Chapter 2. Economic System ◦ A particular set of institutional arrangements and a coordinating mechanism to respond to the economizing problem.

The Market System and Circular Flow

Chapter 2

Economic System◦ A particular set of institutional arrangements and

a coordinating mechanism to respond to the economizing problem

Economic Systems

Differ in 2 Ways1. Who owns the Factors of Production2. The method used to Motivate, coordinate, and

direct economic activity

Economic Systems

Types of Systems1. Market System

◦ Otherwise known as Capitalism

2. Command System◦ Otherwise known as socialism or communism

Economic Systems

Command system◦ Government owns most of the property resources ◦ Decision-making occurs through a Central

Economic Plan◦ A Central Committee specifies allocation of

resources and production goals◦ http://youtu.be/J02RdkvI6zo

Economic Systems

Market System◦ Private Ownership of most of the property

resources ◦ Decision-making occurs through markets and

prices◦ Participants act in their own self-interest◦ Competition between buyers and sellers◦ Increased monetary awards (Motivation)

Economic Systems

Market Systems◦ Laissez-faire

Hand off or Let it Be Government stays out of the decision making

process completely http://youtu.be/8fmEJ7yrnlA

Economics Systems

Market Systems –United States◦ Government does play a role

Promotes economic stability Provides rules for economic activity Provides certain goods and services that would

otherwise be under produced or not produced at all

Economics Systems

Market Systems◦ Characteristics

Private Property Individuals and firms own land and capital Freedom to negotiate contracts, use, and sell property Right to inherit property Encourage investment and innovation (incentives) Legitimizes ownership and facilitates exchange Extends to intellectual property

Economics Systems

Market Systems◦ THINK About it this way:

Would you go out of your way do something that you were not guaranteed credit for in some way?

Economics Systems

Freedom of Enterprise◦ Entrepreneurs and private businesses are free to

obtain and use economic resources to produce what they want and sell them when they want

Freedom of Choice◦ Owners are able to employ and dispose of their

property and their money any way they would like◦ Workers can enter any profession ◦ Consumers can buy whatever they want

Freedom of Enterprise and Choice

Self Interest◦ Motivating force of the various economic units as

they express their free choice◦ Get what you want

Self Interest

Competition◦ Two or more buyers or sellers acting

independently in a particular resource market◦ Freedom of sellers or buyers to leave a market

based on their own self-interest

Competition

Market◦ Brings buyers and sellers into contact◦ Those who listen to what the market wants and

needs are rewarded ◦ Those who don’t fail

◦ Example AOL

Markets and Prices

Advanced Technology◦ The Market System encourages the develop and

advancement of technology◦ More efficient production means much more

abundant output

Technology and Capital Goods

Specialization◦ The use of resources of an individual of firm to

produce one or a few goods or services rather than an entire range

◦ Producers usually do not consume what they produce

Specialization

Division of Labor (human specialization)Contributes by:◦ Making use of different talents and abilities◦ Fosters learning by doing

Develop improved techniques◦ Saves time

No back and forth Focus and move to the next one Less down time

Division of Labor

Geographic Specialization◦ Some items are better suited to be produced in a

certain area (oranges =Florida)◦ Surpluses are sold for other items

Specialization

Both Human & Geographic Specialization◦ Are needed to achieve efficiency in the use of

limited resources

Specialization

Characteristics of Money◦ Medium of Exchange

Makes trade easier It must be generally acceptable to sellers in

exchange for their goods and services Money is socially defined as:

Whatever society accepts as a medium of exchange i.e. Flintstones use clam shells

Use of Money

Barter◦ Swapping Goods for other goods

Main Problem you have to have a coincidence of wants

i.e. You have to want what the other person wants and vice versa

Use of Money

Active, but limited Government is needed◦ Due to market failures

Shortcomings in the market

Active Government

THINK ABOUT IT:◦ Why does government help the market system?

Active Government

1. What goods and services will be produced?

◦ Those that make Profit ◦ Profits or Losses = TR-TC (Total Revenue – Total

Cost)◦ Economic Costs include:

Wages for labor Interest and Rental payments for land and capital Payments to the entrepreneur for organizing and

combining the resources to produce a good

Five Fundamental Questions

Five Fundamental Questions

Expansion & Growth Contraction & Death

TR>TC◦ Industry Expands◦ Resources are put into

the industry◦ Existing firms grow◦ New firms enter

TC>TR◦ Reduced production◦ Exit of resources from

industry◦ Firms contract◦ Firms go out of business◦ Industry contracts

1. What goods and services will be produced?

◦ Consumer Sovereignty Consumers are in control Dollar Votes Crucial in determining the types and quantities to

produce Customers spend their money on what they want

to buy If people want it, it will be made Influences producers and resource suppliers

Five Fundamental Questions

2. How will goods and services be produced?◦ In combinations and ways that minimize the

cost per unit of output◦ Competition will eliminate high-cost producers◦ Profitability will require that firms produce

output at a minimum cost per unit

Five Fundamental Questions

2. What goods and services will be produced?◦ Least-cost production

Firms must employ the most economically efficient technique of production in producing their output

Depends on the available technology (combination of resources needed)

Depends on prices of the needed resources (See page 36 and worked problem 2.1)

Five Fundamental Questions

3. Who will get the goods and services?◦ Distributed based on the willingness and ability

to pay (if you can buy it at the price offered you get it!!)

◦ And your preference (if you want it)

Five Fundamental Questions

4. How will the system accommodate change?

Market systems are dynamic and change◦ Consumer preferences◦ Technology◦ Allocation of resources

Directed and guided by consumer preferences

Five Fundamental Questions

5. How will the system promote progress? Technological Advance

◦ Create technologies that will reduce cost and therefore increase market share and profit

Competitors will have to keep up or fail◦ Creative Destruction

New technology that totally makes other technology or processes obsolete (Cell Phones pay phones)

Five Fundamental Questions

5. How will the system promote progress? Capital Accumulation

◦ Entrepreneur and business owners uses dollar votes for capital goods

◦ Will result in greater future profit◦ Can get money for these investments from

selling shares

Five Fundamental Questions

Individuals will promote the public good of society by doing what is best for them as an individual

This invisible hand will guide resources to areas where they are needed

The “Invisible Hand”

Efficiency◦ Encourages and guides resources to the most

efficient way of production Incentives

◦ Risk can equal great reward◦ Working harder and acquiring more skills will

result in higher individual gains Freedom

◦ Personal freedom to make choices that benefit the individual

Benefits of the Market System

Coordination Problem◦ Central Planning committee had to coordinate the

decisions of numerous people and industries◦ Failure of one decision would set off a domino

effect◦ Managers would get bonuses based on qty not

quality so they would sacrifice quality◦ Also many things were not spelled out◦ i.e. needed 1 lb of nails, company made 1, 1 lb

nail◦ i.e. needed 1,000 nails, company made 1,000 tiny

nails

Demise of the Communist System

Incentive Problem◦ No profit incentive◦ No one then cared◦ Could not gain unless you were political◦ Got paid no matter what

Demise of the Communist System

Resource Market◦ The place where resources or the services of

resource suppliers are sold Product Market

◦ The place where goods and services are bought and sold

Circular Flow Model

Now create your own Circular Flow Model using the desks in the room

Circular Flow Model