ECONOMIC DEVELOPMENT

Module 1
INTRODUCTION TO ECONOMICS

Introduction

This module entitled Introduction to Economics is all about concept of economics particularly Microeconomics, the
fundamental economic problem which is scarcity and the context of opportunity cost.

What Is Economics?

Economics is a social science concerned with the production, distribution, and consumption of goods and services. It
studies how individuals, businesses, governments, and nations make choices about how to allocate resources.

Economics can generally be broken down into macroeconomics, which concentrates on the behavior of the economy
as a whole, and microeconomics, which focuses on individual people and businesses.

The principle (and problem) of economics is that human beings have unlimited wants and occupy a world of limited
means. For this reason, the concepts of efficiency and productivity are held paramount by economists. Increased
productivity and a more efficient use of resources, they argue, could lead to a higher standard of living.

Types of Economics
The study of economics is generally broken down into two disciplines.

• Microeconomics focuses on how individual consumers and firm make decisions; these individuals can be a
single person, a household, a business/organization or a government agency. Analyzing certain aspects of
human behavior, microeconomics tries to explain they respond to changes in price and why they demand
what they do at particular price levels. Microeconomics tries to explain how and why different goods are
valued differently, how individuals make financial decisions, and how individuals best trade, coordinate and
cooperate with one another. Microeconomics' topics range from the dynamics of supply and demand to the
efficiency and costs associated with producing goods and services; they also include how labor is divided
and allocated, uncertainty, risk, and strategic game theory.
• Macroeconomics studies an overall economy on both a national and international level. Its focus can include
a distinct geographical region, a country, a continent, or even the whole world. Topics studied include foreign
trade, government fiscal and monetary policy, unemployment rates, the level of inflation and interest rates,
the growth of total production output as reflected by changes in the Gross Domestic Product (GDP), and
business cycles that result in expansions, booms, recessions, and depressions.
Micro- and macroeconomics are intertwined; as economists gain an understanding of certain phenomena, they can
help us make more informed decisions when allocating resources. Many believe that microeconomics' foundations of
individuals and firms acting in aggregate constitute macroeconomic phenomena.

The Economics of Labor, Trade, and Human Behavior

The building blocks of economics are the studies of labor and trade. Since there are many possible applications of
human labor and many different ways to acquire resources, it is difficult to determine which methods yield the best
results.
 Economics demonstrates, for example, that it is more efficient for individuals or companies to specialize in specific
types of labor and then trade for their other needs or wants, rather than trying to produce everything they need or
want on their own. It also demonstrates trade is most efficient when coordinated through a medium of exchange, or
money.

Economics focuses on the actions of human beings. Most economic models are based on assumptions that humans
act with rational behavior, seeking the most optimal level of benefit or utility. But of course, human behavior can be
unpredictable or inconsistent, and based on personal, subjective values (another reason why economic theories
often are not well suited to empirical testing). This means that some economic models may be unattainable or
impossible, or just not work in real life.

Economic Indicators
Economic indicators are reports that detail a country's economic performance in a specific area. These reports are
usually published periodically by governmental agencies or private organizations, and they often have a considerable
effect on stocks, fixed income, and forex markets when they are released. They can also be very useful for investors
to judge how economic conditions will move markets and to guide investment decisions.

Below are some of the major U.S. economic reports and indicators used for fundamental analysis.

Gross Domestic Product (GDP). The Gross Domestic Product (GDP) is considered by many to be the broadest
measure of a country's economic performance. It represents the total market value of all finished goods and services
produced in a country in a given year or another period (the Bureau of Economic Analysis issues a regular report
during the latter part of each month). Many investors, analysts, and traders don't actually focus on the final annual
GDP report, but rather on the two reports issued a few months before: the advance GDP report and the preliminary
report. This is because the final GDP figure is frequently considered a lagging indicator, meaning it can confirm a
trend but it can't predict a trend. In comparison to the stock market, the GDP report is somewhat similar to the income
statement a public company reports at year-end.

