Chapter#2

The Market System and the Circular Flow

Economic Systems

LO2.1 Differentiate between laissez-faire capitalism, the command system, and the market system.

Every society must establish an economic system—a structured set of institutional

arrangements and a coordinating mechanism—to address the economizing problem, which is
the challenge of allocating scarce resources to satisfy unlimited wants. An effective economic
system must determine:

i. What goods and services will be produced,

ii. How they will be produced,

iii. Who will receive them,

iv. How to adapt to changes in consumer preferences, technology, and resource availability,

v. How to encourage technological innovation and long-term growth.

Economic systems differ primarily in two respects:

i. Ownership of the factors of production (private vs. public), and

ii. The mechanisms used to motivate, coordinate, and direct economic activity.

We can classify economic systems by the extent to which they rely on decentralized decision-
making—through markets and prices—or centralized government control, based on directives
and mandates.

• At one extreme lies laissez-faire capitalism, where government intervention is minimal,

and markets and prices direct all economic activity.

• At the other extreme is the command system, where the government exercises complete
control over production, distribution, and resource allocation.
 • In practice, most national economies operate somewhere between these two extremes.
These mixed or market systems combine elements of market-driven decision-making
with varying degrees of government regulation to balance efficiency, equity, and stability.

Laissez-Faire Capitalism

In laissez-faire capitalism—also referred to as pure capitalism—the government’s role is

narrowly confined to:

i. Protecting private property from theft, fraud, and aggression, and

ii. Maintaining a legal framework that enforces contracts and upholds the rule of law,
enabling individuals and firms to freely engage in market transactions.

The term laissez-faire is French for “let it be,” reflecting the principle that government should
avoid interfering with economic activity.

Proponents’ Viewpoint: Advocates argue that government intervention tends to diminish human
welfare. They contend that excessive involvement allows special interest groups to capture
policy-making, using the state’s economic power to serve their interests rather than the broader
public good. In this view, minimal intervention maximizes efficiency, innovation, and individual
freedom.

The Command System

At the opposite end of the spectrum from laissez-faire capitalism lies the command system—
often referred to as socialism or communism. In this system, the government owns most property
resources, and economic decision-making is guided by a central economic plan.

A central planning board, appointed by the state, determines:

• How resources are allocated

• What goods and services are produced

• How output is distributed

• How production processes are organized

Most business firms are government-owned and operate according to official directives, rather
than market signals.

In its strictest form, the command economy allocates all government-owned resources according
to a central plan. In practice, however, even the Soviet Union—once the most prominent command
economy—allowed some private ownership and market activity before its dissolution in 1992.

Shifts Toward Market Orientation:

• Russia and Eastern Europe: Post-1992 reforms shifted many economies toward
capitalism and market-based systems.

• China: Still retains extensive state ownership, but has significantly reduced central
planning, relying more on markets for coordination.

• North Korea & Cuba: Remain the most notable examples of largely centrally planned
economies today.

The Market System

The market system—also called capitalism or the mixed economy—is the dominant economic
system in most of the world.

It blends:

• Decentralized decisions by individuals and firms

• Centralized government initiatives to guide and regulate economic activity

Key Features:

i. Private Ownership of Resources: Individuals and businesses own capital and property.

ii. Markets & Prices: Buyers and sellers meet in markets, and prices guide production,
consumption, and resource allocation.

iii. Decision-Making Freedom: People and firms choose how to work, consume, and produce
in pursuit of their own goals.
 iv. Incentives for Innovation: The potential for high monetary rewards encourages existing
firms to improve products and processes, and motivates entrepreneurs to take risks—
despite many innovations failing.

Characteristics of the Market System

LO2.2 List the main characteristics of the market system.

An examination of some of the key features of the market system in detail will be very instructive.

Private Property

i. Private Ownership

• In a market system, individuals and firms—not the government—own most land and
capital.

• This private ownership is the basis of capitalism.

ii. Legal Rights & Freedom

• Owners can buy, sell, use, or transfer their property as they wish.

• They can decide who inherits their property.

• Contracts are legally enforceable, ensuring trust in transactions.

iii. Why Property Rights Matter

• Encourage mutually agreeable transactions.

