Chapter
Chapter 2
• Section 2
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SE page!
The revised
Free Market
The Free Market
Objectives You may wish to call students’ attention to the objectives in
the Section Preview. The objectives are
reflected in the main headings of the
section.
Bellringer Ask students what comes
to mind when they hear the term selfinterest. Explain that in this section
they will learn how self-interest motivates the marketplace.
Vocabulary Builder Ask students to
define each key term in their own
words and then check their definitions
against what they read in Section 2.
Then have them explain how each
term is related to the free market.
Preview
Section Focus
Objectives
market an arrangement
that allows buyers and
sellers to exchange
things
hat do a farmers’ market, a sporting
goods store, the New York Stock
Exchange, and the sign you posted on your
community bulletin board advertising
baby-sitting services have in common? All
are examples of markets. A market is an
arrangement that allows buyers and sellers
to exchange things.
W
Lesson Plan
Teaching the Main Concepts L3
Guided Reading and Review
Unit 1 folder, p. 15 asks students to
identify the main ideas of the section
and to define or identify key terms.
28
market
specialization
household
firm
factor market
profit
product market
self-interest
incentive
competition
invisible hand
consumer
sovereignty
Why Markets Exist
Markets exist because no one is self-sufficient. In other words, none of us produces
all we require to satisfy our needs and
wants. You probably didn’t grow the plants
to make the fibers to weave the cloth to
make the shirt you’re wearing. Instead, you
purchased your shirt at a store, which is an
example of a market. Markets allow us to
exchange the things we have for the things
we want.
Specialization
Instead of being self-sufficient, each of us
produces just one or a few products.
A nurse specializes in caring for the sick. A
This Thai spice
stand, Brazilian
stock exchange, and
Indian barber shop
(left to right) are all
examples of markets.
BU
I L D I NG
S
Graphing the Main Idea
EY
K
1. Focus Tell students that from the
moment they came into the world, their
wants and needs were a part of the free
market—even when they were being
fulfilled by a parent. Have students suggest ways that newborn babies affect
the free market.
2. Instruct Discuss with students the
nature of markets and their importance
to economic systems. Explain that in a
free market economy, producers and
consumers interact freely, each in his
or her own self-interest, to regulate
aspects of the market. Be sure that students understand that freedom and
self-interest combine to create a marketplace that satisfies most economic
goals.
3. Close/Reteach Remind students that
although a pure free market offers many
benefits, it fails to achieve some economic goals. Have small groups create
charts listing the advantages and disadvantages of allowing self-interest and
competition to guide the market.
Key Terms
After studying this section you will be able to: Markets exist so that people
can exchange what they have
1. Explain why markets exist.
for what they want. A free
2. Analyze a circular flow model of a free
market is a self-regulating
market economy.
economic system directed by
3. Understand the self-regulating nature of
individuals acting in their own
the marketplace.
self-interest.
4. Identify the advantages of a free market
economy.
C ON CE P
T
Economic Systems To build understanding of the
concept of economic systems, have students use a
web graphic organizer like the one at the right to
describe circular flow. Tell students that a web
shows a main idea and its supporting details.
Explain that students should place the label
“Circular Flow” in the central oval. In the surrounding ovals they should record how various
parts of the system interact with each other.
Section Reading Support Transparencies A template and the answers for this graphic organizer
can be found in Chapter 2, Section 2 of the Section
Reading Support Transparency System.
Chapter
Chapter 2 • Section 2
marine mechanic specializes in repairing
machinery aboard sea craft. A baker
specializes in making breads, cakes, and
cookies. Specialization is the concentration
of the productive efforts of individuals and
firms on a limited number of activities.
Specialization leads to efficient use of
resources, including capital, land, and
labor. It is easier to learn one task or a few
tasks very well than to learn them all.
questions of what to produce, how to
produce it, and who consumes that which
is produced. As you might guess, a free
market economy functions best in an environment of decentralized decision-making
such as enjoyed in the United States.
