Chapter 2: How Economics Affects Business: The Creation and Distribution of Wealth
I. HOW ECONOMIC CONDITIONS AFFECT BUSINESSES.
LEARNING GOAL 1
Compare and contrast the economics of despair with the economics of growth.
A. Much of AMERICAN’S BUSINESS SUCCESS is due to an economic and social climate that allows businesses to operate freely.
1. Any change in the U.S. economic system has a major influence on the business system.
2. GLOBAL ECONOMICS and WORLD POLITICS have a major influence on U.S. business.
3. The THREE BASIC OBJECTIVES of this chapter are to teach students:
a. How the free-market system works to create wealth and prosperity.
b. How free markets differ from government-controlled markets.
c. Some basic economic terms and concepts from economics that students will read in business periodicals.
B. WHAT IS ECONOMICS?
1. ECONOMICS is the study of how society chooses to employ resources to produce goods and services and distribute them for consumption among various competing groups and individuals.
2. MACROECONOMICS is that part of economic study that looks at the operation of a nation’s economy as a whole.
3. MICROECONOMICS is that part of economic study that looks at the behavior of people and organizations in particular markets.
4. Economics is sometimes defined as the allocation of scarce resources.
5. RESOURCE DEVELOPMENT is the study of how to increase resources and to create the conditions that will make better use of those resources.
C. WHY ECONOMICS WAS KNOWN AS “THE DISMAL SCIENCE.”
1. The English economist Thomas Malthus called economics “THE DISMAL SCIENCE.”
a. Many still believe that the solution to poverty is birth control.
b. World population is currently growing more slowly than expected.
c. But population in the developing world will continue to climb quickly.
2. Others believe that a large population can be a valuable resource, especially if people are educated.
3. Business owners provide JOBS AND ECONOMIC GROWTH for their employees as well as for themselves.
4. Technological advances have provided the means to increase production of food and other resources.
5. The challenge is to determine what makes some countries relatively rich and other countries relatively poor, then to implement policies that lead to increased prosperity for everyone.
D. GROWTH ECONOMICS AND ADAM SMITH.
1. ADAM SMITH advocated creating wealth through entrepreneurship.
a. Rather than divide fixed resources, Smith envisioned creating more resources so that everyone could be wealthier.
b. In 1776, Smith wrote a book called THE WEALTH OF NATIONS in which he outlined steps for creating prosperity.
2. Smith believed that FREEDOM was vital to the survival of any economy.
3. Also, he believed that people will work hard if they have INCENTIVES for doing so.
4. Smith is considered by some to be the FATHER OF MODERN ECONOMICS.
E. HOW BUSINESSES BENEFIT THE COMMUNITY.
1. The INVISIBLE HAND is a phrase coined by Adam Smith to describe the process that turns self-directed gain into social and economic benefits for all.
2. Basically, this meant that a person working hard to make money for his or her own personal interest would (like an invisible hand) also benefit others.
a. For example, a farmer trying to make money would grow as many crops as possible.
b. This provides jobs and needed food for others.
c. If everyone worked hard in his or her own self interest, Smith said, society as a whole would prosper.
3. Many U.S. businesspeople are BECOMING CONCERNED ABOUT SOCIAL ISSUES and their obligation to return to society some of what they’ve earned. (Example: The Bill and Melinda Gates Foundation.)
II. UNDERSTANDING FREE-MARKET CAPITALISM.
LEARNING GOAL 2
Explain what capitalism is and how free markets work.
A. Following the ideas of Adam Smith, businesspeople created more wealth than every before.
1. Great disparities in wealth remained or even increased.
2. Although it is not easy, opportunities to start one’s own business have always been there, especially in a free market.
3. CAPITALISM is an economic system in which all or most of the means of production and distribution are privately owned and operated for profit.
a. In capitalist countries, businesspeople decide how to use their resources and how much to charge.
b. No country is purely capitalist, but the FOUNDATION OF THE U.S. IS CAPITALISM.
c. Capitalism is the foundation for the economics of England, Canada, Australia, and most developed nations.
B. THE FOUNDATIONS OF CAPITALISM.
1. People under free-market capitalism have FOUR BASIC RIGHTS:
a. The right to private property.
b. The right to own a business and to keep all of that business’s profits after taxes.
c. The right to freedom of competition.
d. The right to freedom of choice.
