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How the market system operates to solve the economic problem
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Unit 1: lesson 2.
- Property rights in a market system
- Markets and property rights
Lesson overview: economic systems, the role of incentives, and the circular flow model
- Resource allocation and economic systems
Property rights, economic systems, want to join the conversation.
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The Economic Problem
All societies face the economic problem , which is the problem of how to make the best use of limited, or scarce, resources. The economic problem exists because, although the needs and wants of people are endless, the resources available to satisfy needs and wants are limited.
Resources are limited in two essential ways:
- Limited in physical quantity , as in the case of land, which has a finite quantity.
- Limited in use , as in the case of labour and machinery, which can only be used for one purpose at any one time.
Choice and opportunity cost
Choice and opportunity cost are two fundamental concepts in economics. Given that resources are limited, producers and consumers have to make choices between competing alternatives. Individuals must choose how best to use their skill and effort, firms must choose how best to use their workers and machinery, and governments must choose how best to use taxpayer’s money.
Making an economic choice creates a sacrifice because alternatives must be given up. Making a choice results in the loss of benefit that an alternative would have provided. For example, if an individual has £10 to spend, and if books are £10 each and downloaded music tracks are £1 each, buying a book means the loss of the benefit that would have been gained from the 10 downloaded tracks. Similarly, land and other resources, which have been used to build a school could have been used to build a factory. The loss of the next best option represents the real sacrifice and is referred to as opportunity cost . The opportunity cost of choosing the school is the loss of the factory, and what could have been produced.
It is necessary to appreciate that opportunity cost relates to the loss of the next best alternative, and not just any alternative. The true cost of any decision is always the closest option not chosen.
Samuelson’s three questions
America’s first Nobel Prize winner for economics, the late Paul Samuelson , is often credited with providing the first clear and simple explanation of the economic problem – namely, that in order to solve the economic problem societies must endeavour to answer three basic questions – What to produce? How to produce? And, For whom to produce?
What to produce?
Societies have to decide the best combination of goods and services to meet their varied wants and needs. Societies must decide what quantities of different resources should be allocated to these goods and services.
How to produce?
Societies also have to decide the best combination of factors to create the desired output of goods and services. For example, precisely how much land, labour, and capital should be used to produce consumer goods such as computers and motor cars?
For whom to produce?
Finally, all societies need to decide who will benefit from the output from its economic activity, and how much they will get. This is often called the problem of distribution. Different societies may develop different ways to answer these questions.
A free good is one that is so abundant that its consumption does not deny anyone else the benefit of consuming the good. In this case, there is no opportunity cost associated with consumption or production, and the good does not command a price. Air is often cited as a free good, as breathing it does not reduce the amount available to someone else.
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Free Market Economy
Impacts of deregulation, the regulated economy, finding a balance, the bottom line, the cost of free markets.
Katrina Ávila Munichiello is an experienced editor, writer, fact-checker, and proofreader with more than fourteen years of experience working with print and online publications.
The U.S. economy is essentially a free market economy —an economic market that is run by supply and demand —with some government regulation . In a truly free market, buyers and sellers conduct their business without any government regulation, but there is a continuing debate among politicians and economists about how much government regulation is necessary for the U.S. economy.
Those who want less regulation argue that if you remove government restrictions, the free market will force businesses to protect consumers, provide superior products or services, and create affordable prices for everyone. They believe that the government is inefficient and creates nothing but a big bureaucracy that increases the cost of doing business for everyone.
Those who argue that government regulations are necessary to protect consumers, the environment, and the general public claim that corporations are not looking out for the public's interest and that it is precisely for this reason that regulations are required.
In this article, we consider the pros and cons of a completely free market versus a market with some government regulation.
- Economists and policymakers have long argued over how open or restrictive economic and trade policy should be.
- Free markets are theoretically optimal, with supply and demand guided by an invisible hand to allocate goods efficiently.
- In reality, however, free markets are subject to manipulation, misinformation, asymmetries of power & knowledge, and foster wealth inequality.
- Regulation is aimed at balancing the virtues of free markets against their pitfalls.
In its purest form, a free market economy is when the allocation of resources is determined by supply and demand , without any government intervention.
Supporters of a free market economy claim that the system has the following advantages:
- It contributes to political and civil freedom, in theory, since everybody has the right to choose what to produce or consume.