Retail Sales. Reported by the Department of Commerce during the middle of each month, the retail sales report is
very closely watched and measures the total receipts, or dollar value, of all merchandise sold in stores.The report
estimates the total merchandise sold by taking sample data from retailers across the country—a figure that serves as
a proxy of consumer spending levels. Because consumer spending represents more than two-thirds of GDP, this
report is very useful to gauge the economy's general direction. Also, because the report's data is based on the
previous month sales, it is a timely indicator. The content in the retail sales report can cause above normal volatility in
the market, and information in the report can also be used to gauge inflationary pressures that affect Fed rates.

Industrial Production. It is preferable for a country to see increasing values of production and capacity utilization at
high levels. Typically, capacity utilization in the range of 82–85% is considered "tight" and can increase the likelihood
of price increases or supply shortages in the near term. Levels below 80% are usually interpreted as showing "slack"
in the economy, which might increase the likelihood of a recession.

Employment Data.The Bureau of Labor Statistics (BLS) releases employment data in a report called the non-farm
payrolls, on the first Friday of each month. Generally, sharp increases in employment indicate prosperous economic
growth. Likewise, potential contractions may be imminent if significant decreases occur. While these are general
trends, it is important to consider the current position of the economy. For example, strong employment data could
cause a currency to appreciate if the country has recently been through economic troubles because the growth could
be a sign of economic health and recovery. Conversely, in an overheated economy, high employment can also lead
to inflation, which in this situation could move the currency downward.
Consumer Price Index (CPI).The Consumer Price Index (CPI), also issued by the BLS, measures the level of retail
price changes (the costs that consumers pay) and is the benchmark for measuring inflation. Using a basket that is
representative of the goods and services in the economy, the CPI compares the price changes month after month
and year after year. This report is one of the more important economic indicators available, and its release can
increase volatility in equity, fixed income, and forex markets. Greater-than-expected price increases are considered a
sign of inflation, which will likely cause the underlying currency to depreciate.

KEY TAKEAWAYS

• Economics is the study of how people allocate scarce resources for production, distribution, and
consumption, both individually and collectively.
• Two major types of economics are microeconomics, which focuses on the behavior of individual consumers
and producers, and macroeconomics, which examine overall economies on a regional, national, or
international scale.
• Economics is especially concerned with efficiency in production and exchange and uses models and
assumptions to understand how to create incentives and policies that will maximize efficiency.
• Economists formulate and publish numerous economic indicators, such as gross domestic product (GDP)
and the Consumer Price Index (CPI).
Three Basic Economics Decisions
The concepts of opportunity cost and scarcity are vital to understanding how the economy works. Because of the
inevitable imbalance between limited productive resources and unlimited wants, the following questions must be
considered.

1. What will be produced? – the productive potential of the economy must not be wasted to do everything for
everybody. Decisions must be made about what to produce and how much of each item to be produced with
the limited resources available.
2. How will goods and services be produced? – there is more than one way to accomplish any given objective.
Machines or other products (such as chemicals) can be substituted for labor or land when producing any
mix of goods. This involves a certain kind of technology.
The second question an economy must answer involves deciding how the desired goods are to be
produced. There is more than one way to grow wheat, train lawyers, refine petroleum, and transport
baggage. The efficient production of goods and services requires that certain fundamental rules be followed:
no resources should be used in producing one thing when it could produce something more valuable
elsewhere and each product should be made with the smallest-possible amount of resources. A functioning
price system induces all participants in the economy to steer their resources towards activities that yield a
reward. Jobs that pay a high price for labor will attract workers seeking the reward of a high salary. Crops
that yield a greater profit will attract more farmers to cultivate them.
3. To whom will goods and services be distributed? – are they to be distributed equally to everyone so that
each lives in the same type of house, eats the same amount and kind of food and wears the same clothes?

