The Market System and the Circular Flow Model

Economic System Functions Set of institutional arrangements Coordinating mechanism Differ based on: Who owns the factors of production What method directs economic activity

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Economic SystemsThe market system Private ownership Individual markets - variety/choiceEx. Australia, Switzerland, and the U.K.

The command system Government ownership Central planning board

Ex. China, Cuba, North Korea, Soviet Union2-*

Market System Characteristics Private property Freedom of enterprise and choice Self-interest Competition Markets and prices

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Market System Characteristics Technology and capital goods

Specialization Division of labor

Geographic specialization Use of money

Active, limited government

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Five Fundamental Market System Questions

What goods and services will be produced? How will the goods and services be produce? Who will get the goods and services? How will the system promote progress? How will the system accommodate change?

Market System Questions 1 & 2 What will be produced? consumer sovereignty dollar votes

How will goods be produced? technology resource cost

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Market System Questions 3, 4, & 5 Who gets the output? willingness to pay

How is progress promoted? technological advance capital accumulation

How to accommodate change? Price ceilings/floors

Taxes, subsidies, government intervention

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Adam Smith - Wealth of Nations1776“….He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. …. By pursuing his own interest he frequently promotes that of the society more effectually then when he really intends to promote it.”

(Adam Smith [1776/77], Wealth of Nations, Book IV, Chapter II, paragraph 9, p.456?)

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The Invisible Hand Virtues of the market system Efficiency Incentives Freedom

The Command System Soviet Union, Cuba, China, North Korea, etc. The coordination problem Set output targets for all goods The incentive problem No adjustments for shortage or surplus

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The Two Koreas

Circular Flow Model

Depicts the flow of economic resources between households and businesses.

Let’s make our own!

On your Paper... Costs Households sell Businesses sell Money income (wages, rents, interest,

profits) Land, labor, entrepreneurial ability Buy products Resources Goods and services Goods and services Revenue Consumption expenditures Buy resources Sell products Sell resources Households buy Businesses buy

Use the words on the left to create what you think the circular flow model might look like.

There is an inner circle going one direction and an outer circle flowing the other.

Complete Model● Costs● Resources● Money income (wages, rents, interest,

profits)● Land, labor, entrepreneurial ability● Goods and services● Goods and services● Revenue● Consumption expenditures● Buy resources● Sell products● Sell resources ● Buy products● Businesses sell● Households buy● Households sell● Businesses buy