ere is a comprehensive and organised chapter handout based on the provided source,
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"Understanding Business 2nd chapter.pdf".
nderstanding Economics and How It
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Affects Business
Learning Objectives
Upon completion of this chapter, you should be able to:
● O 2–1Explain basic economics.
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● LO 2–2Explain what capitalism is and how free marketswork.
● LO 2–3Compare socialism and communism.
● LO 2–4Analyze the trend toward mixed economies.
● LO 2–5Describe the economic system of the UnitedStates, including the
significance of key economic indicators (especially GDP), productivity, and the
business cycle.
LO 2–6Contrast fiscal policy and monetary policy,and explain how each affects the
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economy.
LO 2–1 Explain Basic Economics
What Is Economics?
conomics isthe study of how society chooses to employresources to produce goods
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and services and distribute them for consumption among various competing groups
and individuals.
Branches of Economics:
● M acroeconomics:Studies the operation of anation'seconomy as a whole(e.g.,
addressing national debt).
● Microeconomics:Studies thebehaviour of people andorganisations in
particular markets(e.g., reasons for purchasing smallercars when petrol prices
rise).
esource Development:Resource development isthestudy of how to increase
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resources and to create the conditions that will make better use of those resources.
Businesses contribute by inventing products that increase available resources, such as new
energy sources (e.g., natural gas for autos), new food production methods (e.g.,
ydroponics, mariculture), and new goods/services through advanced technologies (e.g.,
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nanotechnology, 3D/4D printing).
The Secret to Creating a Wealthy Economy
istorically, economist Thomas Malthus in the late 1700s and early 1800s suggested that
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population growth would eventually outstrip resources, leading to scarcity and poverty. This
led to economics being termed "the dismal science".
owever, modern predictions indicate that global population growth will slow significantly
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and potentially cease by the end of the century, primarily due to declining birth rates as
populations become more urbanised.
he key to economic development is not merely dividing existing resources butincreasing
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them. A large, educated population can be a valuableresource. Business owners are crucial
as they provide jobs and foster economic growth for their employees, communities, and
themselves.
Adam Smith and the Creation of Wealth
cottish economist Adam Smith, often considered the "father" of modern economics,
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proposed that wealth could be created byincreasingresources, rather than just dividing
fixed ones. His seminal work,An Inquiry into theNature and Causes of the Wealth of
Nations, published in 1776, outlined his core ideas.
Smith's Core Beliefs for Economic Prosperity:
● F reedom is vital:This includes the freedom to ownland or property and the right to
retain profits from labour or business operations.
● Incentives:People are motivated to work hard andefficiently if they know they will
be rewarded for their efforts. This drive leads to a prosperous economy with
abundant goods and services.
he Invisible Hand:Smith's concept of the "invisiblehand" describesthe process that
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turns self-directed gain into social and economic benefits for all. Businesspeople
primarily work for their own prosperity, but their efforts to improve their situation (e.g.,
farmers selling crops, hiring workers) unintentionally lead to the production of needed goods,
services, and ideas, benefiting the wider economy and society.
imitations of Smith's Theory in Modern Context:WhileSmith assumed that wealth
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would naturally lead to philanthropy,significantincome inequality and persistent poverty
remain issues in societies today. This has led toan increased focus on corporate social
responsibility and philanthropic initiatives aimed at addressing societal challenges.
O 2–2 Explain What Capitalism Is and How Free
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Markets Work
Understanding Free-Market Capitalism
apitalismisan economic system in which all or mostof the factors of production
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and distribution—such as land, factories, railroads, and stores—are owned by
individuals and operated for profit.
Key Characteristics of Capitalism:
● P rivate Ownership:Individuals and businesses, notgovernment officials, largely
decide:
○ What to produce and in what quantity.
○ What to charge for goods and services.
○ How much to pay workers.
○ Whether to produce goods domestically or import them.
● Absence of Pure Capitalism:No country operates undera purely capitalist system;
governments universally maintain some level of involvement (e.g., minimum wages,
farm prices, business loans).
● State Capitalism:A hybrid system combining freermarkets with significant
government control, such as seen in China's economic growth.
asic Rights Under Free-Market Capitalism:Peopleoperating under free-market
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capitalism are generally afforded four fundamental rights, which encourage risk-taking and
economic activity:
Right Description
. Right to Own
1 Individuals can buy, sell, and use various forms of property
Private Property (land, buildings, inventions) and pass them on to heirs. This is
considered the most fundamental capitalist right.
. Right to Own a
2 usiness owners are incentivised by the ability to retain profits
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Business and Keep (revenues minus expenses) from their ventures.
Profits
. Right to Freedom of Individuals and businesses are free to compete in selling and
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Competition promoting goods and services, within government guidelines.
. Right to Freedom of P
4 eople are free to choose their careers, workplaces,
Choice residences, and what to buy or sell.
ormer U.S. President Franklin Roosevelt also identified additional essential freedoms for
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economic success: freedom of speech and expression, freedom to worship, freedom from
want, and freedom from fear.