The distributions of material things are never perfectly equal. No society has yet discovered how to provide
equally for the needs and wants of everyone while still offering the incentives that encourage high quality
production and technological innovations.
Microeconomics versus Macroeconomics

Economic analysis is divided into two main branches, microeconomics and macroeconomics – Both of them
are essential in the study is SCARCITY.
 Microeconomics deals with a close-up view of the economy by concentrating on the choices made by the
individual participants in the economy, like the consumers, workers, business manager, and inventors.

Macroeconomics looks at the economy from a broader perspective by considering its overall performance
and the way various sectors of the economy relate to one. “The performance of the economy is measured by the total
of annual production, the capacity of the economy to provide jobs, changes in the purchasing power of the peso, and
the growth of employment and output.
Microeconomics deals with the ways individuals choose any various courses of action by weighing the
benefits and cost of alternatives available to them. It emphasizes the role of prices in business and personal decision.
One of its main goals is to understand how the prices particular goods and services are determined and how prices
influence decisions. It is because of this behavior that microeconomics is also known as price theory.
Unemployment and inflation are true issues which are carefully dealt with in macroeconomics.

Module 2
POSSIBILITIES AND OPPORTUNITY COST
Resources, Technology and Production Possibilities
Resources, Labor, Capital, Material Resources and Entrepreneurship

1. Labor – represents the services of human beings in the production of goods and services.
2. Capital – consists of the equipment, tools, structure, machinery, vehicle, materials and skills created to help
produce goods and services.
3. Natural resources – include land used as sites for structures, parts and other facilities as well as the natural
materials that are used in crude form in production.
4. Entrepreneurship – is the talent to develop products and processes and to organize production to make
goods and services available.

Before we can understand the relationship between outputs and cost, we must first understand the physical
relationships between inputs and outputs used.
Production is the process of using the services of labor and other resources to make goods and services
available. These goods and services are the outputs while the economic resources are the inputs.

Technology is the knowledge of how to produce goods and services. It helps us alleviate scarcity.
What is Production?
Production is the process that creates a product. A product that is the outcome of production is a valuable commodity
or service. Production can be whereby factors of production (land, labor, capital, and enterprise) are used to convert
raw material into goods. The production of services may only involve labor/capital, example: massage services.
Production Efficiency. The use of the production possibilities curve shows the consequences of underutilizing or
mismanaging economic resources in a nation.
One factor that contributes to production efficiency is division of labor: It is the breakdown of a large process into
tasks performed by workers who specialize in those tasks. By specializing, workers become more proficient in their
jobs. Division of labor allows manufacturing plants to use mass production technologies to allow workers to produce
more.
Economic growth is the expansion of production possibilities that result from increased availability and increased
productivity of economic resources.
Sources of Economic Growth
Economic growth is the increase in the amount of the goods and services produced by economy overtime. It is
conventionally measured as the percent rate of increase in real gross domestic product, or real GDP. Growth is
usually calculated in real terms, i.e. inflation adjusted terms, in order to net out the effect of inflation on the price of
the goods and services produced. In economics, “economic growth” or “economic theory” typically refers to growth of
potential output, i.e., production at “full employment”, which is caused by growth in aggregate demand or observed
output.
As an area of study, economic is generally distinguished from development economics. The former is primarily the
study of how countries can advance their economies. The latter is the study of the economic aspects of the
development process in low-income countries. As economic growth is measured as the annual percent change of
gross domestic product (GPD), it has all the advantage and drawbacks of the measure.

1. Increased quantities of economic resources. All things being equal, the more workers willing and able to
work, the more capital and the more land, the greater the production possibilities.
2. Improved quality of economic resources. Improvement in skills, education or training of the labor force can
also increase the output obtainable from any given combination of inputs.
3. Advances in technology. Like improvements in the quality of inputs, increased productive potential resulting
from the development of new technologies is a very important source of economic growth.

