The Three Economic Questions
Chapter 2, Section 1


All nations in the world must decide how to answer three economic questions about the
production and distribution of goods.
How a society answers these three economic questions defines its economic system.
Every society must answer the following questions:
What goods will be produced?
Because of scarcity, no country can produce every good it wants in the quantity it would like.
How will the goods be produced?
Will production decisions be made by individuals or by the government?
Will producers use existing technology or new technology?
For whom will the goods be produced?
Will the government decide? Will price decide?
Will goods be produced for the purpose of trade with other countries?
Major Differences between Free Enterprise and Socialism
Use pages 33-38 in your textbook to complete the chart highlighting the characteristics of each economic system. When you are
finished, answer the questions at the top of the next page.
Free Enterprise
Resources
Government’s
Role in the
Economy
Economics Plans
Income
Distribution
Controlling
Prices
Private Property
Socialism
The United States is considered to have a free enterprise (capitalist) economy but why should it really be
considered a mixed economy?
Why are almost all countries “Mixed Economies”?
The Index of Economic Freedom that is in your textbook is a bit outdated. Go online and look up the
2015 Index of Economic Freedom. Choose one country in each of the categories and then describe why
that country earned the score that it did.
Country
Free
Mostly Free
Moderately Free
Mostly Unfree
Repressed
Economic Characteristics
(why did this country earn the score it received)
The Visions behind Free Enterprise and Socialism
Use pages 39-40 in your textbook to complete the chart. You can use the chart on page 39 to make sure you hit the key points.
Adam Smith
Karl Marx
Place and year of birth
Major Work (book)
Economic system based on his
ideas
Ideas contributing to his “visions”
Use the following key to label each of the statements as more like the free enterprise vision of Adam Smith or
more like the socialist vision of Karl Marx.
S = Adam Smith, free enterprise vision
M = Karl Marx, socialist vision
_____
Resources are owned by private individuals
_____
Government decision makers write economic plans
_____
Private property is sacred.
_____
Government makes major decisions concerning the use of resources and the production of goods.
_____
Much attention is given to distribute income away from high earners toward low earners.
_____
Government owns and controls many resources.
_____
Government does not attempt to control prices.
_____
Government plays a small role in the economy.
_____
Government sets wages and the prices of goods.
_____
Government owns most property and uses it for the benefit of the people.
Free Enterprise Class Notes
Economics – Chapter 3
Section 1: Characteristics of Free Enterprise
I.
How Does Free Enterprise Answer the Three Economic Questions?
A. ____________________________ will produce the goods that consumers want to buy.
 For example, General Motors and Ford Motor Company decide what style and make
of cars they will produce based on what they think the car-buying public wants to buy.
B. The individuals who __________________________ and ___________________ the business
firms decide how goods will be produced.
C. Goods are produced for those people who are _____________________ and _______________ to
buy them.
 For example, a person may have $1,000 to spend on a new computer, but be unwilling
to replace his or her old computer. In this case, the potential buyer is able, but not
willing, and a sale will not take place.
II.
Five Features of Free Enterprise
A. PRIVATE PROPERTY

Private property can be described as
any good that is owned by an
__________________ or a business,
such as a car, a house, or a piece of
machinery. Any good that is owned by
the government is referred to as
______________ property.
 Sometimes the government may have a
need for private property. Under the
right of ________________
________________, the government
can take ownership of private property
even without the consent of the owner. In such cases, the government will
__________________ owners for their loss. Eminent domain has been used to obtain private
land for such uses as building new schools, highways, and government buildings.
B. CHOICE (or Freedom to Choose)
 ________________ have the right to choose what work they want to do and whom they will
work for. _______________________ have the right to choose the products they will produce
and offer for sale. Likewise, _______________ have the right to choose the products they will
buy.
C. VOLUNTARY EXCHANGE

In free enterprise, individuals have the right to make exchanges or _____________ that they
believe will make them ___________ _______. Trading $10 cash for a book is an example of
a voluntary exchange.
D. COMPETITION

Consumers are likely to benefit from competition between _________________. Workers can
also benefit from competition. The competition between employers for labor services will
often result in __________________ wages.
E. ECONOMIC INCENTIVES

