02

The Market System and the Circular Flow

McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

The Market System

Known as capitalism
Characteristics of market systems:
Private property
Freedom of enterprise and choice
Self-Interest
Competition
Markets and prices

Australia, Switzerland, and the U.K.

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2-2

Global Perspective
Index of Economic
Freedom,
Selected Nations

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2-3

Technology and Capital Goods

Advanced technology and capital

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goods are encouraged

Specialization
Division of labor
Geographic specialization

2-4

Active, but Limited Government

Government may be needed to

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alleviate market failures

Government can increase
effectiveness of a market system

2-5

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

2-7

How Will the Goods Be Produced?

Minimize the cost per unit by using

the most efficient techniques
Technology
Prices of the necessary resources

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2-8

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

2-9

How Will the System Change?

Changes in consumer tastes

Changes in technology
Changes in resource prices

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2-10

How Will the System Promote Progress?

Technological advance
Creative destruction
Capital accumulation

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2-11

The 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

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2-14

Businesses

Three main categories of businesses

Sole proprietorship
Partnership
Corporation

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2-15