Chapter 4: The Market System Equilibrium prices and quantities are established in individual product and resource market All product markets and resource markets are established through the market system (aka capitalism or private-enterprise system)

Characteristics of the Market System Private Property Freedom of Enterprise & Choice Self-Interest Competition Markets & Prices Reliance on Technology & Capital Goods Specialization Division of Labor Use of Money Active, Limited Government

Private Property Private Property: Private individuals & firms, not government, own most of the property resources Enables individuals & businesses to obtain, use, & dispose of property resources AS THEY SEE FIT. Encourages investment, innovation, exchange, maintenance of property, & economic growth. Includes intellection property through patents, copyrights, and trademarks.

Freedom of Enterprise & Choice Freedom of Enterprise ensures entrepreneurs & private businesses are free to obtain & use economic resources to produce their choice of goods & services and to sell them in their chosen markets Freedom of Choice enables owners to employ of dispose of their property & money as they see fit. Holds for workers & consumers.

Self-Interest Each economic units does what is best for itself Entrepreneur maximizes profits & minimizes losses Property owners aim for highest price on sale or rent of resource Workers find jobs w/ best combination of wages, hours, benefits, & working conditions Consumers find best products they want at the lowest possible price

Competition Requires independently acting sellers & buyers operating in a particular product or resource market Requires freedom of sellers & buyers to enter or leave markets, on the basis of their economic self-interest No buyer or seller can dictate the price of a product Freedom of entry & exit enables economy to adjust to changes in consumer tastes, technology, & resource availability

Markets & Prices The coordinating mechanism of the market system is a system of markets & prices Through mechanism, society decides what the economy should produce, how production can be organized efficiently, and how the fruits of production are to be distributed among the various units that make up the economy

Reliance on Technology & Capital Goods Extensive use of capital goods Encourages use & rapid development of tools, machinery, factories, & facilities.

Specialization Majority of consumers produce virtually none of the goods & services they consume while consuming little or none of what they produce.

Division of Labor Human specialization Specialization makes use of different abilities Specialization fosters learning by doing Specialization saves time Specialization increases total output derived from limited resources

Use of Money Money performs many functions Most important function: Medium of Exchange Convenient means of exchanging goods is required for specialization Barter: swapping goods for goods Coincidence of Wants Must be generally acceptable to sellers in exchange for their goods & services. Paper money

The Market System at Work Four Fundamental Questions 1. What goods & services will be produced? 2. How will goods & services be produced? 3. Who will get the goods & services produced? 4. How will the system accommodate change?

What Good & Services will be produced? Since businesses seek profits and avoid losses, the g & s produced at a continuing profit will be produced; those with continuing losses will not be produced Economic Profit = Total Revenue (TR) – Total Cost (TC) Total Revenue (TR) = Price (P) * Quantity Sold (Q) Total Cost (TC) = Cost of the Resource * Amount of the Resource

Profits & Expanding Industries The presence of an economic profit is evidence that the industry is prosperous  becomes an expanding industry: new firms are attracted by “above-normal” profits & enter, shifting from those less profitable. Entry of new firms is self-limiting. New firms enter the industry, market supply increases relative to market demand, lowering market price  economic profit gradually diminishes Market supply & demand conditions prevail when economic profit reaches zero (0)  industry is at equilibrium size

Losses & Declining Industries Firms are not attracted to unprofitable declining industries, with economic losses (costs > revenue) If losses persist, firms go out of business or shift industries Market supply of product in that industry falls relative to market demand, increasing market price  economic losses gradually decreases, industry would stop shrinking

Consumer’s Dollar Votes Consumers cast votes with the money (dollars) they spend. Consumers register their wants through the demand side of the product market.

How will Goods & Services be Produced? Competition forces out high-cost producers, continual profitability requires firms to produce output at minimum cost. Firms locate production facilities optimally, considering resource prices, & productivity Firms must employ most economically efficient technique of production Availability of Technology Prices of Related Resources Economic Efficiency: Product output w/ least input of scare resources (measured in $) Changes in technology or resource prices may cause firms to shift from current technology.

Who will get the Goods & Services? Any product will be distributed to consumers if they were willing and able to pay its existing market price. Amount of income depends on: Quantities of Property & Human Resources they supply Prices of Property & Human Resources in the market Resource prices (wages, interest, rent, profit) determine the size of a household’s income  ability to buy the economy’s output.

How will the System Accommodate Change? Guiding Function of Prices Through changes in Prices, the market system communicates consumer tastes Role in Promoting Progress Technological Advance Market system provides strong incentive (rapid spread)  Creative Destruction: The creation of new products & production methods that are better than existing ones (DVDs)

Competition & “The Invisible Hand” Principle In 1776, Adam Smith wrote The Wealth of Nations: Union between private & social interests Firms & resource suppliers act in their own self- interest simultaneously to promote public/social interest, as if guided by an “invisible hand.” Competition controls and guides self-interest to further society’s interests. An invisible hand ensures that when firms maximize profits, they also maximize society’s output and income

Merits of Market System Efficiency Promotes efficient use of resources, guiding towards production of most desired goods & services Incentives Encourages skill acquisition, hard work, & motivation  economic rewards Freedom Emphasizes personal freedom Coordinates activity w/out coersion

Chapter 4 Study Questions