by requiring people to paytaxes, obey regulations, and consume certain collec-tive goods and services. Because of its coercive pow-ers, the government can perform functions thatwould not be possible under voluntary exchange.This coercion increases the freedoms and consump-tion of those who benefit while reducing the incomesand opportunities of those who are taxed or regu-lated.

But for all the wide range of possible activities,governments have three main economic functions ina market economy. These functions are increasingefficiency, promoting equity, and fostering macro-economic stability and growth.

1. Governments increase efficiency by promotingcompetition, curbing externalities like pollution,and providing public goods.

2. Governments promote equity by using tax and ex-penditure programs to redistribute income to-ward particular groups.

3. Governments foster macroeconomic stability andgrowth—reducing unemployment and inflationwhile encouraging economic growth—throughfiscal policy and monetary regulation.

We will examine briefly each function.

THE ECONOMIC ROLE OF GOVERNMENT 35

make long-term investments for the future. Productionfalls and the quality of life deteriorates. Indeed, many ofthe most horrifying African famines were caused by civilwar and the breakdown in the legal order, not by badweather.

The environment is another example where poorlydesigned property rights harm the economy. Water andair are generally open-access resources, meaning that noone owns and controls them. As the saying goes, “Every-one’s business is nobody’s business.” As a result, people donot weigh all the costs of their actions. Someone mightthrow trash into the water or emit smoke into the air be-cause the costs of dirty water or foul air are borne byother people. By contrast, people are less likely to throwtrash on their own lawn or burn coal in their own livingroom because they themselves will bear the costs.

In recent years, economists have proposed extendingproperty rights to environmental commodities by sellingor auctioning permits to pollute and allowing them to betraded on markets. Preliminary evidence suggests that thisextension of property rights has given much more pow-erful incentives to reduce pollution efficiently.

Specialization, trade, money, and capital formthe key to the productiveness of an advanced econ-omy. But note as well that they are closely interre-lated. Specialization creates enormous efficiencies,while increased production makes trade possible.Use of money allows trade to take place quickly andefficiently. Without the facility for trade and ex-change that money provides, an elaborate divisionof labor would not be possible. Money and capitalare related because the funds for buying capitalgoods are funneled through financial markets,where people’s savings can be transformed intoother people’s capital.

C. THE ECONOMIC ROLE OFGOVERNMENT

An ideal market economy is one in which all goodsand services are voluntarily exchanged for money atmarket prices. Such a system squeezes the maximumbenefits out of a society’s available resources without

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What is the effect of imperfect competition? Im-perfect competition leads to prices that rise abovecost and to consumer purchases that are reduced be-low efficient levels. The pattern of too high price andtoo low output is the hallmark of the inefficienciesassociated with imperfect competition.

In reality, almost all industries possess some meas-ure of imperfect competition. Airlines, for example,may have no competition on some of their routesbut face several rivals on others. The extreme caseof imperfect competition is the monopolist—a singlesupplier who alone determines the price of a par-ticular good or service. For example, Microsoft hasbeen a monopolist in the production of Windows op-erating systems.

Over the last century, most governments havetaken steps to curb the most extreme forms of im-perfect competition. Governments sometimes regu-late the price and profits of monopolies such as local water, telephone, and electric utilities. In addi-tion, government antitrust laws prohibit actions suchas price fixing and agreeing to divide up markets.The most important check to imperfect competition,however, is the opening of markets to competitors,whether they be domestic or foreign. Few monopo-lies can long withstand the attack of competitors unless governments protect them through tariffs orregulations.

ExternalitiesA second type of inefficiency arises when there arespillovers or externalities, which involve involuntaryimposition of costs or benefits. Market transactionsinvolve voluntary exchange in which people ex-change goods or services for money. When a firmbuys a chicken to make frozen drumsticks, it buysthe chicken from its owner in the chicken market,and the seller receives the full value of the hen. Whenyou buy a haircut, the barber receives the full valuefor time, skills, and rent.