- It contributes to economic growth and transparency .
- It ensures competitive markets.
- Consumers' voices are heard in that their decisions determine what products or services are in demand.
- Supply and demand create competition, which helps ensure that the best goods or services are provided to consumers at a lower price.
Critics of a free market economy claim the following disadvantages to this system:
- A competitive environment creates an atmosphere of survival of the fittest. This causes many businesses to disregard the safety of the general public to increase the bottom line .
- Wealth is not distributed equally—a small percentage of society has the wealth while the majority lives in poverty.
- There is no economic stability because greed and overproduction cause the economy to have wild swings ranging from times of robust growth to cataclysmic recessions .
- Assumptions required for free markets to operate well are inconsistent with reality such as the myth of perfect and symmetric information, rational actors, and costless transactions.
At times, deregulation has produced mixed results, which has led to critiques of the operations of the free market. For example, until the 1980s, AT&T functioned as a regulated national monopoly. During this time period, the telecommunications industry was synonymous with American Telephone & Telegraph (AT&T). AT&T controlled nearly all aspects of the telephone business. Regional subsidiaries of the company (called "Baby Bells") held exclusive operation rights.
In the 1970s, after a period of rapid advances in telecommunications, independent companies that wanted to compete with AT&T began to emerge. These companies asserted that AT&T's telephone monopoly had effectively shut them out.
The deregulation of AT&T occurred in two distinct phases, beginning in the early 1980s. One part of this process was the Telecommunications Act of 1996. There has been extensive research on the impacts of this law (and deregulation in general), which resulted in both intended (and unintended) consequences.
The deregulation of AT&T was intended to provide consumers with more competitive long-distance telephone rates. In actuality, numerous smaller companies began offering local telephone service, countless Internet service providers sprung up to link households to the Internet, many telephone companies merged, the Baby Bells attempted to thwart competition, regional firms were slow to expand into long-distance service, and some consumers—especially residential consumers and people in rural areas—faced higher, not lower, prices as a result of deregulation.
Similarly, the deregulation of U.S. airlines in 1979 was intended to provide consumers with more choices and lower airfares. In actuality, many questions have been raised about whether or not deregulation works. When the Airline Deregulation Act passed in 1978, there were 43 airline companies. But by 2013, there were only nine airline companies. As a result of the passage of this deregulation act, many big airlines were actually forced to shutter, either filing for bankruptcy, merging into, or acquired by a competitor.
Although one of the stated goals of airline deregulation was “the avoidance of unreasonable concentration which would tend to allow one or more air carriers to unreasonably increase prices, reduce services or exclude competition,” the true story is that the airline industry continues to consolidate even further. In fact, the four largest airlines in the United States control 80% of the seats.
While airlines were able to get flight prices low for a period of time, thousands of employees lost their jobs, employees’ pensions were eliminated by bankruptcy, and poor service and customer complaints increased.
In 1978, all airline tickets were refundable, customers were allowed to change flights without penalties, travelers would be compensated for canceled flights, seats had more legroom, meals were free, and checking bags was free. By 2007, the situation had changed: Airlines now charge for checked bags, charge up to $200 for a ticket change, have eliminated most food, reduced legroom, and raised airfares.
The deregulation of the cable industry in 1996 had similar results. Since deregulation, cable TV rates have skyrocketed; according to a 2003 report by the U.S. Public Interest Research Group (PIRG), cable rates increased by more than 50% between 1996 and 2003. Clearly, in this case of deregulation, increased competition did not reduce prices for consumers.
Another example of free-market failure can be seen in environmental issues. For example, for years the oil industry fought and defeated laws requiring double-hull oil tankers to prevent spills, even after the single-hulled oil tanker Exxon Valdez spilled 11 million gallons into Prince William Sound in 1989.
Similarly, the Cuyahoga River in Northeast Ohio was so polluted with industrial waste that it caught fire several times between 1936 and 1969 before the government ordered a $1.5 billion cleanup. As such, critics of a free market system argue that although some aspects of the market may be self-regulating, other things, such as environmental concerns, require government intervention.
Regulation is a rule or law designed to control the behavior of those to whom it applies. Those who fail to follow these rules are subject to fines and imprisonment and could have their property or businesses seized. The United States is a mixed economy where both the free market and government play important roles.
