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ECONOMIC INSTITUTIONSECONOMIC INSTITUTIONS

Chapter 3Chapter 3

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In this chapter we will:In this chapter we will:

• Define market economy.

• Compare and contrast socialism with capitalism.

• Describe how businesses, households, and government interact in a market economy.

• Summarize the advantages and disadvantages of various types of businesses.

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In this chapter we will:In this chapter we will:

• Explain why much of the economic decision making is done by business and government.

• State six roles of government.

• Explain why global issues differ from national policy issues.

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The Market EconomyThe Market Economy• The U.S. economy is a market economy – an

economic system based on private property rights relying on market forces to coordinate economic activity.

• Markets work through a system of rewards and payments.

• Individuals are free to do whatever they want as long as it is legal.

• Fluctuations in prices coordinate resource use.• Most economists believe the market is a good way

to coordinate economic activity.• Historically, market economies have generated the

highest standards of living for the greatest number of people.

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Capitalism and SocialismCapitalism and Socialism• Capitalism is an economic system based

upon the rule of law, private property rights, and markets. The means of production are owned by

individuals.

• Socialism is an economic system based on individuals’ good will toward others, not their own self-interest. Everyone contributes what each can and gets

what each needs.

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Capitalism and SocialismCapitalism and Socialism

• Socialism in practice involves central planning. China calls itself a socialist country, even though it

relies heavily on markets. Venezuela is trying out a “21st century socialism.”

• Most economies are differentiated by the degree to which they rely on markets, not whether they are a socialist or capitalist economy.

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Evolving Economic SystemsEvolving Economic Systems

Feudalism – an economic system based on tradition – dominated the Western world from the 8th to the 15th century.

Mercantilism – an economic system in which the government controls economic activity by doling out the rights to undertake economic activities.

Industrial Revolution – technology and machines rapidly modernized industrial production.

Capitalism

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The U.S. EconomyThe U.S. Economy

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BusinessBusiness

• Businesses produce what they believe will sell and make a profit.

• By channeling the desire to make a profit for the general good of society, the U.S. economic system allows the invisible hand to work.

• Consumer sovereignty means that consumers’ wishes determine what is produced by businesses.

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Forms of BusinessForms of Business

Sole proprietorships (72%) Corporations (84%)

Corporations (20%)

Partnerships (8%)

Partnerships (12%)Sole proprietorships (4%)

By Numbers By Receipts

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Forms of BusinessForms of BusinessAdvantages Disadvantages

Proprietorship

•Minimum regulatory hassle

•Direct control by owner

•Limited ability to get funds

•Unlimited personal liability

Partnership

•Ability to share work and risks

•Relatively easy to form

•Unlimited personal liability

•Limited ability to get funds

Corporation

•No personal liability

•Increased ability to get funds

•Ability to avoid personal income taxes

•Legal hassle to organize

•Possible double taxation of income

•Monitoring problems

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Households Households

• Households supply the resources (land, labor, capital, entrepreneurship) with which businesses produce and government governs.• In return, households earn incomes (rent,

wages, interest, profits).• In the economy, households vote with

their dollars to determine what businesses produce (consumer sovereignty).

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GovernmentGovernment

• Government plays two general roles in the economy: An actor – collects money in taxes and

spends the money on its own projects, such as defense, education, and entitlements.

A referee – sets the rules that determine relations between businesses and households.

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Government as an ActorGovernment as an Actor

• All levels of government consume about 20% of the nation’s total output and employ about 21 million people.

• State and local governments employ 18 million workers and spend nearly $2 trillion per year.

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Income of State and Local Income of State and Local GovernmentGovernment

Sales tax19%

Other9%

Intergovernmental22%

Income tax14%

Property tax17%

Trust revenue19%

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Expenditures of State and Expenditures of State and Local GovernmentLocal Government

Education 29%

Unemployment compensation and

retirement 8%

Environment and Housing 6%

Civilian safety 8%

Transportation 5%

Other 14%

Health and hospitals 7%

Administration and interest 8%

Public welfare 15%

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Income and Expenditures of Income and Expenditures of the Federal Governmentthe Federal Government

Social security taxes and contributions (38%)

Corporate incometaxes (15%)

Excise taxesand other (6%)

Individual income taxes (41%)

National defense (20%)

Interest (10%) Health andeducation (27%)

Income security (31%)

Other (12%)

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Government as a RefereeGovernment as a Referee

• Government sets the rules of interaction between households and businesses.• Some examples are:

Businesses must comply with equal opportunity and labor laws.

