McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 2:
The Market
System and the
Circular Flow
Economic System
Societies develop economic systems to
solve their economic problem.
There are two general types of economic
systems
Command system
Market system
Economic system is a particular set of
institutional arrangements and a coordinating
mechanism for producing goods and services.
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The Command System
Economic systems differ in two main aspects:
Who owns the factors of production;
The method used to motivate, direct, coordinate
economic activity.
In a command system (a.k.a. socialism or
communism):
Government owns most factors of production;
Economic decisions are made by a central governing
body.
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The Market System
In a market system (a.k.a. capitalism):
Factors of production are privately owned;
Markets and prices are used to direct and
coordinate economic activities.
Participants act in their own self-interest resulting
in competition among independent buyers and
sellers of each product and resource.
In the capitalism practiced in the United States and most
other countries, government plays a substantial role in
the economy, but it is not the dominant economic force.
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Key Features of the
Market System
Private property
Freedom of enterprise and choice
Self-interest
Competition
Markets and prices
Technology and capital goods
Specialization
Use of money
Active but limited government
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Private Property is the right of persons and firms
to obtain, own, control, employ, dispose of, and
bequeath land, capital, and other property.
Freedom of enterprise is the freedom of firms to
obtain economic resources, to use those resources
to produce products of the firms own choosing,
and to sell their products in markets of their choice.
Freedom of choice is the freedom of owners of
resources to employ or dispose of them as they
see fit, and the freedom of consumers to spend
their incomes in a manner they think is appropriate.

Key Features of the
Market System
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Key Features of the
Market System
Self-interest is the most advantageous outcome
as viewed by each firm, property owner, worker, or
consumer.
Competition is the presence in a market or
independent buyers and sellers vying with one
another, and the freedom of buyers and sellers to
have a market.
A market is an institution or mechanism that brings
buyers and sellers together.
Technology and capital goods promote efficiency
and the ability to produce more goods and
services.

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Key Features of the
Market System
Specialization is the use of resources of an
individual, region, or nation to produce one or a
few goods and services rather than the entire
range of products.
The use of money where money is any item that
is generally acceptable to sellers in exchange for
goods and services.
Active, but Limited, Government where
government can sometimes increase the overall
effectiveness of the economic system.
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Four Fundamental
Questions
The key features of the market system
allow market economies to answer four
fundamental questions:
What goods and services will be produced?
How will the goods and services be
produced?
Who will get the goods and services?
How will the system promote progress?
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What Will be Produced?
The goods and services produced at a
continuing profit will be produced. Those
producing at a continuing loss will not.
In a market system, consumers are sovereign
(in command) they vote with their dollars.

Consumer sovereignty is the determination by
consumers of the types and quantities of goods
and services that will be produced with the
economys scarce resources.
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How Will Goods and Services
Be Produced?
The combination of resources and
technologies that minimizes the cost per unit
of output will be used to produce goods and
services.
In a competitive market economy, high-cost
producers lose business to low-cost
producers of equal-quality products.

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Who Will Get the Output?
Distribution of goods and services is determined
by:
Prices of these goods and services;
Consumers preferences for these goods and
services;
Consumers ability and willingness to pay for
these good in services. This in turn depends on
income which is determined by:
Quantity of property and human resources they
supply,
Prices those resources command on the resource
market.
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How Will the System
Promote Progress?
Technological advance in encouraged by the
market system
Market rewards invention of new products
New production technologies may help lower cost
of production
Capital accumulation
Entrepreneurs and business owners vote with
their dollars for capital goods.
By paying interest or selling shares firms attract
households income to pay for capital goods.
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The Circular Flow Model
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The Circular Flow Model
Resource Market
Households sell resources
Firms buy resources
Product Market
Households buy products
Firms sell products
Real flow of resources and products
corresponds to the money flow in the
opposite direction.
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