Chapter 2: The Market System and the Circular Flow

• Economic system - A particular set of institutional arrangements + coordinating mechanism used to respond to the economizing problem
  • Determine what goods produced, how goods are produced, who gets them, etc.
• Command system - Socialism/communism; gov’t owns most property + economic decision-making occurs through central economic plan
  • Central planning board makes all major decisions
  • Firms produce according to gov’t directives
  • Some private ownership
• Market system - Capitalism; private ownership of resources + use of markets/prices to coordinate economic activity
  • Acting in own self-interest
  • Competition among independently acting buyers + sellers
  • Laissez-faire capitalism - Limited gov’t interference w/ economy
  • Characteristics
  • Private property - Private individuals + firms own most property resources; encourages investment, innovation, economic growth
  • Freedom of enterprise - Entrepreneurs + businesses can obtain resources to produce + sell goods
  • Freedom of choice - Owners can employ property/money as they see fit; consumers can buy goods and services that best satisfy their wants
  • Self-interest - Each economic unit tries to achieve its own particular goal, usually delivering something of value to others
  • Competition - Between economic units; based on freedom of choice in pursuit of monetary return; spreads economic power between businesses + households
  • Markets - Institution/mechanism that brings buyers + sellers into contact
  • Technology and capital goods
  • Specialization - Use of resources to produce a few goods instead of an entire range
  • Division of labor - Human specialization
  • Medium of exchange - Function of money; makes trade easier
  • Barter - Swapping goods and services for each other; requires coincidence of wants between buyers and sellers
  • Money - Convenient social invention to facilitate exchanges of goods and services
  • Active but limited government
• Five fundamental questions
  • What goods and services will be produced?
  • Only goods and services produced at continuing profit will be produced
  • Consumer sovereignty - Consumers spend income on goods they are willing + able to buy
  • “Dollar votes” - Consumers using dollars to show what goods + services they want in the market; determine which industries survive and fail
  • How will the goods and services be produced?
  • Least-cost production - Most economically efficient techniques of production
  • Who will get the goods and services?
  • Products distributed to consumers based on who is willing and able to pay
  • Depends on income, prices, and preferences
  • How will the system accommodate change?
  • Changes as consumer preferences, production techniques, and resource supplies change
  • Directs expansion/contraction of industries
  • How will the system promote progress?
  • Technological advance
  • Creative destruction - Creation of new products + production methods destroys market positions of firms relying on existing products and older business ways
  • Capital accumulation (dollar votes for capital goods)
• “Invisible hand” - As firms seek to further their own self-interest in a market system, they simultaneously promote social interests
  • Efficiency - Efficient use of resources by guiding them to production of wanted goods + services
  • Incentives - Skill acquisition, hard work, innovation
  • Freedom - Economic activity without coercion
• Problems with command systems
  • Coordination problem
  • Central planners coordinating millions of individual decisions
  • Failure of single industry → Affected several other industries
  • Planning techniques ineffective for large economies
  • Incentive problem
  • Persistent shortages + surpluses
  • No incentive to adjust production to fluctuations
• Circular flow diagram - Shows repetitive flows of goods, services, resources, and money through the economy
  • Resource market - Where resources by households sold to businesses
  • Product market - Where goods and services produced by businesses sold to households

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