MODULE 3
DEMAND AND SUPPLY

A market is an arrangement through which buyers and sellers meet or communicate in order to trade goods and
services.
Supply and demand analysis explains how prices are determined in markets through competition among buyers and
sellers and how these prices affect quantities traded.
Concepts on supply and demand. The amount of an item buyers actually purchase in a market over a given period is
determined by the following factors.

1. Its price.
2. Buyers’ available income.
3. Buyers’ wealth (Value of assets like stocks, bonds, homes and other real estate and business property).
4. Expectation of future price changes.
5. The prices of alternative items.
6. Tastes or current fashion.
7. The population served by the market.
 The quantity demanded of an item is the amount that buyers are willing and able to buy over a period at a certain
price given all other influences on their decision to buy.
Demand is a relationship between the price of an item and the quantity demanded. It is how the quantity buyers’
purchase varies with price, assuming that all other influences on the amount buyers buy, other than the price of
the item are held fixed.
The Law of Demand states that in general, other things being equal, the lower the price of a good the greater
the quantity of the good buyers will purchase over a given period. Conversely, the law implies that buyers will
purchase less of a good over any given period if it price increase while nothing else changes.
A demand schedule is a table that shows how an item’s quantity demanded would vary with price, other things
being equal.
A demand curve is a graph which shows how quantity demanded varies with the price of a good. It is downward
sloping.
A change in relative prices of a good is an increase or decrease in the price of that good relative to the average
change in the prices of all goods.

A change in quantity demanded is the change in the amount of a good which buyers are willing and able to
buy in response to a change in the price of a good. It is represented by a movement along a given demand
curve cause by an increase or decrease in the price of a good.
A change in demand is a change in the relationship between the price of a good and the quantity demanded
caused by a change in something other than the price of a good.

Influences in the Demand for a Good

1. Changes in Consumer Income. An increase in available increases the ability of consumers to buy an item.
Goods whose demand declines as income increases are known as inferior goods. Goods whose demand
increases when income goes up are known as personal goods.
2. Changes in Wealth. Wealth is the net accumulated savings of a nation. People whose wealth declines may
increase their demand for cars in the mid-price range because they can no longer afford luxury cars.
3. Changes in the Price of other Goods. Our willingness to buy a particular item also depends on the prices of
related items. Alternatives are items that serve a purpose similar to that of a given item and they are
substitutes for that item. The demand for a good can also be influenced by a change in the price of its
complements.

Complements are goods when used together enhance the satisfaction a consumer obtains from each of them.
Changes in expectations of future prices. The demand for an item depends on expectations the buyers have
about future events.
Changes in tastes or fashion. The general appeal of an item to buyers can change from time to time.
Change in the number of buyers served by the market. The total quantity of any item demanded at any price also
depends on the number of buyers interested in buying the item at a given price.
Supply

Factors affecting the quantity of a good or services seller are able and willing to sell in the market.

1. Its price.
 2. Current prices of inputs needed to produce and market the good.
3. Current technology available to produce and market the good.
4. Prices of other goods that can be produced with inputs used or owned by the sellers.
5. Expectation about future prices.
6. The number of sellers serving the market.

The price is the payment a seller receives for each unit of a good sold.
The Law of Supply states that in general, all things being equal, the higher the price of a good, the greater the
quantity of that goods sellers are willing and able to make available over a given period.
Supply schedule is a table that shows how an item’s quantity supplied would vary with price all things being
equal.
A supply curve is a graph that shows how quantity supplied varies with the price of a good.
A change in quantity supplied is a change in the amount of a good seller is willing to sell over a period in
response to a change in the price of the good.
A change in supply is a change in the relationship between the price of a good and the quantity supplied in
response to a change in a supply determinant other than the price of the good.

1. Changes in the prices of the input necessary to produce and sell a good. The possible profit at any given
price depends on the prices a seller must pay for the economic resources to produce a good.
2. Change in the technology available to produce a good. Improvements in technology tend to increase the
output for economic resources used to produce a good.
3. Changes in the prices of other goods that can be produced with the sellers resources. The opportunity cost
of producing and selling any good is the sacrifice of the opportunity to sell other goods.
4. Change in the number of sellers serving the market. All things being equal, an increase in the number of
sellers increases the supply of a good.