We can represent a free market economy
in a special kind of drawing called a
circular flow diagram, or model. A circular
flow diagram shows at a glance how individuals and businesses exchange money,
resources, and products in the marketplace.
Figure 2.3 shows a circular flow diagram of
a free market economy. The inner ring of
the diagram represents the flow of
resources and products. The outer ring
represents the flow of money.
specialization the
concentration of the
productive efforts of
individuals and firms on
a limited number of
activities
Households and Firms
profit the financial gain
made in a transaction
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Buying and Selling
Because each of us specializes in producing
just a few products, we need markets to
sell what we have and to buy what we
want. The typical person earns an income
(specializing at a particular job) and uses
this income to buy the products that he or
she wants to consume. If each person were
self-sufficient, producing everything he or
she wanted to consume, there would be no
need for markets.
Free Market Economy
Economic systems that are based on voluntary exchanges in markets are called free
market economies. In a free market
economy, individuals and businesses use
markets to exchange money and products.
In a free market system, individuals and
privately owned businesses own the factors
of production, make what they want, and
buy what they want. In other words, individuals answer the three key economic
The players in the free market economy are
households and firms. A household is a
person or group of people living in the
same residence. Households own the
factors of production—land, labor, and
capital. Households are also the consumers
of goods and services.
A business, or firm, is an organization
that uses resources to produce a product,
which it then sells. Firms transform
“inputs,” or factors of production, into
“outputs,” or products.
household a person or
group of people living in
the same residence
firm an organization
that uses resources to
produce a product,
which it then sells
factor market
market in which firms
purchase the factors of
production from
households
Factor Market
As you can see from the lower half of the
circular flow diagram in Figure 2.3, firms
purchase factors of production from households. This arena of exchange is
called the factor market. Firms
purchase or rent land (natural
resources). They hire workers,
paying them wages or salaries
for their labor. They also
borrow money from households
to purchase capital, paying
households interest or profits in
return. Profit is the financial gain
made in a transaction.
Product Market
Take a close look at the top half
of the circular flow diagram in
$
Econ 101: Key Concepts Made Easy
Economic Systems One of the key concepts in
this section is the invisible hand, an idea that students may find confusing. Explain that the
“invisible hand” is the interaction between selfinterest and competition that acts as a force to
set the price of goods and services.
Ask students to think about the introduction of an
innovative electronic product, such as a highdefinition television. Explain that initially the price
is high because the product is new and may have
little or no competition. When and if consumers
decide that they want this new technology, producers begin competing to manufacture the most
appealing version. This competition causes the
price to moderate, because price is part of a product’s appeal. The price will continue to drop until it
reaches a level that offers producers an acceptable
profit and consumers an affordable product.
Background
Economics in History
From the earliest days of trading
between societies, markets were
located where the transportation
was, usually near seaports and rivers.
The importance of transportation to
markets can be illustrated by the rise
and fall of one of Europe’s most active
market centers—Brugge, Belgium.
This city is sometimes referred to by
its French name, Bruges.
Although not located on the coast,
Brugge was connected to the North
Sea by a canal called the Zwyn. By
the 1300s Brugge was not only an
international trading center but a
financial center as well.
In the 1400s competition from the
harbor at Antwerp began to diminish
Brugge’s importance, but the city was
hurt most by the continual accumulation of silt in the Zwyn. Eventually
the Zwyn completely silted over, and
Brugge lost its connection to the sea.
By the end of the 1500s, Brugge had
ceased to be a center for trade in
Europe. Today its economy is dependent mainly on tourism.
L3
(Reteaching) Ask students to write a
paragraph that explains why markets
exist, giving real-life examples of the
reasons provided. (An example of the
reason “people are not self-sufficient”
would be “I cannot grow all of my
own food.”)
L2
To help students understand a circular
flow diagram, designate a desk on
one side of the room as a “household” and a desk on the other side of
the room as a “firm.” Have volunteers, holding labels that say “Goods
and Services” and “Land, Labor, and
Capital,” act out the principles of
circular flow. Ask students to relate
this kinesthetic activity to the selfregulating nature of the marketplace.