But many interactions take place outside mar-kets. While airports produce a lot of noise, they gen-erally do not compensate the people living aroundthe airport for disturbing their peace. On the otherhand, some companies which spend heavily on re-search and development have positive spillover ef-fects for the rest of society. For example, researchersat AT&T invented the transistor and launched theelectronic revolution, but AT&T’s profits increased


EFFICIENCY

Adam Smith recognized that the virtues of the mar-ket mechanism are fully realized only when thechecks and balances of perfect competition are pres-ent. What is meant by perfect competition? This is atechnical term that refers to a market in which nofirm or consumer is large enough to affect the mar-ket price. For example, the wheat market is perfectlycompetitive because the largest wheat farm, produc-ing only a minuscule fraction of the world’s wheat,can have no appreciable effect upon the price ofwheat.

The invisible-hand doctrine applies to economiesin which all the markets are perfectly competitive.Perfectly competitive markets will produce an effi-cient allocation of resources, so the economy is onits production-possibility frontier. When all indus-tries are subject to the checks and balances of per-fect competition, as we will see later in this book,markets will produce the bundle of outputs most de-sired by consumers using the most efficient tech-niques and the minimum amount of inputs.

Alas, there are many ways that markets can fallshort of efficient perfect competition. The threemost important involve imperfect competition, suchas monopolies; externalities, such as pollution; andpublic goods, such as national defense and light-houses. In each case, market failure leads to ineffi-cient production or consumption, and governmentcan play a useful role in curing the disease.

Imperfect CompetitionOne serious deviation from an efficient marketcomes from imperfect competition or monopoly elements.Whereas under perfect competition no firm or con-sumer can affect prices, imperfect competition oc-curs when a buyer or seller can affect a good’s price.For example, if the telephone company or a laborunion is large enough to influence the price ofphone service or labor, respectively, some degree ofimperfect competition has set in. When imperfectcompetition arises, society may move inside its PPF.This would occur, for example, if a single seller (amonopolist) raised the price to earn extra profits.The output of that good would be reduced below themost efficient level, and the efficiency of the econ-omy would thereby suffer. In such a situation, the in-visible-hand property of markets may be violated.

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by only a small fraction of the global social gains. Ineach case, an activity has helped or hurt people out-side the market transaction; that is, there was an eco-nomic transaction without an economic payment.

Externalities (or spillover effects) occur whenfirms or people impose costs or benefits on othersoutside the marketplace.

Governments are generally more concerned withnegative externalities than positive ones. As our so-ciety has become more densely populated and as theproduction of energy, chemicals, and other materi-als increases, negative externalities or spillover ef-fects have grown from little nuisances into majorthreats. This is where governments come in. Gov-ernment regulations are designed to control exter-nalities like air and water pollution, damage fromstrip mining, hazardous wastes, unsafe drugs andfoods, and radioactive materials.

In many ways, governments are like parents, al-ways saying no: Thou shalt not expose thy workers todangerous conditions. Thou shalt not pour out poi-sonous smoke from thy factory chimney. Thou shaltnot sell mind-altering drugs. Thou shalt not drivewithout wearing thy seat belt. And so forth. Findingthe precisely correct regulations is a difficult task thatrequires complex science and economics and is sub-ject to heavy political pressure, but few today wouldargue for returning to the unregulated economicjungle where firms would be allowed to dump pol-lutants like plutonium wherever they wanted.

Public GoodsWhile negative externalities like pollution or globalwarming command most of the headlines, positiveexternalities may well be economically more signifi-cant. Important examples of positive externalities areconstruction of a highway network, operation of anational weather service, support of basic science,and provision of measures to enhance public health.These are not goods which can be bought and soldin markets. Adequate private production of thesepublic goods will not occur because the benefits areso widely dispersed across the population that no sin-gle firm or consumer has an economic incentive toprovide the service and capture the returns.

The extreme example of a positive externality isa public good. Public goods are commodities forwhich the cost of extending the service to an addi-

tional person is zero and which it is impossible to ex-clude individuals from enjoying. The best exampleof a public good is national defense. When a nationprotects its freedoms and way of life, it does so forall its inhabitants, whether they want the protectionor not and whether they pay for it or not.

Because private provision of public goods is gen-erally insufficient, the government must step in toencourage the production of public goods. In buy-ing public goods like national defense or lighthouses,the government is behaving exactly like any otherlarge spender. By casting sufficient dollar votes in cer-tain directions, it causes resources to flow there.Once the dollar votes are cast, the market mecha-nism then takes over and channels resources to firmsso that the lighthouses or tanks get produced.