2. One benefit of such rights is that people are willing to take more RISKS than they would otherwise.
C. HOW FREE MARKETS WORK.
1. In a free-market system, decisions about what to produce and in what quantities are made by THE MARKET.
2. Consumers send signals to producers about what to make, how many, and so on through the mechanism of PRICE.
3. In the U.S. the price tells producers how much to produce, reducing the changes of a long-term shortage of goods.
D. HOW PRICES ARE DETERMINED.
1. In a free market, prices are not determined by sellers; they are determined by BUYERS AND SELLERS NEGOTIATING IN THE MARKETPLACE.
2. Price is determined through the economic concepts of supply and demand.
E. THE ECONOMIC CONCEPT OF SUPPLY.
1. SUPPLY refers to the quantity of products that manufacturers or owners are willing to sell at different prices at a specific time.
2. The amount supplied will increase as the price increases.
3. The quantity producers are willing to SUPPLY a certain prices are illustrated on a SUPPLY CURVE.
F. THE ECONOMIC CONCEPT OF DEMAND.
1. DEMAND refers to the quantity of products that people are willing to buy at different prices at a specific time.
2. The quantity demanded will decrease as the price increases.
3. The quantity consumers are willing to buy at certain prices are illustrated on a DEMAND CURVE.
G. THE EQUILIBRIUM PRICE OR MARKET PRICE.
1. The key factor in determining the quantity supplied and the quantity demanded is PRICE.
a. At the equilibrium price, THE SUPPLY AND DEMAND CURVES CROSS, and the quantity demanded equals the quantity supplied.
b. MARKET PRICE is the price determined by supply and demand.
2. In free-market economies it is the INTERACTION between SUPPLY and DEMAND that determines the market price in the long-run.
a. If SURPLUSES develop, a signal is sent to sellers to lower the price.
b. If SHORTAGES develop, a signal is sent to sellers to increase the price.
3. In countries without a free-market system, there is no such mechanism, so there are often shortages or surpluses.
4. One benefit of the free-market system is that it allows competition among companies.
H. COMPETITION WITHIN FREE MARKETS.
1. Competition exists in different degrees, ranging from perfect to nonexistent.
2. PERFECT COMPETITION is the market situation in which when there are many sellers in the market and no seller is large enough to dictate the price of a product.
a. Sellers produce products that appear to be identical.
b. There are no true examples of perfect competition, but agricultural products are often used as an example.
3. MONOPOLISTIC COMPETITION exists when a large number of sellers produce products that are very similar but are perceived by buyers as different.
a. PRODUCT DIFFERENTIATION. making buyers think similar products are different, is a key to success.
b. The fast food industry is an example.
4. An OLIGOPOLY is a form of competition in which just a few sellers dominate a market.
a. The initial investment required to enter the market is usually high.
b. Prices among competing firms tend to be close to the same.
c. Examples include breakfast cereal, beer, automobiles, and soft drinks.
5. A MONOPOLY occurs when there is only one seller for a product or service.
a. In the U.S. laws prohibit the creation of monopolies. but do permit approved monopolies such as public utilities.
b. New legislation has ended the monopoly status of utilities in some areas creating intense competition among utility companies.
I. BENEFITS AND LIMITATIONS OF FREE MARKETS.
1. Free market capitalism provides OPPORTUNITIES for poor people to work their way out of poverty.
2. Not all businesspeople agree on how to deal with this INEQUITY.
3. Businesspeople may let greed dictate how they act, as seen in recent scandals in accounting firms, telecommunication firms, and others.
4. SOME GOVERNMENT REGULATIONS ARE NECESSARY to protect stockholders and vulnerable citizens.
III. UNDERSTANDING SOCIALISM.
LEARNING GOAL 3
Discuss the major differences between socialism and communism.
A. SOCIALISM is an economic system based on the premise that some, if not most, basic businesses should be owned by the government so that profits can be distributed among the people.
1. Small businesses are owned by entrepreneurs, but their profits are steeply taxed.
2. Advocates of socialism acknowledge the major benefits of capitalism, but believe that
WEALTH SHOULD BE MORE EVENLY DISTRIBUTED.
