Introduction to MacroeconomicsIntroduction to Macroeconomics

Chapter 1

Market Interaction

J. Patrick Gunning

April 18, 2023

Introduction (1): The Definition of Introduction (1): The Definition of EconomicsEconomics

• Economics: the study of market interaction.

• Market Interaction: an abstract image of interaction among purposeful, "normal human beings," or actors, under a given set of conditions.

Introduction (3): The Definition of Introduction (3): The Definition of Market InteractionMarket Interaction

• Meaning of distinctly human action.• People have definite wants.• People have the goal of satisfying the wants.• People possess imagination, creativity, and

inventiveness.

• Compare normal, distinctly human beings with:• Animals.• Robots.

Distinctly Human ActionDistinctly Human Action

Not Distinctly Human ActionNot Distinctly Human Action

Introduction (2): Subjects Covered in Introduction (2): Subjects Covered in This Chapter This Chapter

The conditions of market interaction. Roles in market interaction. The pure market economy. Why study economics?

First Subject: The Conditions of First Subject: The Conditions of Market InteractionMarket InteractionThree Topics in This Part

• 1. A system of private property rights. • 2. Free enterprise.• 3. The use of money.

The Private Property System: It Has The Private Property System: It Has Two CharacteristicsTwo Characteristics

• 1. For every separable good or resource, there is an individual who is assigned by law as an owner of the legal right to control its use.

• 2. The owner of a legal right also has a legal right to exchange it.

First Characteristic of First Characteristic of Private Property RightsPrivate Property Rights

Every separable good or resource has an owner.

The Assumption of Power andThe Assumption of Power andLoyalty to EnforcementLoyalty to Enforcement

A private property system implies that government agents (the police or the soldiers) have the power to block others from using a good or resource to which an individual has a legal right.

It also implies loyalty of the police or soldiers to the duty of enforcement.

DefinitionsDefinitions

Good: a thing or behavior that can be used to satisfy a want directly.

Resource: a thing of behavior that can be used to satisfy a want indirectly by helping to produce a good.

Ownership in a Complete PrivateOwnership in a Complete PrivateProperty SystemProperty System

• To own the legal right to control a good or resource’s use means that a person can (a) cause it to have or not have beneficial effects either on himself and others and (b) cause it to have or not have harmful effects.

• This implies no government ownership of goods or resources.

Separable and Non-separableSeparable and Non-separableGoods and ResourcesGoods and Resources

Separable good or resource: one for which the benefits and harm due its control and use can only be felt by a single person.

Example of a separable good: a banana. Your eating it does not ordinarily yield benefits to others.

Separable and Non-separableSeparable and Non-separableGoods and ResourcesGoods and Resources

Non-separable good or resource: one for which the benefits and/or harm due to controlling its use can be felt by more than one person.

• Examples of non-separable goods: If one person supplies it, others benefit:• Clean air.• Defense against aliens.

Ownership and Negative ExternalitiesOwnership and Negative Externalities Negative externality: the harm felt by one person resulting

from the action of another person. Example 1: throwing the banana peel on the ground. Example 2: the pig farmer’s allowing waste to flow into the

unpolluted river used for swimming by a neighbor.

A complete property system means that someone owns the legal right to control all such actions. Either the perpetrator or the victim could own the right. Even out outsider could own it. But it must be owned.

Second Characteristic of Second Characteristic of Private Property RightsPrivate Property Rights

Individuals have the legal right to exchange ownership rights.

ExchangeabilityExchangeability

The legal rights associated with ownership of property are exchangeable. A person may sell them or give them away.

The legal right to control and action having an external effect is also exchangeable.

Exchangeability and SpecializationExchangeability and Specialization

The exclusive ownership and exchangeability of ownership rights in a private property system gives individuals an incentive to specialize.A skilled rancher has an incentive to buy a ranch.

Knowing that he can buy a ranch gives an individual an incentive to become a skilled rancher.

Exchangeability and Optimal Negative Exchangeability and Optimal Negative ExternalitiesExternalities

Ownership and exchangeability give individuals incentives to allow the externalities to continue only when the expected benefits are greater than the expected harm, in terms of money. The pig farmer will pollute only if her benefits are greater than

the harm to the person who is damaged by the pollution. Note: Either the farmer owns the right control the action that

pollutes the stream or the swimming neighbor owns the right.