EFFICIENCY 37

Are lighthouses public goods?For many years, lighthouses were used toillustrate the notion of public goods. Theysave lives and cargoes. But lighthouse keep-

ers cannot reach out to collect fees from ships;nor, if they could, would it serve an efficient

social purpose for them to exact an economic pen-alty on ships who use their services. The light can be provided most efficiently free of charge, for it costs nomore to warn 100 ships than to warn a single ship of thenearby rocks.

This view became controversial when Nobel Prize-winning economist Ronald Coase reviewed the history oflighthouses in England and Wales and determined thatthese had been privately operated. Coase found that Eng-lish lighthouses operated profitably under licenses pur-chased from the Crown and were financed by govern-ment-authorized “light duties” levied on ships which usednearby ports. From this history, Coase concluded that“contrary to the belief of many economists, a lighthouseservice can be provided by private enterprise.” Some haveeven concluded that lighthouses are not public goods.

But let’s look carefully here.The two key attributes ofa public good are that the cost of extending the service toan additional person is zero (“nonrivalry”) and that it isimpossible to exclude individuals from enjoying it (“nonex-cludability”). Both these characteristics are applicable tolighthouses.

But a “public” good is not necessarily publicly pro-vided. Often, it is provided by no one. Moreover, just

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because it is privately provided does not indicate that it isefficiently provided or that a market mechanism can payfor the lighthouse.The English example shows the inter-esting case where, if provision of the public good can betied to another good or service (in this case, vessel ton-nage), and if the government gives private persons theright to collect what are essentially taxes, then an alter-native mechanism for financing the public good can befound. Such an approach would work poorly where thefees could not be easily tied to tonnage (such as in inter-national waterways). And it would not work at all if thegovernment refused to privatize the right to collect lightduties on shipping.

America shows quite a different experience. From itsearliest days, the United States believed that navigationalaids should be government-provided. Indeed, one of thefirst acts of the first Congress, and America’s first public-works law, provided that “the necessary support, main-tenance, and repairs of all lighthouse, beacons, [and] buoys . . . shall be defrayed out of the Treasury of the United States.”

But, like many public goods, lighthouses were provid-ed meager funding, and it is interesting to note what hap-pened in the absence of navigational aids. A fascinating caselies off the east coast of Florida, which is a treacherouswaterway with a 200-mile reef lying submerged a few feetbelow the surface in the most active hurricane track of theAtlantic Ocean.This heavily used channel was prime terri-tory for storm, shipwreck, and piracy.

There were no lighthouses in Florida until 1825, andno private-sector lighthouses were ever built in this area.The market responded vigorously to the perils, however.What arose from the private sector was a thriving “wreck-ing” industry. Wreckers were ships that lurked near thedangerous reefs waiting for an unfortunate boat tobecome disabled. The wreckers would then appear, offertheir help in saving lives and cargo, tow the boat into theappropriate port, and then claim a substantial part of thevalue of the cargo. Wrecking was the major industry ofsouth Florida in the mid-nineteenth century and made KeyWest the richest town in America at that time.

While wreckers probably had positive value added,they provided none of the public-good attributes of light-houses. Indeed, because many cargoes were insured, therewas significant “moral hazard” involved in navigation. Con-nivance between wreckers and captains often enrichedboth at the expense of owners and insurance companies.

It was only when the U.S. Lighthouse Service, financed bygovernment revenues, began to build lighthouses throughthe Florida channel that the number of shipwrecks beganto decrease—and the wreckers were gradually driven outof business.

Lighthouses are no longer a central issue of public pol-icy today and are mainly of interest to tourists.They havebeen largely replaced by the satellite-based Global Posi-tioning System (GPS), which is also a public good providedfree by the government. But the history of lighthouses re-minds us of the problems that can arise when public goodsare inefficiently provided.

Taxes. The government must find the revenues topay for its public goods and for its income-redistrib-ution programs. Such revenues come from taxeslevied on personal and corporate incomes, on wages,on sales of consumer goods, and on other items. Alllevels of government—city, state, and federal—col-lect taxes to pay for their spending.

Taxes sound like another “price”—in this casethe price we pay for public goods. But taxes differfrom prices in one crucial respect: taxes are not vol-untary. Everyone is subject to the tax laws; we are allobligated to pay for our share of the cost of publicgoods. Of course, through our democratic process,we as citizens choose both the public goods and thetaxes to pay for them. However, the close connectionbetween spending and consumption that we see forprivate goods does not hold for taxes and publicgoods. I pay for a hamburger only if I want one, butI must pay my share of the taxes used to finance de-fense and public education even if I don’t care a bitfor these activities.