• Without them, the strong could take from the weak without compensation.

iv. Economic Benefits

• Promote investment, innovation, and maintenance of property.

• People are more willing to build, farm, or create if they know their property is protected.

• Extend to intellectual property (patents, copyrights, trademarks) to protect ideas,

inventions, and creative works.
v. Growth & Efficiency

• Reduce the need to waste time protecting what you already own.

• Allow resources to be focused on producing goods and services instead.

Freedom of Enterprise and Choice

Closely related to private ownership of property is freedom of enterprise and choice. The market
system requires that various economic units make certain choices, which are expressed and
implemented in the economy’s markets:

• 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 enables owners to employ or dispose of their property and money as
they see fit. It also allows workers to try to enter any line of work for which they are
qualified. Finally, it ensures that consumers are free to buy the goods and services that
best satisfy their wants and that their budgets allow.

These choices are free only within broad legal limitations, of course. Illegal choices such as selling
human organs or buying illicit drugs are punished through fines and imprisonment.

(Global Perspective 2.1 reveals that the degree of economic freedom varies greatly from economy
to economy.)
Self-Interest

In the market system, self-interest is the motivating force of the various economic units as they
express their free choices.

Self-interest simply means that each economic unit tries to achieve its own particular goal, which
usually requires delivering something of value to others. Entrepreneurs try to maximize profit or
minimize loss. Property owners try to get the highest price for the sale or rent of their resources.
Workers try to maximize their utility (satisfaction) by finding jobs that offer the best combination
of wages, hours, fringe benefits, and working conditions. Consumers try to obtain the products
they want at the lowest possible price and apportion their expenditures to maximize their utility.
The motive of self-interest gives direction and consistency to what might otherwise be a chaotic
economy.

Competition

The market system depends on competition among economic units. The basis of this competition
is freedom of choice exercised in pursuit of a monetary return. Very broadly defined, competition
requires

• Two or more buyers and two or more sellers acting independently in a particular product
or resource market. (Usually, there are many more than two buyers and two sellers.)
• Freedom of sellers and buyers to enter or leave markets, based on their economic self-
interest.

Competition among buyers and sellers diffuses economic power within the businesses and
households that make up the economy. When many buyers and sellers are acting independently in
a market, no single buyer or seller can dictate the price of the product or resource because others
can undercut that price.

Competition also implies that producers can enter or leave an industry; no insurmountable barriers
prevent an industry from expanding or contracting. This freedom of an industry to expand or
contract provides the economy with the flexibility needed to remain efficient over time. Freedom
of entry and exit enables the economy to adjust to changes in consumer tastes, technology, and
resource availability.

Competition is the basic regulatory force in the market system.

Markets and Prices

We may wonder why an economy based on self-interest does not collapse into chaos. If consumers
want breakfast cereal, but businesses choose to produce running shoes, and resource suppliers
decide to make computer software, production would seem to be deadlocked by the apparent
inconsistencies of free choices.
In reality, the millions of decisions made by households and businesses are highly coordinated
with one another by markets and prices, which are key components of the market system. They
give the system its ability to coordinate millions of daily economic decisions. A market is an
institution or mechanism that brings buyers (“demanders”) and sellers (“suppliers”) into contact.
A market system conveys the decisions made by buyers and sellers of products and resources.

Through this mechanism, society decides what the economy should produce, how production can
be organized efficiently, and how the fruits of production are to be distributed among the various
units that make up the economy.

Technology and Capital Goods

i. Market System & Innovation

• Competition + Freedom + Self-Interest + Personal Reward = strong motivation to

innovate.

• Innovators keep monetary rewards from their inventions or new techniques.

ii. Why Capital Goods Matter

• Capital goods = tools, machinery, factories, storage, transport, and communication

facilities.

• Market system encourages rapid development & extensive use of these goods.

iii. Direct vs. Efficient Production

• Most direct methods = often least efficient.

• Example: A farmer using bare hands vs. a farmer using a plough or tractor.

iv. Benefits of Capital Goods

• Increase efficiency → produce more with the same resources.

• Enable abundant output → more goods available for society.

Specialization

i. What is Specialization?

