LEARNING OBJECTIVES

1. Define the three factors of production—labor, capital, and natural resources.

2. Explain the role of technology and entrepreneurs in the utilization of the economy’s factors of
production.

MARKETS AND COMPETITION

WHAT IS A MARKET?

A market is a group of buyers and sellers of a particular good or service. The buyers as a group
determine the demand for the product, and the sellers as a group determine the supply of the
product.

Markets take many forms. Sometimes markets are highly organized, such as the markets for
many agricultural commodities. In these markets, buyers and sellers meet at a specific time and
place, where an auctioneer helps set prices and arrange sales.

More often, markets are less organized. For example, consider the market for ice cream in a
particular town. Buyers of ice cream do not meet together at any one time. The sellers of ice
cream are in different locations and offer somewhat different products. There is no auctioneer
calling out the price of ice cream. Each seller posts a price for an ice-cream cone, and each
buyer decides how much ice cream to buy at each store. Nonetheless, these consumers and
producers of ice cream are closely connected. The ice-cream buyers are choosing from the
various ice-cream sellers to satisfy their hunger, and the ice-cream sellers are all trying to
appeal to the same ice-cream buyers to make their businesses successful. Even though it is not
organized, the group of ice-cream buyers and ice-cream sellers forms a market.

WHAT IS COMPETITION?

The market for ice cream, like most markets in the economy, is highly competitive. Each buyer
knows that there are several sellers from which to choose, and each seller is aware that his or
her product is similar to that offered by other sellers. As a result, the price of ice cream and the
quantity of ice cream sold are not deter-mined by any single buyer or seller. Rather, price and
quantity are determined by all buyers and sellers as they interact in the marketplace.

Economists use the term competitive market to describe a market in which there are so many
buyers and so many sellers that each has a negligible impact on the market price. Each seller of
ice cream has limited control over the price because other sellers are offering similar products.
A seller has little reason to charge less than the going price, and if he or she charges more,
buyers will make their purchases elsewhere. Similarly, no single buyer of ice cream can
influence the price of ice cream because each buyer purchases only a small amount.

In this nodule, we assume that markets are perfectly competitive. To reach this highest form of
competition, a market must have two characteristics: (1) the goods offered for sale are all
exactly the same, and (2) the buyers and sellers are so numerous that no single buyer or seller
has any influence over the market price. Because buyers and sellers in perfectly competitive
markets must accept the price the market determines, they are said to be price takers. At the
market price, buyers can buy all they want, and sellers can sell all they want.

There are some markets in which the assumption of perfect competition applies perfectly. In the
wheat market, for example, there are thousands of farmers who sell wheat and millions of
consumers who use wheat and wheat products. Because no single buyer or seller can influence
the price of wheat, each takes the price as given.

Not all goods and services, however, are sold in perfectly competitive markets. Some markets
have only one seller, and this seller sets the price. Such a seller is called a monopoly. Your local
cable television company, for instance, may be a monopoly. Residents of your town probably
have only one cable company from which to buy this service. Still other markets fall between the
extremes of perfect competition and monopoly.

Despite the diversity of market types, we find in the world, assuming perfect competition is a
useful simplification and, therefore, a natural place to start. Perfectly competitive markets are
the easiest to analyze because everyone participating in the market takes the price as given by
market conditions. Moreover, because some degree of competition is present in most markets,
many of the lessons that we learn by studying supply and demand under perfect competition
apply in more complicated markets as well.

Factors of Production
Choices concerning what goods and services to produce are choices about an economy’s use
of its factors of production, the resources available to it for the production of goods and services.
The value, or satisfaction, that people derive from the goods and services they consume and
the activities they pursue is called utility. Ultimately, then, an economy’s factors of production
create utility; they serve the interests of people.

The factors of production in an economy are its labor, capital, and natural resources. Labor is
the human effort that can be applied to the production of goods and services. People who are
employed or would like to be are considered part of the labor available to the economy. Capital
is a factor of production that has been produced for use in the production of other goods and
services. Office buildings, machinery, and tools are examples of capital. Natural resources are
the resources of nature that can be used for the production of goods and services.

Labor
Labor is human effort that can be applied to production. People who work to repair tires, pilot
airplanes, teach children, or enforce laws are all part of the economy’s labor. People who would
like to work but have not found employment—who are unemployed—are also considered part of
the labor available to the economy.

