Part One: An Introduction to
Economics and the Economy
CHAPTER 2
THE MARKET SYSTEM
AND THE CIRCULAR FLOW
Slides prepared by Dr. Amy Peng, Ryerson University
In this chapter you will learn:
2.1
2.2
2.3
2.4
2.5
2.6
The difference between a command system
and a market system
The main characteristics of the market
system
The Five Fundamental Questions any
economy faces
About the demise of the command
economy
About market failure and how government
can rectify it
The mechanics of the circular flow model
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2
2
Economic Systems
Economic System:
A particular set of institutional arrangements
and a coordinating mechanism
– The command system
– The market system
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2.1
3
Characteristics of the Market System
• Private Property
• Freedom of Enterprise and Choice
– Freedom of enterprise: businesses can buy
and sell as they choose
– Freedom of choice:
• owners can use or sell property as they choose
• workers can work where they like
• consumers can buy what they want
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2.2
4
Characteristics of the Market System
• Private Property
• Freedom of Enterprise and Choice
• Self-Interest
– businesses seek profits
– consumers seek value
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2.2
5
Characteristics of the Market System
•
•
•
•
Private Property
Freedom of Enterprise and Choice
Self-Interest
Competition
– independently acting sellers and buyers
– easy entry and exit of markets
• Markets and Prices
– prices signal scarcity and guide resource allocation
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2.2
6
Characteristics of the Market System
Other Characteristics:
• Technology and Capital Goods
• Specialization
– Division of Labour
– ability differences
– learning by doing
– saving time switching tasks
– Geographic Specialization
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2.2
7
Characteristics of the Market System
Other Characteristics:
• Technology and Capital Goods
• Specialization
• Use of money
– Medium of exchange
• Active, but Limited, Government
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2.2
8
Five Fundamental Questions
1. What will be produced?
•
•
•
those goods and services that can be
produced at a profit
what consumers vote for with their dollars
market restraints on freedom
Consumer Sovereignty
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2.3
9
Five Fundamental Questions
1. What will be produced?
2. How will the goods and services be
produced?
•
with the most efficient, least-costly methods
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2.3
10
Five Fundamental Questions
1. What will be produced?
2. How will the goods and services be
produced?
3. Who will get the goods and services?
•
those with the greatest willingness and
ability to pay
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2.3
11
Five Fundamental Questions
1. What will be produced?
2. How will the goods and services be
produced?
3. Who will get the goods and services?
– guiding
function of prices
4. How will the system
accommodate
– role in promoting progress
change?
•
– technological
by responding to price
and profit advance
signals
– creative destruction
– capital accumulation
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2.3
12
Five Fundamental Questions
1. What will be produced?
2. How will the goods and services be
produced?
3. Who will get the goods and services?
4. How will the system accommodate
change?
5. How will the system promote progress?
•
•
technological advance
capital accumulation
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2.3
13
The “Invisible Hand”
• Prices communicate information about
scarcity and value
• Competition forces producers and
resource suppliers to respond
• Firms, acting in their own best interest,
also promote society’s interests in terms
of efficiency
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2.3
14
The “Invisible Hand”
Three special merits of the market system:
• Efficiency
• Incentives
• Freedom
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Chapter 2.3
15
The Demise of the Command System
• The Coordination Problem
• The Incentive Problem
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2.4
16
Market Failure
Spillovers or Externalities
• spillover costs
– correction through
•
•
Legislation
Specific Taxes
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2.5
17
Market Failure
Spillovers or Externalities
• spillover benefits
– correction through
•
•
Subsidization of consumers/suppliers
Provision of goods via government
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2.5
18
Market Failure
Public Goods and Services
• non-rivalry
• non-excludability
• free-rider problem
Examples
• Airport security
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Chapter 2.5
19
Market Failure
Limitations of the Market System
• market system has remarkable virtues
• it also has well-known limitations
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2.5
20
Figure 2-2
The Circular Flow Diagram
FACTOR
MARKET
FACTORS
OF PRODUCTION
BUSINESSES
©2007 McGraw-Hill Ryerson Ltd.
INPUTS
HOUSEHOLDS
Chapter 2.5
21
Figure 2-2
The Circular Flow Diagram
FACTOR
MARKET
FACTORS
OF PRODUCTION
BUSINESSES
INPUTS
HOUSEHOLDS
GOODS &
SERVICES
GOODS &
SERVICES
PRODUCT
MARKET
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2.5
22
Chapter Summary
 2.1 The Difference Between a Command
System and a Market System
 2.2 The Main Characteristics of the Market
System
 2.3 The Five Fundamental Questions Any
Economy Faces
 2.4 The Demise of the Command Economy
 2.5 Market Failure
 2.6 The Mechanism of the Circular Flow Model
©2007 McGraw-Hill Ryerson Ltd.
Chapter 2
23