• Using resources (labor, capital, land) of an individual, firm, region, or nation to produce
one or a few goods/services.
• Instead of producing everything you need, you exchange your product for other desired
goods and services.

ii. Real-World Examples

• A factory worker who installs windows in airplanes may rarely fly.

• Farmers may sell milk but buy margarine from the store.

ii. Why Specialization Works

• Self-sufficiency (producing everything yourself) → inefficiency.

• “Jack-of-all-trades” ≠
• Specialization allows each person or firm to focus on what they do best, increasing
productivity.

iv. Key Takeaway

In a market system, specialization boosts efficiency and output, and trade connects the specialists
so everyone gets a variety of goods.

Division of Labor Human specialization—called the division of labor—contributes to a society’s

output in several ways:

• Specialization makes use of differences in ability.

Specialization enables individuals to take advantage of existing differences in their
abilities and skills. If LeBron is strong, athletic, and good at shooting a basketball and
Beyoncé is beautiful, agile, and can sing, their distribution of talents can be most
efficiently used if LeBron plays professional basketball while Beyoncé records songs and
gives concerts.
• Specialization fosters learning by doing.
Even if the abilities of two people are identical, specialization may still be advantageous.
By devoting time to a single task, a person is more likely to develop the skills required and
to improve techniques than by working at a number of different tasks. You learn to be a
good lawyer by studying and practicing law.
 • Specialization saves time.
By devoting time to a single task, a person avoids the loss of time incurred in shifting from
one job to another. Also, time is saved by not “fumbling around” with tasks that one is not
trained to do.

For all these reasons, specialization increases the total output society derives from limited
resources.

Geographic Specialization Specialization also works on a regional and international basis. It is

conceivable that oranges could be grown in Nebraska, but because of the unsuitability of the land,
rainfall, and temperature, the costs would be very high.

And it is conceivable that wheat could be grown in Florida, but such production would be costly
for similar geographical reasons. So, Nebraskans produce products—wheat in particular—for
which their resources are best suited, and Floridians do the same, producing oranges and other
citrus fruits. By specializing, both economies produce more than is needed locally. Then, very
sensibly, Nebraskans and Floridians swap some of their surpluses—wheat for oranges, oranges for
wheat.

Similarly, on an international scale, the United States specializes in producing such items as
commercial aircraft and software, which it sells abroad in exchange for mobile phones from China,
bananas from Honduras, and woven baskets from Thailand. Both human specialization and
geographic specialization are needed to achieve efficiency in the use of limited resources.

Use of Money

A rather obvious characteristic of any economic system is the extensive use of money. Money
performs several functions, but first and foremost, it is a medium of exchange. It makes trade
easier.

Specialization requires exchange. Exchange can, and sometimes does, occur through barter—
swapping goods for goods, say, wheat for oranges. But barter poses serious problems because it
requires a coincidence of wants between the buyer and the seller. In our example, we assumed that
Nebraskans had excess wheat to trade and wanted oranges. And we assumed that Floridians had
excess oranges to trade and wanted wheat. So an exchange occurred. But if such a coincidence of
wants is missing, trade is stymied.

Suppose that Nebraska has no interest in Florida’s ranges but wants potatoes from Idaho. And
suppose that Idaho wants Florida’s oranges but not Nebraska’s wheat. And, to complicate matters,
suppose that Florida wants some of Nebraska’s wheat but none of Idaho’s potatoes.

We summarize the situation in Figure 2.1.

In none of the cases shown in the figure is there a coincidence of wants. Trade by barter clearly
would be difficult.

Instead, people in each state use money, which is simply a convenient social invention to facilitate
exchanges of goods and services. Historically, people have used cattle, cigarettes, shells, stones,
pieces of metal, and many other commodities, varying degrees of success, as money. To serve as
money, an item needs to pass only one test: It must be generally acceptable to sellers in exchange
for their goods and services. Money is socially defined; whatever society accepts as a medium of
exchange is money.

Today, most economies use pieces of paper as money.

The use of paper dollars (currency) as a medium of exchange is what enables Nebraska, Florida,
and Idaho to overcome their trade stalemate, as demonstrated in Figure 2.1.
On a global basis, specialization and exchange are complicated by the fact that different nations
have different currencies. But markets in which currencies are bought and sold make it possible
for people living in different countries to exchange goods and services without resorting to barter.