How Free Markets Work
free marketis one wheredecisions about what andhow much to produce are made
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by the market—by buyers and sellers negotiating prices for goods and services.
onsumers influence production by their purchasing choices, signalling demand to
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producers.
rice Determination through Supply and Demand:Ina free market, prices are
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determined by the interaction between buyers and sellers, not dictated solely by sellers. This
negotiation leads to a market price, which is understood through the microeconomic
concepts of supply and demand.
● Supply:
○ D efinition:The quantities of products manufacturersor owners are
willing to sell at different prices at a specific time.
○ Relationship to Price:Generally, the amount suppliedincreases as the price
increases, as sellers can make more profit at higher prices.
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● emand:
○ D efinition:The quantity of products that people arewilling to buy at
different prices at a specific time.
○ Relationship to Price:Generally, the quantity demandedincreases as the
price decreases.
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● quilibrium Point (Market Price):
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efinition:This is theprice toward which the marketwill trend, where the
quantity demanded and quantity supplied are equal. It's the point where the
supply and demand curves intersect.
Market Signals and Government Interference:
● W henquantity supplied exceeds quantity demanded (asurplus), it signals
sellers to lower prices.
● Whenquantity supplied is less than quantity demanded(a shortage), it signals
sellers to increase prices. These price signals are crucial for businesses to
understand what to produce and in what amounts. In command economies or when
governments interfere significantly (e.g., through subsidies), these natural price
signals are absent, often leading to shortages or surpluses.
Competition within Free Markets
Economists identify four degrees of competition in free markets:
Degree of Description Examples (from
Competition source)
. Perfect
1 haracterised bymany sellers in a market, none A
C gricultural products
Competition large enough to dictate the price of a product. (e.g., apples, corn,
Sellers' products appear identical. True examples potatoes).
are rare today due to factors like government price
supports.
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2 eatures alarge number of sellers producing
F ot dogs, sodas,
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Monopolistic very similar products that buyers nevertheless laptop computers,
Competition perceive as different. Success hinges on T-shirts, the
product differentiationthrough advertising, fast-food industry.
branding, and packaging to create perceived
uniqueness.
3. Oligopoly ccurs whenjust a few sellers dominate a
O obacco, gasoline,
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market. High initial investment is often a automobiles,
significant barrier to entry. Products tend to be aluminum, aircraft,
priced similarly, withproduct differentiation and most cereals, soft
advertisingbeing key to market success, rather drinks.
than intense price competition.
4. Monopoly xists whenone seller controls the total supply
E ublic utilities
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of a product or service, and sets the price. In selling natural gas,
the U.S., laws generally prohibit monopolies, but water, and electric
they are permitted for public utilities (e.g., natural power (e.g., Florida
gas, water, electricity) where prices and profits are Power and Light).
regulated by public service commissions.
Deregulation efforts aim to increase competition in
these sectors.
Benefits and Limitations of Free Markets
Benefits:
● F ostersopen competition, which compels businessesto provide high-quality
products, fair prices, and excellent service to retain customers.
● A major driver ofwealth creationin industrialisedcountries.
● Providesopportunities for individuals to overcomepoverty.
● Encourages businesses to beefficientto compete effectivelyon price and quality.
Limitations:
● C an lead toincome inequality, with significant disparitiesin wealth between
business owners/managers and lower-level workers.
● Maynot adequately address the needs of vulnerablepopulations(e.g., older,
disabled, or sick individuals who cannot participate in the market).
● The risk ofgreed-driven unethical behaviourby somebusinesspeople, potentially
leading to deception of the public or stockholders.
ue to these limitations, some government laws and regulations are considered necessary
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to protect stakeholders and ensure basic welfare for those unable to work. This recognition
has led some countries to adopt socialism or mixed economic systems.
LO 2–3 Compare Socialism and Communism
Understanding Socialism
ocialismisan economic system based on the premisethat some, if not most, basic
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businesses (e.g., steel mills, coal mines, and utilities) should be owned by the
government so that profits can be more evenly distributed among the people.
Key Characteristics of Socialism:
● G overnment Ownership:Major industries are government-owned,while
entrepreneurs often retain ownership and operation of smaller businesses.
● High Taxation:Individuals face relatively steep taxesto fund social programmes.
For example, top personal income tax rates can be as high as 61% in some socialist
countries, and value-added taxes (similar to sales taxes) can be 15-20% or more.
● Goal:Socialists acknowledge capitalism's wealth creationbut advocate for its more
even distribution, greater government involvement in environmental protection, and
provision for the poor.
The Benefits of Socialism
he primary stated benefit of socialism issocialequality. This is ideally achieved through
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the government collecting taxes from wealthier individuals and redistributing that income to
poorer people via various government programmes.
Common Benefits Provided by Socialist Governments:
● ree education, often through college.
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● Free healthcare.
● Free childcare.
● Enhanced worker benefits, including longer vacations,fewer weekly working hours,
and generous sick leave, compared to countries with free-market capitalism.
