1. Characteristics of Market Economy
Prices, Profit, and the Economic Flow Chart

2. Roles Three key roles with in a Market Economy Profit Competition
Acts as an incentive
Competition
Acts as a regulator
Prices
Acts as a coordinator

3. Profit Motive
Acts as an incentive because people would not start or engage in business if monetary gains were not possible.
It is the money that remains after all costs are deducted.
Every business venture includes risk , for if it fails the people involved will loose money.
Therefore, people will only enter a market if the potential reward outweighs the risks.
Investors will not provide capital if the potential for their invest to grow is unlikely.
Entreprenuers would not risk their money or time if the potential for profit was absent.
Therefore, without profit economic advancements will not occur.

4. Competition Assumes most productive economy encourages competition
Producers compete against each other for buyers
This drives prices down
This increases efficiency because producers have to charge less, so in order to remain profitable they must increase efficiency
Workers compete against each other for wages
Division of labor increases productivity by dividing work
Example: assembly line, specialization

5. Prices
Smith argued that market economies regulate themselves for maximum productivity through price
Prices set the costs of goods and services
By setting costs, prices balance and regulate a capitalist economic system
Producers can make the most profit & consumers can get the most goods & services

6. Consumer Sovereignty
Recent important development in understanding market economies is called consumer sovereignty
Choices of consumers influence the economy more than the choices of producers
Producers only make a profit if consumers buy their products

7. The Role of Government in Capitalism
To balance the economy, Smith argued, prices must be set by free choices between producers & consumers – not by the government
French made this point with the term laissez-faire:
“let them do”
Smith believed that capitalism would meet the needs of society through the so-called “Invisible Hand”
Producers following their own self interest would benefit everyone because producers make the most profit by serving the wants & needs of consumers

8. Pros & Cons
Pros: efficient, rewards innovation, opportunities for growth, can become wealth
Cons: income inequality, lack of regulation can harm consumers and/or environment

9. The Role of Modern Governments
As discussed yesterday, most economies are mixed.
In the U.S., the government intervenes it certain cases:
Control the flow of money and interests rates in order to control inflation and encourage or discourage lending (Federal Reserve in US; IMF; World Bank)
Ensure competition through breaking up monopolies and other anti-trust laws
Provide public goods when there is no profit motive for private industries such as
Education, parks, and roads

10. The Role of Modern Governments
Protection of private property
Property rights ensure that producers can profit from their innovations.
Free from intellectual theft
Without it people the profit motive would diminish and therefore there would be no incentive.
Copyright laws
Patents
Plagiarism

11. The Ups and Downs of a Market Economy
Two competing models for government intervention during recessions and depressions:
A. Keynesianism says that fiscal policy (government spending & taxation) and deficit spending (the spending of borrowed money by the government to combat recession) can balance the economy
B. Classical response argues that government spending only prolongs the downturn and it is better to do nothing and let it bottom out, so the market can begin its own natural recovery.

12. The flow of a market: Circular flow Chart
Explain the circular flow of economic activities & how interactions determine the prices of goods & services

13. Getting the idea
It is common to hear that there is a circular flow of economic activity
This means economic activity is an ongoing, two-way relationship between:
The factor market (individuals)
The product market (business)

14. The Factor market (households)

15. The factor market (households)
The factor market is where businesses buy two factors of production:
Labor to do the work
Capital to buy the things needed to create the service or product
Households are the source (supply) for both of these factors of production

16. Households Provide labor in the form of household members
Provide capital in the form of savings available to invest in capital in the form of:
Land
Trucks
Machines
Raw materials
Other things needed for production

17. Households
The amount of money available to pay for capital & labor determines how much the firm can produce
The amount of money a household earns selling the factors of production determines how much it can consume & save

18. Households & labor
The price of labor is determined in the market
Households offer their labor to firms for a price and firms offer a price for labor

19. Households & labor
When a household & a business agree on a price for labor & the amount of labor to be provided then the household member agrees to work for the firm
This agreement is a contract
The price may not be determined on the first round of offers
It may take a series of offers & counter-offers to arrive at a price that both sides agree upon

20. Households & capital
The price of capital (interest)is the rate of return that households require firms to pay to get the households to invest in the firm
The investment can be:
A loan (also called a bond)
Equity (also called stock)

21. Households & capital
A base interest rate is usually set by each country’s central bank
That is the lowest interest rate that any household would accept on a loan
Usually loans to businesses are at higher interest rates than the rate set by the central bank
The rate of return on equity is the amount of profit available to each owner divided by the owner’s investment
If a firm does not offer a high enough rate of return, then households will not invest in the firm

22. The product market (businesses)

23. The product market
Is where firms supply goods & services for sale to households
Households buy the goods & services they need or want to consume & do not buy the others

24. The product market
If the firm can sell its product for more than the cost of producing the products, the firm has a profit
The profit is paid out to the owners (equity holders)
If the firm does not make a profit, there is nothing to pay the owners
This type of firm will not be able to get more equity to buy capital & will go out of business

25. The circular flow of economic activity
The households return the money either by purchasing goods & services or by investing in the firm
Money is flowing one way for products; factors of production are flowing the other way
These flow require both firms & households
Also create the economic interdependence of the participants in the economy
Households & firms need each other to keep the economy going

26. The circular flow of economic activity
Is the flow of money from firms to households as wages & salaries
Households either spend the money on products for consumption or save the money to generate income in the future