Under free enterprise, ___________________ acts as an incentive to produce. If you produce
goods and services that people are willing and able to buy, you receive money in return.
III.
Laws, Institutions, and Regulations
A. A country’s _____________________ system determines, to a large degree, how free enterprise
operates.
B. Legal systems and institutions can either help or hinder free enterprise.
IV.
The Circular Flow
A. The circular flow of economic activity in the U.S. economy shows the ______________________
among the key players in the economy.
B. ______________________ sell resources to businesses, and businesses pay for these resources.
C. ______________________ sell goods and services to households, and households pay for these
goods and services.
D. Households pay taxes to _________________________, and ______________________ provides
goods and services to households, such as roads, schools and national defense.
E. Businesses pay ___________ to government, and government provides __________ and
______________ to businesses.
The circular diagram is useful because it helps us see how a ________________ in one economic
activity (such as paying taxes) will lead to a change ______________________ else in the
economy (such as the amount households spend on goods and services produced by businesses).
Chapter 3, Section 1
Applying the Principals
1.
1
What economic activities flow
from businesses to households?
2
2.
What economic activities flow
from households to businesses?
3.
What economic activities flow
from government to households?
4.
What economic activities flow
from households to government?
3
4
5.
What economic activities flow from government to businesses?
6.
What economic activities flow from businesses to government?
In questions 7 – 16, identify the part of the circular flow diagram in which the economic activity listed
occurs. Write 1, 2, 3 or 4 in the blanks provided.
7.
_____
Mycah attends a public school.
8.
_____
Travis buys a new car.
9.
_____
Mikayla works 20 hours a week at Burger Barn.
10. _____
Trish does research at a large corporation.
11. _____
Microsoft relies on the Justice Department to enforce copyright laws.
12. _____
Dianne drives on County Road 1 to get to work.
13. _____
Bruce leases his commercial building to Widgets, Inc.
14. _____
Dawn buys a computer from her local office supply store.
15. _____
Vanh buys a lawn mower from Home Depot.
The following questions relate to the circular flow diagram.
16. If a recession causes households to reduce spending, how might businesses be affected?
17. If government raises taxes on businesses how might households be affected?
18. If government cuts taxes on households, how might businesses be affected?
Section 2: Profit and Loss in Free Enterprise
I.
Profits and Losses
A. Profit equals total _____________________ (price of a good times the units of the good sold)
minus total _________________________ (average cost of a good times the number of units of
the good sold).
B. Profit is the amount of money left over after all the costs of production have been paid. Profit
exists whenever total _________________ is greater than total ___________.
C. A ____________ occurs when total cost is greater than total revenue.
TOTAL REVENUE =
TOTAL COST =
PROFIT =
LOSS =


II.
For example, suppose you sell 10 sets of headphones at $100 each, for a total revenue
of $_______________. If it costs you an average of $70 each to produce those head
phones, your total cost to produce 10 head phones is $_______. Do you have a profit or
a loss on your sale of 10 head phones?
Answer: _____________ of $________
Profit and Loss as “Signals”
A. In a free enterprise economy, some businesses are earning profits and some are taking losses.
Profits and losses are
 ____________ to the firms actually earning the profits or taking the losses, and
 signals to firms standing on the _______________
B. A firm on the sidelines will see what product is profitable and possibly __________ that market.
C. A firm may ________________ a product that is producing losses, and __________________ its
resources to a profitable product.
D. Resources flow _____________ profit and ______________ from losses.
Chapter 3, Section 2
Applying the Principals
Scenario: Bryan sells gadgets at a price of $7 apiece. His average cost is $5 per gadget. On Monday, Bryan sold 10
gadgets; on Tuesday, he sold 7 gadgets; on Wednesday, he sold 9 gadgets; on Thursday, he sold 11 gadgets; and on
Friday, he sold 13 gadgets.
19. What was Bryan’s told revenue for the week? _______________
20. What was Bryan’s told cost for the week? ____________
21. Did Bryan have a profit or a loss for the week? ______________
22. What was the dollar amount of Bryan’s profit or loss for the week? ______________
Section 3: The Ethics of Free Enterprise
I.
Ethics and Free Enterprise
A. Ethics consists of the principles of CONDUCT, such as right and wrong, morality and
immorality, and good and bad.
B. An ethical economic system should have four characteristics. Supporters of free enterprise say
that the free enterprise economic system has these characteristics.
1. Allow individuals to ____________________________ their own occupations or
professions.
2. Produce the goods and services preferred by both the majority and the
____________________________.
3. _________________________ (or ______________________) producers according to
how well (or poorly) they respond to the preferences of the buying public.
4. Provide people with numerous _________________, including the freedom to work
where they want to work, the freedom to start their own businesses if they want, the
freedom to acquire property, the freedom to buy and sell the goods they want to buy and
sell, and even the freedom to ________.
II.
Economic Principles in Key Documents
A. The Bill of Rights shows a high regard for _________________ property.
 The Bill of Rights notes that “private property [shall not] be taken for public use,
without just _________________________.”
B. The Declaration of Independence encourages free ___________________________ - an essential
ingredient of free enterprise.
 The Declaration of Independence lists _____________________ against the king of
Great Britain, George III. One complaint is that the king prevented the 13 colonies
from “___________________ with all parts of the world.”
C. The Constitution preserves ______________________ – an important feature of free enterprise –
by denying states the right to tax each other’s goods.
 Article 1, Section 8, of the U.S. Constitution states that “no tax or duty shall be laid on
articles __________________ from any State.” To preserve competition, it was
important to allow the free trade of goods ____________ state lines.
III.
Economic Rights and Responsibilities in a Free Enterprise Economy
A. People in a free enterprise economy usually share three sets of rights and responsibilities:
1. ___________________________________________
 The right to sell an item comes with the responsibility to disclose any relevant
facts about the item in question.
2. ___________________________________________
 One has the right to use private property as one wishes, within the limits of the
law.
3. ___________________________________________
 The responsibility attached to the right to compete is that one must compete in a
truthful, legitimate manner.
Section 4: Entrepreneurs
I.
Imagine Being an Entrepreneur
A. An entrepreneur is a person who has a special talent for __________________ out and taking
___________________ of new business opportunities.
B. Entrepreneurs play an important role in society by taking ____________ to develop new products
or new ways of doing things that ____________________ the public.
Most people are not entrepreneurs; entrepreneurs are a tiny
_____________________ of the population.
II.
Entrepreneurs, Profit and Risk
A. People will not risk their time and money to develop new products unless they can potentially earn
a __________________.
B. Not all entrepreneurs are ________________.
C. However, a few end up as millionaires and even billionaires, and it is the prospect of such
_________________ that __________________ entrepreneurs.
Critical Thinking Questions
33. Bill Gates, Steven Jobs and Ted Turner are entrepreneurs whose work has made them among the wealthiest
people in the world. Why is it necessary to allow entrepreneurs to benefit from their work?
34. How do we all benefit from the work of entrepreneurs?
Section 5
I.
Government as ______________________ of Contracts
A. A contract is an agreement between two or more people to do something.
 Government ________________________ people who break their contracts. In other
words, the government enforces contracts.
 Without government to enforce contracts, the ____________ of going into business
would be too great for many people.
B. Could the free enterprise system function without a government to enforce contracts? Probably not
as well, because the risks of going into business would be too __________.
II.
Government as Provider of Nonexcludable _______________________ Goods
A. Goods are categorized as two major types: private goods and public goods.
 A ________________ good is a good in which one person’s consumption takes away
from another person’s consumption. Examples include food and gas.
 A ________________ good is a good in which one person’s consumption does not
take away from another person’s consumption. An example would be a movie in a
movie theater.

