Characteristics of Market
Economy
Prices, Profit, and the Economic Flow
Chart
Essential Questions
• What are the synonyms of a Market Economy?
• What are the main features of a Market Economy (private property,
limited government regulation, profits, supply and demand, prices,
competition (invisible hands))?
• How do prices, profits, and competition interact and direct
economic activity within a Market Economy?
• How do modern governments influence economies?
• Why do modern governments influence economies?
• How can economies increase production and efficiency
(specialization, division of labor, increasing human capital, assembly
line, …)?
• How does a circular flow model analyze macroeconomic activity?
• How do businesses determine prices in order to obtain a profit?
Market Economy
Synonyms
• Free Market
• Capitalism
• laissez faire
Key Characteristics
•
•
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None to Limited Government Regulation
Relationship between Supply and demand
Profit motive
• Business are motivated by the
potential to make a profit, this
motivation heavily influences decision
making
Key Characteristics
• Private ownership of
business
• Private property rights
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Copyrights
Trademarks
Patents
Licensing
Royalties
• Invisible Hands
Roles
• Three key roles with in a Market Economy
– Profit
• Acts as an incentive
– Competition
• Acts as a regulator
– Prices
• Acts as a coordinator
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
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
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.
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
o Producers only make a profit if
consumers buy their products
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 laissezfaire:
o “let them do”
Smith believed that capitalism would meet the
needs of society through the so-called “Invisible
Hand”
o Producers following their own self interest
would benefit everyone because producers
make the most profit by serving the wants &
needs of consumers
Pros & Cons
Pros: efficient, rewards innovation,
opportunities for growth, can become wealth
• Cons: income inequality, lack of regulation
can harm consumers and/or environment
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)
– Manage recession and depression
• Monetary policy
• Borrowing
• Bailout, subsidies
– Ensure competition through breaking up monopolies and other antitrust laws
– Allow monopolies deemed necessary
• Utilities, cable, ect.
– Provide public goods when there is no profit motive for private
industries such as
• Education, parks, and roads
The Role of Modern Governments
•
Protection of private property
– Property rights ensure that producers can profit from their innovations.
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Free from intellectual theft
Due Process Rights
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Search and seizure
Fair compensation
Privacy rights
– Without it people the profit motive would diminish and therefore there would be no
incentive.
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Copyright laws
Patents
Plagiarism
Subsidies
– Government offers payments to industries deemed important in order to protect it form
competition, usually foreign competition
•
Farm aid
– Lower costs, so companies can offer goods and services at lower prices without losing profit
margin
– Lower price increase the competiveness of the business or industry
The Ups and Downs of a Market
Economy
Two competing
models for
government
intervention during
recessions and
depressions:
a.
b.
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.
Business Organizations
• Allow people to combine capital and
enterprise to do business for profit
• Come in different forms:
o
o
o
o
Sole proprietorship
General partnership
Limited-Liability partnership
Corporation
Business Organizations
• Sole Proprietorship
•
o Single owner
o Owner takes all risk and all profit
General Partnership
o Form through an agreement among
the owners
o Each partner is fully liable for all
business debts
o Partners decide together what to do
with profits
Business Organizations
• Limited-liability partnership:
o Must file a certificate with the
government
o Organization that is more formal than
general partnership
o Nature of the business is still
determined by the partners
o Limited partners have limited liability
for business debts
Business Organizations
• Corporations
o File charter/certificate with the
government
o Formal organization prescribed by
law
o Shareholders have a limited liability
for the business’s debts and share in
the profits through the value of stock
or dividends
How to improve Productivity
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•
•
••
Innovation
Definition: creates new inventions
& technologies used in business
success
Come from the machines to
technology
Contribute to economic growth
Recent inventions or technological
innovations with large economic
impacts:
o
o
o
Computers
Virtual reality
Wireless networks
• Human Capital
– Definition: a person’s
skills & ability to be
economically productive
– Some comes from
natural talents & abilities
– Most comes from
education & training
– Education & training is
especially important in
our current economy
which depends heavily
on innovation
How to improve Productivity
• Assembly
Line
• Specialization
o Uses division of labor and
specialization
• the
specific task and
o Example: automobiles are
skills that an individual
made on an assembly line
contributes to the
in a factory
• Mass
Production
division of labor
o Made possibly by the
• Concentration
on single
division of labor &
specialization
tasks increases labor
• •Division of labor
productivity
•
•
breaks down a job into a
series of specific tasks for
maximum production
Each worker focuses on
one or a few tasks
Allows workers to practice
and perfect a particular
set of tasks
o Low skilled workers use
machinery to produce large
numbers of standardized
products
Types of Business Costs
• Fixed
costs: business costs that do not
depend on the level of production
o Example: Rent
• Variable
costs: depend on a firm’s level
of production
o Example: Overtime pay
• Total
costs: combination of fixed &
variable costs into the overall cost of
operating at a particular rate of
production
Types of Business Costs
• Marginal
Costs
o
•
Measure the balance of costs & benefits from the
decision to produce an additional unit of good or
service
Marginal Cost of the Additional Unit
o
o
Cost of the additional factors of production
needed to produce the unit
Example: Auto Manufacturer wants to make an
additional truck
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Marginal cost refers to: materials, labor, building costs
that went in to making it
Company stops increasing production when marginal
costs lower profits
Revenue
• Price:
the producer must determine the willingness of
consumers, or the demand, the total and marginal costs
•
of the product, and the desired profit in determining the
price.
Once a projected price is determine the producer can
estimate revenue in order to determine the profit.
•
•
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Total Revenue is the amount of money a business takes in
from selling a good or service; price*amount sold=total
revenue
Marginal revenue is the additional revenue from selling
one more unit
Profit is then determine by subtracting total revenue from
total costs