Transcript The Market System and the Circular Flow

02
The Market System and the Circular Flow
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Economic Systems
• Set of institutional arrangements
• Coordinating mechanism
• Differences in systems exist by:
• Who owns the factors of production
• What method is used to motivate,
coordinate, and direct economic activity
LO1
2-2
Systems of resource allocation
Economists identify three basic types of
economic organization—i.e., systems for
determining what gets produced, how it gets
produced, and who gets what:
1. Traditional economy
2. Command or centrally planned economy
3. Market economy
Traditional Economy
1. Resources are allocated according to longestablished practices.
2. Methods of production tend to be
unchanging.
3. Goods and services are distributed based on
community views about fairness and justice.
Command or central planning
•The planning authorities decide what gets
produced--resources are allocated according to
planning documents issued by central planning
authorities.
•The “visible hand” of the planners overrides the
“invisible hand” of the market.
•Gosplan of the old U.S.S.R. is the classic example
of a central planning agency.
The Market System
•Resources are allocated though individual decision
making.
•The market system relies on the choices made by
individuals (buyers and sellers) to allocate resources in a
socially optimal way.
•The economy is an agglomeration of markets, defined
as “groups of buyers and sellers with the potential to
trade with each other.”
•Income distribution is mainly determined by the
market value of resources owned (including labor).
The Market System
• Known as capitalism
• Well-defined and protected property
•
LO1
rights—including rights to
“intellectual” property.
Decisions based on markets
• Australia, Switzerland, and the U.K.
2-7
Characteristics of the Market System
• Private property
• Freedom of enterprise and choice
• Self-Interest
• Competition
• Markets and prices
LO2
2-8
Global Perspective
LO2
2-9
Technology and Capital Goods
• Advanced technology and capital
•
LO2
goods are encouraged.
Specialization
• Division of labor
• Geographic specialization
2-10
Use of Money
• Makes trade easier
LO2
2-11
The Five Fundamental Questions
• What goods and services will be
•
•
•
•
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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?
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What Will Be Produced?
• Goods and services that create a
•
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profit
“Dollar Votes”
• Method for consumers to determine
which goods will be produced
• Determines which products and
industries survive or fail
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How Will the Goods Be Produced?
• Minimize the cost per unit by using
the most efficient techniques
• Technology
• Prices of the necessary resources
LO3
2-14
How Will the Goods Be Produced?
Three Techniques for Producing $15 Worth of Bar Soap
Units of Resource
Price per
unit of
Resource
Resource
Technique 1
Unit
s
$
Technique 2
Cost
Technique 3
Cost
Units
Units
8
2
$ 4
1
Cost
Labor
$2
4
Land
$1
1
1
3
3
4
4
Capital
$3
1
3
1
3
2
6
Entrepreneur
$3
1
3
1
3
1
3
$ 15
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$ 13
$
2
$ 15
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Who Will Get the Output?
• Consumers with the ability and
•
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willingness to pay will get the product
Ability to pay depends on income.
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How Will the System Change?
• Changes in consumer tastes
• Changes in technology
• Changes in resource prices
LO4
2-17
How Will the System Progress?
• Technological advance
• Creative destruction
• Capital accumulation
LO4
2-18
Invisible Hand
• 1776 Wealth of Nations by Adam
•
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Smith
• Unity of private and social interest
Virtues of the market system
• Efficiency
• Incentives
• Freedom
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Demise of Command Systems
• Soviet Union, Eastern Europe, and
•
•
•
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China
System was a failure
The coordination problem
• Set output targets for all goods
The incentive problem
• No adjustments for surplus or
shortage
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The Circular Flow System
RESOURCE
MARKET
•Households sell
•Businesses buy
BUSINESSES
• buy resources
• sell products
HOUSEHOLDS
• sell resources
• buy products
PRODUCT
MARKET
•Businesses sell
•Households buy
LO5
2-21
Businesses
• Three main categories of businesses:
• Sole Proprietorship
• Partnership
• Corporation
LO5
2-22