EQUITY

Our discussion of market failures like monopoly orexternalities focused on defects in the allocative roleof markets—imperfections that can be corrected byjudicious intervention. But assume for the momentthat the economy functioned with complete effi-ciency—always on the production-possibility frontierand never inside it, always choosing the right amountof public versus private goods, and so forth. Even ifthe market system worked perfectly, it might still leadto a flawed outcome.

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Markets do not necessarily produce a fair distri-bution of income. A market economy may produceinequalities in income and consumption that are notacceptable to the electroate.

Why might the market mechanism produce anunacceptable solution to the question for whom? Thereason is that incomes are determined by a wide va-riety of factors, including effort, education, inheri-tance, factor prices, and luck. The resulting incomedistribution may not correspond to a fair outcome.Moreover, recall that goods follow dollar votes andnot the greatest need. A rich man’s cat may drinkthe milk that a poor boy needs to remain healthy.Does this happen because the market is failing? Notat all, for the market mechanism is doing its job—putting goods in the hands of those who have thedollar votes. If a country spends more fertilizing itslawns than feeding poor children, that is a defect ofincome distribution, not of the market. Even themost efficient market system may generate great in-equality.

Often the income distribution in a market systemis the result of accidents of birth. Every year Forbesmagazine lists the 400 richest Americans, and it’s im-pressive how many of them either received theirwealth by inheritance or used inherited wealth as aspringboard to even greater wealth. Would everyoneregard that as necessarily right or ideal? Probablynot. Should someone be allowed to become a bil-lionaire simply by inheriting 5000 square miles ofrangeland or the family’s holding of oil wells? That’sthe way the cookie crumbles under laissez-faire cap-italism.

For most of American history, economic growthwas a rising tide that lifted all boats, raising the in-comes of the poor as well as those of the rich. Butover the last two decades, changes in family structureand declining wages of the less skilled and less edu-cated have reversed the trend. With a return togreater emphasis on the market has come greaterhomelessness, more children living in poverty, anddeterioration of many of America’s central cities.

Income inequalities may be politically or ethicallyunacceptable. A nation does not need to accept theoutcome of competitive markets as predeterminedand immutable; people may examine the distribu-tion of income and decide it is unfair. If a democratic

society does not like the distribution of dollar votesunder a laissez-faire market system, it can take stepsto change the distribution of income.

Let’s say that voters decide to reduce income in-equality. What tools could the government use to im-plement that decision? First, it can engage in pro-gressive taxation, taxing large incomes at a higher ratethan small incomes. It might impose heavy taxes onwealth or on large inheritances to break the chainof privilege. The federal income and inheritancetaxes are examples of such redistributive progressivetaxation.

Second, because low tax rates cannot help thosewho have no income at all, governments can maketransfer payments, which are money payments to peo-ple. Such transfers today include aid for the elderly,blind, and disabled and for those with dependentchildren, as well as unemployment insurance for thejobless. This system of transfer payments provides a“safety net” to protect the unfortunate from priva-tion. And, finally, governments sometimes subsidizeconsumption of low-income groups by providingfood stamps, subsidized medical care, and low-cost housing—though in the United States, suchspending comprises a relatively small share of totalspending.

These programs have become increasingly un-popular in the last two decades. As the real wages ofthe middle class have stagnated, people naturally askwhy they should support the homeless or able-bod-ied people who do not work. What can economicscontribute to debates about equality? Economics asa science cannot answer such normative questions ashow much of our market incomes—if any—shouldbe transferred to poor families. This is a politicalquestion that can be answered only at the ballot box.

Economics can, however, analyze the costs orbenefits of different redistributive systems. Econo-mists have devoted much time to analyzing whetherdifferent income-redistribution devices (such astaxes and food stamps) lead to social waste (e.g., peo-ple working less or buying drugs rather than food).They have also studied whether giving poor peoplecash rather than goods is likely to be a more efficientway of reducing poverty. Economics cannot answerquestions of how much poverty is acceptable and fair,but it can help design more effective programs to in-crease the incomes of the poor.

