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