Download The Market System and the Circular Flow

02
The Market System and the Circular Flow
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Objectives - Chapter 2
•
Understand differences between command system and
market system
•
The main characteristics of the market system
•
How the market system makes decisions regarding
production, how to produce it and who obtains it.
•
How the market system adjusts to change and promotes
progress.
•
The mechanics of the circular flow model
Economic Systems
•
•
•
Set of institutional arrangements
Coordinating mechanism
– designed to respond to the economizing
problem
Differences in systems that exist:
• Who owns the factors of production
• What method is used to motivate, coordinate,
and direct economic activity
•
LO1
System has to determine: what goods to produce, how to
produce, who gets what, how to accommodate for change,
how to promote tech. progress
2-2
The Command System
• Known as socialism or communism
– not the same, but have some common traits
• Government ownership
– Decisions made by a central planning board.
• use of resources, composition and distribution of output, organization of
production
• central planning board sets production goals, specifies what resources will
be allocated to accomplish goals
• division of output between consumer/capital goods made by central authority
– decisions made based on long term priorities
• Pure command would rely on central plan to allocate the government-owned
property resources
• China, elements of command still exist: one party system, gov. owns majority
of resources, but central planning has given way to free markets that
organize and coordinate its economy.
• North Korea & Cuba are the last prominent govt’s that are largely centrally
planned
• Libya, Myanmar, and Iran.
LO1
2-3
The Market System
•
•
•
Known as capitalism
Private ownership of resources
Decisions based on markets & prices to coordinate and direct economic activity.
– “invisible hand” Adam Smith
– individuals / business seek to achieve economic goals
• make their own decisions re: production, consumption, work
• system allows for private ownership of capital, communicates through prices, and
coordinates econ. activity through markets
• goods / services produced by whoever is willing to do so
• $ rewards incentivize innovation and entrepreneurship
• leads to new products and processes
• Pure Capitalism - laissez-faire : gov’t role limited to protecting private property
rights, establ. environment conducive to operate the market system
• In U.S. form of capitalism the government plays a substantial role in the economy
• provides rules, promotes econom. stability & growth, provides certain goods and
services (that would otherwise not be produced), modifies the distribution of
income (big point of argument) through incentives and taxation
• Is not the dominant economic force in decisions on what to produce, how to
produce, or who will get it the market decides.
2-4
Characteristics of the Market System
• Private property
– in market systems, private individuals and firms own
most of the property resources
– freedom to negotiate binding legal contracts, enables
individuals and businesses to obtain, use and dispose
of property resources as they see fit.
• private owners designate who will receive their
property when they die - helps sustain the
institution of priv. property
• encourages investment, innovation, exchange,
economic growth and maintenance of property
• extend to intellectual property (patents, copyrights,
trademarks)
LO2
2-5
Characteristics of the Market System
•
LO2
Private property continued...
– facilitate exchange
• titles or deeds
• encourage owners to maintain and improve
property to increase value
• enable people to use time and resource to produce
more goods and services rather than to protect and
retain the property they have already acquired
2-5
Characteristics of the Market System
• Freedom of enterprise and choice
– free to obtain and use resources to produce their
choice of goods/services and sell them
– enable owners to employ or dispose of their property
and money as they see fit.
• Allows individuals to designate who receives their property
when they die…… (discuss the estate tax)
– allows workers to pursue any type of
employment they want / qualified for
– consumers are free to buy the goods/services
that bring them the most utility
- must be mutually agreeable
– limit to freedoms of course.... must be legal
activities
LO2
2-5
Characteristics of the Market System
•
Self-Interest
–
Motivating force that means that each economic unit tries to achieve its
own particular goal
–
Motivation for self interest gives direction and consistency to what
otherwise may be a chaotic economy
•
LO2
Adam Smith “self-interest motivates more powerfully and consistently
than kindness, altruism, or martyrdom” “if all people seek to promote
their self-interest, the whole society prospers” “invisible hand”
– Fredrich Hayek, “Competition leads a self-interested person to
wake up in the morning, look outside at the earth and produce
from its raw materials, not what he wants, but what others want.
Not the quantities that he prefers, but in quantities they prefer.
Not at the price he dreams of charging, but at a price reflecting
how much his neighbors value what he has done”
2-5
Characteristics of the Market System
• Competition
– Requires
• Two or more buyers and two or more sellers acting
•
independently in a particular product or resource
market
Freedom of buyers and sellers to enter and exit the
market
– When there are many buyers and sellers in the market,
none can dictate the price alone
– Ability to enter or leave provides freedom for industry’s to
expand or contract
– Allows the economy to adjust to changes in consumer
taste, tech., and resource availability
– Limits abuse of power by diffusing it throughout society
LO2
2-5
Characteristics of the Market System
• Markets and prices
– Market is an institution or mechanism that
brings buyers and sellers into contact
– The decisions of businesses and households
are coordinated through markets and prices
– Society decides
• what the economy should produce,
• how production can be organized efficiently,
• and how the fruits of production are to be
distributed
LO2
2-5
Global Perspective
LO2
2-6
Technology and Capital Goods
•
Advanced technology and capital goods
are encouraged.
– Market system encourages extensive use and rapid
development of complex capital goods
– The more efficient production = more abundant output
• Tools,
• Machinery
• Large-scale factories,
• Facilities for storage,
– Communication
– Transportation
– Marketing
LO2
2-7
Technology and Capital Goods
• Specialization
• Use of resource of individual, firm, region, or
•
•
nation to produce one or a few goods or
services rather than the entire range of goods
and services.
