Chapter 2 economics

Chapter 2: The Market System and the Circular Flow

Role players in the economy

1. Households

• Single person, a family or a group of people who live together

• Depend on a single income

• Primary function: Provide labour

• Intermediate function: Produce goods and services for their own use

• Final function: Use income earned to buy goods and services

1. Business enterprises

• General function is producing goods and services by combining factors of production)

• Aim to make profit

• They are the economic decision taker whose purpose is to earn or make profit by suppling goods and services which are in demand.

1. Government

• Create an environment where the economy can operate freely and fairly.

• Provide a legal framework and the services needed for the economy to run effectively

• Redistributes transfer payments, market interventions and taxation

• Takes care of market failures (when the wrong things are produced)

1. Foreign sector

• Involves international trade

The 2 Different Types of Market

1. Resource market

• The place where resources or resources service suppliers are bought and sold.

• Household sell the resources, businesses buy them.

• The households are the owners of the 4 Factors of Production (the resources)

1. Product market

• The place where goods and services produced by a business are bought ad sold.

• Businesses combine the $ Factors of Production (the resources) to produce goods ad services.

The Circular Flow

1. Households provide labor to the resource market

2. Firms come to the resource market and hire the labor

3. After earning money from the firms the households go to the product market to buy goods and services.

4. The firms provide the goods and services

1. The money spent by households at the product market.

2. Income earned by firms at the product market

3. The income earned pays wages and salaries to households through the resource marketis .

4. The households use the salaries and wages to buy from the product market

1. The households and firms pay taxes to the government.

2. The government provides goods and services to the household and firms, for example, when the annual budget is announced, the government may provide money for schools or provide money to firms to build schools.

3. Government needs to by goods and services from the product market when building schools et cetera.

4. The resource market receives its income from the government.

5. The government needs to hire labor from the resource market.

Economic Systems

It is a particular set of institutional arrangements and a coordinating mechanism to respond to the economizing problem.

• It determines which goods are produced, how they are produced, who gets them, how to accommodate change and promote technological progress.

The Command System (socialism or communism)

• Government owns most of the property resources.

• Economic decision making occurs through a central plan.

• Central planning board selected by the government makes all major decisions.

• Government owns most of the businesses and firms.

• Central planning board determines production goals for each enterprise and amount of resources to be allocated to each enterprise.

The Market System (capitalism)

• There is private ownership of resources.

• The market and the prices direct the economic activities.

• There is self-interest

• Economics goals are achieved through one's decision.

• Allows private ownership of capital

• Goods, services and resources are produced by whoever can.

• There is competition.

• High financial reward encourage competing firms and entrepreneurs to come up with new change and ideas

 In South Africa we have a market system, but the government does contribute a bit therefore it is not a PURE market system.

The characteristics of a Market System

1. Private Property

• Private individuals and firm own most of the property resources

• The word capitalism comes from the large private ownership of capital.

• The property rights extent to intellectual property through patents allowing property owners to come up with new ideas without the fear of them being stolen.

Patent is an exclusive right granted for an invention.

• Property rights encourage maintenance or improvement of property.

• Property rights facilitate exchange by ensuring that both participants are legitimate.

• Property rights encourage production of more good and services rather than focusing on the property that has already been produced.

1. Freedom of enterprise and choice

• Freedom of enterprise ensures that the private sector is able to obtain and use economic resources for production.

• Freedom of choice allows the private sector to employ or dispose of property whenever they see fit.

                                  allows worker to enter a line of work they are qualified for

                                  allows consumers to by anything that suits them and their budget

1. Self-interest

• Creates motivation as freedom of choice is allowed.

1. Competition

• It spreads economic power within the households and businesses involved in the economy.

• It allows businesses to leave or expand within the economy at anytime

• Spreading of economic power prevents the potential abuse of that power.

1. Markets and prices

• Decisions made by households on a daily basis are coordinated by the market and prices which are key components of the market system.

• Households have a lot of choices to choose from and this prevents economic collapse.

A market is an institution that brings buyers and sellers together in contact.

• Decisions made by buyers daily determine the price and value of the product produced.

1. Technology and capital goods

• Competition, freedom of choice, self-interest and personal reward provide the opportunity and motivation for technology advances.

• The market system encourages great use and large development of complex goods such as tools, machinery et cetera.

• Advanced technology and capital goods allow for efficient production of goods.

1. Specialization

• The market economies rely of specialization greatly.