29
Chapter
Chapter 2 • Section 2
Figure 2.3 Circular Flow Model of a Market Economy
L3
You may wish to have students add the
following to their portfolios. Ask students what they plan to do after graduation. Will they get jobs, go to college,
travel, start their own businesses? Tell
students to write a paragraph about
how their choices are motivated by
self-interest. Then ask them to think
about the specifics of their choices.
Which college? Where will they travel?
What kind of job or business? Ask
them to write a second paragraph
explaining how these choices are also
motivated by self-interest. Finally, ask
them to write a third paragraph
explaining how their self-interest
might be affected by competition.
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A circular flow model
shows the interactions
between households
and businesses in the
free market.
Economic Systems
What is exchanged in
the factor market? In
the product market?
Households pay firms
for goods and
services.
Product market
monetary flow
physical flow
Firms supply
households with
goods and services.
Households
Firms
Households supply
firms with land, labor,
and capital.
Economics Assessment Rubric
Economics Assessment Rubrics folder,
pp. 6–7 provides sample evaluation
materials for a writing assignment.
p h y s i ca l fl o w
m o n e t ar y f l o w
Transparency Resource Package
Economics Concepts, 2D:
Circular Flow Diagram of a Market
Economy
L2
English language learners may benefit
from completing the Student Portfolio
activity on this page orally. ELL
Factor market
product market
the market in which
households purchase
the goods and services
that firms produce
Figure 2.3. You can see that the goods and
services that firms produce are purchased
by households in the product market.
If you follow the rings of the diagram,
you will see that households purchase the
products made by firms with the money
they received from firms in the factor
market. The flow between the factor market
and the product market is truly circular.
Firms pay households
for land, labor, and
capital.
products, in the case of households? As
anyone knows who has tried out for the
track team, a part in a play, or has applied
for a job or to a college, we live in a
competitive society. According to Adam
Smith, it is, in fact, competition and our
own self-interest that keep the marketplace
functioning.
Self-Interest
The Self-Regulating Nature
of the Marketplace
How is it that firms and households cooperate to give each other what they want—
factor resources, in the case of firms, and
Adam Smith was a Scottish social philosopher who, in 1776, published a book titled
The Wealth of Nations, in which he
described how the market functions. Smith
observed that an economy is made up of
countless individual transactions. In each
transaction, the buyer and seller consider
Block Scheduling Strategies
Consider these suggestions to take advantage of
extended class time:
Answer to . . .
Building Key Concepts Firms purchase factors of production from
households in the factor market,
and households purchase goods
and services from firms in the
product market.
30
■ Show the Economics Video Library segment
“Internet Impact,” about the Internet as a perfect
free market situation. Then hold a discussion of
how the Internet benefits both consumers and
businesses. Ask students also to examine possible
negative effects of the Internet on these groups.
■ Expand the Meeting NCEE Standards activity
on p. 31 into a group activity. Organize the class
into four groups, one representing each individual
noted. Have each group brainstorm a list of
incentives for that individual. Then ask students
to choose five incentives and to show how they
would benefit the economy of the United States as
a whole. Allow time for the groups to present
their incentives and benefits to the class.
Chapter
Chapter 2 • Section 2
only their self-interest, or their own
personal gain. Self-interest, in other words,
is the motivating force in the free market.
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Meeting NCEE Standards
Competition
Consumers (households), in pursuit of their
self-interest, have the incentive to look for
lower prices. An incentive is the hope of
reward or the fear of punishment that
encourages a person to behave in a certain
way. Adam Smith observed that people
respond predictably to both positive and
negative incentives. As for consumers, we
can predict that they will respond to the
positive incentive of lower prices, because
spending less money on a good lowers the
opportunity cost of the purchase.
