ECON 1 Lecture 7: Free Market Economy

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23 Mar 2017

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Free market economies are econ. sys. that are based on voluntary trade. The players in the free market economy are households and firms. A household is a person or a group of people living in the same residence. Households own the factors of production + consume goods and services. A business, or a firm is an organization that uses resources to produce a product, and then sell it. Firms transform inputs or factors of production, into outputs or products. The lower arena of exchange is called the factor market, in which firms purchase factors of production from households. Overall process (including both factor and product market) Firms purchase factors of production--land, labor, capital-- from households. Households pay firms for goods and services. Note: (firms rent or purchase land (natural resources), hire workers, paying them wages/salaries for their labor, and may borrow money from households to purchase capital, paying interest or profits in return).

Related Questions

What is the market for factors of production?

What is the market for factors of production?
1. The market for factors of production is where households and firms interact to trade factors of production for factor payments. For example this is where people provide firms with labor and firms pay them with wages.
What is the money market?
1. The money market is where households, firms, and the government may save and/or invest their money to earn interests. Money market includes banks, stock market, bonds market, and other financial institutions where economic actors can buy and sell financial assets to earn interests and/or dividends.
Who are the three economic actors in the circular flow model?
1. In a circular flow model, the three main economic actors are the households, firms, and the government. Households include the typical individual consumers. Firms include businesses and similar producers in the economy. Finally, the government refers to the whole government system from federal to local level.
How is the national income of an economy determined?
1. The national income of an economy is determined by measuring the total value of the output produced in an economy or the total income earned by the actors in the economy. In a circular flow model, we can see that the value of total output produced should equal the total value of income generated and earned in the economy. This is because every dollar spent by someone in the economy is received by another person in the economy as income.
What is GDP?
1. The gross domestic product or GDP represents the sum total of the value of the final goods and services produced within the economy for a given year. It is the most commonly used measure of its economy’s productivity and income.

