Chapter 2 The Market System and the Circular Flow ECON 201 Chapter 2 The Market System and the Circular Flow

Learning Objectives Command Systems vs. Market Systems Characteristics of a Market System How Markets Determine What to Produce, How to Produce, and Who Receives the Output How Market System Adjusts to Change and Promotes Progress The Circular Flow

Economic System Economic system is a particular set of institutional arrangements and a coordinating mechanism for producing goods and services. Societies develop economic systems to solve their economic problem. There are two general types of economic systems • Command system • Market system

The Command System Also known as: socialism or communism Government owns most (sometimes all) of the businesses, or factors of production. A ‘central body’ makes all the production decisions. Capital is allocated centrally.

The Market System AKA: Capitalism Factors of production are privately owned Markets and prices are used to direct and coordinate economic activities. Different levels of capitalism used all over the world. The government does play a role, but the central role in all market systems is played by….the market!

Features of the Market System Private Property Freedom of enterprise Self-interest Competition Markets & prices Technology & capital goods Specialization Use of Money Active, but limited government

Comparison of countries GLOBAL PERSPECTIVE Free Mostly Free Mostly Unfree Repressed 1- Hong Kong 3- Ireland 9- United States 22- Belgium 33- Spain 44- France 81- Brazil 111- China 122- Russia 150- Cuba 152- Venezuela 157- North Korea

Key Features of the Market System Private Property is the right of persons and firms to obtain, own, control, employ, dispose of, and bequeath land, capital, and other property. Freedom of enterprise is the freedom of firms to obtain economic resources, to use those resources to produce products of the firms’ own choosing, and to sell their products in markets of their choice. Freedom of choice is the freedom of owners of resources to employ or dispose of them as they see fit, and the freedom of consumers to spend their incomes in a manner they think is appropriate. Private Property is the right of persons and firms to obtain, own, control, employ, dispose of, and bequeath land, capital, and other property. Freedom of enterprise is the freedom of firms to obtain economic resources, to use those resources to produce products of the firms’ own choosing, and to sell their products in markets of their choice. Freedom of choice is the freedom of owners of resources to employ or dispose of them as they see fit, and the freedom of consumers to spend their incomes in a manner they think is appropriate. LO: 2-2

Key Features of the Market System Self-interest is the most advantageous outcome as viewed by each firm, property owner, worker, or consumer. Competition is the presence in a market or independent buyers and sellers vying with one another, and the freedom of buyers and sellers to have a market. A market is an institution or mechanism that brings buyers and sellers together. Technology and capital goods promote efficiency and the ability to produce more goods and services. Self-interest is the most advantageous outcome as viewed by each firm, property owner, worker, or consumer. Competition is the presence in a market or independent buyers and sellers vying with one another, and the freedom of buyers and sellers to have a market. A market is an institution or mechanism that brings buyers and sellers together. Technology and capital goods promote efficiency and the ability to produce more goods and services. LO: 2-2

Key Features of the Market System Specialization is the use of resources of an individual, region, or nation to produce one or a few goods and services rather than the entire range of products. The use of money where money is any item that is generally acceptable to sellers in exchange for goods and services. Active, but Limited, Government where government can sometimes increase the overall effectiveness of the economic system. Specialization is the use of resources of an individual, region, or nation to produce one or a few goods and services rather than the entire range of products. The use of money where money is any item that is generally acceptable to sellers in exchange for goods and services. Active, but Limited, Government can sometimes increase the overall effectiveness of the economic system. LO: 2-2

Private Property Owning your own property is key to a market system. People must be free to do whatever they want with their stuff, and a legal mechanism must be in place to instill confidence in owners Property rights facilitate ‘exchange’ Confident in ownership, owners can now use their time and resources to ‘produce’ rather than ‘protect’.

Freedom of Enterprise and Choice Freedom of enterprise: people can obtain and use resources to produce what they want Freedom of choice: people can use or dispose of what they want, they can work where they want, they can move where they want. But although people have the freedom to choose what they want, they will have to pay the price for their choices.

