Chapter 2: The Market System and the Circular Flow – Study Notes

Economic Systems

  • Set of institutionalized arrangements.
  • Coordinating mechanism.
  • Differences in systems exist by:
    • Degree of decentralized use of markets and prices in decision-making.
    • Degree of centralized government control.
  • LO 2.1

Laissez-Faire Capitalism

  • Keep the government from interfering.
  • Power of government needed to:
    • Protect private property from theft.
    • Provide a legal environment for contract enforcement.
  • People interact in markets to buy and sell.
  • LO 2.1

The Command System

  • The command system is known as socialism or communism.
  • Government ownership of resources.
  • Decisions made by a central planning board.
  • Examples: North Korea, Cuba, Myanmar.
  • LO 2.1

The Market System

  • The market system 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 behavior.
  • LO 2.1

Characteristics of the Market System

  • Private property
  • Freedom of enterprise
  • Freedom of choice
  • Self-interest
  • Competition
  • Market and prices
  • LO 2.2

Global Perspective

  • INDEX OF ECONOMIC FREEDOM, SELECTED ECONOMIES, 2019
  • Access the text alternative for slide images.
  • LO 2.2

Technology and Capital Goods

  • Advanced technology and capital goods are encouraged.
  • Specialization:
    • Division of labor.
    • Geographic specialization.
  • LO 2.2

Use of Money

  • Money makes trade easier. It is a medium of exchange.
  • Without money, people would have to barter.
  • LO 2.2

Active, but Limited, Government

  • Government may be needed to alleviate market failures.
  • Government can increase effectiveness of a market system.
  • Possible government failure.
  • LO 2.2

The Five Fundamental Questions

  • 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 progress?
  • LO 2.3

What Will Be Produced?

  • Goods and services that create a profit.
  • Consumer sovereignty.
  • “Dollar votes”:
    • Allow consumers to indicate which goods and services should be produced.
    • Determine which products and industries survive or fail.
  • LO 2.3

How Will the Goods Be Produced?

  • Minimize the cost per unit by using the most efficient techniques:
    • Technology.
    • Prices of the necessary resources.
  • LO 2.3

Answering the Question of How to Produce

  • Three Techniques for Producing 15 Worth of Bar Soap LO 2.3
  • Note: Details of the three techniques are not provided in the transcript.

Who Will Get the Output?

  • Consumers with the ability and willingness to pay will get the product.
  • Ability to pay depends on income.
  • LO 2.3

How Will the System Change?

  • Changes in consumer tastes
  • Changes in technology
  • Changes in resource prices
  • LO 2.4

How Will the System Progress?

  • Technological advance
    • Creative destruction: The hypothesis that the creation of new products and production methods destroys the market power of existing monopolies.
  • Capital accumulation
  • LO 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.
  • 1776 Wealth of Nations by Adam Smith
  • Unity of private and social interest.
  • Virtues of the market system:
    • Efficiency.
    • Incentives.
    • Freedom.
  • LO 2.4

The Demise of Command Systems

  • Command systems fail to deliver adequate amounts of goods and services.
  • Examples: Soviet Union, North Korea, and pre-reform China
  • The coordination problem: Must correctly set output targets for all goods and services.
  • The incentive problem: No adjustments for surplus or shortage.
  • LO 2.4

The Circular Flow Model

  • Private closed economy: Households. Businesses.
    • Sole proprietorship.
    • Partnership.
    • Corporation.
  • Product market and the resource market.
  • The real flow and the money flow.
  • LO 2.5

The Circular Flow Diagram – Text Description

  • RESOURCES/MARKETS:
    • Households sell resources
    • Businesses buy resources
    • Land, labor, capital, entrepreneurial ability
  • GOODS/PRODUCT MARKETS:
    • Businesses sell products
    • Households buy products
  • MONEY STREAMS:
    • Money income (wages, rents, interest, profits) flows from the resource market to households.
    • Consumption expenditures flow from households to the product market.
    • Revenues flow from the product market to the businesses.
    • Costs flow out of the businesses into the resource market and the cycle begins again.
  • The cycle continues with resources flowing from the resource market to businesses and goods/services flowing from businesses to the product market.
  • LO 2.5

How the System Deals with Risk (Part 1)

  • 1) Business owners and investors face risk:
    • Losses due to input shortages.
    • Changes in consumer tastes.
    • Natural disasters that affect the supply chain.
  • Employees and suppliers have security:
    • Paid whether the firm makes a profit or not.
  • LO 2.6

How the System Deals with Risk (Part 2)

  • 2) Business risks are restricted to owners.
  • Attracts needed inputs: Inputs easier to obtain since many dislike risk.
  • Focuses attention:
    • Owners personally responsible for outcome.
    • Will encourage prudent decisions.
  • Manage risk well and the owners will prosper.
  • LO 2.6

Last Word: Hasta La Vista, Venezuela

  • Venezuela’s economy is on the verge of collapse.
  • 90% of Venezuelans now live in poverty.
  • Bolivarian Socialism
  • Hyperinflation
  • Population exodus
  • LO 2.6

Global Perspective – Accessibility and Text Alternatives

  • Accessibility Content: Text Alternatives for Images
  • Global Perspective – Text Alternative
  • Return to parent-slide containing images.
  • LO 2.2

Figure 2.1: Money Facilitates Trade when Wants Do Not Coincide – Text Alternative

  • Three boxes: NEBRASKA (Has surplus of wheat; Wants potatoes)
  • IDAHO (Has surplus of potatoes; Wants oranges)
  • FLORIDA (Has surplus of oranges; Wants wheat)
  • Trades depicted:
    • (1) Nebraska gives wheat to Florida and receives money.
    • (2) Nebraska gives money to Idaho and receives potatoes.
    • (3) Idaho gives money to Florida and receives oranges.
  • LO 2.2

The Circular Flow Diagram – Text Alternative

  • The diagram indicates the flow of certain things into and out of:
    • RESOURCE MARKET, HOUSEHOLDS, PRODUCT MARKET, BUSINESSES
  • In the resource market:
    • Households sell resources; Businesses buy resources
    • Money income flows from the resource market to households.
  • In the product market:
    • Businesses sell products; Households buy products
    • Consumption expenditures flow from households to the product market.
    • Revenues flow from the product market to the businesses.
  • In the cycle, costs flow from the businesses into the resource market and the cycle begins again.
  • Going the opposite direction, resources flow out of the resource market into businesses.
  • Goods and services flow from businesses to the product market.
  • Goods and services flow from the product market to households.
  • Labor, land, capital, and entrepreneurial ability flow from households to the resource market and the cycle begins again.
  • LO 2.5

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  • Chapter 2: The Market System and the Circular Flow – Study Notes