Evolution of Private Property RightsEvolution of Private Property Rights Two requirements for a modern system of private

property rights:1. Formalness: this usually means a set of written laws

or widely understood laws that are enforced by the police or military.

2. Equality under the law: if a person subject to a law is interchanged with any other member of the community, the enforcement, judgment and punishment for a crime would be the same.

Informal and Formal Informal and Formal Private Property RightsPrivate Property Rights

Informal private property rights can exist in a traditional society. But rewards and punishments in such a society depend only roughly on one’s contribution to the society. When such societies grow large, statuses are usually established. Families favored by the leaders are often given special privileges that are passed on to heirs. But descendants may be incompetent specialists. To give them rewards similar to their ancestors is harmful to the community long run interests.

A more flexible system evolved in England and its codified principles are called the common law.

England as a Mother CountryEngland as a Mother Country

Due to its military power and policy of colonization, England can be regarded as the mother country for the property systems that emerged in the U.S., Canada, Australia, the Indian subcontinent, several countries in Africa and a number of others through out the world. Many of these countries adopted the common law system and its principles after they became independent.

The Common LawThe Common Law Common law: a set of legal rights to control actions that

have external effects. The common law developed in England as a consequence

of centuries of judgment in dispute resolution cases by government-appointed judges.

The judges traveled from place to place, made rulings, and sent written copies of their rulings back to the capital city.

Young judges could learn the principles by studying the rulings.

Dispute ResolutionDispute Resolution

• Procedures under common law.• 1. A person who believed that someone else was responsible for

harming him would make a damage complaint. • 2. A judge, appointed by the king, would decide whether the

complaint was justified. He would rule on whether a damage payment should be made and how much it should be.

• The dog and chicken example.

Emergence of Common LawEmergence of Common Law

Early British judgments in dispute resolution cases were collected and used as precedents in judgments for later decisions.

• Principles were established through trial and error.• These principles enabled new judges to decide the

right of first possession in most cases on the basis of precedent.

Formality and Equality Under the LawFormality and Equality Under the Law

• When judgments came to be made according to principles rather than according to tradition and norms, the judgments met the standard of equality under the law.

• The long tradition of common law in England ultimately led to the formality that is necessary for a more complete system of private property rights.

• Former colonies of England formally adopted the British common law as part of their written constitutions.

The Common Law and the The Common Law and the Right of First PossessionRight of First Possession

Another example of a common law judgment: A nurtures a crop and B takes it. A makes a damage claim. In ruling that B should pay compensation, the judge establishes the legal right of A to benefit from his actions with respect to nurturing the crop.

Note that in deciding the case, the judge is establishing the right of possession and even the right of first possession.

Evolution of the Right of Evolution of the Right of First PossessionFirst Possession

Two kinds of cases: 1. Harmful externality: the dog and chicken

example, assuming that no dog had ever caused damage before.

2. Right of first possession: a person produces, discovers or invents a good or resource.

Judges expanded the application by considering increasingly complex cases.

The Common Sense of the Common LawThe Common Sense of the Common Law

A goal of the best common law judges was to show that the “king’s law” – i.e., judge-made law -- could benefit the community.

The judge aimed to make judgments that he believed were in the “long run community interest.”

He took account of future generations.

First Possession in a KingdomFirst Possession in a Kingdom We can understand the importance of the right of first possession

under common law by comparing it with the right of first possession in a kingdom.

In a kingdom, the king has the right of possession to everything. Do people have an incentive to discover, invent, specialize and

produce goods in a kingdom? It depends on how much the king knows and whether he rewards

the discoverers, inventors, specialists and producers. Could the king, or any other single person, know the kinds of

discoveries and inventions that take place routinely in a modern capitalist society?

Hmmmmmmmmmmmmmmmmmm,

Alternative Means Of Assigning The Alternative Means Of Assigning The Right Of First PossessionRight Of First Possession

Assign it to the leading government official or agency in the community.People would not produce, discover, or invent unless

they expected a share of the benefit. Assign it by means of a lottery.

Because each citizen would have an equal chance of receiving a share, the incentive to produce, discover and invent would be low.

Right of First Possession Right of First Possession Under Common LawUnder Common Law

The benefit of assigning the right of first possession to the producer, discoverer or inventor.

