The Market System and the Circular Flow 02 The Market System and the Circular Flow Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Characteristics of market systems: The Market System Known as capitalism Characteristics of market systems: Private property Freedom of enterprise and choice Self-Interest Competition Markets and prices Australia, Switzerland, and the U.K. LO1 2-2

Index of Economic Freedom, Selected Nations Global Perspective Index of Economic Freedom, Selected Nations LO2 2-3

Technology and Capital Goods Advanced technology and capital goods are encouraged Specialization Division of labor Geographic specialization LO2 2-4

Active, but Limited Government Government may be needed to alleviate market failures Government can increase effectiveness of a market system LO2 2-5

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 2-6

Goods and services that create a profit “Dollar Votes” 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 2-7

How Will the Goods Be Produced? Minimize the cost per unit by using the most efficient techniques Technology Prices of the necessary resources LO3 2-8

Consumers with the ability and willingness to pay will get the product Who Will Get the Output? Consumers with the ability and willingness to pay will get the product Ability to pay depends on income LO3 2-9

How Will the System Change? Changes in consumer tastes Changes in technology Changes in resource prices LO4 2-10

How Will the System Promote Progress? Technological advance Creative destruction Capital accumulation LO4 2-11

1776 Wealth of Nations by Adam Smith The “Invisible Hand” 1776 Wealth of Nations by Adam Smith Unity of private and social interest Virtues of the market system Efficiency Incentives Freedom LO4 2-12

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 2-13

The Circular Flow System RESOURCE MARKET Households sell Businesses buy Costs Rent, Wages, Interest, Profits Land, Labor, Capital, Entrepreneur Land, Labor, Capital, Entrepreneur BUSINESSES buy resources sell products HOUSEHOLDS sell resources buy products Goods and Services Goods and Services PRODUCT MARKET Businesses sell Households buy Expenditures Consumption Revenues LO5 2-14

Three main categories of businesses Sole proprietorship Partnership Corporation LO5 2-15