EQUITY 39

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by active monetary and fiscal policies, the marketeconomies witnessed a period of unprecedented eco-nomic growth in the three decades after World War II.

In the 1980s, governments became more con-cerned with also designing macroeconomic policiesto promote long-term objectives, such as economicgrowth and productivity. (Economic growth denotes thegrowth in a nation’s total output, while productivityrepresents the output per unit input or the efficiencywith which resources are used.) For example, taxrates were lowered in most industrial countries in or-der to improve incentives for saving and production.Many economists emphasized the importance of pub-lic saving through smaller budget deficits as a way toincrease national saving and investment.

Macroeconomic policies for stabilization andeconomic growth include fiscal policies (of taxingand spending) along with monetary policies (whichaffect interest rates and credit conditions). Since thedevelopment of macroeconomics in the 1930s, gov-ernments have succeeded in curbing the worst ex-cesses of inflation and unemployment.

Table 2-1 summarizes the economic role playedby government today. It shows the important gov-ernmental functions of promoting efficiency, achiev-


MACROECONOMIC GROWTH AND STABILITY

Since its origins, capitalism has been plagued by pe-riodic bouts of inflation (rising prices) and recession(high unemployment). Since World War II, for ex-ample, there have been nine recessions in the UnitedStates, some putting millions of people out of work.These fluctuations are known as the business cycle.

Today, thanks to the intellectual contribution ofJohn Maynard Keynes and his followers, we knowhow to control the worst excesses of the business cy-cle. By careful use of fiscal and monetary policies,governments can affect output, employment, and in-flation. The fiscal policies of government involve thepower to tax and the power to spend. Monetary pol-icy involves determining the supply of money and in-terest rates; these affect investment in capital goodsand other interest-rate-sensitive spending. Usingthese two fundamental tools of macroeconomic pol-icy, governments can influence the level of totalspending, the rate of growth and level of output, thelevels of employment and unemployment, and theprice level and rate of inflation in an economy.

Governments in advanced industrial countrieshave successfully applied the lessons of the Keynesianrevolution over the last half-century. Spurred on

Failure of Market Economy Government Intervention Current Examples of Government PolicyInefficiency:

Monopoly Encourage competition Antitrust laws, deregulation

Externalities Intervene in markets Antipollution laws, antismoking ordinances

Public goods Encourage beneficial activities Build lighthouses, provide public education

Inequality:

Unacceptable inequalities of Redistribute income Progressive taxation of income and wealthincome and wealth Income-support or transfer programs (e.g.,

food stamps)Macroeconomic problems:

Business cycles (high Stabilize through macroeconomic Monetary policies (e.g., changes in moneyinflation and unemployment) policies supply and interest rates)

Fiscal policies (e.g., taxes and spending programs)

Slow economic growth Stimulate growth Invest in education

Raise national savings rate by reducing bud-get deficit or increasing budget surplus.

TABLE 2-1. Government Can Remedy the Shortcomings of the Market

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ing a fairer distribution of income, and pursuing themacroeconomic objectives of economic growth andstability. In all advanced industrial societies we findsome variant of a mixed economy, in which the mar-ket determines output and prices in most individualsectors while government steers the overall economywith programs of taxation, spending, and monetaryregulation.

TWILIGHT OF THE WELFARE STATE?

In 1942, the great Austria-born Harvard economistJoseph Schumpeter argued that the United States was“capitalism living in an oxygen tent” on its march tosocialism. Capitalism’s success would breed alienationand self-doubt, sapping its efficiency and innovation.But he was wrong. The next half-century saw sustainedgrowth in government’s involvement in the economiesof North America and Western Europe along with themost impressive economic performance ever recorded.

Rapid economic growth has been accompaniedby increased skepticism about government’s role.Critics of government say that the state is overly in-trusive; governments create monopoly; governmentfailures are just as pervasive as market failures; hightaxes distort the allocation of resources; social secu-rity threatens to overload workers in the decadesahead; environmental regulation dulls the spirit ofenterprise; government attempts to stabilize theeconomy must fail at best and increase inflation atworst. In short, for some, government is the prob-lem rather than the solution.