Active, but Limited, Government

An active, but limited, government is the final characteristic of market systems in modern,
advanced industrial economies.

Although a market system promotes a high degree of efficiency in the use of its resources, it has
certain inherent shortcomings, called “market failures.” We will discover in subsequent chapters
that governments can often increase the overall effectiveness of a market system in several ways.
That being said, governments have their own set of shortcomings that can themselves cause
substantial misallocations of resources. Consequently, we will also investigate several types of
“government failure.”

Five Fundamental Questions

LO2.3 Explain how the market system answers the five fundamental questions of what to produce,
how to produce, who obtains the output, how to adjust to change, and how to promote progress.

The key features of the market system help explain how market economies respond to five
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 accommodate change?
• How will the system promote progress?

They reflect the reality of scarce resources in a world of unlimited wants. All economies, whether
market or command, must address these five questions.

What Will Be Produced?

How will a market system decide on the specific types and quantities of goods 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.
Profits and losses are the difference between the total revenue (TR) a firm receives from the sale
of its products and the total cost (TC) of producing those products. (For economists, total costs
include not only wage and salary payments to labor, and interest and rental payments for capital
and land, but also payments to the entrepreneur for organizing and combining the other resources
to produce a product.)

How Will the Goods and Services Be Produced?

What combinations of resources and technologies will be used to produce goods and services?
How will the production be organized? The answer: In combinations and ways that minimize the
cost per unit of output. This is true because inefficiency drives up costs and lowers profits. As a
result, any firm wishing to maximize its profits will make great efforts to minimize production
costs. These efforts will include using the right mix of labor and capital, given the prices and
productivity of those resources. They also mean locating production facilities optimally to hold
down production and transportation expenses.

Those efforts will be intensified if the firm faces competition, as consumers strongly prefer low
prices and will shift their purchases over to the firms that can produce a quality product at the
lowest possible price. Any firm foolish enough to use higher-cost production methods will go
bankrupt as it is undersold by its more efficient competitors who can still make a profit when
selling at a lower price. Simply stated:

Competition eliminates high-cost producers.

Least-cost production means that firms must employ the most economically efficient technique of
production in producing their output. The most efficient production technique depends on

• The available technology, that is, the available body of knowledge and techniques that can
be used to combine economic resources to produce the desired results.
• The prices of the needed resources.

A technique that requires just a few inputs of resources to produce a specific output may be highly
inefficient economically if those resources are valued very highly in the market.
Economic efficiency requires obtaining a particular output of product with the least input of scarce
resources, when both output and resource inputs are measured in dollars and cents.

The combination of resources that will produce, say, $15 worth of bathroom soap at the lowest
possible cost is the most efficient.

Suppose there are three possible techniques for producing the desired $15 worth of bars of soap.
Suppose also that the quantity of each resource required by each production technique and the
prices of the required resources are as shown in Table 2.1. By multiplying the required quantities
of each resource by its price in each of the three techniques, we can determine the total cost of
producing $15 worth of soap by means of each technique.

Technique 2 is economically the most efficient because it is the least costly. It enables society to
obtain $15 worth of output by using a smaller number of resources—$13 worth—than the $15
worth required by the two other techniques.

Competition will dictate that producers use technique 2. Thus, the question of how goods will be
produced is answered. They will be produced in a least-cost way.

A change in either technology or resource prices, however, may cause a firm to shift from the
technology it is using.

If the price of labor falls to $0.50, technique 1 becomes more desirable than technique 2. Firms
will find they can lower their costs by shifting to a technology that uses more of the resource whose
price has fallen. Exercise: Would a new technique involving 1 unit of labor, 4 of land, 1 of capital,
and 1 of entrepreneurial ability be preferable to the techniques listed in Table 2.1, assuming the
resource prices shown there?
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. If the price of some product, say, a small sailboat, is $3,000, then
buyers who are willing and able to pay that price will “sail, sail away.” Consumers who are
unwilling or unable to pay the price will be “sitting on the dock of the bay.”