3. Socialism became the guiding economic platform for many countries in Europe, Africa, India, and elsewhere.
4. Socialist nations RELY HEAVILY ON GOVERNMENT to provide education, health care, retirement benefits, and other social services.
5. Economies in some countries, such as France, are moving more to the center.
B. The MAJOR BENEFIT OF SOCIALISM is social equality.
1. Income is taken from the wealthier people and redistributed to the poorer members of the population.
2. Workers in socialist countries are given free education, free health care, free child care, and more employee benefits.
C. THE NEGATIVE CONSEQUENCES OF SOCIALISM.
1. Socialism may create more equality than capitalism, but it TAKES AWAY SOME WORK INCENTIVES.
2. Tax rates in some nations once reached 85%.
3. Professionals who earn a lot of money have very high tax rates, and many of them leave socialist countries for countries with lower taxes.
4. The loss of the best and brightest people to other countries is called BRAIN DRAIN.
5. Capitalism results in the freedom of opportunity.
6. Socialist systems tend to discourage the best from working as hard as they can and result in FEWER INVENTIONS AND LESS INNOVATION.
IV. UNDERSTANDING COMMUNISM.
A. Philosopher KARL MARX believed that workers should take over ownership of businesses and share in the wealth.
1. Marx outlined his ideas in THE COMMUNIST MANIFESTO in 1848, becoming the FATHER OF COMMUNISM.
2. COMMUNISM is an economic and political system in which the state (the government) makes almost all economic decisions and owns almost all the major factors of production.
B. PROBLEMS WITH COMMUNISM.
1. The government has no way of knowing what to produce because prices don’t reflect SUPPLY and DEMAND.
2. Shortages of many items may develop.
3. Communism doesn’t inspire businesspeople to work hard, and is slowly disappearing as an alternative economic form.
C. Most communism countries today are suffering severe economic depression. including North Korea and Cuba.
1. The movement now is toward free markets.
2. Russia now has a lower tax rate than the U.S. does.
V. THE TREND TOWARD MIXED ECONOMIES.
LEARNING GOAL 4
Explain the trend toward mixed economies.
A. There are two economic systems vying for dominance in the world:
1. FREE MARKET ECONOMIES.
a. Free market economies exist when the market largely determines what goods and services get produced, who gets them, and how the economy grows.
b. This system is commonly known as CAPITALISM.
2. COMMAND ECONOMIES.
a. Command economies are economic systems in which the government largely decides what goods and services will be produced, who will get them, and how the economy will grow.
b. These economies are known as SOCIALISM and COMMUNISM.
B. NO ONE ECONOMIC SYSTEM is perfect by itself.
1. Free-market mechanisms haven’t been responsive enough to a nation’s social and economic needs.
2. Socialism and communism haven’t always created enough jobs or wealth to keep economies growing fast enough.
3. The trend is for so-called capitalist countries and so-called socialist countries to move toward the center.
4. NO COUNTRY IS PURELY CAPITALIST OR PURELY CAPITALIST. rather some mix of the two systems.
C. MIXED ECONOMIES are economic system in which some allocation of resources is made by the market and some by government.
D. THE U.S. HAS A MIXED ECONOMY.
1. There is much debate about the role of government in many parts of the economy.
2. The basic principles of freedom and opportunity remain so that economic growth is sustainable.
E. In the U.S. the government serves as a means to SUPPLEMENT the basic capitalist system.
F. It is an interesting time to watch how the INTERNET affects business and government.
VI. UNDERSTANDING THE ECONOMIC SYSTEM OF THE UNITED STATES.
LEARNING GOAL 5
Discuss the economic system of the United States, including the significance of key economic indicators, productivity, and the business cycle.
A. While most of the world was moving toward free-market economies, in recent years the U.S. was moving toward MORE SOCIAL PROGRAMS.
1. Issues such as taxes, regulations, and social programs created conflict between business leaders and government leaders.
2. These subjects continue to be part of the political debate.
3. Currently the U.S. economic system is in a state of flux.
B. KEY ECONOMIC INDICATORS.
1. GROSS DOMESTIC PRODUCT (GDP).
a. GROSS DOMESTIC PRODUCT (GDP) is the total value of goods and services produced in a country in a given year.
b. In 1991 the U.S. stopped using gross national product (GNP) and adopted GDP as the key indicator.
c. A major influence on the growth of GDP is how productive the work force is.
d. The total U.S. GDP in the early 2000s was about $10 trillion.
