1
Unit III: The Individual, The Government, and Mix Markets
Key Understandings:
1. Both economic relation and political relation represent cooperation on the part of two or
more individuals.
2. Voluntarily exchanges have mutual benefits to both parties.
3. All exchanges involve private and social cost and benefits.
4. Collective actions to promote the common good do not benefit all individuals equally nor do
they exert the same private cost on each individual.
5. The are no right or wrong solutions to problems, there are only trade-offs. As long as
resources are scarce there will have to be trade-offs.
6. The concept of scarcity applies to both the private individual and the government.
7. Collective action through government decisions will have an impact on the market.
2
Key Terms:
Mix market economy- an economy that is directed by both private individuals and the
government.
Cost- the expenditure of a resource to obtain a goal, cost can be measured in the value of a
resources alternative uses.
Opportunity Cost- highest value alternative given up.
Marginal cost - is the change in the total cost that arises when the quantity produced changes
by one unit.
Private Cost- Are costs paid by only the private firm or consumer and must be included in
production and consumption decisions.
External Cost- An external cost is a cost that a producer or a consumer imposes on another
producer or consumer, outside of any market transaction between them. "External" means
"outside." Here, "outside" means outside of any buying and selling among people or firms. If
there is an external cost on you, you are giving something up without receiving any agreedupon payment. For example if a company pollutes the air.
Social Cost- Social costs include both the private costs and any other external costs to society
arising from the production or consumption of a good or service.
3
Key Terms:
Benefits- increasing utility (improving one’s standard of living) or ability to satisfy one’s needs
and wants. In other words the favorable result from allocation of limited resources for an
economic activity or project.
Marginal Benefits- The additional satisfaction or utility that a person receives from consuming
an additional unit of a good or service. A person's marginal benefit is the maximum amount
they are willing to pay to consume that additional unit of a good or service. In a normal
situation, the marginal benefit will decrease as consumption increases.
Private Benefits- Are benefits enjoyed by only the private firm or consumer and must be
included in production and consumption decisions.
External Benefits- An external benefit is a benefit that someone gains because of someone else's
action, outside of any market transaction between them. Immunizations give external benefits.
When you get a vaccine for a certain disease, you make it less likely that you will contract the
disease. That is the internal benefit. What you also do is make is less likely that other people will
get the disease, because they probably will not catch it from you. That is the external benefit.
Social Benefits- Social benefits include both the private benefits and any other external benefits
to society arising from the production or consumption of a good or service
4
Key Terms:
Equilibrium- When marginal benefits equal marginal costs.
Market failure- An economic term that encompasses a situation where, in any given market, the
quantity of a product demanded by consumers does not equate to the quantity supplied by
suppliers. This is a direct result of a lack of certain economically ideal factors, which prevents
equilibrium. Market failures have negative effects on the economy because an optimal
allocation of resources is not attained.
Government failure- Government failure is a situation where government intervention in the
economy creates inefficiency and leads to a misallocation of scarce resources. Government
failures can refer when government policy is the root of inefficiency. Additionally,
government failure may refer to a situation where government interaction made existing
market failures worse. Finally, passive government failure refers to situations where the
government does not fix the existing market failure.
Trade- offs- a situation that involves losing one quality or aspect of something in return for
gaining another quality or aspect. It often implies a decision to be made with full
comprehension of both the upside and downside of a particular choice.
decision that involves giving up something to gain something else.
“There are no right or wrong “solutions” to problems, there are only trade-offs.”
5
Key Terms:
Private property- property owned by private individuals and not the government.
Eminent domain- The power to take private property for public use by a state, municipality, or
private person or corporation authorized to exercise functions of public character, following
the payment of just compensation to the owner of that property.
Takings clause- located in the 5th Amendment, “nor shall private property be taken for public
use, without just compensation.”
Hold out problem- When an economic exchange requires agreement by multiple independent
parties, the potential exists for an individual to strategically delay agreement in an attempt to
capture a greater share of the surplus created by the exchange. This “holdout problem” is a
common feature of the land assembly literature because development frequently requires the
assembly of multiple parcels of land. Properly understood, it is a form of monopoly power that
potentially arises in the course of land assembly. Once assembly begins, individual owners,
knowing their land is essential to the completion of the project, can hold out for prices in excess
of their opportunity costs."
