Lecture Essentials of economics (3/e): Chapter 2 - Brue, McConnell, Flynn

Chapter 2

The Market System
and the Circular
Flow

McGraw­Hill/Irwin

Copyright © 2014 by The McGraw­Hill Companies, Inc. All rights reserved.
1­1


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

2­2


The Command System

• Known as socialism or communism
• Government ownership

• Decisions made by a central planning
•

LO1

board
North Korea and Cuba are last
remaining examples of largely
centrally planned economies
2­3


Global Snapshot
The Two Koreas
North Korea

LO1

South Korea

GDP

$40 billion

$1.3 trillion

GDP per Capita

$1800

$27,700

Exports

$2.0 billion

$355 billion

Imports

$3.5 billion

$313 billion

Agriculture as %
of GDP

23 percent

3 percent

2­4


The Market System

• Known as capitalism
• Private ownership of resources
• Decisions based on markets

LO1

2­5


Characteristics of the Market System

• Private property
• Freedom of enterprise and choice
• Self-interest
• Competition
• Markets and prices

LO2

2­6


The Market System

LO2

2­7


Technology and Capital Goods

• Advanced technology and capital
•

LO2

goods are encouraged
Specialization
• Division of labor
• Geographic specialization

2­8


Use of Money

• Makes trade easier

LO2

2­9


Active, but Limited Government

• Government may be needed to
•

LO2

alleviate market failures
Government can increase
effectiveness of a market system

2­10


The Four Fundamental Questions

• What goods and services will be
•
•
•
LO3

produced?
How will the goods and services be
produced?
Who will get the goods and services?
How will the system promote
progress?
2­11


What Will Be Produced?

• Goods and services that create a
•

LO3

profit
“Dollar votes”
• Method for consumers to determine

which goods will be produced
• Determines which products and
industries survive or fail
2­12


How Will the Goods Be Produced?

• Minimize the cost per unit by using
the most efficient techniques
• Technology
• Prices of the necessary resources

LO3

2­13


Who Will Get the Output?

• Consumers with the ability and
•

LO3

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

2­14

How Will the System Promote 
Progress?

• Technological advance
• Creative destruction
• Capital accumulation

LO4

2­15


Invisible Hand

• 1776 Wealth of Nations by Adam
•

LO4

Smith
• Unity of private and social interest
Virtues of the market system
• Efficiency
• Incentives
• Freedom
2­16


Demise of Command Systems

• Soviet Union, Eastern Europe, and
•
•
•
LO4

China
System was a failure
The coordination problem
• Set output targets for all goods
The incentive problem
• No adjustments for surplus or
shortage

2­17


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

2­18


Businesses

• Three main categories of businesses:
• Sole proprietorship
• Partnership
• Corporation

LO5

2­19


Businesses
Partnerships
(10%)

Corporations
(18%)

Sole Proprietorships
(72%)

LO5

Corporations
(82%)

2­20


The World’s 10 Largest Corporations

LO5

2­21


U.S. Households
Percentage of
Earned Income

LO5

Percentage of Consumer
Expenditures

2­22