A. What Is a Market?

1. In an economy like the United States, most economic decisions are made in markets, which are mechanisms through which buyers and sellers meet to trade and to determine prices and quantities for goods and services. Adam Smith proclaimed that the invisible hand of markets would lead to the optimal economic outcome as individuals pursue their own self-interest. And while markets are far from perfect, they have proved remarkably effective at solving the problems of how, what, and for whom.

2. The market mechanism works as follows to determine the what and the how: The dollar votes of people affect 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 will increase and businesses can profit by expanding production of that good. Under perfect competition, a business must find the cheapest method of production, efficiently using labor, land, and other factors; otherwise, it will incur losses and be eliminated from the market.

3. At the same time that the what and how problems are being resolved by prices, so is the problem of for whom. The distribution of income is determined by the ownership of factors of production (land, labor, and capital) and by factor prices. People possessing fertile land or the ability to hit home runs will earn many dollar votes to buy consumer goods. Those without property or with skills, color, or sex that the market undervalues will receive low incomes.

B. Trade, Money, and Capital

4. As economies develop, they become more specialized. Division of labor allows a task to be broken into a number of smaller chores that can each be mastered and performed more quickly by a single worker. Specialization arises from the increasing tendency to use roundabout methods of production that require many specialized skills. As individuals and countries become increasingly specialized, they tend to concentrate on particular commodities and trade their surplus output for goods produced by others. Voluntary trade, based on specialization, benefits all.

5. Trade in specialized goods and services today relies on money to lubricate its wheels. Money is the universally acceptable medium of exchangeÑincluding primarily currency and checking deposits. It is used to pay for everything from apple tarts to zebra skins. By accepting money, people and nations can specialize in producing a few goods and can then trade them for others; without money, we would waste much time negotiating and bartering.

6. Capital goodsÑproduced inputs such as machinery, structures, and inventories of goods in processÑpermit roundabout methods of production that add much to a nation’s output. These roundabout methods take time and resources to get started and therefore require a temporary sacrifice of present consumption in order to increase future consumption. The rules that define how capital and other assets can be bought, sold, and used are the system of property rights. In no economic system are private-property rights unlimited.

C. The Economic Role of Government

7. Although the market mechanism is an admirable way of producing and allocating goods, sometimes market failures 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 promote economic growth and stability.

8. Markets fail to provide an efficient allocation of resources in the presence of imperfect competition or externalities. Imperfect competition, such as monopoly, produces high prices and low levels of output. To combat these conditions, governments regulate businesses or put legal antitrust constraints on business behavior. Externalities arise when activities impose costs or bestow benefits that are not paid for in the marketplace. Governments may decide to step in and regulate these spillovers (as it does with air pollution) or provide for public goods (as in the case of public health).

9. Markets do not necessarily produce a fair distribution of income; they may spin off unacceptably high inequality of income and consumption. In response, governments can alter the pattern of incomes (the for whom) generated by market wages, rents, interest, and dividends. Modern governments use taxation to raise revenues for transfers or income-support programs that place a financial safety net under the needy.

10. Since the development of macroeconomics in the 1930s, the government has undertaken a third role: using fiscal powers (of taxing and spending) and monetary policy (affecting credit and interest rates) to promote long-run economic growth and productivity and to tame the business cycle’s excesses of inflation and unemployment. Since 1980, the blend of the mixed economy called the welfare state has been on the defensive in the enduring struggle over the boundary between state and market