Transcript Chapter 2: The Market System - UCSB's Department of Economics

Chapter 2: The Market System
and the Circular Flow
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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.
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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.
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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
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Characteristics of Market System
• Self-Interest: maximize utility or profits
– Each economic actor tries to make themselves as
well-off as possible given constraints.
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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)
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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
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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
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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”)
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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.
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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)
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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.
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