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Unit 1

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Unit 1

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  1. Unit 1 Chapter 2

  2. 2 The Market System and the Circular Flow

  3. Chapter Objectives • Command Systems vs. Market Systems • Characteristics of a Market System • How Markets Determine What to Produce, How to Produce, and Who Receives the Output • How Market System Adjusts to Change and Promotes Progress • The Mechanics of the Circular Flow Model

  4. Economic Systems • Set of instructional arrangements and a coordinating mechanism to respond to the economizing problem • The set of arrangements that a society uses to allocate scarce goods • How they differ: • 1. who owns FOPs • 2. method used to direct economic activity • * Two extremes: market system and command system

  5. Command System • Aka socialism or communism • Gov. owns majority of resources and decision making occurs through a central economic plan (bureaucracy) • Gov makes all major economic decisions • Possible advantages and disadvantages?

  6. Market System • Aka capitalism • Private ownership of FOPs and prices are used to direct economic activity • Activity is coordinated through markets – places where buyers and sellers come together • Market forces determine answers to fundamental economic questions • Laissez –faire – “ let it be”- pure capitalism • Most economies are mixed

  7. GLOBAL PERSPECTIVE The Market System Characteristics • Private Property • Freedom of Enterprise • Freedom of Choice Free Mostly Free Mostly Unfree Repressed 1- Hong Kong 3- Ireland 9- United States 22- Belgium 33- Spain 44- France 81- Brazil 111- China 122- Russia 150- Cuba 152- Venezuela 157- North Korea Source: Heritage Foundation ( and The Wall Street Journal

  8. The Market System Characteristics • Geographic Specialization • Use of Money • Medium of Exchange • Barter • Active but Limited Government

  9. Characteristics of Market System • 1. Private property – capital and land owned privately, also freedom to negotiate binding legal contracts • Property rights encourage investment, innovation, and facilitate change • 2. Freedom of enterprise and choice • Freedom of enterprise allows individuals and firms to produce; freedom of choice allows buyers and sellers to make choices regarding production and consumption

  10. Characteristics of the Market System • 3. Self-Interest –each economic unit attempts to achieve its goals, at the same time delivering something of value to others • 4. Competition – among economic units • -requires two or more sellers independently competing in the marketplace, freedom of sellers and buyers to enter and exit marketplace • -regulatory force in the market system –How?

  11. Characteristics of the Market System • 5. Markets and prices – market system conveys decisions made by buyers and sellers of products and resources • Market system itself is the coordinating and organizing mechanism • Allows for communication b/w buyers and sellers

  12. Characteristics of the Market System • 6. Technology and capital goods – market system encourages use and rapid dev. of complex capital goods • Allow for greater efficiency = more output • 7. Specialization – individual, firm, region, or nation produces one or a few g/s rather than entire range, trade occurs • Also allows for greater efficiency

  13. Characteristics of a Market System • Division of labor – human specialization • Makes use of differences in ability, fosters learning by doing, saves time • Geographic specialization – regional and international basis • Ex. Oranges grown in Florida, US produces commercial aircraft, Honduras produces bananas

  14. Characteristics of the Market System • 8. Use of money – money is a medium of exchange that facilitates trade • Barter exchange (trading goods) is problematic b/c it requires coincidence of wants between buyer and seller • Money must be acceptable to sellers in an exchange; it is socially defined; global currency differences can lead to trade complications

  15. Characteristics of the Market System • 9. Active, but limited, gov. – gov has ltd role, but addresses market failures in order to increase effectiveness of market system

  16. Five Fundamental Questions • Must be addressed by all economic systems • 1. What to produce? • 2. How to produce? • 3. For whom to produce? • 4. How to accommodate change? • 5. How to promote progress?

  17. Five Fundamental Questions • 1. What to produce? • g/s that are profitable will be produced, g/s that are produced at a continuing loss will not • Profit = TR(total revenue)-TC(total cost) • Consumer sovereignty – in a market system, consumers have control over what will be produced • Consumers “vote with their dollars” • See Consider This on page 34…

  18. Five Fundamental Questions • 2. How will the g and s be produced? • In combinations and ways that minimize the cost per unit of output • Depends on the available technology and prices of FOPs • 3. Who will get the output? • Based on ability and willingness to pay its existing market price

  19. Five Fundamental Questions • 4. How will the system accommodate change? • Economy responds to changes in consumer tastes • Changes in prices and profits communicate changes in consumer tastes • 5. How will the system promote progress? • Technological advance – rapid change is promoted, can lead to creative destruction • Capital accumulation – through additional dollar votes for capital goods

  20. The “Invisible Hand” The Market System • 1776 Wealth of Nations by Adam Smith • Efficiency • Incentives • Freedom

  21. The Market System Demise of Command Systems • Two Insurmountable Problems • The Coordination Problem- planning and coordinating became more difficult as economies expanded, products and production processes became more sophisticated • The Incentive Problem – there was no incentive to adjust production in response to shortages and surpluses, no rewards for innovation or enterprise USSR East Germany Yugoslavia

  22. The Circular Flow Model • Circular Flow Model : illustrates how all interactions occur in a market economy (shows the repetitive flows of goods, services, resources, and money) • Shows circular flow b/w product markets (businesses and suppliers) –where G&S are bought and sold; lower half of diagram, and resource markets (market for FOP’s)- where businesses are customers and individuals are producers; represented by upper half of diagram • See Figure 2.2 and Quick Quiz 2.2 on page 39

  23. O 2.4 Circular Flow Resource Market Businesses Households Product Market

  24. O 2.4 Circular Flow Both Flows Are Equal Resource Market Money Income Costs Input Factors Resources Businesses Households Goods & Services Goods & Services Product Market Consumption Revenue

  25. Shuffling the Deck Last Word Markets Systematically and Purposefully Rearrange the World’s Resources • Extreme Number of Playing Card Combinations • Tens of Billions of Worldwide Resources • Many Combinations Useless • Private Property Facilitates Best Choice Selections – Mutual Accommodations • Result is a Complex and Productive Arrangement of Resources • Many Small Decisions that Others Find Helpful