By Laura Lamb & material from McConnell, Brue, Flynn & Barbiero 1.

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Chapter 2 The Market System and the Circular

FlowBy Laura Lamb & material from McConnell,

Brue, Flynn & Barbiero

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All societies have economic systems.

Economic systems differ in two important ways:

1. who owns the factors of production 2. the method used to coordinate economic

activity.

2.1 Economic Systems

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1. The command system

2. The market system

Two main economic systems

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A. Private Property B. Freedom of enterprise & choiceC. Self-interestD. CompetitionE. Markets & pricesF. Reliance on technology & capital goodsG. SpecializationH. Use of money I. Active but limited government

2.2 Characteristics of the Market System

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Property owners have rights:

control, employ, dispose of, and bequeath property.

Rights extend to intellectual property through patents, copyrights, and trademarks.

A. Private Property

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1. Freedom of enterprise means entrepreneurs and businesses have the freedom to obtain

and use resources, to produce products of their choice, & to sell these products in the markets of their choice.

 2. Freedom of choice means: a. Owners of property and money resources can use

resources as they choose. b. Workers can choose the training, occupations, and job

of their choice. c. Consumers are free to spend their income in such a

way as to best satisfy their wants.

B. Freedom of enterprise & choice

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a. Self interest is one of the driving forces in a market system.

b. As each agent tries to maximize profits, income & satisfaction, the economy will benefit if competition is present.

C. Self-interest

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Large numbers of sellers mean that no single producer or seller can control the price or market supply.

Large number of buyers means that no single consumer or employer can control the price or market demand.

Depending upon market conditions, producers can enter or leave industry easily.

D. Competition

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A market is an institution or mechanism that brings buyers and sellers into contact.

Individual decisions by buyers and sellers in the market determine the product and resource prices that, in turn, guide further decisions by resource owners, producers, and consumers.

Those who respond to the market signals will be rewarded with profits and income.

E. Markets & prices

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1. Firms are motivated invest in leading edge technology & capital goods for efficiency & greater output.

 2. Competition, freedom of choice, self-interest, and the potential of profits provide the incentive for capital accumulation (investment).

F. Reliance on technology & capital goods

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Definition: the use of the resources of an individual, a firm, a region, or a nation to produce one or a few goods & services.

Division of labour is important.

What are the benefits of specialization?

G. Specialization

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1. Money is more efficient than barter.◦ Allows for multilateral trades◦ Money wages are more efficient

2. Foreign exchange markets allows easy international trade.

H. Use of money

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The market system promotes efficiency, but it has certain shortcomings ◦ over production of goods with social costs

◦ under production of goods with social benefits

◦ tendency for business to increase monopoly power

◦ macro instability

I. Active, but limited government

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Must be answered by all economic systems:

1.What goods and services will to be produced?

2.How will the goods and services be produced?

3.Who will get the output?4.How will the system accommodate change?5.How will the system promote progress?

2.3 Five Fundamental Questions

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Consumer sovereignty◦ Dollar votes

◦ Businesses are not really free to produce what they wish.

1.What goods and services will to be produced?

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Least costs production Production techniques include:

◦ Optimum location◦ Resource productivity◦ Transportation costs◦ Available technology◦ Resource prices

The most efficient technique: the one that produces a given amount of output with the smallest input of resources.

2. How will the goods and services be produced?

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To those who are willing and able to pay for them.

Depends on:distribution of incometastes & preferences of consumers

3. Who will get the output?

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The guiding function of prices is essential to a well-functioning market system.

4. How will the system accommodate change?

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Firms & entrepreneurs are rewarded with increased revenue & profits for successful changes.

Creative destruction occurs when new products and production methods destroy the market positions of firms that are not able or willing to adjust.

Competition promotes progress.

5. How will the system promote progress?

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 Competition is the mechanism of control for the market system:

◦ guarantees that industry responds to consumer wants

◦ forces firms to adopt the most efficient production techniques

Competition and the “Invisible Hand”

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Concept of the “invisible hand” by Adam Smith

◦ public interest is promoted through a market system where the primary motivation is self‑interest.

◦ by attempting to maximize profits, firms will also be producing the goods and services most wanted by society…thus is best public interest.

Invisible hand

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The failure of command systems can be attributed to two main problems:

1. Coordination problem

2. Incentive problem

2.4 The Demise of the Command Systems

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2.5 The Circular Flow Model for a Market-Oriented System

FACTOR MARKET

FACTORS OF PRODUCTION

INPUTS

BUSINESSES HOUSEHOLDS

$ CO

STS

$ INCO

MES

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GOODS &SERVICES

GOODS &SERVICES

$ CO

NSU

MPT

ION

$ REVENU

E

BUSINESSES

HOUSEHOLDS

FACTORMARKET

PRODUCTMARKET

INPUTS

$ CO

STS

$ INCO

MES

FACTORSOF PRODUCTION

The Circular Flow Diagram Figure 2-2

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Limitations?

What are the limitations to the model?