Topic 2- Microeconomics 1010

The Market System and the Circular Flow (Chapter 2 McGrawHill Microeconomics textbook)

2.1 Economic system

• A particular set of institutional arrangements and a coordinating mechanism for producing goods and services.

2.1 Economic system Laissez Capitalism

• A hypothetical economic system in which the government’s economic role is limited to protecting private property and establishing a legal environment appropriate to the operation of markets in which only mutually agreeable transactions take place between buyers and sellers.

• “Keep the government from interfering with the economy”

2.1 Economic Systems Why is power of government needed?

• To protect private property from theft

• Provide a legal environment for contract enforcement

2.1 Economic Systems Why do people interact in markets?

• To buy and sell

2.1 Economic Systems The command system

– It is known as socialism or communism
– Government ownership of resources
– Decisions made by a central planning board
– Examples: North Korea, Cuba, Myanmar

- An economic system in which most property resources are owned by the government and economic decisions are made by a central government body. (textbook)

2.1 Economic Systems The market system

– It is a mix of decentralized decision making with some government control
– Systems found in much of the world
– Private markets are dominant force
– Private ownership of resources
– Self-interested behaviour

- An economic system in which property resources are privately owned and markets and prices are used to direct and coordinate economic activities. (textbook)

2.2 Markets

Institutions or mechanisms that bring together buyers and sellers of particular goods, services, or resources for the purpose of exchange.

2.1 Global Perspective Index of Economic Freedom

• measures economic freedom using ten broad categories, such as trade policy, property rights, and government intervention, with each category containing more than 50 specific criteria.

• It then ranks 180 nations according to the degree of economic freedom.

2.2 Market system

An economic system in which property resources are privately owned and markets and prices are used to direct and coordinate economic activities.

2.2 Characteristics of the market system Private property

– Property rights encourage people to cooperate by helping to ensure that only mutually agreeable economic transactions take place.

- The right of private persons and firms to obtain, own, control, employ, dispose of, and bequeath land, capital, and other property. (Textbook)

2.2 Characteristics of the market system Freedom of enterprise

– Ensures that entrepreneurs and private businesses are free to obtain and use economic resources to produce their choice of goods and services and to sell them in their chosen markets.

- The freedom of firms to obtain economic resources, to use these resources to produce products of the firm’s own choosing, and to sell their products in markets of their choice. (Textbook)

2.2 Characteristics of the market system Freedom of choice

– Enables owners to employ or dispose of their property and money as they see fit.

- The freedom of owners of property resources to employ or dispose of them as they see fit, and of consumers to spend their incomes in a manner that they think is appropriate. (Textbook)

2.2 Characteristics of the market system Self interest

– Self-interest gives direction and consistency to what might otherwise be a chaotic economy.

- That which each firm, property owner, worker, and consumer believes is best for itself. (Textbook)

2.2 Characteristics of the Market System Competition

– Competition among buyers and sellers diffuses economic power within the businesses and households that make up the economy.

- The presence in a market of a large number of independent buyers and sellers competing with one another and the freedom of buyers and sellers to enter and leave the market. (Textbook)

2.2 Characteristics of the market system Market and prices

– The decisions made on each side of the market determine a set of product and factor prices that guide resource owners, entrepreneurs, and consumers.

2.2 Characteristics of the market system Use of money (For trade, what it acts as, what would happen without it?)

– Money makes trade easier.
– Acts as Medium of Exchange.
– Without money, people would have to barter(exchange without money). Barter requires coincidence of wants.

2.2 Characteristics of the market system What does “active but limited government” mean in the context of a market system?

– Government may be needed to alleviate market failures.
– Government can increase the overall effectiveness a market system
– The central government, along with the central bank, needs to take action if a market economy is experiencing recession or inflation.
– Possible government failure.

2.3 Five fundamental question What will be produced?

– The goods and services that create a profit (TR > TC).

– Consumer sovereignty determines the types and quantities.
– Dollar votes reflect wants and needs of consumers.
– Determine which products and industries survive or fail

2.3 Five fundamental questions How will the goods and services be produced?

• Minimize the cost per unit by using the most efficient techniques
– The right mix of labour and capital
– Optimal location of production facilities
– Technology
– Prices of the necessary resources

2.3 Five fundamental questions Who will get the output?

• Consumers with the ability and willingness to pay will get the product.
– Ability to pay depends on income.
- Income depends on (a) property and human resources and (b) resources price in the factor market.
– Willingness to pay depends on preference.

2.3 Five fundamental questions How will the system accommodate change?

• Changes in consumer tastes

• Changes in technology

• Changes in resource prices
– The directing or guiding function of prices and profits is a core
element of the market system.

2.3 Five fundamental questions How will the system promote progress?

• Technological advance

• Capital accumulation

2.3 Five fundamental questions How will the system promote progress? (Technological advance)

– The market system provides a strong incentive for technological advance and enables better products and processes to supplant inferior ones
-Innovation in product (income increasing)
-Innovation in process (cost reducing)
-Creative destruction: The hypothesis that the creation of new products and production methods destroys the , market power of existing monopolies

2.3 Five fundamental questions How will the system promote progress? (Capital accumulation)

– Most technological advances require additional capital goods.

– Who counts the dollar votes for capital goods?
- Entrepreneurs and business owners use part of profit to purchase capital goods to receive higher profit in the future

2.4 The invisible hand

• The tendency of competition to cause individuals and firms to unintentionally but effectively promote the interests of society even when each individual firm only attempts to pursue its own interests.

• The tendency of firms and resource suppliers seeking to further their own self-interest in competitive markets to also promote the interest of society as a whole. (Textbook)

2.4 The invisible hand 1776 wealth of nations by Adam Smith

– Unity of private and social interest

• Under a highly competitive market system, private interest and social interest coincide.
– Prices communicate information about scarcity and value.
– Competition forces producers and resource suppliers to respond.
– Firms, acting in their own best interest, also promote society’s interests in terms of efficiency

2.5 The Circular Flow Model

Depiction of the flows of resources from households to firms and of products from firms to households. These flows are accompanied by reverse flows of money from firms to households and from households to firms.

2.5 The Circular Flow Model Households

• One or more persons occupying a housing unit.
– Buy the goods and services provided by businesses in the product market.
– Obtain the income needed to buy the products by selling resources in the factor market.
-Wages, rents, interest, and profits flows to households for their labour, land, capital, and entrepreneurial ability.

2.5 The circular flow model Business

• Economic entities that purchase factors of production in the factor market and sell goods and services in the product market.
– Sole Proprietorship: an unincorporated business owned and operated by a single person.

– Partnership: two or more individuals pool their financial resources and business skills to operate the business and share the profits/losses.

– Corporation: an independent legal entity that can acquire resources, own assets, produce, sell, incur debts, extend credit, etc.

2.5 The Circular Flow Model Product Market

– Where the goods and services produced by businesses are bought and sold.

– Households use the income they receive from the sale of resources to buy goods and services.

– The money spent on goods and services flows to businesses as revenue.

2.5 The Circular Flow Model Factor Market

– Where households sell resources to businesses.
-Households sell resources to generate income. - Businesses buy resources to produce goods and services.

– Productive resources flow from households to businesses.
– The money flows from businesses to households as wages, rents, interest, and profits.

2.5 The Circular Flow Model Diagram