1. What are the two basic assumptions that economists make about individuals and firms?
The two basic assumptions that economists make about individuals and firms are that they attempt to maximize their utility using the available resources and that they want to make the most amount of profit possible.
2. What is the role and significance of prices in the market economy?
Prices in the market economy are extremely useful because they help gauge what consumers want and how badly they want it. High prices indicate strong consumer desire for that product while low ones indicate little interest.
3. What’s so great about a market economy anyway?
A market economy is so good because it corresponds with normal human behavior and allows for optimum allocation of resources. It may not be completely fair, but it is the most stable and best option compared to a communist system. Chapter 2: Incentives Matter
4. Explain how each of the following relates to efficient outcomes in a market economy: adverse selection, “perverse incentives”, principal-agent problem, and the prisoner’s dilemma.
Adverse selection hinders efficient outcomes in a market economy because it involves one party in an economic action having less information than the other, therefore it might agree to buy a certain product or service and pay for more than what it gets (or vice versa if seen from the ignorant seller’s perspective). The avoidance of negative perverse incentives leads governments into better policy making and achieving the desired economic effect and increase in efficiency. If the principal-agent problem is addressed correctly, business managers and employees will strive to improve the product or service and achieve economic growth in the long run because it is beneficial to them, not only the owners. The prisoner’s dilemma will probably lead to an inefficient outcome in which both parties involved will not achieve maximum profit.