Others expectations about future prices of goods and services and inputs, taxes and subsidies.
Market Equilibrium Price and Quantity

Equilibrium prevails when economic forces balance so that economic variables neither increase nor
decrease.
Market equilibrium is attained when the price of a good adjusts so that the quantity buyers will buy at that price is
equal to the quantity sellers will sell.
A shortage exists in a market when the quantity demanded of a good exceeds the quantity supplied over a given
period.
A surplus exists in a market when the quantity supplied of a good exceeds the quantity demanded over a given
period of time.

A surplus results in downward pressure on price.

A shortage results in upward pressure on price.

The Impact of changes in demand in Market Equilibrium. Sellers do not respond directly to the decrease in demand.
Instead, they respond to the decline in price caused by the decrease in demand.
 The Impact of changes in Supply in Market Equilibrium. Buyers do not respond directly to the decrease in supply.
Instead, they respond to the increase in market price caused by the decrease in supply.
Module 4
LABOR MARKET

Non- Scarce Goods are goods for which the quantity demanded does not exceed the quantity supplied at
zero prices. It is available in amounts that result in no shortage even if the price of the item is zero.

A necessarily non-scarce good is a thing in a demand that can be replicated without so that can have one,
you can have one, we can all have one. This is a condition under which there can be no contest ownership. As
Hoppe says, under these conditions, there would be no need for norms governing their ownership and use.

This non-scarce status might apply to many things but it always applies to non-finite things, that is, goods
that can be copied without limit, with no additional copy having displaced the previous copy and with no degradation
in the quality of the copied good from the original good.

The price of a new product influences the quantity demanded. Firms must be able to sell new products at
prices that exceeds the costs sufficiently to allow a profit. It is crucial determinant of its success in a market.

Markets for Labor and Credit

Labor Markets. In modern economics, workers sell their services to employers in labor markets. In a
competitive labor market, may workers independently offer skills of a given quality to many employers who compete
for the workers’ services. Wages which are the prices paid for labor services are important determinants of the
amount of labor demanded and supplied over a given period. The lower the wage, the greater the quantity of labor
services demanded by employers. The demand curve for labor services is downward and slopping because
employers substitute other inputs, like machines for labor services as wages go up, while they substitute labor
services for other inputs when wages are low.

The nominal market which workers find paying work, employers find willing workers, and wage rates are
determined.

Labor markets may be local or national (even international) in their scope and are made up of smaller,
interacting labor markets for different qualifications, skills, and geographical locations. They depend on exchange of
information between employers and job seekers about wage rates, conditions of employment, level of competition,
and job location.
Labor Market

Definition: a labor market is the place where workers and employees interact with each other. In the labor market,
employers compete to hire the best, and the workers compete for satisfying job.

Description: A labor market in an economy functions with demand and supply of labor. In this market, labor demand
is the firm’s demand for labor and supply is the worker’s supply of labor. The supply and demand of labor in the
market is influenced by changes in the bargaining power.

How do Labor Markets Work?

The function of a labor market is to establish the price of labor. That price should reflect the value labor has
added to the production process and the ability and willingness of worker’s to provide the labor. This is most likely to
occur in a competitive labor market. In such a market there are many employers seeking workers and any workers
seeking work. The employers’ demand for labor and the willingness of individuals to supply labor determine the level
of wage or salary for a job. If the demand is high or supply is low, wages and salaries will be high. Where the demand
for workers is low or a great many are available to do the job, wages will be low. To understand a labor market, one
must know something about the factors that influence the employer’s demand for the workers, willingness to supply
labor. The employer’s demand for labor depends on the demand for the product the labor produces. For example, if
there is an increase in the demand for automobiles, the demand for autoworkers will rise, as will their wages.

