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.
LO1 2-2
 Global Perspective

Index of Economic
Freedom,
Selected Nations

LO2 2-3
 Technology and Capital Goods

• Advanced technology and capital

goods are encouraged
• Specialization
• Division of labor
• Geographic specialization

LO2 2-4
 Active, but Limited Government
• Government may be needed to
alleviate market failures
• Government can increase
effectiveness of a market system

LO2 2-5
 The Five Fundamental Questions
• What 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?
LO3 2-6
 What Will Be Produced?

• Goods and services that create a

profit
• “Dollar Votes”
• Method for consumers to determine
which goods will be produced
• Determines which products and
industries survive or fail

LO3 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

LO3 2-8
 Who Will Get the Output?

• Consumers with the ability and

willingness to pay will get the product
• Ability to pay depends on income

LO3 2-9
 How Will the System Change?

• Changes in consumer tastes

• Changes in technology
• Changes in resource prices

LO4 2-10
 How Will the System Promote Progress?

• Technological advance
• Creative destruction
• Capital accumulation

LO4 2-11
 The “Invisible Hand”

• 1776 Wealth of Nations by Adam

Smith
• Unity of private and social interest
• Virtues of the market system
• Efficiency
• Incentives
• Freedom

LO4 2-12
 Demise of Command Systems

• Soviet Union, Eastern Europe, and

China
• System was a failure
• The coordination problem
• Set output targets for all goods
• The incentive problem
• No adjustments for surplus or
shortage
LO4 2-13
 The Circular Flow System

RESOURCE
MARKET
•Households sell
•Businesses buy

BUSINESSES HOUSEHOLDS
• buy resources • sell resources
• sell products • buy products

PRODUCT
MARKET
•Businesses sell
•Households buy

LO5 2-14
 Businesses

• Three main categories of businesses

• Sole proprietorship
• Partnership
• Corporation

LO5 2-15