Chapter 2: The Market System and Circular Flow

Honors Econ

Command system

An economic system in which government owns most resources and centrally directs production and allocation

Laissez-faire capitalism

A hypothetical system with minimal government intervention, mainly protecting property and enforcing contracts

Market system / mixed economy

An economy primarily coordinated by private ownership, markets, and prices, with a substantial government role

Private property rights

Rights to own, use, control, and transfer property. They encourage investment and care of resources

Freedom of enterprise and choice

Businesses choose what to produce; individuals choose their work, purchases, and uses of their resources in a competitive market, fostering innovation and efficiency.

Self-interest and competition

Self-interest motivates people to pursue their own goals. Competition limits their power and encourages useful, lower-cost production

Specialization and division of labor

Concentrating on particular products or tasks to improve productivity. Specialization makes exchange necessary.

Money as a medium of exchange

Money allows people to trade without finding someone who simultaneously wants exactly what they offer

Consumer sovereignty / dollar votes

Consumers influence what businesses produce through their spending choices

Five fundamental economic questions

What to produce?

How to produce?

Who receives the output?

How to adjust to change?

How to promote progress?

Profit-and-loss signals

Profits encourage entry and expansion. Losses encourage contraction and exit

Invisible hand

Competition can channel self-interested decisions toward socially beneficial outcomes, such as efficient production.

Limits of the invisible hand

Monopoly, externalities, public goods, and information problems can prevent efficient outcomes. Efficiency also does not guarantee fairness

Creative destruction

New products, technologies, and firms replace older ones.

Product market

Households buy goods and services; businesses sell them. Spending flows from households to businesses

Resource market

Households sell resource services; businesses buy them. Resource payments flow from businesses to households

Circular flow

Goods and resources flow in one direction; the money paid for them flows in the opposite direction

Residual claimant

A business owner who receives what remains after contractual payments and bears business losses

Business ownership forms

Sole proprietorship: one owner

Partnership: shared ownership

Corporation: a separate legal entity owned by shareholders

Government’s economic roles

Protect property and contracts, provide defense and public goods, support competition, and address market failures.