Market System & the Circular Flow

1. Market System & the Circular Flow Chapter 2

2. In this Chapter, you will learn: • The difference between a command system & a market system • The main characteristics of the market system • How the market system decides what to produce, how to produce it, & who obtains it • How the market system adjusts to change & promotes progress • The mechanics of the circular flow model.

3. Economic Systems (2.1 & 2.2) • Determine what goods are produced, how they are produced, & how to promote technological progress • Differ as to the following: • Who owns the resources • Method used to motivate, coordinate, & direct economic activity • Have two polar extremes: command system & market system

4. Command System • Also known as socialism or communism • Government owns most property resources • Economic decision making occurs through a central economic plan • Central planning board determines production goals for each enterprise • Specifies the amount of resources to be allocated to each enterprise so that it can reach its production goals • North Korea & Cuba are the last prominent remaining examples of largely centrally planned economies

5. Market system • Characterized by the private ownership of resources • Use of markets & prices to coordinate & direct economic activity • Participants act in their own self-interest • Economic activities are coordinated through markets • High monetary rewards create powerful incentives for existing firms to innovate & entrepreneurs to pioneer new products & processes

6. Characteristics of the market system • Private property • Freedom of enterprise and choice • Self-interest • Competition • Markets & prices • Technology & capital goods • Specialization (division of labor & geographic) • Use of money • Active, but Limited, Government

7. Use of Money (cont) • Performs several functions • Most impt – “medium of exchange” • Makes trade easier • Barter- swapping goods for goods • Problem: requires a “coincidence of wants” between buyer & seller • Each party has to want what the other person has

8. Five Fundamental Questions (2.3) • What goods & services will be produced? • Consumer sovereignty • “dollar votes” • How will the goods & services be produced? • Who will get the goods & services? • How will the system accommodate change? • How will the system promote progress? • Technological advance • Capital accumulation

9. Creative Destruction • Creation of new products & production methods completely destroys the market positions of firms that are wedded to existing products & older ways of doing business • Rival firms must follow the lead of the most innovative firm or else suffer immediate losses & eventual failure

10. The “Invisible Hand” (2.4) • Adam Smith – “Wealth of Nations” • This book first noted that a market system creates a unity between private interests & society interests • Examples: • In a competitive environment, businesses seek to build new & improved products to increase profits. Those enhanced products increase society’s well-being • Businesses also use the least costly combination of resources to produce a specific output that maximizes their profits

11. Demise of the Command Systems • Two insurmountable problems • Coordination problem • Central planners had to coordinate millions of individual decisions by consumers, resource suppliers, & businesses. • The coordination problem became more difficult as economies expanded. • Incentive problem • Central planners determined the output mix. • If they misjudged, there were a lot of shortages or surpluses at the government-determined price. • No incentives are provided for workers or managers to adjust their production levels so many products were not available.

12. Circular Flow Model (Figure 2.2) • Market economy creates continuous, repetitive, flows of goods & services, resources, & money • Diagram groups private decision makers into businesses and households • Markets are grouped into the resource market and the product market

13. Resource market • Resources or the services of resource suppliers are bought & sold • Households sell resources & businesses buy them (ex. Looking for a job) • Funds that businesses pay for resources are costs to businesses but are flows of (wage, rent, interest, & profit) income to households • Productive resources therefore flow from households to businesses, and money flows from businesses to households

14. Product market • Place where goods & services produced by businesses are bought & sold • Businesses combine resources to produce & sell goods & services • Monetary flow of consumer spending on goods & services yields sales revenues for businesses