Question

The fundamental lessons about interactions among people are 1) that trade and interdependence can be mutually beneficial, 2) that markets are usually a good way of coordinating economic activity among people, and 3) that the government can potentially improve market outcomes by remedying a market failure or by promoting greater economic equality. Discuss each one of these concepts and explain how the implementation of these principles can improve people’s lives. Use relevant examples where appropriate.

Answer 1

1. Trade can make everyone better off

• Trade is not like a sports competition, where one side gains and the other side loses.
• Consider trade that takes place inside your home. Your family is likely to be involved in trade with other families on a daily basis. Most families do not build their own homes, make their own clothes, or grow their own food.
• Countries benefit from trading with one another as well.
• Trade allows for specialization in products that benefits countries (or families)

2. Markets are usually a good way to organize economic activity

Many countries that once had centrally planned economies have abandoned this system and are trying to develop market economies.

• Definition of market economy: an economy that allocates resources through the decentralized decisions of many firms and households as they interact in markets for goods and services.
• Market prices reflect both the value of a product to consumers and the cost of the resources used to produce it.
• Centrally planned economies have failed because they did not allow the market to work.
• Adam Smith and the Invisible Hand
  • Adam Smith’s 1776 work suggested that although individuals are motivated by self-interest, an invisible hand guides this self-interest into promoting society’s economic well-being.

3. Government can sometimes improve market outcomesEdit

There are two broad reasons for the government to interfere with the economy: the promotion of efficiency and equality.

• Government policy can be most useful when there is market failure.
  • Definition of market failure: a situation in which a market left on its own fails to allocate resources efficiently.
• Examples of Market Failure
  • Definition of externality: the impact of one person’s actions on the well-being of a bystander. (Ex.: Pollution)
  • Definition of market power: the ability of a single economic actor (or small group of actors) to have a substantial influence on market prices.
  • Because a market economy rewards people for their ability to produce things that other people are willing to pay for, there will be an unequal distribution of economic prosperity.
• Note that the principle states that the government can improve market outcomes. This is not saying that the government always does improve market outcomes.