1. The Market System and the Circular Flow
Chapter 2
The Market System and the Circular Flow
This chapter begins with a brief comparison of the command and market systems, transitioning quickly to a discussion of the institutional framework of the American market system. Brief explanations are given for these characteristics of the market system: private property, freedom of enterprise and choice, the role of self-interest, competition, markets and prices, the reliance on technology and capital goods, specialization, use of money, and the active but limited role of government. The authors then address the Five Fundamental Questions faced by every economy and explain 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 final part of the chapter introduces the circular flow model as an overview of how resources and goods move through a market system.
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Set of institutional arrangements Coordinating mechanism
Economic Systems
Set of institutional arrangements
Coordinating mechanism
Differences in systems exist by:
Who owns the factors of production
What method is used to motivate, coordinate, and direct economic activity
Economic systems are a set of institutional arrangements and a coordinating mechanism to solve economic problems. Economic systems differ in two important ways: Who owns the factors of production and the method used to coordinate economic activity.
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3. Known as socialism or communism Government ownership
The Command System
Known as socialism or communism
Government ownership
Decisions made by a central planning board
North Korea and Cuba are last remaining examples of largely centrally planned economies
Resources are owned by 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.
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4. Global Snapshot The Two Koreas North Korea South Korea GDP $40 billion
$1.3 trillion
GDP per Capita
$1800
$27,700
Exports
$2.0 billion
$355 billion
Imports
$3.5 billion
$313 billion
Agriculture as % of GDP
23 percent
3 percent
This snapshop reveals how North Korea’s centrally planned economy compares to the market economy of its neighbor, South Korea.
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5. Private ownership of resources Decisions based on markets
The Market System
Known as capitalism
Private ownership of resources
Decisions based on markets
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 and in pure capitalism the government plays a very limited role. 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 and choice
Self-interest
Competition
Markets and prices
Private individuals and firms own most of the private property (land and capital):
(1) Private property, coupled with the freedom to negotiate binding legal contracts, enables individuals and businesses to obtain, control, use, and dispose of this property. (2) Private property rights encourage investment, innovation, exchange of assets, maintenance of property, and economic growth. (3) Property rights extend to intellectual property through patents, copyrights, and trademarks.
Freedom of enterprise and choice exist:
(1) to best satisfy 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 choice. (2) Freedom of choice means owners of property and money resources can use resources as they choose; workers can choose the training, occupations, and job of their choice; and consumers are free to spend their income in such a way as 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: this characteristic reflects that the decisions made on each side of the market determine a 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. The Market System
This snapshot ranks countries on their economic freedom using several different broad categories.
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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.
Saving time.
Geographic specialization can be regional or it can be international.
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9. Use of Money Makes trade easier
It is much easier to sell what you produce for money and then buy what you want. Otherwise, you not only have to find someone that has what you want, but also wants what you have.
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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
Although the market system promotes efficiency, it has certain shortcomings. There is an overproduction of goods with social costs, and an underproduction of goods with social benefits. There are tendencies for businesses to increase monopoly power.
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11. The Four 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 promote progress?
These four 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. Goods and services that create a profit “Dollar votes”
What Will Be Produced?
Goods and services that create a profit
“Dollar votes”
Method for consumers to determine which goods will be produced
Determines which products and industries survive or fail
Reminder: Profit is the difference between total revenues and total costs.
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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 the firm 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. Consumers with the ability and willingness to pay will get the product
Who Will Get the Output?
Consumers with the ability and willingness to pay will get the product
Ability to pay depends on income
Our market system is based on the willingness-to-pay principle—if the consumer is willing and able to pay, the consumer gets the product. However, our system has some modifications to the pure willingness-to-pay principle for those who are willing to purchase the product but for some reason are not able to make the purchase.
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15. How Will the System Promote 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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16. 1776 Wealth of Nations by Adam Smith
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 results 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.
Entrepreneurs and workers are free to make choices based on their own self-interest.
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17. Demise of Command Systems
Soviet Union, Eastern Europe, and China
System was a failure
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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18. The Circular Flow System
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
The circular flow system is 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 products market. The prices that are paid in the products market are determined by supply and demand.
Businesses buy the resources providing income to the households. Businesses buy the resources to produce goods and services that are then sold in the products market to households. When firms sell their products, the money that they receive is called revenue.
Goods and Services
Goods and Services
PRODUCT
MARKET
Businesses sell
Households buy
Expenditures
Consumption
Revenues
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19. Three main categories of businesses: Sole proprietorship Partnership
Corporation
Sole proprietorship — a business owned and managed by a single person.
Partnership —a business owned and managed by two or more persons.
Corporation — an independent legal entity that can engage in any legal business activity.
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20. Sole Proprietorships (72%)
Businesses
Partnerships
(10%)
Corporations
(18%)
These figures demonstrate that while corporations represent only 18 percent of all businesses, they produce 82 percent of all sales revenue.
Corporations
(82%)
Sole Proprietorships (72%)
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21. The World’s 10 Largest Corporations
This chart demonstrates that in today’s global economy, only 2 of the top 10 corporations are located in the United States.
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22. Percentage of Consumer Expenditures
U.S. Households
Percentage of
Earned Income
Percentage of Consumer Expenditures
Households comprise the second part of the private sector. These charts illustrate where their income comes from and when they spend their money. Notice that the bulk of total U.S. income goes to labor, not to capital.
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