10/16/ Market System & the Circular Flow Chapter 2

In this Chapter, you will learn: 1. The difference between a command system & a market system 2. The main characteristics of the market system 3. How the market system decides what to produce, how to produce it, & who obtains it 4. How the market system adjusts to change & promotes progress 5. The mechanics of the circular flow model. 10/16/2015 2

3 Economic Systems (2.1 & 2.2) Determine what goods are produced, how they are produced, & how to promote technological progress Determine what goods are produced, how they are produced, & how to promote technological progress Differ as to the following: Differ as to the following: Who owns the resources Who owns the resources Method used to motivate, coordinate, & direct economic activity Method used to motivate, coordinate, & direct economic activity Have two polar extremes: command system & market system Have two polar extremes: command system & market system

Command System Also known as socialism or communism Also known as socialism or communism Government owns most property resources Government owns most property resources Economic decision making occurs through a central economic plan Economic decision making occurs through a central economic plan Central planning board determines production goals for each enterprise Central planning board determines production goals for each enterprise Specifies the amount of resources to be allocated to each enterprise so that it can reach its production goals Specifies the amount of resources to be allocated to each enterprise so that it can reach its production goals North Korea & Cuba are the last prominent remaining examples of largely centrally planned economies North Korea & Cuba are the last prominent remaining examples of largely centrally planned economies 10/16/2015 4

Market system Characterized by the private ownership of resources Characterized by the private ownership of resources Use of markets & prices to coordinate & direct economic activity Use of markets & prices to coordinate & direct economic activity Participants act in their own self-interest Participants act in their own self-interest Economic activities are coordinated through markets Economic activities are coordinated through markets High monetary rewards create powerful incentives for existing firms to innovate & entrepreneurs to pioneer new products & processes High monetary rewards create powerful incentives for existing firms to innovate & entrepreneurs to pioneer new products & processes 10/16/2015 5

Characteristics of the market system Private property Private property Freedom of enterprise and choice Freedom of enterprise and choice Self-interest Self-interest Competition Competition Markets & prices Markets & prices Technology & capital goods Technology & capital goods Specialization (division of labor & geographic) Specialization (division of labor & geographic) Use of money Use of money Active, but Limited, Government Active, but Limited, Government 10/16/2015 6

Use of Money (cont) Performs several functions Performs several functions Most impt – “medium of exchange” Most impt – “medium of exchange” Makes trade easier Makes trade easier Barter- swapping goods for goods Barter- swapping goods for goods Problem: requires a “coincidence of wants” between buyer & seller Problem: requires a “coincidence of wants” between buyer & seller Each party has to want what the other person has Each party has to want what the other person has 10/16/2015 7

8 Five Fundamental Questions (2.3) 1. What goods & services will be produced? 1. Consumer sovereignty 2. “dollar votes” 2. How will the goods & services be produced? 3. Who will get the goods & services? 4. How will the system accommodate change? 5. How will the system promote progress? 1. Technological advance 2. Capital accumulation

Creative Destruction Creation of new products & production methods completely destroys the market positions of firms that are wedded to existing products & older ways of doing business Creation of new products & production methods completely destroys the market positions of firms that are wedded to existing products & older ways of doing business Rival firms must follow the lead of the most innovative firm or else suffer immediate losses & eventual failure Rival firms must follow the lead of the most innovative firm or else suffer immediate losses & eventual failure 10/16/2015 9

10 The “Invisible Hand” (2.4) Adam Smith – “Wealth of Nations” Adam Smith – “Wealth of Nations” This book first noted that a market system creates a unity between private interests & society interests This book first noted that a market system creates a unity between private interests & society interests Examples: Examples: 1. In a competitive environment, businesses seek to build new & improved products to increase profits. Those enhanced products increase society’s well-being 2. Businesses also use the least costly combination of resources to produce a specific output that maximizes their profits

10/16/ Demise of the Command Systems Two insurmountable problems Two insurmountable problems 1. Coordination problem Central planners had to coordinate millions of individual decisions by consumers, resource suppliers, & businesses. Central planners had to coordinate millions of individual decisions by consumers, resource suppliers, & businesses. The coordination problem became more difficult as economies expanded. The coordination problem became more difficult as economies expanded. 2. Incentive problem Central planners determined the output mix. Central planners determined the output mix. If they misjudged, there were a lot of shortages or surpluses at the government-determined price. If they misjudged, there were a lot of shortages or surpluses at the government-determined price. No incentives are provided for workers or managers to adjust their production levels so many products were not available. No incentives are provided for workers or managers to adjust their production levels so many products were not available.

10/16/ Circular Flow Model (Figure 2.2) Market economy creates continuous, repetitive, flows of goods & services, resources, & money Market economy creates continuous, repetitive, flows of goods & services, resources, & money Diagram groups private decision makers into businesses and households Diagram groups private decision makers into businesses and households Markets are grouped into the resource market and the product market Markets are grouped into the resource market and the product market

Resource market Resources or the services of resource suppliers are bought & sold Resources or the services of resource suppliers are bought & sold Households sell resources & businesses buy them (ex. Looking for a job) Households sell resources & businesses buy them (ex. Looking for a job) Funds that businesses pay for resources are costs to businesses but are flows of (wage, rent, interest, & profit) income to households Funds that businesses pay for resources are costs to businesses but are flows of (wage, rent, interest, & profit) income to households Productive resources therefore flow from households to businesses, and money flows from businesses to households Productive resources therefore flow from households to businesses, and money flows from businesses to households 10/16/

Product market Place where goods & services produced by businesses are bought & sold Place where goods & services produced by businesses are bought & sold Businesses combine resources to produce & sell goods & services Businesses combine resources to produce & sell goods & services Monetary flow of consumer spending on goods & services yields sales revenues for businesses Monetary flow of consumer spending on goods & services yields sales revenues for businesses 10/16/