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#2 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