Self-Interest Self-interest is what motivates people to exercise their freedom of choice. Everyone tries their hardest to choose what is best for them. Self-interest is what allows us to avoid chaos.

Competition Competition requires: 2 or more buyers/sellers acting independently Freedom of sellers and buyers to enter or leave the market if they want. The more buyers/sellers there are, the greater competition you have. Competition limits the abuse of power that a single buyer/seller can have.

Markets & Prices Markets bring buyers and sellers together to ‘negotiate’ deals. Imagine a vegetable market where sellers and buyers are yelling back and forth, all at the same time, trying to negotiate deals. Because of the 2 freedoms, buyers or sellers can simply pack up and leave if they want.

Technology & Capital Goods Because everyone is free to do what they want, those who do it best are rewarded. Technology advances can give buyers or sellers the advantage. Farmers can now produce more food with machinery than with their bare hands. Also, those with greater access to the capital they need have the advantage.

Specialization Specialization is critical for a market to be the best that it can be. Consumers produce virtually NONE of the goods they consume or consume much of what they produce. A farmer will sell milk to the dairy, then buy butter from the store. We learned a looooong time ago that producing everything you need is inefficient.

2 key parts of specialization: Division of labor: the car repairman seeks legal advice from the lawyer, and the lawyer will get his oil changed with the car repairman. By dividing the work, we can become more skilled at what we do. Geographic Specialization: We grow corn in the midwest, and we grow oranges in Florida. Bananas are grown in Honduras and cars are made in Germany.

Use of money Money is what we use to exchange in the market. We don’t ‘barter’ anymore. We don’t exchange a chicken for a hammer. Money only has value if everyone in the market thinks that it has value. If everyone thought that buttons were more valuable than coins, then buttons would be what we used at the store.

Active by limited government Even though the market system has a high degree of efficiency in the use of its resources, there are some ‘failures’. An active, but limited, government is in place to solve those failures in market economies.

5 fundamental questions that market economies MUST answer

#1: What will be produced? Whatever can produced a profit with be produced, whatever can’t…will go away. “Consumer sovereignty” means that the buyers answer this question with their “dollar votes”. Whatever they spend their money on, wins!

#2: How will it be produced? With multiple sellers in a market, whomever produces the most efficiently, and provides a product that most people want, will win. Those sellers that don’t do it as well, will constantly strive to change and become like the seller that is doing it the best. If they don’t change, they die.

#3: Who will get the output? The only ones who will get the output that the sellers provide are those buyers who are willing to pay the price that is offered. Also, the only ones who will get the output are those who have the resources (money) to purchase it. If you have no buyers for your product, you will die.

#4: How will the system promote progress? Creative destruction: new products that enter the market that make current products obsolete. Ex: vinyl records vs CDs Those who don’t change with the times, die. Those who accumulate capital (money, equipment, people, etc) build for the future so they can be ready to adjust for change.

Adam Smith’s “Invisible Hand” “Firms and resource suppliers, seeking to further their own self-interest and operating within the framework of a highly competitive market system, will simultaneously , as though guided by an ‘invisible hand’ promote the public and social interest.” Basically, just let the market do its thing, and everyone will be better off.

Why are ‘command’ economies failing all over the planet? USSR East Germany Yugoslavia 2 basic problems Coordination problem: economies eventually get so large that nobody can provide enough planning Incentive problem: workers have no incentive for doing a good job. They are simply expected to meet a certain production goal.

The Circular Flow model

The Circular Flow Model Resource Market Households sell resources Firms buy resources Product Market Households buy products Firms sell products Real flow of resources and products corresponds to the money flow in the opposite direction. To summarize, households sell and firms buy resources on the resource market, households buy and firms sell products on the product market. Real flow of resources and products corresponds to the money flow in the opposite direction. LO: 2-5

End