Market System and Circular Flow - Comprehensive Notes

Economic Systems

  • Definition: Economic systems are a set of institutionalized arrangements and a coordinating mechanism that differ by how decentralized decision-making via markets and prices is versus the degree of centralized government control.

  • Key distinction: Differences exist in the degree to which markets/prices are used in decision-making and the degree of government control.

  • Laissez-Faire Capitalism (LO2.1)

    • Goal: Keep the government from interfering.
    • Government role: Needed to protect private property from theft and to provide a legal environment for contract enforcement.
    • Market interaction: People interact in markets to buy and sell.

  • The Command System (LO2.1)

    • Also known as socialism or communism.
    • Government ownership of resources.
    • Decisions made by a central planning board.
    • Examples: North Korea, Cuba, Myanmar.

  • The Market System (LO2.1)

    • A mix of decentralized decision making with some government control.
    • Systems found in much of the world.
    • Private markets are a dominant force.
    • Private ownership of resources.
    • Self-interested behavior.

Characteristics of the Market System

  • LO2.2 Core characteristics:
    • Private property
    • Freedom of enterprise and choice
    • Self-interest
    • Competition
    • Markets and prices
    • Technology and capital goods
    • Specialization
    • Use of money
    • Active, but limited, government

Global Perspective 2.1

  • LO2.2 INDEX OF ECONOMIC FREEDOM, SELECTED ECONOMIES, 2021
  • Source: Heritage Foundation (www.heritage.org)

Technology and Capital Goods

  • Advanced technology and capital goods are encouraged.
  • Specialization concepts:
    • Division of labor
    • Geographic specialization

Use of Money

  • Money makes trade easier; it is a medium of exchange.
  • Without money, people would have to barter.

Figure 2.1: Money Facilitates Trade when Wants Do Not Coincide

  • Concept: Money links disparate wants across regions or groups to facilitate trade when wants do not coincide.

Active, but Limited, Government

  • Government may be needed to alleviate market failures.
  • Government can increase the effectiveness of the market system.
  • Beware of possible government failure.

The Five Fundamental Questions LO2.3

  • What goods and services will be produced?
  • How will the goods and services be produced?
  • Who will get the goods and services?
  • How will the system accommodate change?
  • How will the system promote technological progress?

What Will Be Produced? LO2.3

  • Goods and services that create a profit will be produced.
  • Consumer sovereignty ("Dollar votes"): Consumers indicate which goods and services should be produced and determine which products/industries survive or fail.

How Will the Goods Be Produced? LO2.3

  • Minimize the cost per unit by using the most efficient techniques:
    • Technology
    • Prices of the necessary resources

Answering How to Produce: Three Techniques for Producing $15 Worth of Bar Soap LO2.3

  • Resource price per unit:
    • Labor: p_L = 2
    • Land: p_{land} = 1
    • Capital: p_{cap} = 3
    • Entrepreneurial ability: p_E = 3
  • Technique 1
    • Labor: nL^{(1)} = 4 ext{ units} ightarrow CL^{(1)} = pL imes nL^{(1)} = 2 imes 4 = 8
    • Land: n{land}^{(1)} = 1 ext{ unit} ightarrow C{land}^{(1)} = p{land} imes n{land}^{(1)} = 1 imes 1 = 1
    • Capital: n{cap}^{(1)} = 1 ext{ unit} ightarrow C{cap}^{(1)} = p{cap} imes n{cap}^{(1)} = 3 imes 1 = 3
    • Entrepreneurial ability: nE^{(1)} = 1 ext{ unit} ightarrow CE^{(1)} = pE imes nE^{(1)} = 3 imes 1 = 3
    • Total cost: C^{(1)} = 8 + 1 + 3 + 3 = 15
  • Technique 2
    • Labor: nL^{(2)} = 2 ext{ units} ightarrow CL^{(2)} = 2 imes 2 = 4
    • Land: n{land}^{(2)} = 3 ext{ units} ightarrow C{land}^{(2)} = 1 imes 3 = 3
    • Capital: n{cap}^{(2)} = 1 ext{ unit} ightarrow C{cap}^{(2)} = 3 imes 1 = 3
    • Entrepreneurial ability: nE^{(2)} = 1 ext{ unit} ightarrow CE^{(2)} = 3 imes 1 = 3
    • Total cost: C^{(2)} = 4 + 3 + 3 + 3 = 13
  • Technique 3
    • Labor: nL^{(3)} = 1 ext{ unit} ightarrow CL^{(3)} = 2 imes 1 = 2
    • Land: n{land}^{(3)} = 4 ext{ units} ightarrow C{land}^{(3)} = 1 imes 4 = 4
    • Capital: n{cap}^{(3)} = 2 ext{ units} ightarrow C{cap}^{(3)} = 3 imes 2 = 6
    • Entrepreneurial ability: nE^{(3)} = 1 ext{ unit} ightarrow CE^{(3)} = 3 imes 1 = 3
    • Total cost: C^{(3)} = 2 + 4 + 6 + 3 = 15
  • Summary of the three techniques:
    • Technique 1 total cost: C^{(1)} = 15
    • Technique 2 total cost: C^{(2)} = 13
    • Technique 3 total cost: C^{(3)} = 15
  • The cheapest way to produce the same $15 worth of bar soap according to this example is Technique 2 with total cost 13.