6
Key Terms:
Pareto improvement- an action done in an economy that harms no one and helps at least one
person. The theory suggests that Pareto improvements will keep adding to the economy until it
achieves a Pareto equilibrium, where no more Pareto improvements can be made.
Pareto efficiency- If there is no way of improving the situation of one person, without making
that of another person worse, the solution found is Pareto-efficient
Entrepreneur- one who organizes, manages, and assumes the risks of a business or enterprise.
It is important to note that successful entrepreneurs are innovators that satisfy the wants of the
society.
Risk-is the potential of loss resulting from a given action, activity and/or inaction. Potential
losses themselves may also be called "risks". Any human endeavor carries some risk, but some
are much riskier than others. The market penalizes those who take unnecessary risk.
Incentive- An incentive is something that motivates an individual to perform an action. The
study of incentive is central to the study of all economic activities.
Creative destruction- According to Joseph Schumpeter, process of industrial mutation that
incessantly revolutionizes the economic structure from within, incessantly destroying the old
one, incessantly creating a new one." In other words, old dated methods of using resources are
replaced with newer more efficient methods.
7
Key Terms:
Demand- principle that describes a consumer's desire, willingness and ability to pay a price for
a specific good or service
Supply- amount of a product that is available to customers.
Equilibrium Price- the Price where the quantity demanded is equal to the quantity supplied.
Price
Price ceiling- government mandated limit on how high a price can rise.
Price floor- government mandated limit on how low a price can fall.
Surplus- when quantity supplied is greater than the quantity demanded resulting from price
floors.
Shortages- when quantity supplied is less than the quantity demanded resulting from price
ceilings.
Economic regulations- Regulation consists of requirements the government imposes on private
firms and individuals to achieve government’s purposes and centrally planned goals.
Monopoly- When a single supplier owns all or nearly all of the market of a product or service.
8
the absence of competition often results in high prices and inferior products.
Outside Readings:
Government and the Economy
Kelo v New London Summary
Abundance and Scarcity
How the Price System Works
9
Introduction:
The economy of the United States can be described as a mixed market. In mixed market
economies there is a combination of free market principles with central planning by the
government. Another way of looking at mixed markets is the idea that the American economy
consist of individual choices and collective choices.
Both economics and governing necessitate cooperation between multiple individuals. The
differences arise in how the multiple individual self- interests arrive at equilibrium points.
Economically the individual is the smallest unit of decision making. Free market advocates
claim that only the individual knows what is best for themselves. Individuals will not engage in
exchanges if they don't feel that they are benefitting. Individuals will compete and cooperate
with other individuals and these interactions allocate scarce resources to their most useful
places. In short, individual decision making based on competing self-interest is the foundation
of free market equilibrium.
The foundation of government decision making comes from collective action in the name of the
public good or the common good. Government decisions take the form of laws, regulations,
programs that are intended to help the majority of individuals. But does collective action exert
the same cost to each individual? And does each individual benefit from the collective action?
When the answer is no, that is when the debate begins.
10
In unit 3 we will study each free market principle, first through the scope as an individual
decision maker and next through the scope of collective decision making i.e. government.
Although a person, can at the same time value individual freedoms while he also recognizes the
need for collective action, in many cases people tend to favor one approach over the other.
There are some free market advocates that deem any amount of government interaction no
matter how small, to be unacceptable. To them government interaction only hinders society’s
progress.
At the same time others just as firmly believe that only through the government can we as a
society ever hope to achieve our collective goals. To them individual self-interest is an evil
notion that has prevented our nation from fully reaching its creed that all men are created
equal.
Who is right? That may be an impossible question to answer. There are too many variables,
too any different unique situations, and too many diverse perspectives to even be able to say
without bias that they may both be right. In other words, it might not be proper to take a look
at society as a whole and claim that overall both perspectives should meet somewhere on the
middle.
Instead, it may be more beneficial to look at each situation on a case by case nature. Often as
voters we are forced to make a decision between two candidates, neither of which we 100%
agree with, however if we looked at the composition of each voter we would find that the
combinations of interests is infinite. We may be locked into two choices in some elections11but
the same constraints need not apply to developing your own ideas.
People develop their own ideas and perspectives based on their own set of priorities, morals,
and experiences. When an individual is fixed to a dogmatic point of view of only one way or
the other, inconsistencies and intolerance tend to arise. As Milton Friedman once jokingly
pointed out, its only the other guys’ program that is a waste of money.
