Chapter 2: The Market System and the Circular Flow – Vocabulary

Vocabulary flashcards covering key terms and concepts from Chapter 2: The Market System and the Circular Flow.

Market System

]A market system is a way of organizing an economy where buyers and sellers freely exchange goods and services. It’s based on supply and demand — what people want to buy and what’s available to sell — and prices are set by the market, not by the government.

Simple example:

If many people want apples and there aren’t many apples available, the price goes up. If there are too many apples and not enough people want them, the price goes down.

Laissez‑Faire Capitalism

Laissez-faire capitalism is a type of market system where the government does not interfere in the economy — or interferes as little as possible.

In simple terms:

It means “let it be” or “leave it alone” in French.

What it looks like:

• Businesses and individuals make their own decisions about what to produce, sell, and buy.

• Prices, wages, and competition are all controlled by the free market, not the government.

• There are no (or very few) rules or regulations.

Command System

A command system (also called a command economy) is an economic system where the government makes all the big decisions about what to produce, how to produce it, and who gets what.

In simple terms:

The government controls the economy instead of letting businesses and consumers decide.

What that means:

• The government owns most businesses.

• It decides things like:

  • What products should be made (e.g., cars, bread, clothing).

  • How much should be made.

  • What price things should be sold for.

  • Who gets the goods and services.

Example:

If you lived in a command economy and needed a new pair of shoes, the government would decide:

• What kind of shoes are made.

• How many are available.

• Where you can get them.

• How much they cost.

Socialism

Imagine this:

You and a group of friends are baking cookies together.

• In capitalism, each person makes their own cookies, keeps them, and sells them if they want. If someone doesn’t have ingredients, they just don’t get cookies.

• In socialism, everyone works together to make the cookies, and then you all share them equally, even if some helped more than others. The idea is that everyone should get cookies, not just the ones who can afford the ingredients.

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Super simple definition:

Socialism means:

The government helps run big parts of the economy so that everyone has access to important things like healthcare, education, and housing — not just the rich.

Communism

🏛 In real life (what actually happens):

• The state (government) owns everything: land, businesses, homes, farms, factories, etc.

• The government controls jobs, prices, what gets made, and who gets what.

• People don’t own private property (like businesses or land).

• The government is supposed to make everything equal — but often, it just ends up being in control of everything.

So when your teacher says “everything is owned by the state,” that’s how communism actually works in the real world, like in:

• North Korea

• Cuba

Private Property

The legal right to own and use resources as one chooses, protected by law.

Freedom of Enterprise

The freedom to enter, operate, and expand businesses in markets.

Freedom of Choice

The consumer freedom to select among goods and services (without getting forced )

Self‑Interest

Individuals acting in their own best interest, which often leads to efficient market outcomes through competition.

Like:
You want a good phone.
Companies want to sell phones.
They try to make the best phone for you.
You get better choices and prices!

Competition

Rivalry among sellers to attract buyers, leading to better prices, quality, and efficiency.

Market and Prices

The price system and markets coordinate production and consumption by signaling scarcities and opportunities.

Market and Prices mean:

Prices and markets help people decide what to make and what to buy.

When something is scarce (hard to find), the price goes up — this tells producers to make more and consumers to buy less.

When there’s a lot of something, the price goes down — this tells producers to make less and consumers to buy more.

The Invisible Hand

It’s a way to explain how people working for their own benefit can actually help everyone, even if they don’t mean to.

For example, if you open a lemonade stand because you want to make money, you have to make good lemonade at a good price so people will buy it. When lots of people do this—starting businesses and selling things—the whole community benefits because there are more choices, better products, and fair prices.

The “invisible hand” is like an invisible force that guides the economy without anyone controlling it. People chasing their own goals end up helping society by making things run smoothly.

Adam Smith is the guy who came up with the idea of the Invisible Hand. He was an 18th-century Scottish economist and philosopher, often called the father of modern economics.

In his famous book “The Wealth of Nations” (published in 1776), Adam Smith explained that when individuals try to make the best choices for themselves—like starting a business or buying something—the economy naturally works well as if guided by an “invisible hand.” This means people don’t need a boss or government to control everything; their own actions, driven by self-interest, end up benefiting society as a whole.

Five Fundamental Questions

What to produce? How to produce? Who gets the output? How to accommodate change? How to progress?

Consumer Sovereignty

Consumers’ preferences determine which goods and services are produced.

Dollar Votes

Consumers’ purchasing choices that indicate preferred products and industries.

When you spend money (use your dollar) to buy something, you’re like voting for that product.

• If lots of people “vote” by buying a product, businesses make more of it.

