May 14th, 2012
Of all the aspects of a free enterprise economy, the most misunderstood is profits. The very word “profit” evokes among many people images of exploitation of workers and consumers. The level of profits is greatly exaggerated by the general public. While surveys indicate that the public believes profits to amount to 30 or 40 cents per dollar of sales, they actually amount to about 7 to 10 cents per dollar. (Ironically, the public believes 20 cents per dollar of sales to be a “fair” profit). After taxes, most manufacturers’ profits amount to 4 or 5 cents per dollar of sales. The Canadian steel company Dofasco’s 1975 profit of $55.3 million sounds less excessive when viewed in the following perspective: on a capital investment of $800 million, it represents a rate of return of just under 7 percent – less than the return on Canada Savings Bonds. In general, the average after-tax rate of return on capital invested in manufacturing in Canada is in the 10- to 12-percent range.
The public also has many misconceptions concerning the uses of profits, which are widely regarded as being hoarded away in corporate coffers or being paid out lavishly as dividends to wealthy shareholders or “capitalists.”
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May 9th, 2012
The division of the economic pie among various individuals and groups is influenced by many factors, the most important one being the interplay between the supply of and the demand for various productive skills. For example, highly skilled people are in short supply as compared to the demand for them, so their incomes (and share of the economic pie) tend to be quite high. There may be an even larger demand or semi-skilled labor (as measured by the numbers employed),but their incomes are quite low because of the large supply of them as compared to the demand for them. As the contrasts between the incomes of professional athletes, nurses and farm laborers show, market forces (supply and demand) can generate some incomes that are extremely high and others that are extremely low, in a way that is quite unrelated to how hard people work or to most people’s view of the social value of the work done. On the other hand, such a system provides strong incentives for people to move into occupations that are in demand and to work harder. Both of these factors contribute to society’s economic prosperity.
Thus, people’s incomes (and thus the division of the economic pie) are basically determined in markets, by the forces of supply and demand. There are, of course, other factors, including labor unions and government policies such as minimum wage laws and taxation policies, that influence the distribution of society’s output among various groups and individuals. These matters, however, are “microeconomic” in nature and are therefore considered in a separate text.
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May 5th, 2012
The operation of this market system provides a strong contrast with the command type of economic system. In a very decentralized way, without any direction or control from the government, the people of the island community have themselves provided answers to the three basic questions.
What to produce is decided by the demand of consumers, as the profit he motive and price changes give producers an economic incentive to produce what consumers want.
How to produce each product is decided by the producers. The profit motive provides an incentive for each producer to use the most efficient production methods available, thus contributing to the economic efficiency and prosperity of the society.
The question of for whom to produce it, or how to divide the economy’s output among various individuals and groups, is a more complex matter. The answer is determined by the incomes of individuals and groups, which are in turn determined in the marketplace by the supply of and demand for each type of productive skill. The demand for a particular productive skill depends ultimately on the demand for the product produced by it. The supply of that type of labor depends on the number of people who are willing and able to do that type of work. Thus, in a very real sense, no one “decides” incomes and the division of the economic pie – this is determined quite impersonally in the marketplace, by supply and demand.
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May 1st, 2012
Suppose that a particular productive input, such as the fertilizer used in farming, were to become less plentiful. Obviously, it would be economically desirable to use less of this scarce resource. In a market system, the price of this fertilizer, would rise, increasing farmers’ costs and reducing their profits, creating an economic incentive for them to use less of this fertilizer or to turn to an alternative. Furthermore, the higher price of this fertilizer would provide an incentive for fertilizer producers to increase their production of it or of alternatives to it. As before, the necessary economic adjustments take place automatically, in response to price changes.
The foregoing examples show how a market type of economic system adapts to changing circumstances: the system adjusts its production or production methods automatically as people respond to the economic incentives created by price changes. Because of the key role played by prices and price changes in such a system, the market system is sometimes referred to as the “price system.”
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April 27th, 2012
In the simple desert island economy, individual people were both producers and consumers of products. In a modern economic system, the production of goods and services is done by privately owned businesses – mostly by corporations (owned by many shareholders and managed by hired professional managers) and also by smaller enterprises owned by one or more individuals (sole proprietorships and partnerships, respectively). Consumption, on the other hand, is done by households, which buy and use consumer goods and services. Members of households contribute to the production of goods and services by providing businesses with productive inputs, the most important of which is labor. Also, by purchasing stocks and bonds issued by businesses, households provide businesses with funds (capital) for the purchase of capital equipment. In exchange for productive inputs such as these, businesses pay households incomes in the form of wages, salaries, interest and dividends.
This process involves two pairs of “flows” within the economy. The dotted lines represent the flows of money between the business and household sectors, while the solid lines depict the “real flows” of real goods and services and real productive inputs. The real flows depict the most basic and essential economic activities – the production and distribution of goods and services.
A modern market-system economy (also known as a “free enterprise” or “capitalist” system) answers the three basic questions of economics in essentially the same way as our simplified desert island market system did. Since the fundamental goal of business is to earn a profit, businesses will produce those goods and services that are in demand. Therefore, ultimately, the question of what to produce can be said to be decided by the consumer. This process is described by the phrases “consumer sovereignty” (meaning that the consumer’s purchase of a product is, in effect, “casting a vote” for the production of that product).
The question of how to produce it is decided by producers, or businesses, who will strive for the most efficient possible method of producing the product. Lower costs mean higher profits, and, in a highly competitive industry, may mean survival.
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April 23rd, 2012
Tight-money policies are used to slow down (or even reduce) bank lending and spending by consumers and businesses during periods when excessive aggregate demand is generating unusually rapid inflation. By holding down the demand for goods and services, tight-money policies can help to slow down inflation.
This effect of tight money on the rate of inflation will not always occur automatically, though. If expectations regarding the future are favorable, consumers and businesses may continue to borrow and spend despite high interest rates. This is particularly likely to happen if they expect prices to continue to rise and are prepared, therefore, to borrow in order to “buy now, to beat inflation.” Despite having their cash reserves reduced by a tight-money policy, the banks may be able to continue lending. If they had been carrying some excess reserves before the tight-money policy, they may still have enough cash reserves left to continue expanding their lending, thus frustrating the tight-money policy.
When tight-money policies do succeed in depressing the level of aggregate demand, their effects are not all beneficial. While such policies will help to slow down inflation, a side effect of the depressed level of aggregate demand will be slower economic growth and higher unemployment. These tend to be costly politically as well as economically. Indeed, it is fair to say that the major limitation on policies to combat inflation is that they tend to increase unemployment – a problem into which we will look further.
This is not the only problem associated with tight-money policies, however. Tight money does not affect all sectors of the economy evenly; it hits some much harder than others. First, small businesses are affected considerably more severely by tight money than are big corporations. Because they generally exercise more control over the price of their product, big businesses tend to have higher rates of profit that enable them to finance much of their investment spending out of profits, or retained earnings.
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