1. The Market System and the Circular Flow
Chapter 2
This chapter begins with a brief comparison of command and laissez-faire systems, then transitions to a discussion of the characteristics of a market system. The five fundamental questions faced by every economy are presented along with how a market economy answers each one. A discussion of Adam Smith’s “invisible hand” leads into an explanation of why command systems have failed. The circular flow model provides an overview of how resources and goods move through a market system. The chapter includes a discussion of how a market system deals with risk. The Last Word provides a look at the vast number of ways resources could be arranged and why this doesn’t result in randomness.
The Market System and the Circular Flow

2. Economic Systems Economic systems Differences in systems exist by
Set of institutionalized arrangements
Coordinating mechanism
Differences in systems exist by
Degree of decentralized use of markets and prices in decision-making
Degree of centralized government control
Economic systems are a set of institutional arrangements and a coordinating mechanism to solve economic problems. Economic systems differ in how much decentralized decision-making is enjoyed in the country versus how much centralized government command and control is used to direct economic activity in that country.
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3. Laissez-Faire Capitalism
Ideal economy
“Keep the government from interfering with the economy”
Power of government just needed to
Protect private property from theft
Provide a legal environment for contract enforcement
People interact in markets to buy and sell
Laissez-faire capitalism is the ideal economic system that Adam Smith envisioned in his book “The Wealth of Nations”. There is no need for government interference in markets because the system is a self-correcting one. In laissez-faire systems, the role of government is limited to providing a legal environment for protection of private property and to enforcement of private contracts.
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4. The Command System
The command system is known as socialism or communism
Government ownership of resources
Decisions made by a central planning board
North Korea, Cuba, Myanmar
Resources are owned by the government and economic activity is coordinated by a central planning board. This means that what is produced, how much is produced and the prices that are charged for the output are determined by the central planning board. Many countries formerly under communist or socialist control have begun reducing their reliance on central planning and implementing more market-oriented systems. However, there are still some mainly communist countries like North Korea, Cuba, and Myanmar.
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5. The Market System
The market system is a mix of decentralized decision making with some government control
Systems found in much of the world
Private markets are dominant force
Private ownership of resources
Self-interested behavior
With a market system, resources are owned by private individuals and institutions. Markets and prices coordinate and direct economic activity. Each participant acts in his or her own self-interest. Monetary rewards are possible but not without some degree of financial risk. In the U.S. version of capitalism, the government plays a substantial role.
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6. Characteristics of the Market System
Private property
Freedom of enterprise
Freedom of choice
Self-interest
Competition
Market and prices
Private individuals and firms own most of the private property resources of land and capital.
Private property, coupled with the freedom to negotiate binding legal contracts, enables individuals and businesses to obtain, control, use, and dispose of this property. Private property rights encourage investment, innovation, exchange of assets, maintenance of property, and economic growth. Property rights extend to intellectual property through patents, copyrights, and trademarks.
Freedom of enterprise means that entrepreneurs and businesses have the freedom to obtain and use resources, to produce products of their choice, and to sell these products in the markets of their preference.
Freedom of choice means that owners of property and money resources can use resources as they choose, workers can choose the training, occupations, and job of their choice, consumers are free to spend their income in such a way as to best satisfy their wants.
Self interest is one of the driving forces in a market system. Entrepreneurs try to maximize profits or minimize losses; resource suppliers try to maximize income; consumers maximize satisfaction. As each tries to maximize profits, income, and satisfaction, the economy will benefit if competition is present.
Competition requires two or more independently acting buyers and sellers. This serves to decentralize economic power. Also, it requires freedom to enter or leave the markets.
Markets and prices is the characteristic that reflects the decisions made on each side of the market and determines the set of product and resource prices that guide owners, entrepreneurs and consumers as they all make choices based on their respective self-interests.
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7. Global Perspective
The Index of Economic Freedom measures economic freedom using 10 economic freedoms such as trade policy, property rights, and government intervention. The index then ranked 179 economies according to their degree of economic freedom. A few selected rankings for 2015 are listed here.
