Chapter 2 The Market System and the Circular Flow McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Main Discussions Economic systems Market – Command – Islamic Economics Common Features of Economic System Distinctive Features of Economic System 3 Main Economic Questions 2-2
Economic Systems Set of institutional arrangements Coordinating mechanism Differ based on: Who owns the factors of production What method directs economic activity At which level decisions are made What motivates economic decision 2-3
Common Features of Econ. System The market system Private ownership Markets Self-interest The command system Government ownership Central planning board Collective interest 2-4
Common Features of Econ. System The Islamic Econ. system Private and state ownership Markets + positive role of government Self and public interest The Mixed Econ. system 2-5
Index of Economic Freedom Ranking of 157 countries for 2008 Free Mostly Free Mostly Unfree Repressed 1- Hong Kong 3- Ireland 5- United States 20- Belgium 31- Spain 48- France 101- Brazil 126- China 134- Russia 148- Venezuela 156- Cuba 157- North Korea 2-6
Basic Econ. Questions What and how much to produce How to produce For whom Additional questions; How the economic system adjusts to change and promotes progress 2-7
Market System Private property Freedom of enterprise Freedom of choice encourage investment, innovation, exchange of assets, maintenance of property, and econ. growth Freedom of enterprise freedom to obtain and use resources, to produce and sell products of their choice Freedom of choice E.g. Owners of property and money resources; Workers; Consumers. 2-8
Market System Self-interest Competition- controlling mechanism Entrepreneurs maximize profits; resource suppliers maximize income; consumers maximize satisfaction. Competition- controlling mechanism Markets and prices Brings together buyers and sellers Determine product and resource prices Influence production and allocation decision 2-9
Market System Technology and capital goods Specialization Use of money Division of labor Use of money limited government 2-10
Market System Questions What will be produced? consumer sovereignty dollar votes How will goods be produced? technology resource cost Who gets the output? Willingness and ability to pay 2-11
Market System Questions How is change accommodated? self-interest pursuit market mechanism How is progress promoted? technological advance capital accumulation 2-12
The Invisible Hand 1776 Wealth of Nations by Adam Smith Unity and harmony of private and social interest Virtues of the market system Efficiency Incentives Freedom 2-13
The Command System Soviet Union, Eastern Europe, China System was a failure The coordination problem Set output targets for all goods The incentive problem No adjustments for shortage or surplus 2-14
Circular Flow Resource Market Businesses Households Product Market 2-15
Circular Flow Both Flows Are Equal Money Income Costs Input Factors Figure 2.2; page 40 Resource Market Money Income Costs Input Factors Resources Both Flows Are Equal Businesses Households Goods & Services Goods & Services Product Market Consumption Revenue 2-16