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Unit 1. Chapter 2. 2. The Market System and the Circular Flow. Chapter Objectives. Command Systems vs. Market Systems Characteristics of a Market System How Markets Determine What to Produce, How to Produce, and Who Receives the Output

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unit 1

Unit 1

Chapter 2

slide2

2

The Market System and the

Circular Flow

chapter objectives
Chapter Objectives
  • Command Systems vs. Market Systems
  • Characteristics of a Market System
  • How Markets Determine What to Produce, How to Produce, and Who Receives the Output
  • How Market System Adjusts to Change and Promotes Progress
  • The Mechanics of the Circular Flow Model
economic systems
Economic Systems
  • Set of instructional arrangements and a coordinating mechanism to respond to the economizing problem
  • The set of arrangements that a society uses to allocate scarce goods
  • How they differ:
  • 1. who owns FOPs
  • 2. method used to direct economic activity
  • * Two extremes: market system and command system
command system
Command System
  • Aka socialism or communism
  • Gov. owns majority of resources and decision making occurs through a central economic plan (bureaucracy)
  • Gov makes all major economic decisions
  • Possible advantages and disadvantages?
market system
Market System
  • Aka capitalism
  • Private ownership of FOPs and prices are used to direct economic activity
  • Activity is coordinated through markets – places where buyers and sellers come together
  • Market forces determine answers to fundamental economic questions
  • Laissez –faire – “ let it be”- pure capitalism
  • Most economies are mixed
the market system

GLOBAL PERSPECTIVE

The Market System

Characteristics

  • Private Property
  • Freedom of Enterprise
  • Freedom of Choice

Free

Mostly

Free

Mostly

Unfree

Repressed

1- Hong Kong

3- Ireland

9- United States

22- Belgium

33- Spain

44- France

81- Brazil

111- China

122- Russia

150- Cuba

152- Venezuela

157- North Korea

Source: Heritage Foundation (www.heritagefoundation.com) and The Wall Street Journal

the market system1
The Market System

Characteristics

  • Geographic Specialization
  • Use of Money
    • Medium of Exchange
    • Barter
  • Active but Limited Government
characteristics of market system
Characteristics of Market System
  • 1. Private property – capital and land owned privately, also freedom to negotiate binding legal contracts
  • Property rights encourage investment, innovation, and facilitate change
  • 2. Freedom of enterprise and choice
  • Freedom of enterprise allows individuals and firms to produce; freedom of choice allows buyers and sellers to make choices regarding production and consumption
characteristics of the market system
Characteristics of the Market System
  • 3. Self-Interest –each economic unit attempts to achieve its goals, at the same time delivering something of value to others
  • 4. Competition – among economic units
  • -requires two or more sellers independently competing in the marketplace, freedom of sellers and buyers to enter and exit marketplace
  • -regulatory force in the market system –How?
characteristics of the market system1
Characteristics of the Market System
  • 5. Markets and prices – market system conveys decisions made by buyers and sellers of products and resources
  • Market system itself is the coordinating and organizing mechanism
  • Allows for communication b/w buyers and sellers
characteristics of the market system2
Characteristics of the Market System
  • 6. Technology and capital goods – market system encourages use and rapid dev. of complex capital goods
  • Allow for greater efficiency = more output
  • 7. Specialization – individual, firm, region, or nation produces one or a few g/s rather than entire range, trade occurs
  • Also allows for greater efficiency
characteristics of a market system
Characteristics of a Market System
  • Division of labor – human specialization
  • Makes use of differences in ability, fosters learning by doing, saves time
  • Geographic specialization – regional and international basis
  • Ex. Oranges grown in Florida, US produces commercial aircraft, Honduras produces bananas
characteristics of the market system3
Characteristics of the Market System
  • 8. Use of money – money is a medium of exchange that facilitates trade
  • Barter exchange (trading goods) is problematic b/c it requires coincidence of wants between buyer and seller
  • Money must be acceptable to sellers in an exchange; it is socially defined; global currency differences can lead to trade complications
characteristics of the market system4
Characteristics of the Market System
  • 9. Active, but limited, gov. – gov has ltd role, but addresses market failures in order to increase effectiveness of market system
five fundamental questions
Five Fundamental Questions
  • Must be addressed by all economic systems
  • 1. What to produce?
  • 2. How to produce?
  • 3. For whom to produce?
  • 4. How to accommodate change?
  • 5. How to promote progress?
five fundamental questions1
Five Fundamental Questions
  • 1. What to produce?
  • g/s that are profitable will be produced, g/s that are produced at a continuing loss will not
  • Profit = TR(total revenue)-TC(total cost)
  • Consumer sovereignty – in a market system, consumers have control over what will be produced
  • Consumers “vote with their dollars”
  • See Consider This on page 34…
five fundamental questions2
Five Fundamental Questions
  • 2. How will the g and s be produced?
  • In combinations and ways that minimize the cost per unit of output
  • Depends on the available technology and prices of FOPs
  • 3. Who will get the output?
  • Based on ability and willingness to pay its existing market price
five fundamental questions3
Five Fundamental Questions
  • 4. How will the system accommodate change?
  • Economy responds to changes in consumer tastes
  • Changes in prices and profits communicate changes in consumer tastes
  • 5. How will the system promote progress?
  • Technological advance – rapid change is promoted, can lead to creative destruction
  • Capital accumulation – through additional dollar votes for capital goods
the market system2

The “Invisible Hand”

The Market System
  • 1776 Wealth of Nations by Adam Smith
    • Efficiency
    • Incentives
    • Freedom
the market system3
The Market System

Demise of Command Systems

  • Two Insurmountable Problems
    • The Coordination Problem- planning and coordinating became more difficult as economies expanded, products and production processes became more sophisticated
    • The Incentive Problem – there was no incentive to adjust production in response to shortages and surpluses, no rewards for innovation or enterprise

USSR

East Germany

Yugoslavia

the circular flow model
The Circular Flow Model
  • Circular Flow Model : illustrates how all interactions occur in a market economy (shows the repetitive flows of goods, services, resources, and money)
  • Shows circular flow b/w product markets (businesses and suppliers) –where G&S are bought and sold; lower half of diagram, and resource markets (market for FOP’s)- where businesses are customers and individuals are producers; represented by upper half of diagram
  • See Figure 2.2 and Quick Quiz 2.2 on page 39
circular flow

O 2.4

Circular Flow

Resource

Market

Businesses

Households

Product

Market

circular flow1

O 2.4

Circular Flow

Both Flows Are Equal

Resource

Market

Money Income

Costs

Input Factors

Resources

Businesses

Households

Goods & Services

Goods & Services

Product

Market

Consumption

Revenue

shuffling the deck
Shuffling the Deck

Last

Word

Markets Systematically and Purposefully Rearrange the World’s Resources

  • Extreme Number of Playing Card Combinations
  • Tens of Billions of Worldwide Resources
  • Many Combinations Useless
  • Private Property Facilitates Best Choice Selections – Mutual Accommodations
  • Result is a Complex and Productive Arrangement of Resources
  • Many Small Decisions that Others Find Helpful