Lecture 3:
Free Markets,
Voluntary Exchange,
and Money
EC101 DD & EE / Manove Market System>Money
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EC101 DD & EE / Manove Clicker Question
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Economics Systems
Different cultures have different economic
systems…
with different rules or codes of behavior.
EC101 DD & EE / Manove Economic Concepts>Economic Systems
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In some places, the entire economy works like
the army: orders are passed down from the top.
In other places, the economy is completely
decentralized: families run their own businesses
any way they want.
Some standard examples are:
 Feudalism and Serfdom
 The Command Economy
 Free Market System
But many other economic systems have been
described. [Read about the Incas in LaunchPad or the course
website.]
EC101 DD & EE / Manove Economic Concepts>Economic Systems
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Basic Economic Choices
As a group, economic agents must make a
number of important economic choices:
What to produce
Production
decisions
How to produce it
Who gets the outputs
Who provides the inputs
Distribution
decisions
In different economic systems, these
decisions are made in different ways.
EC101 DD & EE / Manove Economic Concepts>Economic Choices
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Free-Market System
In the free-market economic system,
most economic activity is voluntary—
stimulated by economic incentives.
Production
voluntary activity of
private firms.
Distribution
voluntary exchange
EC101 DD & EE / Manove Free-Market System
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Example: Shanu’s Pizza Palace
Shanu opens a pizza restaurant.
She leases space, buys ovens.
She hires workers at $12/hour.
They produce pizza.
Shanu sells pizza to customers.
EC101 DD & EE / Manove Free-Market System>Example
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Real Free-Market Economies
Most countries, even countries with communist
governments, now have free-market economies.
They rely mainly on the voluntary economic
activities of households and private firms.
But real free-market economies also include
involuntary private exchange and production
government production, induced by political rather
than economic incentives
EC101 DD & EE / Manove Free-Market System>EC101
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Involuntary Economic Activities
Example: Shanu’s Pizza Palace (again)
 Shanu must pay taxes to the local government, but
she receives police protection.
 The local health authorities require her to keep her
restaurant kitchen very clean.
 She must not allow smoking in her restaurant.
EC101 DD & EE / Manove Free-Market System>Deviations
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Government Production
Example: Even in the US, governments operate
many firms.
universities
schools
hospitals
the post office
 other examples ….
EC101 DD & EE / Manove Free-Market System>Countries
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EC101 DD & EE / Manove Clicker Question
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The Free-Market System and EC 101
Real free-market economies are difficult to
analyze.
So in EC101 we spend a lot of time on the freemarket model.
In the model, all economic activities are private
and voluntary (arising from economic incentives).
The model may help us understand the real world.
But the results of the model aren’t always
accurate.
EC101 DD & EE / Manove Free-Market System>EC101
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Voluntary Exchange
In free-market economies, voluntary exchange
is usually used to distribute outputs and inputs.
Households, firms and governments sell and
buy, (exchange), goods and services.
Voluntary exchange normally increases welfare
of both parties…
…or, at least, doesn’t decrease it.
Most voluntary exchange takes place in markets.
EC101 DD & EE / Manove Market System>Voluntary Exchange
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Markets
 Markets are “meeting places” for voluntary
exchange
Traditional markets
Supermarkets
NASDAQ
EC101 DD & EE / Manove Market System>Voluntary Exchange>Markets
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Some markets are diffuse and exist in many
places simultaneously.
market for petroleum
US labor market
EC101 DD & EE / Manove Market System>Voluntary Exchange>Markets
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Voluntary Exchange Examples
Example 1:
You have
I have
but prefer
but prefer
Outcome:
EC101 DD & EE / Manove Market System>Voluntary Exchange>Examples
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Example 2:
You have
I have
and prefer
and prefer
Outcome:
EC101 DD & EE / Manove Market System>Voluntary Exchange>Examples
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Example 3:
You have
I have
and prefer
and prefer
Outcome:
EC101 DD & EE / Manove Market System>Voluntary Exchange>Examples
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Example 4:
You have
I have
and prefer
and prefer
Outcome:
EC101 DD & EE / Manove Market System>Voluntary Exchange>Examples
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Voluntary Exchange: Moral
Voluntary exchange tends to make agents better
off, because it is voluntary.
It never makes agents worse off (well, almost
never).
Important exceptions:
temptation
poor information
ignorance
EC101 DD & EE / Manove Market System>Voluntary Exchange>Moral
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Voluntary Exchange and Trust
 In most markets, the seller has a lot more
information about the product or service than
the buyer has.
 There are laws that “protect the unsuspecting
from the unscrupulous.”
 But voluntary exchange always requires
trust, a form of social capital.
EC101 DD & EE / Manove Market System>Voluntary Exchange>Moral
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Voluntary-Exchange Mechanisms
Voluntary exchange is a fundamental aspect of
the free market system.
But how is voluntary exchange conducted?
Two primary mechanisms:
Barter
Selling and Buying
EC101 DD & EE / Manove Market System>Money
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Exchange Mechanisms: Barter
Accomplished in one step
Direct Exchange: you have oranges and
want apples.
“Double Coincidence of Wants.” You
must find a market with people who…
have what you want…
and want what you have.
EC101 DD & EE / Manove Market System>Voluntary Exchange>Barter
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Exchange Mechanisms: Selling & Buying
Two steps (rather than one)
Selling what you have:
Buying what you want
EC101 DD & EE / Manove Market System>Voluntary Exchange>Selling&Buying
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Selling and Buying requires two steps and a
special tool (money).
But searching for the right market is easier.
When you sell, you must find a market with
people who
want what you have,…
but they don’t need to have what you want.
When you buy, you must find a market with
people who
have what you want,…
but they don’t need to want what you have.
EC101 DD & EE / Manove Market System>Voluntary Exchange>Selling&Buying
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Advantages of Selling and Buying
Being able to find the right market easily is very
important in complex economies with millions of
goods and services.
That’s why barter is uncommon in advance
economic systems.
EC101 DD & EE / Manove Market System>Voluntary Exchange>Selling&Buying
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Money
Barter requires no special tools,…
But selling and buying require a medium of
exchange: Money
Selling means obtaining money in exchange
for goods.
Buying means obtaining goods in exchange
for money.
EC101 DD & EE / Manove Market System>Money
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Types of Money
 Commodity money
 Fiat money
 has no value of its own
 declared to be money by the state or other institution
 often exists only as paper (currency),…
 or as intangible notations in computer memory banks
(checkable deposits).
EC101 DD & EE / Manove Market System>Money>Types of Money
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Acceptance of Money
Why do people accept paper money in return
for valuable goods and services?
The role of “legal tender”?
Bitcoin ?
EC101 DD & EE / Manove Market System>Acceptance of Money
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What would happen if I told you…
“Don’t accept US dollars—they’re worthless.”
But suppose Fed Governor Janet Yellen
went on television with President Obama
and said that US dollars are worthless.
What would happen then?
EC101 DD & EE / Manove Market System>Acceptance of Money
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EC101 DD & EE / Manove Clicker Question
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EC101 DD & EE / Manove End of File
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