Chapter 4: The Market
System
Equilibrium prices and quantities are
established in individual product and
resource market
All product markets and resource
markets are established through the
market system (aka capitalism or
private-enterprise system)
Characteristics of the Market
System
Private Property
Freedom of Enterprise & Choice
Self-Interest
Competition
Markets & Prices
Reliance on Technology & Capital Goods
Specialization
Division of Labor
Use of Money
Active, Limited Government
Private Property
Private Property: Private individuals & firms,
not government, own most of the property
resources
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Enables individuals & businesses to obtain, use, &
dispose of property resources AS THEY SEE FIT.
Encourages investment, innovation, exchange,
maintenance of property, & economic growth.
Includes intellection property through patents,
copyrights, and trademarks.
Freedom of Enterprise &
Choice
Freedom of Enterprise ensures entrepreneurs
& private businesses are free to obtain & use
economic resources to produce their choice of
goods & services and to sell them in their
chosen markets
Freedom of Choice enables owners to employ
of dispose of their property & money as they
see fit. Holds for workers & consumers.
Self-Interest
Each economic units does what is best for
itself
Entrepreneur maximizes profits & minimizes
losses
Property owners aim for highest price on sale
or rent of resource
Workers find jobs w/ best combination of
wages, hours, benefits, & working conditions
Consumers find best products they want at
the lowest possible price
Competition
Requires independently acting sellers &
buyers operating in a particular product or
resource market
Requires freedom of sellers & buyers to enter
or leave markets, on the basis of their
economic self-interest
No buyer or seller can dictate the price of a
product
Freedom of entry & exit enables economy to
adjust to changes in consumer tastes,
technology, & resource availability
Markets & Prices
The coordinating mechanism of the market
system is a system of markets & prices
Through mechanism, society decides what
the economy should produce, how production
can be organized efficiently, and how the
fruits of production are to be distributed
among the various units that make up the
economy
Reliance on Technology &
Capital Goods
Extensive use of capital goods
Encourages use & rapid development of
tools, machinery, factories, & facilities.
Specialization
Majority of consumers produce virtually
none of the goods & services they
consume while consuming little or none
of what they produce.
Division of Labor
Human specialization
Specialization makes use of different
abilities
Specialization fosters learning by doing
Specialization saves time
Specialization increases total output
derived from limited resources
Use of Money
Money performs many functions
Most important function: Medium of
Exchange
Convenient means of exchanging goods is
required for specialization
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Barter: swapping goods for goods
Coincidence of Wants
Must be generally acceptable to sellers in
exchange for their goods & services.
Paper money
The Market System at Work
Four Fundamental Questions
1.
2.
3.
4.
What goods & services will be produced?
How will goods & services be produced?
Who will get the goods & services
produced?
How will the system accommodate
change?
What Good & Services will be
produced?
Since businesses seek profits and avoid
losses, the g & s produced at a continuing
profit will be produced; those with continuing
losses will not be produced
Economic Profit = Total Revenue (TR) – Total
Cost (TC)
Total Revenue (TR) = Price (P) * Quantity
Sold (Q)
Total Cost (TC) = Cost of the Resource *
Amount of the Resource
Profits & Expanding Industries
The presence of an economic profit is evidence
that the industry is prosperous  becomes an
expanding industry: new firms are attracted by
“above-normal” profits & enter, shifting from
those less profitable.
Entry of new firms is self-limiting. New firms
enter the industry, market supply increases
relative to market demand, lowering market price
 economic profit gradually diminishes
Market supply & demand conditions prevail when
economic profit reaches zero (0)  industry is at
equilibrium size
Losses & Declining Industries
Firms are not attracted to unprofitable
declining industries, with economic losses
(costs > revenue)
If losses persist, firms go out of business or
shift industries
Market supply of product in that industry falls
relative to market demand, increasing market
price economic losses gradually decreases,
industry would stop shrinking
Consumer’s Dollar Votes
Consumers cast votes with the money
(dollars) they spend.
Consumers register their wants through
the demand side of the product market.
How will Goods & Services be
Produced?
Competition forces out high-cost producers, continual
profitability requires firms to produce output at
minimum cost.
Firms locate production facilities optimally,
considering resource prices, & productivity
Firms must employ most economically efficient
technique of production
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Availability of Technology
Prices of Related Resources
Economic Efficiency: Product output w/ least input of
scare resources (measured in $)
Changes in technology or resource prices may cause
firms to shift from current technology.
Who will get the Goods &
Services?
Any product will be distributed to consumers
if they were willing and able to pay its
existing market price.
Amount of income depends on:
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Quantities of Property & Human Resources they
supply
Prices of Property & Human Resources in the
market
Resource prices (wages, interest, rent, profit)
determine the size of a household’s income 
ability to buy the economy’s output.
How will the System
Accommodate Change?
Guiding Function of Prices
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Through changes in Prices, the market system
communicates consumer tastes
Role in Promoting Progress
Technological Advance
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Market system provides strong incentive (rapid
spread)
 Creative Destruction: The creation of new products &
production methods that are better than existing ones
(DVDs)
Competition & “The Invisible
Hand” Principle
In 1776, Adam Smith wrote The Wealth of
Nations:
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Union between private & social interests
Firms & resource suppliers act in their own selfinterest simultaneously to promote public/social
interest, as if guided by an “invisible hand.”
Competition controls and guides self-interest
to further society’s interests.
An invisible hand ensures that when firms
maximize profits, they also maximize society’s
output and income
Merits of Market System
Efficiency
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Promotes efficient use of resources, guiding
towards production of most desired goods &
services
Incentives
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Encourages skill acquisition, hard work, &
motivation  economic rewards
Freedom
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Emphasizes personal freedom
Coordinates activity w/out coersion
Chapter 4 Study Questions
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