C H A P T E R 2: The Economic Problem: Scarcity and Choice
Unit I: Basic Economic Concepts
Topic C:
The Market System and the
Circular Flow
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Systems
• The economic problem: Given
scarce resources, how, exactly,
do large, complex societies go
about answering the three
basic economic questions?
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Systems
• Economic systems are the basic
arrangements made by societies to
solve the economic problem. They
include:
• Command economies
• Laissez-faire economies
• Mixed systems
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Systems
• In a command economy, a central
government either directly or indirectly
sets output targets, incomes, and
prices.
• In a laissez-faire economy, individuals
and firms pursue their own selfinterests without any central direction
or regulation.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Systems
• The central institution of a laissezfaire economy is the free-market
system.
• A market is the institution through
which buyers and sellers interact
and engage in exchange.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Systems
• Consumer sovereignty is the idea
that consumers ultimately dictate
what will be produced (or not
produced) by choosing what to
purchase (and what not to
purchase).
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Systems
• Free enterprise: under a free market
system, individual producers must
figure out how to plan, organize, and
coordinate the production of
products and services.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Systems
• In a laissez-faire economy, the
distribution of output is also determined
in a decentralized way. The amount that
any one household gets depends on its
income and wealth.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Economic Systems
• The basic coordinating mechanism in
a free market system is price. Price
is the amount that a product sells for
per unit. It reflects what society is
willing to pay.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Mixed Systems,
Markets, and Governments
Since markets are not perfect, governments intervene
and often play a major role in the economy. Some of
the goals of government are to:
• Minimize market inefficiencies
• Provide public goods
• Redistribute income
• Stabilize the macroeconomy:
• Promote low levels of unemployment
• Promote low levels of inflation
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Let’s recap
Characteristics of a market economy:
private property; freedom of
enterprise and choice; self-interest;
competition; market and prices;
technology and capital goods;
specialization—division of labor and
geographic specialization; use of
money; active but limit government.
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Principles of Economics, 7/e
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Adam Smith
What is the invisible
hand and how do I
know it’s there?
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Circular Flow Model
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Firms and Households:
The Basic Decision-Making Units
• A firm is an organization that transforms
resources (inputs) into products (outputs). Firms
are the primary producing units in a market
economy.
• An entrepreneur is a person who organizes,
manages, and assumes the risks of a firm, taking
a new idea or a new product and turning it into a
successful business.
• Households are the consuming units in an
economy.
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Principles of Economics, 7/e
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Input Markets and Output Markets:
The Circular Flow
• The circular flow of
economic activity
shows how firms
and households
interact in input and
output markets.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Input Markets and Output Markets:
The Circular Flow
• Product or output
markets are the markets
in which goods and
services are exchanged.
• Input markets are the
markets in which
resources—labor,
capital, and land—used
to produce products, are
exchanged.
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Principles of Economics, 7/e
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Input Markets and Output Markets:
The Circular Flow
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• Goods and services flow
clockwise. Firms provide
goods and services;
households supply labor
services.
• Payments (usually
money) flow in the
opposite direction
(counterclockwise) as the
flow of labor services,
goods, and services.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Input Markets and Output Markets:
The Circular Flow
• Input or factor markets are the markets
in which the resources used to produce
products are exchanged. They include:
• The labor market, in which
households supply work for wages to
firms that demand labor.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Input Markets and Output Markets:
The Circular Flow
And. . .
• The capital market, in which
households supply their savings, for
interest or for claims to future profits,
to firms that demand funds to buy
capital goods.
• The land market, in which households
supply land or other real property in
exchange for rent.
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C H A P T E R 2: The Economic Problem: Scarcity and Choice
Input Markets and Output Markets:
The Circular Flow
• Inputs into the production process
are also called factors of
production.
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