A regulated economy provides the following advantages:
- It looks out for the safety of consumers.
- It protects the safety and health of the general public as well as the environment.
- It looks after the stability of the economy.
The following are disadvantages to regulation:
- It creates a huge government bureaucracy that stifles growth.
- It can create huge monopolies that cause consumers to pay more.
- It squashes innovation by over-regulating.
Some historical examples that show how well regulation works include the ban on DDT and PCBs, which destroyed wildlife and threatened human health; the establishment of the Clean Air and Water Acts, which forced the cleanup of America's rivers and set air quality standards; and the creation of the Federal Aviation Administration (FAA), which controls air traffic and enforces safety regulations.
Several historical examples of regulatory failures include:
- In response to the Sarbanes-Oxley Act of 2002 (SOX), an act written in response to accounting scandals, many companies decided it was too cumbersome to list in the United States and decided to do their initial public offerings (IPOs) on the London Stock Exchange (LSE) where they didn't have to worry about Sarbanes-Oxley.
- The coal industry has so many regulations that it is more profitable to ship coal overseas than to sell it domestically.
- Many labor and environmental regulations force businesses to move jobs offshore, where they can find more reasonable regulations
There is a delicate balance between an unregulated free market and a regulated economy. The following are some examples in which it appears that the U.S. has struck a good balance between the two:
- The Federal Deposit Insurance Corporation (FDIC) was created after the Great Depression . The FDIC insures depositors' money so that even if banks fail, the depositors won't lose their deposits.
- The Securities and Exchange Commission (SEC) regulates the stock markets , ensures honest disclosure on all stock transactions , and fights insider trading .
- The ban on CFCs prevents the destruction of the ozone layer.
Several ways in which the economy has become out of balance as a result of deregulation include:
- The deregulation of the savings and loan (S&L) industry in 1982 led to fraud and abuse, causing the federal government to spend billions to stabilize the industry after many S&Ls went under.
- Improperly trained crews led to the near-meltdown of a nuclear reactor at Three Mile Island, which released radiation into the air and water. Gordon MacLeod, the secretary of state for Pennsylvania, was fired for voicing his concerns about the lack of oversight of the nuclear industry and the inadequate preparedness of the state to respond to such emergencies.
- The lack of adequate regulation of silicone breast implants led to a situation in which manufacturers knew that the implants leaked but continued to sell them anyway, leading to a settlement of $4.75 billion to 60,000 women affected in 1994.
Free market economics isn't perfect, but neither are completely regulated economies. The key is to strike a balance between free markets and the amount of government regulation needed to protect people and the environment. When this balance is reached, the public interest is protected, and private business flourishes.
U.S. Embassy. " Chapter 2: How the U.S. Economy Works ."
Internet Archive. " Disconnecting Parties: Managing the Bell System Break-Up: An Inside View ," Page 180.
General Accounting Office. " Airline Deregulation: Changes in Airfares, Service, and Safety at Small, Medium-Sized, and Large Communities ," Page 2.
The Federation of State PIRGs. " The Failure of Cable Deregulation ."
Office of Response and Restoration. " A Final Farewell to Oil Tankers With Single Hulls ."
National Aeronautics and Space Administration. " History of the Cuyahoga River ."
Federal Aviation Administration. " A Brief History of the FAA ."
Environmental Protection Agency. " Summary of the Clean Water Act ."
Environmental Protection Agency. " DDT - A Brief History and Status ."
Congressional Research Service. " Sarbanes-Oxley and the Competitive Position of U.S. Stock Markets ," Page 1.
Energy Information Administration. " In 2018, U.S. Coal Exports Were the Highest in Five Years ."
Energy Information Administration. " Coal Explained ."
Federal Deposit Insurance Corporation. " History of the FDIC ."
Securities and Exchange Commission. " About the SEC ."
National Aeronautics and Space Administration. " Ozone Hole Is Big, but Tempered by CFC Reductions ."
Federal Deposit Insurance Corporation. " The Savings and Loan Crisis and Its Relationship and Its Relationship to Banking to Banking ," Page 169.
Office of Scientific and Technical Information. " Staff Reports to the President's Commission on the Accident at Three Mile Island ," Page 327.
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