Chapter 3

ECONOMIC INSTITUTIONS

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 3-2

Today’s lecture 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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 3-3

Today’s lecture 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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 3-4

The Market Economy

• The U.S. economy is a market economy – an
economic system that gives private property rights
to individuals and relies 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 individuals’
wants.
• Most economists believe the market is a good way
to coordinate economic activity.

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 3-5

Capitalism and Socialism

• Capitalism is an economic system based
upon the market.
 The means of production are owned by a
small group of individuals (capitalists).
• 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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 3-6

Capitalism and Socialism

• Socialism in practice involved 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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 3-7

Evolving 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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 3-8

The U.S. Economy

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 3-9

Business
• 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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 3-10

Forms of Business
By Numbers By Receipts

Sole
proprietorships
(72%) Corporations (84%)

Partnerships (8%)
Sole proprietorships (4%)
Corporations (20%) Partnerships (12%)

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Forms of Business
Advantages Disadvantages
•Minimum regulatory •Limited ability to get
hassle funds
Proprietorship •Direct control by owner •Unlimited personal
liability
•Ability to share work •Unlimited personal
and risks liability
Partnership •Relatively easy to form •Limited ability to get
funds
•No personal liability •Legal hassle to
•Increased ability to get organize
Corporation funds •Possible double
•Ability to avoid personal taxation of income
income taxes •Monitoring problems
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 3-12

Forms of E-Commerce
(buying and selling over the Internet)

B2B (Business-to- Business) B2C (Business-to-Consumer)

Firms exchanging goods and Firms selling goods and services to
services through online sales and consumers through online catalogs
auctions. and shopping cart software.

C2B (Consumer-to-Business) C2C (Consumer-to-Consumer)

An individual offering goods and Individuals buying and selling goods
services to firms online. to one another online.

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 3-13

Households
• Households supply the labor with which
businesses produce and government
governs.
• The largest source of household income is
wages and salaries.
• In the economy, households vote with
their dollars to determine what businesses
produce.

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 3-14

Government

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

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 3-15

Government 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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 3-16

Income of State and Local

Government
Other Intergovernmental
9% 22%

Trust revenue
19%

Property tax
17%

Sales tax
19%
Income tax
14%
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 3-17

Expenditures of State and

Local Government
Administration and
interest 8% Transportation 5%

Civilian safety 8%
Other 14%
Environment and
Housing 6%

Unemployment
Health and hospitals 7% compensation and
retirement 8%

Public welfare 15%

Education 29%

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 3-18

Income and Expenditures of

the Federal Government
Individual income
taxes (41%)
Social security taxes and Health and
contributions (38%) Interest (10%)
education (27%)

Other (12%)

National
defense
(20%)

Excise taxes Corporate income Income security (31%)

and other (6%) taxes (15%)

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 3-19

Government 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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 3-20

Six Roles of Government

in a Market
1. Provide a stable institutional framework.
2. Promote effective and workable competition.
• Correct for externalities – the effect of a
decision on a third party not taken into
account by the decision maker.

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 3-21

Six Roles of Government

in a Market
• Ensure economic stability and growth.
• 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.
3. Adjust for undesirable market results.

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 3-22

Market Failures and

Government 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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 3-23

Global 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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 3-24

Global 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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 3-25

Coordinating 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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 3-26

Coordinating 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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 3-27

Summary
• 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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 3-28

Summary
• 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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 3-29

Summary
• 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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 3-30

Review Question 3-1: Discuss the differences be-

tween capitalism and socialism.

Capitalism gives property rights to individuals and

relies 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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 3-31

Review Question 3-2: Which sectors and markets are

involved and what is their role in the following transactions?
c. 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 to
Dell, a business.

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

F150.
Tom is a household who has purchased a product in
the goods market. Ford is a business who supplied
the product for sale in the goods market.

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