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

Economic Systems An economic system is a set of institutional arrangements and a coordinating mechanism to respond to the basic economizing problem. All economic systems need to answer some basic questions. LO1 2-2

Basic Questions  What to produce  How to Produce  For Whom to Produce  How to Accommodate Change  How to Promote Technological Change

Economic Systems differ in two respects:  Who owns the factors of production  The method used to coordinate and direct economic activity

The Command System A Command System is also known as socialism or communism. Here the government owns most property resources and economic decisions are made through central planning. LO1 2-6

Examples include the former Soviet Union, China, North Korea and Cuba. The government basically answers the what, how and for whom questions.

The Market System A market system, also called capitalism, is characterized by the private ownership of resources and the use of markets and prices to coordinate and direct economic activity. LO1 2-8

In pure capitalism or laissez faire capitalism the government’s role would be limited to protecting private property and establishing an environment appropriate to the operation of the market system. Laissez Faire means “let it be” and implies government should not interfere with the economy or people’s ability to make their own decisions.

The capitalism practiced in the U.S. and most other countries allows for substantial government involvement. In reality then all economic systems are mixed. There are no purely command or market economies in the world today.

Characteristics of the Market System Private Property- Private individuals and firms, not the government, own most of the property resources. People are able to obtain, use, and dispose of their property as they see fit. LO2 2-11

Property rights encourage investment, innovation, exchange and maintenance of property because people know they will reap any rewards from their efforts. Property rights also extend to intellectual property through patents, copyrights and trademarks.

Freedom of Enterprise & Choice- Businesses, consumers and workers are free to make economic decisions that are in their best interest such as what products to produce, how to spend income, and what career to choose. It is clear that economies that exhibit the highest degree of freedom are also the most successful.

Global Perspective LO2 2-14

Self-interest- simply means that each economic unit tries to achieve its own particular goal, which usually requires delivering something of value to others. The motive of self-interest gives direction and consistency to what might otherwise be a chaotic economy. Entrepreneurs try to maximize profits, property owners try to get the highest price for the sale or rent of their property, consumers attempt to maximize utility from the various goods and services they buy and employees try to get the highest wages and other fringe benefits from their jobs.

Competition- competition requires large numbers of buyers and sellers acting independently in a given market and also the ability to enter or leave markets easily based on their self-interest.

Consumers benefit from competitive markets because they get lower prices and better quality products. Competition is the basic regulatory force in the market system.

Markets & Prices- The millions of decisions made by households and businesses are highly coordinated with one another by markets and prices. A market is simply a location or mechanism that brings buyers and sellers together. A market system is a communication network through which many individual free choices are recorded, summarized, and balanced.

Through this mechanism society decides what the economy should produce, how production can be organized efficiently, and how the resulting output can be distributed to those who want it.

Technology & Capital Goods- A market system encourages extensive use and rapid development of capital goods and technical improvements because rewards accrue to the innovator. Businesses who adopt capital goods and the latest technology will lower costs and therefore earn higher profits.

Specialization- Rather than trying to produce all the goods and services by themselves people, firms, regions and nations specialize in one or a few things. Society learned long ago that self- sufficiency breeds inefficiency.

Human specialization is called division of labor and has several advantages.  Specialization takes advantage of differences in ability  Specialization fosters learning by doing  Specialization saves time

Use of Money- Money is an important characteristic because it helps to facilitate the exchange of goods and services. It makes trade easier. A barter economy involves exchanging goods for goods or goods for services which is not very efficient because it requires a coincidence of wants.

Use of Money Makes trade easier LO2 2-24

Active, but Limited Government- Although a market system promotes a high degree of efficiency in the use of its resources, it has certain inherent shortcomings, called market failures. In the event of such failures government can increase the overall effectiveness of a market system.

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 2-26

What will be Produced?- The answer to this question is twofold. The goods and services that can be produced at a continuing profit will be produced, while those whose production generates a continuing loss will be discontinued. When TR>TC profits result but when TR<TC firms incur losses. Continuing profits in an industry result in expanded production and the movement of resources toward that industry. Existing firms grow and new firms enter.

The second question relates to consumer sovereignty which states that consumers “rule” the market by the way they spend their money referred to as dollar votes. Businesses must match their production choices with consumer choices or else face losses and eventual bankruptcy.

How will goods & services be produced?- What combinations of resources and technology will be used to produce goods and services? Production will occur in the least costly way which depends on the available technology and the prices of the necessary resources. Economic efficiency requires obtaining a particular output with the least input of scarce resources, when both output and resource inputs are measured in dollars and cents.

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 2-30

Who will get the output?- Generally any output will be distributed to consumers on the basis of their ability to pay the market price, and of course one’s ability to pay is based on income.

How will the system accommodate change?- Market systems are dynamic. Consumer preferences, technology and resource supplies all change. What if the demand for fruit juice increases and the demand for milk decreases? What is the result? The guiding function of prices and profits will bring about the necessary changes.

How will the system promote progress?- Entrepreneurs are driven by profits. As they adopt new technology and purchase capital goods costs will fall resulting in greater profits.

Invisible Hand Wealth of Nations Adam Smith noted that firms and resource suppliers, seeking to further their own self- interest will also, as though guided by an invisible hand, promote the public interest. “It is not from the benevolence of the butcher, baker, or brewer that we expect our dinner, but from their regard for their own self-interest.” LO4 2-34

Virtues of a Market System A market system promotes the efficient use of resources by guiding them into the production of the goods and services most wanted by society. A market system encourages skill acquisition, hard work, and innovation. Successful innovation generates economic rewards. A market system also promotes personal freedom. In contrast to central planning, a market system coordinates economic activity without coercion. LO4 2-35

Circular Flow Model The dynamic market economy creates continuous, repetitive flows of goods and services, resources, and money. This model illustrates these flows for a simplified economy in which there is no government.

Households- are defined as one or more persons occupying a housing unit. Households buy the goods and services that businesses make available in the product market. Households obtain the income needed to buy those products by selling resources in the resource market. It is assumed that all resources in our no government economy are owned by households so they also receive all the income.

Businesses- are commercial establishments that attempt to earn profits for their owners by offering goods and services for sale. Businesses are typically 1 of 3 types. Sole proprietorships- a business owned and run by 1 person. Partnership- a business owned by 2 or more people. Corporation- a separate legal entity recognized by law as having all the rights of an individual.

Businesses sell goods and services in the product market in order to obtain revenue, and they incur costs in the resource market when they purchase the labor, land, capital, and entrepreneurial ability they need to produce their respective goods and services.

Two Types of Markets Product Market- Is the place where goods and services are bought and sold. Resource Market- is the place where resources are bought and sold.

The Circular Flow SystemRESOURCEMARKET Households sell Businesses buy PRODUCTMARKET Businesses sell Households buy BUSINESSES buy resources sell products HOUSEHOLDS sell resources buy products LO5 2-41