The Market System and the Circular Flow

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McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Economic Systems

• Set of institutional arrangements• Coordinating mechanism• Differences in systems exist by:

• Who owns the factors of production

• What method is used to motivate, coordinate, and direct economic activity

LO1 2-2

The Command System

• Known as socialism or communism• Government ownership• Decisions made by a central planning

board.

• Libya, Myanmar, and Iran.

LO1 2-3

The Market System

• Known as capitalism• Private ownership of resources• Decisions based on markets

• Australia, Switzerland, and the U.K.

LO1 2-4

Characteristics of the Market System

• Private property • Freedom of enterprise and choice• Self-Interest• Competition• Markets and prices

LO2 2-5

Global Perspective

LO2 2-6

Technology and Capital Goods

• Advanced technology and capital goods are encouraged.

• Specialization

• Division of labor

• Geographic specialization

LO2 2-7

Use of Money

• Makes trade easier

LO2 2-8

Active, but Limited Government

• Government may be needed to alleviate market failures

• Government can increase effectiveness of a market system

LO2 2-9

The Five Fundamental Questions

• What goods and services will be produced?

• How will the goods and services be produced?

• Who will get the goods and services?• How will the system accommodate

change?• How will the system promote

progress?LO3 2-10

What Will Be Produced?

• Goods and services that create a profit

• “Dollar Votes”

• Method for consumers to determine which goods will be produced

• Determines which products and industries survive or fail

LO3 2-11

How Will the Goods Be Produced?

• Minimize the cost per unit by using the most efficient techniques

• Technology

• Prices of the necessary resources

LO3 2-12

How Will the Goods Be Produced?

Three Techniques for Producing $15 Worth of Bar Soap

Price per unit of

Resource

Units of Resource

Technique 1 Technique 2 Technique 3

Resource Units

Cost Units Cost Units Cost

Labor $2 4 $ 8 2 $ 4 1 $ 2

Land $1 1 1 3 3 4 4

Capital $3 1 3 1 3 2 6

Entrepreneur $3 1 3 1 3 1 3

$ 15 $ 13 $ 15

LO3 2-13

Who Will Get the Output?

• Consumers with the ability and willingness to pay will get the product

• Ability to pay depends on income.

LO3 2-14

How Will the System Change?

• Changes in consumer tastes• Changes in technology• Changes in resource prices

LO4 2-15

How Will the System Progress?

• Technological advance

• Creative destruction• Capital accumulation

LO4 2-16

Invisible Hand

• 1776 Wealth of Nations by Adam Smith

• Unity of private and social interest• Virtues of the market system

• Efficiency

• Incentives

• Freedom

LO4 2-17

Demise of Command Systems

• Soviet Union, Eastern Europe, and China

• System was a failure• The coordination problem

• Set output targets for all goods• The incentive problem

• No adjustments for surplus or shortage

LO4 2-18

The Circular Flow System

RESOURCEMARKET

• Households sell

• Businesses buy

PRODUCTMARKET

• Businesses sell• Households

buy

BUSINESSES• buy

resources• sell products

HOUSEHOLDS• sell

resources• buy products

LO5 2-19

Businesses

• Three main categories of businesses:

• Sole Proprietorship

• Partnership

• Corporation

LO5 2-20

Shuffling the Deck

• Extremely large number of ways to arrange a deck of cards

• Arrangement of economy’s resources is even larger

• Avoid random outcomes in market due to:

• Private property

• Rational decisions about property

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