1. The Market System and the Circular Flow02
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.
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin

2. Objectives - Chapter 2
Understand differences between command system and market system
The main characteristics of the market system
How the market system makes decisions regarding production, how to produce it and who obtains it.
How the market system adjusts to change and promotes progress.
The mechanics of the circular flow model

3. Set of institutional arrangements Coordinating mechanism
Economic Systems
Set of institutional arrangements
Coordinating mechanism
designed to respond to the economizing problem
Differences in systems that exist:
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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4. The Command System Known as socialism or communism
not the same, but have some common traits
Government ownership
Decisions made by a central planning board.
use of resources, composition and distribution of output, organization of production
central planning board sets production goals, specifies what resources will be allocated to accomplish goals
division of output between consumer/capital goods made by central authority
decisions made based on long term priorities
Pure command would rely on central plan to allocate the government-owned property resources
China, elements of command still exist: one party system, gov. owns majority of resources, but central planning has given way to free markets that organize and coordinate its economy.
North Korea & Cuba are the last prominent govt’s that are largely centrally planned
Libya, Myanmar, and Iran.
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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5. The Market System 2-4 LO1 Known as capitalism
Private ownership of resources
Decisions based on markets & prices to coordinate and direct economic activity.
“invisible hand” Adam Smith
individuals / business seek to achieve economic goals
make their own decisions re: production, consumption, work
system allows for private ownership of capital, communicates through prices, and coordinates econ. activity through markets
goods / services produced by whoever is willing to do so
$ rewards incentivize innovation and entrepreneurship
leads to new products and processes
Pure Capitalism - laissez-faire : gov’t role limited to protecting private property rights, establ. environment conducive to operate the market system
In U.S. form of capitalism the government plays a substantial role in the economy
provides rules, promotes econom. stability & growth, provides certain goods and services (that would otherwise not be produced), modifies the distribution of income (big point of argument) through incentives and taxation
Is not the dominant economic force in decisions on what to produce, how to produce, or who will get it the market decides.
Australia, Switzerland, and the U.K
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
in market systems, private individuals and firms own most of the property resources
freedom to negotiate binding legal contracts, enables individuals and businesses to obtain, use and dispose of property resources as they see fit.
private owners designate who will receive their property when they die - helps sustain the institution of priv. property
encourages investment, innovation, exchange, economic growth and maintenance of property
extend to intellectual property (pattens, copyrights, trademarks)
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:
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, 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: 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. Characteristics of the Market System
Private property continued...
facilitate exchange
titles or deeds
encourage owners to maintain and improve property to increase value
enable people to use time and resource to produce more goods and services rather than to protect and retain the property they have already acquired
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:
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, 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: 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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8. Characteristics of the Market System
Freedom of enterprise and choice
free to obtain and use resources to produce their choice of goods/services and sell them
enable owners to employ or dispose of their property and money as they see fit.
allows workers to pursue any type of employment they want / qualified for
consumers are free to buy the goods/services that bring them the most utility
limit to freedoms of course.... must be legal activities
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:
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, 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: 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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9. Characteristics of the Market System
Self-Interest
Motivating force that means that each economic unit tries to achieve its own particular goal
Motivation for self interest gives direction and consistency to what otherwise may be a chaotic economy
Adam Smith “self-interest motivates more powerfully and consistently than kindness, altruism, or martyrdom” “if all people seek to promote their self-interest, the whole society prospers” “invisible hand”
Fredrich Hayek, “Competition leads a self-interested person to wake up in the morning, look outside at the earth and produce from its raw materials, not what he wants, but what others want. Not the quantities that he prefers, but in quantities they prefer. Not at the price he dreams of charging, but at a price reflecting how much his neighbors value what he has done”
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:
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, 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: 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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10. Characteristics of the Market System
Competition
Requires
Two or more buyers and two or more sellers acting independently in a particular product or resource market
Freedom of buyers and sellers to enter and exit the market
When there are many buyers and sellers in the market, none can dictate the price alone
Ability to enter or leave provides freedom for industry’s to expand or contract
Allows the economy to adjust to changes in consumer taste, tech., and resource availability
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:
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, 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: 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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11. Characteristics of the Market System
Markets and prices
Market is an institution or mechanism that brings buyers and sellers into contact
Society decides
what the economy should produce,
how production can be organized efficiently,
and how the fruits of production are to be distributed
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:
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, 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: 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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12. Global Perspective
The Index of Economic Freedom measures economic freedom using 10 broad categories such as trade policy, property rights, and government intervention, with each category containing more than 50 specific criteria. The index then ranks 179 economies according to their degree of economic freedom. A few selected rankings for 2010 are listed here.