Module 5

THE MARKET STRUCTURES

BASIC MARKET MODELS

A modern economy has many different types of industries. However, an economic analysis of the different firms or
industries within an economy is simplified by first segregating them into different models based on the amount of
competition within the industry. There are 4 basic market models: pure competition, monopolistic competition,
oligopoly, and pure monopoly. Because market competition among the last 3 categories is limited, these market
models imply imperfect competition.

1. Pure Competition

In a purely competitive market, there are large numbers of firms producing a standardized product. Market
prices are determined by consumer demand; no supplier has any influence over the market price, and thus, the
suppliers are price takers. The primary reason why there are many firms is because there is a low barrier of entry into
the business. The best examples of a purely competitive market are agricultural products, such as corn, wheat, and
soybeans.

2. Monopolistic Competition

Monopolistic competition is much like pure competition in that there are many suppliers and the barriers to
entry are low. However, the suppliers try to achieve some price advantages by differentiating their products from
other similar products. Most consumer goods, such as health and beauty aids, fall into this category. Suppliers try to
differentiate their product as being better, so that they can justify higher prices or to increase market share.
Monopolistic competition is only possible, however, when the differentiation is significant or if the suppliers are able to
convince consumers that they are significant by using advertising or other methods that would convince consumers
of a product's superiority. For instance, suppliers of toothpaste may try to convince the public that their product
makes teeth whiter or helps to prevent cavities or periodontal disease.

3. Oligopolistic Competition

An oligopoly is a market dominated by a few suppliers. Although supply and demand influences all markets,
prices and output by an oligopoly are also based on strategic decisions: the expected response of other members of
the oligopoly to changes in price and output by any 1 member. A high barrier to entry limits the number of suppliers
that can compete in the market, so the oligopolistic firms have considerable influence over the market price of their
product. However, they must always consider the actions of the other firms in the market when changing prices,
because they are certain to respond in a way to neutralize any changes, so that they can maintain their market share.
Auto manufacturers are a good example of an oligopoly, because the fixed costs of automobile manufacturing are
very high, thus limiting the number of firms that can enter into the market.

4. Pure Monopoly

A pure monopoly has pricing power within the market. There is only one supplier who has significant market
power and determines the price of its product. A pure monopoly faces little competition because of high barriers to
entry, such as high initial costs, or because the company has acquired significant market influence through network
effects, such as Facebook, for instance.

One of the best examples of a pure monopoly is the production of operating systems by Microsoft. Because many
computer users have standardized on software products compatible with Microsoft's Windows operating system,
most of the market is effectively locked in, because the cost of using a different operating system, both in terms of
acquiring new software that will be compatible with the new operating system and because the learning curve for new
software is steep, people are willing to pay Microsoft's high prices for Windows.

MARKET STRUCTURES

When analyzing a market, we first need to understand what we see as a market and which characteristics
define a market structure. A market refers to buyers and sellers who through their association, both in reality and
potentially build the cost of a good or service. A market structure could then be seen as the characteristics of a
market that impact the behavior and results of the organizations working in that market.

The main characteristics that determine a market structure are:

A.the number of organizations in the market (selling and buying);
B.their relative negotiation power in relation to the price setting;
C.the degree of concentration among them;
D.the level product of differentiation and uniqueness; and
E.the entry and exit barriers in a particular market.
So, the structure of the market affects how firm price and supply their goods and services, the entry and exit
barriers, and how efficiently a seller carries out its business operations.
A mix of the above-mentioned characteristics determine several market structures, from which we feature the most
important ones:

Perfect competition

An efficient market where goods are produced using the most efficient techniques and the least number of factors.
The market is characterized by the following aspects:

• All sellers offer an identical product

• Sellers can’t affect the price
• Sellers have a relatively small market share
• Buyers know the nature of the product being sold and the prices charged by each firm
• The industry is characterized by freedom of entry and exit (no barriers)
Monopoly

Represents the opposite of a perfect competition. This market is composed of a single seller who will therefore in full
control to set the prices.