TWILIGHT OF THE WELFARE STATE? 41

Guardians of economic freedom:Friedrich Hayek and Milton FriedmanEconomists, being human, are subject to fluc-

tuations in opinions and ideology. Because gov-ernment policies seemed so successful in mobi-

lizing the U.S. and U.K. war economies for military victoryover Germany and Japan during World War II, and becauseactive macroeconomic policies seemed to succeed in con-quering the Great Depression, conservative laissez-faireideologies came to represent only minority opinion amongmost free-world professional economists.

Two eminent scholars never wavered in their skepti-cism about the merits of heavy government intervention

in the economy. Friedrich Hayek (1899–1992), of Vienna,London, and Chicago, and Milton Friedman (1912– ), ofthe University of Chicago and the Hoover Library at Stan-ford, received Nobel Prizes in economics for their scien-tific innovations. Their work is today highly regarded byconservative and “libertarian” economic thinkers.

Hayek’s most influential work examined the efficiencyof different forms of economic organization.The 1920s and1930s witnessed a great debate as to whether resourcescould be efficiently organized under socialism. Oskar Langeand Abba Lerner argued that a socialist firm could use cap-italist-style pricing and thereby emulate a market economywithout the monopolistic tendencies of capitalism. Hayekprovided an important rebuttal. He pointed out that costsand production possibilities are not known. Only with theincentives of a private, free-enterprise system could the in-formation dispersed among the millions of economic agentsbe effectively mobilized and used. No system can generateinnovations without the carrot of profits and the stick ofbankruptcy. Modern economics, with its emphasis on dis-persed and asymmetrical information, owes much to thebrilliant insights of Hayek.

Hayek’s best-seller, and the book that most capturedthe attention of the broader public, was The Road to Serf-dom. In this work he warned that the road to the hell oftotalitarian tyranny and economic inefficiency was pavedby the good intentions of modest interferenes with freemarkets and private enterprises.

Friedman’s statistical and analytic researches haveranged widely. He documented how small the differencesare between the saving rates of rich and poor in the longrun after adjusting saving for temporary ups and downs inincome.This led to the permanent-income theory of con-sumption (which is discussed in the macroeconomic sec-tions of this text).Together with Anna Schwartz, Friedmanauthored the definitive Monetary History of the UnitedStates, 1876–1960 (1993). This book launched the mone-tarist revolution and led to an appreciation among macro-economists of how the money supply can affect aggregatespending, prices, and output. Friedman helped convinceeconomists that monetary policy definitely matters foroverall economic activity.

During the last half of the twentieth century, every-where—in the United States, Western Europe, and Asia,as well as in Stalin’s Soviet Union and Mao’s China—therehas been a significant swing back toward the competitive-market pole and away from the centralized-command pole. No one within the economist guild has been more

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have increased literacy and life expectancy. Macro-economic successes have reduced the sting of infla-tion and unemployment, while government transferprograms have brought health care to the poor andimproved the quality of life for the aged. State-sup-ported science has penetrated the atom, discoveredthe DNA molecule, and explored outer space.

Of course, these successes do not belong to gov-ernments alone. Governments harnessed private in-genuity through the market mechanism to helpachieve these social aims. And, in some cases, gov-ernments were like orators who didn’t know whenenough was enough.

The debate about government’s successes andfailures demonstrates again that drawing the bound-ary between market and government is an enduringproblem. The tools of economics are indispensableto help societies find the golden mean between lais-sez-faire market mechanisms and democratic rulesof the road. The good mixed economy is, perforce,the limited mixed economy. But those who would re-duce government to the constable plus a few light-houses are living in a dream world. An efficient andhumane society requires both halves of the mixedsystem—market and government. Operating a mod-ern economy without both is like trying to clap withone hand.


SUMMARY

A. What Is a Market?

1. In an economy like the United States, most economicdecisions are made in markets, which are mechanismsthrough which buyers and sellers meet to trade and todetermine prices and quantities for goods and serv-ices. Adam Smith proclaimed that the invisible hand ofmarkets would lead to the optimal economic outcomeas individuals pursue their own self-interest. And whilemarkets are far from perfect, they have proved re-markably effective at solving the problems of how, what,and for whom.

2. The market mechanism works as follows to determinethe what and the how: The dollar votes of people af-fect prices of goods; these prices serve as guides for

the amounts of the different goods to be produced.When people demand more of a good, its price willincrease and businesses can profit by expanding pro-duction of that good. Under perfect competition, abusiness must find the cheapest method of produc-tion, efficiently using labor, land, and other factors;otherwise, it will incur losses and be eliminated fromthe market.