2. THE UNEMPLOYMENT RATE.
a. The UNEMPLOYMENT RATE refers to the number of civilians at least 16 years old who are unemployed and tried to find a job within the prior four weeks.
b. There are four types of unemployment. frictional, structural, cyclical, and seasonal.
3. THE PRICE INDEXES help measure the health of the economy.
a. INFLATION refers to a general rise in the prices of goods and services over time.
b. DISINFLATION is a situation in which price increases are slowing (the inflation rate is declining.)
c. DEFLATION is a situation in which prices are actually declining, occurring when countries produce so many goods that people cannot afford to buy them all.
d. CONSUMER PRICE INDEX (CPI).
i. The Consumer Price Index (CPI) are the monthly statistics that measure the pace of inflation or deflation.
ii. Some wages, rents, government benefits, and interest rates are based on the CPI.
e. The PRODUCER PRICE INDEX (PPI) is an index that measures prices at the wholesale level.
C. PRODUCTIVITY IN THE UNITED STATES.
1. Productivity in the U.S. has gone up in recent years because computers have made production faster.
a. The higher productivity is, the lower costs are in producing goods and services, and the lower prices can be.
b. Jobs in the U.S. pay well because U.S. workers are very productive.
2. The USE OF MACHINES led to the increase in productivity in the manufacturing industry.
3. The U.S. economy is a service economy –and very labor intensive–creating significant productivity issues.
D. PRODUCTIVITY IN THE SERVICE SECTOR.
1. In the service sector, computers, word processors, and other technology increase productivity.
2. Actually these machines may add to the quality of the services but not to the output per worker which is the definition of productivity.
3. New measures of productivity for the service economy need to be developed to measure quality as well as quantity of output.
E. THE BUSINESS CYCLE.
1. The rapid decline in stock prices in 2000-2003 represents a sharp FLUCTUATION IN THE LONG-TERM BUSINESS CYCLE.
2. Business cycles are the periodic rises and falls that occur in economies over time.
3. Joseph Schumpter identified FOUR PHASES OF BUSINESS CYCLES:
a. ECONOMIC BOOM.
b. A RECESSION is two or more consecutive quarters of decline in the GDP.
c. A DEPRESSION is a severe recession, usually accompanied by deflation.
d. A RECOVERY occurs when the economy stabilizes.
4. The goal of economics is to predict these fluctuations.
5. The government uses fiscal and monetary policy to minimize these disruptions.
LEARNING GOAL 6
Define fiscal policy and monetary policy. and explain how each affects the economy.
F. STABILIZING THE ECONOMY THROUGH FISCAL POLICY.
1. FISCAL POLICY refers to the federal government’s efforts to keep the economy stable by increasing or decreasing taxes or government spending.
2. The first half of fiscal policy involves TAXATION.
a. High tax rates may discourage small business ownership.
b. Low tax rates would tend to give the economy a boost.
c. The PERCENTAGE OF GDP taken by all levels of government through taxes was about 18.4% in 2001.
3. The second half of fiscal policy involves GOVERNMENT SPENDING.
a. The national deficit is the amount of money that the federal government spends over and above the amount it gathers in taxes.
b. The NATIONAL DEBT is the sum of government deficits over time.
4. One way to lessen the annual deficits is to CUT GOVERNMENT SPENDING. but there is a continuing need for social programs and for military spending.
G. USING MONETARY POLICY TO KEEP THE ECONOMY GROWING.
1. The FEDERAL RESERVE SYSTEM (THE FED) lends money to the federal government when it spends more than it collects.
2. MONETARY POLICY is the management of the monetary supply and interest rates; it is controlled by the Fed.
a. When the economy is booming, the Fed tends to raise interest rates.
b. Lowering interest rates encourages more business borrowing.
c. Raising and lowering interest rates helps control the rapid ups and downs of the economy.
3. The Federal Reserve also controls the MONEY SUPPLY.
a. The more money the Fed makes available to businesspeople, the faster the economy grows.
b. To slow the economy, the Feds lowers the money supply.
4. The economic goal is to keep the economy growing.
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