The Market System and the Circular Flow Chapter 2 Catherine Boulatoff (section 02)

Economic Systems: Every society needs to develop an economic system – a particular set of institutional arrangements and a coordinating mechanism – to respond to the economic problem (who will produce what…) – In a laissez-faire (or pure) capitalism, the government’s role is limited to protecting private property from theft and aggression, and establishing a legal environment in which contracts can be enforced and people can interact in markets to buy and sell goods, services, and resources. – In a Command system, a central authority owns most resources, and makes most economic decisions (who will produce what, who will consume what…) – For the most part in XXIst century, economies rely on market systems in which production and distribution decisions are left to individuals and firms interacting in markets (mixed market economies)

Main Characteristics of the Market System (1/3): Private property: individuals and firms own most of property resources (land and capital); with freedom to negotiate binding legal contracts, they can use and dispose of these as they see fit. Encourages investment, innovation, exchange, maintenance of property, and economic growth. Freedom of Enterprise and Choice Self-Interest: Motivating force of the different economic units as they express their free choices.

Main Characteristics of the Market System (2/3): Competition: functions as a regulatory or control mechanism. Markets, Prices, and profits: organize and make effective the many millions of individual economic decisions that occur daily (“Invisible Hand”) Specialization, Technology and Capital Goods: common features of market systems.

Main Characteristics of the Market System (3/3): Use of money: functions as a medium of exchange, eliminates problems with bartering, and permits easy trade and greater specialization (domestically and internationally). Active but Limited Government: Important when market left on its own doesn’t work (pollution, monopoly power, lack of information), as well as to deal with redistribution (equity) issues. Different in different countries.

Overall Market systems answers five fundamental questions every economy faces: 1)What goods and services (g&s) will be produced? 2)How will the g&s be produced? 3)Who will consume these g&s? 4)How will the system accommodate change? 5)How will the system promote progress?

Questions 1 -3: What? Who? How? Products whose production and sale yield total revenue large enough to cover total costs will be produced – If positive profits, more competition, entry, reducing price. Consumer sovereignty: Businesses and resource suppliers are subject to the wants of consumers. – Consumers will spend depending on their income (wages received on labour resource)

Questions 4 & 5: Change and Risk? By communicating changes in consumer tastes to entrepreneurs and resource suppliers, the market system prompts appropriate adjustments in the allocation of the economy’s resources. Ex: “Buy local” or “organic food” movement. The market system also encourages technological advance and capital accumulation, both of which raise a nation’s standard of living. Ex: Creative Destruction; “old ways out” (Vinyl records, and CDs) Ex: part of profit invested in new capital…

Market or Command system? Compared to Command Systems, Market systems: Promote greater efficiency Provides the right incentives (encourage skill acquisition, hard work, and innovation). Places emphasis on personal freedom: Major noneconomic argument in contrast to central planning.

Discussion (in pairs: 5 mn) “No economic system, including the market system, is flawless.” Can you think of incidents/ events/ topics of key importance that would damper somewhat what we just described?

FACTORMARKET Households sell Businesses buy PRODUCTMARKET Businesses sell Households buy BUSINESSES buy resources sell products HOUSEHOLDS sell resources buy products LO ©2013 McGraw-Hill Ryerson Ltd. Chapter 2, LO5 11 The Circular Flow Model: a simplified model of how the Economy works.

How the Market System Deals with Risk Producing g&s is risky. Consumer preferences (income as well) may change, natural disasters may occur… in market systems, business owners are confronted with the financial consequences of their decision. If they do well, $$$, else, may lose everything. Note: “Too big to fail” (by Sorkin, 2009) With the market system, employees and suppliers shielded from business risk to some extent (and most people risk averse).

For next class: Read Chapter 2, Answer additional problem (next)

Additional problem Let us put dollars amounts on the flows in the circular flow diagram seen earlier. a)Suppose that businesses buy a total of $100 billion of four resources (labour, land, capital, and entrepreneurial ability) from households. If households receive $60 billion in wages, $10 billion in rent, and $20 billion in interest, how much are household paid for providing entrepreneurial ability? b)If households spend $55 billion on goods and $45 billion on services, how much revenue do businesses receive in the product market?