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Role of Government in Market Economies What is a Market Economy? Consumers and businesses jointly answer the 3 main questions – What, Whom, and How to Produce This is an economic system where supply, demand, and the price system help people make economic decisions and allocate their resources In a market economy, people have the freedom to start any business they wish This system is usually referred to as capitalism What is the Role of Government? Relatively small Only when it concerns national defense, environmental protection, and some care for the elderly The government usually tries to stay out of the way of buyers and sellers However, when the government establishes new regulations, the cost of production can change This can cause a change in supply When the government demands things like “all cars must come equipped with airbags” that raises the production costs which are then passed on to the consumer Some consumers may not care about airbags and would prefer to make that decision themselves Increased government regulations decrease supply How Does the US Measure Economic Activity? GDP – Gross Domestic Product This measures the output Measuring GDP is easy – multiply all the final goods and services produced in a 12 month period by their prices and then add them all together GDP is done quarterly It is impossible to measure all things sold, so they do leave a margin of error What is left out of GDP? Intermediate products – goods used to make other goods For example – tires on a car – they are in the GDP when you buy new ones, but not when you buy a new car Secondhand sales are also excluded – only the original sale – examples – houses and used cars Nonmarket transactions – activates that generate no expenditures – for example – cutting your own lawn Underground economy – activities that are not reported Some of these might be illegal such as gambling, prostitution and drug trade Others are legal but are difficult to trace such as garage sales, flea markets, etc. Computing GDP Because prices can go up as a result of a decrease in supply – GDP can appear to be increasing when it is really just the price So, economist must add in inflation They use a set of constant prices Real GDP is measured with the constant base Current GDP is not Problems with looking at GDP It tells us nothing about the composition of output If GDP increases by $10 billion we know that production is going up and more jobs are being created – on the flip side, what if that increase was due to military nerve gas stockpiles and not libraries or parks We would not be so thrilled It tells us little about the impact of production 10,000 new homes may have been built which is great, but what if we discovered that they were built on a wildlife refuge – the value of them might be viewed differently Some GDP is used to control activities that give us little satisfaction Such as the war on drugs or money spent to fight crime If we had less crime then less money would be spent to fight it – but less crime would leave us happier