If the law gives the discoverer of a good or resource the legal right of first possession, people will have a greater incentive to discover goods and resources. The same is true of a right of first possession that is given to an inventor or a producer.

First Possession and Teamwork (1)First Possession and Teamwork (1)

In the eyes of common law judges, an employment compact supersedes what would otherwise be the rule of first possession.

Under the legal right of first possession, every team member possesses a share of the total output. However, the members may agree to give up their rights.

First Possession and Teamwork (2)First Possession and Teamwork (2)

Today the employment agreement is recognized in courts as an implicit agreement by employees to give up their legal rights to the output.

The seller of a resource – a component in the production of another product also implicitly gives up his legal right to share in the output.

An Example of First PossessionAn Example of First Possession

Who has the right of first possession to a book that you own?

Contract LawContract Law Example of another common law judgment: A nurtures the crop and

gives it to B in return for B’s promise to pay. B does not pay. In ruling that B should pay compensation, the judge helps to establish the law of contracts.

Besides establishing the right of first possession, common law established the law of contracts.

Contract: a promise to perform some action, usually in writing. Contract law: the system of rules for determining whether a promise

has been broken, whether the person who broke it should compensate the promissee, and what the compensation should be.

Free Enterprise (1)Free Enterprise (1)• Definition: with some exceptions, individuals are

free from coercion to enter into any kind of business they wish, to apply for any kind of job, to buy and sell, and to make binding contracts.

• Exceptions:• Slavery.• Free enterprise – a person may cause damage to a

competitor in an effort to sell his goods or services to others.

Free Enterprise (2)Free Enterprise (2)

• Two implications for the role of government:• 1. The government should make no laws that prevent or

deter individuals from making business exchanges.• 2. The government should use its power to stop others

from preventing or deterring people from making business exchanges.

• Free enterprise means that everyone faces potential competition.

Free Enterprise (3)Free Enterprise (3)

• Restrictions on free enterprise in history:• Restrictions on entry onto business in 17th and 18th

century Europe.• Entrance into a particular trades was often limited to

those whose families were already in the trade or who had apprenticed for many years.

• Licenses are often required today by the U.S. state and federal governments.

Evolution of Free EnterpriseEvolution of Free Enterprise

• Proponents of free enterprise:• Economists who recognize its benefits.

• Opponents of free enterprise: • People who do not recognize its benefits• People who recognize the benefits and who want exceptions for

themselves.

• History of free enterprise begins with the development of economics; but the conflict between opponents and proponents never ends.

Functions of moneyFunctions of money

• Medium of exchange.

• Store of value.

• Unit of accounting.

Money as a Medium (1)Money as a Medium (1): : Barter Vs. Barter Vs. Money ExchangeMoney Exchange

Barter society: a society in which individuals acquire goods directly by trading their own goods for those of others.

Money economy: a society in which individuals acquire goods indirectly by trading their goods for money and then their money for the goods of others.

Money as a Medium (2):Money as a Medium (2): Barter Vs. Barter Vs. Money ExchangeMoney Exchange

• Barter society: people trade

goods directly for other goods.

This is direct exchange.

• Money society: people trade

goods for money and then

trade the money for other

goods. This is indirect exchange.

Money as a Medium (3):Money as a Medium (3): Money vs. Other Money vs. Other Media of ExchangeMedia of Exchange

Medium of exchange: an item that is wanted not because one plans to use it but because one plans to exchange with others. It is wanted not because of its expected value in use but because of its expected value in exchange.

Money: the generally accepted medium of exchange. This means that practically everyone will accept it in exchange.

Money As a Medium (4): The Origin Money As a Medium (4): The Origin and Characteristics of Moneyand Characteristics of Money

• One theory: the more marketable item becomes money.• Characteristics of a marketable money: durable, cheap to store,

small in relation to their value in exchange, divisible, and capable of easy quantitative measurement.

• Whether a particular item is used as money depends on peoples' expectations about its marketability.

• As barter exchange grows and becomes more complex, some items are acquired mainly because people want to exchange them for other items. The people who acquire them do not plan to use them, although others may.

• One item eventually dominates the others in exchange.

Money As a Medium (5): Modern Money As a Medium (5): Modern Money FormsMoney Forms

Government-issued paper money and coins.

