The Modern Mix Economy

No single individual or organization or government 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.
A market economy is an elaborate mechanism for coordinating people, activities,
and businesses through a system of prices and markets. It is a communication
device for pooling the knowledge and actions of billions of diverse individuals.
Without central intelligence or computation, it solves problems of production and
distribution involving billions 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.
A market is a mechanism through which buyers and sellers interact to determine
prices and exchange goods, services, and assets. The central role of markets is to
determine the price of goods. A price is the value of the good in terms of money
(the role of money will be discussed later in this chapter). At a deeper level, prices
represent the terms on which different items can be exchanged.
In addition, prices serve as signals to producers and consumers. If consumers
want more of any good, the price will rise, sending a signal to producers that more
supply is needed. Prices coordinate the decisions of producers and consumers in a
market. Higher prices tend to reduce consumer purchases and encourage
production. Lower prices encourage consumption and discourage production.
Prices are the balance wheel of the market mechanism.
Markets are constantly solving the what, how, and for whom. As they balance all
the forces operating on the economy, markets are finding a market equilibrium of
supply and demand. A market equilibrium represents a balance among all the
different buyers and sellers.
Like a farmer using a carrot and a stick to coax a donkey forward, the market
system deals out profits and losses to induce firms to produce desired goods
efficiently.
Consumers buy goods and sell factors of production; businesses sell goods and
buy factors of production. Consumers use their income from the sale of labor and
other inputs to buy goods from businesses; businesses base their prices of goods
on the costs of labor and property.
Prices in goods markets are set to balance consumer demand with business
supply; prices in factor markets are set to balance household supply with business
demand. All this sounds complicated. But it is simply the total picture of the
intricate web of supplies and demands connected through a market mechanism to
solve the economic problems of what, how, and for whom.
The invisible hand—that private interest can lead to public gain when it takes place
in a well-functioning market mechanism.
Adam Smith discovered a remarkable property of a competitive market economy.
Under perfect competition and with no market failures, markets will squeeze as
many useful goods and services out of the available resources as is possible. But
where monopolies or pollution or similar market failures become pervasive, the
remarkable efficiency properties of the invisible hand may be destroyed.
Three important features of modern economy are:

1. An advanced economy is characterized by an elaborate network of trade

that depends on specialization and an intricate division of labor.
2. Modern economies today make extensive use of money, which provides
the yardstick for measuring economic values and is the means of payment.
3. Modern industrial technologies rest on the use of vast stocks of capital.
Capital leverages human labor into a much more efficient factor of
production and allows productivity many times greater than that possible in
an earlier age.
Specialization and trade are the key to high living standards. By specializing,
people can become highly productive in a very narrow field of expertise. People
can then trade their specialized goods for others’ products, vastly increasing the
range and quality of consumption and having the potential to raise everyone’s
living standards
Money is the means of payment in the form of currency and checks used to buy
things. Money is a lubricant that facilitates exchange. When everyone trusts and
accepts money as payment for goods and debts, trade is facilitated.
Capital—a produced and durable input which is itself an output of the economy.
Capital consists of a vast and specialized array of machines, buildings, computers,
software, and so on.
Economic activity involves forgoing current consumption to increase our capital.
Every time we invest—building a new factory or road, increasing the years or
quality of education, or increasing the stock of useful technical knowledge—we are
enhancing the future productivity of our economy and increasing future
consumption.
The ability of individuals to own and profit from capital is what gives capitalism its
name. We have highlighted some key features of a modern economy:
Specialization and the division of labor among people and countries create great
efficiencies; increased production makes trade possible; money allows trade to
take place effi ciently; and a sophisticated financial system allows people’s savings
to flow smoothly into other people’s capital.

Governments have three main economic functions in a market economy:

1. Governments increase effi ciency by promoting competition, curbing externalities
like pollution, and providing public goods.
2. Governments promote equity by using tax and expenditure programs to
redistribute income toward particular groups.
3. Governments foster macroeconomic stability and growth—reducing
unemployment and inflation while encouraging economic growth—through fi scal
and monetary policy.
Perfect competition: This technical term refers to a market in which no firm or
consumer is large enough to affect the market Price.
Imperfect competition occurs when a buyer or seller can affect a good’s price.
Externalities (or spillover effects) occur when firms or people impose costs or
benefits on others outside the marketplace. The polar case of a positive externality
is a public good. Public goods are commodities which can be enjoyed by everyone
and from which no one can be excluded. The classic example of a public good is
national defense.
Taxes: The government must find the revenues to pay for its public goods and for
its income-redistribution programs. Such revenues come from taxes levied on
personal and corporate incomes, on wages, on sales of consumer goods, and on
other items. All levels of government—city, state, and federal—collect taxes to pay
for their spending.
Markets do not necessarily produce a fair distribution of income. A market
economy may produce inequalities in income and consumption that are not
acceptable to the electorate. Macroeconomic policies for stabilization and
economic growth include fiscal policies (of taxing and spending) along with
monetary policies (which affect interest rates and credit conditions). Since the
development of macroeconomics in the 1930s, governments have succeeded in
curbing the worst excesses of inflation and unemployment.
This new system, called the welfare state, is one in which markets direct the
detailed activities of day-today economic life while government regulates social
conditions and provides pensions, health care, and other necessities for poor
families. The debate about government’s successes and failures demonstrates that
drawing the boundary between market and government is an enduring problem.
The tools of economics are indispensable to help societies find the golden mean
between an efficient market mechanism and publicly decided regulation and
redistribution. The good mixed economy is, perforce, the limited mixed economy.
But those who would reduce government to the constable plus a few lighthouses
are living in a dream world.