In some contexts, it is useful to distinguish two forms of labor. The first is the human equivalent
of a natural resource. It is the natural ability an untrained, uneducated person brings to a
particular production process. But most workers bring far more. The skills a worker has as a
result of education, training, or experience that can be used in production are called human
capital. Students who are attending a college or university are acquiring human capital. Workers
who are gaining skills through experience or through training are acquiring human capital.
Children who are learning to read are acquiring human capital.
 The amount of labor available to an economy can be increased in two ways. One is to increase
the total quantity of labor, either by increasing the number of people available to work or by
increasing the average number of hours of work per week. The other is to increase the amount
of human capital possessed by workers.

Capital

Long ago, when the first human beings walked the earth, they produced food by picking leaves
or fruit off a plant or by catching an animal and eating it. We know that very early on, however,
they began shaping stones into tools, apparently for use in butchering animals. Those tools
were the first capital because they were produced for use in producing other goods—food and
clothing.

Modern versions of the first stone tools include saws, meat cleavers, hooks, and grinders; all
are used in butchering animals. Tools such as hammers, screwdrivers, and wrenches are also
capital. Transportation equipment, such as cars and trucks, is capital. Facilities such as roads,
bridges, ports, and airports are capital. Buildings, too, are capital; they help us to produce goods
and services.
Capital does not consist solely of physical objects. The score for a new symphony is capital
because it will be used to produce concerts. Computer software used by business firms or
government agencies to produce goods and services is capital. Capital may thus include
physical goods and intellectual discoveries. Any resource is capital if it satisfies two criteria:
1. The resource must have been produced.
2. The resource can be used to produce other goods and services.

One thing that is not considered capital is money. A firm cannot use money directly to produce
other goods, so money does not satisfy the second criterion for capital. Firms can, however, use
money to acquire capital. Money is a form of financial capital. Financial capital includes money
and other “paper” assets (such as stocks and bonds) that represent claims on future payments.
These financial assets are not capital, but they can be used directly or indirectly to purchase
factors of production or goods and services.

Natural Resources

There are two essential characteristics of natural resources. The first is that they are found in
nature—that no human effort has been used to make or alter them. The second is that they can
be used for the production of goods and services. That requires knowledge; we must know how
to use the things we find in nature before they become resources.

Consider oil. Oil in the ground is a natural resource because it is found (not manufactured) and
can be used to produce goods and services. However, 250 years ago oil was a nuisance, not a
natural resource. Pennsylvania farmers in the eighteenth century who found oil oozing up
through their soil were dismayed, not delighted. No one knew what could be done with the oil. It
was not until the mid-nineteenth century that a method was found for refining oil into kerosene
that could be used to generate energy, transforming oil into a natural resource. Oil is now used
to make all sorts of things, including clothing, drugs, gasoline, and plastic. It became a natural
resource because people discovered and implemented a way to use it.

Defining something as a natural resource only if it can be used to produce goods and services
does not mean that a tree has value only for its wood or that a mountain has value only for its
minerals. If people gain utility from the existence of a beautiful wilderness area, then that
wilderness provides a service. The wilderness is thus a natural resource.
The natural resources available to us can be expanded in three ways. One is the discovery of
new natural resources, such as the discovery of a deposit of ore containing titanium. The
second is the discovery of new uses for resources, as happened when new techniques allowed
oil to be put to productive use or sand to be used in manufacturing computer chips. The third is
the discovery of new ways to extract natural resources in order to use them. New methods of
discovering and mapping oil deposits have increased the world’s supply of this important natural
resource.

Technology and the Entrepreneur

Goods and services are produced using the factors of production available to the economy. Two
things play a crucial role in putting these factors of production to work. The first is technology,
the knowledge that can be applied to the production of goods and services. The second is an
individual who plays a key role in a market economy: the entrepreneur. An entrepreneur is a
person who, operating within the context of a market economy, seeks to earn profits by finding
new ways to organize factors of production. In non-market economies the role of the
entrepreneur is played by bureaucrats and other decision makers who respond to incentives
other than profit to guide their choices about resource allocation decisions.

The interplay of entrepreneurs and technology affects all our lives. Entrepreneurs put new
technologies to work every day, changing the way factors of production are used. Farmers and
factory workers, engineers and electricians, technicians and teachers all work differently than
they did just a few years ago, using new technologies introduced by entrepreneurs. The music
you enjoy, the books you read, the athletic equipment with which you play are produced
differently than they were five years ago. The book you are reading was written and
manufactured using technologies that did not exist ten years ago. We can dispute whether all
the changes have made our lives better. What we cannot dispute is that they have made our
lives different.

To understand why people choose to depend on others for goods and services and how this
choice improves their lives, let’s look at a simple economy. Imagine that there are two goods in
the world: meat and potatoes. And there are two people in the world—a cattle rancher and a
potato farmer—each of whom would like to eat both meat and potatoes.

The gains from trade are most obvious if the rancher can produce only meat and the farmer can
produce only potatoes. In one scenario, the rancher and the farmer could choose to have
nothing to do with each other. But after several months of eating beef roasted, boiled, broiled,
and grilled, the rancher might decide that self-sufficiency is not all it’s cracked up to be. The
farmer, who has been eating potatoes mashed, fried, baked, and scalloped, would likely agree.
It is easy to see that trade would allow them to enjoy greater variety: Each could then have a
steak with a baked potato or a burger with fries.

Although this scene illustrates most simply how everyone can benefit from trade, the gains
would be similar if the rancher and the farmer were each capable of producing the other good,
but only at great cost. Suppose, for example, that the potato farmer is able to raise cattle and
produce meat, but that he is not very good at it. Similarly, suppose that the cattle rancher is able
to grow potatoes but that her land is not very well suited for it. In this case, the farmer and the
rancher can each benefit by specializing in what he or she does best and then trading with the
other.

The gains from trade are less obvious, however, when one person is better at producing every
good. For example, suppose that the rancher is better at raising cattle and better at growing
potatoes than the farmer. In this case, should the rancher choose to remain self-sufficient? Or is
there still reason for her to trade with the farmer? To answer this question, we need to look
more closely at the factors that affect such a decision.

PRODUCTION POSSIBILITIES

Suppose that the farmer and the rancher each work 8 hours per day and can devote this time to
growing potatoes, raising cattle, or a combination of the two. The table in the figure shows the
amount of time each person requires to produce 1 ounce of each good. The farmer can produce
an ounce of potatoes in 15 minutes and an ounce of meat in 60 minutes. The rancher, who is
more productive in both activities, can produce an ounce of potatoes in 10 minutes and an
ounce of meat in 20 minutes. The last two columns in the table show the amounts of meat or
potatoes the farmer and rancher can produce if they work an 8-hour day producing only that
good.

Panel (b) of the Figure illustrates the amounts of meat and potatoes that the farmer can
produce. If the farmer devotes all 8 hours of his time to potatoes, he produces 32 ounces of
potatoes (measured on the horizontal axis) and no meat. If he devotes all his time to meat, he
produces 8 ounces of meat (measured on the vertical axis) and no potatoes. If the farmer
divides his time equally between the two activities, spending 4 hours on each, he produces 16
ounces of potatoes and 4 ounces of meat. The figure shows these three possible outcomes and
all others in between.

This graph is the farmer’s production possibilities frontier. A production possibilities frontier
shows the various mixes of output that an economy can produce.
In this case, the rate at which society could trade one good for the other depended on the
amounts that were being produced. Here, however, the farmer’s technology for producing meat
and potatoes (as summarized in the Figure) allows him to switch between the two goods at a
constant rate. Whenever the farmer spends 1 hour less producing meat and 1 hour more
producing potatoes, he reduces his output of meat by 1 ounce and raises his output of potatoes
by 4 ounces—and this is true regardless of how much he is already producing. As a result, the
production possibilities frontier is a straight line.

Panel (c) of Figure 1 shows the production possibilities frontier for the rancher. If the rancher
devotes all 8 hours of her time to potatoes, she produces 48 ounces of potatoes and no meat. If
she devotes all her time to meat, she produces 24 ounces of meat and no potatoes. If the
rancher divides her time equally, spending 4 hours on each activity, she produces 24 ounces of
potatoes and 12 ounces of meat. Once again, the production possibilities frontier shows all the
possible outcomes.

If the farmer and rancher choose to be self-sufficient rather than trade with each other, then
each consumes exactly what he or she produces. In this case, the production possibilities
frontier is also the consumption possibilities frontier. That is, without trade, the figure shows the
possible combinations of meat and potatoes that the farmer and rancher can each produce and
then consume.

These production possibilities frontiers are useful in showing the trade-offs that the farmer and
rancher face, but they do not tell us what the farmer and rancher will actually choose to do. To
determine their choices, we need to know the tastes of the farmer and the rancher. Let’s
suppose they choose the combinations identified by points A and B in Figure 1: The farmer
produces and consumes 16 ounces of potatoes and 4 ounces of meat, while the rancher
produces and consumes 24 ounces of potatoes and 12 ounces of meat.

1. Explain how buyers’ willingness to pay, consumer surplus, and the demand curve are
related.

2. Explain how sellers’ costs, producer surplus, and the supply curve are related.
3. In a supply-and-demand diagram, show producer and consumer surplus in the market
equilibrium.
4. What is efficiency? Is it the only goal of economic policymakers?
5. What does the invisible hand do?
6. Name two types of market failure. Explain why each may cause market outcomes to
be inefficient.