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The Market System and the Circular Flow
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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
2-2
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
2-3
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
2-4
The Market System
• Known as capitalism
• Private ownership of resources
• Decisions based on markets
LO1
2-5
Characteristics of the Market System
• Private property
• Freedom of enterprise and choice
• Self-interest
• Competition
• Markets and prices
LO2
2-6
The Market System
LO2
2-7
Technology and Capital Goods
• Advanced technology and capital
•
LO2
goods are encouraged
Specialization
• Division of labor
• Geographic specialization
2-8
Use of Money
• Makes trade easier
LO2
2-9
Active, but Limited Government
• Government may be needed to
•
LO2
alleviate market failures
Government can increase
effectiveness of a market system
2-10
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?
2-11
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
2-12
How Will the Goods Be Produced?
• Minimize the cost per unit by using
the most efficient techniques
• Technology
• Prices of the necessary resources
LO3
2-13
Who Will Get the Output?
• Consumers with the ability and
•
LO3
willingness to pay will get the product
Ability to pay depends on income
2-14
How Will the System Promote Progress?
• Technological advance
• Creative destruction
• Capital accumulation
LO4
2-15
Invisible Hand
• 1776 Wealth of Nations by Adam
•
LO4
Smith
• Unity of private and social interest
Virtues of the market system
• Efficiency
• Incentives
• Freedom
2-16
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
2-17
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
2-18
Businesses
• Three main categories of businesses:
• Sole proprietorship
• Partnership
• Corporation
LO5
2-19
Businesses
Percentage of Firms
Percentage of Sales
Revenue
Partnerships
Sole
(10%)
Proprietorships
(4%)
Partnerships
(14%)
Corporations
(18%)
Sole Proprietorships
(72%)
LO5
Corporations
(82%)
2-20
The World’s 10 Largest Corporations
LO5
2-21
U.S. Households
Percentage of
Earned Income
Wages and Salaries
Proprietor's Income
Corporate Profits
Interest
Rents
LO5
Percentage of Consumer
Expenditures
Services
Nondurable Goods
Durable Goods
2-22