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8. Technology and Capital Goods
Advanced technology and capital goods are encouraged
Specialization
Division of labor
Geographic specialization
Market systems reward individuals and businesses for development of new technologies thereby encouraging their development and implementation. Specialization allows economies to take better advantage of their resources and their capabilities. Division of labor or human specialization increases productivity by making use of differences in abilities, fostering learning by doing, and saving time. Geographic specialization can be regional or it can be international.
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9. Use of Money Money makes trade easier Medium of exchange
Without money, people would have to barter
It is much easier to sell what you produce for money and then buy what you want. Otherwise, you would have to barter for what you want which means that you not only have to find someone that has what you want, but also wants what you have. Money is socially defined, whatever society accepts as a medium of exchange is money.
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10. Active, but Limited Government
Government may be needed to alleviate market failures
Government can increase effectiveness of a market system
Possible government failure
Although the market system promotes efficiency, it has certain shortcomings. There can be an over production of goods that have social costs and an underproduction of goods that have social benefits. There are tendencies for businesses to increase monopoly power. Governments also have shortcomings that lead to misallocation of resources.
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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?
These five questions highlight the economic choices underlying the production possibilities model. All economies whether a market system, or otherwise, must address these questions.
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12. What Will Be Produced? Goods and services that create a profit
Consumer sovereignty
“Dollar votes”
Method for consumers to determine which goods will be produced
Determines which products and industries survive or fail
Profit is the difference in total revenues and total costs. In a market system, consumers ultimately decide what will be produced through their dollar votes for a product. If there are not enough “votes” for a product, the firm will cease production of that product. Businesses must match their production choices with consumer choices or else face losses and bankruptcy.
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13. How Will the Goods Be Produced?
Minimize the cost per unit by using the most efficient techniques
Technology
Prices of the necessary resources
When firms face competition, the market forces the producers to use the most efficient production techniques, otherwise they will be driven out of business. The combination of technology and the prices of the required resources determines the most efficient production technique.
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14. How Will the Goods Be Produced? Continued
Three Techniques for Producing $15 Worth of Bar Soap
Price per unit of Resource
Units of Resource
Technique 1
Technique 2
Technique 3
Resource
Units
Cost
Labor $2 4
$ 8 2
$ 4 1
$ 2
Land $1 3
Capital $3 6
Entrepreneur
$ 15
$ 13
The producer will rationally choose the least costly method because it is this method that leads to the greatest profit (or to loss minimization).
Total Revenue - Total Cost = Economic Profit or Loss. Here $15 - $13 = $2 economic profit.
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15. Who Will Get the Output?
Consumers with the ability and willingness to pay will get the product
Ability to pay depends on income
A market system is based on the willingness to pay principle which means if the consumer is willing and able to pay, the consumer gets the product. The ability to pay depends on income which depends on the amount of resources the person has and the price those resources obtain in the market.
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16. How Will the System Change?
Changes in consumer tastes
Changes in technology
Changes in resource prices
A market system is a dynamic environment and is able to quickly adapt to changes in consumer tastes and preferences.
The business firm will find it in its best interest to make the changes reflected in the consumer choices.
The market system acts like a giant communications system. The consumers communicate their preferences through their dollar votes, the business then responds to this by producing more, or less, or none of the product. This will soon be reflected in the demand for the resources employed in the production of the product.
When technology and resource prices change, this affects the costs the producer faces when producing the good, changing the amount of the good that will be produced and the price of the good.
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17. How Will the System Progress?
Technological advance
Creative destruction
Capital accumulation
The market system promotes technological improvements and capital accumulation. An entrepreneur or firm that introduces a popular new product will be rewarded with increased revenue and profits. New technologies that reduce production costs, and thus product price, will spread rapidly throughout the industry as a result of competition. Creative destruction occurs when new products and production methods destroy the market positions of firms that are not able or willing to adjust.
The market system leads to even greater capital accumulation as it provides the resources necessary to produce more capital goods through the increased dollar votes for capital goods. The entrepreneurs and business owners are able to purchase more capital goods as they become more and more profitable.
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18. The Invisible Hand The “invisible hand”
1776 Wealth of Nations by Adam Smith
Unity of private and social interest
Virtues of the market system
Efficiency
Incentives
Freedom
Adam Smith is often referred to as the “father of economics.” His emphasis on the role of self‑interest in motivating economic activity is especially important. Self-interested behavior of both the business and the suppliers of resources result in the greatest amount of economic efficiency possible. The market system guides resources into the production of the goods and services most desired by society. It enforces use of the most efficient production techniques while encouraging new production techniques. The market system encourages skill acquisition and hard work because you will be rewarded for your efforts. Entrepreneurs and workers are free to make choices based on their own self-interest.