Market Analysis Market Participants Market participants act as if they are rational, self-interested, and forward-looking. For example, financial managers try to maximize the present value of profits for their particular companies, rather than ignore future values. Companies pursue many goals, but it is a financial mistake for managers to pursue any goal that conflicts with the primary goal of maximizing their firm's profits. Decentralized decision making by individual market participants is more economically efficient that centralized decision making by government policymakers. For example, it is more economically efficient to have financial managers obtain financing for their particular companies than to have government obtain it. A high degree of competition among market participants is the most economically efficient disciplining mechanism. For example, highly competitive financial markets discipline financial managers to pay fair market interest rates on the debt securities issued by their particular companies. The market system of prices is the most economically efficient allocative mechanism. For example, it is more economically efficient to distribute a firm's corporate stock to those buyers who are willing and able to pay the market price of the stock than to have the government distribute the stock. It is economically efficient for market participants to buy low and sell high globally. For example, it is economically efficient for U.S. firms to sell their financial securities to the highest bidders, no matter where they live in the world economy. Market imperfections can create considerable risk to market participants. For example, because of market imperfections, firms operating in the international financial markets encounter foreign exchange rate risk, political risk, interest rate risk, and default risk. Consumer Sovereignty The principle of consumer sovereignty tells us that by making their dollar votes, consumers indirectly determine the quantity and quality of products that firms will produce. For example, it is not economically efficient for financial managers to obtain more financing for their particular firms than is needed for their firms to produce the profit-maximizing level of output demanded by consumers. Market Economy A highly competitive market economy is largely self-regulating, in the absence of substantial market imperfections, in that economic conditions cannot be substantially improved by government regulation or other types of government intervention beyond laissez-faire policies. For example, if a firm's corporate stock is overvalued by a market economy, market forces will tend to drive down the value of the stock to a market price at which it is neither overvalued nor undervalued. As if by an invisible hand, highly competitive market forces will tend to create a harmony of interests among individual market participants, in the absence of substantial market imperfections. Consequently, the interests of shareholders and other stakeholders are compatible. For example, in trying to maximize profits, firms produce employment, income, consumer products, and wealth for households, as well as tax revenue for government, which helps maximize consumer utility and maximize social welfare. In a market economy, resources, products, and assets flow to their highest valued uses among alternative uses. For example, the shares of firms' corporate stocks will be acquired by those market participants who most highly value them, as indicated by the fact that they are willing to pay the most to acquire them. The efficient economic role of government is limited to Laissez-Faire ("hands off") policies, which create very little intervention in a market economy. For example, government regulations of banking and securities industries to maintain healthy, reasonably profitable, consumer-oriented financial markets would not be needed in a highly competitive market economy in the absence of substantial market imperfections. In a market economy, it is economically efficient for each market participant to specialize according to comparative advantage in producing what they can produce relatively better than other market participants, rather than produce all the outputs they can produce absolutely better than others. For example, it is economically efficient for people who are relatively better at being financial managers than others, to specialize in financial management even if they are absolutely better than others in doing many other types of work. If all labor were allocated to its comparative advantage, then no possible reallocation of labor would exist that could increase the rate of return to labor (i.e., the wage). There is no such thing as a free lunch, because all resources, products, and assets in a market economy are scarce. For example, current federal government budget deficits are not free to current market participants in that the deficits must be financed by future tax increases and/or future decreases in government spending and/or future inflation. For additional information on the Market Economy click here. Marks, R. E. (2006, December). There Is No Such Thing As Free Lunch. Australian Journal of Management. 31(2). 1-7. Financial Decisions An efficient financial decision, practice, transaction, or condition is one that is optimal -- meaning best; it cannot be improved, from society's perspective. If there is some profitable way to improve some business practice that would benefit society, that practice is somewhat inefficient. Any change in a financial decision, practice, transaction, or condition that improves society is an efficiency improvement. For example, it is an efficiency improvement for a business to cut production costs by reducing waste (e.g., by reducing spending on unprofitable activity. A financial decision, practice, transaction, or condition is fair-- meaning just or equitable, if the financial benefits are distributed to those involved in proportion to how much they each voluntarily contributed to produce those benefits. For example, a financial practice that discriminates against some people on the basis of race, age, gender, nationality, or religion is unfair. For example, an unethical business practice is unfair. For additional information relating to Market Analysis and fair financial decisions, click on the following: Teaching Ethical Economic Practices to Business Managers. Johnston, C. (2009, October). The Proceedings of the Annual Conference of The International Academy of Business and Economics. Fairness is a necessary condition, but not a sufficient condition, for efficiency. All efficient financial practices are fair, but some fair practices may still fail to be efficient. For example, embezzling company funds is an unfair and inefficient, criminal financial activity. As another example, an ethical business practice that could be improved is fair but not efficient. Opportunity Cost Principle Opportunity cost principle: The efficient measure of the cost of any allocation of resources, products, money income, wealth, or time is its opportunity cost -- the value of the next best use. The opportunity cost of how one uses his or her resources is the value of the highest valued alternative use. The opportunity cost of one investment is the expected return on the next best investment available to the firm. For example, the opportunity cost of a firm using some of its profits to pay dividends to its stockholders would be the present value of future income those profits could have earned if invested in the firm's highest valued investment project.

Discussion Questions These questions stem from the Class Discussion Questions you will be anwering in the Discussion Board. Think about the questions and how they relate to the financial management principles above.

2. Applications: State the financial management principle that appears to be violated in each of the following cases and explain how it is violated:

(a) A corporation is maximizing sales growth and the price of its corporate stock is falling.

(b) A highly paid financial manager in the auto industry quit his job to set up his own small auto repair shop, which is expected to incur a loss for the first three years then earn normal profits.

1. Which of the following groups of countries are all advanced economies?

		Hong Kong, Japan, France, and the United Kingdom
		Italy, the United States, China, and Russia
		Singapore, Russia, France, and Chad
		Australia, Brazil, and the United States

QUESTION 2

1. The most people live in ________ economies and the fewest people live in ________ economies.

		developing; emerging market
		advanced; emerging market
		emerging market; developing
		advanced; developing

QUESTION 3

1. Households and firms in the U.S. economy interact with those in the rest of the world in the ________ market and the ________ market.

		goods; financial
		government; goods
		goods; factor
		financial; factor

QUESTION 4

1. As a factor of production, oil reserves are counted as

		labor.
		capital.
		entrepreneurship.
		land.

QUESTION 5

1. ________ the owners of the factors of production, while ________ what amounts of those factors to hire.

