1. Slides prepared by Dr. Amy Peng, Ryerson University Part One: An Introduction to Economics and the Economy CHAPTER 2 THE MARKET SYSTEM AND THE CIRCULAR FLOW

2. ©2007 McGraw-Hill Ryerson Ltd.Chapter 22 In this chapter you will learn: 2.1The difference between a command system and a market system 2.2 The main characteristics of the market system 2.3 The Five Fundamental Questions any economy faces 2.4 About the demise of the command economy 2.5 About market failure and how government can rectify it 2.6 The mechanics of the circular flow model

3. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.13 Economic Systems Economic System: A particular set of institutional arrangements and a coordinating mechanism –The command system –The market system

4. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.24 Private Property Freedom of Enterprise and Choice –Freedom of enterprise: –Freedom of enterprise: businesses can buy and sell as they choose –Freedom of choice: owners can use or sell property as they choose workers can work where they like consumers can buy what they want Characteristics of the Market System

5. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.25 Private Property Freedom of Enterprise and Choice Self-Interest –businesses seek profits –consumers seek value Characteristics of the Market System

6. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.26 Private Property Freedom of Enterprise and Choice Self-Interest Competition –independently acting sellers and buyers –easy entry and exit of markets Markets and Prices –prices signal scarcity and guide resource allocation Characteristics of the Market System

7. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.27 Other Characteristics: Technology and Capital Goods Specialization –Division of Labour – ability differences – learning by doing – saving time switching tasks –Geographic Specialization Characteristics of the Market System

8. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.28 Other Characteristics: Technology and Capital Goods Specialization Use of money –Medium of exchange Active, but Limited, Government Characteristics of the Market System

9. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.39 Five Fundamental Questions 1.What will be produced? those goods and services that can be produced at a profit what consumers vote for with their dollars market restraints on freedom Consumer Sovereignty

10. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.310 Five Fundamental Questions 1.What will be produced? 2.How will the goods and services be produced? with the most efficient, least-costly methods

11. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.311 Five Fundamental Questions 1.What will be produced? 2.How will the goods and services be produced? 3.Who will get the goods and services? those with the greatest willingness and ability to pay

12. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.312 Five Fundamental Questions 1.What will be produced? 2.How will the goods and services be produced? 3.Who will get the goods and services? 4.How will the system accommodate change? by responding to price and profit signals –guiding function of prices –role in promoting progress –technological advance –creative destruction –capital accumulation –guiding function of prices –role in promoting progress –technological advance –creative destruction –capital accumulation

13. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.313 Five Fundamental Questions 1.What will be produced? 2.How will the goods and services be produced? 3.Who will get the goods and services? 4.How will the system accommodate change? 5.How will the system promote progress? technological advance capital accumulation

14. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.314 The “Invisible Hand” Prices communicate information about scarcity and value Competition forces producers and resource suppliers to respond Firms, acting in their own best interest, also promote society’s interests in terms of efficiency

15. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.315 Three special merits of the market system: Efficiency Incentives Freedom The “Invisible Hand”

16. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.416 The Demise of the Command System The Coordination Problem The Incentive Problem

17. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.517 Market Failure Spillovers or Externalities spillover costs –correction through Legislation Specific Taxes

18. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.518 Market Failure Spillovers or Externalities spillover benefits –correction through Subsidization of consumers/suppliers Provision of goods via government

19. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.519 Market Failure Public Goods and Services non-rivalry non-excludability free-rider problem Examples Airport security

20. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.520 Market Failure Limitations of the Market System market system has remarkable virtues it also has well-known limitations

21. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.521 FACTORMARKET FACTORS OF PRODUCTION INPUTS BUSINESSES HOUSEHOLDS Figure 2-2 The Circular Flow Diagram $ COSTS $ INCOMES

22. ©2007 McGraw-Hill Ryerson Ltd.Chapter 2.522 GOODS & SERVICES SERVICES $ CONSUMPTION $ REVENUE BUSINESSES HOUSEHOLDS FACTORMARKET PRODUCTMARKET INPUTS $ COSTS $ INCOMES FACTORS OF PRODUCTION Figure 2-2 The Circular Flow Diagram

23. ©2007 McGraw-Hill Ryerson Ltd.Chapter 223 Chapter Summary 2.1The Difference Between a Command System and a Market System 2.2The Main Characteristics of the Market System 2.3The Five Fundamental Questions Any Economy Faces 2.4The Demise of the Command Economy 2.5Market Failure 2.6The Mechanism of the Circular Flow Model