Firms, meanwhile, seek to make greater
profits by increasing sales. Let’s take, for
example, a shirt manufacturer. The manufacturer finds that striped shirts are far outselling
polka-dotted shirts. The manufacturer has
the incentive—from more potential sales and
profits—to produce more striped shirts.
Other manufacturers, observing consumers’
desire for striped shirts, also have the incentive to sell them. With all these manufacturers
in the market, consumers have all the striped
shirts they want.
Manufacturers also have a second incentive—to make the most profit in selling
striped shirts. What keeps manufacturers’
pursuit of profit from causing prices to
skyrocket? If one begins charging $30.00 for
a striped shirt, another can sell striped shirts
for $25.00. If the first manufacturer wants
“Son, your mother and I have decided to let the
free market take care of you.”
to sell any more striped shirts, he or she had
better drop the selling price. Consumers,
pursuing their self-interest, will buy the
lower-priced shirt. Economists call this
struggle among producers for the dollars of
consumers competition. While self-interest is
the motivating force behind the free market,
competition is the regulating force.
Incentives come in two forms. Profit is a
monetary incentive, or an incentive that
rewards in the form of money. Nonmonetary
incentives reward consumers and business in
other ways, such as gifts, services, and other
goods.
The Invisible Hand
Self-interest and competition work together
to regulate the marketplace. Self-interest
spurs consumers to purchase certain goods
How could the
free market take
care of this young
man?
self-interest one’s own
personal gain
incentive an
expectation that
encourages people to
behave in a certain way
competition the
struggle among
producers for the
dollars of consumers
Competing
Use the following benchmark activity from the Voluntary National
Content Standards in Economics to
evaluate student understanding of
Standard 4.
Compare and contrast the incentives an individual might face in serving as an elected official, the owner
of a small business, the president of
a large company, and the director
of a local United Way office.
L2
Ask students to write and illustrate a
simplified version of the “striped
shirts versus polka-dotted shirts”
scenario on this page to demonstrate
their understanding of competition.
Guide this activity by engaging students in a prewriting discussion of
what to do. LPR
Learning Styles Activity
Learning Styles Lesson Plans folder,
p. 9 asks students to present panel
discussions demonstrating the
strengths and shortcomings of the
free market in the United States.
L3
(Reteaching) After students have
read the section, ask pairs of students to create an advertisement for
the free market, highlighting its
advantages. Encourage them to
think creatively.
businesses scream
for the attention of
consumers.
✓
Preparing for Standardized Tests
Have students read the section titled “Competition” and then answer the question
below.
Which of the following is an accurate definition of competition?
A
B
C
D
the hope of reward that encourages a person to behave in a certain way
the struggle among producers for the dollars of consumers
the financial gain made in a transaction
an organization that uses resources to produce a product
Answer to . . .
Cartoon Caption He could sell his
labor in the factor market and use
the income he earns to make purchases in the product market.
31
Chapter
Chapter 2 • Section 2
GTE
Guide to the Essentials
Chapter 2, Section 2, p. 7 provides
support for students who need additional review of the section content.
Spanish support is available in the
Spanish edition of the guide on p. 7.
Quiz Unit 1 folder, p. 16 includes
questions to check students’ understanding of Section 2 content.
Self-interest and the free market will
provide social services—if there’s a
profit to be gained. One large
temporary employee agency recruits
and trains workers from the ranks of
the urban poor. Bypassing the socialwelfare agencies that are charged
with getting people off public
assistance, it finds work for individuals
and employees for businesses, and
makes a profit for itself.
Presentation Pro CD-ROM
Quiz provides multiple-choice
questions to check students’ understanding of Section 2 content.
Advantages of the Free Market
Competition and the pursuit of self-interest
serve the public interest. The free market,
on its own, meets many economic goals.
Answers to . . .
Section 2 Assessment
1. Specialization allows each of us to
focus on individual tasks and not
worry about all of our basic needs at
once, thus making us more efficient.