• If no one “votes” (buys it), businesses stop making it.

Technology

Advances in knowledge and techniques that improve production efficiency.

Capital Goods

Goods used to produce other goods and services (machinery, equipment).

Capital goods are things made by people that are used to make other things.

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Examples:

• Machines in a factory

• Tools like hammers or drills

• Buildings like factories or warehouses

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Why they matter:

They help make products that people want, like cars, clothes, or food.

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Simple way to think about it:

If you want to build a table, the wood is a raw material, but the saw and hammer you use are capital goods because they help you make the table

Specialization

Focusing production on a narrow range of goods or tasks to increase productivity.

When individuals, businesses, or countries focus on producing a limited range of goods or services in which they have an advantage or skill, to increase efficiency and productivity.

Division of Labor

Breaking down a job into smaller, simpler tasks, with different workers each doing one part to increase efficiency and speed..

Geographic Specialization

Regions specialize in producing goods due to resources or climate and trade for others.

Money

Medium of exchange that makes trade easier and avoids the inefficiencies of barter.

Barter

Direct exchange of goods/services without using money.

If you have apples and your friend has bread, and you both agree to swap some apples for some bread, that’s bartering.

Money Facilitates Trade (Wants Do Not Coincide)

Money allows exchanges when the wants of trading partners do not match in barter.

What it means:

Before money, people used barter — trading goods directly. But this only works if both people want what the other has at the same time (called the “coincidence of wants”).

Problem:

If you have apples but want bread, and the person with bread wants something else (not apples), you can’t trade.

Active, but Limited, Government

Government involvement to correct market failures while avoiding excessive control.

The government helps fix problems when the market messes up, but doesn’t take over everything.

Like stopping pollution or making sure things are fair, but letting people and businesses mostly do their own thing.

Market Failure

A situation where markets on their own fail to allocate resources efficiently.

Market failure happens when the free market doesn’t work properly and can’t give people what they need or want in a fair way.

What that means:

• Sometimes, businesses don’t provide enough of something important (like clean air or public parks).

• Sometimes, things get too expensive or unfair.

• Sometimes, people or companies do things that hurt others (like polluting).

Why it matters:

When markets fail, the government might need to step in and help fix the problem.

Government Failure

When government intervention reduces overall welfare due to poor design or implementation.

Government failure happens when the government tries to fix a problem but ends up making things worse or causing new problems.

What that means:

• The government’s actions don’t work as planned.

• Sometimes rules or policies create more problems than they solve.

• Sometimes it costs too much or wastes resources.

Why it matters:

Just like markets can fail, governments can also mess up when they try to help.

What Will Be Produced?

Goods/services produced based on profit and consumer preferences (consumer sovereignty).

How Will the Goods Be Produced?

Produce with minimum cost per unit using technology and resource prices.

Who Will Get the Output?

Those with the ability and willingness to pay, influenced by income.

How Will the System Change?

Changes in tastes, technology, or resource prices that alter production and allocation.

How Will the System Progress?

Technological progress, creative destruction, and capital accumulation drive growth.

Creative Destruction

New products/methods destroy old monopolies or inefficient firms, propelling progress.

Capital Accumulation

🟦 What is Capital Accumulation?

Capital accumulation means building up money, tools, machines, and skills that help people and businesses produce more things over time.

🛠 Examples in Simple Words:

• A farmer buys a new tractor to grow more crops.

• A bakery saves money to buy a second oven.

• A student goes to school to learn more and get a better job later.

The Circular Flow Model

Diagram of the real and monetary flows between households, firms, and markets (resource and product markets).

The Circular Flow Model shows how money, goods, and services move between households (people) and businesses in an economy.

Resource Market

Market where households supply factors of production (land, labor, capital, entrepreneurial ability) and firms demand them.

The resource market is where households sell their resources (like labor, land, and capital) to businesses.

Product Market

Market where firms supply goods/services and households demand them; revenues and expenditures flow between sectors.

The product market is where businesses sell goods and services to households (people).

Households

Owners of resources; consumers who spend income and demand goods.

Businesses

Firms that hire resources, produce goods, and sell them in markets; incur costs and earn revenues.

Risk

Uncertainty faced by owners and investors from events like shortages, changing tastes, or disasters.

Hyperinflation

Extremely high inflation that can devastate an economy (e.g., Venezuela).

When the prices of things you buy — like food, clothes, or gas — go up over time.

Economic Freedom Index

An index (Heritage Foundation, 2019) ranking economies by level of economic freedom.

The Economic Freedom Index is a score that shows how free people are to make economic decisions in a country.