The Market System and the Circular Flow

02

McGraw-Hill/IrwinCopyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

The Market System

• Known as capitalism

• Characteristics of market systems:Private property

Freedom of enterprise and choice

Self-Interest

Competition

Markets and prices

• Australia, Switzerland, and the U.K.

LO1 2-2

Global Perspective

LO2

Index of Economic

Freedom,

Selected Nations

2-3

Technology and Capital Goods

• Advanced technology and capital

goods are encouraged

• Specialization

• Division of labor

• Geographic specialization

LO2 2-4

Active, but Limited Government

• Government may be needed to

alleviate market failures

• Government can increase

effectiveness of a market system

LO2 2-5

The Five Fundamental Questions

• What goods and services will be

produced?

• How will the goods and services be

produced?

• Who will get the goods and services?

• How will the system accommodate

change?

• How will the system promote

progress?LO3 2-6

What Will Be Produced?

• Goods and services that create a

profit

• “Dollar Votes” (Below) “Voting with

your Dollars.”

• Method for consumers to determine

which goods will be produced

• Determines which products and

industries survive or fail

LO3 2-7

How Will the Goods Be Produced?

• Minimize the cost per unit by using

the most efficient techniques

• Technology

• Prices of the necessary resources

LO3 2-8

Who Will Get the Output?

• Consumers with the ability and

willingness to pay will get the product

• Ability to pay depends on income

LO3 2-9

How Will the System Change?

• Changes in consumer tastes

• Changes in technology

• Changes in resource prices

LO4 2-10

How Will the System Promote Progress?

• Technological advance

• Creative destruction (Joseph

Schumpeter)

• Capital accumulation most

technological advances require

additional capital goods. (Page 37)

LO4 2-11

The “Invisible Hand”

• 1776 Wealth of Nations by Adam

Smith

• Unity of private and social interest

• Virtues of the market system (page

38)

• Efficiency

• Incentives

• Freedom

LO4 2-12

Demise of Command Systems

• Soviet Union, Eastern Europe, and

China

• System was a failure

• The coordination problem Page 38

• Set output targets for all goods

• The incentive problem Page 38

• No adjustments for surplus or

shortage

LO4 2-13

The Circular Flow System

RESOURCE

MARKET

•Households sell

•Businesses buy

PRODUCT

MARKET

•Businesses sell

•Households buy

BUSINESSES

• buy resources

• sell products

HOUSEHOLDS

• sell resources

• buy products

LO5 2-14

Businesses

• Three main categories of businesses

• Sole proprietorship

• Partnership

• Corporation

LO5 2-15