A public good can be excludable or non-excludable.
1. An excludable public good is a public good that individuals can be
excluded (physically prohibited) from ________________. An example
would be a college lecture, which is available only to enrolled students
of the college.
2. A non-excludable public good is a public good that individuals cannot
be _____________________ from consuming. An example would be
national defense.
 ___________________________ are people who receive the benefits of a good
without paying for it.
B. Who will want to produce a nonexcludable public good? Economists say that in a free enterprise
system, ___________________ will want to. After all, people will not pay for something they get
anyway.
 However, even in a free enterprise economy, people want non-excludable public goods,
such as national defense or flood protection (dams). Who will produce these goods?
The ___________________________ will provide non-excludable public goods and
pay for them with _______________.
C. One way for people to communicate what nonexcludable public goods they want is through the
__________________________ process.
III.
Externalities
A. There are two kinds of externalities: negative and positive externalities.
 A negative externality is an ______________________ side effect of an act that is felt
by others.
 A positive externality is a ________________________ side effect of an action that is
felt by others.
B. Some people argue that _____________________ generates positive externalities. What you learn
at school will not only help you earn a living, but also help you become a better citizen and a more
informed voter.
 Following that argument, if the public _______________ from your education and the
education of others, then the _____________ should pay for that education. Some
people argue that ________________________ should pay for all activities that
generate positive externalities for society.
C. When it comes to negative externalities, some might say that the role of government is to
______________ the negative externalities. Government can reduce the negative externalities
through the following: the __________________________, ____________________, and
_______________.
1. If you have a ___________________ against a negative externality, the courts are
available to hear your case and find a resolution.
2. The government ________________ regulations, such as speed limits and pollution
standards, to deal with negative externalities.
Chapter 3, Section 5
Applying the Principals
Use the following key to label each of the goods in questions 8-15 as a private good (P), an excludable public good
(E), or a nonexcludable public good (N).
35.
36.
37.
38.
39.
40.
41.
42.
_____
_____
_____
_____
_____
_____
_____
_____
fireworks display
public radio
cell phone
dam
toll road
national defense
rock concert
hamburger
Use the following key to label each of the situations described as a positive externality (P)
or a negative externality (N).
43. _____
Your neighbor has loud parties late into the night, keeping you awake.
44. _____
Your neighbor has a large oak tree that shades your yard.
45. _____
Your neighbor does not take care of his house; the house is literally falling apart.
46. _____
Your community has excellent schools.
47. _____
The person sitting next to you in a restaurant is talking loudly on a cell phone.
48. _____
A factory in your town spews pollution into the air.
49. _____
Your state requires children to get vaccinated for common diseases.
50. _____
People in your community shoplift at local stores.