The Market System and the Circular Flow 2 C H A P T E R.

The Market The Market System and System and the Circular the Circular

FlowFlow2C H A P T E R

PROPERTY RESOURCESPROPERTY RESOURCES

1. LAND1. LAND

2. CAPITAL2. CAPITAL

HUMAN RESOURCESHUMAN RESOURCES

3. LABOR3. LABOR

4. ENTREPRENEURIAL ABILITY4. ENTREPRENEURIAL ABILITY

SCARCE RESOURCESSCARCE RESOURCESECONOMIC RESOURCESECONOMIC RESOURCES

Resource payments: correspond to resource Resource payments: correspond to resource categoriescategories

RENTALRENTALINCOMEINCOME

INTERESTINTERESTINCOMEINCOME

WAGESWAGES

PROFIT &PROFIT &LOSSLOSS

PROPERTY RESOURCESPROPERTY RESOURCES

LANDLAND

CAPITALCAPITAL

HUMAN RESOURCESHUMAN RESOURCES

LABORLABOR

ENTREPRENEURENTREPRENEUR

Macroeconomics Starts Here

Economic Systems

• Definition: A particular set of institutional arrangements and a coordinating mechanism to respond to the economizing problem.

• Economic systems differ as to:

1) who owns the factors of production

2) the method used to motivate, coordinate, and direct economic activity.

The Command System

• The government owns most property resources and economic decision making occur through a central economic plan.

• The central planning board determines production goals for each firm and resources to be allocated.

The Market System

• There is private ownership of resources.

• Markets and prices coordinate and direct economic activity.

• Each participant acts in its own self-interest.

• In pure capitalism the government plays a very limited role.

Characteristics of the Market System

• Private Property.• Freedom of firms to choose.• Self interest.• Competition.• Markets and prices.• Technology and capital goods.• Specialization.• Use of money.• Active, but limited government.

The Circular Flow Model

• There are two groups of decision makers in There are two groups of decision makers in the private economy: households the private economy: households (resource (resource owners)owners) and businesses and businesses (resource users)(resource users)

• The market system The market system (resource markets and (resource markets and product markets)product markets) coordinates these decisions. coordinates these decisions.

What happens in the resource markets? What happens in the resource markets? a.a. Households Households sellsell resources directly or resources directly or

indirectly (through ownership of corporations) to indirectly (through ownership of corporations) to businesses.businesses.

b. Businesses b. Businesses buybuy resources in order to produce resources in order to produce goods and services.goods and services.

c.c. Interaction of these sellers and buyers Interaction of these sellers and buyers determines the determines the price of each resourceprice of each resource, which in , which in turn provides turn provides incomeincome for the owner of that for the owner of that resource.resource.

d.d. Flow of payments from businesses for the Flow of payments from businesses for the resources constitutes business resources constitutes business costscosts and resource and resource owners’ owners’ incomesincomes..

What happens in the product markets?What happens in the product markets?a. Households are on the a. Households are on the buyingbuying side of these side of these

markets, purchasing goods and services.markets, purchasing goods and services.

b.b. Businesses are on the Businesses are on the sellingselling side of these side of these markets, offering products for sale.markets, offering products for sale.

c.c. Interaction of these buyers and sellers determines Interaction of these buyers and sellers determines the price of each product.the price of each product.

d.d. Flow of consumer expenditures constitutes Flow of consumer expenditures constitutes sales receiptssales receipts for businesses. for businesses.

CIRCULAR FLOW MODEL

BUSINESSES HOUSEHOLDS

RESOURCEMARKET

PRODUCTMARKET

BUSINESSES HOUSEHOLDS

RESOURCEMARKET

RESOURCES INPUTS

PRODUCTMARKET

CIRCULAR FLOW MODEL

BUSINESSES HOUSEHOLDS

RESOURCEMARKET

RESOURCES INPUTS

$ COSTS $ INCOMES

GOODS &GOODS &SERVICESSERVICES

GOODS &GOODS &SERVICESSERVICES

PRODUCTMARKET

CIRCULAR FLOW MODEL

BUSINESSES HOUSEHOLDS

RESOURCEMARKET

RESOURCES INPUTS

$ COSTS $ INCOMES

PRODUCTMARKET

GOODS &SERVICES

GOODS &SERVICES

CIRCULAR FLOW MODEL

BUSINESSES HOUSEHOLDS

RESOURCEMARKET

RESOURCES INPUTS

$ COSTS $ INCOMES

PRODUCTMARKET

GOODS &SERVICES

GOODS &SERVICES

$ CONSUMPTION$ REVENUE

CIRCULAR FLOW MODEL

CIRCULAR FLOW MODEL

BUSINESSES HOUSEHOLDS

RESOURCEMARKET

RESOURCES INPUTS

$ COSTS $ INCOMES

PRODUCTMARKET

GOODS &SERVICES

GOODS &SERVICES

$ CONSUMPTION$ REVENUE

More Realistic Circular Flow

Macroeconomic Policies

Limitations of the model:

1. Does not depict transactions between households and between businesses (inter-businesses).

2. Ignores government and the “rest of the world” in the decision-making process (we will take care of them later on).

3. Does not explain how prices of products and resources are actually determined.