How People Interact

The first four principles discussed how individuals make decisions. As we go about our lives, many of our decisions affect not only ourselves but other people as well. The next three principles concern how people interact with one another.

Principle 5: Trade Can Make Everyone Better Ofp

You have probably heard on the news that the Japanese are our competitors in the world economy. In some ways, this is true because American and Japanese firms produce many of Ihe same goods. Ford and Toyota compete for the same customers in tin; market for automobiles. Apple and Sony compote for the same customers in the market for digital music players-

Yet it is easy to be misled when thinking about competition among countries. Trade between the United States and Japan is not like a sports contest in which one side win» and Ihe other side lose». In fact, the opposite is true: Trade between two countries can make each country better off.

To see why, consider how trade affects your family. When a member of your family looks for a job. he or she competes against members of other families who are looking for job». Families also compete against one another when they go shopping because each family wants to buy the best goods at the lowest prices. In a sense, each family in the economy is competing with all other families.

Despite this competition, your family would not be better off isolating itself from all other families. If it did, your family would need to grow it» own food, make its own clothes, and build its own home. Clearly, your family gains much from its ability to trade with others. Trade allows each person to specialize in Ihe activities he or slu: doits best, whether it is farming, sewing, or home building. By trading with others, people can buy a greater variety of gcvds ami services at lower cost.

Countries as well as families benefit from the ability to trade with one another. Trade allows countries lo specialize in what they do best and to enjoy a greater variety of goods and service». The Japanese, a» well a» the French and the Egyptians and the Brazilians, arc as much our partners in the world cconomy as they are our competitors.

Principle 6: Marrets Are Usually a Good Way to Organize Economic Activity

The collapse of communism in the Soviet Union and Eastern Europe in the 1980s may be tin; most important change in the world during the past half century.

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G^mmunist countries worked on the premise that government officials were in the best position to allocate the economy's scarce resources. These central planners decided what goods and services were produced, how much was produced, and who produced and consumed these good» and scrvices- The theory behind central planning was that only the government could organize economic activity in a way that promoted economic well-being for the country as a whole.

Most countries that once lud centrally planned economies have abandoned the system and are instead developing market economies- In a market economy, the market economy an economy that alio cates resources through the decentralized decisions of many firms and households as they interact in markets *or goods and scrviccs decisions of a central planner are replaced by the decisions of millions of firms and households. Firms decide whom to hire and what to make. Households decide which firms to work /or and what to buy with their incomes. These firnts ami households interact in the marketplace, where prices and self-interest guide their decisions.

At ftrsi glance, the success of market economies is puzzling. In a market economy, no one is looking Out for the economic well-being of society as a whole. Free markets contain many buyers and sellers of numerous goods and services, and all of them are interested primarily in their own well-being. Yet despite decentralized division making and self-interested decision makers, market economies have proven remarkably succcssfiil in organizing economic activity to promote overall economic well-being.

In his 1776 book An Inquiry into the Nature ami Causes of the Wealth of Nations, economist Adam Smith made the most famous observation in all of economics: Households and firms interacting in markets act as if they are guided by an "invisible hand" that leads them to desirable market outcomes. One of our goals in this book is to understand how this invisible hand works its magic.

As you study economics, you will learn that prices are the instrument with which the invisible hand directs economic activity. In any market, buyers look at the price when determining how much to demand, and sellers look at the price when deciding how much to supply. As a result of the decisions that buyers ami sellers make, market prices reflect both tire value of a goixl to society and the cost to soctcty of making the good. Smith's great insight was that prices adjust to guide these individual buyers and sellers to reach outcomes that, in many cases, maximize the well-being of society as a whole.

Smith's insight has an important corollary: When the government prevents prices from adjusting naturally to supply and demand, it impedes the invisible hand's ability to coordinate the decisions of tlx- households and firms that make up the economy. This corollary explains why taxes adversely affect the allocation of resources, for they distort prkes and thus the decisions of household* and firms It also explains the great harm caused by policies that directly control prices, such as rent control. And it explains the failure of communism. In Communist countries, prices were not determined in the marketplace but were dictated by central plan-iKrs These planners lacked the necessary information about consumers' tastes and producers' costs, which in a market economy are reflected in prices. Central planners failed because they tried to run the economy with one hand tied behind their backs—the invisible hand of the marketplace.

Principle 7: Governments Can Sometimes Improve Market Outcomes

If the invisible hand of the market is so groat, why do wc need government? One purpose of studying economics is to refine your view about the proper role and scope of government policy.

One reason we need government is that the invisible hand can work its magic only if the government enforces the rules and maintains the institutions that are property riqhts key to a market economy. Most important, market economic« need institutions the ability cA ar indmri to property rights so individuals can own and control scarce resources, ual to own »«d «wetttse A former won't grow fotnl if he expects his crop to be stolen; a restaurant won't control over scarce serve meals unless it is assured that customers will pay before they leave; and a resources music company won't produce CDs if too many potential customers avoid paying


by making illegal copies. We nil rely on government-provided police and courts to enforce our rights over the things we produce—and the invisible hand counts on nur ability to enforce Our rights.

Vet there is another reason we need government: The invisible band is powerful, but it is not omnipotent. There are two broad reasons for a government to intervene in the economy and change the allocation of resources that people would chouse on tlu-ir own: to promote efficiency >>r to pn>mote equality. That is, most policies aim either to enlarge the economic pie or to change bow the pie is divided.

Consider first the goal of efficiency. Although the invisible hand usually leads markets to allocate resources to maximize the size of the economic pie. this is not always the case, e conomists use the term market failure to refer to a situation in which the market on its own fails to produce an efficient allocation of resources. As we will see, one possible cause of market failure is an externality, which is the impact of one person's actions on the well-being of a bystander. The classic example of an externality is pollution. Another possible cause of market failure market failure a iit.iat.on in which a market left on it» own foils to allocate resources efficiently externality th& impact of ono parson's actions on ll>e welt-being ol a bystander

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is market power, which refers to the ability of «1 single person (or small group) to unduly influence market prices. For example, if everyone in town needs water but there is only one well, the owner of the well is not subject to the rigorous competition with which the invisible hand normally keeps self-interest in check. In the presence of externalities or market power, well-designed public policy can enhance economic efficiency.

Now consider the goal of equality. Even when the invisible hand is yielding efficient outcomes, it can nonetheless leave sizable disparities in economic well-being. A market economy rewards people according to their ability to produce things that other people are willing to pay for. The world's best basketball player earns more than the world's best chess player simply because people are willing to pay more to watch basketball than chess- The invisible hand does not ensure that everyone has sufficient food, decent clothing, and adequate healthcare. This inequality may, depending on one's political philosophy, eall for government intervention. In practice, many public policies, such as the income tax and the welfare system, aim to achieve a more equal distribution of economic well-being.

To say thai the government cum improve on market outcomes at times does not mean that it always will. Public policy is made not by angels but by a political pn>-cess that is far from perfect. Sometimes policies are designee! simply to reward the politically powerful. Sometimes they are made by well-intentioned leaders who are not fully informed. As you sludy economics, you will become a better judge of when a government policy is justifiable because it promotes efficiency or «-quality and when it is not.

QUICK QUIZ Why it * country better off not lK>latlng ¡twlf from all other eountrl*»? • Why do we have markets and, according to economists, what roles should government play in them?

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