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