The Market System and the Circular Flow 02 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 2-2

Systems of resource allocation Economists identify three basic types of economic organization—i.e., systems for determining what gets produced, how it gets produced, and who gets what: 1.Traditional economy 2. Command or centrally planned economy 3.Market economy

1.Resources are allocated according to long- established practices. 2.Methods of production tend to be unchanging. 3.Goods and services are distributed based on community views about fairness and justice. Traditional Economy

The planning authorities decide what gets produced--resources are allocated according to planning documents issued by central planning authorities. The “visible hand” of the planners overrides the “invisible hand” of the market. Gosplan of the old U.S.S.R. is the classic example of a central planning agency. Command or central planning

Resources are allocated though individual decision making. The market system relies on the choices made by individuals (buyers and sellers) to allocate resources in a socially optimal way. The economy is an agglomeration of markets, defined as “groups of buyers and sellers with the potential to trade with each other.” Income distribution is mainly determined by the market value of resources owned (including labor). The Market System

Known as capitalism Well-defined and protected property rights—including rights to “intellectual” property. Decisions based on markets Australia, Switzerland, and the U.K. LO1 2-7

Characteristics of the Market System Private property Freedom of enterprise and choice Self-Interest Competition Markets and prices LO2 2-8

Global Perspective LO2 2-9

Technology and Capital Goods Advanced technology and capital goods are encouraged. Specialization Division of labor Geographic specialization LO2 2-10

Use of Money Makes trade easier LO2 2-11

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 2-12

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 2-13

How Will the Goods Be Produced? Minimize the cost per unit by using the most efficient techniques Technology Prices of the necessary resources LO3 2-14

How Will the Goods Be Produced? Three Techniques for Producing $15 Worth of Bar Soap Price per unit of Resource Units of Resource Technique 1Technique 2Technique 3 ResourceUnit s CostUnitsCostUnitsCost Labor$24$ 82$ 41$ 2 Land$ Capital$ Entrepreneur$ $ 15$ 13$ 15 LO3 2-15

Who Will Get the Output? Consumers with the ability and willingness to pay will get the product Ability to pay depends on income. LO3 2-16

How Will the System Change? Changes in consumer tastes Changes in technology Changes in resource prices LO4 2-17

How Will the System Progress? Technological advance Creative destruction Capital accumulation LO4 2-18

Invisible Hand 1776 Wealth of Nations by Adam Smith Unity of private and social interest Virtues of the market system Efficiency Incentives Freedom LO4 2-19

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 2-20

The Circular Flow SystemRESOURCEMARKET Households sell Businesses buy PRODUCTMARKET Businesses sell Households buy BUSINESSES buy resources sell products HOUSEHOLDS sell resources buy products LO5 2-21

Businesses Three main categories of businesses: Sole Proprietorship Partnership Corporation LO5 2-22