The use of resources of an individual or firm to produce one or a few good and  services rather an entire range of goods and services.

• The goods and services produced are traded for a wide range of desired goods and services.

• For example farmers produce milk (which for instance they do not consume) and trade it for butter (the desired good).

1. Division of labor

• It is also called human specialization.

• It allows humans to take advantage of their existing difference in their abilities and skills.

• It allows individual producers to develop and improve techniques  when they devote their time to one work. For example to be a good lawyer you need to practice law.

• Specialization saves time because when a person devotes their time to one job they do not lose time by moving from one job to another.

1. Geographic specialization

• Specialization also works on a regional and international basis.

• For example, Free State can produce citrus fruits but the location and weather conditions may make it more expensive. Limpopo can produce maize but similarly the cost of production is too high. Therefore Free State can produce maize (conditions allow) and Limpopo can produce citrus fruits (conditions allow) the two provinces can trade and this will allow for each province to produce more for their people.

• On an international level South Africa trades coal for other goods from other countries.

• Both geographic and human specialization contribute to achieving efficiency using limited resources.

1. Use of money

• Money is a medium of exchange and makes trade easier.

• Specialization requires exchange which can sometime occur through bartending- trading goods for goods.

• However for bartending to work there should be a coincidence that each participant must have what the other participant has.

• This rarely happens and therefor this is where money comes in.

• Money is defined socially which means whatever society accepts as a medium of exchange is money.

1. Active but limited government

• Market system promotes a high degree of efficiency in the use of resources but however sometimes there might be "market failures".

• The government can help increase the overall effectiveness of an economy.

The general economic questions: The market system

1. What goods will be produced?

• Goods and services produced at a continuing profit will be produced more contrary to those produced at a continuing loss.

Profit= Total Revenue(TR)-Total Cost(TC)

Where: TR < TC

• This is known as continuing profit which occurs as result of expanded production.

Loss= Total Revenue(TR)-Total Cost(TC)

Where: TR>TC

• This is known as continuing loss which occurs due to reduced production.

• In the market system consumers are sovereign (in command)

• Consumer sovereignty determines which goods and services can be produced.

• Consumers spend their income on goods they want to buy "rand votes"

• If the rand votes of a particular product create profit, businesses will produce more of that product and the opposite is true.

1. How will the goods and services be produced?

• In combinations and ways that minimize the cost per unit of output (in a way that the cost of production will be cheaper).

• Competition eliminates high cost production therefore for firms to acquire profit they should produce their products at minimum cost per unit.

1. Who will get the output?

• Products are distributed to the consumers on the ability and willingness to pay the market price.

• Ability to pay the price depends on the income the consumers have.

• Resource prices (wages, interest, rent and profit) determine the size of each person's income and thus the ability of the person to buy part of the economy's output.

The "invisible hand": The market system

1776 Wealth of Nations by Adams Smith

• He noted the market system creates a curious unity between personal interest and social interest.

• When firms and resource suppliers try to fulfil their self-interest they simultaneously, guided by the invisible hand, promote the interest of society.

• The three ways the invisible hand ensures this:

• Efficiency: Market system promotes the use of resources for products in demand, it forces that the most effective means of productive may be used, encourage the development and adoption of effective production techniques.

• Incentives: The market system encourage learning of new skills, hard work and innovation. These result in high production and more income, which eventually leads to a higher standard of living. Similarly when entrepreneurs take risks it leads to high profit.

• Freedom: The market system promotes freedom of enterprise and choice. Entrepreneurs and workers are free to further their own self-interest.

The demise of the command system

• The command system encountered to insurmountable problems. It was used by Soviet Union, Eastern Europe and China.

1. The coordination problem.

• It was difficult (if not impossible) for central planners to effectively coordinate the allocation of resources and satisfaction of wants of millions of consumers, resource suppliers, and businesses. 

• If an industry failed to meet the production target, it will lead to the disruption of the entire system.

• Larger economies faced even more difficulties because the larger the economy the more complex the decisions that have to be made become.

• Without market signals (i.e. prices) it was difficult to measure success.  Even if quantitative production targets were met, ambiguities in the targets led to perverse outcomes in terms of poor quality, excessive costs, and the wrong mix of goods.

1. The incentive problem

• With central planners determining what and how much would be produced, and how much resource suppliers would receive, there was little incentive to innovate, contain costs, or otherwise improve the quantity and quality of goods and services.