3. At the same time that the what and how problems arebeing resolved by prices, so is the problem of for whom.The distribution of income is determined by the own-ership of factors of production (land, labor, and capi-tal) and by factor prices. People possessing fertile landor the ability to hit home runs will earn many dollar

important, both as an architect and as an expositor of thisshift, than Milton Friedman. His classic book, Capitalism and Freedom (1962), argues why a rational thinker might,along with advocating free international trade and maxi-mal deregulation, deplore the minimum wage, state licens-ing of surgeons, and prohibition of drugs like heroin andcocaine. All thoughtful economists should study his argu-ments carefully.

In weighing the relative merits of state and mar-ket, public debate often oversimplifies the complexchoices that societies face. Markets have worked mir-acles in some countries. But without the right kindof legal and political structure, and without the so-cial overhead capital that promotes trade and privateinvestment, markets have also produced corrupt cap-italism with great inequality, pervasive poverty, anddeclining living standards.

In economic affairs, success has many parents,while failure is an orphan. The success of marketeconomies may lead us to overlook the many successesof collective action over the last century, as the caseof the lighthouse reminds us. Collective action hashelped reduce malnutrition and conquered many ter-rible diseases like smallpox. Government programs

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votes to buy consumer goods. Those without propertyor with skills, color, or sex that the market underval-ues will receive low incomes.

B. Trade, Money, and Capital

4. As economies develop, they become more special-ized. Division of labor allows a task to be broken intoa number of smaller chores that can each be mas-tered and performed more quickly by a singleworker. Specialization arises from the increasing ten-dency to use roundabout methods of productionthat require many specialized skills. As individualsand countries become increasingly specialized, theytend to concentrate on particular commodities andtrade their surplus output for goods produced byothers. Voluntary trade, based on specialization,benefits all.

5. Trade in specialized goods and services today relies onmoney to lubricate its wheels. Money is the universallyacceptable medium of exchange—including primarilycurrency and checking deposits. It is used to pay foreverything from apple tarts to zebra skins. By accept-ing money, people and nations can specialize in pro-ducing a few goods and can then trade them for oth-ers; without money, we would waste much timenegotiating and bartering.

6. Capital goods—produced inputs such as machinery,structures, and inventories of goods in process—per-mit roundabout methods of production that addmuch to a nation’s output. These roundabout meth-ods take time and resources to get started and there-fore require a temporary sacrifice of present con-sumption in order to increase future consumption.The rules that define how capital and other assetscan be bought, sold, and used are the system of prop-erty rights. In no economic system are private-prop-erty rights unlimited.

C. The Economic Role of Government

7. Although the market mechanism is an admirable wayof producing and allocating goods, sometimes marketfailures lead to deficiencies in the economic outcomes.The government may step in to correct these failures.Its role in a modern economy is to ensure efficiency,to correct an unfair distribution of income, and to pro-mote economic growth and stability.

8. Markets fail to provide an efficient allocation of re-sources in the presence of imperfect competition orexternalities. Imperfect competition, such as monop-oly, produces high prices and low levels of output. Tocombat these conditions, governments regulate busi-nesses or put legal antitrust constraints on business be-havior. Externalities arise when activities impose costsor bestow benefits that are not paid for in the mar-ketplace. Governments may decide to step in and reg-ulate these spillovers (as it does with air pollution) orprovide for public goods (as in the case of public health).

9. Markets do not necessarily produce a fair distributionof income; they may spin off unacceptably high in-equality of income and consumption. In response, gov-ernments can alter the pattern of incomes (the forwhom) generated by market wages, rents, interest, anddividends. Modern governments use taxation to raiserevenues for transfers or income-support programsthat place a financial safety net under the needy.

10. Since the development of macroeconomics in the1930s, the government has undertaken a third role:using fiscal powers (of taxing and spending) and mon-etary policy (affecting credit and interest rates) to pro-mote long-run economic growth and productivity andto tame the business cycle’s excesses of inflation andunemployment. Since 1980, the blend of the mixedeconomy called the welfare state has been on the de-fensive in the enduring struggle over the boundary be-tween state and market.

