The Market System and the Circular Flow

2

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

The Command System

• Known as socialism or communism

• Government ownership

• Decisions made by a central planning board.

• Libya, Myanmar, and Iran.

LO1

The Market System

• Known as capitalism

• Private ownership of resources

• Decisions based on markets

• Australia, Switzerland, and the U.K.

LO1

Characteristics of the Market System

• Private property

• Freedom of enterprise and choice

• Self-Interest

• Competition

• Markets and prices

LO2

Global Perspective

LO2

Technology and Capital Goods

• Advanced technology and capital goods are encouraged.

• Specialization

• Division of labor

• Geographic specialization

LO2

Use of Money

• Makes trade easier

LO2

Active, but Limited Government

• Government may be needed to alleviate market failures

• Government can increase effectiveness of a market system

LO2

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

What Will Be Produced?

• Goods and services that create a profit

• “Money Votes”

• Method for consumers to determine which goods will be produced

• Determines which products and industries survive or fail

LO3

How Will the Goods Be Produced?

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

• Technology

• Prices of the necessary resources

LO3

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

Who Will Get the Output?

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

• Ability to pay depends on income.

LO3

How Will the System Change?

• Changes in consumer tastes

• Changes in technology

• Changes in resource prices

LO4

How Will the System Progress?

• Technological advance

• Creative destruction

• Capital accumulation

LO4

Invisible Hand

• 1776 Wealth of Nations by Adam Smith

• Unity of private and social interest

• Virtues of the market system

• Efficiency

• Incentives

• Freedom

LO4

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

The Circular Flow System

RESOURCERESOURCEMARKETMARKET

•Households sell•Businesses buy

PRODUCTPRODUCTMARKETMARKET

•Businesses sell•Households buy

BUSINESSES• buy resources• sell products

HOUSEHOLDS• sell resources• buy products

LO5

Businesses

• Three main categories of businesses:

• Sole Proprietorship

• Partnership

• Corporation

LO5

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