2. Factor markets provide goods and
services that are necessary to produce more goods and services,
whereas product markets provide finished goods to consumers.
3. Profit is the financial gain made in a
transaction.
4. Households provide the factors of
production in factor markets and the
buying power in product markets;
firms are the buyers of factors of production and the suppliers of goods
and services.
5. Competition benefits consumers by
causing firms to sell higher-quality
goods at lower prices.
6. Smith meant that the combination of
consumers’ self-interest and competition among firms would naturally lead
to an economy in which consumers
can buy products they want at reasonable prices.
7. Consumer sovereignty has to do with
the power that consumers have to
choose what they will buy, so that
they exert control over what is produced by creating the incentive for
firms to produce high-quality goods
and services.
8. Economic equity is difficult to achieve
in a free market economy because not
every person functions in the market
with the same skills and abilities, and
therefore differences in compensation arise.
9. Students should complete the activity
and present data on the results.
Students should find that they can make
more fold-its when they specialize.
32
and services and firms to
produce them. Competition
causes more production and
moderates firms’ quests for
higher prices. The overall
result is that consumers get
the products they want at
prices that closely reflect the
cost of producing them. All
of this happens without any
central plan or direction.
Adam Smith called this
phenomenon “the invisible
hand of the marketplace.”
economic freedom of any system. This
includes the freedom of workers to work
where they want, of firms to produce
what they want, and of individuals to
consume what they want.
3. Economic growth Because competition
encourages innovation, free markets
encourage growth. Entrepreneurs are
always seeking profitable opportunities,
contributing new ideas and innovations.
4. Additional goals Free markets offer a
wider variety of goods and services than
any other system, because producers
have incentives to meet consumers’
desires. Consumers, in essence, decide
what gets produced. This is called
consumer sovereignty.
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FAST FAC T
invisible hand term
economists use to
describe the selfregulating nature of the
marketplace
consumer sovereignty
the power of
consumers to decide
what gets produced
1. Economic efficiency Because it is selfregulating, a free market economy
responds efficiently to rapidly changing
conditions. Producers make only what
consumers want, when they want it, and
generally at prices they are willing to pay.
2. Economic freedom Free market
economies have the highest degree of
Section 2 Assessment
Key Terms and Main Ideas
1. How does specialization make us more efficient?
2. What is the difference between the factor market and the
product market?
3. What is profit?
4. What are the roles of households and firms in a market
economy?
5. How does competition among firms benefit consumers?
6. Explain what Adam Smith meant by “the invisible hand of
the marketplace.”
7. What is the connection between incentives and consumer
sovereignty in a free market economy?
Applying Economic Concepts
8. Critical Thinking Why is economic equity difficult to
achieve in a free market economy?
10. Answers should reflect an understanding that a
change in one part of the economy will lead to a
change elsewhere in the economy. For example, a frost
in Florida will result in losses for orange juice manufacturers and higher prices for consumers.
Despite its advantages, no pure market
economy exists on any meaningful scale.
The same features that make free markets
attractive also represent the weaknesses of
the free market. The goals of economic
equity and economic security are difficult
to achieve in a pure market system. In
Section 4, you will read about how the free
market system has been modified by
various nations in order to better meet the
entire array of economic goals.
Progress Monitoring Online
For: Self-quiz with vocabulary practice
Web Code: mna-1026
9. Try This You will need a stack of paper and two staplers.
You and a friend create “fold-its” by folding each sheet
of paper in thirds and stapling both ends. How many
fold-its can you make in two minutes? Next, try specializing: one of you folds while the other staples. Now how
many fold-its can you make in two minutes?
10.Critical Thinking Provide at least three real-world
examples to illustrate the circular flow model of a market
economy.
PHSchool.com
For: Current Events Activity
Visit: PHSchool.com
Web Code: mnd-1022
Progress Monitoring Online
For additional assessment, have students access
Progress Monitoring Online at Web Code: mna1026
Typing in the Web Code
when prompted will bring students directly
to detailed instructions for this activity.