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2
C HAPTE R
The Market
System and
the Circular
Flow
SCARCE RESOURCES
ECONOMIC RESOURCES
PROPERTY RESOURCES
1. LAND
2. CAPITAL
HUMAN RESOURCES
3. LABOR
4. ENTREPRENEURIAL ABILITY
Resource payments: correspond to resource
categories
PROPERTY RESOURCES
RENTAL
LAND
INCOME
INTEREST
CAPITAL
INCOME
HUMAN RESOURCES
LABOR
ENTREPRENEUR
WAGES
PROFIT &
LOSS
Macroeconomics Starts Here
Economic Systems
• Definition: A particular set of institutional
arrangements and a coordinating mechanism to
respond to the economizing problem.
• Economic systems differ as to:
1) who owns the factors of production
2) the method used to motivate, coordinate, and
direct economic activity.
The Command System
• The government owns most property resources
and economic decision making occur through a
central economic plan.
• The central planning board determines
production goals for each firm and resources to
be allocated.
The Market System
• There is private ownership of resources.
• Markets and prices coordinate and direct
economic activity.
• Each participant acts in its own self-interest.
• In pure capitalism the government plays a very
limited role.
Characteristics of the Market System
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Private Property.
Freedom of firms to choose.
Self interest.
Competition.
Markets and prices.
Technology and capital goods.
Specialization.
Use of money.
Active, but limited government.
The Circular Flow Model
• There are two groups of decision makers in
the private economy: households (resource
owners) and businesses (resource users)
• The market system (resource markets and
product markets) coordinates these decisions.
What happens in the resource markets?
a. Households sell resources directly or indirectly
(through ownership of corporations) to businesses.
b. Businesses buy resources in order to produce
goods and services.
c. Interaction of these sellers and buyers
determines the price of each resource, which in
turn provides income for the owner of that
resource.
d. Flow of payments from businesses for the
resources constitutes business costs and resource
owners’ incomes.
What happens in the product markets?
a. Households are on the buying side of these
markets, purchasing goods and services.
b. Businesses are on the selling side of these markets,
offering products for sale.
c. Interaction of these buyers and sellers determines
the price of each product.
d. Flow of consumer expenditures constitutes sales
receipts for businesses.
CIRCULAR FLOW MODEL
RESOURCE
MARKET
BUSINESSES
HOUSEHOLDS
PRODUCT
MARKET
CIRCULAR FLOW MODEL
RESOURCE
MARKET
RESOURCES
INPUTS
BUSINESSES
HOUSEHOLDS
PRODUCT
MARKET
CIRCULAR FLOW MODEL
$ COSTS
$ INCOMES
RESOURCE
MARKET
RESOURCES
INPUTS
BUSINESSES
HOUSEHOLDS
GOODS &
SERVICES
GOODS &
SERVICES
PRODUCT
MARKET
CIRCULAR FLOW MODEL
$ COSTS
$ INCOMES
RESOURCE
MARKET
RESOURCES
INPUTS
BUSINESSES
HOUSEHOLDS
GOODS &
SERVICES
GOODS &
SERVICES
PRODUCT
MARKET
CIRCULAR FLOW MODEL
$ COSTS
$ INCOMES
RESOURCE
MARKET
RESOURCES
INPUTS
BUSINESSES
HOUSEHOLDS
GOODS &
SERVICES
GOODS &
SERVICES
PRODUCT
MARKET
$ REVENUE
$ CONSUMPTION
CIRCULAR FLOW MODEL
$ COSTS
$ INCOMES
RESOURCE
MARKET
RESOURCES
INPUTS
BUSINESSES
HOUSEHOLDS
GOODS &
SERVICES
GOODS &
SERVICES
PRODUCT
MARKET
$ REVENUE
$ CONSUMPTION
More Realistic Circular Flow
Macroeconomic Policies
Limitations of the model:
1. Does not depict transactions between
households and between businesses (interbusinesses).
2. Ignores government and the “rest of the
world” in the decision-making process (we
will take care of them later on).
3. Does not explain how prices of products and
resources are actually determined.