2. Copyright 2008 The McGraw-Hill Companies 2-1 2 The Market System and the Circular Flow

3. Copyright 2008 The McGraw-Hill Companies 2-2 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. Copyright 2008 The McGraw-Hill Companies 2-3 Economic Systems Economic Systems differ as to: –Who owns the factors of production –What method Used to motivate, coordinate, and direct economic activity –How will the basic economic questions of what gets produced, how, and who gets what answered? O 2.1

5. Copyright 2008 The McGraw-Hill Companies 2-4 Economic Systems Command System –Also known as Socialism or Communism –Property is government owned –A central planning board attempts to make most decisions: in reality, some markets are also used

6. Copyright 2008 The McGraw-Hill Companies 2-5 Economic Systems Market System –Also known as Capitalism –Resources are privately owned –Markets and prices coordinate economic activity –Pure Capitalism – Laissez-Faire, role of government would be very minimal –In reality, government does play a role

7. Copyright 2008 The McGraw-Hill Companies 2-6 The Market System Private Property Freedom of Enterprise Freedom of Choice Characteristics FreeMostly 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 (www.heritagefoundation.com) and The Wall Street Journal GLOBAL PERSPECTIVE

8. Copyright 2008 The McGraw-Hill Companies 2-7 The Market System Self-Interest motives Competition among buyers and sellers Markets and Prices coordinate activity Technology and Capital Goods encouraged due to efficiency Reliance on specialization and the division of labor Characteristics O 2.2O 2.3

9. Copyright 2008 The McGraw-Hill Companies 2-8 The Market System Specialization requires exchange Exchange is facilitated by the use of Money Finally government is Active but Limited Characteristics

10. Copyright 2008 The McGraw-Hill Companies 2-9 The Market System What Goods Will Be Produced? –Consumer Sovereignty –Dollar Votes How Will the Goods Be Produced? –Available Technology –Prices of Needed Resources Five Fundamental Questions W 2.1

11. Copyright 2008 The McGraw-Hill Companies 2-10 The Market System Who Will Get the Output? How Will the System Accommodate Change? How Will the System Promote Progress? –Technological Advance –Creative Destruction –Capital Accumulation Five Fundamental Questions

12. Copyright 2008 The McGraw-Hill Companies 2-11 The Market System 1776 Wealth of Nations by Adam Smith: the market system encourages –Efficiency –Incentives –Freedom The “Invisible Hand”

13. Copyright 2008 The McGraw-Hill Companies 2-12 The Market System Two Insurmountable Problems –The Coordination Problem –The Incentive Problem Demise of Command Systems USSR Yugoslavia East Germany

14. Copyright 2008 The McGraw-Hill Companies 2-13 Circular Flow Resource Market Product Market BusinessesHouseholds O 2.4

15. Copyright 2008 The McGraw-Hill Companies 2-14 Circular Flow Resource Market Product Market BusinessesHouseholds O 2.4

16. Copyright 2008 The McGraw-Hill Companies 2-15 Circular Flow Resource Market Product Market BusinessesHouseholds Both Flows Are Equal O 2.4

17. Copyright 2008 The McGraw-Hill Companies 2-16 Shuffling the Deck 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 The invisible hand at work Last Word Markets Systematically and Purposefully Rearrange the World’s Resources

18. Copyright 2008 The McGraw-Hill Companies 2-17 Key Terms economic system command system market system private property freedom of enterprise freedom of choice self-interest competition market specialization division of labor medium of exchange barter money consumer sovereignty dollar votes creative destruction “invisible hand” circular flow diagram resource market product market

19. Copyright 2008 The McGraw-Hill Companies 2-18 Next Chapter Preview… Demand, Supply, and the Market Equilibrium