McGraw-Hill/Irwin Chapter 2: The Market System and the Circular Flow Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

Economic System  Societies develop economic systems to solve their economic problem.  There are two general types of economic systems  Command system  Market system LO: 2-1 Economic system is a particular set of institutional arrangements and a coordinating mechanism for producing goods and services. 2-2

The Command System  Economic systems differ in two main aspects:  Who owns the factors of production  The method used to motivate, direct, coordinate economic activity  In a command system (a.k.a. socialism or communism):  Government owns most factors of production  Economic decisions are made by a central governing body LO:

The Market System  In a market system (a.k.a. capitalism):  Factors of production are privately owned;  Markets and prices are used to direct and coordinate economic activities.  Participants act in their own self-interest, resulting in competition among independent buyers and sellers of each product and resource. In the capitalism practiced in the United States and most other countries, government plays a substantial role in the economy, but it is not the dominant economic force. LO:

Key Features of the Market System Private property LO: 2-2 Freedom of enterprise and choice Self-interest Competition Markets and prices Technology and capital goods Specialization Use of money Active but limited government 2-5

Key Features of the Market System  Private Property is the right of persons and firms to obtain, own, control, employ, dispose of, and bequeath land, capital, and other property.  Freedom of enterprise is the freedom of firms to obtain economic resources, to use those resources to produce products of the firms’ own choosing, and to sell their products in markets of their choice.  Freedom of choice is the freedom of owners of resources to employ or dispose of them as they see fit, and the freedom of consumers to spend their incomes in a manner they think is appropriate. LO:

Key Features of the Market System  Self-interest is the most advantageous outcome as viewed by each firm, property owner, worker, or consumer.  Competition is the presence in a market or independent buyers and sellers vying with one another, and the freedom of buyers and sellers to have a market.  A market is an institution or mechanism that brings buyers and sellers together.  Technology and capital goods promote efficiency and the ability to produce more goods and services. LO:

Key Features of the Market System  Specialization is the use of resources of an individual, region, or nation to produce one or a few goods and services rather than the entire range of products.  The use of money where money is any item that is generally acceptable to sellers in exchange for goods and services.  Active, but Limited, Government where government can sometimes increase the overall effectiveness of the economic system. LO:

Four Fundamental Questions  The key features of the market system allow market economies to answer four fundamental questions:  What goods and services will be produced?  How will the goods and services be produced?  Who will get the goods and services?  How will the system promote progress? LO:

What Will be Produced?  The goods and services produced at a continuing profit will be produced. Those producing at a continuing loss will not.  In a market system, consumers are sovereign (in command) – they “vote” with their dollars. LO: 2-3 Consumer sovereignty is the determination by consumers of the types and quantities of goods and services that will be produced with the economy’s scarce resources. 2-10

How Will Goods and Services Be Produced?  The combination of resources and technologies that minimizes the cost per unit of output will be used to produce goods and services.  In a competitive market economy, high-cost producers lose business to low-cost producers of equal-quality products. LO:

Who Will Get the Output?  Distribution of goods and services is determined by:  Prices of these goods and services  Consumers’ preferences for these goods and services  Consumers’ ability and willingness to pay for these good and services. This in turn depends on income which is determined by:  Quantity of property and human resources that they supply  Prices that those resources command on the resource market LO:

How Will the System Promote Progress?  Technological advance is encouraged by the market system  Market rewards invention of new products  New production technologies may help lower cost of production  Capital accumulation  Entrepreneurs and business owners “vote” with their dollars for capital goods.  By paying interest or selling shares firms attract households’ income to pay for capital goods. LO: 2-3,

The Circular Flow Model LO:

The Circular Flow Model  Resource Market  Households sell resources  Firms buy resources  Product Market  Households buy products  Firms sell products  Real flow of resources and products corresponds to the money flow in the opposite direction. LO: