Chapter 2: The Market System and the Circular Flow ECO 2111 Graphs and Tables Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Economic System An economic system is an institution that responds to society’s economic problems. Economic systems differ in two aspects: – Who owns the factors of production. – The method used to motivate, coordinate, and direct economic activity. ECO 2112

Command vs. Market The Command System (communism): the government owns most property resources, and economic decision-making is according to a central plan. The Market System (capitalism): resources are privately owned, and markets determine which goods are produced. ECO 2113

Characteristics of Market System → Two main themes: Incentives and Coordination Private Property (land, capital, intellectual) → Owner is able to capture benefits, and parties cooperate to find mutually agreeable outcomes. Freedom of Enterprise and Choice ECO 2114

Characteristics of Market System Self-Interest: maximize utility or profits – Each economic actor tries to make themselves as well-off as possible given constraints. ECO 2115

Characteristics of Market System Competition: no single buyer or seller can set the price - no market power. – Free entry and exit (no barriers) – many buyers and sellers in a market acting independently Prices: main coordinating tool of market – Determined by the interaction of buyers and sellers - a market (demand and supply) ECO 2116

Characteristics of Market System Technology and Capital Goods Specialization of Production: producing a few goods efficiently and trading for what else is needed rather than producing everything - “comparative advantage” – Division of Labor (human specialization) – Geographic Specialization and Trade ECO 2117

Characteristics of Market System Money: a generally acceptable medium of exchange between buyers and sellers - Chapter 31 Active, but Limited Government: fix “market failures” - Chapter 5 – Monopoly, price-fixing cartels, pollution, underprovided goods ECO 2118

Five Fundamental Questions Five Fundamental Questions - How Does the Market Respond? 1.What will be produced? – Goods that consumers actually buy → consumer sovereignty (“dollar votes”) ECO 2119

Five Fundamental Questions 2. How will the goods be produced? – In the most efficient way! i.e. by minimizing costs 3. Who will get the output? – Consumers who are willing and able to pay for it. ECO 21110

Five Fundamental Questions 4. How will the system accommodate change? – Prices and profits! (self-interest & consumer sovereignty) 5. How will the system promote progress? – Competition among firms (to lower costs or improve products) leads to technological advances and capital accumulation. – Creative Destruction: new products completely destroy old products (and firms and markets) ECO 21111

Adam Smith - “Wealth of Nations” (1776) Market prices act as an “invisible hand,” coordinating an economy by rationing scarce resources, and providing incentives to produce the most desired goods and services. Efficiency and Incentives Markets aren’t perfect. ECO 21112

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