Transferable deposits.

Money As a Store of Value (1)Money As a Store of Value (1)• Money enables people to economize

on their savings. They prefer to save marketable items that do not deteriorate or become obsolete.

• This is a major reason why durability is an important characteristic of money. Besides physical durability, people must believe that it will retain its exchange value.

Money As a Store of Value (2)Money As a Store of Value (2)

• Historically, gold and silver coins have been good examples of durable money.

• Children in a market economy must learn to use money.

Money As a Unit of AccountingMoney As a Unit of Accounting

Definition of capital accounting : using a rate of interest to compare the revenue and costs that are expected at one time in the future with those that are expected at a different time.

Examples:Should you continue your education beyond

undergraduate school?Choosing to buy a car or house.

Roles in Market Interaction (1): Roles in Market Interaction (1): IntroductionIntroduction

• The concept of a role:• Example 1: the role of a student. Nobody is only a

student. But it is often useful to refer to a person as a student.

• Example 2: the roles of a father, mother, first son, grandmother in a family.

Roles in Market Interaction (2): Roles in Market Interaction (2): IntroductionIntroduction

• In market interaction, a person must first earn money. He can do this by being an employer of others’ resources or by allowing others to employ his resources. Thus, he becomes a producer or a resource supplier.

• Once the money is received, a person must choose whether to spend or save. Usually, he chooses to spend some of his money and to save some.

Thus, he becomes a consumer and saver.

Roles in Market Interaction (3): the Roles in Market Interaction (3): the Most Fundamental RolesMost Fundamental Roles

1. Resource supplying: hiring out work or other resources.

2. Producing: hiring resources to produce a saleable good and then selling it.

3. Consuming: using income to buy a good for the purpose of consuming it in the near future.

4. Saving: setting aside some income in order to buy goods in the future.

Impossibility of the Pure Market Impossibility of the Pure Market EconomyEconomy

Pure market economy: an economy in which the private property system is complete and there is completely free enterprise.

But a market economy can never be pure because the private property system can never be complete.

Why a Private Property System is Why a Private Property System is Always Incomplete (1)Always Incomplete (1)

The Reasons

• 1. It is physically impossible or not worthwhile to enforce some private property rights.

• 2. There are common property resources.• 3. There are public goods.• 4. Personal freedom means that no one can completely

control another person's actions.• 5. Governments have other goals.

Why a Private Property System is Why a Private Property System is Incomplete (2)Incomplete (2)

It is not worthwhile to enforce some private property rights.

The case of small benefits, such as rights to control the use of abusive and socially unacceptable language or actions.

The case of high costs, such as clean air, ocean minerals and food, sound waves, light waves, and radio waves.

Why a Private Property System is Why a Private Property System is Incomplete (3)Incomplete (3)

• There are common property resources and public goods.

• Common property resource – a resource for which members of a community have not established private property rights.

• Two characteristics of public goods:• 1. A number of people benefit simultaneously.• 2. It is impossible to exclude beneficiaries.• Examples: dam, flood control project, lighthouse.

Why a Private Property System is Why a Private Property System is Incomplete (4)Incomplete (4)

• There is personal freedom.• Personal freedom: one person cannot own another

person. In other words, slavery is prohibited because it would violate the principle of equality under the law and restrict freedom of enterprise.

• A person cannot sell herself into slavery even if she wants to do so.

Why a Private Property System is Why a Private Property System is Incomplete (5)Incomplete (5)

• Governments have other goals.• Examples:

• Redistributing wealth.• Protecting the culture or state religion against foreign

influence.• Enforcing moral values.

Why a Private Property System is Why a Private Property System is Incomplete (6)Incomplete (6)

• Cultural intervention:• 1. Blocking the production and sale of particular goods

or services that are generally unwanted although some individuals may want them – drugs, prostitution, gambling, pork products.

• 2. Making government decisions subject to the will of the people (democracy). Elected representatives may pass laws that lead to market interventions.

Types Of Government Intervention That Types Of Government Intervention That Restrict Free EnterpriseRestrict Free Enterprise

1. Government regulation and price setting.

2. Government enterprises.

Why Study EconomicsWhy Study Economics

• To help evaluate arguments for and against intervention in market interaction.

• To know what you are defending when you say you are defending the capitalist system.