How a Market System Functions

Vocabulary flashcards covering key concepts from the lecture notes on how a market system functions (Chapter 4).

Circular Flow Diagram

A visual model showing the movement of resources, finished goods/services, and money between households and firms, with markets and money facilitating trade in a mixed economy.

Households

Individuals or groups that own factors of production and consume goods/services; they are buyers in goods markets and sellers in factor markets.

Firms

Business organizations that hire factors of production and produce/sell goods and services; they are sellers in goods markets and buyers in factor markets.

Markets for Goods and Services

Markets where finished goods and services are traded; households demand and firms supply.

Markets for Factors of Production

Markets where inputs like labor, land, and capital are traded; households supply and firms demand.

Money

Asset socially and legally accepted as payment for goods and services; it facilitates exchange in an economy.

Medium of Exchange

Money used to pay for goods and services; a primary function of money.

Store of Value

Money’s function of holding purchasing power over time.

Unit of Measure

Money provides a common unit to express and compare prices and values.

Demand

The relationship between the price of a good and the quantity consumers are willing and able to buy, holding other factors fixed.

Supply

The relationship between the price of a good and the quantity firms are willing and able to sell, holding other factors fixed.

Law of Demand

All else equal, as price falls, quantity demanded rises (downward-sloping demand curve).

Law of Supply

All else equal, as price rises, quantity supplied rises (upward-sloping supply curve).

Equilibrium

A stable price-quantity combination where the quantity demanded equals the quantity supplied.

Equilibrium Price (p*)

The price at which quantity demanded equals quantity supplied.

Equilibrium Quantity (q*)

The quantity traded at the equilibrium price.

Buyer’s Reservation Price

The maximum price a buyer is willing to pay for a given unit.

Seller’s Reservation Price

The minimum price a seller is willing to accept for a given unit.

Entrepreneur

Someone who starts, organizes, and oversees a business venture, driving resource allocation and bearing risk.

Profit

A signal that guides resource allocation: positive profits attract resources and negative profits push resources away.

Spontaneous Order

Natural, unplanned coordination that emerges from individuals pursuing their self-interest in a market.

Invisible Hand

Adam Smith’s idea that individuals pursuing their own interests can unintentionally promote societal well-being.

"I, Pencil"

Leonard Read’s essay illustrating that a pencil is produced through the dispersed cooperation of millions, without a master planner.

Determinants of Demand

Non-price factors that shift the demand curve (income, prices of substitutes/complements, preferences, expectations, market size, etc.).

Determinants of Supply

Non-price factors that shift the supply curve (costs, technology, weather, market size, expectations).

Increase in Demand

Rightward shift of the demand curve; at every price, quantity demanded increases.

Decrease in Demand

Leftward shift of the demand curve; at every price, quantity demanded decreases.

Increase in Supply

Rightward shift of the supply curve; more is supplied at every price.

Decrease in Supply

Leftward shift of the supply curve; less is supplied at every price.

Normal Good

A good for which demand rises as income rises (most goods).

Inferior Good

A good for which demand falls as income rises.

Complement Good

A good whose demand increases when the price of its complement falls (e.g., buns with hotdogs).

Substitute Good

A good whose demand increases when the price of its substitute rises (e.g., Pepsi when Coke gets more expensive).

Change in Demand vs Change in Quantity Demanded

Change in own price moves along the demand curve (quantity demanded changes); a shift of the curve means a change in demand.

Change in Supply vs Change in Quantity Supplied

Change in own price moves along the supply curve (quantity supplied changes); a shift of the curve means a change in supply.

Excess Demand

At a given price, quantity demanded exceeds quantity supplied.

Excess Supply

At a given price, quantity supplied exceeds quantity demanded.

Self-Enforcing Equilibrium

An equilibrium that persists because market forces push toward it without external intervention.

Unique Equilibrium

There is one distinct equilibrium in the model.

Stable Equilibrium

An equilibrium that remains unless an outside factor shifts the market; deviations are corrected by price adjustments.

Market Equilibrium

The intersection of the demand and supply curves indicating the equilibrium price and quantity.

Creative Destruction

Schumpeter’s idea that innovation and entrepreneurial activity continually destroy old structures to create new ones in a market economy.