MODERN MIXED ECONOMY

Think for a moment about some of the goods and services that you consumed over the last few days. Perhaps you took an airline fl ight to school or bought some gasoline for the family car. You surely had some home-cooked food bought in a grocery store or a meal purchased at a restaurant. You might have bought a book (such as this textbook) or some pharmaceutical drugs. N ow consider some of the many steps that pre- ceded your purchases. The airplane fl ight will illus- trate the point very well. You may have purchased an airline ticket on the Internet. This simple-sounding purchase involves much tangible capital such as your computer, intellectual property (in software and designs), and sophisticated fi ber-optic transmission lines, as well as complicated airline reservation sys- tems and pricing models. The airlines do all this to make profi ts (although profi ts have been very mod- est in that sector).

A t the same time, government plays an important role in air travel. It regulates airline safety, owns many airports, manages the traffi c-control system, produces the public good of weather data and forecasting, and provides information on fl ight delays. And this list could go on into the public and private support of aircraft manufacturing, international agreements on airline competition, energy policy on fuels, and other areas. T he same point would apply—in different degrees depending upon the sector—to your purchases of clothing or gasoline or pharmaceuticals or just about any item. The economy of every country in the world is a mixed economy— a combination of private enter- prise working through the marketplace and gov- ernment regulation, taxation, and programs. What exactly is a market economy, and what makes it such a powerful engine of growth? What is the “capital” in “capitalism”? What government controls are needed

26 CHAPTER 2 • THE MODERN MIXED ECONOMY

suitable amounts, gets transported to the right place, and arrives in a palatable form at the dinner table. But a close look at New York or other economies is convincing proof that a market system is neither chaos nor miracle. It is a system with its own internal logic. And it works. A market economy is an elaborate mechanism for coordinating people, activities, and businesses through a system of prices and markets. It is a com- munication device for pooling the knowledge and actions of billions of diverse individuals. Without central intelligence or computation, it solves prob- lems of production and distribution involving bil- lions of unknown variables and relations, problems that are far beyond the reach of even today’s fastest supercomputer. Nobody designed the market, yet it functions remarkably well. In a market economy, no single individual or organization is responsible for production, consumption, distribution, or pricing. H ow do markets determine prices, wages, and outputs? Originally, a market was an actual place where buyers and sellers could engage in face-to-face bargaining. The marketplace—fi lled with slabs of but- ter, pyramids of cheese, layers of wet fi sh, and heaps of vegetables—used to be a familiar sight in many vil- lages and towns, where farmers brought their goods to sell. In the United States today there are still impor- tant markets where many traders gather together to do business. For example, wheat and corn are traded at the Chicago Board of Trade, oil and platinum are traded at the New York Mercantile Exchange, and gems are traded at the Diamond District in New York City. M arkets are places where buyers and sellers inter- act, exchange goods and services or assets, and deter- mine prices. There are markets for almost everything. You can buy artwork by old masters at auction houses in New York or pollution permits at the Chicago Board of Trade. A market may be centralized, like the stock market. It may be decentralized, as is the case for most workers. Or it may exist only electroni- cally, as is increasingly the case with “e-commerce” on the Internet. Some of the most important markets are for fi nancial assets, such as stocks, bonds, foreign exchange, and mortgages.

A market is a mechanism through which buyers and sellers interact to determine prices and exchange goods, services, and assets.

to make markets function effectively? The time has come to understand the principles that lie behind the market economy and to review government’s role in economic life.

A. THE MARKET MECHANISM

Most economic activity in most high-income coun- tries takes place in private markets—through the market mechanism—so we begin our systematic study there. Who is responsible for making the deci- sions in a market economy? You may be surprised to learn that no single individual or organization or govern- ment is responsible for solving the economic problems in a market economy. Instead, millions of businesses and consumers engage in voluntary trade, intending to improve their own economic situations, and their actions are invisibly coordinated by a system of prices and markets. T o see how remarkable this is, consider the city of New York. Without a constant fl ow of goods into and out of the city, New Yorkers would be on the verge of starvation within a week. But New Yorkers actually do very well economically. The reason is that goods travel for days and weeks from the surrounding coun- ties, from 50 states, and from the far corners of the world, with New York as their destination. H ow is it that 10 million people can sleep easily at night, without living in mortal terror of a breakdown in the elaborate economic processes upon which they rely? The surprising answer is that, without coercion or centralized direction by anyone, these economic activities are coordinated through the market. E veryone in the United States notices how much the government does to control economic activity: it regulates drugs, fi ghts fi res, levies taxes, sends armies around the world, and so forth. But we seldom think about how much of our ordinary economic life pro- ceeds without government intervention. Thousands of commodities are produced by millions of people every day, willingly, without central direction or mas- ter plan.

Not Chaos, but Economic Order The market looks like a jumble of sellers and buyers. It seems almost a miracle that food is produced in

THE MARKET MECHANISM 27

buyers and sellers. Too high a price would mean a glut of goods with too much output; too low a price would produce long lines in stores and a defi ciency of goods. Those prices for which buyers desire to buy exactly the quantity that sellers desire to sell yield an equilibrium of supply and demand.

How Markets Solve the Three Economic Problems

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