The Negative Consequences of Socialism
Despite its promise of equality, socialism also presents several drawbacks:
● R educed Incentives:High tax rates can significantlylower the incentive for
businesspeople to start new ventures or for individuals to work harder, as a large
portion of their earnings is redistributed.
● Brain Drain:The loss of highly skilled and talentedindividuals (innovators, doctors,
lawyers, business owners) who migrate to other countries with lower taxes and
greater financial incentives is a common issue.
● Fewer Inventions and Less Innovation:The reducedpotential for significant
personal reward for new ideas discourages invention and innovation compared to
capitalist systems.
● Slower Economic Growth:Socialist economies tend toexperience higher
unemployment rates and slower overall growth rates than capitalist economies.
Understanding Communism
ommunismisan economic and political system in whichthe government makes
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almost all economic decisions and owns almost all the major factors of production. It
represents a more intensive and restrictive version of socialism, intruding further into
citizens' lives.
Key Problems with Communism:
● L ack of Market Signals:Without prices reflectingsupply and demand, the
government must guess what goods and services are needed, often leading to
widespread shortagesof essential items like foodand clothing.
● Absence of Incentives:Communism does not typicallyinspire individuals, including
businesspeople, to work hard due to the lack of personal incentives and rewards for
increased productivity or innovation.
● Economic Stagnation and Depression:Communist countriesoften suffer severe
economic depression, characterised by a lack of available goods and services (e.g.,
North Korea, Cuba).
● Restrictions on Personal Freedoms:Communist regimesfrequently limit personal
freedoms, such as the right to practice certain religions, change jobs, or choose one's
town of residence.
urrent Status:Communism is gradually declining asan economic system. As of the
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source material, only China, North Korea, Vietnam, Laos, and Cuba are identified as
communist countries.
LO 2–4 Analyze the Trend Toward Mixed Economies
The Trend toward Mixed Economies
istorically, nations largely aligned with eitherfree-market economies(capitalism, where
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the market primarily determines production, distribution, and growth) orcommand
economies(socialism and communism, where the governmentlargely decides these
factors).
However, neither system has proven optimal in its pure form:
● F ree-market economieshave not adequately addressedthe needs of the poor,
elderly, or disabled, nor have they done enough to protect the environment. This has
led capitalist countries, such as the United States, to adopt numerous social and
environmental programmes (e.g., Social Security, welfare, clean air and water acts).
● Socialism and communismhave struggled to generatesufficient jobs or wealth to
sustain rapid economic growth. This has resulted in the decline of communist
governments and socialist governments reducing social programmes and lowering
taxes to stimulate business growth and revenue.
he global trend is towards a blend of these systems, resulting in the emergence of
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mixed economies. This involves a shift from capitalistcountries adopting more socialist
elements (e.g., greater government involvement in healthcare) and socialist countries
incorporating more capitalist features (e.g., more private businesses, lower taxes).
ixed Economy Definition:Amixed economyis an economicsystem wheresome
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allocation of resources is made by the market and some by the government.
Characteristics and Benefits of Mixed Economies:
● H ybrid Approach:These economies combine private ownershipand market
mechanisms with government regulation and social programmes.
● Balance:They aim to strike a balance between thewealth creation benefits of free
markets and the social equality and environmental concerns often associated with
socialism.
● Prevalence:Most industrialised countries, includingthe United States, now operate
as mixed economies.
O 2–5 Describe the Economic System of the United
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States, including the Significance of Key Economic
Indicators (Especially GDP), Productivity, and the
Business Cycle
Understanding the U.S. Economic System
he economic system of the United States is a mixed economy founded on capitalist
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principles. Its performance is tracked using various key economic indicators.
ey Economic Indicators:Three major indicators gaugeeconomic conditions, along with
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productivity:
| Indicator | Definition and SignificanceTABLE: KeyConcepts in Macroeconomics
Economic Term Definition
hat is the "invisible hand" and how does it relate to
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economic growth?
he term "invisible hand" was coined by Adam Smith to describe a process through which
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individuals, while pursuing their self-interests, inadvertently contribute to broader social and
economic benefits.
Here's how it relates to economic growth:
● S elf-Interest as a DriverIn Smith's view, businesspeople are primarily motivated by
their own desire for prosperity and growth. They work hard, driven by the incentive of
keeping the profits from their labour or business.
● Creating Wealth for OthersThe "invisible hand" operatesas these self-directed
efforts lead to the production of needed goods, services, and ideas that benefit the
wider economy. For instance, a farmer aiming to become wealthy sells crops to
others and hires workers to produce more food. This self-serving act provides jobs
for some and food for many. The same principle applies across industries, from
clothing to technology.
● Economic ProsperityAs individuals strive to improvetheir own situations, their
collective actions cause the economy to grow and prosper, making plenty of goods,
services, and food available to everyone.
● Foundation for GrowthThis process is considered criticalto understanding
economic growth in the United States and other free countries.
In summary, the "invisible hand" suggests that a free market, where individuals are free to
pursue their own economic interests, leads to an overall increase in societal wealth and
well-being, even without direct intent to benefit others.