CONCEPTS FOR REVIEW 43

CONCEPTS FOR REVIEW

The Market Mechanism

market, market mechanismmarkets for goods and for factors of

productionprices as signalsmarket equilibriumperfect and imperfect competitionAdam Smith’s invisible-hand doctrine

Features of a Modern Economy

specialization and division of labormoneyfactors of production (land, labor,

capital)capital, private property, and prop-

erty rights

Government’s Economic Role

efficiency, equity, stabilityinefficiencies: monopoly and exter-

nalitiesinequity of incomes under marketsmacroeconomic policies:fiscal and monetary policiesstabilization and growth

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FURTHER READING AND INTERNET WEBSITES

Further Reading

A useful discussion of globalization is contained in “Sym-posium on Globalization in Perspective,” Journal of Eco-nomic Perspectives, fall 1998.

For examples of the writings of libertarian economists, seeMilton Friedman, Capitalism and Freedom (University ofChicago Press, 1963), and Friedrich Hayek, The Road toSerfdom (University of Chicago Press, 1994).

A strong defense of government interventions in the econ-omy can be found in Robert Kuttner, Everything for Sale:The Virtues and Limits of the Market (University of ChicagoPress, 1999) and in Anne Alstott and Bruce Ackerman, TheStakeholder Economy (Yale University Press, New Haven, CT,1999).

A fascinating example of how a small economy is organ-ized without money is found in R. A. Radford, “The Eco-nomic Organization of a P.O.W. Camp,” Economica, vol. 12,November 1945, pp. 189–201.

Websites

You can explore recent analyses of the economy along witha discussion of major economic policy issues in the Eco-nomic Report of the President at w3.access.gpo.gov/eop/. Seewww.whitehouse.gov for federal budget information and asan entry point into the useful Economic Statistics BriefingRoom.

Major issues are presented from a conservative or liber-tarian economic perspective at the website of the Cato In-stitute, www.cato.org/.

QUESTIONS FOR DISCUSSION

1. What determines the composition of national output?In some cases, we say that there is “consumer sover-eignty,” meaning that consumers decide how to spendtheir incomes on the basis of their tastes and marketprices. In other cases, decisions are made by politicalchoices of legislatures. Consider the following exam-ples: transportation, education, police, energy effi-ciency of appliances, health-care coverage, televisionadvertising. For each, describe whether the allocationis by consumer sovereignty or by political decision.Would you change the method of allocation for any ofthese goods?

2. When a good is limited, some means must be foundto ration the scarce commodity. Some examples of ra-tioning devices are auctions, ration coupons, andfirst-come, first-served systems. What are the strengthsand weaknesses of each? Explain carefully in whatsense a market mechanism “rations” scarce goods andservices.

3. This chapter discusses many “market failures,” areas inwhich the invisible hand guides the economy poorly,and describes the role of government. Is it possiblethat there are, as well, “government failures,” govern-ment attempts to curb market failures that are worse

than the original market failures? Think of some ex-amples of government failures. Give some examples inwhich government failures are so bad that it is betterto live with the market failures than to try to correctthem.

4. Consider the following cases of government interven-tion: regulations to limit air pollution, income supportfor the poor, and price regulation of a telephone mo-nopoly. For each case, (1) explain the market failure,(2) describe a government intervention to treat theproblem, and (3) explain how “government failure”(see the definition in question 3) might arise becauseof the intervention.

5. The circular flow of goods and inputs illustrated in Fig-ure 2-1 has a corresponding flow of dollar incomes andspending. Draw a circular-flow diagram for the dollarflows in the economy, and compare it with the circu-lar flow of goods and inputs. What is the role of moneyin the dollar circular flow?

6. Give three examples of specialization and division oflabor. In what areas are you and your friends thinkingof specializing? What might be the perils of overspe-cialization?

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7. “Lincoln freed the slaves. With one pen stroke he de-stroyed much of the capital the South had accumu-lated over the years.” Comment.

8. The table opposite shows some of the major expendi-tures of the federal government. Explain how each onerelates to the economic role of government.

QUESTIONS FOR DISCUSSION 45

Major Expenditure Categories for Federal Government

Budget category Federal spending, 2001 ($, billion)

Social security 426

Health care and Medicare 387

National defense 291

Income security 260

Interest on public debt 208

Natural resources and 25environment

International affairs 20

Source: Office of Management and Budget, Budget of theUnited States Government, Fiscal Year 2001.

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