Government regulates working conditions, such as safety, wage, and hours of work rules.

Businesses cannot meet with each other to set prices.

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Six Roles of Government Six Roles of Government in a Marketin a Market

1. Provide a stable institutional framework.

2. Promote effective and workable competition.

3. Correct for externalities – the effect of a decision on a third party not taken into account by the decision maker.

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Six Roles of Government Six Roles of Government in a Marketin a Market

4. Ensure economic stability and growth.

5. Provide for public goods – a good that if supplied to one person must be supplied to all and whose consumption by one individual does not prevent its consumption by another individual.

6. Adjust for undesirable market results.

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Market Failures and Market Failures and Government FailuresGovernment Failures

• Market failures are situations in which the market does not lead to a desired result.

• Government failures are situations where government intervention makes things worse.

• Policy makers must decide which is the least problematic – market failure or government failure.

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Global InstitutionsGlobal Institutions

• The U.S. economy makes up 20% of world output and consumption, but only 6% of the world’s land mass and less than 5% of the world’s population.

• U.S. economic institutions, such as global corporations, are integrated with the world’s economy.

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Global CorporationsGlobal Corporations• Global corporations – corporations with

substantial operations in both production and sales in more than one country.

• Global corporations create jobs, bring new technologies, and provide competition for domestic companies.

• There is no global government to regulate global corporations.

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Coordinating Global IssuesCoordinating Global Issues

• United Nations – an organization designed to achieve international cooperation but having no power to tax or enforce its policies on its members.

• World Bank – a multinational, international financial institution that works to secure loans for developing countries.

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Coordinating Global IssuesCoordinating Global Issues• International Monetary Fund (IMF) – a

multinational international financial institution concerned with monetary issues.

• Group of Five – Japan, Germany, Britain, France, and the U.S. – meets to promote negotiations and coordinate economic relations among nations.

• Group of Eight – includes the Group of Five plus Canada, Italy, and Russia – does much the same work as the Group of Five.

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SummarySummary

• The U.S. economy is a market economy, capitalism, which gives private property rights to individuals.

• A market economy relies on prices to solve the what, how, and for whom problems.

• Socialism is an economic system in which society, based on individual goodwill, rather than self-interest, to solve the what, how, and for whom problems.

• In practice socialism was an economic system based on government ownership of production, with economic activity governed by central planning.

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SummarySummary• The circular flow diagram of the U.S.

market economy shows the 3 sectors: Businesses – decide what, how much, and for

whom in producing goods and services. The 3 main forms are proprietorships, partnerships, and corporations.

Households – supply labor in the factor market and influence business decisions through consumer sovereignty.

Government – serves as a referee and actor in the economy.

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SummarySummary

• Six roles of government are to provide a stable set of institutions and rules promote effective and workable competition correct for externalities ensure economic stability and growth provide public goods adjust for undesirable market results

• Because there is no world government, governments enter voluntary organizations that regulate international markets.

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Review Question 3-1: Discuss the differences be-tween capitalism and socialism.

Capitalism gives property rights to individuals andrelies on market forces through prices to answer the what, how, and for whom economic problems.

In socialism society answers the what, how, and for whom economic problems in the best interest of the individuals in society. Government usually owns the means of production and coordinates economic activity with central planning.

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Review Question 3-2: Which sectors and markets areinvolved and what is their role in the following transactions?a. Susie works her first month for Dell Computers as an engineer and receives a check for $10,000 (her salary).

Susie is a household who has sold her resources(labor and human capital) in the factor market toDell, a business.

b. Tom pays $18,000 to Ford Motor Company for a new F150.

Tom is a household who has purchased a product inthe goods market. Ford is a business who suppliedthe product for sale in the goods market.