Use trade to satisfy needs and wants or
desired products
Majority of consumer produce virtually none of
the goods and services they consume
• Self-sufficiency breeds inefficiency
LO2
2-7
Technology and Capital Goods
Division of labor
•Human specialization
• Makes use of differences in ability
• Saves time
– Avoids the need to switch tasks moving from
one task to another
• Fosters learning by doing
– Devoting time to a single task allows for skills to
develop that improve expertise and innovation
• Increases the total output society derives
from limited resources
LO2
2-7
Technology and Capital Goods
Geographic Specialization
•
•
regional and international focus on
different outputs
Nebraska – Wheat, Florida – Citrus,
United States – commercial aircraft, software, computers
Honduras – bananas, Thailand – Baskets
LO2
2-7
Technology and Capital Goods
Use of Money
• $ is a medium of exchange that makes
•
•
•
trade easier
Socially designed : if society accepts it as
money, then it is money
Money is a convenient social invention to
facilitate exchanges of goods and
services
Specialization requires exchange
–
LO2
Barter system: swapping goods…. Requires a
coincidence of wants
- If coincidence is missing than barter is inefficient
2-7
Use of Money
• Makes trade easier
LO2
2-8
Active, but Limited Government
• Government may be needed to
•
LO2
alleviate market failures
Government can increase
effectiveness of a market system
2-9
The Five 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 accommodate
change?
How will the system promote
progress?
2-10
What goods and services will be produced?
• Profitability requires businesses to
respond to consumers’ wants and
desires
• When firms are profiting output will increase, firms
•
that aren’t profitable reduce output or exit the
market
Consumer sovereignty : “Dollar Votes”
– Determines the types and quantities of the various
products that will be produced
– Determines which products and industries will continue to
exist and which ones will fail
» McHits and McMisses – McRib v. Shaker Salads
– Business must match production choices with consumer
choices or face losses
LO3
2-10
How Will the Goods Be Produced?
• Decisions based on minimizing the
cost per unit by using the most
efficient techniques
• Requires firm produce output at minimum cost
• Technology
• Prices of the necessary resources
•
When firms face competition, the market forces the producers to
use the most efficient production techniques (least –costproduction techniques),
– otherwise the firm will be driven out of business.
– The combination of technology and the prices of the required resources
determines the most efficient production technique.
LO3
2-12
How Will the Goods Be Produced?
• Decisions based on minimizing the
cost per unit by using the most
efficient techniques
• Locate production facilities optimally to hold down
•
production and transp.
Efficiency depends on:
– Utilize available technology, combinations of resources to
produce desired results
– Prices of available resources
– Requires obtaining a particular output of product with the
least input of resources
» Firms that choose higher-cost production techniques
will be forced out of business
LO3
2-12
How Will the Goods Be Produced?
Three Techniques for Producing $15 Worth of
Bar Soap
Units of Resource
Price per
unit of
Resource
Resource
Technique 1
Units
$
Cost
Technique 3
Cost
Units
Units
8
2
$ 4
1
Cost
Labor
$2
4
Land
$1
1
1
3
3
4
4
Capital
$3
1
3
1
3
2
6
Entrepreneur
$3
1
3
1
3
1
3
$ 15
LO3
Technique 2
$ 13
$
2
$ 15
2-13
Who Will Get the Output?
• Consumers with the ability and
•
LO3
willingness to pay will get the product
Ability to pay depends on income.
• quantity of the property and
human resources they supply
(resource prices = wages,
interest, rent, profit)
• and the prices those resources
command in the resource market
2-14
How Will the System Change?
•
Markets are dynamic and change with
– Changes in consumer tastes
– Changes in technology
– Changes in resource prices
–
representative of consumer sovereignty : as tastes change,
sales of one item goes up while others go down.
• signal to producers to shift resources to accommodate
demand
• Increase in demand leads to higher prices – induce greater
quantities of output from suppliers and vice/versa
• Higher prices leads to more profits and new firms entering the
market – opposite is true of lower prices
– Price serves as the guiding function of market systems. Provide signals
to people and firms on where to direct their resources.
LO4
2-15
How Will the System Progress?
• Technological advance
• Reduce production costs, and thus product price,
will spread throughout the industry due to
competition
• Creative destruction
• New products and production methods destroy the
market positions of firms that are unable to adjust
• Capital accumulation
• Entrepreneurs cast “dollar votes” for capital,
drawing resources to the production of capital
goods
LO4
2-16
Invisible Hand
• 1776 Wealth of Nations by Adam Smith “Invisible Hand”
• Unity of private and social interest
• Firms will produce the goods and services most
wanted by society
• Virtues of the market system
• Efficiency – in resource allocation
• Incentives – people have a vested interest to
•
LO4
acquire skills and be productive
Freedom – people are free to make economic
decisions
2-17
Demise of Command Systems
• Soviet Union, Eastern Europe, and
•
China – all gave way to market agency
System was a failure
– Reasons ???
• The coordination problem: difficult (impossible) to
•
adequately predict future demand and coordinate the
allocation of resources
w/o market signals (prices) difficult to measure success
• The incentive problem
•
LO4
Little incentive to innovate, contain costs, improve the
quantity and quality
2-18
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
2-19
The Circular Flow System
• Households – one or more persons occupying a
housing unit.
• All resources (not incl. gov’t) are owned by
Households.
• All income flows into households as payments
for resources.
• Business – commercial establishment that seeks
profit by selling goods/services
• Model illustrate the complex web of decisionmaking and economic activity that give rise to
money flows
LO5
2-19
Businesses
• Three main categories of businesses:
• Sole Proprietorship
• Partnership
• Corporation – owners aren’t held
responsible for actions of company
• Company can live on after death of
founder
LO5
2-20
Shuffling the Deck
• Extremely large number of ways to
•
•
arrange a deck of cards
Arrangement of economy’s resources
is even larger
Avoid random outcomes in market
due to:
• Private property
• Rational decisions about property
2-21