The ability to pay the prices for sailboats and other products depends on the amount of income that
consumers have, along with the prices of, and preferences for, various goods. If consumers have
sufficient income and want to spend their money on a particular good, they can have it. The amount
of income they have depends on (1) the quantities of the property and human resources they supply
and (2) the prices those resources command in the resource market. Resource prices (wages,
interest, rent, profit) are crucial in determining the size of each person’s income and therefore each
person’s ability to buy part of the economy’s output. If a lawyer earning $130 an hour and a janitor
earning $13 an hour both work the same number of hours each year, then each year the lawyer will
be able to purchase 10 times more of society’s output than the janitor.

How Will the System Accommodate Change?

Market systems are dynamic: Consumer preferences, technologies, and resource supplies all
change. This means that the particular allocation of resources that is now the most efficient for a
specific pattern of consumer tastes, range of technological alternatives, and amount of available
resources will become obsolete and inefficient as consumer preferences change, new techniques
of production are discovered, and resource supplies change over time. Can the market economy
adjust to such changes?

Suppose consumer tastes change. For instance, assume that consumers decide they want more fruit
juice and less milk than the economy currently provides. Those changes in consumer tastes will
be communicated to producers through an increase in spending on fruit and a decline in spending
on milk. Other things equal, prices and profits in the fruit juice industry will rise and those in the
milk industry will fall. Self-interest will induce existing competitors to expand output and entice
new competitors to enter the prosperous fruit industry and will in time force firms to scale down—
or even exit—the depressed milk industry.
The higher prices and greater economic profit in the fruit-juice industry will not only induce that
industry to expand but also give it the revenue needed to obtain the resources essential to its
growth. Higher prices and profits will permit fruit producers to attract more resources from less
urgent alternative uses. The reverse occurs in the milk industry, where fewer workers and other
resources are employed. These adjustments in the economy are appropriate responses to the
changes in consumer tastes. This is consumer sovereignty at work.

The market system is a gigantic communications system.

Through changes in prices and profits, it communicates changes in such basic matters as consumer
tastes and elicits appropriate responses from businesses and resource suppliers. By affecting price
and profits, changes in consumer tastes direct the expansion of some industries and the contraction
of others. Those adjustments are conveyed to the resource market. As expanding industries employ
more resources and contracting industries employ fewer, the resulting changes in resource prices
(wages and salaries, for example) and income flows guide resources from the contracting
industries to the expanding industries.

This directing or guiding function of prices and profits is a core element of the market system.
Without such a system, a government planning board or some other administrative agency would
have to direct businesses and resources into the appropriate industries. A similar analysis shows
that the system can and does adjust to other fundamental changes—for example, to changes in
technology and in the prices of various resources.

How Will the System Promote Progress?

Society desires economic growth (greater output) and higher standards of living (greater output
per person). How does the market system promote technological improvements and capital
accumulation, both of which contribute to a higher standard of living for society?

Technological Advance The market system provides a strong incentive for technological advance
and enables better products and processes to supplant inferior ones. An entrepreneur or firm that
introduces a popular new product will gain revenue and economic profit at the expense of rivals.
Firms that are highly profitable one year may find they are in financial trouble just a few years
later. Technological advance also includes new and improved methods that reduce production or
distribution costs. By passing part of its cost reduction on to the consumer through a lower product
price, a firm can increase sales and obtain economic profit at the expense of rival firms.

Moreover, the market system promotes the rapid spread of technological advance throughout an
industry. Rival firms must follow the lead of the most innovative firm or else suffer immediate
losses and eventual failure. In some cases, the result is creative destruction: The creation of new
products

and production methods completely destroys the market positions of firms that are wedded to
existing products and older ways of doing business. Example: Compact discs largely demolished
vinyl records before MP3 players and then online streaming subsequently supplanted compact
discs.

Capital Accumulation Most technological advances require additional capital goods. The market
system provides the resources necessary to produce additional capital goods through increased
dollar votes for those goods. That is, the market system acknowledges dollar voting for capital
goods as well as for consumer goods.

But who counts the dollar votes for capital goods?

