THE MARKET SYSTEM AND

THE CIRCULAR FLOW

Chapter II

BA142 - Basic Microeconomics | Asuncion, Arnoco, Camaya

 LEARNING OBJECTIVES

2.1 2.2 2.3

CHARACTERISTICS OF FIVE FUNDAMENTAL

ECONOMIC SYSTEMS
THE MARKET QUESTIONS

2.4 2.5 2.6

HOW THE MARKET

THE CIRCULAR FLOW
THE INVISIBLE HAND SYSTEM DEALS WITH
MODEL
RISK
2.1 Economic Systems

➢ Economic system is the way in which economic activities are managed in a

country.

➢ The factors of production, such as land, capital, labor, and physical

resources, are governed by economic systems.

➢ Economic systems can be classified by their degree of centralized or

decentralized decision making.

➢ There are three types of economic systems: laissez-faire capitalism,

command systems, and market systems.
2.1 Economic Systems
LAISSEZ-FAIRE
CAPITALISM
laissez-faire - "leave alone" or
“let it be”
● Government intervention
is minimal
● Government’s role is to
protect the rights of the
individual
● NOTE: No society has ever
employed the system
MARKET SYSTEM
a.k.a capitalism or mixed
economy
● Used by the vast majority
of the world
COMMAND SYSTEM ● Combination of
government and people
a.k.a socialism or communism
● All economic activity is
under government control
● Lack of competition
● Lack of innovation
● Lack of coordination
2.2 Characteristics of the Market Systems

PRIVATE PROPERTY FREEDOM OF ENTERPRISE

& CHOICE

SELF-INTEREST COMPETITION

MARKETS & PRICES TECHNOLOGY &

CAPITAL GOODS

SPECIALIZATION USE OF MONEY

ACTIVE BUT LIMITED

GOVERNMENT
2.2 Characteristics of the Market Systems

PRIVATE PROPERTY

➢ Private individuals and firms own most of the property resources (land and
capital).

➢ In a world of legally enforceable property rights, any person who wants

something from you must offer you something that you value more in
return.

➢ Property rights enable people to use their time and resources to produce
more goods and services, rather than using them to protect and retain the
property they already own.
2.2 Characteristics of the Market Systems

FREEDOM OF ENTERPRISE AND CHOICE

Freedom of Enterprise – ensures that entrepreneurs and private businesses are free
to obtain and use economic resources to produce their choice of goods and services
and to sell them in their chosen markets.

Freedom of Choice – it ensures that consumers are free to buy the goods and
services that best satisfy their wants and that their budgets allow.
2.2 Characteristics of the Market Systems

SELF-INTEREST

➢ Serves as the driving force in the market system.

➢ Simply means that each economic unit tries to achieve its own particular
goal.

➢ Gives direction and consistency to what might otherwise be a chaotic

economy.
2.2 Characteristics of the Market Systems

COMPETITION

➢ Competition requires the following:

○ Two or more buyers and two or more sellers acting independently in a
particular product or factor market.
○ Freedom of sellers and buyers to enter or leave (exit) markets, on the
basis of their economic self-interest.

➢ Enables the economy to adjust to changes in consumer tastes, technology,

and factor availability.
2.2 Characteristics of the Market Systems

MARKETS AND PRICES

➢ Two essential elements of the market system

2.2 Characteristics of the Market Systems

TECHNOLOGY AND CAPITAL GOODS

➢ In the market system, the monetary rewards for new products or

production techniques accrue directly to the innovator.

➢ Increased productivity results from more effective production.

➢ Huge benefits can be derived from creating and using such capital
equipments.
2.2 Characteristics of the Market Systems

SPECIALIZATION

➢ Focuses on the production of a limited scope of goods to gain a greater

degree of efficiency

Division of Labor
○ Specialization Makes Use of Differences in Ability
○ Specialization Fosters Learning-by-Doing
○ Specialization Saves Time By
○
Geographic Specialization
○ Availability does not always mean executing
2.2 Characteristics of the Market Systems

USE OF MONEY

➢ Any economic system makes

extensive use of money.

➢ Money is socially defined:

Whatever society accepts as a
medium of exchange is money.

➢ Money facilitates trade when

wants do not coincide.
2.2 Characteristics of the Market Systems

ACTIVE BUT LIMITED GOVERNMENT

2.3 Five Fundamental Questions

What goods and services How will the goods and

will be produced? services be produced?

Who will get the goods and How will the system
services? accommodate change?

How will the system

promote changes?
2.3 Five fundamental questions

What goods and services will be produced?

How will the market system decide on the specific types and
quantities of goods and services to be produced? The simple
answer is this: The goods and services that can be produced at a
continuing profit will be produced, while those whose production
generates a continuing loss will be discontinued.
2.3 Five fundamental questions

How will the goods and services be produced?

It will be done in ways that minimizes the cost per

unit of output. Because inefficiency drives up cost
and lower profits.
2.3 Five fundamental questions

Who will get the output?

The market system enters the picture in two ways

when determining the distribution of total output.
Generally any product will be distributed to
consumers on the basis of their ability and willingness
to pay its existing market price.
2.3 Five fundamental questions

How will the system accommodate change?

The market system are dynamic: consumer

preferences, technology, and supplies of
resources can all change at the same time.
2.3 Five fundamental questions

How will the system promote progress?

