02
The Market System and the Circular Flow
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin

LO1
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
2-2

Systems of resource allocation
Economists identify three basic types of economic organization—i.e., systems for determining what gets produced, how it gets produced, and who gets what:
1. Traditional economy
2. Command or centrally planned economy
3. Market economy

Traditional Economy
1. Resources are allocated according to longestablished practices.
2. Methods of production tend to be unchanging.
3. Goods and services are distributed based on community views about fairness and justice.

Command or central planning
•The planning authorities decide what gets produced--resources are allocated according to planning documents issued by central planning authorities.
•The “visible hand” of the planners overrides the
“invisible hand” of the market.
•Gosplan of the old U.S.S.R. is the classic example of a central planning agency.

The Market System
•Resources are allocated though individual decision making.
•The market system relies on the choices made by individuals (buyers and sellers) to allocate resources in a socially optimal way.
•The economy is an agglomeration of markets, defined as “groups of buyers and sellers with the potential to trade with each other.”
•Income distribution is mainly determined by the market value of resources owned (including labor).

LO1
The Market System
•
Known as capitalism
•
Well-defined and protected property rights —including rights to
“intellectual” property.
•
Decisions based on markets
•
Australia, Switzerland, and the U.K.
2-7

LO2
Characteristics of the Market System
•
Private property
•
Freedom of enterprise and choice
•
Self-Interest
•
Competition
•
Markets and prices
2-8

LO2
Global Perspective
2-9

LO2
Technology and Capital Goods
•
Advanced technology and capital goods are encouraged.
•
Specialization
•
Division of labor
•
Geographic specialization
2-10

LO2
Use of Money
•
Makes trade easier
2-11

LO3
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?
2-12

LO3
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
2-13

LO3
How Will the Goods Be Produced?
•
Minimize the cost per unit by using the most efficient techniques
•
Technology
•
Prices of the necessary resources
2-14

How Will the Goods Be Produced?
LO3
Three Techniques for Producing $15 Worth of Bar Soap
Resource
Labor
Land
Capital
Entrepreneur
Units of Resource
Price per unit of
Resource
Technique 1
$2
$1
$3
$3
Technique 2 Technique 3
Unit s
Cost
4 $ 8
Units
2
Cost
$ 4
Units
1
Cost
$ 2
1
1
1
1
3
3
$ 15
3
1
1
3
3
3
$ 13
4
2
1
4
6
3
$ 15
2-15

LO3
Who Will Get the Output?
•
Consumers with the ability and willingness to pay will get the product
•
Ability to pay depends on income.
2-16

LO4
How Will the System Change?
•
Changes in consumer tastes
•
Changes in technology
•
Changes in resource prices
2-17

LO4
How Will the System Progress?
•
Technological advance
•
Creative destruction
•
Capital accumulation
2-18

LO4
Invisible Hand
•
1776 Wealth of Nations by Adam
Smith
•
Unity of private and social interest
•
Virtues of the market system
•
Efficiency
•
Incentives
•
Freedom
2-19

LO4
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
2-20

LO5
The Circular Flow System
RESOURCE
MARKET
•Households sell
•Businesses buy
BUSINESSES
• buy resources
• sell products
HOUSEHOLDS
• sell resources
• buy products
PRODUCT
MARKET
•Businesses sell
•Households buy
2-21

LO5
Businesses
•
Three main categories of businesses:
•
Sole Proprietorship
•
Partnership
•
Corporation
2-22