Oligopoly

Products are offered by a small number of sellers were actions of one firm significantly influence the others.
Important characteristics are:

• A limited number of sellers collude, either explicitly or silently, to limit output and/or fix prices, so as to realize
above normal market revenues
• Economic, legal, and technological factors can contribute to the formation and maintenance, or dissolution,
of oligopolies
• The major difficulty that oligopolies face is the prisoner's dilemma that each member faces, which
encourages each member to cheat
• Government policy influence oligopolistic behavior, and sellers in mixed economies often seek government
support for ways to limit competition

Monopolistic competition

The market is formed by a high number of sellers with similar products or services, but differ due to differentiation,
that will allow prices. Entry and exit barriers in a monopolistic competitive industry are low, and the decisions do not
directly affect those of its competitors. Monopolistic competition is closely related to the business strategy of brand
differentiation.
Important characteristics are:

• Monopolistic competition occurs when an industry has many firms offering products that are similar but not
identical
• Unlike a monopoly, these firms have little power to set curtail supply or raise prices to increase profits
• Firms in monopolistic competition typically try to differentiate their product in order to achieve in order to
capture above market returns
• Heavy advertising and marketing is common among firms in monopolistic competition and some economists
criticize this as wasteful

Monopsony
It’s similar to a monopoly, but in this case, there are many sellers with only one buyer, the monopsonist, who will have
full power whit price negotiations.
Important characteristics are:

• A monopsony refers to a market with a single buyer

• In a monopsony, a single buyer generally has a controlling advantage that drives its consumption price
levels down
• Monopsonies usually experience low prices from wholesalers and an advantage in paid fees
Oligopsony

It's similar to monopsony, but with a few buyers. Sellers will have to deal with the increased negotiating power of the
oligopsonists. Oligopsony occurs when a few firms dominate the purchase of product or services. This means that
the few buyers have considerable market power and therfore control over the sellers in driving down prices.

THE PRICE SYSTEM AND THE MIXED ECONOMY

Capitalism and the Market Economy

Capitalism is an economic system characterized by private ownership of economic resources and freedom
of enterprise in which owners of factories and other capital hire workers to produce goods and services.

Mixed Economy. Provides goods and services to government as well as business firms. In such economies,
governments supply roads, defense, pensions, and schooling directly to citizens. They also commonly intervene in
markets to control and correct prices.

Price System is a mechanism by which resource use in a market economy is guided by price.

Characteristics of Capitalism

1. Freedom of Enterprise. The right of business firm owners to employ private economic resources for whatever
purpose they want.

2. Economic Rivalry. A situation in which large number of buyers are competing for available supplies of goods and
services for sale in markets.

Free Markets is the situation which exists when there are no restrictions that prevent buyers or seller from
entering or exiting from a market.

Circular flows are classified as: Real Flow and Money Flow

Real Flow – in a simple language, is the flow of factor services from households to firms corresponding flow of goods
and services from firms to households.

Assume in a simple two sector economy-household and firm sectors, in which the households provides
factor services to firms, which in return provides goods and services to them as reward. Since there will be an
exchange of goods and services between the two sectors in physical form without involving money, therefore, it is
known as real flow.

Money Flow – in a modern two sector economy, money acts as a medium of exchange between goods and
services. Money flow of income refers to a monetary payment from firms to household for their factor services and in
return monetary payments from households to firms against their goods and services.

Households
The primary economic function of households is to supply domestic firms with needed factors of
production – land, human capital, real capital, enterprise. The factors are supplied by factor owners in
return for a reward. Land is supplied by landowners, human capital by labor, real capital by capital
owners (capitalists) and enterprise is provided by entrepreneurs. Entrepreneurs combine the other three
factors, and bear the risks associated with production.

Firms
The function of firms is to supply private goods and services to domestic households and firms, and to
households and firms abroad. To do this they use factors and pay for their services.