Answer: Entrepreneurs and business owners. As receivers of profit income, they often use part of
that income to purchase capital goods. Doing so yields even greater profit income in the future if
the technological innovation that required the additional capital goods is successful. Also, by
paying interest or selling ownership shares, the entrepreneur and firm can attract some of the
income of households as saving to increase their dollar votes for the production of more capital
goods.
The Circular Flow Model

LO2.5 Describe the mechanics of the circular flow model.

The dynamic market economy creates continuous, repetitive flows of goods and services,
resources, and money. The circular flow diagram, shown in Figure 2.2 (Key Graph), illustrates
those flows for a simplified economy in which there is no government. Observe that in the diagram
we group this economy’s decision makers into businesses and households. Additionally, we divide
this economy’s markets into the resource market and the product market.
Households

The blue rectangle on the right side of the circular flow diagram in Figure 2.2 represents
households, which are defined as one or more persons occupying a housing unit. There are
currently about 118 million households in the U.S. economy.

Households buy the goods and services that businesses make available in the product market.
Households obtain the income needed to buy those products by selling resources in the resource
market.

All the resources in our no-government economy are ultimately owned or provided by households.
For instance, the members of one household or another directly provide all of the labor and
entrepreneurial ability in the economy. Households also own all of the land and all of the capital
in the economy either directly, as personal property, or indirectly, as a consequence of owning all
of the businesses in the economy (and thereby controlling all of the land and capital owned by
businesses). Thus, all of the income in the economy—all wages, rents, interest, and profits—flows
to households because they provide the economy’s labor, land, capital, and entrepreneurial ability.

Businesses

The blue rectangle on the left side of the circular flow diagram represents businesses, which are
commercial establishments that attempt to earn profits for their owners by offering goods and
services for sale. Businesses fall into three main categories.

• A sole proprietorship is a business owned and managed by a single person. The proprietor
(the owner) may work alone or have employees. Examples include a woman who runs her
own tree-cutting business and an independent accountant who, with two assistants, helps
his clients with their taxes.
• The partnership form of business organization is a natural outgrowth of the sole
proprietorship. In a partnership, two or more individuals (the partners) agree to own and
operate a business together. They pool their financial resources and business skills to
operate the business, and they share any profits or losses that the business may generate.
Many law firms and dental practices are organized as partnerships, as are a wide variety
of firms in many other industries.
 • A corporation is an independent legal entity that can—on its own behalf—acquire
resources, own assets, produce and sell products, incur debts, extend credit, sue and be
sued, and otherwise engage in any legal business activity.

The fact that a corporation is an independent legal entity means that its owners bear no personal
financial responsibility for the fulfillment of the corporation’s debts and obligations. For instance,
if a corporation has failed to repay a loan to a bank, the bank can sue the corporation but not its
owners.

Professional managers run most corporations. They are hired and supervised by a board of
directors that is elected annually by the corporation’s owners. Google, Ford, and American
Airlines are examples of large corporations, but corporations come in all sizes and operate in every
type of industry.

There currently are about 30 million businesses in the United States, ranging from enormous
corporations like Walmart, with 2012 sales of $444 billion and 2.2 million employees, to single-
person sole proprietorships with sales of less than $100 per day.

Businesses sell goods and services in the product market in order to obtain revenue, and they incur
costs in the resource market when they purchase the labor, land, capital, and entrepreneurial ability
that they need to produce their respective goods and services.

Product Market

The red rectangle at the bottom of the diagram represents the product market, the place where the
goods and services produced by businesses are bought and sold. Households use the income they
receive from the sale of resources to buy goods and services. The money that they spend on goods
and services flows to businesses as revenue.

Resource Market

Finally, the red rectangle at the top of the circular flow diagram represents the resource market in
which households sell resources to businesses. The households sell resources to generate income,
and the businesses buy resources to produce goods and services. Productive resources flow from
households to businesses, while money flows from businesses to households in the form of wages,
rents, interest, and profits.
To summarise, the circular flow model illustrates a complex web of economic activity in which
both businesses and households act as both buyers and sellers. Businesses buy resources and sell
products. Households buy products and sell resources. The counterclockwise flow of economic
resources and finished products which is illustrated by the red arrows in Figure 2.2, is paid for by
the clockwise flow of money income and consumption expenditures, illustrated by the blue arrows.