Society desires economic growth and higher

standards of living. Technological Advance and
Capital Accumulation.
2.4 The Invisible Hand

The Invisible Hand is the tendency of firms and resource

suppliers seeking to further their own self-interest in
competitive markets to also promote the interest of society
as a whole.
2.4 The Invisible Hand

Of the various virtues of the market system, three stand

out:

1. Efficiency - The market system promotes the efficient

use of resources by guiding them into the production of
the goods and services most wanted by the society.
2.4 The Invisible Hand

THE DEMISE OF THE COMMAND SYSTEM

1. The Coordination Problem
- the first difficulty was the coordination problem. The central
planners had to coordinate millions of individual decisions by
consumers, resource suppliers, and business.
2. The Incentive Problem
- The command economies also faced an incentive problem. Central
planners determined the output mix. When they misjudged how
many automobiles, shoes, shirts, and chickens were wanted at the
government-determined prices.
2.5 The Circular Flow Model

Households, Businesses, Factor Market Product, Market

The Households are responsible for purchasing all the products from the
Product Market and selling some factor of the products to the Factor
Market after selling the products The Factor of Production from the Factor
Market then goes to the Businesses and back to the Product Market then
repeats the cycle.

The other way around the diagram is the Households would be doing the
consumption expenditure from the Product market then then from the
Product market it Would go to Businesses part then lastly to the Factor
Market then it would repeat the cycle starting from the Households again
2.5 The Circular Flow Model
2.6 How The Market System Deals with Risks

Shielding Employees and

The Profit System
Supplier from Business Risk

Benefits of Restricting
Business Risk to Owners
2.6 How The Market System Deals with Risks

The Profit System

- it is handled by the entrepreneurs that has the abilities to
perform well in the field of economics which has a win or lose
system. That creates a clear and careful area for the
entrepreneurs to avoid suffering from losses and potential
risks that would hit the business badly.
2.6 How The Market System Deals with Risks

The Profit System

- it is handled by the entrepreneurs that has the abilities to
perform well in the field of economics which has a win or lose
system. That creates a clear and careful area for the
entrepreneurs to avoid suffering from losses and potential
risks that would hit the business badly.
2.6 How The Market System Deals with Risks

Shielding Employees and Supplier from Business Risk

This part is about how a business should defend their

employees and suppliers to all the risks the business would
encounter the safety of the employees are the top priority
without the employees and suppliers the business will go
down.
2.6 How The Market System Deals with Risks

Benefits of Restricting Business Risk to Owners

By doing this owners of businesses would be safe from any

risky plans that would make them go down and it would let
the owners think thoroughly whats the next move they should
do knowing the Benefits of Restricting Business Risks.
Chapter Summary
Chapter Summary
Chapter Summary
Terms and Concepts
economic system
A particular set of institutional arrangements and a coordinating mechanism for producing goods and services.

laissez-faire capitalism
A hypothetical economic system in which the government’s economic role is limited to protecting private property and establishing a legal environment appropriate to the
operation of markets in which only mutually agreeable transactions take place between buyers and sellers.

command system
An economic system in which most property resources are owned by the government and economic decisions are made by a central government body.

market system
An economic system in which property resources are privately owned and markets and prices are used to direct and coordinate economic activities.

private property
The right of private persons and firms to obtain, own, control, employ, dispose of, and bequeath land, capital, and other property.

freedom of enterprise
The freedom of firms to obtain economic resources, to use these resources to produce products of the firm’s own choosing, and to sell their products in markets of their choice.

freedom of choice
The freedom of owners of property resources to employ or dispose of them as they see fit, and of consumers to spend their incomes in a manner that they think is appropriate.
Terms and Concepts
self-interest
That which each firm, property owner, worker, and consumer believes is best for itself.
competition
The presence in a market of a large number of independent buyers and sellers competing with one another and the freedom of buyers and sellers to enter and
leave the market.
market
Any institution or mechanism that brings together buyers and sellers of particular goods, services, or resources for the purpose of exchange.
specialization
The use of the resources of an individual, a firm, a region, or a nation to produce one or a few goods and services.
division of labour
Dividing the work required to produce a product into a number of different tasks that are performed by different workers.
medium of exchange
Items sellers generally accept and buyers generally use to pay for a good or service.
barter
The exchange of one good or service for another good or service.
money
Any item that is generally acceptable to sellers in exchange for goods and services.
Terms and Concepts
consumer sovereignty

Determination by consumers of the types and quantities of goods and services that will be produced with the scarce resources of the economy.
dollar votes

Through their purchases in the product and resource markets, consumers and entrepreneurs determine the production of consumer and capital goods,
respectively.
creative destruction

The hypothesis that the creation of new products and production methods simultaneously destroys the market power of firms that are wedded to existing products
and older ways of doing business.
invisible hand

The tendency of firms and resource suppliers seeking to further their own self-interest in competitive markets to also promote the interest of society as a whole.
circular flow diagram

Depiction of the flows of resources from households to firms and of products from firms to households. These flows are accompanied by reverse flows of money
from firms to households and from households to firms.
households

One or more persons occupying a housing unit, who buy businesses’ goods and services in the product market using income derived from selling resources in the
factor market.
businesses

Economic entities (firms) that purchase factors of production and provide goods and services to the economy.
Terms and Concepts
sole proprietorship

An unincorporated firm owned and operated by one person.

partnership

An unincorporated firm owned and operated by two or more people.

corporation

A legal entity chartered by the federal or provincial government that operates as a distinct and separate body from the individuals who own it.
product market

A market in which products are sold by firms and bought by households.

factor market

A market in which households sell and firms buy factors of production.

residual claimant

The owners of a firm who in a market system are the rightful legal recipients (that is, are claimants) of whatever profit or loss remains (is residual) after all other
input providers have been paid. The residual is compensation for providing the economic input of entrepreneurial ability and flows to the firm’s owners.
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