Who Will Get the Output? LO2.3

  • Consumers who have the ability and willingness to pay will obtain the product.
  • Ability to pay depends on income.

How Will the System Accommodate Change? LO2.4

  • Changes in consumer tastes
  • Changes in technology
  • Changes in resource prices or availability

How Will the System Progress? LO2.4

  • Technological advance contributes to progress:
    • Creative destruction: The creation of new products and production methods can destroy the market power of existing monopolies.
  • Capital accumulation

The Invisible Hand LO2.4

  • Definition: The tendency of competition to cause individuals and firms to unintentionally but effectively promote the interests of society even when each firm pursues its own interests.
  • 1776: Wealth of Nations by Adam Smith
  • Unity of private and social interest
  • Virtues of the market system:
    • Efficiency
    • Incentives
    • Freedom

The Demise of Command Systems LO2.4

  • Command systems fail to deliver adequate amounts of goods and services.
  • Examples: Soviet Union, North Korea, pre-reform China
  • Coordination problem: Must correctly set output targets for all goods and services.
  • Incentive problem: No adjustments for surplus or shortage.

The Circular Flow Model LO2.5

  • Private closed economy: Households, Businesses; Product market and the Resource market; Real flow and money flow.
  • Diagram elements (text description):
    • RESOURCE MARKET: Households sell resources; Businesses buy resources (land, labor, capital, entrepreneurial ability).
    • PRODUCT MARKET: Businesses sell goods and services; Households buy goods and services.
    • Money incomes and costs connect the two markets:
    • Households earn money income from selling resources.
    • Businesses earn revenue from selling products.
  • The circular flow diagram shows the seamless interaction between resource market and product market through money flows (income, revenue) and real flows (resources, goods/services).

How the Market System Deals with Risk (LO2.6)

  • Part 1 (1 of 2):
    • Business owners and investors face risk from:
    • Losses due to input shortages
    • Changes in consumer tastes
    • Natural disasters affecting the supply chain
    • Employees and suppliers have security: paid whether the firm makes a profit or not.
  • Part 2 (2 of 2):
    • Market-risk is typically borne by owners; it attracts needed inputs because many dislike risk.
    • Focuses attention on outcomes:
    • Owners are personally responsible for outcomes
    • Prudent decision-making is encouraged
    • If risk is managed well, owners prosper.

Last Word: Hasta La Vista, Venezuela LO2.6

  • Venezuela’s economy on the verge of collapse.
  • Issues include: staples like food and gasoline becoming too expensive or unavailable, hyperinflation, population exodus, and Bolivarian socialism.

Accessibility Content and Text Alternatives

  • Text alternatives exist for images (Slide 28, 29, 31, 32 content).
  • Global Perspective and data are supported with text alternatives for accessibility.

Money Facilitates Trade – Text Alternative (Figure 2.1)

  • Text description summarizes a network where regions with surpluses and deficits trade using money and goods (example involving Florida, Nebraska, and Idaho).
  • Key idea: Money links surplus regions to regions with wants to enable trade when wants do not coincide.

Answering the Question of How to Produce – Text Alternative (Table-free summary)

  • Three techniques are compared by resource usage and costs across four resources:
    • Labor, Land, Capital, Entrepreneurial ability
    • Each technique has different units used and total cost
  • Totals for the three techniques illustrate how resource allocation affects cost and production decisions.

The Circular Flow Diagram – Text Alternative

  • Relationships in the circular flow:
    • Resource market: Households sell resources; Businesses buy resources.
    • Product market: Businesses sell products; Households buy products.
  • The resource market links to households via money income and to businesses via resource costs.
  • The product market links to households via consumption expenditures and to businesses via revenues.
  • The circular flow illustrates how real and monetary flows sustain the economy.