An exchange is a voluntary agreement between two
people in which each gives something to the other and gets
in return something that he considers of greater value. When
John and Jim exchange baseball cards, John gets cards that
he considers more valuable than those he gives to Jim, and
Jim gets cards that he considers more valuable than those he
gives to John. Unless both sides of the exchange feel that
the exchange benefits them, the exchange will not take
place. Because both sides benefit, exchange is, in the terms
of game theory, a positive-sum game.
An alternative to interaction by exchange is interaction
that involves coercion. With coercion, the actions of
one side are not voluntary but forced. If Jim takes baseball
cards away from John and threatens to beat him up if he
complains, we have interaction based on coercion. Economics
focuses almost exclusively on interactions based on exchange
and ignores those based on coercion. As a result, it has
more to say about markets than about government, which
is the primary agent of coercion in society.
People engage in exchange to attain goals. Exchange is
not just take; in order to get, one must give.
People must do things that they do not want to do in order
to get things that they desire. The unpleasant part of this
process is work and production, and the pleasant part is
consumption. Economists assume that work and production are not pursued for their
own sakes, but only because without them we cannot consume.
This division of economic life is illustrated below in what
Frank Knight called the Wheel of Wealth, but which is now
commonly known as circular flow.
The circular flow diagram divides the economy into two
sectors: one concerned with producing goods and services,
and the other with consuming them. Resources are converted
into goods and services by business, and in this transformed
state travel back to consumers. Money flows in the opposite
direction. These flows involve two markets in which exchange
takes place: the resource or factor market in which business
buys resources, and the goods and services market in which
business sells goods. (Some economists define a "factor
of production" as the service of some resource. If
resources are land, labor, and capital, the factors of
production are the services of land, labor, and capital. We
will ignore the distinction between resources and factors of
production in the discussion that follows.)
This group of readings focuses on the right side of the diagram above,
examining the business firm and the constraints or
limitations that it faces in its fight for survival. The household side is examined elsewhere, in discussions of consumer choice and maximizing utility.
The economic theory of the firm is founded on the
three fundamental tasks of a