		Households are; the government determines
		Firms are; households that determine
		The government is; firms determine
		Households are; firms that determine

QUESTION 6

1. The emerging market economies are

		the nations that are currently agricultural in nature.
		most of the nations of Western Europe.
		the largest grouping including the nations of China and India.
		in the transition from state-owned production to free markets.

QUESTION 7

1. In the United States, the productive factor that, as a group, receives the largest fraction of the nation's total income was

		consumption of goods and services.
		entrepreneurship.
		capital.
		labor.

QUESTION 8

1. Items bought by individuals to provide personal enjoyment are termed

		personal goods.
		consumption of goods.
		consumption or investment goods.
		standard goods.

QUESTION 9

1. In the advanced economies, ________ of the factories use advanced capital equipment and in the developing economies ________ of the factories use advanced capital equipment

		virtually all; none
		some; some
		virtually all; virtually all
		virtually all; some

QUESTION 10

1. The productive resource that includes all the "gifts of nature" is called

		land.
		labor.
		entrepreneurship.
		capital.

QUESTION 11

1. What would be an example of government good?

		Donald Trump purchases furniture for his office.
		Antonio, the manager of the local Taco Hut, purchases a new deep fryer.
		The local driver's license office purchases a new digital camera and printer.
		Jake buys an iPhone.

QUESTION 12

1. The world population is approximately ________ people.

		2 trillion
		680 million
		6.8 billion
		6.8 million

QUESTION 13

1. Computers and insurance coverage produced in the United States and sold to people in other nations are categorized as

		U.S. exports of goods and services.
		U.S. government goods and services.
		foreign capital goods.
		U.S. consumer goods and services.

QUESTION 14

1. Of the following, the federal government obtains most revenue from

		corporate income taxes.
		excise taxes.
		sales taxes.
		social security taxes.

QUESTION 15

1. Items bought by businesses to help produce other goods and services are called

		capital goods.
		government goods and services.
		consumption of goods and services.
		exports of goods and services.

QUESTION 16

1. The majority of the income earned in the United States is paid in

		profit.
		interest.
		rent.
		wages.

QUESTION 17

1. Dan missed class the day the professor covered the circular flow model. Dan asked his friend Joan to explain markets to him. Joan correctly stated that a market

		must include a written contract between buyers and sellers.
		requires a physical location for buyers and sellers to get together.
		is only a place to purchase groceries.
		is an arrangement that brings buyers and sellers together.

QUESTION 18

1. The United States possesses a large amount of human capital. As a result of this fact, in the United States, there is a

		highly skilled and educated labor force.
		a large number of kind and generous humans.
		a large number of people and a great deal of land.
		a large amount of machinery and equipment.

QUESTION 19

1. Which of the following correctly lists the categories of factors of production?

		labor, machines, buildings, capital, and entrepreneurship
		land, buildings, capital, and entrepreneurship
		land, labor, capital, and entrepreneurship
		forests, fish, buildings, capital, and entrepreneurship

QUESTION 20

1. Which of the following correctly lists the categories of factors of production?

		capital, money, and labor
		hardware, software, land, and money
		land, labor, capital, and entrepreneurship
		machines, buildings, land, and money

QUESTION 21

1. In the United States, the poorest 20 percent of households receive roughly ________ percent of total income.

		10
		3
		15
		20

QUESTION 22

1. What would be an example of a consumption service?

		Jake buys an iPhone.
		The local driver's license office purchases a new digital camera and printer.
		Antonio, the manager of the local Taco Hut, purchases a new deep fryer.
		Rhianna gets a haircut.

QUESTION 23

1. The total value of capital in the United States is around

		$47 trillion.
		$10 trillion.
		$100 trillion.
		$79 trillion.

QUESTION 24

1. An export good is a good produced

		by foreigners in the United States and purchased by U.S. households.
		in another country and purchased by U.S. residents.
		in the United States and sold to foreigners living in the United States.
		in the United States and sold in other countries.

QUESTION 25

1. ________ paid for the use of land; ________ paid for the services of labor; and ________ paid for the use of capital.

		Interest is; wages are; profit is
		Rent is; wages are; interest is
		Rent is; interest is; wages are
		Mortgages are; interest is; wages are

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ECON 1 Lecture 7: Free Market Economy

ECON 1 Full Course Notes

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