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19. The Demise of Command Systems
Command system was a failure
Soviet Union, Eastern Europe, and China
The coordination problem
Set output targets for all goods
The incentive problem
No adjustments for surplus or shortage
Failures along the supply chain were common because one factory’s output was another factory’s input. A failure at any step along the way would cause a chain reaction. This became more difficult as the economies grew.
There were no indicators of success like in a market system where we have profit or loss to indicate how successful the business firm is. There were no price signals to indicate more or less of a product was desired resulting in surpluses and shortages.
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20. The Circular Flow Model
The circular flow diagram
Households
Businesses
Sole proprietorship
Partnership
Corporation
Product market and the resource market
The real flow and the money flow
The circular flow diagram is a simple economic model showing a private closed economy in which there is only a private sector consisting of households and businesses who interact with each other in the markets. The real flow consists of resources flowing from households and used in producing products that flow from businesses. The money flow facilitates the workings of the economic system.
Households are housing units occupied by one or more persons. Businesses combine resources and attempt to earn profits for the owners by offering goods and services for sale. Businesses are generally one of three basic types. The sole proprietorship is a business owned and managed by a single person.
A partnership is a business owned and managed by two or more persons and a corporation is an independent legal entity that can engage in any legal business activity.
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21. The Circular Flow Diagram
RESOURCE
MARKET
Households sell
Businesses buy
Costs
Rent, Wages, Interest,
Profits
Land, Labor, Capital,
Entrepreneur
Land, Labor, Capital,
Entrepreneur
BUSINESSES
buy resources
sell products
HOUSEHOLDS
sell resources
buy products
A simplified dynamic economy of continuous flows of goods and services, resources, and money. This simple economy consists of households and businesses and there is no government.
Households are the owners of the resources (selling their resources in the resource market) and income flows into the households. Households are the ones who buy the goods and services in the product market. The prices that are paid in the product market are determined by supply and demand.
Businesses buy the resources, thereby providing income to the households. Businesses buy the resources to produce goods and services that are then sold in the product market to households. When firms sell their products, the money that they receive is called revenue. The counterclockwise flow of economic resources and finished products that is illustrated by the red arrows is paid for by the clockwise flow of money income and consumption expenditures illustrated by the blue arrows.
Goods and Services
PRODUCT
MARKET
Businesses sell
Households buy
Goods and Services
Expenditures
Consumption
Revenues
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22. How the System Deals with Risk
Business owners and investors face risk
Losses due to input shortages
Changes in consumer tastes
Natural disasters that affect the supply chain
Employees and suppliers have security
Paid whether the firm makes a profit or not
In a market system, businesses all face risks. Profitability of the firm will depend on how well risk is managed. Profits flow to the owners as their reward for bearing the risk of losses. On the other hand, employees and suppliers to the firm do not face any risk, they get paid regardless of how well the firm is doing.
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23. How the System Deals with Risk Continued
Business risks are restricted to owners
Attracts needed inputs
Inputs easier to obtain since many dislike risk
Focuses attention
Owners personally responsible for outcome
Will encourage prudent decisions
Manage risk well and the owners will prosper
The market system will experience better economic outcomes over time since owners bear responsibility for their own management decisions. Compare this to the command and control system where no one bears any responsibility for bad management or loses any money if they make bad decisions. They receive the same salary regardless.
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24. Shuffling the Deck
Extremely large number of ways to arrange a deck of cards
Arrangement of economy’s resources is even larger
Avoid random outcomes in market due to
Private property
Rational decisions about property
Shuffling the deck illustrates how many different arrangements can be obtained with 52 items, like a deck of cards, and then how many different arrangements could be made with the vast number of resources available to make goods and services. The number of possible ways to arrange a deck of cards is so large that it is incomprehensible; imagine the number of ways to allocate resources. The reason we do not have random outcomes is because of private property and people’s abilities to make decisions about their own property that will make themselves better off, not worse off.