Prior to investigating the specific free market principles it may be beneficial to once again revisit the fundamental economic concepts of scarcity, trade-offs, costs and benefits.
As a review, all resources are scarce (limited) and have alternative uses. The purpose of any
economic system is to allocate scarce resources that have alternative uses, to the their most
useful place.
There is no right or wrong way to allocate these resources, there are only trade-offs that
involve both costs and benefits. The goal being is that each additional cost equals each
additional benefit.
We can view cost as the expenditure of a resource to obtain a goal, cost can be measured in the
value of a resource’s alternative uses. If a factory is built next to a river, the cost of that factory
can be measured in the alternative uses of the lumber, glass, concert, steel, time, labor, land, and
knowledge that it took to build the factory.
How did society know to direct the resources to the factory? Price.
When deciding to build a factory next to the river the firm had to consider its private costs.
12
Private cost are costs imposed only on the firm and they had to be included in production and
consumption decisions.
The firm also will factor in the benefits of its decision to build a factory next to the river.
Economically a benefit can be explained as the increase in utility after resources have been
allocated.
As with private cost, the private benefits are benefits that are only enjoyed by the decision
maker, in this case the firm.
Economist agree that most decision makers think at the margin, meaning they look at how the
next action will impact them. In the case of building a factory by the river, the firm needs to
take into account the marginal (additional) cost and the marginal (additional) benefits of their
decision to build.
In this course our discussion on trade-offs, costs, and benefits does not end with simply
evaluating the marginal private cost and marginal private benefits of a decision. More often
than not additional costs and benefits of an exchange between two individuals “spill over” and
impact other individuals who were not part of the exchange. Economist call these
“neighborhood” effects an externality. An externality is a cost or benefit which results from an
activity or transaction and which affects an otherwise uninvolved party who did not choose to
incur that cost or benefit.
Continuing with our example, imagine if the new factory begins polluting the river.
13
The factory is now imposing an external cost on the local residents or anybody else who relied
on the river for fresh drinking water or good fishing.
By adding the private cost and the external cost together we can get the social cost of the
factory, because of external costs, the social cost is always higher than the private cost.
There are also external benefits. Perhaps the factory produces flu shots. Maybe only a quarter
of the community receives the flu shot, but because the flu virus cannot travel as quickly others
benefit even though they did receive the shot.
Once again if you add together private benefits and external benefits we get the social benefit.
Externalities represent market failures because the price does not take into account the entire
costs and benefits and therefore the product may be over or under produced. Many people feel
it is the government’s job to correct for externalities by taxes, regulations, laws, or subsidies.
Although it is admirable for the government to desire to limit social costs and to promote social
benefits it is very difficult and often government action makes the situation worse.
Additionally, it is unrealistic to believe that once politicians are in office that they will lose their
desire to promote their own self-interest. This self-interest often leads to exchanges between
politicians and other self-interested folks resulting in new legislation and programs that
benefits some while costing other.
Although individual actions in the market differ than the collective actions of the government
14
one area where they are similar is externalities. According to Milton Friedman, “there's a
smokestack on the back of every government program.” Friedman argued that it was a failure
of government to impose costs on individuals for programs that did not benefit them.
Decisions made in the market and government are also similar in the sense that the decisions
are made by humans beings and no human is perfect. Additionally, in most cases the
government is also restricted by the same limitations as the market.
Because governments can create policies and programs that also lead to inefficiencies and the
misallocating of scarce resources, government failure is just as possible as market failure.
Therefore when we study problems in our economy it cannot be considered a complete study to
only look at the market failure without investigating for the possibility government failure.
Finally, the most important similarity between market decisions and government decisions is
that fact that all decisions are trade-offs. These trade-offs involve both costs and benefits.
What message do you think Milton Friedman was trying to convey about government programs
when he stated, “there is no such thing as a free lunch.”
15
Mixed markets attempt to balance free market principles and government intervention and
planning. Below are two list, on the left are the established free market principles and on the
right are the common economic roles assumed by the government. Although the ideas of the
two list often conflict with each other, they can also augment each other to improve standards
of living.
Government Economic Roles
Free Market Principles
System of Limited Government
Private Property
Freedom of Enterprise and
Choice
Motive of Self Interest
System of Markets and Prices
Competition
16