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13. Technology and Capital Goods
Advanced technology and capital goods are encouraged.
Market system encourages extensive use and rapid development of complex capital goods
Tools,
Machinery
Large-scale factories,
Facilities for storage,
Communication
Transportation
Marketing
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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14. Technology and Capital Goods
Specialization
Use of resource of individual, firm, region, or nation to produce one or a few goods or services rather than the entire range of goods and services.
Use trade to satisfy needs and wants or desired products
Majority of consumer produce virtually none of the goods and services they consume
Self-sufficiency breeds inefficiency
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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15. Technology and Capital Goods
Division of labor
Human specialization
Makes use of differences in ability
Saves time
Avoids the need to switch tasks moving from one task to another
Fosters learning by doing
Devoting time to a single task allows for skills to develop that improve expertise and innovation
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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16. Technology and Capital Goods
Geographic Specialization
regional and international focus on different outputs
Nebraska – Wheat, Florida – Citrus,
United States – commercial aircraft, computers
Honduras – bananas, Thailand – Baskets
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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17. Technology and Capital Goods
Use of Money
$ is a medium of exchange that makes trade easier
Money is a convenient social invention to facilitate exchanges of goods and services
Specialization requires exchange
Barter system: swapping goods…. Requires a coincidence of wants
If coincidence is missing than barter is inefficient
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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18. Use of Money Makes trade easier 2-8
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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19. 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 over production 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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20. 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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21. Determines which products and industries survive or fail
What Will Be Produced?
Goods and services that create a profit Reminder: Profit is the difference in total revenues and total costs.
“Dollar Votes”
Method for consumers to determine which goods will be produced Consumer sovereignty
Determines which products and industries survive or fail
Reminder: Profit is the difference in total revenues and total costs.
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22. How Will the Goods Be Produced?
Decisions based on minimizing the cost per unit by using the most efficient techniques
Requires firm produce output at minimum cost
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.
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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23. How Will the Goods Be Produced?
Decisions based on minimizing the cost per unit by using the most efficient techniques
Locate production facilities optimally to hold down production and transp.
Efficiency depends on:
Utilize available technology, combinations of resources to produce desired results
Prices of available resources
Requires obtaining a particular output of product with the least input of 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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24. How Will the Goods Be Produced?
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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25. 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.
quantity of the property and human resources they supply (resource prices= wages, interest, rent, profit)
and the prices those resources command in the resource market
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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26. How Will the System Change?
Changes in consumer tastes
Changes in technology
Changes in resource prices
representative of consumer sovereignty : as tastes change, sales of one item goes up while others go down.
signal to producers to shift resources to accommodate demand
A market system is a dynamic environment.
A market system is able to quickly adapt to changes in consumer tastes and preferences.
The business firm will find it in their 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 impacts the costs that 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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27. 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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28. 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 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
Entrepreneurs and workers are free to make choices based on their own self- interest.
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29. 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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30. The Circular Flow System
RESOURCE
MARKET
Households sell
Businesses buy
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 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.
PRODUCT
MARKET
Businesses sell
Households buy
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31. 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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32. Extremely large number of ways to arrange a deck of cards
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 – a comparison of how many different arrangements can be obtained with 52 items, like a deck of cards, and how many different arrangements can 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.
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