Chapter 2. The Market System and the Circular Flow

Chapter 2The Market System and the Circular FlowCopyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.Economic SystemsEconomic systemsSet of institutionalized arrangementsCoordinating mechanismDifferences in systems exist byDegree of decentralized use of markets and prices in decision-makingDegree of centralized government controlLO1Laissez-Faire CapitalismIdeal economy“Keep the government from interfering with the economy”Power of government just needed to Protect private property from theftProvide a legal environment for contract enforcementPeople interact in markets to buy and sellLO1The Command SystemThe command system is known as socialism or communismGovernment ownership of resourcesDecisions made by a central planning boardNorth Korea, Cuba, MyanmarLO1The Market SystemThe market system is a mix of decentralized decision making with some government controlSystems found in much of the worldPrivate markets are dominant forcePrivate ownership of resourcesSelf-interested behaviorLO1Technology and Capital GoodsAdvanced technology and capital goods are encouragedSpecializationDivision of laborGeographic specializationLO2Use of MoneyMoney makes trade easierMedium of exchangeWithout money, people would have to barterLO2Active, but Limited GovernmentGovernment may be needed to alleviate market failuresGovernment can increase effectiveness of a market systemPossible government failureLO2The Five Fundamental QuestionsWhat 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 accommodate change?How will the system promote progress?LO3What Will Be Produced?Goods and services that create a profitConsumer sovereignty“Dollar votes”Method for consumers to determine which goods will be producedDetermines which products and industries survive or failLO3How Will the Goods Be Produced?Minimize the cost per unit by using the most efficient techniquesTechnologyPrices of the necessary resourcesLO3Who Will Get the Output?Consumers with the ability and willingness to pay will get the productAbility to pay depends on incomeLO3How Will the System Change?Changes in consumer tastesChanges in technologyChanges in resource pricesLO4How Will the System Progress?Technological advanceCreative destructionCapital accumulationLO4The Invisible HandThe “invisible hand”1776 Wealth of Nations by Adam SmithUnity of private and social interestVirtues of the market systemEfficiencyIncentivesFreedomLO4The Demise of Command SystemsCommand system was a failureSoviet Union, Eastern Europe, and ChinaThe coordination problemSet output targets for all goodsThe incentive problemNo adjustments for surplus or shortageLO4The Circular Flow ModelThe circular flow diagramHouseholdsBusinessesSole proprietorshipPartnershipCorporationProduct market and the resource marketThe real flow and the money flowLO5How the System Deals with RiskBusiness owners and investors face riskLosses due to input shortagesChanges in consumer tastesNatural disasters that affect the supply chainEmployees and suppliers have securityPaid whether the firm makes a profit or notLO6How the System Deals with RiskBusiness risks are restricted to ownersAttracts needed inputsInputs easier to obtain since many dislike riskFocuses attentionOwners personally responsible for outcomeWill encourage prudent decisionsManage risk well and the owners will prosperLO6